We shouldn’t be afraid of wage pressure

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CE Financial Observer: Poland’s central bank, NBP, has published its survey on the economic situation of enterprises. More than 2,500 companies were surveyed. The results show that the investment growth and the wage pressure will start falling off. Does it mean that the Polish economy will not be able to improve further its currently record low unemployment levels, and GDP growth rates?

Piotr Boguszewski: It is possible that Poland is approaching a turning point in the business cycle, but in this edition of the survey, we have noticed two interesting trends which suggest that Poland’s economy still has some growth potential left. Firstly, it turns out that the barrier of full capacity utilization is somewhat conventional. That is because enterprises, faced with such high capacity utilization levels, make various adjustments to their operations. Contrary to popular beliefs, they relatively rarely raise prices. The more frequent response is to optimize the portfolios of orders, or to hire subcontractors.

Which companies are doing that?

The Polish economy is not homogeneous when it comes to the shortage of production capacities. The situation varies depending on the individual industries and regions. This doesn’t mean, of course, that it has full substitutability, where any complex machine can be easily operated by an unqualified employee transferred from the high-unemployment regions. Nevertheless, it should be noted that despite the very low rate of unemployment in the economy, there are regions with double-digit unemployment.

Is it the case that employers don’t want these people, or are they simply not looking for employment?

The quick monitoring survey does not address this issue directly, but other data and observations indicate that both factors play an important role. Let’s start with the enterprises. Our research shows that when discussing their maximum production capacities, enterprises often think about the economically optimal levels, and not about the technical and physical limits to the production capacities of their facilities. The economically optimal level of production is one that is the most beneficial for the company in terms of its resources and incurred costs.

Figuratively speaking, it’s similar to the optimal driving speed — if we’re driving at 110 kilometers per hour on the motorway, we are burning 7 liters of gas per 100 kilometers, and at the same time we are still moving pretty quickly. Sure, our car could technically go as fast as 220 km/h, but driving at such a speed would be both illegal and unsafe, and we would be burning 20 liters of gas. We would reach our destination faster, but in a way that is far from optimal.

So, if we apply this to the economy — increasing production capacity may not be profitable for employers because it could require reaching for unemployed people from a remote area of the country, training them and offering them salaries that would be high enough to get them to move?

Yes, such barriers do exist. Firstly, in many cases these employers already have access to immigrant workers who are willing to start working right away. Moreover, this pool of foreign workers is clearly growing. It’s no longer limited to countries from which foreign workers have traditionally come, like Ukraine or Belarus, but increasingly often includes various Asian countries.

Now, let’s take a look at this situation from the point of view of an employee from a high-unemployment area, who is considering the possibility of relocating in search for a better job. Wages in Poland are rising sharply, but in many occupations, even in the most affluent regions, they have not yet reached a level that would compensate for much higher costs, such as renting a flat and living. We often do not fully appreciate the extent of differences between the individual Polish regions in this respect, and we overlook the degree to which the high cost of renting a flat in large cities is creating a barrier for the entry of new workers into a given labor market.

“In the Q1’18, labor costs were the fastest growing item among the main expenditures. They increased by 9.1 per cent y/y,” we read in the report. To what extent does this translate into upward cost pressure in the companies?

We should keep in mind that although the labor costs grew at the fastest rate, they accounted for a mere 12.6 per cent of the overall costs and wasn’t even the biggest item in the cost structure. Costs of supplies account for as much as 28 per cent of the operating costs of enterprises. Additionally, the survey shows that the pressure on wage growth, although it remains historically high, has leveled off, at least for a while. Compared to the previous survey, the percentage of enterprises planning to increase wages has decreased and the scale of the planned increases has also fallen.

Are we demonizing the effects of wage pressure? After all, there is a chart in the report showing that since the beginning of 2017 wages in Poland have been rising faster than the labor productivity. How long could such a situation last without threatening the competitiveness of the economy?

To be honest, in many companies it could probably last longer than it actually does, because we still have areas of efficient and possibly underpaid labor. We should also take into account the dynamic nature of these processes. Let’s imagine raising the Average Joe’s salary, giving him a gym membership and sending him on an inspiring training course. It’s simply not true that in such a situation we would only see the labor costs go up, while the worker’s productivity would not increase. Of course, in the short term that could be true. But in the long run the Average Joe will be more efficient and more loyal to the company, etc. At the macro level this means that labor productivity increases should follow costs increases, with some lag.

Unless the employer decides that it’s simply not worth it and fires the Average Joe.

Of course, such a scenario could also happen. The employer might come to the conclusion that labor costs are so high that he has to switch to a less labor-intensive technology or change the production profile and consequently reduce employment or hire cheaper employees. If many employers do that — the situation on the labor market will deteriorate and the future wage growth will weaken.

You’ve mentioned pockets of underpaid labor, but this probably doesn’t apply to all the sectors of the economy. We wrote about a study prepared by Bank Pekao, in which the researchers calculated how much labor costs would have to increase in order to bring corporate profit margins down to zero. Exporters are relatively safe, because only a 30 to 40 per cent increase in labor costs would wipe off their profits completely. The second group is retail trade, transport services and construction, where an increase of between 10 and 30 per cent would have the same effect. Meanwhile, simple services, such as security guard services, cleaning, and home appliances repair would only need a single-digit increase in labor cost in order for the profits to go down to zero.

