Presentation by Tony Cole - China and the Lewis Turning Point

Transcription

1 Presentation by Tony Cole - China and the Lewis Turning Point Tony Cole is a CDU University Fellow and a Senior Partner, Mercer, based in Sydney. Over recent years he has led the Asia Pacific investment consulting business. Tony recently moved to a new role centred on key client consulting, thought leadership. Before joining Mercer in 1996, he was executive director of the Life Investment and Superannuation Association of Australia. Earlier, he served the Australian government in various senior positions, including Chairman of the Industry Commission, Secretary to the Treasury, and Secretary of the Department of Human Services and Health. Tony has a bachelor's degree in economics from the University of Sydney. In 1995, he was awarded an Order of Australia for service to government and industry. Tony was the Chairman of the Advisory Board of the Melbourne Institute of Applied Economic and Social Research for 10 years to He is a member of the minimum wages panel of Fair Work Australia and of the Advisory Board of the Northern Territory Treasury Corporation. He was a member of the Abbot Government s Commission of Audit. Tony is also a Trustee Director of the Commonwealth Superannuation Corporation which manages retirement savings for Australian Government employees and a director of Australian Ethical Investors Ltd. China - at a turning point? As the world's largest trader with the world's largest foreign currency reserves and soon to be the World's largest economy, China's economic performance is vital to the world economy - especially during a period when so much of the world economy is in the doldrums. For Australia, China is even more important: it takes 30% of our exports and supplies 18% of our imports. I have argued previously that China's continuing strong economic growth should not be seen as a cyclical boom that would inevitably be followed by a bust. It is instead a long term structural change which is likely to continue for decades to come. While there will almost certainly be periods of less strong growth and bursts of very rapid growth this will reflect cycles within a longer run growth path. As long term investors need to focus more on the opportunities provided by long term trends rather than short term cyclical ups and downs. Because the economic outlook for China is so important to us all it gets enormous scrutiny from economists around the world. While some of this is well informed, much of it is frankly alarmist nonsense. The alarmists have predicted hard landing after hard landing but none of them have occurred. And it is the alarmist nonsense which is most likely to be reported prominently in the press. Stephen Roach (Yale University, formerly Chairman of Morgan Stanley, Asia) has observed that "the China Crash Syndrome is a malady that seems to afflict economic and political commentators every few years, never mind the recurring false alarms over the past couple of decades". (1) Roach describes the current China hardlanding debate as "Just another false alarm". Whilst I agree with Roach's conclusion, there are some new arguments being put by several of the doomsayers (and some who have not previously been in that group) which need to be given some attention. The new arguments postulate that while there has been a multi-decade growth trend in China, the conditions that made that possible have now disappeared. China is therefore unlikely to enjoy such rapid growth in the future. It needs to engineer a transformation of its economy to focus on domestic consumption if it is to maintain trend growth at around the slower 7% or so it has recently canvassed as a target. Implicitly, if its future trend rate of growth is around 7%, there will be times in the economic cycle when growth will dip well below that.

