Richard Koo: Implications of rising food prices and Chinese wage inflation

Richard Koo r-koo@nri.co.jp

Nomura Securities Co Ltd, Tokyo Japanese Equity Research Flash Report

15 February 2011
Egyptian President Hosni Mubarak finally stepped down last week. The price of oil and other commodities fell back and markets stabilized as tensions eased. In Egypt, however, the only result was a transfer of power from the president to the military. The social and economic problems driving the demonstrations that ultimately toppled the governmentunemployment, delays in democratization, inflation, and the large gap between rich and poorremain unresolved. With no easy solutions to these problems, I think we should view recent events as little more than a temporary stabilization of the situation. There are also signs of popular unrest in other countries besides Tunisia and Egypt, and I think such movements have the potential to recast the balance of global power in the longer term. Adding to concerns is the lack of a solution to the rising food prices that helped fuel the recent uprising. Consequently, I think food prices will remain a destabilizing factor. * Rising food prices should not be addressed with monetary policy The recent rise in commodity pricesand especially in food pricesmay have both natural (ie, climatic) and man-made factors. Although nothing can be done about the former, there have been discussions about what central banks and governments can do to address the latter, chief among which is speculation. Some are even arguing that central banks should respond by shifting from fighting a deflation to a focus on inflation. To be sure, rising commodity prices need to be monitored closely because they can lead to higher prices for a variety of products. But it is difficult to argue that higher commodity prices should be addressed using monetary policy at a time when other prices remain stable. If all prices were rising or falling at the same time, that could safely be deemed a monetary phenomenon deserving a monetary treatment. But mobilizing monetary policy, which affects all prices equally, in response solely to rising commodity prices would be inappropriate. A tightening of monetary policywhich would have an impact on all pricesmight stabilize commodity prices, but could also lead to the deflation of other prices. That is why monetary policy is not the right tool for dealing with rising commodity prices, and why Fed Chairman Ben Bernanke took a cautions stance on such policy in a recent speech. * Speculative inflows to commodity markets should be taxed If commodity prices are rising because of an excess of investment or speculative funds, one option is for the government to repel hot money by levying a higher tax rate on short-term gains from these markets. For example, governments might assess a high tax on profits from positions held for less than three months, a somewhat lower rate for positions held for less than six months, and the original low rate on positions held for a year or more. This would reduce the number of commodities market speculators who feel they can enter or exit the market at a moments notice, leaving only those with a longer-term investment horizon. Such a measure would help to curb inflation driven by short-term inflows of hot money. (issued in Japanese on 14 February 2011)

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That said, the fact that commodity prices have spiked twice in the last three years can also be interpreted as a signal that the supply of commodities needs to be increased in the long term. In that sense, I think governments should welcome long-term capital investments in this sector aimed at boosting supply. One policy option might be to assess a heavy tax on short-term (< 1 year) funds while providing tax incentives for investments of a year or longer. * Rising commodity prices may be legacy of quantitative easing Although monetary policy should not be mobilized just to fight commodity price increases, central banks that are engaged in quantitative easing cannot ignore the recent surge in commodity prices. This is because the portfolio rebalancing effect, the only way quantitative easing can have an impact during a balance sheet recession, may have affected commodity markets. Fed Chairman Ben Bernanke has acknowledged that, when private-sector demand for funds is essentially nonexistent quantitative easing will not lead to an increase in the money supply. The policys effect is therefore limited to the portfolio rebalancing effect, whereby private fund managers take the proceeds from sales of Treasury securities to the Fed and invest them elsewhere, causing the prices of other assets to rise. But with businesses and households continuing to deleverage (ie, not borrowing) and the Fed purchasing the majority of newly issued Treasury securities as part of the quantitative easing program, the only investment options remaining for private fund managers are equities and commodities. If the recent rise in stock and commodity prices is attributable to such factors, I think quantitative easing needs to be reconsidered. While there may not be any downside to higher stock prices, rising commodity prices can negatively impact the lives of people in poor countries and thereby fuel social unrest, which clearly has negative implications for the global economy. There is no solid data on the extent to which funds from Mr Bernankes QE2 have flowed into the commodity markets. However, if the kind of situation described above does exist, I think it is time to reconsider QE2 itself. * A new view on Chinas economic situation I spent all of last week visiting investors in Australia with Chi Hung Kwan, an expert on the Chinese economy who works for the Nomura Institute of Capital Markets Research. Since hearing him talk about the Chinese economy, I gained inspiration on how best to interpret what is happening in the Chinese economy. It is well known that Chinas sustained rapid economic growth has resulted in numerous problems. Four in particular stand out. Domestic consumption is just 35% of GDP, and the country faces a widening disparity between rich and poor, a sharp increase in wages in coastal regions, and growing indications of inflation. Weak domestic consumption is the flip side of Chinas investment-driven economic growth, but a key contributing factor has been the Chinese preference for savings over consumption. The US government, for example, has criticized the resulting surplus of savings as a chief cause of the trade imbalance between the two nations. Many argue that the Chinese save so much because the country lacks a reliable social safety net, forcing them to put aside more money in preparation for old age. Consequently, Chinas economy cannot achieve a better balance until a stronger social security system is in place. I used to concur with this view. However, the outlook is bleak when we consider the amount of time it will likely take for a developing nation of 1.3 billion people to establish such a system and earn the peoples trust.