Indeed, there is a range of industries in which the space for further wage increases seems limited, but such analyses are very static by nature, as we compare new costs of wages with the previously achieved profit levels. Meanwhile, in reality profits often rise as well. We’ve already stated that higher wages will probably result in higher productivity in the future, and employees who are more efficient and more satisfied with the conditions of their employment also translate into higher consumption demand. As a result, higher labor cost can go hand in hand with higher corporate profits. Of course, as long as we keep things in proportion.

And what if the cost increases don’t go hand in hand with profit increases?

There are many different possibilities here, but this often means that a given company is ineffective, poorly managed, and offers unattractive products. And we should honestly ask — will it be really bad if such a company shuts down? After all, wage pressure is also a selection mechanism. Fundamentally speaking, it is a positive process when bad jobs are disappearing, and new ones are created that are better for the economy.

Many economists believe that only a significant increase in labor cost could serve as an impulse to modernize. However, since wage pressure may turn out to be rather weak, is there any risk that these modernization mechanisms in the Polish economy will not be launched at all?

Looking at it from the supply-side point of view, we can only say that although the rate of GDP growth will be slightly lower in 2019 and 2020, it will still be very robust. Meanwhile, the supply of labor will be limited, not least due to demographic reasons. If we add the fact that the pool of immigrant workers is growing at a slower pace and may additionally be less stable, it becomes clear that starting from 2019 the companies will have incentive to modernize and search for more labor-saving technologies. However, this will be a longer process.

And is it not the case that this process has already started, mainly in large companies, while small enterprises are simply not engaging in it? In the report we read that “foreign enterprises operating within global value chains and participating in international trade are the leaders in terms of modernization”. Meanwhile, “smaller, mainly domestic enterprises, which do not expand beyond the local markets, have relatively fewer modern assets, especially considering global standards”.

What is really important in this assessment is that these are the opinions of the entrepreneurs themselves. They perceive the quality of their assets in such a way. Of course, such a risk exists. However, enterprises that are technologically weaker usually have lower ability to absorb the increases in costs, including labor costs, and they often operate within highly competitive markets. So, they may quickly face the following alternative: “change or die”.

Almost 52 per cent of the surveyed companies declared that the use of solutions replacing human work does not apply to them.

This figure leads us to several very important conclusions. Firstly, that in the case of the remaining 48 per cent of companies there are some areas of possible actions in this respect. At least theoretically. Secondly, this figure indicates that the share of labor-intensive products and technologies in the Polish economy is high. This 52 per cent group of enterprises may be particularly vulnerable to changes in wages. This means that the relationship between wage growth and labor productivity should be analyzed very carefully, especially in some industries. Thirdly, we should keep in mind that there are certain areas in every economy, where robotization and costly modernization will not really make any economic sense for a long time. Nevertheless, this figure indicates that we have relatively many such areas in Poland.

What threats do you see for Polish companies in the shorter term?

I’m mainly concerned about external factors, including, for example, the potential effects of customs wars for the economies of our main trading partners. For example, if I am a Polish exporter working as a subcontractor for the German automotive industry, which is a pretty common situation, then the introduction of substantial tariffs on German cars by the United States would be a very difficult scenario.

Are there any phenomena that the responses provided in the survey do not explain?

There are certain phenomena that we would like to investigate more thoroughly next year. This concern, among other things, the processes behind the pricing decisions that are made in companies and a broader overview of their investment activity.

With regard to the pricing decisions, it’s about…

It’s about the fact that in the environment of low inflation it is worth considering how we could better analyze the price developments. In the survey the companies are usually asked about the price changes that were made or that are planned in a given month or quarter. If the rate of inflation in the economy is high, for example, around 8-10 per cent per year, then an average price increase of 2-2.5 per cent falls on each quarter. Increases of this magnitude are usually centralized — they are made by the owner or the management in a way that is noticeable for the company’s various stakeholders. In an environment of low inflation, these mechanisms may work differently: they may result to a lesser extent from the assumed strategies or plans, and to a greater extent — from the reactions to specific events, even ones that only have a local impact.

And how could we improve investment’s level?

In the contemporary economy, measuring of investment can be even more difficult than determining the mechanism of price changes. Let’s take a simple example — we have a machine that is operated by a specialist who earns PLN5,000 per month. However, we conclude that we need a better-qualified professional — for example, one who has programming skills — and we employ him for PLN20,000. The company’s costs increase by PLN15,000, but the traditionally defined capital expenditures amount to zero — there is no increase in the value of fixed assets. It turns out, however, that after half a year our production doubles thanks to the work of that highly-skilled professional. Yet, the financial accounts only indicate an increase in the wages cost. Meanwhile, we have made a significant investment, but it was an investment in the so-called human capital.

The second novelty which complicates the work of an analyst is that in a growing group of businesses we are currently observing big changes in their models of operation, “from owning to using”. We can now rent machines or services, oftentimes under very flexible contracts, for a short period of time, and in various locations. We therefore need to develop and expand the traditional methods used in the analysis of these phenomena.

Piotr Boguszewski, PhD, is an expert in the Economic Analyses Department of Poland’s central bank, NBP.

(creditscoregeek.com, CC BY)

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