2 The Lewis Turning Point (2) A common theme of these commentaries has been that China has reached, or will very shortly reach, the Lewis Turning Point. The Lewis Turning Point is a concept created by Professor Arthur Lewis in 1954 to explain and predict the growth path followed by labour surplus economies in their initial stages of development. The model assumes a dualistic economy, with a highly productive modern sector and a large rural or village sector with productivity that is barely above subsistence. A very simple path to a burst of very rapid economic growth is to transfer workers from the low productivity subsistence sector into the much higher productivity modern sector, which typically exports the extra production. This is profitable and can be sustained because the modern sector is able to keep wages low while there is a surplus of labour in rural areas willing to migrate to the modern sector. The uneven distribution of income - profits high, wages low - results in a high savings level, and high profitability leads to high levels of investment. The larger economy provides higher revenue for government, which enables it to invest in education and physical infrastructure which also helps growth to accelerate. Over time, the surplus of labour declines as a large proportion of rural workers have moved to the modern sector. The migration from the farm sector has typically forced modernisation and efficiency gains within the sector so that the disparity of incomes between the traditional and modern sectors has narrowed. At this point, wages in urban areas begin to rise as competition for jobs from migrant workers diminishes. If they are to remain competitive in export markets, employers must improve their factories' productivity or seek to move up the scale of quality or complexity in what they produce. Businesses may also attempt to re-focus their production on local demand as the population has become progressively better off as the wages share of income has risen. The issues I am going to address are:- (1) whether China has reached the turning point or is approaching it? (2) if it has, what are the implications for China? And (3) what are the implications for the rest of the world, including investors? Has China reached the Lewis Turning Point? The Lewis model seems to fit the Chinese experience very well. China has had very rapid growth fuelled by migration of workers from the rural sector to the cities on the Eastern coast. Labour costs have been low so that Chinese manufactured goods have been supercompetitive in international markets. Income distribution has been very uneven and saving and investment rates have grown to extremely high levels. Government has invested massively in infrastructure and education, further enhancing competitiveness of industry. In various parts of the country, industrial activity and wages have been rising and there have been reports of simple manufacturing activities such as toys and textiles migrating to Western provinces in search of lower wage costs or to other less developed economies such as Bangladesh or Vietnam. Industry (with encouragement from government) has responded by attempting to move up the scale of complexity and quality where wage costs are not so determinative of profitability. The turning point concept seems pretty straightforward so that it should not be too difficult to assess whether China has reached it or is rapidly approaching it. Unfortunately, this is not so. Economists are still debating when Japan passed the turning point. Fei and Ranis (3) postulate that the turning point in Japan occurred around This was based on the view that agriculture had modernised (so having no labour left to free up) and there was a burst of wage increases around the end of WW1. Most economists (even Japanese economists) believe Japan's farm sector remains extremely backward to this day (4) so the story does

3 not fit the model. Arthur Lewis himself suggested the turning point in Japan was somewhere in the 1950s. The increases in wages around the end of WW1 were a false indicator. Minami (5) has estimated that the point was passed sometime in the early sixties. His analysis is based on real wages in the subsistence sector (in which he includes textile workers as well as rural labour). He concludes that, measured over appropriate time periods, real wages in the subsistence sector were almost constant in the pre-ww2 period but showed a strong increase in the postwar period, especially since the end of the fifties. Minami argues that the turning point is not an event that occurs at a particular time or even in a year. It is a major development for an economy that takes place over several years. The timing and speed of change will vary across regions and industries. It is important to carefully distinguish between the demographic/economic trends and the business cycle or even longer periods of higher than usual economic activity. Following his work it has become more common in the literature to refer to a turning 'period' rather than a turning point. Ross Garnaut first wrote about China nearing the Lewis Turning Point in (6) He was reacting to reports of labour shortages and sharp increases in wages in the Guangdong area in The wage rises led to a fresh burst of migration into the region. Shortly afterwards the global financial crisis erupted, which resulted in many migrant workers having to return to their home villages. These developments took attention off the topic for some time. Garnaut returned to the topic in (7) He picked up the concept of a turning period rather than a turning point. He noted that, in a very large and diverse country like China, with very differentiated regional labour markets, the pace and timing of change will vary considerably. Real wages will rise strongly in some regions leading to a reduction in profit margins, increases in labour's share of income and increases in consumption, and a move out of simple labour intensive manufacturing. For a time this will co-exist with a prosperous, and even still expanding, labour intensive industry in other regions. He argues that his earlier observations were almost certainly consistent with the early part of the turning period for the market he was observing. In their 2011 paper, Jane Golley and Xin Meng, (8) strongly argued the "not yet" case. They noted that had the turning period been reached, the gap between skilled and unskilled wages would tend to have narrowed. They showed that the real wages of migrant workers had not increased at all between 2000 and a period when skilled wages had risen strongly. Golley and Meng also examined whether there was evidence of surplus rural labour running out. They noted that only a little over 20% of China's total rural labour force migrates to cities. Migrant workers do not tend to stay in urban areas for very long periods. If the average number of years of migration increased by just 4 years the stock of migrants would more than double. Clearly there are still abundant workers in rural areas who are underemployed and earning very low incomes. This raises the question of why more of them are not migrating and why so few of those that do actually remain in the cities for longer periods of time. Golley and Meng concluded that continuation of the well-known range of institutional barriers to immigration (Hukou) is a major factor. In a paper with a foreboding title - "Chronicle of a Decline Foretold: Has China Reached the Lewis Turning Point" - the IMF (9) actually also joins the 'not yet' case, although it does warn that demographics is likely to outweigh market and policy responses to a declining workforce as the turning period approaches. The Fund notes that there have been rapid wage increases, particularly in the inland provinces as companies have relocated from the coast. Nominal wage growth has ranged between 10%-15% for more than a decade but has nevertheless trailed productivity gains. The Fund estimates that there is surplus rural labour of approximately 150 million people at present but expects this to decline to about 30 million by 2020 and that the turning period will commence over the following 5 years. The paper

