China: First the credit writedowns, but then what?
I have been in holiday mode for a while here. But having seen Michael Pettis’ latest entry on the RMB and currency speculation, now is as good a time as any to talk about developments in China. Specifically, I want to talk about where China is headed.
The Present: Labour Shortage
Let’s start with this:
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. Over the last twenty years, the introduction into the global economy of the former Eastern Bloc and China has meant a huge surge in available labour. Despite a flood of money from the Japanese and U.S. central banks, this influx of labour has effectively capped consumer price inflation in developed economies. The result has been the so-called Great Moderation.
If China has reached its Lewis Turning Point, all of that is out the window and Central banks will face a Scylla and Charybdis flation challenge for years. China’s labour shortage will work in concert with resource constraints and likely excess money supply as an inflationary force. These forces are countered by major deflationary forces from the debt overhang resulting from the implosion of the global asset bubble.
Labour is in short supply in China right now, the key phrase being ‘right now’. And China is exhibiting the macro conditions that one would expect: higher inflation, higher wages, and a deteriorating current account.
I used some of Andy [Lees]’s analysis to suggest that China is losing competitiveness in its export markets. While wage rate suppression and capital substitution might make sense on a micro level, these tactics are poison on a macro level since it supresses consumer demand. And increasing internal demand is key to the shift in China’s economic policy. China’s rebalancing toward a more internal demand-focused economic policy is vital because protectionist sentiment is still high, and with the US dollar still relatively weak, the Chinese currency is depreciating on a trade-weighted basis. Translation: if the currency wars break out again, China will get the stick. So wage rates will rise.
Obviously, the right way to deal with the increased labour costs (Lewis Turning Point) is via the increased productivity that comes from moving up the value chain, rather than substituting capital for labour. Let Vietnam have the lower value-added production.
Even so, Michael Pettis suggests that rebalancing through wage increases will not be enough.
The Medium-Term: Non-Performing Loans
Now I happen to be a China (and Asia) bull. I think Jim Rogers has the long-term macro story right. And I agree with China expert Shaun Rein who told me “I’m bullish on real economy not nec investing. Roach underestimates problems. US-China rel. could cause issues”. 100%. The macro picture in China and emerging Asia is better than it is in the US and Europe. If you had to pick regions that will see real economic growth, emerging Asia would be top of the list.
But there are risks. As I see it, the biggest problems are the currency wars and protectionism on the political side. China as the Bad Guy? Yes. On the resource side, demographics, water, and fossil fuels are all big issues. More than that, there is little doubt that China has a malinvestment problem. I am probably less bullish on the medium-term real economy because of it. The Chinese government has tightened monetary policy to deal with this. And as Michael’s latest post attests, over the medium-term, the non-performing loans (NPLs) are going to be a problem as a result. So, I say first come the credit writedowns.
Asia bull Marc Faber think the tightening and the writedowns will lead to a “technical recession” in China over the next year. Basically, he is calling for a growth slowdown – what I have called a hard landing.
And hard landings spell labour gluts, not labour shortages.
This is how Michael Pettis put it to me a week and a half ago regarding a post by Michael Shedlock:
Edward, it is not that I disagree with you about the impact of rising wages, I was just responding to Mish’s email and saying that I am very uncomfortable with applying the econometric model to a very different demographic (and institutional) structure, especially since I think the reason for rising wages in China is primarily an (unsustainable) increase in real estate and infrastructure development. My guess is that once investment levels are brought down, we are going to be faced with too many, not too few, workers.
I am also not sure that it is important for China to remain competitive in the export market. As i think we both agree strongly, a large continental economy like China’s should focus primarily on developing the domestic market and the real purpose of productivity growth should be to increase household income, not to stay competitive in international markets
He makes a fair point. China is an aging society that has none of the demographic hallmarks that one traditionally sees in higher-growth emerging markets. Read Claus’ last piece on Russian demographics and you could substitute China for Russia in many instances – and add in the one child policy to boot. So when we look at the so called BRIC economies of Brazil, Russia, India and China driving global growth in this recovery, the demographics are starkly different between Brazil and India on the one hand and China and Russia on the other.
Since monetary policy acts with a lag, I speculated in April that the hard landing is already happening. China is slowing right now. We shall see by how much and what the policy response will be.
The Longer-Term: Demographics or continued growth?
My response to Michael was:
Michael, yes we agree wholeheartedly here. On some level, the overhang from resource misallocation is so large, it probably doesn’t even make sense for policy makers to worry about moving up to more value added production since there may soon be an excess of labour.
Here’s what I said to Mish:
"I think my view on the Lewis Turning Point is that it could be real, meaning that right now the malinvestment-stimulated economic growth has left China with a labour shortage much as the U.S. had a 3.9% unemployment rate in the late 1990s. The problem is the bubble and how its end will play out. The prospect of labour surplus is very real in the near term.
That said, if China overcomes its bubble by successfully socialising losses, it can resume growth and then you might face the same problems again."
The immediate problem is the excess capital investment and the costly maintenance of the projects it has spawned. If the Chinese ratchet back this cap. inv., problems will come hard and heavy for housing, commodities, employment, NPLs, etc, etc.
I might write something up on this and quote you (if you don’t mind). Let me know if you have any other thoughts.
So, that’s what I am doing here.