Part IV – Why China won’t follow Japan

China might well suffer from the consequences of the after-effects of its aggressive lending in 2009 and 2010. Bad debts are certain to mount for Chinese banks. Might these rising losses, combined with inflationary pressures, lead to a sharp puncture of the bubble? Quite possibly.

However unlike in Japan where a speculative crash accompanied the country into two decades of recessions and stagnation, a short-term crash in China won’t nullify the country’s forward-looking economic policy and planning.

As I noted in Part II, Japan’s fall from grace was due to country’s stagnant labour market and overall inability to navigate its economy forward. Comparative advantage is always far from static, i.e. others catch up. Japan was never able to direct investment and competition policy in a manner to ensure its ongoing and sustained growth. Eventually component manufacture and design moved offshore and little else replaced it. Japan’s reign as the next great economic power was over before it ever began.

China’s future is likely different.

At its most basic, China is still very much a developing country, thus the space for economic growth remains extremely large, especially given its relatively nascent domestic consumer market and its still comparatively low wage levels.

While some have disputed this latter notion, highlighting that between 1997 and 2007, average real wages in China more than tripled, recent research has shown that this increase is mostly associated with high skilled work in finance, science and the public sector. (Yang, Chen  & Monarch 2009). Low skilled manufacturing wages have grown much more modestly, and remain at or below those of their developing country neighbours.

Moreover, fears of labour shortage, both skilled and unskilled, have proven to be largely unfounded. Recent estimates show that there remains surplus rural labour of 110 million, of which 58 million is under 40. Similarly, urban unemployment, thought to have doubled in 2009 from 4.3 to upwards of 10 per cent, is an equally able source of labour inputs. On the higher skilled end, university enrolment continues to skyrocket with government figures noting 5.6 million university graduates in 2008, up nearly 20 per cent from the previous year. Similarly, the Chinese government is heavily recruiting Chinese expatriates and potential returners in order to help fill senior level skill shortages in the economy.

Overall, Chinese wages lie between 7 and 21 per cent of wages in developed Asian economies such as Hong Kong, South Korea and Taiwan, and a whopping 2.9 per cent of US wage figures, leaving a substantial differential and incentive for continued foreign investment in China.

Moreover, labour productivity in China continues to grow, in step with the diversification of the economy and associated labour market reforms. Between 2000 and 2005, labour productivity increased at  an average rate of 5.7 per cent. Research by Linda Yueh at Oxford University has shown that productivity increases in China continue to be on the upswing and are a result of labour reforms, domestic competition, and continued foreign investment.

For example, between 1996 and 2002, over 40 million State employees were laid off from their public sector employers, resulting in a 34 per cent increase in overall productivity. A secondary advantage of such reforms is the equivalent release of lower-skilled employees for the broader labour pool. Yueh’s research also shows that increased domestic competition, facilitated by government incentives and the creation of regional manufacturing hubs that compete for government subsidies, leads to a ten-fold increase in labour productivity. Finally, China’s openness to foreign investment, and its preference for FDI to be in joint-venture form, is likely the largest contributor to productivity increases. Yueh finds that for technology focused joint ventures, labour productivity increases by 57 per cent in the host firm.

The combination of significant wage differentials, rising skill levels and the potential for labour productivity increases will continue to incent foreign investment in China and thus continue to stimulate the local economy. And while much of this has been focused on the country’s export processing zones, it is likely that a growing share will focus on the domestic Chinese market, where government efforts to build the social safety net and simultaneously stimulate domestic spending rather than savings, could yield tremendous opportunity.

China’s openness to foreign investment, and thus by default foreign technology, is one of the major differentiators of China and Japan. Japan was notoriously unwilling to let foreign companies operate in Japan and saw FDI peak at $8 billion. Combined with higher wage levels and a rising Yen, the stalled growth of foreign investment in Japan, and the country’s high protectionist walls for domestic industry, forestalled the country’s ability to navigate an innovation based economy.

