Since it is the Christmas holiday, and I am spending the week in southern Spain with my family, I have not been focusing too heavily on economic data and have instead been reading lots of different stuff, including Frederic Wakeman´s excellent The Fall of Imperial China, about the transition from the Qing, especially the late Qing, to the early Republic.  Among other things I have been reading there is a very interesting article in the Winter 2010 edition of National Affairs, by Jim Manzi, and AI entrepreneur and senior fellow at the Manhattan Institute, that discusses the US within what he calls “the inherent conflict between the creative destruction involved in free-market capitalism and the innate human propensity to avoid risk and change.” 

This has some relevance to China’s long-term economic and social prospects, and is a topic that I have discussed a lot with my students.  In fact it is almost a subtext in Frederic Wakeman´s book.  To put it simply, one of the great strengths of the US is its ability to change quickly and dramatically, even though this ability necessarily comes with a sometimes brutal insensitivity to the short-term social costs of the change.  As Manzi puts it,

An economy built upon constant and relatively free innovation is inherently difficult to sustain in a democracy. This is not so much a matter of anti-market ideology as of the painful realities of economic change. Innovation forces change, and the pain involved tends to be felt immediately while the benefits are usually diffuse and harder to perceive in the short term.

It is therefore natural for people to organize to prevent the spread of significant innovation. The original Luddites were cotton weavers who, in the throes of Britain’s Industrial Revolution, responded to their displacement by automated weaving technology directly: They smashed looms. In America, people in similar situations rarely assault property en masse, but they do form political coalitions to pass laws that restrict innovation. It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition. But for that economy to prosper, the unease and opposition must be overcome.

A big question for me is how China decides in the future to face the continuing trade-off between social stability and rapid change.  In the past it is pretty clear that China has experienced wrenching social change.  This change began from a widespread recognition during the 1970s that the Chinese model simply was not working, and that without a dramatic transformation, China was likely to collapse.  It took the brilliance of Deng Xiaoping to understand how to steer China forward without risking an even worse crisis, and the economic rewards for this transformation have been dramatic, even as the social cost of such rapid change has put increasing pressure on the political and social systems of the country.  How is China likely to face the continuing trade-off in the future?

This is not just an abstract and very macro question.  It addresses much more specific things such as the liquidation process following a financial crisis.  For example, if we were to see a break in the housing bubble, there are broadly speaking two ways to address the problem.  The so-called “Anglo-Saxon” model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies.  The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.  

Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries.  One obvious example is the massive railroad bankruptcies that occurred in the US after 1873.  The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business.  More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of Amazon.com, Ebay, Google and a host of other new technology companies.

But there is a cost.  Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on.  Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger.  Other societies are less so.

The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the “Japanese” model.  Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers’ expense of course), and excess inventory taken off the market.  The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy.  In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings.  The advantage, of course, is that it much less socially disruptive and painful.

When I discuss this with my students at Peking University their responses, not surprisingly, vary.  A number of them insist that Chinese have learned long ago to suffer disruption, and they will be forced to continue absorbing the costs of change since there is a widespread consensus among the leadership that China must continue in its forward rush.  Others, the majority, think that although socially the Chinese are used to absorbing the cost of rapid social change, the political system itself is less able to do so.  Most interestingly to me is that whenever we have these discussions it becomes pretty clear to me that for most of my students our discussions are not the first time they have thought of this or related issues.  This is something that many students, at least within the elite schools, have thought about.

This discussion extends into the whole issue of financial reform, and not just for China.  Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short.   Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for.  The recent financial crisis, which seemed most to affect “Anglo-Saxon” financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.

But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis.  Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk.  Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.  It doesn’t matter if the system is highly fragmented and deregulated or highly regulated and monolithic.  After all a large part of the prestige of the “Anglo-Saxon” model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.

So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems?  Neither, it turns out.  All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.

So is there no room for financial sector reform?  Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim “Never again!”  That is silly.  It will happen again and again and again.  Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during “normal” periods.  A financial system designed to minimize the risks of crisis is probably a waste of time.  It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.   Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy.   So in China’s case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk.  It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system.  China´s financial sector issues are different.   China´s systematic misallocation of capital is its biggest financial problem.  China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth.  It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth.  But no matter how well-designed it is, the regulators should have a plan for the inevitable crisis, because it will come.  The interesting question is not how China can avoid problems, but rather how it should deal with them when they come.

There was something else I thought was interesting in Manzi’s article discussed at the beginning of this entry.  The graph below reproduces data about the recent history of manufacturing in the US.  One of the claims that has been repeated so often that it has become true merely by virtue of repetition is that the US is losing its status as a great manufacturing power.  The US used to make real “stuff”, according to this argument, but now it no longer does so.  What this graph shows is that this claim is at best exaggerated, and almost certainly wrong.

The huge (and hugely disruptive) surge in manufacturing productivity in the last sixty years has dramatically reduced the share of American workers employed in manufacturing, but manufacturing’s share of GDP has barely budged. 

 

The decline in US manufacturing labor has created a sense of crisis in manufacturing, but it mostly means that labor productivity has risen sharply.  That is unquestionably a good thing.   Unfortunately fears about US manufacturing decline have, unnecessarily I think, complicated discussions about China´s rise in the US, and created more worry then is merited.  China´s growth is not hollowing out US manufacturing.  There are certainly problems with imbalances that need to be addressed, but they need to be addressed rationally with a clear understanding of the difficult issues each country faces within the relationship.

By the way, and on a different subject, for those who are interested in demographics, the US Census Bureau released its latest projections.  According to the release:

China’s population is projected to peak at slightly less than 1.4 billion in 2026, both earlier and at a lower level than previously projected. Meanwhile, India’s population is projected to surpass China’s population in 2025, according to new data being released by the U.S. Census Bureau.  These figures come from the population estimates and projections for 227 countries and areas released today through the Census Bureau’s International Data Base. This release includes revisions for 21 countries, including China.

The latest projections indicate that by 2026, the population of China will begin to decline. Population growth in China, the world’s most populous country, is slowing and currently stands at 0.5 percent annually. China surpassed the 1.2 billion population mark in 1994 and reached 1.3 billion in 2006.  According to the latest revisions, India is projected to become the world’s most populous country in 2025. The population growth rate in India currently is about 1.4 percent, nearly three times that of China. The difference in the growth rate between the two countries is explained by fertility. India’s total fertility rate — the number of births a woman is expected to have in her lifetime — is currently estimated at 2.7 and projected to decline slowly, and that is driving population growth in the country.

The slowdown in China’s population growth is the result of declining fertility. China’s total fertility rate is estimated to have been 2.2 in 1990, 1.8 in 1995 and less than 1.6 since 2000. China’s fertility rate is currently half a birth below that of the United States, which is more than two births per woman. Key evidence for the new fertility estimates comes from analysis of data from China’s recent census and surveys.  One of the consequences to China’s declining fertility rate is that the number of new entrants to China’s labor force may be near its peak. The population ages 20-24 is projected to peak at 124 million in 2010. This peak is earlier than in India, which is projected to reach 116 million in 2024.

