China May Face Out of Control Inflation

An interesting post by Edward Harrison on the Credit Writedowns website suggests a Labour shortage could spell inflation and trade deficits for China

Informed researchers are asking what happens to China based on the recent demographic shift from rural labour surplus to rural labour deficit. The answer may be slower growth and higher inflation, according to a paper released last month by China's Center for Economic Research at Peking University. But other impacts may also be increased consumption and a deteriorating external balance.

The paper by Huang Yiping and Jiang Tingsong is a very technical and dense work based on macroeconomic modelling. But the results are clear: If China's rural labour surplus evaporates (as seems to already have occurred), we are going to see savings drop and productivity collapse.

The paper is based on the work of Sir Arthur Lewis, an economist from St. Lucia.

What Lewis found is that industrial wages rise very quickly when the supply of excess rural labour is exhausted. This is called the Lewis Turning Point and is where China is right now.

This will have major implications for the Chinese domestic economy and the world economy. The first implication is inflation. Without the endless stream of excess rural labour, wages are going to go way up in China and this means inflation will be a problem.

Shortage of Labor? Now?

The situation Harrison describes is based on the document What Does the Lewis Turning Point Mean for China?

The thesis is interesting, but how probable is a labor shortage in China, and in what timeframe? I certainly see no reason to be concerned over a "Lewis Turning Point " now or for that matter any time soon.

However, inflation can certainly happen for other reasons such as rampant credit growth and malinvestment in infrastructure. That said, the Chinese property bubble is likely to pop at any time, and with it China's credit bubble.

Certainly China is overheating now, struggling to find useful work for its citizens. Malinvestment abounds because of it.

Michael Pettis Chimes In

Wanting another opinion, I pinged Michael Pettis at China Financial Markets about the Labor Shortage theory and Pettis responded ...

I think there are many reasons to be concerned about the rapid decline in the Chinese working population over the next decade or two, but I wonder if the Lewisian turning point is one of them.

As I understand it, Lewis' work was based on countries with very different demographic structures -- much younger, rising population as well as rising work population, and "normal" age distributions (i.e. more younger people than older for nearly every age group).

None of this applies to china. This doesn't mean that china might not see soaring wages per worker, and with it inflation, but it does suggest that we should be very skeptical about applying the Lewisian concept to china.

I always worry when economists apply highly technical econometric models to cases that are structurally very different than the cases on which the model was built. It may make for some great research credits, but it also makes for pretty random predictions.

Michael

Thanks for responding Michael!

Rebalancing Through Wage Increases

Also consider a recent post of Michael Pettis Rebalancing through wage increases

I worry about the reasons for rising wages – I suspect that demand for workers is driven primarily by unsustainable and unhealthy increases in the past two years in real estate and infrastructure development, and so is itself unsustainable.

There is one thing we can say with a little more assurance. If wages are rising and interest rates are declining, then there should be transfers of wealth within the economy. Specifically, wealth is being transferred from corporates to households in the form of higher wages, and is also being transferred from households to corporates in the form of lower interest rates. This means that labor-intensive industries are bearing more than the full cost of the adjustment and capital-intensive industries are bearing a negative cost.

If this is the case, we should expect to see a shift in China from labor-intensive growth to capital-intensive growth as the former get squeezed out and the latter profit. Unfortunately that is exactly what seems to be happening.

China isn’t yet rebalancing. The way that its growth model works suggests that it cannot happen except with a sharp contraction in investment growth, something we are not seeing, and the empirical evidence so far seems to support the theory. It will probably take a couple of years of this kind of unbalanced growth before this point is more widely recognized, but I suspect that another year or two of stagnant consumption as a share of GDP is finally going to convince policymakers. Until then, expect more of the same, and with it rapidly rising debt levels.

Interesting Questions and Replies to the Article

"RS" had three questions for Pettis.

