Beyond Cheap Labor: Lessons for Developing Economies

The specter of China and it's massive fleet of low-cost laborers haunts developing economies worldwide. However, for middle-income countries, focusing on cheap labor is not the answer for sustained economic growth, according to The McKinsey Quarterly. Using Mexico as a basis for discussion, this report offers alternative strategies for successful competition. More effective routes to economic development involve transitioning to higher-value-added industries, exploiting comparative advantage, and pursuing reforms that increase entrepreneurship and encourage competition. In short, middle-income countries would do best to avoid panicked responses to offshoring; as the authors warn, "Don't overestimate the value of low-wage employment." – YaleGlobal

Beyond Cheap Labor: Lessons for Developing Economies

How can middle-income countries like Mexico compete with China? By adding higher value
Diana Farrell
Tuesday, December 21, 2004

Buoyed by the North American Free Trade Agreement (NAFTA), Mexico in the 1990s was the bustling factory floor of the Americas. But since 2000, as China rose to assume that role, more than 270,000 Mexicans have lost assembly jobs, hundreds of factories have closed their doors, and Mexico's trade deficit with China has grown to more than $5 billion. The ubiquitous "Made in China" stamp, found on everything from toys to textiles to statues of Our Lady of Guadalupe, has become the incarnation of the single greatest perceived threat to Mexico's economic prosperity—and a symbol of the pitfalls of globalization.

Mexico's fears are not unique. China's economic surge and its entry into the World Trade Organization have sparked alarm across the developing world. In middle-income countries such as Brazil, Poland, Portugal, and South Korea, a rising standard of living makes their position as low-wage producers and exporters increasingly tenuous.

Rather than fixating on jobs lost to China, these countries should remember a fact of economic life: no place can remain the world's low-cost producer forever—even China will lose that title one day. Instead of trying to defend low-wage assembly jobs, Mexico and other middle-income countries should focus on creating jobs that add higher value. Only if more productive companies with higher-value-added activities replace less productive ones can middle-income economies continue down the development path. Even so, being part of the global economy requires these countries, like Lewis Carroll's Alice in Through the Looking Glass, to do a lot of running just to stay in the same place. Unfortunately, for too many of them the focus on China—and, more broadly, political rhetoric against globalization—are blocking reform efforts.

Blame China?

To developing countries watching foreign investors head east, China's economic prowess might seem invincible, but history suggests otherwise. Only 20 years ago, for example, the United States was convinced that the superior business models and industrial policies of Germany and Japan would shutter every last domestic factory door. In the 1990s, the United States fretted about the threat from the high-tech industries of South Korea and Taiwan, while presidential candidates warned of the "giant sucking sound" made by the migration of jobs to Mexico under NAFTA. These days, the United States is more concerned about the effect of China's economy on its trade balance and employment rate.

Nearly all countries worry about jobs lost to others—a fact often exploited for political ends. The demagoguery obscures the fact that countries must evolve to meet the challenges presented by new competitors outside their borders.

Mexico is a case in point. Like most middle-income countries, it has grown more prosperous through freer trade and liberalization. Its average household income is now more than twice the level in China and other low-wage countries, and its manufacturing wage rates reflect this increasing prosperity. But the maquiladora assembly operations that line the US border—often the most visible face of Mexico's entry into the global economy—are only a small part of the cause. Since NAFTA came into effect, in 1994, the country has received upward of $170 billion in foreign direct investment—more than three times the amount that India attracted. Yet less than 15 percent of this investment has gone to the maquiladoras; the vast majority has been motivated by a desire to sell into Mexico's large domestic market, not to produce cheap goods for export. Our research shows that non-maquiladora investments have generated a wide range of benefits for Mexico's economy by creating jobs, boosting competition and productivity, lowering prices, and enhancing consumer choice. Consider the impact of foreign investment on Mexico's automobile market: consumers can now choose from dozens of models, compared with just a few of them before. In the retailing industry, the price of fresh food in Mexico City is 40 percent below its level in 1993, the year before NAFTA opened up the economy. The lesson for Mexico and for other countries where jobs are going offshore is this: don't overestimate the value of low-wage employment.