Despite a shrinking younger population, China’s labor force may continue to grow for several years since the population ages 20 to 59 (prime working ages) is not expected to peak until 2016 at 831 million, an increase of 24 million from the current estimated level. “These changes in China’s age structure may affect its economic growth and competitiveness in the world market,” said Daniel Goodkind, demographer in the Census Bureau’s Population Division.  Given that China and India together account for 37 percent of the world’s population, their demographic trends have major implications for worldwide population change.  The Census Bureau’s International Data Base includes projections by sex and age to 100-plus for 227 countries and other areas with populations of 5,000 or more and provides information on population size and growth, mortality, fertility and net migration.

So much for 2009.  In two days I return to Beijing in time for the crazy end-of-year festivities at D22.  I wish you all a great 2010.

The Christmas season, upcoming exams, student job hunting, and lots of visitors have made this a tough time to keep track of things but, before I go on to discuss the reason for the title of this entry, I wanted to make a quick comment on the economic numbers that came out last week.  As expected all the economic data points in the same direction as in the past three months.  If you are an optimist, you take great comfort in the fact that the data seems to be pointing towards continued growth in most indicators.  Industrial production was strong and lending for November was way down from previous months.

If you are a pessimist you worry again that the rapid growth has clearly been fueled by little more than massive credit and investment expansion, and you note that although at RMB 295 billion, net new lending in November is much lower than the 890 billion monthly average for 2009 (and even lower than RMB 477 billion net new lending in November, 2008 – the first time this year any month in 2008 exceeded the same month in 2009), it nonetheless brings the 2009 year to date total to an astonishing RMB 9.2 trillion.  The market consensus is that next year’s lending will total RMB 7 trillion, which is being presented as a gentle tightening of credit conditions.

Since 2008’s net new lending was RMB 4.9 trillion, I would suggest that in any other year RMB 7 trillion would have been considered an extraordinary expansion in lending.  After a year in which net new lending will probably come close to RMB 10 trillion, we would probably need something much lower even to pretend that loan growth next year will be prudent.  Also bear in mind that gossip among bankers suggests that in the rush to grab funding when it was freely available, a significant fraction of 2009 lending is still sitting as unused deposits, to be used next year for current investment projects, so that in terms of real new lending, a part of 2009’s net new loan figures really belong in 2010.  This means that it is very possible that if there really are “only” RMB 7 trillion in net new lending next year, real credit expansion next year will be equal to or even greater than this year.

The other thing to bear in mind is that the RMB 7 trillion that the market expects is not carved in stone.  As I wrote last year in my “All but the Kitchen Sink” entry, Beijing will do whatever it can to generate whatever growth rate it deems necessary, and Beijing can get any growth rate it chooses to get as long at its borrowing capacity is credible.

Next year we will almost certainly see growth of over 8%, and the total amount of new lending will be determined by whatever credit expansion Beijing requires to get there.  This means that the external environment, the increase in trade tensions (the recent “Buy Chinese” provisions announced for government procurement will almost certainly make things worse), and the impact of inventory build-up, among other things, are going to determine what amount of domestic credit expansion we will need.  Since no one can accurately predict any of those things, it is pointless to predict loan growth next year.  One thing that will almost certainly happen, as my friend Logan Wright told me yesterday, is that banks will rush to lend early in the year, so we should be prepared for shocking new loan numbers in the first quarter which will moderate quickly over the rest of the year.

Pessimists looking at the recent economic data would also note the very high investment rates and worry about the cost to future consumption of misallocated investment.  They would hear the continued, and louder, worry about lending at the PBoC and CBRC.  On Tuesday for example both the PBoC and the BoC warned again about credit quality and loan growth, covered in front page reports in the People’s Daily.  Since a rise in inflation will create a real difficult problem for monetary policy, pessimists will also wonder whether or not it is time to start worrying about inflation (I think it is too early, although my students are telling me that their parents are complaining about rice prices).  According to an article in Friday’s Financial Times:

A series of data published on Friday indicated that the rebound remained firmly on track, with industrial production and imports both increasing well in advance of forecasts. One of the main risks to face the economy is a surge in inflation as a result of the massive monetary and fiscal stimulus measures introduced this year.

Consumer prices rose 0.6 per cent last month from a year ago, after falling 0.5 per cent the month before, while prices at the factory gate fell 2.1 per cent last month compared with a 5.8 per cent decline the month before.

Several economists argued that the shift back to inflation was caused specifically by rising food costs, as well as by some rises in energy prices, rather than as a result of the money supply increasing at an annual rate of nearly 30 per cent.

However, the return of even modest inflation will feed into the intense discussion in Beijing about how quickly to ease stimulus measures and whether to abandon a de facto peg against the US dollar and to allow the renminbi to appreciate.

So to summarize, as I have for the last three series on monthly economic data, the numbers will do nothing to resolve the debate within China.  Optimists and pessimists both have more grist for their mills.

Turning away from the recent data, I wanted briefly to discuss urban migration in China.  For a lot of analysts, it seems that the phrase “urban migration” is the correct response to many of the problems you might identify with China’s growth model.  Is there a real estate bubble?  No there isn’t because urban migration will create a near infinite future demand for residential and commercial real estate.  Does China under consume?  Yes but urban migration will raise consumption rates.

This latter claim was highlighted in a Tuesday article in the South China Morning Post, which claims that “President Hu Jintao’s pledge yesterday to spur urbanisation and domestic demand next year has been seen as an attempt to tackle the growing problem of industrial overcapacity.”  The article goes on to say:

Announcing the development strategies at the end of the annual three-day central economic work conference, Hu said the government would focus on urging the rural population to work and live in small and medium-sized urban cities while boosting further the spending power of workers and low-income groups.

At the same time, he ordered that new investment in industries with excess capacity be reined in and the problem of underutilised plants be addressed.  The moves signalled domestic demand had left much to be desired, as the latest statistics showed 21 out of 24 industries incurred excess capacity in the third quarter, compared with 19 in the first quarter, said Zhang Tao, a researcher at the Chinese Academy of Social Sciences.

“The latest data tells us that overcapacity is not only a problem for several industries but across the industries,” said Zhang, who cited a 2010 economic development blueprint backing Hu’s strategies. “It also shows weak domestic demand.”

There is a surface plausibility to these claims about the benefits of urbanization, but they need to be considered much more carefully than they sometimes are.  First, as far as urbanization and consumption go, what China needs, as I argued in last weeks’s posting, is not so much more consumption but rather, as Zhang Tao implicitly points out in the article above, to close the gap between the amount if produces and the amount it consumes.

It is almost certainly true that as migrants move from the rural areas to the cities, their average consumption is likely to rise, but the key here is their net impact, not their total impact.  So if rural migrants move to the city and become engaged in expanding infrastructure or manufactured products – after all they need to earn an income before they can start consuming – they are not necessarily resolving the domestic imbalance.  They may actually be exacerbating it.  If however they migrate to the cities and take jobs in the service sector, then they have a positive net impact.

In that case it is not urban migration per se that matters but rather the strucutre of Chinese economic growth.  If it continues to be capital intensive, and to favor manufacturers and real estate developers at the expense of service industries, then urban migration is not really part of the rebalancing solution.  We would still be stuck with the same old problem – a growth model that favors overinvestment at the expense of household income, and that leads inexorably, in my opinion, to the very imbalances that China is trying to resolve.

After all, during the past decade there has been substantial urban migration in China, and yet the imbalance became worse, not better.  Why?  Because for whatever structural reason, urban migration has favored faster growth in the production of tradable goods than in their consumption.  Until this structural reason (or reasons) changes, urban migration won’t resolve the problem – unless of course in some way greater urban migration itself forces the structural change.

