From China: Deflation or Inflation?
toqueville.com
December 10th, 2002
A consensus has been building up that the world economy is being overcome by powerful forces of deflation. The Economist keeps a tally of stories in the Wall Street Journal and the Financial Times that mention deflation. The quarterly total has recently shot up to over 350 from less than 100 a few months ago.
In a recent article, Robert Samuelson summarized the roots of the prevailing scenario: “China’s low labor costs and undervalued currency suck investments and jobs from elsewhere. Legions of multinational companies are relocating in China, whose exports threaten global deflation”. Extrapolating these current trends (which Samuelson does not do), one would anticipate price declines to spread to other countries, depressing economic activity and corporate profits around the globe. This, in turn, could lead to financial upheaval as overextended borrowers find it increasingly difficult to service and repay debts.
In another article, Business Week points out that, “At a time when most of the global economy is on its knees, Chinese exports have rocketed by 20 percent so far this year”. And, to give an idea of the deflation that China is exporting, the magazine adds that, “In China itself, overproduction has helped push prices down by 7 percent over the past five years and retail prices by 10 percent”.
At present, describing China as an engine of deflation seems plausible. In just twelve months, its exports to the United States, Europe and the Pacific Rim have grown by more than 30 percent each. Even to Japan, which struggles with recession, China’s exports are up almost 13 percent. Moreover, since these figures are expressed in U.S. dollars and export prices have generally declined, the volume of goods exported by China has expanded even faster.
This trend is compounded by the enormous amount of investment flowing into the Mainland. China is sucking in about $50 billion of annual foreign investment, much of it from U.S., European and Japanese multinationals building ultramodern factories that keep boosting productivity even as wages increase. The result is that many traditional industries in developed economies have been left with unutilized capacity, while new manufacturing investment has plunged in most of Southeast Asia and “Mexico is seeing the flight of whole industries to the Mainland”.
Over the longer term, however, we believe that the deflationary argument does not hold water. Like inflation, deflation is above all a monetary phenomenon and central banks have been supplying plenty of fuel to the world economy. Many have ordered studies on how to avoid deflation, the gist of which was summarized in recent comments by Fed governor Bern Bernanke: “The U.S. government has a technology, called a printing press, … that allows it to produce as many dollars as it wishes at essentially no cost.” Further, central banks in Europe and Japan are now likely to provide additional liquidity, as their economies struggle to emerge from recession. Finally, Asia’s tigers are attempting to supplement export revenues by stimulating domestic consumption, which will add to world demand.
Even from a shorter-term perspective the deflationary argument, especially as it relates to China’s emergence as a manufacturing powerhouse, may be mostly a questionable extrapolation of trends that may already have begun to turn.
Inflationary Straws In The Wind
· Over the last ten years, China’s oil consumption has more than doubled, while its oil production has risen by less than 20 percent. As a result of these trends, a net exporter of oil until 1993, China now imports about a third of its annual consumption of more than 5 million barrels/day. Most estimates point to imports of 4 million barrels/day by 2010 -- only seven years away. This would be nearly half the 9 million barrels/day or so that the United States, the world’s oil guzzler, currently imports.
What is interesting about these now-“old” developments is that the price of oil started to rise in early 1994, only a few months after China became an importer, and rose by two-thirds in the following three years. It temporarily peaked at about $25 in early 1997, at the onset of the Asian crisis.
Of course, there may have been other factors than China’s emergence as a major importer behind the sharp of reversal of oil prices in 1994, but we believe that it was more than a coincidence that the two were concurrent. More importantly, while it could have been anticipated, this major change in the supply/demand balance for oil seems to have taken the world by surprise. Indeed, this surprise effect seems to be typical of trends originating in China.
· Several other commodities now seem on the verge of repeating oil’s experience. Over the five years since 1997, China’s consumption of copper doubled while domestic production increased only 32 percent. As a result, the copper content of imports (concentrates and scrap) almost tripled and Chinese imports, which amounted to just over 3 percent of world consumption in 1997 are now close to 8 percent of that total. Of course, no one really knows which levels of consumption and imports will destabilize the copper market but the Chinese factor has surely increased the potential for surprises. In that respect, we notice that the first inkling of recovery in the copper-hungry “tech” industry recently triggered a 10 percent rally in the price of that metal.
· The story is repeated in commodity after commodity. A recent headline in the Financial Times read: “China sucks in a quarter of world’s steel output”. Indeed, China’s steel consumption is up 81 percent in just five years and, though production is up 60 percent, imports have more than tripled to approach 20 percent of the world’s total consumption. As a result, the consumption of nickel, which goes into stainless steel, is up more than 80 percent and, with production up less than half that, China has swung from a small exporter to a growing importer of nickel.
· We should also point out that, although the United States thought it necessary earlier this year to call for tariffs on imported steel, the metal’s output in most major producing countries has been rising strongly – by more than 20 percent year-to-year in the United States and 12 percent globally. As a result of this demand growth, steel prices have been in an up trend since last spring. This buoyancy in production and prices is hard to explain without invoking a huge absorption by China.
· Even for paper pulp, consumption is up 104 percent in five years against only 25 percent for production, resulting in a more than tripling of imports. (Source for the above production and export statistics: UBS Warburg).
