Over the past 15 years, the United States has become the world’s sole superpower, dwarfing every other nation in terms of economic and military might. And while Japan, Russia,..
The Increasingly Binary Global Economy
Over the past 15 years, the United States has become the world’s sole superpower, dwarfing every other nation in terms of economic and military might. And while Japan, Russia, and the EU have fallen further behind, one nation has emerged to join the U.S. as the primary driver of global prosperity: China. In astronomical terms, we might envision the U.S. and Chinese economies as two stars revolving about each other, while accelerating and pulling a host of planets along with them.
This trend has emerged so quickly that few people really understand it. Consider that, over the past four quarters, the world economy has grown at nearly 5 percent ? its fastest pace in two decades. That growth has been enabled by two factors:
1. America’s loose monetary policy, which has encouraged consumers to keep spending.
2. China’s unprecedented investment boom.
As a result, America and China together generated almost half of global growth over the past year. It’s important to recognize that these two drivers are not independent, but mutually reinforcing. The Yuan is pegged to the Dollar. China’s higher interest rates have attracted large inflows of capital that have inflated domestic liquidity, encouraging intensive investment and excessive bank lending in some sectors.
This means that, in the short-term, we are not faced with a meltdown like the one that occurred in the early 1990s. Fortunately, the Chinese economy is not as overheated as it was then, when investment, credit, and inflation were all growing much faster. Furthermore, the authorities have acted much sooner to correct imbalances.
As a result, we’re likely to see Chinese economic growth slow for a soft landing, which most economists are defining as 7 percent annual GDP growth. This Chinese slowdown is also likely to slow the pace of global growth, but nothing like the shock of the Asian economic bubble collapse of a decade ago.
But what’s going to happen in the longer-term? As investors, business professionals, and Americans, what can we expect to happen? And, what can we do to make the most of it? To answer those questions, we need to look at why China is suddenly making such a large impact on the global economy.
As The Economist recently reported, most of China’s growth over the past quarter-century can be explained by high rates of investment and the movement of workers from subsistence farming to more productive use in industry. Looking ahead, there are still enormous opportunities to increase productivity as workers move from rural occupations into industry. Today, two-thirds of China’s population still live in the countryside: a much higher share than in Japan at the same stage in its development.
Moreover, unlike many low-wage nations, China has the advantages of good infrastructure, an educated workforce, a high rate of saving available to finance investment, and an extremely open economy. Its average tariffs have fallen from 41 percent in 1992 to 6 percent today: the lowest tariffs of any developing country. Many non-tariff barriers have also been dismantled.
And more importantly, China has welcomed foreign direct investment, which has driven growth by increasing the stock of fixed capital and by providing new technology and management know-how. Joint ventures with foreign firms produce 27 percent of China’s industrial output. Even the steadily shrinking state-owned sector is expected to boost productivity by ensuring a better use of resources. China’s private sector, which now accounts for about half of its GDP, is growing twice as fast as the rest of the economy.
Looking back to the history of Japanese emergence, we can safely say that China’s ascent will affect the outside world more than Japan’s did in its time. That’s not only because of the potential size of its economy, but because of two distinctive features:
First, for such a big economy, China is unusually open to trade and investment. This year, the sum of exports and imports of goods and services is likely to reach 75 percent of China’s GDP. By comparison, for the United States, Japan, India, and Brazil, the figure is 30 percent or less. At its peak, Japan’s trade reached only 32 percent of its GDP. Similarly, the stock of total investment in China by foreign firms is equivalent to 36 percent of China’s GDP, compared with 2 percent in Japan.
Second, Chinese manufacturers have access to an almost unlimited supply of cheap labor. By some estimates, there are almost 200 million underemployed workers in rural areas who could move into industry. This labor surplus will take at least two decades to absorb. This will continue to hold down wages for low-skilled workers, who currently earn less than 50 cents an hour. By contrast, Japan and South Korea absorbed their rural labor much more quickly.
