The cleansing effect of the minimum wage in China

Florian Mayneris, Sandra Poncet

Minimum wage laws are often shown to have little impact on employment as the labour price rise can be offset by lower turnover, lower markups, and heightened efficiency, or ‘cleansing’ effects. This column shows that in a fast-growing economy like China, there is a ‘cleansing’ effect of labour market standards. Minimum wage growth allows more productive firms to replace the least productive ones and forces incumbent firms to become more competitive. Both mechanisms boost the aggregate efficiency of the economy.

Can higher minimum wages ensure that economic development benefits the poorest without hindering growth? The question is controversial in both academic and policy circles. The recent riots in Bangladesh and Cambodia show that the social demand for a more equal distribution of the benefits of growth is high in developing countries. In China, polls reveal that concerns about inequality have grown as "roughly eight-in-ten have the view that the rich just get richer while the poor get poorer'' (Pewresearch Center 2012). The debate is also heated in developed economies. Renowned politicians and economists have called for a significant rise in minimum wages in the US (Woellert 2014), as has Barack Obama in his 2014 State of the Union address. On the other hand, any attempt by authorities to increase minimum wages is opposed by employer federations, who argue that higher wages will erode their margins, forcing them to fire workers or entirely relocate their activities to countries with lower wages. Some economists also argue that a minimum wage has detrimental effects on employment, especially for low-skilled workers (Neumark et al. 2013)

In a recent article (Mayneris et al. 2014), we investigate these issues in the case of China, the fastest growing economy of the past 15 years, both at the firm level and at the aggregate level

How are minimum wages set in China?

Minimum wages were first introduced in China in 1993. As different Chinese regions have very different living standards, China does not have one national minimum wage; minimum wages are rather established following a decision process involving both national and local authorities. Each province, municipality, autonomous region, and even district sets its own minimum wage according to both local conditions and national guidelines.

However, the 1993 rules did not really cover migrants, and the penalties in the case of non-enforcement were only low. As such, minimum wages in the 1990s did not really bind in China. In March 2004, the Rules for Minimum Wages (2004 Rules) took effect. These extended minimum-wage coverage to migrant workers, and penalties in the case of non-enforcement were dramatically increased.

Why is China an interesting case?

China is a relevant case to analyse for a number of reasons. First, China is a showcase in terms of low wages. In 2004, average monthly wages in manufacturing were $141 in China, versus $342 in Mexico and over $2,500 in the US. Moreover, China is characterised by great variations in both the level and the growth-rate of minimum wage across cities. This decentralised fixation of minimum wages ensures spatial variations in the level of minimum wages but gives rise to an endogeneity problem. Local authorities may fix the level of minimum wage depending on local economic conditions, which makes it difficult to disentangle the effect of minimum wage from other local factors.

The reform passed in 2004 is interesting in this respect, since it follows a top-down logic. The aim of this reform was to increase workers' wages and bring about convergence between localities in terms of the minimum wage. After 2004, city-level minimum wages had to fall within a range of 40-60% of the local average wage. This rule imposed unprecedented rises in the minimum wage, in particular in localities where they were initially the lowest. We exploit this quasi-natural experiment feature of the reform for the estimation of firm-level and aggregate effects of minimum wage growth.

How binding is the 2004 reform of minimum wages in China?

The reform imposes a massive rise in city-level minimum wages. As shown in Figure 1, city-level minimum wages increase all over the 2000-07 period, with a clear acceleration from 2004 onwards. While the average annual growth rate in city-level minimum wages was 6.9% between 2000 and 2003, it was 15.5% between 2003 and 2007. Moreover, as targeted by national authorities, the dispersion of minimum wages across localities narrowed significantly (the coefficient of variation of city-level minimum wages decreasing by 25% between 2003 and 2007, (Figure 2)).

Figure 1.

Figure 2.

City-level minimum wages may have only little effect for two reasons: a lack of enforcement, or the minimum wage not really binding (if firm-level wages are rising faster than the minimum wage, for example). This does not seem to be the case.

First, the 2004 reform aimed to increase firm-level compliance by strengthening controls and reinforcing non-compliance penalties. Prior to 2004, average wages were at least equal to the local city-level minimum wage in roughly 88.5% of active firms. This figure rose to 93.2% after 2004, suggesting that the Chinese minimum-wage reform was accompanied at the local level by greater enforcement.

