Thursday, January 27, 2011

Three China Predictions

I just came across the following link, that suggests that many investors are now seeing an abrupt end to China's rapidly expanding economy, a view the TSI has held for years.

As a bonus link, I include the Economist website that has moved forward the date of China's ascendancy to the world's largest economy. In essence, the Economist assumes that China's nominal GDP will grow strongly, even as real GDP growth begins to decline (due to inflation running at 4%), but that since the Yuan will continue to appreciate against the dollar, high inflation will actually serve to help make China richer, faster.

I promised you 3 predictions about China, though, and here they are:

1) China will become the largest economy in the world in the 2020s

2) By 2050, it will have fallen back to third.

3) Slower economic growth will provoke a political crisis in China, and this will lead to a major recession and a fall in China's output.

My rationale:

1) China's continued growth coupled with inflation and a slow but steady increase in the value of the Yuan, will enable China to overtake the US sometime in the 2020s. I now think it unlikely, given policy preferences in both countries, for this not to happen. However....

2) China's economic "miracle" is coming to an end, and it is being challenged already by India, whose macroeconomic situation appears stronger. However, to be 3rd, means to be passed by 2 countries, and the other country will be ..... drumroll please .... the United States. Thus, I am predicting that China's growth rate will fall below that of the US after 2030.

Let us consider how this happens, to increase economic growth you have to increase either labor (hours worked) or capital (productivity). The rapid productivity gains that every "tiger" economy, be it Japan, Korea, Taiwan, or Ireland, indeed every industrializing country, experiences in early stages of industrialization inevitably comes to an end. Remember that it took Britain 100 years, the Americans 70, the Germans 50, and pretty much everyone else 30 years to convert, with higher rates of growth the later a country started. The reason for this is not leadership, or "economic system" but simple math - the later you start industrializing the cheaper any given productivity-enhancing technology is, thus you can "skip" generations of technologies (the Chinese did not start industrializing by using Arkwrights Water Frame to drive their textiles), and move productivity ahead faster.

Having caught up several generations of technology, China must now deploy more expensive technologies which require more sophistication, and China doesn't produce any of them. While they can purchase much of this (from Germany and elsewhere), it is not clear that Chinese firms have the education an educated workforce and competent corporate managers. It is not clear that an education system run by the Communist Party can create such a workforce. It has not succeeded anywere else. Services productivity, the driver of eocnomic growth for developed economies, is even harder to sustain without specific management skillsets, suggesting that the services sector in China will remain a productivity laggard, even as it becomes the largest part of the economy beyond 2030. I suspect that Chinese education will prove to be inadequate to the task, suggesting that their productivity may grow more slowly than that of the US, and more on European levels of around 1% per year, particularly after 2030.

But slower and slowing productivity growth is only half the story - the other half is labor. China's labor market has benefitted from abundant rural labor and the "demographic dividend" which occurs at early stages of low birth rates. With fewer children being born, the share of the population that is working age rises, increasing output per head, and crucially, enabling women to enter the workforce in significant numbers and to invest in becoming middle- or highly-skilled (thus increasing both hours worked and output per hour). This dividend might be considered something of a "loan" because it has a nasty consequence: eventually, low birthrates and few children leads to fewer new labor force entrants.

If the situation becomes particularly acute, as it is in Japan, Italy, much of Eastern Europe and now China, the actual labor force can shrink. So while adding workers (or making them work longer) adds to GDP, fewer workers, will subtract from it. Moreover, increasingly wealthy Chinese may decide to consume more leisure time (everyone else who gets rich does), which would mean fewer workers working fewer hours. A decline in the labor force of even 0.2% would be enough to convert the 1% productivity gain into a mere 0.8% growth rate. A more severe decline could virtually wipe out all economic growth (see Japan for a real life example of how this happens, note that huge government spending, or "investment" if you are of a lefty persuasion, has failed to change the basic math).

Even if you believe China can sustain Anglo levels of productivity growth, a declining workforce means that China will grow more slowly than the US, where labor force growth continues apace, in part do to strong net immigration. The Chinese could also seek to import labor from elsewhere, but culturally Asian econmies are not immigrant friendly.

But wait, I hear some voices say - what about the rise in the currency? Clearly the rise in the Yuan will aid China's ascension. Indeed, it is because of this that I believe China cannot help but become the largest economy in the world. If the currencies were allowed to float, China's currency might increase by 30-35% against the dollar as everyone who is currently shut out of holding Yuan piles in. Because China has a managed-peg, or allows only a bit of adjustment each year, there is lots of demand to hold Yuan and apparently little downside. If you can borrow in US dollars at next to zero percent and invest in China with at 7-10% (holding Chinese short term paper) and you "know" that China's currency is going to rise against the dollar, you essentially have a case of risk-free arbitrage in which you can borrow cheap, earn positive carry on the interest differential and experience the compounding effect of having the currency you are holding rise against the one you are borrowing. An investor's wet dream. All you need is leverage....

However, the macroeconomic rationale for holding Yuan fades as China's status as the boom economy does. Therefore, that which investors "know" turns out to be wrong, and the UNWINDING of those positions will lead to a surge in the value of the dollar. Thus, I expect the dollar to rise against the Yuan after 2030 on macro fundamentals.

Ergo, the US reclaims its lead over China. This post is too long to cover India, but suffice it to say that India has many advantages, including the fact that its economy is more open, it's currency convertible, English is widely spoken, it has focused on services and on training top management talent, and it is now looking to manufacturing to employ more of its poor, oh, and India's birthrate, while falling, remains above replacement rate, which means it will have a growing labor force over the next 4 decades. It's less rapid growth is more sustainable, and its political system better able to resist a major social crisis, which gets us to our final prediction.

3) A final factor that will impede China's growth and rise, and will contribute to a currency crisis, is the political crisis almost certain to accompany an abrupt end to Chinese growth. The Chinese have become accustomed to getting much richer each year, and have been willing to put up with quite a bit of grief from Communist party apparatchiks in order to maintain it. Rural folks who feel left out of the boom have been demonstrating against the Party in increasing numbers. The Party has been able to hold onto the critical support of coastal regions, where the money and the power lie. Once these people experience the disillusionment that inevitably comes from having their expectations disappointed, particularly those among the rapidly expanding lower middle class that sees itself on the first rung of a ladder that will carry it to the wealth of the upper class Chinese, if not in this generation than in the next, the Communist Party will have difficulty maintaining legitimacy. It is possible that the entire edifice will collapse. It is also possible that it will increasingly resort to nationalism as a justification for strong central command, which may result in China getting involved in regional wars, wars it may not win (though it may not "lose" them either). Either way, a crisis within the Communist Party, or within the political system more generally will lead to major disruption and a withdrawal of foreign investment and a fall in domestic investment as well. Lower investment means lower productivity, and indeed, output will fall for the first time since the 1970s.

I suspect that the disruption will be on a scale with that of Russia, though different, since China is building better institutions than the creaking Soviet sytem did. If the CCP tries to hold power by force, as they did in 1989, the situation could be particularly bad. Ultimately, China will come through it, but with a possible decade of political turmoil holding back productivity gains, the legitimacy of its government undermined and a major foreign crisis, such as a war with India or Taiwan, will leave its position in the world much diminished. Indeed if this crisis comes sooner (with the next leadership transition scheduled to begin in 2012), China may never make it to number 1, with the US able to hold out until the 2030s when it gets passed by India, instead.

And now the best thing about long range predictions - it will be decades before anyone knows if I'm right. But I reiterate my view that investment in China is fraught with danger.

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