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Monday, February 10, 2003

China: The Internet of the Decade?

The internet, or at least it's information technology component. Well this is the view of Moragn Stanley's Andy Xie. He argues that China's economic impact is so big that it changes relative factor prices globally, and, thus, inevitably triggers a major economic realignment. During the 1990's IT dramatically decreased the unit cost of information and depressed the relative value of information-intensive products. As Andy Xie points out financial services and information providers generally are still living through the consequences of the 90's boom. China's impact will be mainly in manufacturing (global services could be more an India story) but its reach could be of similar (and in all probability greater) magnitude. He highlights five factor areas: natural resources, labour, capital, land and intellectual property. On resources, he reminds us that since China is not especially rich in natural resources, there will be a potential upside push on prices reminiscent of post world war two industrial reconstruction in Europe and Japan. This can benefit those countries in a position to radically increase their resource output: Australia and South Africa heve been mentioned among others, but this may also benefit Indonesia and possibly Thailand. China's impact here will, if anything, be inflationary.

On the other hand, thinking in terms of land, China's impact on global agricultural prices should be broadly deflationary, as the productivity gains being made in rural China begin to exert an impact on global food markets through China's increasing export participation - remember China has long since left behind the problem of feeding its own population. Ditto and even more so for labour and capital. The rapid entry of relatively cheap labour from China's enormous labour force into the global environment cannot but depress global wages (this is not the same thing as reducing living standards, as falling prices can actually mean that the real value of wages rises), and China's savings-rich population can also start to supply increasingly important inputs for world capital markets as living standards rise, and this again can contribute to a plentiful supply of relatively cheap capital, so, deficits aside, don't look for a strong upside on interest rates in the near future.

On the IP front things are bound to be more complicated. China's relatively low current living standards makes realising high per-unit benefits unlikely. As Andy suggests, made-in-China products paying process licenses is a far more probable outcome, and a far less beneficial one for companies based in developed countries. The relatively weak legal infrastructure also makes protecting property rights far from easy, as Cisco, among others, are currently discovering - although this situation does seem to be improving. All-in-all a complex picture, but an important one, and, above all, watch for the deflation downside!

Factor price equalization is the best starting point to picture China’s interaction with the global economy, in my view. Why should it matter? After all, didn’t Japan and the Tiger economies develop through the same process –factor price equalization with mature economies through trade? The difference is China’s size and its development speed. Other East Asian economies changed relative prices somewhat during their development process and didn’t leave lasting effects on relative factor prices once they matured because they were quite small relative to the developed world and are still relatively small even in their maturity.

China’s labor force is bigger than that in all of the OECD countries combined. Its rapid development has caused dramatic shifts in relative factor prices in a short period of time. Some of the changes will be permanent even with China’s maturity. The most important one is that the value of labor will be permanently devalued against scarce resources. This is likely to have far-reaching consequences to the distribution of income in the world. The speed comes from the fact that the labor productivity gap between China and the mature economies is far less than the wealth gap between them. Labor productivity is a combination of learning-by-doing and education. The former needs investment and the later doesn’t. Labor productivity in developing economies comes mostly from generational shifts, in my view. Indeed, the saying that “you can’t teach an old dog new tricks” appears to have some merit of truth. Therefore, labor productivity is mostly about the quality of education and childhood environment. Apart from the decade of the Cultural Revolution, China maintained a focus on education during its turbulent periods, which allowed its labor productivity to grow even though household wealth didn’t.

China’s reintegration into the global economy, therefore, presents a major discontinuity. The gaps between China and developed economies for productivity and for wealth are expressing themselves through rapid capital reallocation from mature economies to China and the consequent rapid growth of China’s exports. The key driver is China’s low wages resulting from its vast surplus labor and low level of wealth. These are two sides of the same coin – if China’s wealth had kept up with productivity, China’s labor force wouldn’t be so underemployed in the first place.

There are five major factors in production that can be priced distinctly: intellectual property (IP), labor, capital, land and natural resources. China’s story for natural resource isn’t ambiguous. China’s households have low wealth levels and spend their income disproportionately on housing, food or buying automobiles for the first time. China’s household spending is much more commodity-intensive compared with how marginal income is spent in mature economies. When China’s economy matures, its commodity consumption might decelerate but won’t decline. Therefore, China’s development is unambiguously a bullish story for commodities.