The other claim, that urban migration prevents the possibility of the existence of a real estate bubble, is more pervasive and, to my mind, even harder to justify.  First, I should point out that although I believe we are in bubble territory in both the stock and real estate markets, and clearly policymakers are increasingly concerned that we may be, I am less concerned than others about the economic impact of the bursting of the bubble.  I am much more worried about overinvestment in infrastructure and manufacturing.

Last week (sorry, but I lost the article) I read that the head of one of Beijing’s and China’s largest real estate developers (Vance, I think I remember) publicly warned that we are in the midst of a property bubble, making it the second time in the past month that the CEO of one of China’s biggest real estate developers has made the claim.  He may be right, and of course the muted warnings by the PBoC that we are in the midst of a stock market bubble may also be correct, but to me the wealth effect of collapses in the two markets are not large enough really to matter.  The wealth effect isn’t likely to be big enough to affect consumption.  Not only are these markets relatively small as a share of Chinese savings, but ownership is heavily concentrated among the relatively richer.

The main way a fall in real estate prices would hurt China, in my opinion, is if it causes a sharp drop in real estate development and, with it, a sharp drop in employment and the business activities of industries that feed the real estate sector.  I suspect however that if we were to see a drop in real estate prices, the decline in activity would be much less than expected because banks and the government would continue actively supporting real estate development projects as long as they had the credibility to do so.  This is not an economy where price signals always decide business strategy.

But to get back to urbanization and real estate overcapacity, the logic is that because we can expect 200 million, 300 million, 400 million or whatever number of people moving to cities in the next several years (any number is plausible as long as it is large), then by simple math it becomes obvious that there cannot be overcapacity in real estate.  We need new buildings to accommodate all those new people.

But this argument, or some form of it, has been used to justify nearly every period of overbuilding in modern history.  After all there was huge urban migration in the US in the 1920s, which was used to justify soaring real estate prices in the major American cities, but after 1929-31 real estate prices nonetheless crashed and apartments and offices when begging for tenants – even though urban migration continued for decades.  Another example: I grew up in Malaga, in southern Spain, which has been since the late 1990s and until last year experiencing an out-of-control boom in real estate development and land prices.  For years I had been telling my friends there in real estate (and nearly all my friends were in real estate – itself a very worrying sign) that prices were not sustainable.

But whenever I said this, they would immediately pull out the charts showing the inexorable rise in the number of aging Europeans, point out that all these old people wanted to retire in sunny communities along the Mediterranean, and that all the beaches in southern Europe simply could not accommodate a fraction of the expected retires.  Conclusion?  As long as the sun continues to favor southern Spain, real estate prices could not ever stop going up.  The inexorable pace of migration justified rising prices.

Needless to say the sun is still shining over sunny Malaga, but real estate prices have nonetheless dropped sharply and sales of BMWs and Mercedes (the favorite cars, it seems, for successful real estate agents) have collapsed.  The old people are still retiring, but new apartments are proving impossible to sell.

Massive expected migration, in other words, is not only perfectly compatible with overbuilding and real estate collapses, it may even be a prerequisite.  Bubbles need a plausible-sounding story that allows people to throw caution to the winds, and near-infinite inward migration is one such story.

The problem of course is that even if the migration projections are true, they are long-term projections and they cannot possibly tell us much about either how many people are coming in next year and how much money they will have to spend.  Worse, the migration itself is highly pro-cyclical – overbuilding to satisfy future migration encourages current migration, and more generally more people come when there are more jobs, and fewer when there are less.  The migration pattern can become very irregular and, more importantly, it tends to exacerbate current trends.  For the financial historians reading this, it is the pro-cyclicality of the process that is the grimmest warning signal.

I am not suggesting, of course, that expected urban migration is not important and will not radically change a number of Chinese parameters.  But I will insist that urban migration is not at all incompatible with continued overinvestment, underconsumption, and overbuilding.  In fact these things have gone hand in hand many times before.

Last week China Daily had an interesting article on job prospects for university graduates on the mainland.  In 2006, as a reaction to rising unemployment among college graduates – even with GDP growth buzzing at rates above 12% – the government launched a program to help students find jobs as university teachers.  The program has been expanded this year.  According to the article:

 

Schools across China will hire 50,000 college graduates as short-term teachers this year to help ease employment pressure.  That is almost triple the number of teachers hired last year.

 

They will work under three-year contracts with local education departments and be paid by a special central government fund, the Ministry of Education said.  “Most of the jobs are only open to students who will graduate from colleges this year,” ministry spokeswoman Xu Mei said on Wednesday.

 

The newspaper article comes with a graph listing the number of graduates in the past nine years.  According to the graph, Chinese universities graduated 1.45 million students in 2002.  Five years later that number had risen to 4.95 million.  In 2008, 5.59 million students graduated and later this year 6.10 million are expected to graduate.

 

Meanwhile job offers are declining.  The same issue of China Daily has a second article on the prospects for college employment in Guangdong province.

.

Only about 7 percent of the students who are about to graduate in July have managed to secure jobs till now, down 50 percent from the same period last year, the Guangdong education bureau said yesterday.

 

About 331,000 local college students will graduate in July this year, 14.2 percent more than last year.  A large number of graduating students from other provinces have been coming to Guangdong in search of jobs, the bureau said, adding that almost 500,000 graduates would be applying for jobs in Guangdong this year.

 

The demand for graduates has dipped by 20 percent in the wake of the global economic slowdown, Luo Weiqi, director of the Guangdong provincial education bureau, said.

Till March 10, only 7.61 percent of four-year college graduates have found jobs and signed work contracts, Luo said. 

 

In contrast, 8.43 percent of two-year or three-year college graduates, and 14.87 percent of all postgraduates have signed labor contracts, he added.  So far, the bureau has organized 36 job fairs for fresh graduates. However, according to Luo, the number of available jobs in finance and real estate is far less than previous year’s.

 

I have heard that the Guangdong numbers are pretty consistent with numbers from other provinces, with roughly 30% of last year’s graduates still unemployed, and current graduates getting job offers at half the rate of last year – already a bad year.  The (small bit of) good news is that unemployment prospects may increase the likelihood of Chinese graduates starting their own businesses.  Often in the foreign press I have read ecstatic paeans to Chinese entrepreneurialism, some thing that doesn’t jibe at all with my experiences as a university professor or in running a music club and independent music label, and the first of the two China Daily articles seems to confirm my skepticism:

 

Special funds and subsidies have been earmarked to encourage college graduates to work in rural and grassroots positions or to start their own businesses.  However, “most graduates are focusing on jobs in large cities and few would like to start their own businesses”, Wang [Yadong, deputy director of Ministry of Human Resources and Social Security employment promotion department] said.

 

A recent study by the MHRSS found only 0.3 percent of college graduates in 2007 started their own businesses. That is much lower than some developed countries where the rate is about 40 percent.

 

If more Chinese graduates are forced – by terrible job prospects – to consider starting their own businesses, the long term consequences for China should be positive although, as everyone running a small business in China will tell you unendingly, starting and running businesses here is extremely difficult and, what is worse, it is never easy to know when you are and when you aren’t legally compliant.  Still, China really does need more entrepreneurialism and one of the unexpected benefits of the crisis may be to boost small businesses.