Furthermore, even if these jobs were worth protecting, it would not make sense for Mexico to see China as the source of its woes. El Salvador, Guatemala, and Honduras have wage rates just 25 to 40 percent of Mexico's and offer almost the same advantages of proximity. Economists at the Federal Reserve Bank of Dallas have shown that increases in Mexico's wage costs relative to these non-Chinese competitors and the decline in US industrial production together account for 80 percent of the maquiladora jobs lost since their peak in 2000. Offshore assembly operations, by their very nature, are exceedingly sensitive to changes in the global business cycle, since multinational companies tend to adjust production volumes abroad before doing so at home. Foreign investment thus poured into Mexico during the boom years of the late 1990s but then dropped with the US downturn of 2001–02. Just as predictably, Mexican assembly operations started to grow again in 2004 as US demand picked up. In the first five months of the year, maquiladora exports rose by more than 20 percent and employment turned to growth as well. But Mexico shouldn't be content with this recovery; policy makers must still push reforms to move the country up the economic ladder.

The road to adding higher value

Rather than try to win back low-wage, low-skill assembly jobs, middle-income countries should undertake three essential steps to further their economic development. They must encourage the transition to higher-value-added activities, identify and exploit their comparative advantage, and push forward with reforms that create more competition, entrepreneurship, and flexibility.

Encouraging the transition

The experience of developed countries suggests that expansion into higher-value-added activities comes not from a shift into entirely new industries, such as high tech, biotech, or nanotech, but from the natural evolution of companies within existing industries.

As countries around the world develop, a similar series of events has played out: companies start out in the simple, labor-intensive parts of an industry but over time hone their skills to compete in more profitable areas, such as marketing, product design, and the manufacture of sophisticated intermediate inputs. In northern Italy's textile and apparel industry, for example, the majority of garment production has moved to lower-cost locations, but employment remains stable because companies have put more resources into tasks such as designing clothes and coordinating global production networks. In the US automotive industry, imports of finished cars from Mexico increased rapidly after NAFTA took effect, but exports of US auto parts to it have quadrupled, allowing much of the more capital-intensive work—and many of the higher-paid jobs—to remain in the United States.

Unfortunately, governments in both developing and developed countries often do a poor job of encouraging this transition. In the United States, for instance, the offshore assembly program (OAP) requires goods produced abroad to use a certain percentage of US components (typically 80 percent) to qualify for reduced tariffs. Since this stipulation is the basis of the maquiladora regime itself, Mexico allows foreign companies to import machinery, raw materials, and parts duty-free if the final products are exported. As a result, imported inputs represent 76 percent of these goods' total export value, and most of the rest is labor; locally produced intermediate inputs represent less than 2 percent of production value. Moreover, while allowing foreign competitors into the export segments, the government of Mexico sheltered the rest of its economy from the benefits of global competition. Today fewer than 50 companies, most of them foreign, dominate Mexican exports—Petróleos Mexicanos (Pemex) being the main exception.

Furthermore, many countries unintentionally hamper the transition to higher-value-added activities by adopting regulations aimed at creating positive spillover effects from foreign investment in local industry. Mexico, for instance, instituted local-content requirements in the automotive and consumer electronics industries; it also capped foreign ownership in the latter. Yet in almost all cases, these policies have failed to spark the development of strong local suppliers or domestic companies; they merely serve to create a protective umbrella for the supplier sectors, which therefore don't flourish. In these industries, Mexico's experience mirrors that of Brazil, China, and India.

Exploiting a comparative advantage

To justify higher wages in a globalized economy, middle-income nations must find their comparative advantage. The former Eastern Bloc countries, for instance, have highly educated, moderately paid scientists and engineers and are therefore a natural offshoring base for Western European companies. India's well-educated, English-speaking workforce gives it a comparative advantage in information technology and business outsourcing. Members of the Association of South East Asian Nations (ASEAN) have a common market the size of Europe and thus offer foreign investors not just a low-wage export base but also a huge domestic market. Brazil and India too have the advantage of market size.

Fortunately, Mexico also has a unique advantage: it sits next to the world's largest consumer market. Some Mexicans may see that as a political or social liability, yet the country is an ideal location for designing and producing items for which proximity to the end user matters.

Proximity is important for many reasons. Some goods, such as large-screen TVs and white goods, have high transportation costs. A very different example is the almost $4 billion market for the plastic bottle caps that seal most of the soft-drink and water bottles sold in the United States. They may be small and light, but their aggregate bulk makes for high shipping costs, so it is more economical to produce them in the United States.

