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The Long March To Rebalancing China’s Economy

The World Bank’s latest quarterly update on China’s economy, published earlier this week, highlights a policy conundrum facing Beijing. The growth driver has swung back to exports from domestic demand as the effects of fiscal and monetary stimulus wear off and the global economy recovers from the Great Recession. Yet the new five-year plan calls for the economy to be driven more by domestic demand and less by exports, and there is wide agreement beyond the country and considerable inside it, too, that that is the direction in which China needs to move if its economy is to continue its development and if global imbalances are to be redressed. How to get back on track without causing short-term disruption, political or economic, and how to do so during a significant leadership transition and when the new five-year plan proposes implementing an equally significant formal change of focus from growth (economic) to development (economic and socio-political)?

The outgoing leadership of President Hu Jintao and Prime Minister Wen Jiabao has increasingly emphasized the socio-political aspects of growth under its banner of promoting a harmonious society. The new five-year plan specifically embraces them: the reduction of regional wealth gaps, lessening income inequality, restoration and expansion of social services and more environmental protection. At the same time, it has made sure to deliver 8%+ GDP growth, the minimum deemed necessary to keep the lid on any social instability threatening the Party’s legitimacy to govern. When the global financial crisis hit, the leadership reacted quickly and decisively with its stimulus.

The World Bank now reports that GDP growth has slowed from 10.6% in the first half of the year as the stimulus impact faded and investment and urban consumption decelerated. The Bank says that slowdown has now ceased. It is forecasting 10% growth for the year as a whole, a slight increase on its previous quarterly forecast. It says the growth rate will ease to 8.7% in 2011 as investment falls further and the global economy’s recovery remains moderate, fragile and uncertain. This Bystander thinks the Bank’s 2011 number to be too low and that China’s growth will be closer to this year’s than to the Bank’s forecast. Beijing’s policymakers have got the growth rate into a comfort zone and will want to keep it there. They have anyway in their back pockets new pubic investment programs likely to be started next year to speed up development of inland cities and to promote strategic new industries as insurance if the global economic winds blow unexpectedly ill.

Beyond the external risk to the domestic economy from the fragility of the global economy, the Bank identifies three homegrown risks that could also undercut its growth forecast: a property bubble, strained local government finances and bad bank debt. It notes that measures continue to be undertaken to minimize them, even if success is mixed. Property prices are proving particularly intractable despite an endless barrage of measures to rein in property speculation. In addition, weather-related higher food prices could keep inflation above the government’s 3% target for a while though core inflation remans in check, and price controls and stockpiles give the authorities some scope to hold rice and wheat prices.

However, the global inflation outlook is uncertain and likely to be volatile depending on how much liquidity central banks pump. (China took a pop at the U.S. Federal Reserve’s second round of quantitative easing on Friday.) While the exchange rate could bear some of the strain of that adjustment, Beijing won’t be moved into letting the yuan appreciate any faster against the dollar than it has been. That is one reason we think the People’s Bank of China will continue to raise interest rates, as an alternative damper on inflation despite the hot money rate rises would attract.

The Bank reaffirms its preference of market-based incentives to reorient the economy to greater domestic demand. It would like to see the cost of energy, capital and polluting raised and that of labour lowered. It does not advocate lower wages but tax changes and productivity gains to encourage consumption and employment. Manufacturing wages have been rising anyway since the mid-1990s, at least until the onset of the global financial crisis in 2008 put a brake to them. It is worth noting that productivity gains were more than enough to offset the cost of the increases in as much as unit labour costs fell over the same period and have been little changed since 2008.

The Bank also says that “rebalancing of the economy won’t happen by itself—it will require significant policy adjustment”. Which is easier said than done. Boosting private-sector development means opening areas of the economy where state champions are being groomed. It means stopping the big state owned banks making loans based on their connections to state owned enterprises rather than on true credit risk considerations. It means less direct local government control over economic development, via both planning and regulation. We don’t see any of those measures in the next five-year plan. Indeed, its headline policy is to steer more development to the interior to minimize regional wealth gaps.

The swing of economic power during the financial crisis back to state owned enterprises and away from the private sector doesn’t bode well. The new five-year plan calls for the development of service industries, where state-owned interests are less entrenched than they are in manufacturing industry, but it also calls for China’s multinationals, which are predominantly large state owned enterprises to become more vertically integrated. The danger is that they will crowd out the private sector in most everything from finance and technology to foreign direct investment that is now meant to bring China the higher-value-added technology and human expertise to upgrade its domestic industries and to offset the looming long-term problem of skills shortages and an ageing workforce.

Beyond the inherent conflict of state-directed capitalism, letting the private sector expand its reach, even to develop domestic demand, threatens vested political interests. These do not want reforms such as to the intergovernmental fiscal system that now channels tax revenues to them, or any undoing of the close ties between the Party’s princelings and big state-owned enterprises, or any competition for the business interests of powerful state institutions such as the military. Does the prospective new leadership, including president-apparent Xi Jinping, himself a princeling, have the stomach or capability, let alone the political mandate, to take on such battles?

Yet the need to rebalance China’ economy is greater than ever. Its sheer size and role in the world is significantly greater than at start of even the current five-year plan–which also had rebalancing the economy towards more domestic demand as an objective, don’t forget. It will be a long process; a multiple five-year-plan project. And politically very difficult. For now, political short-termism drives China’s economic policymaking just as much as it does policymaking in all the world’s heavyweight economies.

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China’s Welcome Rising Wages

Much of the commentary about China written by non-Chinese, scholarly, commercial, journalistic, is written by Americans, as weight of numbers suggests it would. That may be, though, why historical perspective is often missing. America is a country where history is regarded as the refuse of the present rather than prologue to the future. As we read coverage of the strikes and pay rises at the likes of the Foxconn and Honda factories and of Uncle Wen Jiabao’s tribute to the migrant workers filling all the other workshops and assembly plants of China’s industrial heartland, this strikes us as being particularly the case when it comes to China’s economic development.

There is an arc to industrial revolutions. Economies transverse it in their own ways and at their own speeds, but they don’t avoid it. That is as true for China as it was for England, Germany, the U.S., Japan, South Korea and many others before it.  One characteristic of China’s industrial revolution is that it is being carried out under the umbrella of state-owned capitalism. Another is that, unlike, say, Japan, which became the low-cost export manufacturer to the world by taking labour out of manufacturing, China did so by putting low-cost labour in.

That was always going to be unsustainable as China’s industries started moving up the development ladder as they are now doing. One measure of that is the rising level of capital per employee. Another is the rising skill levels being required from workers. The inevitable consequence is a rise in productivity. The International Labor Organization’s most recent biennial international productivity study shows China’s productivity increasing by an annual average of 5.7% since 1980 (the figures run to 2006 but the trend is clear). Wages should be rising to reflect that, just as wages in England and America did at comparative stages of development. (Not that those pay rises didn’t come without their share of labor struggles.)

Even the scale of pay rises being seen at Foxconn, a special situation anyway, and Honda would not materially change retail prices for China’s exports. Labour accounts for about 5% of the price of consumer electronic goods like an iPhone. There a plenty of points along global supply chains where some if not all of any wage cost increases can be absorbed. If wage inflation is to push manufacturing out of the present industrial heartlands it is more likely to go to inland than to Vietnam or other lower-cost countries. True, some Western multinationals are looking at shortening their international supply chains, but that is more because of factors such as event risk (think volcanic dust disrupting transport) and carbon footprint concerns than labour costs.

There is one more reason to cheer rising wages in China. More money in the pockets of Chinese workers and thus more purchasing power. That is a prerequisite for domestic-demand driven growth.

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