Economic & Business Focus: Global Labor Arbitrage Resets Wages

Offshoring will flatten wages in the United States and other advanced economies.

Global labor arbitrage — the practice of constantly replacing expensive labor in one location with cheaper labor in another — has been a cornerstone of corporate strategy for more than a century. This strategy matured over the past decade as technology and higher levels of development in the low-wage nations enabled their workers to take on service jobs and knowledge work; no longer is the practice limited to low-level production jobs. As developing countries provide an increasingly skilled workforce, developed nations’ ability to differentiate themselves is dissolving, and the companies operating in those countries no longer need to pay their workers a premium. The most widespread and lasting impact of the maturation of global labor arbitrage is the decline in real wages in the developed nations. CFOs of U.S. companies can prepare now for a permanent resetting of wages for many workers in the upper salary ranges.

Increased global competition and low pricing power are driving the more aggressive forms of arbitrage: overseas sourcing, offshoring and foreign direct investment. In the IT industry, these practices are already moving into their second generation; Indian companies that took work from the United States and Europe are now offshoring less-skilled jobs to lower-cost locations such as China and Malaysia. IT wages in the United States dropped by an average of 3 percent in 2004.

Although corporations around the world increasingly practice labor arbitrage, most are still reluctant to call it what it is. TeleTech Holdings Inc. is one of few companies that use that term. The Englewood, Colo.-based company operates 66 customer management centers (CMCs) staffed with 33,000 employees spread over 16 countries, including 10,000 in the low-wage regions of Asia and Latin America. “TeleTech was one of the first customer management providers to successfully implement a labor arbitrage strategy more than 7 years ago,” says Dennis Lacey, executive vice president and CFO. “Since then, we have expanded our labor arbitrage strategy globally, providing our clients high-quality, lower-cost customer management solutions in various languages and from many countries, including India, Argentina, Canada, Mexico and the Philippines.”

Call-center workers in low-wage regions make 10 percent to 12 percent of what U.S. call-center workers earn, according to Datamonitor. That firm predicts wage inflation in the offshore markets and wage deflation in the United States as more call-center jobs move abroad. “Labor-arbitrage customer management centers have a lower cost profile than comparable CMCs in the United States, which lowers the overall cost to serve,” Lacey says. Although wages in the United States have flattened, wages in India and the Philippines are rising rapidly. “Wage inflation is a natural component of a growing and evolving industry, particularly in developing countries,” he notes.

Expanding Cost Differential

The labor cost differential between the developed and developing nations is so large that rapid wage increases in the developing nations will not reduce the cost savings created by global labor arbitrage for the foreseeable future. According to industry analysts at The Boston Consulting Group Inc., wages will rise 5 percent to 10 percent annually in the developing nations that attract offshoring and 1.5 percent to 2.5 percent in the United States, Japan and most of Europe.

However, the labor cost advantage in the developing nations will actually expand in the short term. If wages in China continue to rise at their current average of 8 percent annually, the average production worker will still earn just $1.27 an hour in 2009, a 47 cents-an-hour increase over 2003, compared with $25.34 per hour for a U.S. worker — $3.48 per hour higher than in 2003. The savings on labor costs for U.S. companies that use Chinese workers will rise from $21.06 per hour in 2003 to $24.07 in 2009.

Real wages will grow rapidly in the developing countries at the forefront of the offshoring movement, according to Robert E. Kennedy, executive director of The William Davidson Institute and professor of business administration at the University of Michigan’s school of business in Ann Arbor. “But this is good for the United States,” he notes. “Ask yourself: Is the U.S. better off if the average Indian makes $500 per year or $5,000? The obvious answer is $5,000 — India’s cost advantage would be lower, and Indians would have more income to spend on U.S. goods and services. If you walk around offshoring complexes in India, China and Indonesia, you see that they are filled with U.S. computers and telecommunications equipment, that the workers spend the day surfing U.S. Web sites, and that they aspire to U.S. educations and holidays.”

