Monthly Archives: April 2011

Yuan Rising

By breaking through an exchange rate of 6.50 yuan to the dollar on Friday, China’s currency passed through one of those symbolic milestones beloved of market commentators. Thumbing through our records we see that level was last reached in 1993. A lot of Chinese exports have flowed under the bridge since then.

While a spurt of yuan appreciation usually precedes Sino-American talks (there is a round due in Washington mid-May), the People’s Bank of China seems now to be  belatedly letting the yuan shoulder more of the burden of fighting inflation, by making energy and food imports cheaper. The currency has gained almost a full percentage point against the dollar this month, as much as it was allowed in the whole first quarter. Since Beijing freed the yuan from its dollar peg in 2005, with a near two-year repegging after the global financial crisis hit in 2008, the yuan has gained 27.5% against the dollar under the central bank’s managed appreciation regime. Since it was unpegged for a second time in June 2010 the yuan has appreciated 4.6% against the dollar, though it has depreciated in nominal effective terms.

As the chart below, from the World Bank, shows, the yuan’ effect exchange rate has been trending up if not by as much as the nominal figures for its appreciation against the dollar might have one imagine. REER stands for real (i.e. inflation-adjusted) effective exchange rate (the value against a trade-weighted basket of currencies),  NEER for nominal effective exchange rate. Note the widening gap between the two since mid-2010 during which time exports have been resurgent.

The question for investors now is whether April’s appreciation against the dollar signals a willingness on the central bank’s part to step up the pace of appreciation of the currency in the face of stubbornly high inflation, or, as we suspect, just that it plans to continue to let the yuan rise as it has been doing.

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When China’s Demographic Dividend Becomes A Demographic Tax

Much of the follow-up attention given to the census results published this week has concentrated on the implications for China’s one-child policy. This Bystander is more struck by the long-term economic impact of the key demographic trends–low birth rates, a greying of the population and an unbalanced sex ratio (15% of young Chinese men won’t be able to find a partner among their fellow citizens in 20 years time).

These will, we believe, likely combine to make China a deficit country within two decades. Working population is a proxy for production, and when it grows faster than the total population (a proxy for consumption), as it has for the past three decades, the difference becomes exports. Some time over the next decade that trend will reverse and the reversal intensify over the subsequent three decades reaching its peak in 2050. The consequent demographic bias will work through to the trade account long before then.

For now, China’s demographic dividend has brought it more than just merchandise trade surpluses. Add on dramatically rising productivity from economic reform to the country’s working population growing much faster than its total population and the inevitable consequence has been a sharp improvement in per-capita income and living standards. The peak in the workforce forecast for sometime in the next decade will be accompanied by an explosive growth in the number of over-65s. China’s working population will begin to grow more slowly than its total population. The demographic dividend will become a demographic tax. As China is getting old really fast, it will become an increasingly heavy tax relatively quickly.

That will drive the transformation of the economy towards being more led by domestic demand. The supply of surplus labor available to low-cost export manufacturers will dry up. Manufacturers will move up the value chain, and a domestic market for products and services for the elderly will expand domestic demand, helping to run up domestic consumption and down domestic savings. The era of manufacturing in China predominantly for export comes to a close, replaced by an era of manufacturing and services provision in China for Chinese consumers.

How this all turns out in detail will depend on other factors, such as  changes in worker productivity, savings rates, institutional reform, whether monocultural China proves open enough to deal with future labor shortages through immigration, and, yes, what happens with the one-child policy. But today’s fast economic growth and huge export-driven current-account surpluses will by then be but a distant memory.

Footnote: Certainly the numbers can be used to argue the one-child policy policy should be scrapped. Wang Feng, Director of the Brookings-Tsinghua Center in Beijing, does just that in a commentary in Caixin.

To put the growth of the population in some perspective, since the previous census in 2000, China’s population has grown by 74 million to 1.34 billion. The increase alone would be sufficient to rank as one of the 20 largest countries in the world by population, with about the same number of people as Turkey or Iran. Over the same decade India’s population increased by 181 million. And while we are making such comparisons, on present demographic trends, by 2050, silver China, the nation of Chinese over 65 years old, will constitute a larger nation than the U.S. today.

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China’s Economy Not Slowing As Fast As Expected

The World Bank’s latest quarterly economic outlook for China suggests that the economy is not slowing as rapidly as previously thought. The Bank forecasts GDP growth of 9.3% for this year. Last November, it had expected 8.7% growth, the same rate it now forecasts for  2012. China’s economy grew at 10.3% in 2010.

The Bank also warns that inflation and the property market remain a risk, with, in the latter case, the effectiveness of measures to slow down private house building in part being offset by the government’s ambitious social housing construction plans. While inflation is expected to moderate eventually as the pace of food price rises continues to slow, much of the impact of higher oil and industrial commodity prices is still working through the pipeline, so inflation expectations are high. Thus, the Bank says, the government should continue to tighten monetary policy.

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Turning The PLA Into A Modern Joint Command

We are starting to hear murmurs and whispers about the People’s Liberation Army’s new five-year plan. Unlike the detail made public about the national five-year plan and even the White Paper on the PLA published at the end of last month, the military budget is held close to the chest.