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* Chinas steadily widening income disparity Regarding the growing gap between rich and poor, many have argued that the issue of excess savings will not be resolved as long as Chinas growing upper class has a low propensity to consume. There have also been concerns that further increases in the gap between rich and poor would increase the sense of inequality in the nation, leading to discontent, riots and general social instability. This has been viewed as one of the key elements of Chinas country risk. * Rising Chinese wages and concerns about global cost-push inflation Surging wage levels, particularly in the nations coastal regions, have forced many businessesincluding Japanese firms with local production facilitiesto raise wages dramatically. Some firms are now asking whether they can continue to operate profitably in China or whether they should move their factories to lower-wage countries like Bangladesh. Rising wages have also led to an acceleration of inflation. Unless businesses raise wages they cannot attract the workers they need, but the concern is that inflation will continue to climb if many businesses raise wages at the same time. Concerns about wage-driven cost-push inflation have fueled worries that China, which until now has been exporting deflation as a result of its low wages, will start exporting inflation as domestic wage levels rise, and that this could lead to higher inflation around the globe. Although there are many other arguments regarding the Chinese economy, these issues are often discussed separately, as are the solutions being proposed. * Conventional wisdom on Chinese economy has begun to collapse But if all four of these phenomena can be viewed as part of a larger and inevitable progression of events leading to economic growth, it becomes possible to predict what is likely to happen and what needs to be done. The key factor here is that the huge surplus of labor in Chinas rural areas is beginning to dry up. The conventional wisdom until now has been that most Chinese were farmers, and with hundreds of millions of under-employed farmers available, urban factories could attract as much labor as they needed simply by paying slightly higher wages than were available in rural areas. This view was valid for some three decades after China began opening up its economy in 1980. However, it is now being undermined by the two factors discussed below. * Surplus labor in rural China dries up One is the one-child policy that commenced in 1980 and now, 30 years later, is beginning to act as a major brake on labor force growth. According to data released by the United Nations in 2008, Chinas labor force (those aged 1559) as a percentage of the overall population peaked in 2010 and is now declining. The other factor helping to overturn the conventional wisdom is that the countrys intensive industrialization, which started in 1980, elicited massive outflows of labor from rural areas and has largely eliminated the surplus of labor that characterized these areas. Official statistics describing Chinas urbanization indicate that approximately half the population still lives in the countryside. But when I spoke with Chinese government economists in Beijing at the end of 2009, I was told that these data are based on family registers, and that in reality more than 70% of Chinese are city-dwellers today. The authorities are now in the process of implementing major reforms to the family register system that will make it easier for people living in cities to transfer the registers

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from rural to urban areas. I was told that once those reforms are complete, the percentage of city-dwellers according to the official statistics will increase substantially. Mr Kwan also said that many villages in China now resemble rural areas in Japan in that they are populated almost entirely by children and the elderly. * Urban Chinese workers nearly six times as productive as rural counterparts Even in the official statistics, the percentage of total employment accounted for by primary industries had fallen to 38.1% in 2009, and these industries generated just 10.3% of the nations GDP. Other industries were responsible for 61.9% of Chinas employment and 89.7% of its GDP, which implies the average urban worker was nearly six times as productive as his rural counterpart. * But China was in capital-accumulation phase The problem is that these urban workers were not receiving wages commensurate with their productivity. In the past, city factories could attract as much labor as they needed simply by paying slightly higher wages than were available in rural areasregardless of how productive their employees werebecause there was a nearly endless stream of rural workers seeking work in the cities. No matter how much capital investment was carried out to raise worker productivity, companies did not have to pay wages reflecting that improved productivity, and as a result the labor share remained low for many years. This situation led to tremendous profits for the factory owners. Instead of the consumer surplus that economists often talk about, Chinas economy was characterized by a massive producer surplus. A large producer surplus meant large profits, which prompted owners to further increase investment, leading to further GDP growth. Meanwhile, the labor share of GDP actually decreased because wages did not keep pace with productivity gains. Capitalists share of GDP increased steadily, and the proceeds were reinvested in the hope of further profits. As a result, investments share of Chinas GDP growth continued to grow. From a longer-term perspective, China was in a capital-accumulation phase. The Chinese economy was able to take off, so to speak, because of the reinvestment of capital accumulated during this phase. * Winners (owners) and losers (workers) Exhibit 1 provides a graphic representation of the situation. Until recently, a seemingly endless supply of fresh labor from Chinas rural areas meant that wages did not rise along with the number of workers (the horizontal axis in the graph). In other words, the labor supply curve S is horizontal until the point (K in the graph) at which surplus labor from rural areas dries up.