1. Do you expect wage ‘give-back’ in China in the future if indeed home prices fall and input prices go down?
2. Do you feel that there is beginning to be growing acceptance among the mainstream economists and financiers/investors that China does have a “growth problem” and either growth must slow or the bubble must pop?
3. Do you think that the commodity markets a signalling anything about Chinese/world growth in the near future?

Pettis Replied ...

1)Yes, but not yet. It will take a decline in investment growth to reduce labor demand.

2)Yes, an increasing if still-minority number of economists now recognize that the growth model is unsustainable, although I am not sure all of them fully understand why it is unsustainable and the role of rising debt. For that reason, I think they misunderstand the nature and difficulty of the adjustment process. I suspect that after another year or two in which consumption growth continues to remain below GDP growth, there will be much greater awareness of how intractable the problems are.

3)This is hard to say, but a Chinese copper trader told me that the recent decline in copper prices was caused at least in part by the decision by the Peoples Bank of China to go after the copper financing schemes.

Lewisian Model Incorrect or Premature

Even if the Lewisian model was reasonable, China's structural problems are currently so great, its infrastructure building so excessive, and its property and credit bubbles so massive, that rather than running out of workers, China's next concern will be how to rebalance and keep its population employed in the slowdown on the near-term horizon.

Global Economy Cooling

The entire global economy is cooling as noted in Huge Cracks in Global Recovery Thesis; Industrial Production Unexpectedly Drops in Germany, France; UK Weaker than Expected

China and the US will slow too. I believe a recession is highly likely, yet few see it.

Pettis has been calling for a Chinese slowdown as well. For details, please see China’s Real-Estate Developers Struggle with Debt; Servicing China's Total Debt Load is Problematic; Dramatic Slowdown in China Coming

Scapegoating China

However, one reference in Harrison's article caught my eye that I completely agree with. Please consider Roach: GD II awaits if China bashing rhetoric turns into protectionism.

Stephen Roach is pulling no punches now. After quipping "I think we should take the baseball bat out on Paul Krugman" regarding pro-protectionist statements Krugman made earlier this month, Roach has launched a blistering attack on the protectionist rhetoric in America.

In an opinion piece released today in the Financial Times, Roach blamed America's problems on a deficit of savings and warned "scapegoating of China could take the world to the brink... [of a crisis which] would make the crisis of 2008-09 look like child’s play."

Of course, Roach is entirely correct. The United States has been living beyond its means for a generation, running up enormous private sector debts and running large current account deficits as investment outstripped savings. America's problem is America, not China.

As Roach points out, the US has a multilateral problem as it is in deficit with 90 countries around the world.

As for protectionism, Michael Pettis makes very good points when dissecting a recent US-China Business Council report. They validate Roach's view that tariffs would just shift the US deficit to other producers. Pettis says:

The failure to recognize that adjustments are more likely to occur via shifts in multilateral trade than shifts in bilateral trade is, I think, the basic problem.

The tariffs or exchange rate change do not necessarily change anything about the US's own aggregate trade imbalance except that the protectionism transfers wealth from domestic consumers to protected producers and decreases consumption demand. This is one reason why protectionism doesn't work.

But the most important reason that protectionism is poison is retaliation. Tariffs, export quotas, subsidies, competitive currency devaluations via quantitative easing and low interest rates and the like all serve to erode the collective sense of mutual dependence. It ends in the kind of spectacle we witnessed in the 1930s with protectionism as a major contributor to economic and social upheaval which ended in a long depression and world war.

On that score I agree with Roach, Pettis, and Harrison. Tariffs, protectionism, and QE I through QE X will not solve a thing.

Nor will all the denials in Europe (Please see Trichet Goes Ballistic, Walks Out of Meeting Over the Term "Soft Restructuring"; Infighting Over Who Replaces IMF Chief; Some Suggest Trichet)

However, Roach's suggestion of taking a baseball bat to Krugman certainly has merit.

Source: Global Trend Analysis