 

As for the job creation program, today’s South China Morning Post has a more sobering assessment:

 

New selection criteria are expected to eliminate existing substitute teachers from contention for 200,000 new teaching positions in village schools and give the edge to this year’s crop of 6 million or so university graduates, state media reported yesterday.

 

Under regulations issued by the Ministry of Education, all candidates for teaching positions at mainland primary or secondary schools will have to pass a tough exam that many poorly educated substitute teachers would generally not be able to pass.  It is the first time that the mainland has stipulated prerequisites for teachers.

 

The article goes on to say:

 

But education experts have raised doubts about the scheme’s feasibility, given that fewer than 59,000 graduates have joined since it was introduced in western provinces more than three years ago. Others say the plan simply brushes reality aside.  “Even with government subsidies, rural teaching jobs are still the least attractive positions for the vast majority,” mainland columnist Song Guifang said.  

 

“Village schools could end up with no teachers if regulators raise the recruitment standards too high.  You will immediately understand that this action is leading you down a blind alley when you visit any of the 100,000 shabby village schools deep in the mountains. Qualified candidates that do pass the tough examination are very likely to pass up the offer.”

 

Many substitute teachers in poor areas claim the Ministry of Education has sacked tens of thousands of their counterparts since 2006 without proper severance payments, all the while subsidising the expensive scheme to help jobless graduates.   Substitute teacher Zhang Xicang – from Nayong county in Guizhou, one of the nation’s poorest areas – said he had taught there for a decade and was paid just 50 yuan a month, about 8 per cent of the pay that a fresh graduate would receive for the same job.

 

More than 765,000 students graduate as teachers every year and compete for the 200,000 or so vacancies at primary and secondary schools.

 

Regular blog readers know that I have worry a lot about graduate employment, not just out of concern for my students (most of whom mercifully don’t have to worry about unemployment), but also because I think of college employment as being a very useful way of understanding China’s development model.  If all the growth of the past four or five years has nonetheless been unable to absorb the employment needs of China’s university graduates, that tells us something both about the composition of job creation in China as well as the possible impact of a sharp slowdown.

 

By coincidence an ADB report released today highlights this issue while cutting its growth forecast for China.  According to an article in today’s Bloomberg:

 

China’s 4 trillion yuan ($585 billion) fiscal stimulus spending won’t create enough jobs, making unemployment the nation’s “most pressing issue,” the Asian Development Bank said.  “Investment projects in the stimulus package will generate jobs, but not enough to absorb the growing labor surplus,” the ADB said. “Infrastructure projects are generally less labor-intensive than export-oriented manufacturing.” The ADB cut its forecast for China’s economic growth this year to 7 percent from 9.5 percent in a report released in Hong Kong today

 

I am more than a little skeptical about the 7% growth forecast – I think that will be a tough target to reach – and I suspect it will be further downgraded this year.  The article goes on to say:

 

China will find it more difficult to create jobs than it has in the past, the ADB said. Between 2000 and 2007, 13.6 million non-farm jobs were created each year as growth averaged 10.2 percent a year, the ADB said.  “Employment generation on this scale will be more difficult in the future because employment elasticity — the rate of employment growth to GDP growth — has declined in recent years,” the ADB said.

 

About 9 million jobs may be created this year by stimulus spending with growth in the region of 7 percent, said Wihtol. With 20 million migrant workers already jobless, that still leaves “quite a significant gap,” he added.

 

On a much more positive note last week’s South China Morning Post heralds a surge in real estate prices:

 

A countrywide surge in sales since the beginning of the year has injected a sense of optimism that the worst is over for the mainland property market and a sustainable rebound is under way.  The market improvement was proven by inventory depletion as well as price stability in some cities, analysts said.  

 

While optimists said home buyers had regained confidence after the government’s stimulus package including falling mortgage loans and lower transaction tax expenses, some said the rebound was spurred by pent-up demand and bargain prices.  They were also concerned that prices were not following deal volumes higher.

 

“It is definitely a sustainable volume recovery,” said Lee Wee-liat, a property analyst at investment brokerage Nomura International HK.  Mr Lee based his call of a rise in demand since February – following a short-term rebound by the end of last year – on data compiled by Nomura showing a widespread surge in deal volumes nationwide last week.

 

The number of property deals was up on the previous week’s sales by 24 per cent in Beijing and Tianjin, and 71 per cent and 19 per cent higher, respectively, in Qingdao and Dalian, the data found. In Shanghai, 19 per cent more properties changed hands.  Guangzhou and Shenzhen recorded slight volume declines on the week, Mr Lee said, but remained at around the highest levels seen in the two cities for two years.  The increasing pace of sales was beginning to reduce unsold housing inventory, he said.

 

I have to admit that as a former investment banker I always take bullish statements from members of the selling profession with a big grain of salt.  The Guanghua Students Monetary Policy Committee discusses property prices in each of its weekly meetings, and I don’t remember any of their comments being this optimistic.  Needless to say the rebound of housing prices is very important both to confidence and to bank portfolio quality.

 

On a different note I found another very interesting article in today’s South China Morning Post:

 

Shenzhen foreign-exchange dealer Fang Zhen has been worried for months by a surge in people exchanging yuan for Hong Kong dollars based on fears that the mainland currency would plummet in value amid the financial crisis.  The fears were so strong that they drove up demand for and the price of the Hong Kong dollar on the black market.  

 

People soon realised they could make quick money by buying Hong Kong dollars at official banks and selling them on the black market. Mr Fang said he had reported his concerns to his superiors at the China Construction Bank and industry supervisors at the People’s Bank of China. Since October, many people in Shenzhen had discovered they could make a profit from currency trading between official banks and the black market. The margin between the buying price for Hong Kong dollars listed by state banks and the selling price set by black market dealers was growing. By the Lunar New Year, the gap was up to half a percentage point, Mr Fang said.

 

The widening spread between the official and underground prices was spurred by expectations that the central government would heed calls from influential think-tanks since late last year for depreciation of the yuan against the US dollar, to help beleaguered exporters.

 

Two weeks ago I wrote about the latest (rumored) reserve figures for January and surmised that there were at least $20-30 billion in hot money outflows that month.  The SCMP article is consistent with my assumptions.

 

And finally, on a completely different note, my student Gao Ming is writing a paper that involves a mention of the Mexican crisis in 1982.  He asked me some questions about President Lopez Portillo’s failed attempts to defend the peso, and that question led to some searching.  In so doing I dug up an old quote that I had forgotten.  During the oil boom of the latte 1970s, when every expert knew that oil prices would soar forever and would result in a major realignment of geopolitical forces, the president, presiding over Mexico’s then-massive oil wealth, ecstatically announced that his job was to administer the era of Mexican abundance (“¡Vamos a administrar la abundancia!” he proclaimed).

 

He went on to say: “En el mundo de la economía los paises se dividen en dos: los que tienen petróleo y los que no lo tienen. ¡Y nosotros lo tenemos!” which translates as: “In the world of economics there are two types of country: those that have oil and those that don’t.  And we have it!”

 

What does this have to do with China or the world financial crisis?   Perhaps not much, but it is good to remind ourselves about how utterly wrong we can be about predicting major changes or historic turning points.  By the way Gao Ming’s favorite part of the story was my telling him that for years after his failed defense of the peso (“We will defend the peso like a dog!” he shouted), whenever ordinary Mexicans saw him in public they started barking like dogs.  Mexicans have never lost their very healthy skepticism, it seems.