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1. Model of Chinas labor market

Wages A S

B C Trapezoid ABGH ( ) H D Workers income G D1 Square GFIH ( ) E F I D2 No. of w orkers J M K D3 L China in the future (normalization of domestic demand)

Ow ners profit

China until now (capital-accumulation phase)

Source: Nomura

Even if owners hire more workers (ie, a shift in the labor demand curve from D1 to D2), the income for all workers will only increase by the amount described by the square GFIH (II) because wages do not rise. Owners profits, meanwhile, increase by an amount described by the trapezoid ABGH (I). As long as I is larger than II, any increase in hiring will result in higher profits for owners and push the labor share lower. The labor market structure is therefore the source of the nations income disparity. As long as there are large numbers of people in rural areas working for low wages, the income disparity between owners and workers will only widen. Meanwhile, if domestic consumption rises in proportion to the increase in II (square GFIH), consumption as a percentage of GDP will either fall or stagnate as the labor share declines. * Corporations, not workers, drove high savings and high investment Put differently, Chinas high savings and high investment were due largely to actions taken by foreign and domestic businesses investing in the country, and not to the behavior of ordinary workers. From a macroeconomic perspective, these businesses large profits and their reinvestment of the same appear as high savings and high investment. The people actually working in Chinese factories do not earn enough to save 60% or 70% of their salaries. If anything, the opposite is true: given their low wages, I suspect their propensity to consume (when we include remittances to family members) is extremely high. If so, neither corporations nor workers are likely to change their behavior significantly even if the government does succeed in bolstering the social security system, and the nations propensity towards high savings and low consumption will persist. After all, it is Chinas corporate sectorwhich is unaffected by the presence or lack of a social safety netthat is doing the saving.

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* Exhaustion of surplus labor could be trigger for higher wages Recently, however, there are signs that companies ability to attract unlimited quantities of cheap labor may be about to end. The reason is simply that the supply of rural labor is drying up. Nevertheless, Chinas labor share remains low, and there are many businessmen both inside and outside China who still believe, correctly or not, that expanding business in China will be more profitable than expanding it elsewhere. As I noted in my previous report, fully 84% of the developed nation CEOs interviewed in a PricewaterhouseCoopers survey said they had decided to boost investment in China and other emerging economies within the last two years. That suggests continued strong demand for labor at a time when Chinas productive population is beginning to decline and the supply of surplus labor in rural areas has dried up. With the supply of labor constant and the demand increasing, wages will almost certainly rise. The fact that many businesses are now giving in to employee demands for higher wages is, in a sense, a reflection of the fact that workers were not receiving wages commensurate with their productivity in the past. * Higher wages will drive structural changes in Chinas economy In the context of Exhibit 1, this represents the situation in which further growth in corporate demand for labor shifts the labor demand curve outward from D2 to D3. That will lead to a steady decline in the producer surplus and rapid increases in worker incomes, thereby resolving the problems of a widening income gap and sluggish domestic consumption. In short, if we agree that Chinas income disparity has been driven by an unusually large producer surplus, fewer new millionaires are likely to be created as that surplus contracts. A decrease in the producer surplus also entails an increase in the labor share and a corresponding increase in domestic consumption. And when it becomes clear that the economy will no longer generate the large producer surpluses seen in the past, investment will fall correspondingly, putting a damper on GDP growth. * Capex ratio will fall to global average as capital share drops That said, the fact that China is starting with a larger producer surplus then other markets means that investment is likely to continue growing until the gap narrows. Even if the capital share is declining, the fact that it started out at levels higher than those in other economies means that investment will continue to expand, although at a significantly reduced pace. This kind of investment will discontinue once Chinas capital share falls to levels similar to those seen in other countries. At that point I anticipate that capital investment as a percentage of GDP will settle around a level not appreciably different from those found in other countries. In short, the producer surplus will continue growing as long as the rural labor surplus persists, leading to widening income disparities and increased capital investment. While the absolute value of consumption will rise, its growth will be sluggish relative to investment. But once the labor surplus dries up, the producer surplus will begin to shrink, lifting the labor share. This will dampen capital investment and prevent further widening of the income disparity. At the same time, consumption will begin to grow rapidly.

