Raw material prices, wages, and profitability in China industry : how was profitability maintained when input prices and wages increased so fast?

41861 WORLD BANK CHINARESEARCH PAPER NO. 8 RAW MATERIALPRICES, WAGES,AND PROFITABILITYIN CHINA'S INDUSTRY--HOW WAS PROFITABILITY MAINTAINED WHEN INPUT PRICES AND WAGES INCREASED SO FAST? Song-Yi Kim */ and Louis Kuijs **/ October 2007 Abstract China's industrial sector has faced large increases in raw material prices, and wages have also risen significantly. This paper aims at analyzing and quantifying the impact of the cost pressures on the profitability of industry, as well as the way that China's industry has responded to the pressures. By combining information from the input output table and time series from the enterprise survey and on prices, wages, and employment, we estimate what has happened to the "technical efficiency" of the usage of intermediate inputs: the amount of intermediary inputs adjusted for price changes. We find that it has improved significantly since 2002 in most sectors in core manufacturing, although not for all. The second factor that has offset increases in input prices and wages is labor productivity growth, measured here as value added per worker. Our results suggest that sectors that faced higher cost pressures have made larger efforts to offset the cost pressures. The gap between output price rises and input price rises increased from 4 percentage points in 2005 to 4.3 percentage points in 2006 for core manufacturing. That this was possible while at the same time increasing the average profit margin shows that the ability of China's industry to offset rising raw material prices by increasing efficiency has so far remained undiminished. Keywords: China, profitability, commodity price, raw material, wage * The JFK School of Government, Harvard University. ** World Bank Office, Beijing, China; corresponding author; akuijs@worldbank.org. We thank Bert Hofman for encouragement and comments. The views expressed are those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. 1  I. Introduction Many have raised concerns about the impact of input price increases and wages in recent years and in the future on the profitability of China's industrial sector. However, to our knowledge, no systematic study has been done to quantify the impact of these cost pressures and to analyze quantitatively the way that China's industry has responded to them. This paper aims to fill this gap. Input prices have increased significantly since 2002. Many raw material prices rose very rapidly, even though for some primary commodities products China's prices did not grow as rapidly as international ones and prices of some "raw materials", including chemicals and certain machinery and equipment, rose only modestly. On average, raw material prices increased 34 percent between 2002 and 2006. As some rose much more in price than others, different sectors were hit differently, depending on which raw materials they consumed. While output prices (PPI) also rose significantly for most sectors, they generally lagged behind raw material prices significantly. As a result, relative (or, real) input prices went up substantially for almost all sectors, putting pressure on profitability. Wages rose even faster, adding to the pressure. Yet, profit margins did not decline in most industrial sectors. On the contrary, they have continued to rise in most sectors. In this paper we investigate how these developments add up. Using information from China's (2002) input output table and time series from the enterprise survey and on prices, wages, employment, we quantify the costs pressures bearing on different sectors. We also look at what have been the key avenues by which sectors have offset the cost pressures. By putting together this information and data, we are able to estimate what has happened to the "technical efficiency" of the usage of intermediate inputs: the amount of intermediary inputs adjusted for price changes. We find that it has improved significantly since 2002 in most sectors in core manufacturing, although not for all. The second factor that has offset increases in input prices and wages is labor productivity growth, measured here as value added per worker. The third factor has been that net taxes, as a share of gross output, have gone down by almost 1 percentage point, further contributing to the improved profit margin. We also analyze whether sectors that faced higher cost pressures have made larger efforts to offset the cost pressure coming in via input prices. Our results suggest that this has been the case, although we need to interpret the results carefully. Against a backdrop of concerns about different kinds of cost pressures impinging on China's industry, our analysis is useful in identifying the key source of cost pressures. Our results suggest that the dominant source has been via higher raw material prices. Since 2002, average weighted output prices have risen significantly less than average weighted input prices. The gap between output price rises and input price rises increased from 4 percentage points in 2005 to 4.3 percentage points in 2006 for core 2  manufacturing.1 That this was possible while at the same time increasing the average profit margin shows that the ability of China's industry to offset rising raw material prices by increasing efficiency has so far remained undiminished. II. Conceptual Framework and data We combine information on the cost structure from the input output (IO) tables with time series data on those cost items to analyze the changes in the cost structure. We get information on the revenue and cost structure of different sectors of China's industry using the input-output table of 2002.2 We identify time series data on prices, wages, employment, taxes, and depreciation that best proxies the concepts used in the input output tables. These time series come from the enterprise survey and statistics on employment, wages, taxes, and investment of the National Bureau of Statistics (NBS). We focus on industry, and within that, on manufacturing.3 The industry classification in our analysis is the same as the one used in input-output table. The data on total gross output in the IO table matches conceptually the data on sales revenue from the enterprise survey. The absolute levels are not the same, due to differences in coverage. But we assume that changes over time are sufficiently similar between the 2 data sets. Intermediate input in the IO tables is the value of all the intermediate goods and services consumed to produce output. Each sector consumes intermediate input from all other sectors, at sectoral prices. Value added is the newly added value in the production process. It can be broken down into compensation of employees, operating surplus, depreciation of capital, and net taxes on production. These items are assumed to develop over time in the same way as the following items from other NBS statistics: business profit, depreciation, labor cost (wages * employment), and various taxes and extra charges. Firm's profit Let i be sector i's profit, pi the output price (PPI), Yi output, rij the price of input from sector j, Mi the amount of input from sector j, wi the wage, Li employment, i depreciation, and ti intermediate input. i = piYi - rijMij - wi Li- di- ti (1) Dividing both sides by piYi gives margi = 1 - (rij p / i) * (Mij Yi) - (wi pi )* (Yi. Li ) - di p Yi)