 

Tags: Lopez Portillo, University graduates

A friend of mine sent me the following table. It comes from a paper presented at the September 2007 International Conference on the CCP’s 17th Congress by Daniel Xu and Ning Ding (”Distortion of Population Growth and Pressure on Employment”) and shows the number of people, in millions, entering the job market in China every year from 2006 to 2020. I assume this means the number of people turning 18.

2006	20.2
2007	21.7
2008	23.2
2009	24.5
2010	24.4
2011	23.0
2012	21.9
2013	20.2
2014	17.0
2015	16.0
2016	15.1
2017	14.4
2018	13.5
2019	13.8
2020	13.4

This numbers at first were very surprising to me, but they are at least visually consistent with a graph derived from UN data of population by age cohort, which shows a significant bulge in children born in 1985-1990 and then a rather sharp falling off until 2005. Thereafter, give or take a few surges and retreats, births are expected to decline by just under one-half percent annually until 2050.

Before anyone blasts these projections as meaningless because it cannot be possible to project that far out into the future, let me say that my understanding is that immigration rates are tough to project (which is why it is hard to make projections about US population growth), but birth rates are much less difficult. In 1954, for example, the UN predicted that world population in 2000 would be 6.3 billion. In fact it was 6.1 billion – so they were able to project 46 years into the future with only a 3% error (and in fact much of their “error” came from their failure to predict that China would implement a one-child policy in the 1970s – a fairly unique factor that would have been hard to predict).

As I read these numbers, from 2006 to 2010 the number of young people joining the job market has grown or is projected to grow by 6.6% a year on average. From 2010 to 2020 the number of new job seekers is expected to decline on average by 5.8% a year. Remember that this is the growth rate of one part of the marginal change in the working population (the other part is the number of retirees), not the growth rate of the total working population, which will necessarily be lower in absolute terms.

These numbers seem plausible. I vaguely remember that last year a government report said that there would be 24 million people entering the job market and, I think, 4 million retiring. If we net out people of retirement age (I am using 65 as a proxy for retirement), the change in the positive growth of new entrants into the job market is less dramatic until 2009-2010, and then the negative growth rate is more dramatic thereafter. China still has a young population and so the number of retirees is currently small but is growing very dramatically every year, until roughly 2050, after which the number of people entering retirement is very high. Today about 7% of the population is 65 or older, but in 2050 about 23% will be over 65 (332 million people – by the way much more than the combined retired population of Europe, North America and Japan).

Until the 1960s China was among the youngest countries in the world, with a median age of 20. Today the median age is 33, and the UN projects it to be 45 by the middle of the century. By comparison the median age in the US is around 34, and is projected to be 41 by the year 2050, or a couple of years lower if we assume current immigration rates.

It is incredibly complicated to think about the economic implications of such dramatic demographic changes, but I think there are a couple of points that can be made:

¨ China currently needs extremely high growth rates – I think I agree with Xinxin Li’s suggestion of 10% annually – in order to keep the urban unemployment rate from rising, but this pressure will abate soon. After 2010 the number of young people joining the job market will begin to drop quickly, while the number of retirees will continue growing rapidly. The combination will reduce the need for job creation on the order of 1 million jobs or more a year for several years.

¨ In the short term this will be a good thing because it will allow China a little more room to maneuver on the jobs front and will create less pressure for breakneck growth. In the longer term of course it means that there will be a sharp drop in the number of people working – much sharper than the drop in overall population. That means workers will need higher levels of productivity to generate the same amount of per capita income.

¨ The rapid reduction in the number of young people and the rise in the number of older people are probably good for political stability.

Before ending this entry I wanted to throw in a few more numbers – not related to demographics, however. Yesterday I said that new loans had grown by a relatively low 15.7% in February year on year. Total new loans in February were RMB 243 billion. This compares with the huge RMB 804 billion net growth in new loans in January. It seems to me that there must have been some anticipation of February loans in the January numbers, although remember that every January we get a big number (though not this big) because of some left-over demand from the previous year.

Total new loans for the first two months of the year, then, amounted to RMB 1,047 billion. This is 83% of the first quarter quota of RMB 1.26 trillion and 29% of the total 2008 quota of RMB 3.60 trillion. I don’t think these quotas are going to last very long.

One last thing: I saw that according to the New York Times the CEO of Blackstone received $350 million in compensation in 2007. I hope that doesn’t become too widely known in China.

As a finance guy whose area of interest is financial stability and the impact of short-term adjustments on the economy, I usually don’t spend a lot of time thinking about what might happen in the next few decades, but because of the significant and historically unprecedented demographic imbalances we are seeing in the world today, and especially in China, in spite of myself I have found myself paying attention to demography. In that light a few weeks ago I began hearing rumors that the Chinese government was seriously considering revising the one-child policy. Yesterday a number of newspapers around the world carried articles on the topic. This is what The Times of London had to say:

China’s political leadership is considering ending the country’s hated “one-child” policy because it is damaging the economy and creating a demographic timebomb, a senior minister admitted today.

Zhao Baige, Vice Minister of the National Population and Family Planning Commission, revealed that there is concern at the highest levels that the policy is already tearing apart the fabric of society.

“This has become a big issue among decision makers,” Ms Zhao told reporters at a routine government press conference in Beijing. “We want incrementally to have this change. I cannot answer at what time or how.”

…Ms Zhao suggested that long-term planning on how to bring the policy to at least a partial close may already have begun. “The attitude is to do the studies, to consider it responsibly and to set it up systematically,” she said

There have been similar reports in the past about a reconsideration of the one-child policy. So far nothing much has happened and this may be another case of more of the same – it usually takes a crisis to get the leadership to reverse course dramatically. Still, as things stand today China has a real demographic problem.

Not only is the population aging at an alarming rate – it is among the most rapidly-aging countries in the world, and the only low-income member in the club of rapidly-aging countries – but it has a serious sex imbalance with about 60-70 million more males than females. Along with the rate of aging the sex imbalance is also supposed to be a consequence of the one-child policy, although sex imbalances in other Asian countries without birth policies suggest that the reason may be more complex. As for the rate of aging, I don’t have the numbers in front of me but I think I remember that today just under one in ten Chinese is above the age of 65, whereas in twenty years just over one in four will be. Please don’t quote me on this because I am relying on my terrible memory for the ratios, but certainly China is aging rapidly.

That makes the need to address the one-child policy more urgent than ever. The members of China’s big baby boom of the 1950s and early 1960s are for the most part still working, but in ten to twenty years they will be moving into retirement, and the number of working age people whose efforts will be needed to support them is not growing nearly as quickly. To solve the problem China needs more young people.

The problem is that while a relaxation of the one-child policy may be very good for China in the long term, and perhaps even necessary if China is not to suffer a terrible old-age crisis in the next few decades, in the short run it may create even more demographic challenges that may make the authorities less willing than ever to move.

For that reason it is worth considering what the impact of a relaxation of the one-child policy might have in the medium term. In the long term birth rates would probably decline naturally in China as they have everywhere else. I read one poll that suggested that most urban Chinese said they wanted to have at most two children, and I think in twenty or thirty years Chinese fertility, even without a one-child policy, would be similar to that of many other urban Asian countries.