· Aluminum is a more complex story. According to B&T Capital Markets, China already is the world’s largest aluminum producer and its second largest consumer. Domestically, smelter capacity has grown 30 percent just this year, while growth in demand for the metal remained fairly steady at 10% per year. As a result, China has moved from a major importer of aluminum to a modest exporter. Not surprisingly, this sudden switch caused a marked weakness in the price of the metal, which returned to its recession low of late 2001. However, B&T sees the recent developments as merely a temporary disruption.
China, they argue, has a multitude of small, inefficient and environmentally dirty smelters. Furthermore, operating costs are high due to expensive power and alumina (the prime material used in aluminum production). A policy decision by Beijing to modernize the larger smelters, partly to improve environmental conditions, resulted in an expansion of total capacity. It had been intended that this would be partly offset by shutdowns of smaller, older-technology smelters, which still account for 33 percent of China’s aluminum capacity. But in China, the policies of local governments, motivated mainly by employment and tax revenue goals, are often at odds (for a while at least) with those of the central authority. Thus, Beijing’s intended smelter closures have not been implemented at the local level. In time, however, rising aluminum production may cause a shortage and higher prices for alumina. This will further weaken the small smelters and allow Beijing to enforce its aluminum policy. Meanwhile, recent developments simply demonstrate that supply and demand surprises from China can strike both ways.
· One last example will serve to illustrate that surprises do not only happen in the materials industries. In the six years to 2002, the Chinese TV market went through a period of large overcapacity and fierce competitive price cuts. In the same time, however, the industry concentrated, from eighty producers in the early 1990s to 40-50 now. In addition to capacity shutdowns, the better producers increasingly moved to higher-end models (flat screens, rear projection, plasma displays, etc.), while producers of low-end models developed export markets in Southeast Asia, Eastern Europe and Africa. Suddenly in the first half of 2002, with China now supplying almost 30 percent of the world’s TVs, demand caught up with capacity. Not atypically, TV sales were up 30 percent year-to-year but, for the first time, prices stabilized. Margins took off and so did profits.
Not A Zero-Sum Game
The main question today is whether China’s manufacturing boom is part of a zero-sum game where China’s exports merely replace production in developed economies or exports to these economies from other developing countries. If this were the case, one could argue that there will be no addition to global final demand, and that China’s lower production costs will cause overcapacity and continued price declines elsewhere. But we do not think this is the case.
When China “steals” production from other countries, it enriches workers who will have a stronger propensity to consume, as their incomes rise, than workers in more developed economies. These consumers will not only spend rapidly growing wages for the foreseeable future but, as more goods become available, they will also spend a portion of their large, accumulated savings and will even start borrowing to invest in homes and household durable goods (appliances, furniture, automobiles, etc.) In brief, jobs for Chinese workers have a greater multiplier effect on economic activity than jobs for European, Japanese or even Korean and Taiwanese workers whom they replace.
UBS Warburg argues that Chinese consumption is taking off because China is heading into the “J curve” where critical income levels multiply consumption and economic activity. This is what happened in Japan, Korea and others when they reached the level of income per capita that China’s large metropolitan areas are approaching. Already, thanks to the government’s effort to promote private ownership of homes, appliance sales were up 23 percent in the first eight months of 2002. Chinese automobile sales were up 33 percent over the same period, at a rate approaching 3 million vehicles. More significantly, perhaps, the number of registered private cars jumped 43 percent in 2001 to 7.7 million units (up from just 820,000 in 1990).
But China’s export boom is not helping only its domestic consumption. First, to accommodate this growth, a continued effort is under way to improve the country’s infrastructure. Partly as a result, Chinese imports are up strongly year-to-year: 42.3 percent from Japan, 39.5 percent from the Pacific Rim, 18.1 percent from Europe and 7.3 percent from the United States. So, while Chinese exports are hurting profits and jobs in some foreign industries, its imports are providing a strong stimulus to others.
And these imports are not just materials and heavy or sophisticated machinery. They also include consumer goods and services. For example, arrivals of Chinese tourists in Hong Kong, Singapore, Korea, Thailand and Malaysia almost doubled in four years, to reach 6.7 million visitors in 2001. In Hong Kong, the average Chinese tourist spent US$ 662 in 2001 – just below the amount spent by U.S. tourists and well above the spending by tourists from Southeast Asia (BNP Paribas Peregrine).
In Paris (France), the annual number of visitors from the Mainland has tripled in four years, to 455,000 in 2001. While this is only the seventh largest contingent of visitors to the French capital, they already are the biggest-spending, at 240 euros per person per day – nearly two and a half times the 100-euro daily average spent by European tourists. As an anecdote, Mainland visitors already are the second-largest customer group of the Moulin Rouge cabaret – talk about spending on necessities….
Finally, China is beginning to share the foreign direct investment (FDI) wealth. FDI inflow into China is approaching $50 billion, while most Southeast Asian countries have been experiencing declines. But FDI outflow from China, only a pittance a few years ago, reached $27.2 billion in 2000. As trade flows between the Mainland and Asian countries build up, this outflow is expected to increasingly benefit other countries in the region.
To paraphrase what Paul Samuelson was fond of telling his students, the only true question in economics is the size of the multiplier. The multiplier effect of China’s export boom on the world economy may well prove to be, not the deflationary force that has been advertised, but instead a major new source of global growth and, perhaps in time, inflation.
François Sicart
December 10, 2002
© Tocqueville Asset Management L.P.
The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change. |