4 examines various scenarios and suggests that the current growth model which relies so heavily on factor accumulation (capital and labour) will not be sustainable. China needs to switch to a model where it invests less, but in better capital, so as to improve total factor productivity. This is, of course, consistent with current strategy. The Fund also suggests China needs to address Hukou reform to increase labour force participation. Action on this front could delay the turning period by around 5 years to the period 2025 to The implications of The Turning Period for China Numerous commentators, particularly American commentators, argue with seemingly great glee that passing the turning point means big trouble for China. A prime example is Nobel laureate turned columnist, Paul Krugman. (10)Krugman claims that China's "whole way of doing business, the economic system that has driven three decades of incredible growth, has reached its limits. You could say that the Chinese system is about to hit its Great Wall, and the only question now is just how bad the crash will be." He goes on, "China's lowconsumption high-investment economy is a kind of Ponzi scheme. Chinese businesses are investing furiously not to build capacity to service consumers who were not buying much, but to serve buyers of investment goods - in effect investing to take advantage of future investment, adding even more capacity. Would there ever be buyers for what all this capacity could produce? Unclear. So, a kind of Ponzi scheme. Also, my worries are that China doesn't know how to slow down - that it is a bicycle economy that falls over if it stops moving forward. And, of course I have argued that running out of peasants creates a wall. So the Chinese Ponzi bicycle is running into a brick wall." I have so fully quoted Krugman's column for two reasons. First, I wanted to show how little analysis goes into many of the pieces which are circulated about the Chinese economy or about the economic and investment outlook more generally. When we read something screaming about a coming catastrophe we all need to sit back and think a bit before panicking. Secondly, Krugman has form on matters like this. He wrote a very alarming paper about the newly industrialising economies of Asia in 1994 entitled "The Myth of Asia's Miracle" (11). He described the growth process in these countries (Singapore, Hong Kong, Korea and Taiwan) as more perspiration than inspiration and likened them to the communist states of Eastern Europe. The main thrust of his case was that their growth was coming to an end and they would never reach the per capita income levels of counties like America. While Korea and Taiwan still have some way to go, I am sure that Singaporean officials delight that their GDP per head beats the US by 20% and Hong Kong is also a little ahead. Despite its alarming title, the IMF paper clearly sees the turning period as an event that will require China to adjust its economic model rather than a catastrophe. Garnaut's paper takes this line too. Both point out that the Chinese Government has been addressing the issues. It is making massive investments in education to lift workforce skills. China has become the second largest investor in R&D. Attitudes to industrial intellectual capital have changed dramatically as China itself develops new processes and products and seeks to develop brand names. The Chinese government has been talking out loud about these issues for at least a decade. It is clear in dealing with its business community that it does not want China to remain competitive in low value products such as toys and textiles. In the interim these industries can relocate to western areas with surplus labour but in the long run they would better move to lower income countries. Effectively, the low value add simple manufacturing exports sector is to become the supplier of labour to higher value add activities as it becomes more difficult to source labour from the rural sector. My view is that having around 150 million of the population either unemployed or in subsistence agriculture or very lowly paid casual work is a tragedy, not a blessing. The blessing of China is the hundreds of millions of people its economic growth has lifted out of

