Who coined the term “widget” anyway?  Ah, but we are talking about China now, so perhaps they were one of the four (five) great inventions that benefited mankind.  The others, of course, being soccer, pizza, Koreans, and unsanitary conditions.

But anyway, today we talking about the dilemma of a widget maker in China, or the value of increasing your own value, in the value-added chain.  This is an especially sensitive time for China in this regard, and if they continue their present course, China is likely to become too expensive before it becomes rich.  Let me explain:

For some 5,000 odd years, China’s greatest economic strength has been cheap labor.  Chinese suits of armor are decidedly less flashy than those in Europe or Japan, because it was much cheaper and easier to send 10 Chinese farmer-warriors into battle wearing burlap sacks instead of sending a single knight in steel plate mail.  The Chinese do have an impressive history of literature on war, but from the Three Kingdoms era up through the Korean War, the Chinese strategy on the ground has almost always been “make up for poor weapons and strategy with numbers”.

Today that army has been loosed in Guangdong and around Shanghai, in the form of cheap assembly work.  The sheer size of the Chinese population means wages are low and stay low.  China is a huge country, and this helps too, since you can pick up shop and move somewhere else if your city’s wages are too high.

But very rapidly, and with full government support, China is moving up the value-added chain.  Instead of making t-shirts for a dollar a day, the Chinese government wants to encourage high tech industry with appropriately higher salaries.  This is a good thing for factory workers (maybe?), but bad for many others.

Take our widget maker Mr. Cheng for example.  Mr. Cheng’s factory opened in 1990 with 30 workers making widgets by hand.  Business grew briskly, and in 10 years, Mr. Cheng had 10,000 workers, all making widgets by hand.  By the year 2000, the government started it’s push to move industries up the value-added chain, and offered discount loans to Mr. Cheng to buy specialized widget-making machines.  The improvement in quality meant Mr. Cheng could charge $2 per widget instead of $1.  In fact, he almost had to because of the increased cost of purchasing new machines and hiring engineers to run them.  But overall, he was able to cut 5,000 workers and still produce the same number of widgets per year.

By 2005, Mr. Cheng is making a healthy profit on widgets.  Labor costs have increased, but he’s been able to balance it out slowly by purchasing new machines in time and offering more varieties of widgets.  However, the government wants more new policies to increase value-added industries.  This time, instead of offering loan incentives, they threaten stiff penalties for high polluting industries, like Mr. Cheng’s widget-works.  Still, some favorable loans are still available, and he is able to purchase new Korean-made widget machines that are less polluting.  Overall efficiency is increased, and his workforce can shrink to only 2,500 people.  They are relatively highly paid, but he is able to off set this by increasing widget prices to $5 a piece.  Compared to the US price of $10 per piece, it’s still a bargain.

In 2010, another round of environmental laws come up, more strict than before.  Also, a minimum wage law is introduced, 1500 per month.  Unskilled labor is quite expensive.  Loans are still not too difficult to get.  Mr. Cheng buys German widget machines, the most advanced and environmentally friendly in the world.  But like salaries, prices for raw materials have increased.  In order to keep his current profit margin, he has to charge $7 for a widget.  As the cost in the US is only $10 per widget, most retailers buy domestic and save on logistics costs and headaches.  Mr. Cheng loses some business, but still manages.  He now has 100 highly skilled engineers at his factory.

American consumers continue to buy locally for advanced widgets, and now turn to Vietnam for low-end widgets.  Vietnam has been busy setting up made-by-hand widget factories, and have thousands of low-wage, unskilled workers making widgets by the container-full.  Imports from China decline.  Meanwhile, loans for capital investment are still reasonably easy to come by.  Mr. Cheng hires his own R and D team to make widgets of equal quality to American widgets, and sells them for $9.  Only 10 workers are needed to run these cutting edge machines.

Mr. Cheng is screwed.  Bringing Chinese widgets to the US will easily make them more expensive than US-made ones, and the quality is identical.  He has millions of RMB in outstanding loans because of the easy money and pressure to move his goods up the value chain.  But when the quality got “too good,” his customers bailed.

China is also screwed.  The “value-added” drive has directly led to the loss of 9990 jobs at Mr. Cheng’s factory.  The minimum wage push means that it will be difficult for anyone to replicate Mr. Cheng’s old business model because labor is expensive now.  All the other widget makers will have to buy machines to remain competitive, and in fact they are encouraged to because of the cheap loan structure.  What’s worse, once you set a minimum wage in a certain area, it is difficult to offer a dramatically lower wage elsewhere.  Why would I work for peanuts in Gansu when I can move to Shenzhen and make my millions?  So wages as a whole will go up, meaning the cost savings of moving from the US to China may once have been enormous, but now the cost savings of moving from Shenzhen to Chengdu are minuscule.

The result is not good.  Mr. Cheng makes world-class widgets, but the cost is so similar in the US, it’s not worth the hassle or logistics fees.  Unemployment, especially among unskilled workers, rises dramatically.  Manufacturers of cheap widgets pop up in Vietnam and India, and major corporations set up shop in those countries.  China can’t really go back to how things once were.

Mr. Cheng also has hundreds of obsolete widget machines that he can’t sell to anyone.  This will happen in any industry no doubt, but the speed at which it’s happening in China means everyone is stuck with these machines, not just Mr. Cheng.

What does China gain in this scenario?  Well, some workers become very wealthy and learn important skills.  Chinese products are considered “world-class”, so there is a prestige element (technical term: bragging rights).  But there are still vast swaths of farmers who have never even entered the industrial sector, and so will have an extremely hard time leaping from peasant farmer to advanced widget engineer.

There is also massive industrial overcapacity.  Easy loans mean factory owners invest like crazy to improve capacity, only to find that their goods are no longer price competitive.  Banks get stuck with the bill, and tax revenues bail out the bad loans.

People say, “there is no ‘next China'”.  I disagree.  What has made China a good place for manufacturing has been cheap labor and a relatively stable political environment.  Indonesia, Vietnam, and India all have levels of comparable stability today, and much lower labor rates.  India in particular has substantially lower logistics rates as well.  The education level is still far behind China, but the labor and investment is starting to flow in that direction.

It might sound cruel, but Chinese workers should have had lower salaries for a longer period of time.  Countries normally go high-tech when labor becomes more expensive, but in this case, the high-tech preceded the labor becoming expensive.  The two tiered society of farmers and highly skilled engineers doesn’t seem stable.  Employment is excellent right now, but the situation will become very difficult very fast if they keep pushing the value-added idea.