Caught in a Chinese pricing pincer

Chinese exporters, already battling a slump in demand and an intense squeeze on profit margins, will come under even more pressure following the decision of two of China's largest cities to raise their minimum wage rates.

The decisions by Beijing and Shenzhen are likely to prompt other local governments to follow suit in raising minimum wages. But this year's increase in minimum wage rates is well below the 20 per cent annual increases seen in the past two years.

The southern city of Shenzhen, which traditionally offers China's highest minimum wage, will boost its minimum monthly rate by 15.9 per cent in February to 1,500 yuan ($US238), while the city of Beijing has raised its minimum wage rate by 8.6 per cent to 1,160 yuan.

The Chinese government has encouraged this move towards higher minimum wages because it is keen to boost domestic consumption, which would reduce China's heavy reliance on exports. Higher minimum wages also help address the country's growing income inequality, which is sparking social unrest. In the country's five-year plan for 2011-15, the Chinese government said that minimum wages should rise by at least 13 per cent annually.

But the combination of hefty wage increases and the appreciation of the Chinese currency – the yuan has climbed nearly 12 per cent against the US dollar on an inflation-adjusted basis since June 2010 – has meant that part of China's export industry has become uncompetitive.

Increasingly, labour intensive industries such as textiles, garments and toys, are being shifted to other Asian countries, such as Indonesia and Vietnam, where wage rates are lower.

China's export growth has slowed from 40 per cent to 20 per cent (which is below 10 per cent in inflation-adjusted terms). Some believe that Chinese exports, after adjusting for inflation, could even contract this year as Europe slides deeper into recession, which will further erode demand for Chinese exports.

Slumping export earnings mean that China is extremely unlikely to allow the yuan to appreciate any further, despite continued pressure from the Obama administration.

Just over a week ago, the US Treasury administration released its overdue semiannual currency report, which again criticised Beijing for failing to allow its currency to appreciate further. Even though it noted the yuan had risen nearly 12 per cent against the US dollar on an inflation-adjusted basis since mid-2010, the report said China's persistent current account surpluses indicated that the currency remained "substantially undervalued”.

But even if China's exports slow sharply, Beijing will be acutely aware that it will not be able to push the yuan lower, because this would almost certainly trigger a major trade conflict with both the United States and Europe.

As a result, China's exporters will continue to be caught in the pincer of rising costs and slowing demand.