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What Foxconn's Wage Rise Means for Gold

The giant Foxconn chip maker just kick-started inflationary pressure worldwide...

, chances are you'd never even heard of Taiwan's Foxconn International Holdings, writes Martin Hutchinson at Money Morning.

Yet Foxconn is one of the world's most important manufacturers. And 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 ailing British oil giant BP.

If that weren't enough, China's decision to let the Yuan appreciate against the US 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: The Sony Inc. PlayStation, the Microsoft Corp. Xbox and the Nintendo Co. Ltd. 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 US 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 US 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 play of Buying Gold 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) – also 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 US 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 US 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.

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Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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