Lower labor costs abroad will continue to drive trade, foreign investment and offshoring, despite protests by the workers who are displaced in the developed nations. “Everyone who uses a General Electric product benefits from the fact that GE employs high-skill, low-wage workers in India doing everything from answering phones to software development,” says Kennedy. Although the overall benefits of global labor arbitrage vastly out-weigh the costs imposed on displaced workers, the costs are more visible because they are borne by an easily identified group, he notes.

Wage Compression

Now that global labor arbitrage destinations such as India and China are prepared to compete on the basis of both low wages and high tech development, the developed countries are quickly losing their only remaining competitive advantages: technology and skills. Nations that specialize in providing highly skilled labor cannot sustain their advantage once a global labor market for skilled workers emerges. Labor-intensive production, including relatively skilled work, is already offshored or marked for offshoring. Only services that must be performed close to home, such as health care, and niche knowledge-based fields, such as tort law, are now locked into specific geographic locations. All other sectors are subject to arbitrage and the resulting downward pressure on wages.

The shift toward lower wages in the developed nations is most evident in the compression of real wages and the bifurcation in hiring that now characterize U.S. employment trends. When hiring here finally resumed in 2004 after three years of stagnation, low-end jobs accounted for almost half of the job growth — double their share of the workforce, according to research conducted by Stephen Roach, chief economist and director of global economic analysis for Morgan Stanley in New York City. The compression of real wages that began soon after the 2001 recession and continues today is the sharpest ever recorded by the U.S. Department of Labor, Bureau of Labor Statistics. Although U.S. consumers may benefit from lower prices for goods generated by using cheaper labor abroad, the benefits will be less noticeable as the recent bout of equity-financed consumer spending comes to a necessary end.

Knowledge-based and niche industries will keep some upward pressure on wages for the highest-value-added positions in the developed nations. When the Lenovo Group, China’s computer giant, bought IBM’s personal computer division in December 2004, it immediately offshored all the high-level managerial work back to the United States. This is clearly a temporary arrangement to fill the gap while China raises managerial skill levels, but that process will take many years.

The wages of U.S. workers rose for decades, supporting a steady increase in the standard of living. But now, wages have reached a plateau, and further improvements in living standards will depend more on falling prices than on the traditional annual wage hike. CFOs can shape long-term planning around lower wages here, higher wages in offshore locations and an ongoing need for global labor arbitrage as a prerequisite for competitive success.

Other Reasons for Falling U.S. Wages

Substantial downward pressure on wages in the United States stems not only from offshoring and overseas sourcing, but also from regulatory shifts and massive technological changes that lower the skill levels required for what were once relatively high-paying jobs. In the financial services sector, for example, many jobs have been offshored, but many more have been fundamentally changed by technological and regulatory developments.

“Because of a number of structural and legislative changes in the financial services industry, I am seeing an increase in commoditization and a decrease in rates of wage growth and, in some cases, actual wage decreases,” says Richard Lipstein, principal with Boyden Global Executive Search in New York City. “Increased use of technology to trade stocks by asset management institutions is leading to lower commission rates and less need for human traders. This has led to layoffs among the trading community and lower compensation for those still employed in this activity.”

Regulatory changes have forced the restructuring of equity research analyst positions and driven down compensation for these jobs by 25 percent to 30 percent over the past four years, Lipstein notes. “Every firm has instituted material analyst layoffs. What this industry is experiencing is no different than most of the rest of corporate America. It has just taken several decades to have to deal with high labor costs and major restructuring.”

Technological displacement is a reality for Wall Street traders and offshore call-center workers alike. Datamonitor reports that speech-enabled self-service technology may soon eliminate some jobs in offshore call centers. The cost of a call serviced through speech automation is 15 percent to 25 percent of the cost of a call handled by an agent in India.

Originally printed in the April 2005 issue of Business Finance

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