China’s Very Strange Decade

It's true that many of the elements of China’s mainland growth in the 1990s and the first half of this decade are similar to those of the Asian "tigers" 30 years ago. However, most observers today have only vague memories of those heady Asian growth days of yore, and in any case China's experience also has a number of unique elements. Consider the following trends:

1. The macro rollercoaster

No other country in Asia has seen so many sharp boom and bust cycles in rapid-fire succession. Its economic path has moved from massive boom in the mid-1980s to outright recession in 1988-89, back to nearly 15% real GDP growth again in the early 1990s bubble — and then back to hard landing in the latter half of the decade. In short, China has been a chronic macro "rollercoaster" for as long as most analysts have been covering the economy.

2. Rural stagnation

Another unique factor in China is the sharp contrast between supercharged increases in urban incomes and relative stagnation in the rural sector. From 1995 to 2003, disposable farm incomes barely rose as food prices fell and local governments imposed onerous taxes and agricultural fees. This situation pushed a disproportionate amount of investment into eastern seaboard areas, and left the rural economy behind.

3. Unlimited cheap labor reserves

Because of weak farm incomes and a large supply of excess young rural workers, Chinese manufacturing enjoyed a decade of virtually unlimited growth at essentially flat wages, which of course meant sharp gains in global market share without undue inflationary pressures.

4. Deflation

Normally high-growth economies have high inflation as well — but despite the fact that Chinese GDP expanded at nearly 9% year-on-year in real terms, average consumer prices actually fell in the second half of the 1990s and the beginning of this decade. This reflected a host of factors, including monetary tightening, low rural migrant wages and industrial overcapacity.

5. "Market share, everywhere"

China has not only taken over global light industrial markets (such as toys and textiles), it is also rapidly establishing itself as the premier electronics manufacturer. What's more, in the past few years the mainland has also suddenly exploded onto the scene as a net exporter of key heavy industrial materials and equipment. In short, China is currently the low-cost producer in virtually every goods category, a seemingly flagrant violation of the law of comparative advantage.

6. Enormous trade surpluses

For the past 20 years, China never recorded a significant external imbalance — until two years ago, when the trade surplus suddenly jumped to record-high levels. As we enter into 2007, the mainland current account surplus is running at more than 10% of GDP, an enormous level by international standards and virtually unheard of for a large continental economy. This puts considerable pressure on the currency as well as significant strain on China's international relations.

7. Global fixation with the renminbi

With large external imbalances and across-the-board Chinese manufacturing market share gains, global attention has fixed on the renminbi exchange rate as the root cause of all China's problems. The U.S. Treasury, U.S. Congress, the European Central Bank, the G7 working groups and most other international forums are heavily preoccupied with argument and debate over how to pry loose the renminbi from its current quasi-peg against the dollar.

8. Global fixation with "rebalancing"

In view of the list above, nearly every observer agrees that the Chinese economy is "out of whack." The consensus view is that imbalances have reached a point where they are not going away by themselves. As a result, global policy and academic circles are also engulfed in debate on how to rebalance mainland growth.

Back to the real world

The above list describes the situation over the past number of years, but in my view it does not apply to the future. In fact, every one of these trends is coming to a natural end — not tomorrow, of course, but the next two to three years will be a crucial transition period for bringing China back to the "real world":

1. No more boom/bust economy

A combination of ongoing privatization, market liberalization and better macro policy capacity have already considerably dampened the volatility of economic cycles in mainland China. With the current round of excess capacity creation winding down, one can expect a more stable growth outlook at 8.5% to 9% through the end of the decade.

2. Rising rural wages

From easier times over the past ten years, one of the most pressing concerns for Chinese light industrial manufacturers today is now "labor shortage." This doesn't mean the economy is running out of workers, but with over 100 million rural migrants already working off the farm and demographic pressures kicking in, the economy is running out of young, single workers. As a result, migrant wages are now rising more aggressively — and mainland exporters have been forced to increase prices accordingly.

3. The return of China's farmers

Farm incomes have benefited from increased migrant remittances in recent years — and even more from structurally rising food prices and higher government support levels. In fact, after years of stagnation, rural incomes actually grew faster than their urban counterparts in 2004-06. China's rural resurgence is one of the most exciting medium-term themes, with strong implications for new development and investment strategy going forward.

4. Back to inflation

Rising food prices, rising wages and the gradual winding of excess capacity all point to higher inflationary pressures over the next few years, and we are confident that China's role as a deflationary force in the global economy is coming to an end.

5. The end of manufacturing domination

The mainland may look hypercompetitive across all industries today, but this situation can't last very long. With cost pressures cutting into low-end competitiveness and strong demand — and slowing capacity growth pulling heavy industrial products back into the domestic economy — one expects China will begin giving up market share at both ends of the production spectrum.

6. Back to balanced trade

As this happens, the current massive trade surplus should peak and then subside over the next two years. The biggest drivers here will be renewed imports of industrial materials and equipment, as well as continued strong appetite for natural resources and commodities. Renminbi appreciation should help — but the currency would play a minor role at best.

7. No more renminbi fixation

If a falling trade surplus, ongoing capital account liberalization and state-led capital outflows relieve the central bank of its current intervention duties over the next two years or so, there would no longer be a "smoking gun" for an undervalued renminbi. This would take pressure off the authorities to further appreciate the exchange rate — and would also stifle cries of currency manipulation from the rest of the world.

8. The rebalancing of China

The consensus view is that China needs to take urgent steps to boost consumption and reduce household savings in order to rebalance the economy away from overinvestment. These are long-term priorities, but they are not the solution to near-term imbalances. Instead, China needs to reduce corporate savings through consolidating excess capacity industries. This process is already underway through market forces.