Can China continue to provide low-cost labour in high-tech industries?

Business in China

Talent arbitrage
Sep 20th 2007 | HONG KONG
From The Economist print edition




EVEN in the overheated world of Chinese initial public offerings, the listing and subsequent ballooning of the shares in WuXi PharmaTech has drawn gasps. It began trading on the New York Stock Exchange on August 9th at $14 a share, and the price has since doubled, giving it a market value of $1.65 billion. It would be hard to exaggerate the enthusiasm this suggests: in 2006 WuXi's revenues were only $70m, and its profits $9m.

The market's gusto has three causes. The most obvious is the vertiginous pattern of WuXi's financial performance, albeit from a low base. Revenues grew from $21m in 2004 to $34m in 2005, doubled last year, and may do so again this year. A second cause is the firm's business model. Successful Chinese companies typically have a stake in a government-constrained oligopoly (banks or mobile phones) or a basic industry such as property, steel, or mining. WuXi, by contrast, provides outsourced research for most of the world's big drug companies. It illustrates how China is evolving from producing basic products to sophisticated ones.

Hence the third cause for enthusiasm. China is thought to be an ideal spot for this sort of business. It is not fussy about animal testing unlike, say, India; the government is enthusiastic (providing tax and land incentives, plus the likelihood of intellectual-property protection); and, as in so many other industries in China, labour is cheap. Starting salaries for a PhD are $23,000 a year, compared with $200,000 a year in America, according to UBS, an investment bank. For a big drugs firm, WuXi offers a flexible outsourcing partner that is cheap to use and easy to dump: WuXi's contracts can be cancelled with as little as 30 days' notice.

But is this model sustainable? There are hints of problems to come. WuXi trades on the New York Stock Exchange through an odd depository share tied to a Cayman incorporation. The accounting is a bit odd, but in the initial regulatory filing there is a brief note explaining that profits were cut in half by a share-based compensation plan. That plan is projected to end soon, but another will surely take its place, because compensation costs in China are rising, particularly for firms that employ people whose talents are in demand around the world. WuXi's staff has grown eight-fold since 2003; at the end of May it had 2,000 employees and planned to hire many more. Demand for labour is almost certainly rising faster than supply, so sought-after employees are beginning to demand employment guarantees—and if WuXi and similar firms have to provide them, they will no longer be able to allow their customers to bail out at short notice.

Furthermore, there are questions about the suitability of the outsourcing model in fields such as pharmaceuticals. Companies in the industry are finicky. Quality must be consistently high and the work often involves strict secrecy, all of which argues for keeping it in-house. Recognising China's evolution, several drugs giants have set up their own Chinese operations, but they stress that the quality of employees, not cost, is the main reason, at least in the long term. WuXi may, of course, justify the market's confidence. If it does not, its investors will obviously be aggrieved, but that will not necessarily be bad news for its potential employees, or even for China. It will merely reflect how a glaring inefficiency in the market for world-class talent will have disappeared.