Despite this progress, The Economist points out, China faces many obstacles to growth: its fragile banking system, the lack of a transparent legal system, corruption, the risk of social and political unrest caused by widening income inequalities or the abuse of human rights, and severe environmental pollution. Yet if reforms continue, there are good reasons to believe that rapid growth can be sustained.
The idea that China may become the world’s biggest economy, with an enormous army of cheap workers, fills many in the rich Western world with dread. Yet China’s combination of rapid growth, vast size, and openness could generate wealth for people and businesses outside China as well as at home. Somewhat like America when it entered the world economy in the late 19th century, China will be giving a huge boost to both global demand and supply.
What will that mean for the developed world, and particularly the United States over the next two decades? No one can say for sure. However, the available data and the fundamental laws of economics provide the basis for some meaningful forecasts.
Let’s start by considering the future shape of the Chinese consumer markets. China is the world’s fastest-growing market, and by around 2010, total spending in absolute dollar terms there will probably be increasing faster than in America. Even if average incomes remain low, a growing number of Chinese will enjoy high incomes.
For example, if China’s real income grows by 8 percent a year and its income distribution remains unchanged, by 2020 the top 100 million households will have an average income equivalent to the current average in western Europe. That will open up a vast market for consumer goods. For global enterprises positioning themselves in China, this is a very attractive opportunity. Similarly, as C.K. Prahalad reminds us in his recent book The Fortune at the Bottom of the Pyramid, technology is likely to yield exciting ways for these multi-nationals to serve China’s 700 million impoverished residents profitably, who will still be poor by Western standards in 2020 and beyond.
However, the biggest economic impact of China will be the supply-side stimulus that it could give to developed economies. In the October 2, 2004 issue, The Economist presents seven specific forecasts:
First, China’s development will expand the size of the global market. As Adam Smith observed, “the bigger the market, the greater the scope for the division of labor.” Opening up China should boost global productivity growth by allowing greater specialization and other economies of scale. Initially, China is likely to specialize mainly in relatively low-skilled labor-intensive manufacturing, whereas developed economies will concentrate on activities needing higher skills. Jobs will be lost in manufacturing in the developed world, but new jobs will be created, largely because most of the money that China earns from exports is being spent on imports from rich economies. Sustained growth in income and jobs relies on a continuous shift of resources to higher-value industries. A frozen job market with no hiring or firing would be in nobody’s interest.
Second, another important way in which China will affect the world economy is by changing relative prices. A country can become better off not just by producing more, but through a rise in the price of what it produces relative to the price of what it buys. The prices of products that China makes will fall; the prices of goods that it needs to import will rise. China is already pushing down the prices of labor-intensive manufactured goods, thereby boosting the real incomes of consumers in developed countries. For example, the average prices of shoes and clothing in America have fallen by 30 percent in real terms over the past 10 years. At the same time, there will be a rise in prices of capital- and skill-intensive goods and services, which China needs to import. Admittedly, these gains for developed economies are being partly offset by higher prices for oil and other raw materials, which China also needs to import, but producers of raw materials, such as Australia, Brazil, and South Africa, have gained handsomely over the past couple of years. However, a recent analysis by the IMF concludes that while China’s full integration into the global economy will benefit most of the world, some other Asian countries, such as Bangladesh and Cambodia, could be net losers, especially once global import quotas for textiles and clothing are scrapped next January.
Third, China’s demand for oil and other commodities is expected to skyrocket for at least the next two decades. The recent spike in global oil prices has been fueled by a combination of increased Chinese demand and short-term supply fears related to terrorism. China is already the world’s biggest consumer of many commodities, such as steel, copper, coal, and cement, and the second-biggest consumer of oil, after the United States. Therefore, changes in Chinese demand have a big impact on world prices. It is no coincidence that oil prices hit an all-time high this year. China still has a modest share of global oil demand, at 8 percent, but it has been responsible for nearly 40 percent of the increase in global consumption since 2000. China’s surge in energy demand is also the main reason for the doubling in the world price of coal over the past year. Last year, China consumed 40 percent of all the coal and 30 percent of all the steel in the world, and accounted for most or all of the increase in world demand for copper and steel. China is therefore responsible for much of the 50 percent rise in The Economist’s commodity-price index over the past three years. In around 20 years’ time, China’s income per person could be close to South Korea’s today. If its energy consumption per person also rose to current South Korean levels, its energy demand would quadruple. The increase alone would be greater than America’s total consumption today, yet China’s energy use per person would still be only half that in America. At present there is only one car for every 70 people in China, against one car for every two Americans. If car ownership were eventually to rise to American levels, there would be 650 million cars on Chinese roads ? more than all the cars in the world today.
