One of the benefits of globalisation to consumers in advanced economies has been that the prices of many goods and services have become cheaper. Companies realised that by outsourcing elements of the manufacturing process to economies with lower wages, they could reduce their production costs. Competition among firms meant that some of these savings were passed onto consumers. Complex supply chains were built as some countries, and indeed some regions within countries (e.g. Guangdong province in China), developed specialisations within particular areas of manufacturing. This also applies to some areas of services (e.g. outsourcing call centres and back office functions to locations in India).
However, this business model is unlikely to be sustainable forever. Emerging markets are constantly seeking to move up the value chain; to progress from making plastic toys to complex electronics and eventually, to break out of manufacturing altogether. As their skill levels rise, so does the value of their labour. Firms are used to moving offshore manufacturing around to take account of this; for example, South East Asian economies such as Vietnam are currently benefiting from increased foreign investment as a result of rising wages in China. But, eventually, labour costs in Vietnam will go up in the same way. In our new International Wage Projections to 2040 report, we explore how quickly wages in emerging markets could catch up with those in advanced economies and what that means for UK firms in particular.
To do this, we took wage data for a range of emerging markets and advanced economies and projected these out to 2040 in constant US dollar terms, based on estimates of future labour productivity growth using an updated version of our World in 2050 model. We then made downward revisions to projected wage growth in the advanced economies to reflect the fact that this has, on average, tended to lag somewhat behind labour productivity growth over the past decade or two. Finally, we projected forward real exchange rates in all of the economies relative to the US to represent the expected gradual convergence of market exchange rates and purchasing power parity (PPP) rates as economies mature, based on historical evidence on convergence rates.
The results of our analysis suggest that wage levels in emerging markets will continue to narrow the gap with those in advanced economies such as the UK over the next 20 years, but this process will be far from complete even in 2040 (see chart and table below). Wages in China, for example, could rise from around 30% of levels in UK in 2017 to almost 60% of UK levels by 2040. But in emerging markets that are starting from a lower level of economic development, the differential with the UK will remain wider. In India, for example, wages are projected to grow from around 10% of the UK level in 2017 to around 25% of UK levels in 2040, but this will still leave a large labour cost gap.
Relative average monthly wages compared with UK average wage levels (index, UK=100)
Implications for UK business strategy
We think that this process will have three key strategic implications for UK businesses over the next two decades. First, outsourcing will remain a cost-saving practice for many firms, but the size of the savings will continue to diminish. To keep a wider wage differential, companies will need to consider relocating from existing locations to less expensive ones.
Second, automation may become an increasingly viable alternative to outsourcing low-end manufacturing (and indeed services such as call centres). Higher relative wages could be offset by higher productivity, although we note that choosing locations for automation would depend on a different set of criteria, including trade union power and labour regulations.
Third, the growing wealth of emerging markets will mean that UK firms should focus more on these as export destinations in their own right, rather than merely locations for lowering the cost of manufacturing and other business processes. We note that average GDP per head (on a PPP basis) in Malaysia in 2040 might be only narrowly behind that of the UK, while that in China could come close to doubling over the next 20 years. Given the possibility that the UK will not enjoy the same access to markets in the EU after Brexit, a focus on exporting more to fast-growing emerging markets is likely to be an increasingly important strategic imperative for many UK businesses.