In addition to this general demand story, one must bring timing and supply into the picture. Certain commodities take off only when China’s per-capita income hits a particular point. For example, when a large number of Chinese could afford to purchase flats, steel demand took off. Foodstuffs are a rolling story. Palm oil and pistachios are there, but wine and cheese are not yet but prices for these goods will likely take off at some point in this decade.

However, China’s own supply capacity should remain a constraint on commodity price inflation. Anything that is about capital and labor will have a hard time maintaining high prices. Sooner or later, China will produce enough a good for itself and export some. Semiconductors are a great example. Chips are now on China’s chopping block, which means they will not likely be highly profitable in the next upturn. Investors who look only in the rearview mirror will be badly hurt, in my view.

On the other extreme, China is clearly a deflationary force for labor. Wages for low-skilled workers are under pressure. As China’s education improvements progress and its manufacturing base becomes more sophisticated, wages for skilled workers globally will also come under threat. Many would argue that some sectors are not tradable and, therefore, should be immune. This is an erroneous assumption, in my view. As college graduates in mature economics shift into these non-tradable sectors because of the higher wages, wages for those non-tradable sectors will likely come under pressure as well.

Intellectual property in theory should be the biggest winner. China’s development means a bigger market for something with zero reproduction cost. The real story is, of course, more complicated. IP rights for mass consumer market products might not benefit their owners initially. China’s income level is too low for IP owners to price IP goods at affordable prices for China’s consumers. Otherwise, it would cut their revenue too much in developed markets. When China’s consumers become rich enough, IP providers should be able to integrate China into their pricing strategy and benefit as a result.

However, the situation in the business sector is much better. The enforcement of IP rights by China’s government is clearly having an impact on the revenue of IP providers in China. For example, companies in China have become big enough now that they don’t want to risk their overall businesses for the small savings of using pirated software. They are also trying to use licensed technologies as a competitive advantage and, therefore, are becoming vigilante in defending IP rights as a result.

Even on IP, I believe one must take into account China’s supply capacity. IP based on production processes can easily be duplicated without violating patents. The traditional manufacturing powerhouses tend to count on such IP and might not benefit much from China’s development at all. Whereas IP that is rooted in standards, brands or fundamental science should benefit greatly from China’s development.

China’s most important impact on financial markets globally is likely to perhaps be on inflation. It is quite popular to argue that deflation is just a monetary phenomenon. However, when relative prices are changing fast, monetary policy may not be and, indeed, shouldn’t try to keep prices rising for a product category. For example, if a monetary authority tries to keep manufactured goods prices increasing, it may simply translate into more imports without much effect on price. The right monetary policy should target positive GDP deflator only, in my view.

The equilibrium inflation rate in the global economy will likely remain quite low at least in this decade. Therefore, the decline in sovereign bond yields should be viewed as permanent. This disinflationary impact on credit quality is the opposite. Diminishing pricing power in general increases the credit risk associated with business operations. Therefore, corporate paper should be treated cautiously.

Will low inflation rates turn into outright deflation? It really depends on fiscal policy. As capacity formation shifts to China, mature economies will suffer structural shifts in savings rates. Low interest rates might encourage household demand for capital through property purchases for a while but aren’t likely to do much for business demand for capital. Savings rates don’t really respond to interest rates. Therefore, sustained and large fiscal deficits are the only instrument to keep deflation at bay. I believe that the US and, soon, Europe will embark on this trend. The world could avoid deflation.

Finally, how would the income spillover from China benefit other economies? Tourism is a good example. Its beneficial effects depend on a country’s income gap with China. Malaysia and Thailand, for example, are likely to benefit substantially from increased Chinese tourism. Their per-capita income is similar to China’s and Chinese tourism can create jobs in their economies at the prevailing wage levels. However, increased Chinese tourism would likely be much less of a benefit for Hong Kong or Singapore. People who like to dress in Armani can’t make a good living by serving people who shop in Giordano.
Source: Morgan Stanley Global Economic Forum

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