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May 1, 2010

A LITTLE PERSPECTIVE ON CHINA

It's not always easy to see, but China has problems, too. Big ones.

It is all too easy to forget the lessons of history, and our experience of even the last few decades, when thinking about the growth of China and its long-term implications for Western economies. So it is useful to keep in mind four “big picture” trends that will have a significant impact on China’s longer-term role in the world economy.

Demographics

The first of these is the role that demographics have played, and will continue to play, in China’s development. China has been growing around 10% per year, with almost zero inflation. One reason this has been possible is that the country has been in a demographic sweet spot.

In the 2000s, China hit its peak in terms of the number of new entrants into the labor market. This was because China had a baby boom in the late ’50s and into the ’60s, and those baby boomers created a demographic echo of the baby boom when they had children in the ’80s. The result? In the early 2000s, the 15-to-19-year-old age cohort was numerically the largest in China.

Keep in mind that in the late 1990s, China laid off some 30 million workers from moribund state enterprises. These furloughed workers combined with the baby boomers to create a labor market in which labor had very little pricing power because there was so much of it—plus almost no protection from government for worker rights—and this meant that productivity could rise way ahead of real wages. Demographically, it was a golden era for Chinese growth (but not so golden for Chinese workers).

The situation is changing. In the 1980s, China began to implement a new one-child per family policy—aggressively. This intervention meant that the baby boom flipped into baby squeeze in an unnaturally rapid fashion. We are now past the demographic peak for new entrants into the labor force. We are just beginning to feel the difference in the labor market and will feel it increasingly going forward. The main structural effect, I suggest, is on the inflation rate as labor gains a little pricing power. We began to feel this before the global financial crisis when Chinese consumer price inflation hit a monthly year-on-year peak of 8%. The crisis plunged the world into deflation, but in China we will begin to see the return of higher inflation as soon as this summer.

The implications are important in the short and the long term. In the short term, a little inflation will further encourage a return to modest appreciation of the renminbi (yuan) against the U.S. dollar, and to a modest slowing of the Chinese economy in the second half of 2010 as government moves to rein in the inflation. In the medium term, a higher structural rate of inflation in China (perhaps 5-6% a year) likely means higher consumption as people buy things today because they expect that they will be more expensive tomorrow (the opposite of what has happened with consumption in China in the past 15 years).

More consumption in China will please almost everybody, not least American businessmen. The risk with a higher inflation rate is that it reinforces a tendency toward speculation and asset bubbles in China, but my guess is that the government’s fear of inflation— failure to control it pre-1949 was instrumental in bringing the communists to power—means Beijing will not let things get out of hand.

Fast Growth

Since World War II, 13 countries in the world have grown at an average of more than 7% a year for at least 25 years. What is more striking, however, is that most of these countries are still poor. Brazil grew fast for a quarter century before the 1982 Latin American debt crisis. Malaysia, Indonesia and Thailand did the same before the 1997 Asian financial crisis. None hit the developmental big time. Indeed, at an extreme, a country like Thailand today looks a bigger mess than it did in the 1980s despite all that growth.

The point is that in the modern world, it is possible to mobilize labor, capital and foreign technology to generate very impressive growth very quickly. This was not possible in the same way back when the United Kingdom and the United States were developing.

However, fast growth does not guarantee developmental success. A country’s savings can easily be consumed in investments that do not prove to be sustainable. A country’s population can lose the will to work long hours for low pay if people do not believe that a better life awaits them. What matters in the end is an economy’s capacity for indigenous innovation, for producing globally competitive corporations and for periodic self-renewal.

China has many things working in its favor, including a unitary continent-size economy with a vast population, but it is too early to say that it is investing its savings efficiently enough to become a developed nation rather than merely a more developed nation than it was before.

The Manufacturing Issue

To continue the previous point: despite the fact that so much “stuff” is made in China, the country is finding it difficult to create large, globally competitive firms which can take on the best in the world around the world. The main problem seems to be that with its rather confused mix of state and private business—where state companies do not go bust but private companies can enter the market—industrial sectors are subject to extraordinary levels of fragmentation.

Steel, where capacity is split roughly equally between hundreds of state and private producers, is a typical example. Fragmentation tends to reduce margins, and it cuts company-level cash flows to a point where firms do not have the large sums of cash over long periods of time that are necessary to innovate and, critically, to commercialize innovations.

If you look at listed companies, you will see a striking illustration of the point that I am making. The Chinese manufacturing firms with the highest market capitalizations are worth only a couple of billion U.S. dollars. This, at least in capital markets theory, reflects the market’s expectations of their future earnings. By contrast, the really valuable listed Chinese businesses are the oligopolies that have been structured by the central government in services like insurance, banking, telecoms, and in oil, where companies are valued at $150-300 billion. This is where the margins and cash flows are concentrated, not in Chinese manufacturing. It is an unusual state of affairs, and not at all like the United States (think of General Electric, with a market cap of $174 billion, even when its share price is totally bombed out).

The only Chinese industrial company that has shown itself to be truly globally competitive thus far is Huawei, the telecommunications company. But Huawei may be the exception that proves the rule. In its sector, foreign mobile telecoms firms were allowed to wipe out the domestic competition in the 1990s and nothing replaced them. There is an unusually high level of concentration in Chinese telecoms infrastructure, and this has given Huawei the cash flows to pay for innovation. The market knows it. Were privately held Huawei listed, it would be valued around $50 billion, a multiple many times that of any other Chinese manufacturing firm. For now, however, Huawei is a reminder of the threat that other Chinese manufacturers could be, not the threat that they are.

Historical Perspective

My last point is a kind of plea. When we think about China and about how to deal with China, we must have a clear sense of history rather than parroting economic platitudes. The three Asian states which grew fast for 25 years and went on to become the most successful post-Second World War developmental states—Japan, Korea and Taiwan—were all heavily indulged and supported by the United States as Cold War allies. They were allowed to run undervalued currencies and trade surpluses.

When Britain was in the midst of the first industrial revolution in the 18th century, it enforced Navigation Acts, which meant that no vessel that was not under the British flag could trade in its ports, one of the most brazen acts of protectionism imaginable. When the U.S. was becoming the world’s pre-eminent economic power around 1900, it was running an average tariff of 40%. I could go on.

The point is that developing states, like children, need a bit of nurture and indulgence in order to develop. At least that is what history teaches us. So when we deal with China, I think the best way to proceed is simply to say that we have minimum expectations for China’s conduct, if we are to support its development, and not to get bogged down in theoretical economic arguments about ‘free markets’ that have little basis in historical fact.

I am quite ready to see tariffs imposed on Chinese exports if the country heads back in the direction of a current account surplus amounting to 11% of GDP, as was the case before the global financial crisis, or if China makes no movement on its currency. But if this happens, I would say to the Chinese simply that they failed to negotiate seriously with people who were willing to be supportive. I don’t think it is useful to accuse them of breaking some sacred free market law, which we never followed ourselves.


 

Joe Studwell is a journalist, broadcaster and author of numerous books about business in China and Asia. He is former editor of the China Economic Quarterly and a director of Dragonomics, an independent research and advisory firm. His latest book is “Asian Godfathers: Money and Power in Hong Kong and South-East Asia.”