But in the short to medium term if the one-child policy were to be relaxed there would almost certainly be a baby boom. That suggests that for the next 20-25 years China’s dependency ratio, which is already expected to deteriorate dramatically after 2010-2011, will probably get a lot worse before it gets better. A smaller proportion of China’s population, in other words, would need to produce the goods and services – including expanded health care, education facilities, and a social safety net – needed by a rapidly-growing elderly population and a rapidly-growing population of children.

As an aside, my friend Dan Rosen and I have in the past discussed the evolution of China’s trade balance and foreign currency reserve position, and Dan has argued, and I agree, that one consequence of China’s aging population may be future pressure on the trade account. It may not be irrational, in other words, for China to accumulate such a huge stockpile of foreign exchange reserves because for some period in the future China may be forced to pay for demographic adjustments and finance a trade deficit by liquidating foreign holdings. If China were to experience a baby boom in the near term the pressure would be even greater.

According to Friday’s China Daily (and a host of other newspapers around the world), a just published Gallup survey claims that most Americans think China will be the world’s largest economy within 20 years. We obviously need to take these opinions with a grain of salt since, according to the same survey, 40% of Americans believe the China is today the world’s top economy, compared to 33% who believe it is the US. Since the US economy is currently more than four times the size of China’s, it is a little hard to understand why 40% of Americans think China’s is the world’s largest, but there you have it.

I suppose it is the combination of China hype and US paranoia that explains these bizarre opinions. To their credit, it doesn’t seem that informed opinion in China takes the results of this survey very seriously. The China Daily article pointed out that Chinese experts are a lot less confident about the validity of these predictions than their American counterparts, and I suspect they are right.

Perhaps this Chinese skepticism is because Americans have made similar predictions before, and these predictions turned out to be absurd. It was well known in the late 1950s that thanks to their superior technology and better economic management the Soviet Union was all but certain to overtake the US economically before the end of the 20th Century. That didn’t pan out, of course, but without missing a beat Americans then switched their focus to Germany, whose inexorable rise as a quality-oriented export machine in the 1960s and 1970s made it seem that it was just a matter of time before it did the trick (in the 1930s they were also supposed to overtake the US at some not-too-distant time, but that didn’t pan out either). By the mid 1980s all other contenders were chucked into the waste bin when it seemed breathtakingly obvious that the Japanese juggernaut was the one that would crush everyone before it. Now, apparently, it is the turn of China.

I don’t want to make too much fun of US paranoia. Americans are intensely competitive and we seem to need a serious challenger to justify ourselves existentially. Perhaps that is part of our strength. On the other hand, as I’ve seen printed on numerous t-shirts, “Just because I am paranoid doesn’t mean they aren’t out to get me.” So is the paranoia justified?

I pulled out my trusty calculator to see what it would take for China’s GDP to overtake that of the US by 2028. If we assume that China grows by 10% a year for the next few decades years, and that the US grows by 2% a year during that same period, the mathematical conclusion is inescapable: the Chinese economy will equal that of the US in twenty years and will be nearly six times as big by the middle of the century.

But how likely is this? In my opinion it is extremely implausible. First, US GDP growth is much more likely to average 2.5-30% a year, as it has for much of its recent history. Second the idea that China can grow at 10% on average for the foreseeable future is, to put it charitably, a little unlikely.

Why is it unlikely? Since it began its reforms in the mid-1970s, China’s economy has in fact grown at roughly 10% a year, and participants in the earlier “Asian miracle” were also able to achieve similar levels of growth for many years, so why is it so hard to think that this growth level cannot continue for China into the indefinite future?

Let us leave aside the statistical observation that it is far more likely for smaller countries to end up in the “tails” of a probability forecast than for a country as large as China – in other words for purely statistical reasons small countries are more likely to be on the very high or very low end of a standard distribution of outcomes than are large countries. This observation, by the way, dovetails nicely with the actual range of historical growth rates in Asia, where smaller countries have been both the best and the worst performers. There are still at least three other sets of reasons why this 10% forecast is unlikely and why we need to adjust these numbers sharply downwards.

Special circumstance

The first set of reasons involves the special circumstances that have so far underpinned China’s recent growth and its sustainability, the second has to do with demographics, and the third has to do with a few obvious emerging problems facing China’s economy as it continues to grow. To address the first set of reasons, Chinese growth since the 1970s, as I see it, was powered by three special circumstances, none of which are sustainable over the long or even medium term. The first special circumstance occurred in the early stages of China’s reform, when Deng Xiaoping began to unshackle the Chinese economy in the late 1970s. As is widely known, many of his immensely successful government reforms consisted simply of unwinding some of the policies of his predecessors – which were among the most inefficient economic policies ever put into place.

Remember that in the 1930s, China’s per capita income was not much below that of Japan and Taiwan, and I believe it was higher than that of South Korea (although perhaps not of the more highly industrialized North Korea, which anyway put into place some of the same policies that China had before the Deng Xiaoping reforms, and suffered a similar fate). China’s per capita income at the time was also substantially higher than many of its Asian neighbors who subsequently undertook their own economic reforms, and who still far surpass China in GDP per capita. Under the economically repressive policies of its early leaders post-1949 China fell way behind its neighbors, and so it is no surprise that simply unwinding some of the policies that so sharply repressed Chinese economic growth would have created a massive growth spurt that would allow it to narrow the tremendous lead its neighbors had enjoyed. In a similar way I have little doubt that when North Korea finally begins its economic reforms, its growth rate will even surpass that of China as it too is able to take advantage of the reversal of economic repression.

China is still benefiting from unwinding of its failed economic experiment, but clearly as China advances it becomes harder and harder to sustain the growth differential simply by removing the earlier political impediments. Simply put, once all the worst policies of the 1950s, 1960s and 1970s are eliminated, there will be no more free lunch.

The second big cause of recent growth, in my opinion, was the tremendous fiscal expansion China underwent in the 1990s. It is hard to measure the extent of this expansion because it occurred almost entirely through a rapid expansion of bank lending to unprofitable state-owned enterprises, but it also left the banks saddled with enormous amounts of non-performing loans and it nearly crippled the banking system. This hidden fiscal expansion still occurs to some extent, but clearly there are very tight limits as to how much more expansion the government can engineer, and of course fiscal expansion is not a free lunch. It must be paid for in the future.

Finally, the third cause of extraordinary growth (and the period of most extraordinary growth) began roughly in 2003 or thereabouts, when China found itself locked into a monetary regime that resulted in out-of-control money expansion. China is still living with this monetary regime, and while the early stages of this kind of growth are always wonderful – asset price increases, plentiful credit, rapid growth – at some point the consequences, as we are already seeing, lead to significant economic imbalances and the need for adjustment. We may begin to see already in 2008 the process of this unwinding. At any rate, this latest phase of Chinese growth is also unsustainable, in my opinion (for reasons I have discussed many times in this blog).

The demographic crisis

So assuming that there are no special changes or challenges facing China, and assuming that absent these special circumstances things can continue as they have, what is a reasonable projected growth rate? I am not smart enough to say, but certainly I think we can say 10% annual growth for the medium- or long term horizon is at best the upper limit, not the expected mean. Let’s assume that if current circumstances remain in place and if we eliminate the special circumstances that underpinned the impressive growth rates of the last three decades, China can grow at an upper limit of 9-10%. I think this may be a little generous, but I want to be conservative as I work this number down.