Time sensitivity is another consideration. Fresh food can spoil, and fashionable items or promotional materials can miss their window of relevance. In a fast-evolving market, goods such as computers have slim margins and depreciate rapidly in value after production. This factor helps explain why many of the PCs sold in the United States are assembled in North America, though most of the components are produced in Asia.

Products that require extensive interaction among different players in the value chain also benefit from proximity. Sales of customized products—from personal computers to tailor-made clothing to look-alike bobble-head dolls—are expanding rapidly thanks to the online channel.

To justify higher wages in a global economy, middle-income nations must find a comparative advantage

What's more, lean retailing in the United States demands shorter delivery times for a wider range of products, since suppliers must replenish their stock more frequently in response to changes in sales and inventory volumes. This factor, combined with the growing number of consumer goods that retailers offer, means that many suppliers face an exponential increase in the complexity of their logistics. Consider the Lands' End pinpoint cotton Oxford dress shirt, which offers the usual choices of neck and sleeve length, five different collar types, and two cuts. Even if the shirt were available to consumers in only blue and white, that still generates hundreds of possible combinations. Add other fabrics, colors, and patterns, and this simple shirt quickly goes into the tens of thousands of SKUs (stock-keeping units). As a result, the optimal strategy for most apparel makers is to split production between nearby locations and lowest-cost countries. Thus Mexico's share of time-sensitive goods like jeans for teenagers increased during the 1990s, while China's production of commodity items such as knit pullovers has also grown.

Push reform

As low-skill, labor-intensive operations head elsewhere, middle-income countries may try to lure them back with tax breaks and other financial incentives. They should resist this temptation. Such initiatives are not likely to influence foreign investment significantly and won't compensate for rising wage rates over the longer term. Enticements of this sort merely divert resources from the government and society to multinational companies. In some cases they can lead to counterproductive overinvestment. In Brazil's auto sector, foreign carmakers responded to subsidies worth more than $100,000 for each new job by adding many more workers—and saddling the industry with 80 percent overcapacity a few years later.

Instead of spending tax money to offer financial incentives to foreign investors, governments should use the funds to improve transportation networks, power grids, and telecommunications lines. Beyond that, policy makers must boost competition in the broader economy so that companies are compelled to improve their operations, adopt best practices, innovate, and move up the economic value chain. Too often, developing countries concentrate on special economic zones or preferred export industries while competition languishes in the remaining sectors. Price controls, tariffs, licensing requirements, and other product regulations limit market entry and reduce competition.

As India's $5 billion auto industry demonstrates, the gains from removing these stifling regulations can be dramatic. Twenty years ago, two state-owned carmakers—Hindustan Motors and Premier Automobiles Limited (PAL)—dominated the market and offered just a handful of outdated models. In 1983 the government allowed Suzuki Motor to take a minority stake in a joint venture with the small state-owned automaker Maruti Udyog, and in 1992 nine more foreign automakers were allowed to invest in India. This infusion of new capital and technology created serious competition for the two incumbents, eventually forcing PAL out. The industry, one of the fastest growing in the world, now produces 13 times more cars than it did 20 years ago. Tata Motors hit a milestone in 2004 by exporting 20,000 cars to the United Kingdom, to be sold under the MG Rover brand. Meanwhile, prices for consumers in India have fallen by 8 to 10 percent annually, unleashing a burst of demand and allowing steady employment despite rapidly rising productivity.

The reform agenda for each middle-income country will vary. In Brazil, for example, a major obstacle to growth is the informal economy, which consists of businesses that fail to comply with tax and regulatory obligations. The World Bank estimates that this gray sector employs 55 percent of all labor in Brazil and shows no sign of diminishing: according to our research, it has grown rapidly in some industries, such as construction. The unearned cost advantage that informal businesses enjoy allows them to undercut the prices of more productive competitors and stay in business despite very low productivity. Butchers, for instance, can save nearly 30 percent of their costs by skirting hygiene and quality standards. Modern supermarkets have found that acquiring informal grocers is unprofitable once value-added and labor taxes are paid. The informal economy thus distorts competition and disrupts the natural evolution in which more productive companies replace less productive ones. We estimate that if Brazil reduced the size of its informal economy by 20 percent, GDP growth would increase by as much as 1.5 percent annually. The potential benefits to Portugal and Turkey are similar.