The headline spending number we do know, from the national five-year plan: a military budget of 601 billion yuan ($92.5 billion) for 2011 and an annual increase of 12.5% for the life of the plan, restoring the double-digit annual growth derailed by the 2008 global financial crisis. But that is only the half of it. Also to be taken into account are off-budget items, spending done under the aegis of internal security and disaster relief, in both of which the PLA plays a significant role, and R&D in industries whose technologies have dual military-civilian applications. Together they likely double the formal budget number.

As for the detail that lies behind, we are told that Xi Jinping, the man slated to succeed Hu Jintao as president next year and then after as chairman of the Party’s central military commission (he was appointed as first vice-chairman last October), has signed off on a final draft. Xi is said to have good relations with the group of more than 100 fellow princelings who hold the rank of major-general and above. (As an aside, that group may prove to be an important soft factor in the coming leadership transition.)

The heading of Section XV of the national five-year plan, the one that relates to the PLA, is “Advance Military Power.” The main thrust  will be, first, to continue to modernize the PLA and to make it a more professional fighting force, particularly its officer class, and, second, to turn it into a more integrated tri-service force, commensurate with the needs of China’s growing global presence and better equipped to fight what are being called information wars. For historic reasons, ground forces have dominated the PLA. Yet the PLA Navy (PLA-N) and the PLA Air Force (PLAAF) are at the forefront of the PLA’s modernization. Witness the new aircraft carriers, submarines, ballistic missiles, and fighter jets, in keeping with China’s desire to project regional power, particularly in the waters off its coast. The PLA command structure, including its communications and logistics, does not yet anything like fully reflect the growing prominence of the naval and air services, though progress is being made a great speed on the communications infrastructure. A unified joint military command is also needed for the tighter integration between the PLA and internal security forces that the national five-year plan envisions for ensuring domestic stability.

The process of integration is likely to be least comfortable for the army. Senior officers have already been fighting a rearguard to protect the structure of the seven military regions that Mao divided China into–and to protect the multiplicity of high ranking posts they provide. They will also have to deal with the overwhelming majority of a planned cut of 500,000 personnel during the five-year plan coming from the PLA’s 1.3 million-strong ground forces, 60% of its total strength of 2.3 million personnel (excluding 6 million militia). Better pay and conditions will be provided for those remaining.

The PLAAF has already undergone a similar slimming down, ridding itself of antiquated planes and equipment and the personnel to operate and maintain them. In the process it has become a stronger combat force through modernization of what was left. It is not just new aircraft, such as the much hyped J-20 stealth fighter flaunted earlier this year. The air force has undergone a makeover of its ability to deploy over large distances. Its relief efforts in the aftermath of the Sichuan earthquake in 2008 showed up shortcomings in its capacity to transport men and materials from all over the country to a distant front. These failings are since being redressed.

As well as modernizing the command and communications structure, upgrading hardware will continue apace. The navy and the air force will get more by way of newest and deadliest toys than the ground forces, although there will be some arm-wrestling between the air force and the Second Artillery Corps, the missiles force, over who owns space weaponry and counterweaponry. Money to be put into advanced weapons and their development is likely to drive an expansion of the country’s state-owned defense industries, too, creating stiff competition for Western arms makers in Asia and Africa in particular where Chinese firms will be less encumbered with ethical restrictions on arms sales than Western competitors; China is currently the world’s ninth largest arms exporter with sales of $2.4 billion in 2010. The five-year plan calls for this number to double over its duration, with profits being used to fund more R&D in weaponry, particularly fighters and missiles.

Defense companies have more expertise and experience than the PLA in aviation, electronics, transportation, machine-building and especially the IT necessary for infowar and electronic espionage. They will be able to tap into the $1.5 trillion being earmarked under the national five-year plan to expand seven strategic industrial sectors. Most of the septet have technologies with joint military-civilian applications.

Industrial companies now account for two-thirds of the institutions that are licensed for weapons R&D and production. Beijing is consolidating the country’s defense contractors into fewer than 10 giant state-owned groups. State funds are also being allocated to them to attract top science, technology and engineering talent to the R&D effort, and to match similar incentives for scientists and technical personnel in PLA research and weapons plants. These defense contractors are also able to strike civilian joint ventures with foreign groups to acquire technologies around composite materials, turbine blades and flight control systems where their own lags. As with civilian heavy engineering markets, Western companies will have to decide if access to China’s domestic market is worth the trade-off of giving up technology.

However, they decide, the PLA’s supply chain is going to become more blended with civilian industry over the next five years–with consequent implications for the pace of economic reform in strategic areas where the military interest, already strong in some parts of the economy, will coagulate as a strong vested interest against change.

China continues to stress publicly the defensive nature of its armed forces. Peace has certainly been good for its economic growth. Yet the PLA’s modernization seems aimed at giving a modernizing country modern armed forces and Beijing the ability to project regional power and to protect its growing global commercial interests–or at least to create the perception of sufficient strength to do so, an important deterrent in its own right.

