Why China will dominate the world economy for a decade
Andy Xie Guozhong (Managing Director of Morgan Stanley in Hong Kong)
This article originally appeared in the February 12, 2003 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher.
China's role in this decade is similar to that of information technology in the 1990s. It changes relative prices of production factors - such as labour and capital - and, hence, triggers economic realignment. IT dramatically decreased the cost of information and depressed the value of information-intensive products relative to others.
China reduces the prices for labour and capital. But unlike IT, labour and capital do not travel well in the global economy. The equalisation process of these prices between China and the developed economies works through trade of manufacturing products. While IT's impact was to change the income distribution between sectors, China's impact changes income distribution between both sectors and countries.
In the post-IT world, the financial community is looking for the next big idea. China increasingly looks to be it. If the life sciences do not create another technology-based bull market in the next decade, China's dominant influence in the global economy could remain for an extra decade. The most productive approach is to form the right model about China's role in the world and select investment opportunities accordingly.
Relative price equalisation is the best starting point to picture China's interaction with the global economy. Why should it matter? Did Japan and the tiger economies not develop through the same process? The difference is China's size and its speed of development. Other East Asian economies changed relative prices somewhat during their development process. But they did not leave lasting effects because they were quite small, relative to the developed world.
China's labour force is bigger than that in all of the countries of the Organisation for Economic Co-operation and Development combined. Its rapid development causes dramatic shifts in relative-factor prices in a short period. The most important is that the value of labour will be permanently devalued against scarce resources. It has far-reaching consequences for the distribution of income in the world.
The speed comes from the fact that the labour productivity gap between China and mature economies is far less than the wealth gap between them. Labour productivity is a combination of learning-by-doing and education. In developing economies, it comes mostly from generational shifts, in my view. The saying: "You can't teach an old dog new tricks" is true. Hence, labour productivity is mostly about education quality and childhood environment. As China kept up its education focus during its turbulent period - apart from the decade during the Cultural Revolution - its labour productivity kept growing, even though household wealth did not.
The different gaps between China and developed economies in productivity and wealth express themselves through rapid capital reallocation from mature economies to China and the rapid growth of China's exports. The driving force is China's low wages that result from both its vast surplus labour and low wealth level. These are two sides of the same coin. If Chinese wealth had kept up with productivity, China's labour force would not be so underemployed.
There are five major factors in production that can be priced separately: intellectual property, labour, capital, land and natural resources (or commodities).
China's effect on commodities is not ambiguous. Chinese households have low wealth levels and spend their income disproportionately on housing, food or buying cars for the first time. It is much more commodity intensive compared with in mature economies. When China's economy matures, its commodity consumption may decelerate, but it will not decline. Therefore, China's development is unambiguously bullish for commodities.
Certain commodities will take off only when China's per-capita income hits a particular level. For example, as large numbers of Chinese are able to afford to buy a flat, steel demand has taken off. Foodstuffs is another case in point. Palm oil and pistachios are already popular. As income grows, wine and cheese will take off at some point in this decade.
China's own supply capacity is a constraining force on the rising prices of commodities. Any business heavily dependent on capital and labour will have a hard time. Sooner or later China will produce enough goods for itself and begin to export some. Semiconductors are a good example. As China begins to churn them out, prices worldwide will drop.
At the other extreme, China is clearly a deflationary force for labour. Wages for low-skilled workers are under pressure. As China's education progresses and its manufacturing base becomes more sophisticated, skilled workers will also come under pressure.
Many would argue that some sectors cannot be traded, and therefore, should be immune. This is a mistake. College graduates respond to incentives and will shift to higher wage sectors. That increases skilled-labour supply in non-tradeable sectors in mature economies.
Intellectual property - such as trademarks, patents and copyright - should, in theory, be the biggest winner. China's development means there will be a bigger market for something which costs nothing to produce.
The real story is, of course, more complicated. Intellectual property for the mass consumer market may not benefit its owners initially. China's income level is too low for owners to make intellectual property affordable to Chinese consumers. Otherwise, it would cut their revenue too much in developed markets. When Chinese consumers become rich enough, intellectual property providers can integrate China into their pricing strategy and benefit as a result.
Even on intellectual property, China's supply capacity must be taken into account. Intellectual property based on production processes can easily be duplicated without violating patents. The traditional manufacturing powerhouses tend to count on such intellectual property and may not benefit much from China's development. International property rooted in standards (for example, Microsoft), brands (McDonald's) or fundamental science (General Electric) should benefit greatly from China's development.
China's most important impact on financial markets is perhaps on inflation. The equilibrium inflation rate in the global economy will remain quite low, at least in this decade. Would low inflation turn into outright deflation? It depends on fiscal policy. As capacity formation shifts to China, mature economies will suffer a structural savings surplus. Low interest rates may encourage household demand for capital through property purchases for a while, but they will not do much for business' demand for capital. Savings rates do not really respond to interest rates. Therefore, a sustained and large fiscal deficit is the only way to keep deflation at bay. I believe that the US and, soon, Europe will embark on this course.
Finally, how will the income spillover from China benefit other economies? Tourism is a good example. Its beneficial effect depends on the income gap with China. Malaysia and Thailand, for example, benefit substantially from Chinese tourism. Their per capita income is similar to China's and Chinese tourism can create jobs in their economies at the prevailing wage level.
But Chinese tourism benefits Hong Kong or Singapore much less. People wearing Armani cannot make a good living by serving those in Giordano clothing.