In Mexico's case, the main barriers to movement up the economic value chain are a thicket of burdensome regulations and an inadequate infrastructure. According to a World Bank report, it takes an average of 58 days to start a business in Mexico, compared with 8 in Singapore and 9 in Turkey. It takes 74 days to register a property in Mexico but only 12 in the United States. Enforcing a contract requires 37 different procedures and takes 421 days to wind through the legal system, while closing an insolvent business can drag on for more than a year and a half. Moreover, Mexico's corporate-income-tax rate of 34 percent is twice as high as China's. These problems not only discourage foreign investment but also stifle local entrepreneurship and the growth of domestic companies.

Since capital-intensive production is highly sensitive to factor costs, Mexico must invest in infrastructure. Electricity costs are, on average, 10 percent higher than US levels, for example, and more than 40 percent above China's. By some estimates, the country should invest $50 billion to upgrade its power grid. Mexico's telecommunications network is equally lamentable—a prime reason the country isn't a more prominent location for offshore operations serving Spanish-speaking customers. Mexico's ground, air, and sea transportation systems all need improvement to build on its advantage of proximity to the United States.

Development: One company at a time

Although government reform can create the conditions for economic development, one company must act as a catalyst for change within an industry. As individual plant managers assess the competitive environment, they react by improving their operations.

Some Mexican companies have shown that they can compete by producing more lucrative goods

US semiconductor players, for instance, responded to competition from Japanese companies in the late 1980s. Japan quickly became dominant in sectors such as memory chips, spurring a public outcry in the United States over unfair competition and the loss of high-paying white-collar jobs. But US chip makers reinvented themselves. The big players—Intel, Motorola, and Texas Instruments—abandoned the dynamic-random-access-memory (DRAM) business and then invested more heavily in the manufacture of microprocessors and logic products, the next wave of growth in semiconductors. Intel became an even more significant global force in microprocessors, while TI became a dominant player in digital signal processors (the "brain" in mobile telephones). Motorola gained a strong position in microcontrollers and automotive semiconductors. Throughout this shift toward higher-value-added activities, the total number of US jobs in semiconductors and closely related electronics fields held constant at around half a million.

The experience of a handful of Mexican companies has already shown that they too can compete by shifting their production to more advanced and lucrative goods for the North American marketplace. Their success should provide a dose of optimism for their compatriots as well as for businesses in other middle-income nations anxiously watching cost advantages erode.

One such company is Jabil Circuit, a contract manufacturer of electronics products for the likes of Dell and Nokia. Few Mexican industries have been hit harder over the past few years than electronics. As orders were lost to Asia, Jabil saw its workforce of 3,500 shrink by half from 2001 to 2002. Instead of trying to win back lost orders, it learned to make more complex and customized products (computer routers and handheld credit-card machines, for example) that were traditionally made in the United States.

Managers at one of the company's Mexican plants very deliberately studied the US market to ascertain the necessary performance levels and the areas in which lower-cost labor could create an advantage. As a result, the factory retooled its inventory system and trained workers to undertake more than one task at a time, so the number of items it was able to produce rose to more than 6,000, from 600. Orders have flooded in, and employment is now 10 percent higher than it was at its peak in 2001. Other companies in Mexico have made similar transitions.

Some of the country's most promising growth opportunities might arise in unexpected areas. Software engineers at Universidad Nacional Autónoma de México, for example, played an important role in commercializing the Linux operating system through their Gnome project, which opened the door for more possibilities in this arena. And Wal-Mart Stores' acquisition of the food-retailing chain Cifra will provide Mexican suppliers with a global distribution network; Brazilian apparel manufacturers have already used Wal-Mart's reach to establish a global presence.

China's rapid rise as a global exporter seems to have caught some business leaders in middle-income nations by surprise. If they are to create a niche in the global economy, they cannot panic or close their borders; rather, they must restart their reform agenda. If they fail to do so, other more responsive countries will be ready to take their place.

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Diana Farrell is the director of the McKinsey Global Institute, Antonio Puron is a director in McKinsey’s Mexico City office, and Jaana Remes is a consultant in the San Francisco office.

Copyright © 1992-2004 McKinsey & Company, Inc. Reprinted from The McKinsey Quarterly, 2005 Number 1.