beyondbrics

By Valentina Romei and Ranjit Lall

Chinese manufacturers have come to dominate world markets with their brand of low-cost, low-price production. But with inflation soaring to a two-year high and businesses passing on the costs to consumers, is the “workshop of the world” losing its competitive edge?

This week’s beyondbrics chart breaks down China’s Purchasing Managers Index into its individual components and shows how these have changed between December 2008 and 2010. The chart makes grim reading for Chinese manufacturers: while costs continue to soar, translating into higher prices, export growth has begun to slow.

The monthly PMI is constructed from Markit survey responses from 400 manufacturing companies (selected to represent the full spectrum of regional and sectoral production in China). Index values of more than 50 indicate expansion, while values less than 50 indicate contraction.

At first glance, Chinese manufacturing appears to be in rude health. Unlike in 2008 – when the global financial crisis was at its worst – most components of the PMI (including the overall index itself) are now expanding. Output and new orders are showing particularly strong growth, with both edging towards to the 60 mark.

Unfortunately for businesses, however, the biggest increase since 2008 has been in input prices. The value of this sub-index has risen an astonishing 50 points over the two years, largely due to the soaring price of raw materials, and particularly metal.

Rising costs have fed through into higher prices: the sub-index representing the price charged for goods almost doubled between 2008 and 2010.

Unsurprisingly, manufacturers are being adversely affected. While sales continue to rise, the rate of growth is slowing: new orders (including export orders) and output have both slipped since 2009.

Is this the beginning of the end for Chinese manufacturing predominance?

Not according to Stephen King, chief economist at HSBC, who points out that Chinese labour costs are still very low relative to other countries. “This means that a modest increase in the price of inputs won’t make Chinese goods uncompetitive in foreign markets,” King told beyondbrics.

King’s claim is supported by the latest trade data. In spite of the declining trend in the PMI’s new export order sub-index, Chinese exports continued to rise in the last quarter of 2010, increasing 17.9 per cent year-on-year in December, 34.9 per cent in November and 22.9 per cent in October.

Further, King argues, it’s not only abroad that Chinese goods will remain competitive:

Real wages are rising at around twice the rate of inflation in China. This means that the purchasing power of Chinese consumers is increasing, which will boost demand for domestic products. This is part of a broader rebalancing of the Chinese economy, of which an appreciation in the renminbi’s real exchange rate is also a key element.

Mark Williams, senior China economist at Capital Economics, agrees, adding that the price of Chinese goods is unlikely to rise substantially in the long run. He told beyondbrics:

The manufacturing sector is highly competitive and innovative in China. This means that, in the long run, higher costs won’t result in higher prices – it will merely encourage firms to raise productivity in order to maintain their low prices.

If Chinese inflation gets out of control, of course, all this may change. Low labour costs and innovation may not be enough to keep prices competitive, and domestic real wages (and therefore purchasing power) will be eroded.

But with year-on-year inflation running at 5.1 per cent – less than that in many of China’s emerging market peers – and authorities not afraid to take remedial measures, it seems very premature to toll the death knell for Chinese manufacturing.