China - walking the tightrope

In the same week that Barack Obama returned to the White House as US President for the next four years, the Communist Party of China opened its 18th Party Congress, so beginning its once-in-a-decade process of leadership change. The full details remain unclear, but we do know that Xi Jinping will replace Hu Jintao as party leader next spring, thus becoming the President of China.

China's new leader arguably faces greater challenges even than President Obama. Despite its annual growth rate of 7.4% - the envy of many a Western counterpart - the Chinese economy suffers a number of imbalances, not least the need to guide its industry away from reliance on cheap exports to indebted developed economies. There are also concerns that growing inequality, combined with increasingly open access to media, will lead to social unrest.

China's urban population has grown by 480 million in the last 30 years. Economist Arthur Lewis formulated a theory of development where a 'capitalist sector' develops by drawing a seemingly unlimited supply of cheap labour from the rural 'subsistence' economy. This allows the sector to expand without the need to raise wages. However, eventually a turning point is reached where the supply of cheap labour dries up, and further development requires wages to rise.

Many now believe China has reached this 'Lewis turning point' and rising wages may start to erode its competitiveness, with other countries such as Vietnam still able to keep costs low. Wages in China have certainly been on a steep rising trend in the past few years, and there are fears this could prove a headwind for the manufacturing sector, with firms needing to increase productivity per worker if they are to remain profitable.

However, technological progress, more capital investment and an increasingly skilled and well-educated labour force have allowed productivity to increase at a rate of around 10% per year since the early 1990s (see chart below). This mitigates increasing labour costs - factories might have to pay each worker more, but if those workers are more productive they will need fewer of them.

These productivity gains suggest China may avoid getting caught in the 'middle-income trap', where a country becomes stuck at a certain stage of economic development, with wages too high to compete with lower-cost producers of basic goods, but still lacking the expertise to compete with developed economies in the production of more advanced goods. Figures from the World Bank show that high-tech goods made up almost a third of Chinese exports in 2008, up from a fifth at the turn of the millennium.

A report by Credit Suisse entitled "Why some countries succeed and others fail" identifies China and Malaysia as the countries best positioned to progress towards developed markets status over the next decade. High and consistent labour productivity gains are cited as a key factor, along with rising Research & Development spending and high-quality physical infrastructure.

There are signs the Chinese economy is emerging from the slowdown the media seem so concerned with. The most recently published growth rate of 7.4% is the slowest since early 2009. However, this year-on-year figure hides a recent acceleration - between the second and third quarters the economy grew at an annualised pace of 9%. Retail sales and industrial output figures have beaten expectations in the past month, while inflation continues to slow (providing scope to loosen monetary policy to stimulate growth if necessary).

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Just as important as the speed of growth is the source of growth. Figures from the China Statistical Yearbook show that consumption now accounts for 55% of Chinese economic growth, suggesting the economy could be successfully rebalancing away from external trade and investment. The rising wages cited as a negative by so many commentators are aiding this transition. Indeed wage rises are being targeted by the Chinese authorities - the latest Five Year Plan aims for annual growth in the minimum wage of 13% from 2011 to 2015.

The Credit Suisse report highlights "exceptionally poor demographics" as the biggest threat to China's economy. The controversial 'one child' policy, intended to curb the growth of China's vast population, is partially to blame. The working-age population is peaking as a proportion of the total, and the proportion of over 60s has risen from 10.4% to 13.3% in the decade to 2010. Meanwhile the proportion of under-14s declined by 6.3 percentage points to 16.6%. Bank of Japan Deputy Governor Kiyohiko Nishimura recently warned that China is entering the "demographic danger zone".

China's long-term economic prospects are undoubtedly strong, but it might face a race against time to complete its transition into a developed, high-tech economy before its demographics start to act as a significant brake. Its old-age dependency ratio (the number of over-65s expressed as a percentage of the working-age population) is forecast to rise from 12-13% currently to over 25% by 2030.

Meanwhile the prospects for investors in its stock market remain unclear, with the key question being whether the challenges noted above have been adequately factored into share prices. Chinese shares look cheap on most measures - currently trading at around 7 or 8 times next year's earnings. The market has fallen recently whereas earnings haven't. Time will tell whether the market is correctly predicting a fall in corporate earnings in the coming years, or whether the market's drop is unjustified and therefore represents a buying opportunity.

This article is taken from AGENDA - our new economics bulletin.

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