Thus the military five-year plan is predicated on a continuation of developing leaner, more technologically sophisticated armed forces with a joint command structure capable of “winning local wars under conditions of high technology and informatisation”. At the same time, the PLA is being prepared to play a more central role in internal security should that be needed, particularly during the coming leadership transition, and one able to deal with the cyber side of modern civil unrest should the current crackdown on dissent by traditional means prove insufficient.

This Bystander could readily conclude that while China is not expecting, or wanting, a serious military conflict during the course of the current five-year plan, or beyond, it does see itself becoming strong enough to deflect others from doing so,  especially off its own coast and around islands large and small in those waters, and to be able to engage in–and win–information and cyber skirmishes at home and abroad.

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Drought Lingers In Guangdong

Though nothing on the scale of the arid weather experienced on the North China Plain earlier this year, a lingering drought northwest of Guangzhou has left some 60,000 people short of drinking water and damaged 160,000 hectares of crops. Water levels in the Beijiang River around Qingyuan City have fallen to the point where boats in side creeks have been left stranded on dry ground (pictures here). Since last October, Guangdong has received almost half as much rain as normal. No break in the dry weather is expected for at least a month.

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Back From The Brink

The Shanghai lorry drivers protest has been worn down to an irrelevance after five days by a mix of minor concessions over port fees and determined containment of it from spreading via copycat actions, mostly by the imposition of a news blackout in domestic media though we have heard reports of some drivers being detained by police. Disruption to port traffic turned out to be minimal. As we noted earlier, this was a dispute it was important for the authorities not to lose, and they didn’t. One lingering question, though, is, as the lorry drivers, mostly independent owner-operators, disperse, will the message they carry home be of resigned defeat or of still disgruntled resentment? To snuff out the latter turning into anything and to reinforce the former, any drivers identified by the authorities as organizers can expect to be quietly cracked down on.

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The China-ASEAN-U.S. Triangle

The U.S. has a new ambassador, one whose post reflects the changing nature of Washington’s relations with Beijing. David Lee Carden, a lawyer who was a fundraiser for U.S. President Barack Obama during his presidential election campaign, presented his credentials today to Surin Pitsuwan, secretary-general of the Association of South-East Asian Nations (ASEAN) in Jakarta. The U.S. is the second non-member nation after Japan to establish permanent resident diplomatic representation to ASEAN and it follows Obama’s visit to Indonesia last year.

Both Washington and Tokyo want to develop strategic and economic ties with ASEAN as a counterweight to Beijing’s growing influence in the region, and specifically its military power in the waters of the South China Sea. ASEAN members welcome the interest for the same reasons, as well as hoping, in the U.S.’s case, that it will bring a more uniform approach to trade. But on both the economic and strategic fronts, all parties need to move judiciously so as not to complicate their links with China, whose Prime Minister Wen Jiabao is also due to visit Jakarta this week.

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From Tripoli To Pyongyang

Our man in New York sends word of a passage that caught his eye in a critical analysis by Daily Beast/Newsweek journalists Christopher Dickey and John Barry of U.S. President Barack Obama’s flailing Middle East policy:

A former U.S. ambassador says he’s heard that the North Koreans are telling the Chinese “if this is the best the Americans can do in Libya, we’ve got nothing to worry about.”

That does not sound good. And we rather suspect we know how the Chinese side would have replied.

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China’s Income-Tax Cut Postponed

Proposed income tax cuts that would have taken 50 million people out of having to pay tax have been put on hold. State media’s report of the closing session of the National People’s Congress said the proposal wouldn’t be put to a vote until after more public opinion had been sought and further discussion undertaken. That won’t take place until later this year.

It is highly unusual for the legislature to do anything but rubber stamp legislation put in front of it. The finance ministry had approved, and the State Council signed off on the proposed tax cut, which would have raised the threshold at which income tax kicks in to 3,000 yuan a month from 2,000 yuan a month as part of the broad range of measures to offset the impact of inflation on low- and middle-income Chinese.

Question now is whether this presages a broader range of tax changes to tackle inflation–raising the threshold to 5,000 yuan a month is being talked about along with lessening the number of tax bands at which higher rates start and raising their thresholds, too–and whether some of the additional cost will be clawed back by higher taxes on higher earners. We are also intrigued by where the undermining of the initial proposal lies.

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Driven To The Brink

The protests in Shanghai by lorry drivers against rising fuel costs and port fees is a particular nightmare for the Party leadership. Discontent over inflation is a perennial concern for fear it could turn into something more challenging to Party authority. Lorry drivers threaten the tactic of keeping disputes localized and contained. They also have the potential for causing economic as well as political damage. The economic damage is difficult to quantify at this point because of the news blackout that has been imposed but we already hear of delayed shipments out of Baoshan. The disruption will quickly multiply if the Shanghai drivers inspire copycat protests elsewhere, as happened with the foreign-owned car factories where workers struck over pay last summer.

A dispute over rising fuel costs will resonate far beyond a few hundred drivers to the hundreds of thousands of drivers of taxis and farm vehicles who need to buy diesel and have been hit with two price rises this year, and to the broader population suffering from the worst inflation in nearly three years. This is a dispute the authorities can not allow themselves to be seen to lose.

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