Fourth, China’s success could encourage other emerging economies to speed up reform. Jonathan Anderson, an economist at UBS, argues that China is one of the most rapidly liberalizing economies in the world, and is opening markets far more than India or Brazil. Its reliance on imports and exports could well make it a champion for free trade. Based on the expectation that other big emerging economies will copy it, China’s economic integration could boost annual growth in developed economies, including the U.S. and EU, by half a percentage point for the next two decades. Add in the faster growth in emerging economies themselves, and the world economy might enjoy growth of 1 percent a year more than it would have done otherwise. That would surpass the boost to productivity growth the U.S. is receiving from the IT revolution. Moreover, the benefits from China’s integration may continue to accrue for much longer than the IT boost. China’s GDP per head, even after adjusting it for purchasing power parity, is still only one-eighth that found in the U.S. Suppose that over the next 50 years China’s real income per head rose by an average of 4 to 5 percent a year, lifting it to a still-modest half of that in America today. That would imply an increase in China’s GDP at today’s prices of more than $40 trillion; in other words, it would be nearly four times the size of America’s economy today.
Fifth, the benefits and penalties of integrating China into the world’s economy will not be shared equally among developed nations. Individual countries can maximize their gains from Chinese integration and minimize their losses by making their own economies more flexible, increasing mobility between sectors, and improving education. A study by the McKinsey Global Institute looked at what happened to workers who lost their jobs because of firms moving their production to low-wage countries such as China or India. McKinsey estimates that in America, 70 percent of them find new work within six months, but in Germany only 40 percent do, partly because of a generous benefit system as well as strict hiring and firing laws. Another study by Ben Broadbent, an economist at Goldman Sachs, suggests that consumers in the EU have also benefited much less from the outsourcing of production to low-cost countries than have consumers in America or Britain, who have enjoyed a sharp decline in the price of clothes in recent years. But in the EU, clothes prices have not fallen; they are now one-third higher than in Britain. Broadbent suggests that this is either because clothing manufacturers have been slower to outsource production, or because there is less competition, so retailers have not passed on cost reductions.
Sixth, as the two largest trading nations, China and the United States will be both economic competitors and allies. That’s because it’s in the interest of both to help prop up the other to insure a smoothly functioning international system. This is clearly demonstrated by the current and expected financial flows between the two. In a series of papers, Michael Dooley, David Folkerts-Landau, and Peter Garber of Deutsche Bank forecast that America’s current-account deficit will be financed by China and other Asian countries for at least another decade. The present arrangements, they say, look like a revived Bretton Woods, the system of fixed exchange rates that prevailed for a quarter of a century after the Second World War. Once again, America is at the center of the system. Under Bretton Woods, the periphery consisted of Europe and Japan, which used undervalued currencies, supported by capital controls and the purchase of dollar reserves, to rebuild their economies after the war. Under the reborn system, the periphery is made up of China and other Asian economies, which, it is argued, also peg their currencies to the dollar at artificially low rates. These countries want to keep their exports competitive in order to create jobs for their vast pool of underemployed workers. China compensates the United States for the rising imports and loss of manufacturing jobs in two ways:
First, it allows foreign firms to invest in Chinese factories, using cheap labor to earn fat profits.
Second, the Chinese government invests a large chunk of its export earnings in Treasury bonds, helping to finance America’s current-account deficit. This keeps American interest rates low and so supports US consumer spending. In essence, China is buying dollar assets to ensure that Americans can afford to keep buying its exports. The return on Treasury bonds is lower than the returns at home in China but, the Chinese government is prepared to pay that price to ensure export-led growth.