Moreover, Figure 3 shows that firm-level wages increase markedly between 2003 and 2005, the distribution of individual wages in 2005 being right-shifted as compared to the one observed before the 2004 reform. However, these changes do not occur uniformly along the distribution. In 2005, fewer firms declare an average wage lower than the local minimum wage as compared to 2003. In contrast, more firms now declare an average wage that is equal or slightly higher than the local minimum wage. This concentration of the distribution of firm-level average wages around the level of the city-level minimum wage cannot be attributed to a specific trend, since no such pattern is observed when comparing 2001 and 2003.

Figure 3.

The 2004 reform thus produced unprecedented changes in the minimum wage, both in nominal and real terms. Moreover, these changes seem to be binding. The share of complying firms rose sharply, as did the share of firms with average wages that are equal to or only slightly higher than the minimum wage.

Minimum wages as a way to foster productivity

Regarding the micro effects of this reform, we find that higher minimum wages reduced the survival probability of local firms between 2003 and 2005. However, in the surviving firms wages rose without any effect on employment. The main explanation for this finding is that productivity rose significantly, allowing firms to absorb the cost shock without affecting employment or profitability. At the city level, our results suggest that the overall effect of firm-level adjustments in city-level industrial employment is zero, with entries cancelling out exits. Moreover, higher minimum wages increase aggregate productivity growth thanks to productivity improvements among incumbent firms and the net entry of more productive firms. The effects we measure are economically large. Minimum wage growth between 2003 and 2005 explains on average 20% of firm-level and city-level productivity gains in China over the period under consideration.

Conclusion

Other studies on developed countries such as the US or the UK find little or null effects of minimum wage on employment (Schmitt 2013). There might be good reasons for this. From a theoretical viewpoint, the cost shock brought about by a minimum wage increase can be compensated by reduced turnover of employees, lower markups for firms (as shown by Draca et al. 2011 in the UK) or better efficiency.

Both firm-level inefficiency and the misallocation of resources across firms have been proposed as explanations of the lower aggregate productivity in developing countries (Hsieh and Klenow 2009). Regarding the first channel, a number of recent papers have shown that there is a fixed cost of adopting better practices/technologies, due to specific investments, cognitive bias or a fixed utility cost for entrepreneurs associated with a change in the way they usually do (Bloom et al. 2013; Duflo et al. 2011). Low wages reduce the cost of not adopting the best production processes. In some developing countries, the absence of minimum wage might thus give incumbent firms little incentive to adopt more efficient but also more costly technologies or management practices; they might also allow some inefficient firms to survive.

In line with this intuition, our results show that in a fast-growing economy like China, there is a cleansing effect of labour market standards. Minimum wage growth allows more productive firms to replace the least productive ones and forces incumbent firms to become more competitive, these two mechanisms boosting the aggregate efficiency of the economy.

References

Bloom N, J Liang, J Roberts and Z J Ying (2013), "Does working from home work? Evidence from a Chinese experiment", NBER WP No. 18871.

Draca M, S Machin and J Van Reenen (2011), "Minimum Wages and Firm Profitability", American Economic Journal: Applied Economics 3(1): 129-51.

Duflo E, M Kremer and J Robinson (2011), "Nudging farmers to use fertilizer: Theory and experimental evidence from Kenya", American Economic Review 101(6), 2350-2390.

Hsieh, C T and P Klenow (2009), "Misallocation and Manufacturing TFP in China and India", Quarterly Journal of Economics 124 (4): 1403-48.

Mayneris F, S Poncet and T Zhang (2014), "The cleansing effect of minimum wage : Minimum wage rules, firm dynamics and aggregate productivity in China", CEPII Working Paper, N°2014-16, September.

Neumark D, J M I Salas and W Wascher (2013), "Revisiting the Minimum Wage-Employment Debate: Throwing Out the Baby with the Bathwater?", NBER Working Paper No. 18681.

Pewresearch Center (2012), Growing Concerns in China about Inequality, Corruption.

Schmitt, J (2013), "Why Does the Minimum Wage Have No Discernible Effect on Employment?", CEPR working paper. February.

Woellert, L (2014), "Seven Nobel laureates endorse higher US minimum wage," The StarPhoenix, Bloomberg Wire Service, January 15.