How a Chinese Wage Increase Could Strengthen Gold

By Martin Hutchinson at Money Morning

Before this month, chances are pretty good that you'd never even heard of Taiwan's Foxconn International Holdings. And yet, Foxconn is one of the world's most important manufacturers.

Given that the formerly anonymous giant is now at the forefront of the zooming escalation in labor costs that's currently taking place in Mainland China - and given the enormous implications of the inflationary pressures that will result - chances are excellent that Foxconn will have a bigger effect on the world economy this year than even BP plc.

If that weren't enough, China's decision to let the yuan appreciate against the U.S. dollar will actually magnify this impact: If the Chinese currency strengthens, then the yuan-denominated wage increases will have an even-more-inflationary effect on the cost of China-made goods selling at your local Wal-Mart.

Foxconn, which trades on the Taiwan stock exchange as Hon Hai Precision Industries Inc., is the world's largest contract manufacturing company: In its factories in Shenzhen, on the Chinese mainland, it employs 300,000 people, and makes most of the electronic gadgetry that we all crave.

The Foxconn/Hon Hai client list - and its product list - is a veritable who's who of computers and consumer electronics. At one time or another, in addition to motherboards for Intel Corp., cell phones for Nokia Inc. and the iPod and iPhone for Apple Inc., the contract-manufacturing giant has produced - at the same time - all three of the major gaming consoles: Sony Inc.'s PlayStation, Microsoft Corp.'s Xbox and Nintendo Co. Ltd.'s Wii.

Despite such impressive credentials, until recently Foxconn was a quiet giant - that is, until 10 workers killed themselves and another three attempted suicide, all over a dispute about wages.

As a result, Foxconn has offered its work force a 30% pay raise, with an additional 60% if incentive targets are met.

So how does a wage dispute - albeit a tragic one - half a world away figure to impact the world economy in a manner that's deeper - and with a more-lingering impact - than the BP oil-spill catastrophe?

The answer is simple: The economic effects of the current revolution in China's labor costs are immense. And that was before Beijing decided to let the yuan appreciate against the U.S. dollar.

Beijing engineered the immense growth in the Chinese economy during the last two decades by intentionally allowing investment to expand at the expense of consumption. With a population of 1.3 billion, it appeared that cheap labor would always be available, so wages failed to keep pace with growth.

Consumption has declined from 45% of China's gross domestic product (GDP) a decade ago to 35% today, compared with around 70% in Western economies. Meanwhile, the Gini coefficient of inequality has increased from around 40% to close to 50%, giving China - nominally a Communist country - an inequality problem almost as large as Brazil.

Eventually, even in a disciplined Asian society ruled by a police state, the populace noticed they were receiving little benefit from all the growth. More important, even in China, the supply of subsistence rural labor is not infinite, as Foxconn found in its gigantic factory. This year has thus seen a rash of strikes - including, for example, in the large Honda Motor Co. Ltd. operation in Southern China.

There can be no doubt that Foxconn is merely the leader of a trend; rapidly escalating pay awards will spread throughout Chinese manufacturing in the coming months. Competitors will need to keep up with the trend toward higher wages - or risk the disappearance of their work forces.

In theory, international companies could simply shift their sourcing to other countries, where wages remain cheaper. There are a few such countries - most notably Vietnam and Indonesia - where this might be advantageous.

However, most very poor countries are so badly governed - and possess such poorly educated and poorly trained work forces - that there is no cost advantage to be gained from locating any type of operation there, not even a labor-intensive manufacturing plant. The reason: The productivity that's lost offsets any wage costs gained.

India, one other potential destination, has its own inflation problem right now. That country's wholesale prices are up 16% in the past year, and it is also experiencing a rise in labor militancy and high wage awards.

For the global economy, this implies that the increasingly-ever-cheaper imports that modern telecoms and globalization have brought us since about 1995 may no longer be available.

The "holiday from history" of ultra-low interest rates without inflation that the West has enjoyed since 1995 - and particularly since 2000 - is over.

Going forward, two forces will push prices higher:

  • The direct cost of Chinese manufactured goods.
  • And the higher commodity prices needed to satisfy newly wealthy Chinese consumption desires. (When fast income growth comes to poor countries, it produces demand for things like washing machines, housing and cars that take a lot of materials.)

A yuan that rises against the U.S. dollar could well be a third factor that helps send prices higher - in China, in the United States, and in many markets around the world.

For us as investors, there are three implications.

First, the gold play remains a good one - we can now see the inflation coming, even if it is still a few months away. Another traditional inflation hedge - Treasury Inflation-Protected Securities (TIPS) - merits study.

Second, of course, Chinese consumer-goods companies are just a great buy. Don't put too much money into Chinese infrastructure companies or the big state-owned behemoths. Instead, look for companies making products and services on which the Chinese people will want to spend their new higher incomes.
Third, China will export these inflationary pressures into the U.S. market, meaning investors must position themselves for this eventuality. Western-made products with strong consumer brands will be in demand in China as household incomes rise, meaning those top brands will be worth a close look. The rising yuan will also help U.S. exporters become more competitive, since their wares will become cheaper on a relative basis.

But the imports on which the rich nations too intently depend will rise in price. Thus, inflation will return to the "rich" countries - via the poor ones. For investors, the accompanying erosion of purchasing power will be difficult to deal with.

Martin Hutchinson is a Money Morning contributing editor and a former merchant banker and market historian.

About the Author
Martin Hutchinson

Martin Hutchinson is global investment strategist for Money Morning and a former merchant banker and market historian

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