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* Developed economies have all experienced problems now facing China Viewed in this light, most of the nations problems are in a sense part of an inevitable progression of events that is not unique to China. Other economies faced similar problems during the corresponding phases of their own development. To take the example of Japan, there was a large surplus of rural labor during the period of industrialization lasting from the Meiji era to the Showa era. Around this time numerous industrial groupings, called zaibatsu, emerged as major forces in the economy. Similar conditions were also observed in other developed nations, which also experienced widening income disparities. But as the high capital share prompts investors to continue reinvesting profits, the rural labor surplus eventually dries up. This causes wages to rise, and the income disparity contracts. Japan reached this point around 1970. To the extent that the labor share increased, domestic consumption grew and the producer surplus declined, prompting businesses to invest less (because profits were smaller). In Japan, this process was augmented by the postwar agricultural land reforms and break-up of the zaibatsu ordered by US occupation forces, resulting in a particularly even distribution of income. By the 1980s, Japan was unique in that nearly the entire population counted itself as belonging to the middle class. China had a communist planned economy until the end of the 1970s. As the economy subsequently opened up to the world, Chinese leaders took a different path from Japan and actively encouraged the introduction of foreign capital. This policy prompted companies from Taiwan and Hong Kong to build a huge number of factories in China, which along with subsequent investment by Japanese, US, and European firms absorbed all the surplus labor in Chinas rural villages in just 30 years. Had China, like Japan, refused to accept foreign capital, this process could easily have taken 50 or more. Another critical point was that China chose to emulate countries that had gone before it like Japan and Taiwan and build its economy around exports. This growth model, driven by the repeated reinvestment of a large producer surplus, is premised on the existence of willing buyers for the nations manufactured output. But as noted above, domestic demand in China is anemic at best, with personal consumption accounting for just 35% of GDP. It was only because of strong demand in overseas markets, coupled with the willingness of those markets to open their doors to Chinese products, that Chinas growth model was successful. * China in midst of transition from producer to consumer Chinas economic development means that while the country will grow more appealing as a consumer market, it will become a less attractive place to produce. At the very least, the capital share is unlikely to remain at past levels. I think China has tremendous potential as a consumer market as the purchasing power of Chinese consumers grows along with the rising labor share and the appreciation of the RMB. Last year Chinese automobile sales topped 18mn units, which is more than the sales of cars in Japan and the US combined. China was by far the worlds largest market for vehicles. When a large surplus of labor still existed in the nations rural areas, the first priority of government policy was to boost employment, and for that it was essential to foster laborintensive export industries. A strong currency is not desirable under those conditions. But once the problem of surplus labor is resolved and wages start to experience upward pressure, inflation becomes the more pressing concern, and a rising currency becomes useful.

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* Transition to consumption-led economy will leave authorities more tolerant of strong RMB If Chinas surplus of rural labor has in fact been exhausted, the authorities are more likely to tolerate additional appreciation of the currency. The rising price of wheat and other foodstuffs also makes it easier to support a stronger RMB, as higher overseas wheat prices limit the negative impact of RMB appreciation on Chinese wheat farmers. In summary, I think the Chinese authorities are likely to allow a gradual appreciation of the RMB as wage inflation becomes more evident. On the other hand, individual business owners are likely to reject this approach, claiming that rising wages and a rising currency represent a double blow to their global competitiveness. But we need to keep in mind that these are the same owners who did not pay workers wages commensurate with their productivity because the surplus of rural labor meant they did not have to. That golden era for owners of capital has now passed. As Chinas economy reaches full employment and wages normalize, labor-intensive industries whose business model is based solely on low wages will either have to raise employee productivity or leave China. Nearly all of these changes are occurring as part of an inevitable shift in Chinese demographics. I expect the balance between investment, consumption, and wages will gradually normalize as the remaining surfeit of rural labor dries up. Richard Koos next article is scheduled for release on 22 February 2011.

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