That brings us to the second set of reasons why a 10% annual growth rate is unlikely for the future – the demographic challenge. During the period of Chinese growth since the late 1970s, China benefited from a double advantage. Not only was its population growing, albeit slowly, but more importantly, its dependency ratio improved dramatically (the dependency ratio is the percentage of non-workers – basically the too-old and the too-young – in the total population).

After the horrors and dislocations of the anti-Japanese war and the subsequent civil war, with the establishment of peace and the New China in 1949, the country not surprisingly enjoyed a baby boom. One consequence of the baby boom, of course, was deterioration in the dependency ratio, as an explosion of births meant that an increasing fraction of the population was too young to work. From 1949 to the mid-1970s China saw its dependency ratio rise (deteriorate) quickly.

This deterioration in the dependency ratio began to reverse itself in the 1970s as young people born in the 1950s and 1960s became old enough to join the work force, causing a surge in employable workers. With the implementation at that time of the one-child policy, the improvement in the dependency ratio accelerated sharply as China saw the number of children drop as a share of its population. The combination of the two factors was impressive. Thanks to the maturing baby-boomers and one-child policy, from the mid-1970s to the present China enjoyed one of the most dramatic improvements in the dependency ratio that the world has seen.

This had to come to an end, however, because fewer children today also means that in the future there will be fewer workers. Demographic experts project that China’s dependency ratio will continue improving for another two or three years, but after that it will begin to deteriorate almost as dramatically as it had previously improved (the baby boom moves into retirement but there are too few young adults to replace them). This deterioration will be exacerbated by the fact that China’s total population is at or near its peak, and will decline slowly over the next few decades.

How will this affect Chinese growth? It is of course hard to say, especially since the scale is unprecedented and we don’t have too many examples of similar circumstances with which to compare China, but economic growth is equal to the growth in the number of workers multiplied by the growth in productivity per worker. From the mid-1970s to now, my very rough back-of-the-envelope calculations suggest that China’s working population grew on average by about 2% to 2.5% a year. From 2010 to 2050 my equally rough calculations suggest that the working population will decline by around 1% annually.

That means that China will face roughly a 35 to 3.5% differential growth rate of workers between the last 30 years and the next 30 years. There are too many unpredictable factors that can result from this decline in workers, so it is dangerous to imply any precision at all in my predictions, but I would guess that a plausible, unbiased prediction would suggest that in order to account for this dramatic change in the growth rate of the working population, we should reduce the current “equilibrium” growth rate by 3.0-3.5%.

That takes us to projected growth rates of around no more than 6-7%, and perhaps less. This may seem like a very low number (and there are additional reasons to think it should be adjusted downward). Certainly it is well below what nearly every economist seems to be predicting for China, especially in light of the high and persistent growth rates enjoyed by other Asian countries, but it is not as crazy as it sounds. It is true that many Asian countries were able to generate growth rates at substantially higher levels for many years, but a significant part of that growth was also generated by improvements in the dependency ratio. I have seen one World Bank report that argues that as much as 30% of the Asian “miracle” can be explained by this factor alone, and of course Paul Krugman in his notorious Foreign Affairs article (in 1997, I think) argued that much of the rest of Asian “miracle” growth could be explained by other factor labor-growth-related inputs. As surprising as it may seem at first, it is not out unreasonable at all to assume that a sharp reduction in the growth rate of the working population must also result in a sharp reduction in output growth.

By the way demographic changes do not have the same adverse effect on the US because not only is the US population growing steadily during this whole period (from four times as big today, China’s population may be 2.5 to 3 times as big as the US by 2050), but its dependency ratio is more or less stable. US population is expected to grow at around 1% annually into the middle of the century, and its working population is expected to keep pace – and perhaps even grow a little faster as Americans are increasingly likely to work later years.

Emerging problems

These two sets of sets of reasons explain why I think a projected 10% annual growth rate into the medium term is very optimistic, but there is still a third set of reasons to doubt the optimists. China has many other, almost unimaginably tough problems that need to be addressed in order to maintain high growth rates, and by addressing these problems the “equilibrium” growth rates may, and probably will, decline. One of the most obvious is that Chinese growth has come at the expense of a very serious degradation of its environment. Chinese environmental problems are by now so well known that it is unnecessary to argue why this process isn’t sustainable in the long run or even in the medium run, but it is worth wondering what the growth consequences will be when Chinese businesses are no longer able to count on the free depletion of their natural endowment.

What do I mean by this? If I create $10 of economic value in my factory while destroying $2 of economic value by depleting my natural endowment, my real contribution to the economy should be measured as $8. However in recent years Chinese businesses have been able to ignore the $2 they have destroyed (polluting rivers, destroying agricultural land, etc.) and have claimed the full $10 as economic value-added. This can’t go on for ever, and once these businesses are forced to recognize and pay for the $2 of damage, their contribution to economic growth per equivalent unit of activity will decline. This must show up as slower GDP growth (and I am not including the cost of reversing the previous environmental degradation).

I have no idea what the net effect will be, but I have heard estimates of the annual cost of environmental degradation ranging from 1% to 3% of GDP. Let’s say that these numbers are exaggerated, and that there are also secondary GDP benefits to environmentalism, perhaps it is still reasonable to shave 0.5% to 1% off GDP growth projections.

There is more. China has a severe water shortage – it is so bad that many water experts refer to a looming water crisis in the next decade. I am not enough a good enough economist or engineer to figure out the economic impact, but it can’t be controversial to suggest that the need to resolve the water crisis will somehow constrain economic growth. This constraint may be very significant, especially in the north where the water crisis is most severe.

Similarly with other commodities. For China to catch up to the US in total size by 2050, Chinese per capita income in 2050 must equal or exceed US per capita income today (I explained why in an entry last month). It is hard to imagine that if 20-25% of the world population move from the poverty of China today to the consumption level of the US today, the demands on the world’s resources won’t be strained somewhat. This will undoubtedly have a cost to GDP growth. By the way, one measure of how implausible the idea that China’s GDP will equal that of the US by 2050 is precisely that it would require Chinese per capital income in 2050 to be equal to or more than US per capita income today. Anyone who has traveled though China will find that a little hard to imagine.

But wait, since constraints on the world’s resources are a global problem, and not a Chinese problem, won’t that also constrain US growth? Almost certainly yes, but it seems pretty safe to say that the world’s wealthier, more flexible economies generally suffer less from high commodity prices and commodity shortages than the poorer countries, so the cost will be borne disproportionately by China and other poor countries.

I am ignoring in my calculations the possibility of serious social or political disruptions because these possibilities don’t necessarily change the expected outcome – they simply reduce the certainty we associate with those expectations. The most obvious uncertainty is political. Given the rapid social change China is undergoing (probably unprecedented in history in its magnitude) and the rigidity of its political structure, it is very hard to make a meaningful prediction about how the political system will react to the tremendous pressure China faces. Still, it is at least as plausible to argue that there will be occasions of difficult change and adjustment, and that these periods may have adverse economic impacts, as it is to argue that the process will be smooth and uneventful. This means that whatever the expected outcome, we would have to assign a much wider standard deviation than we might have for predictions about other countries.