5 poverty. It will be a triumph rather than a disaster to lift as many as possible of the remaining 150 million up to the standards achieved for the rest of the population. China has a transition to manage - just as we have. All economic transitions are difficult to manage. One advantage China has is that it has been thinking about the issues for a long time now and socialising them. In other words national leadership has been leading. This was started by Premier Wu in his earliest days in office and has been continued by Premier Li and President Xi Jinping. Another advantage China has in managing its transition is that it does not have the inconvenience of a two party system or of a parliamentary system where only on rare occasions does a government have a majority in both parliamentary chambers. Its media is generally less of a problem in terms of opposing change. As wealth and social media grow following the tipping period these advantages might diminish but they do make change easier for now. Very little progress seems to have been made on Hukou reform, although it is beginning to be part of the conversation about economic policy change, particularly the process of increasing consumption's share of GDP. In addition to moving more quickly on this, the regime might also usefully start talking about lifting the retirement age. Another obvious area for attention is the one-child policy. However, it is too late for any change in this policy to have much impact and having till now enforced it with great vigour has made the policy hard to retreat from. In any event it is probably likely that it would make little difference to the birth rate which normally drops as more of the population moves into the middle class. In conversations with Chinese citizens they frequently refer to how crowded their country is and how it is necessary to avoid significant further growth. Implications for investors The tipping point/period is not something investors should be spooked by. Garnaut is right. It will occur progressively across the country just as industrialisation has done. As the IMF work shows, it is unlikely to be in full swing before 2025 or even In the meantime, more of the rural population will move to urban areas and will hopefully be allowed to become full local citizens. Such an outcome would be likely to mean that demand for our commodities (other than steaming coal) will continue to grow (although it is probably too much to expect it to keep up with the current pace of supply growth). As the turning period occurs we will be able to see just how well the authorities and businesses manage the process. A lot of preparatory political work has been done and many low value added businesses have already moved to the West or lower cost countries. That needs to accelerate. We will want to see wages share of GDP rising and see this converted into greater retail spending. Better health and social security schemes (including retirement savings schemes) will help make this possible by reducing the level of precautionary savings workers feel they need. We will also want to see the authorities face up to Hukou reform and the retirement age issue. Finally, we will want to see whether China's increasingly more sophisticated exports can do as well in world markets as they have been able to do with simpler products in the past. In this regard, with apologies to Paul Krugman, the Great Wall truck range looks like a good start. If China can deliver on this menu of issues we can expect it to continue to be a major and fast growing trading nation. There is not a lot more than this that its trading partners can reasonably demand of it, especially as it appears likely that the RMB will become a freely exchangeable currency by the end of this decade.

6 Bibliography: (1)) Why China's Economic Rebalancing is Good News, World Economic Forum, July 30, (2) Lewis,W A 1954, "Economic Growth With Unlimited Supplies of Labour", Manchester School of Economics and Social Studies, vol XX11 May, pp (3) Fei, JCH and Ranis, G, "Development of the Labour Surplus Economy: Theory and Policy", Richard D Irwin, Inc, Homewood, Illinois, (4) See for example Ohkawa Kazushi, "Agriculture and Turning Points" in Economic Growth, the Developing Economies, vol 3, issue 4 pp ' Dec (5) Minami, Ryoshin "Further Considerations on the Turning Point in the Japanese Economy", Hototsubashi Journal of Economics,10(2), pp issue (6) Garnaut,R and Huang,Y, "Continued Rapid Growth and the Turning Point in China's Rapid Development",in R Garnaut L Song (eds), The Turning Point in China's Economic Development, Asia Pacific Press, ANU, Canberra. (7) Garnaut,R, "Macro-economic Implications of the Turning Point", conference paper, Beijijng April (8) Golley,Jane and Xin Meng "Has China Run Out of Surplus Labour", China Economic Review, 01/2011. (9) IMF Working Paper, Mitali Das and Papa N'Diaye, January (10) Krugman, Paul, "Hitting China's Wall", New York Times 18/7/13 and New York Times Blog 20/7/13. (11) Krugman, Paul, "The Myth of Asia's Miracle", Foreign Affairs, Nov/Dec 1994.