China on the other hand has well understood these lessons, and has continued to court foreign investment in new sectors of the economy, to the tune of some $55 billion annually. The entry of foreign competition into the country’s domestic markets as further incented productivity and efficiency increases, and has now borne globally-competitive high value industry.

Such competition is now the ethos of the Chinese version of capitalism. The State may still direct, or incent, investment and development in specific industries, but once established, they allow the market to determine the winners and losers amongst entrants. A virtuous circle of innovation ensues.

They’re now extending this concept of directed competition to higher education by developing what a highly-placed Canadian university official noted was “the academic equivalent of a special-economic-zone.” Covering 100km2 outside of Chonquing, the shared campus will house all institutions focused on a specific area of scientific research, and will see institutions and their faculty and students collaborate and compete for government funding.

Put all of this together, and its clear that China has so far been able to build a tiered-economy, one tier focused on low-value exports and the exploitation of a large, unskilled labour supply; the other on the creation of high-skill industry that has taken advantage of foreign technology agreements and increasing domestic education attainment.

And they’re far from done on this latter front.

Massive investments in infrastructure may be positioned as immediate job creation stimulus but may yield significant long-term advantages, especially with regards to the country’s development of high speed transportation links, university and colleges, and soon to be ubiquitous broadband access.

Cheap credit and government funding have seen China become the world’s leader in solar and wind power infrastructure, supplying much of the U.S.’s vaunted supply. It now has 5,000 scientists engaged in the emerging field of nanotechnology alone. And while in 1995, China ranked fourteenth in the world in the number of papers it published in science and engineering journals, by 2007 it was just second to the United States.  A 2008 study by the Georgia Institute of Technology found “that within the next decade or two, China will pass the United States in its ability to transform its research and development into products and services that can be marketed to the world.”

The future is where China wants to be.

And with its combination of labour market breadth (high and low end), government policy that increasingly incents competition and innovation, they’re likely to have much greater staying power than Japan did.

One area which will continually challenge China (amongst many) is its artificially-constrained currency. The entire world is shouting at China to allow a gradual, and significant, revaluation of the Renminbi as a means of narrowing trade deficits with China. These calls sound very familiar to those voiced by the US prior to the 1985 Plaza Accords. That accord saw the value of the Japanese Yen appreciate dramatically overnight in order to, in theory, help alleviate the struggling US economy and growing US/Japan trade deficit. Unlike China, Japan had little power to say no. Militarily and historically tied to the US, they acquiesced and saw the rising Yen decimate what little growth was still left.

But China doesn’t have to say yes. Their strictly mercantilist (to steal from Paul Krugman) strategy doesn’t seem to be changing. While G20 calls for currency reform have China agreeing in public, whispers persists that real change is very unlikely. China is in it for China. Evidently they need to balance the need for growth and demand from the US and Europe with their own self-interest but the growth of the Chinese and other Asian domestic markets may soon wean China off of Western interests. As it stands 40 per cent of China’s exports go to other developing countries.

Thus China may play hardball to retain a competitive, if not game changing, currency advantage. Which when combined with its forward looking investment and competition policies, may allow China to continue growing well into the future, and thus avoid Japan’s fate.

Japan saw its rise to economic superpower status derailed by a hollowing out of their economic growth  caused by a combination of short-sighted policy related to market openness, as well as labour market stagnation and an appreciating currency. Macroeconomic and monetary policy in the subsequent twenty years haven’t found a way to rescue them.

China seems to be looking far enough ahead to navigate through those pitfalls. The question shouldn’t be if China will become the world’s largest economy but when. However, aggregate size comparisons aren’t quite fair.

So perhaps the real question is how high will per-capita incomes rise in China, and equally important, whether the global economy can grow sufficiently to allow that income growth without a simultaneous drop in per-capita incomes elsewhere.

I’ll leave that for another day.

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