I could go on, but I will make one final point. It is fairly well accepted among economists that rapid growth is easier for countries that are further behind technologically than the leaders, but as these countries advance the speed of the catch-up declines. This will probably happen to China too.

When will China overtake the US?

So where does that leave us? It is hard to say. These projections are necessarily imprecise and the mathematician in me insists that false precision is a great as sin as bad math, so I don’t want to refine the numbers too much. In the end I have no idea what a reasonable projected growth rate for China is for the next few decades, but I am very certain that 10% is implausible – almost impossible. I would suggest that anywhere between 5-7% is far more likely, and even lower numbers are not implausible. As you can see if you have been following the math, I am actually marking down my projection by a lot less than my arguments above would indicate because, like anyone else, it is not easy for me to want to vary too widely from the consensus. You can just write it off to my cowardice and inability to trust my own arguments.

At any rate if I reprogram these new set of numbers into my calculator, I show the following:

1. If we assume that the US grows at 2% a year forever, and that China grows at either 5% or 7% forever, in the first case China will be two-thirds the size of the US by the year 2050 and in the second it will be one-and-a-half times the size of the US by 2050.

2. If we assume the US grows by 2.5% forever, in the first case China will be little more than half the size of the US by 2050 and in the second case it will be 40% bigger.

3. If we assume the US grows by 3% forever, in the first case China will be little less than half the size of the US by 2050 and in the second case it will be 10% bigger.

4. Even in the most favorable relative case for China, China will be less than half the size of the US in 20 years. My guess is that this calculation distorts the likely outcome a little because whatever the average growth rate for China over the next forty years, it is likely to be higher in the first twenty than in the second (for many of the same reasons I downgraded the forecast). Still, it is in my opinion extremely unlikely that China will overtake the US in size within 20 years.

The world seems fervently to believe that China’s rise as the world’s largest economy is more or less a done deal even though it is hard to get the numbers necessary for such an outcome to work. China is clearly a large and growing economy, and there is little doubt in my mind that it will soon be the world’s second most important economy. There is even a possibility that it will be the world’s largest economy within our lifetimes, but that possibility is no certainty and, in my opinion, is not even highly likely. Perhaps paranoia just sells better.

Tags: Overtake

I am often asked if the one-child policy is still in force here in China.  It is a confusing topic and I know there are lots of exceptions, but China Daily recently released some interesting information about the most recent population census.  In 1990 there were 3.92 people in each family in China, on average.  That declined to 3.44 people in 2000, and to 3.13 in the most recent census, which ended in early 2006.  This seems to me to be a pretty dramatic decline in family size in such a short time.

 

People under the age of 14 represented 19.55% of the population in 2006, down from 22.89% six years earlier.  The share of the population of people over the age of 65 rose from 6.96% to 9.10%.

 

Urban population in 2006 was 44.8% of the total population, compared to 36.1% in 2000.  A rough back-of-the-envelope calculation suggests that this implies net migration over the last six years if about 110-120 million, although I am sure this is understated, since many rural migrants are living illegally in the cities and are probably still listed as residing in their home towns – and although this should have been captured in the census, I am not sure illegal migrant workers are likely to want to talk to guys taking notes..

 

By the way, in another article today, the China Daily says, in reporting about the recently released (Thursday) annual report on social development by the Chinese Academy of Social Sciences: “The Engel Index, a measure of what percentage of a person’s income goes into food, was 35.8 percent for urban residents, 1.9 percent less than in 2002. For rural residents, it was 43 percent, 3.2 percent less than in 2002.”

 

Adding all this stuff together, I get that food spending comprises 40% of total income on average for the country.  I am not sure how you calculate the food component of the CPI basket from this, but I would guess that since total expenditures are less than 100% of total income, the food component of the CPI basket should be higher than 40%.  I cannot reconcile this number with the claim that food comprises 33% of the CPI basket.  As an aside the report says that 66.5% of urban respondents and 57.6% of rural respondents listed rising prices as the most worrying social issue of 2007.

 

On a separate note, in today’s edition the China Daily discusses a new report by the Chinese Academy of Social Sciences which claims that Chinese consumer spending will hit a two-decade record low this year:

 

Despite a rosy picture about income growth, consumption by Chinese residents remained at a low level. It contributed about 36 percent to the country’s gross domestic product (GDP) in the first three quarters, according to the report. The 2007 figure would hit a record low against around 60 percent in the period from the country’s opening up initiative in 1978 to 2002. The figure had slipped by bigger margins thereafter to reach a low of 50 percent in 2006.

 

I haven’t seen the report, but the China Daily article suggests that the combination of high food prices, high real estate prices and monetary tightening measures are driving consumption down.  If so, imports are also likely to decline, and with declining imports we will inevitably see more upward pressure on the trade surplus.  As I wrote last week, the model you use to explain Chinese inflation will determine whether the tightening measures are likely to make things better or worse. I am afraid that a rising trade surplus will make things worse, not better.  The next few months of inflation data will tell us.

Finally, and curiously, the PBC ended its annual policy meeting yesterday.  I am still waiting for the translation of the statement coming out of the two-day conference to appear on the website, but from what I gather, what they did not announce may be more interesting than what they did.

 

The PBoC said it will take more steps to cool inflation and overheating, using “tighter monetary policy” to “prevent price increases from spreading.”  No big surprise here, since the annual end-of-year Economic Conference last month made it pretty clear that overheating and inflation are the government’s top concerns for 2008.  The PBoC also announced the standard stuff about reforming the exchange rate system and liberalizing financial markets.  The statement seems to have been, however, a little skimpy on specifics. 

 

More importantly the PBoC did not announce growth rate targets for money creation or new loans, which, if I remember correctly, they have always announced in previous years.  Cary Huang of the South China Morning Post reports that “Sources said the meeting failed to announce the projected annual growth rate for the money supply or for lending due to differences among officials.”

 

There have been rumors for a while now about sharp disagreements between “pro-growth” elements of the leadership versus those who are worried about imbalanced growth caused by excess monetary expansion.  The former see little to no overheating in the economy, are worried about a US recession and about domestic unemployment, think inflation is a one-off food problem that will soon be reversed, and want to leave the money spigots on more or less at full blast.  The latter worry about overinvestment and excess capacity creation, rising inflation, and explosive growth in money and new lending, and are looking for ways to slow down money creation.  For me the most important result of December’s Economic Conference was that it seemed to represent a shift in concern away from the former to the latter, but that doesn’t mean that the conflict is resolved.

 

In and around March there will be the major reshuffling of top level positions, including provincial governorships, decided during the Plenum, and traditionally the imposition of new leadership is a time of explosive growth in new investment projects as the new provincial leaders try quickly to make a favorable impression.  That may be part of the reason for resisting caps, especially quarterly caps, on new loan growth.  I understand also that a number of banks are under pressure to provide more loans to their best clients and are worried that they may be constrained from doing so.  Finally, the possibility of a US recession is also weighing heavily on the minds of some.

 

The argument over China’s future monetary policy is far from over, and that is going to matter a lot in 2008, even if you believe, as I do, that their attempts so far to rein in excess money are focusing on the wrong things.  If inflation and investment numbers stay high in the first quarter of this year, which I expect, the pro-growth groups may lose further prestige and power, but if China is indeed suffering from monetary expansion, as I think it is, the longer we keep this game going the harder it will be to adjust.