Seventh, China will increasingly participate in international economic-policy forums. China is currently not a member of the G7 group of finance ministers and central bankers, which includes the United States, Japan, Germany, the UK, France, Italy, and Canada, or the G8, which adds Russia. This makes no sense when we consider that China is the world’s third-biggest trader, and holds the second largest foreign-exchange reserves after Japan. We expect to see it receive membership in a “new G9” by 2008. That would give China a bigger stake in the smooth functioning of the global economy and ensure that its actions were coordinated with those of the other major economies.
Fears about the economic threat from China derive from four widely-held myths, detailed in the September 30, 2004 edition of The Economist, that the Trends editors expect to be fully discredited over the coming decade:
Myth #1: We import much more from China than we export. The reality is that China imports almost as much as it exports, and many of those imports come from nations with which the U.S. has a trade surplus. For example, China imports motherboards, memory chips, and other parts, while it exports personal computers. Thanks to this new global supply chain, China now has a trade surplus with America and Europe, but a deficit with most of Asia. Its overall trade position is close to balance. In other words, China spends virtually all its export revenues on imports. If China is taking jobs away from any country, it is other emerging economies like Mexico, not America.
Myth #2: China is taking market share from the rest of the world. The reality is that over the past decade, foreign multinationals’ subsidiaries or joint ventures in China have accounted for two-thirds of the increase in China’s exports. But that doesn’t mean that there are a huge number of American jobs being relocated to China. Goldman Sachs estimates that in the past three years, 1 million manufacturing jobs at most, have moved off-shore. Unlike Asian firms, which tend to use China as an export platform, most American and European firms have invested in China primarily to sell to the domestic market. Most job losses in the U.S. manufacturing sector have resulted from changes in technologies.
Myth #3: Even high-skilled industries in the developed world are at risk because China is moving up the value chain to higher-tech goods, such as mobile phones and personal computers. The reality is that electronic goods now account for 25 percent of China’s exports, but China’s imports of electronic components have grown just as rapidly. China still concentrates mainly on the labor-intensive assembly of such components.
Myth #4: China can make everything more cheaply, so all jobs will eventually shift there from high-wage countries. The reality is that low wages are linked to low productivity. As China’s productivity increases, its workers’ wages or the exchange rate will eventually rise. If the latest technology could lift China’s average productivity to American levels, and global industry shifted there en masse, China’s surplus labor would vanish and wages would soar. Also, even if China can make everything more cheaply than America, it will enjoy a much bigger cost advantage in labor-intensive industries such as making running shoes, because it has lots of cheap, low-skilled labor. As David Ricardo explained in the early 19th century, countries will be better off if they specialize in goods in which they have a comparative advantage and then trade with each other. America will always have a comparative advantage in something.
References List : 1. The Economist, October 2, 2004, "The Real Great Leap Forward. ⓒ Copyright 2004 by The Economist Newspaper Limited. All rights reserved.2. ibid.3. The Economist, October 2, 2004, "The Halo Effect." Copyright 2004 by The Economist Newspaper Limited. All rights reserved.4. The Fortune at the Bottom of the Pyramid: Eradicating Poverty Through Profits by C.K. Prahalad is published by Wharton School Publishing. ⓒ Copyright 2005 by Pearson Education, Inc. Publishing as Wharton School Publishing. All rights reserved.5. The Economist, October 2, 2004, "The Halo Effect." ⓒ Copyright 2004 by The Economist Newspaper Limited. All rights reserved.6. The Economist, October 2, 2004, "A Hungry Dragon." ⓒ Copyright 2004 by The Economist Newspaper Limited. All rights reserved.7. The Economist, October 2, 2004, "A Fair Exchange?" ⓒ Copyright 2004 by The Economist Newspaper Limited. All rights reserved.8. The Economist, October 2, 2004, "The Halo Effect." ⓒ Copyright 2004 by The Economist Newspaper Limited. All rights reserved.
