China: The Phantom Arbitrage
Andy Xie (Hong Kong)
Investors compare China with various economies at similar stages of development and draw the conclusion that commodity and/or asset prices will go much higher. Property speculators compare Shanghai with London and view the gap in property prices between the two as the potential upside. Currency traders look at the productivity growth in China and believe that the renminbi will appreciate as the yen did 30 years ago. The global financial community is making the mistake of assuming that Chinese prices will rise to international levels as the economy develops. Instead, international prices are more likely to decline to Chinese levels through arbitrage by global companies, in my view.
When a small economy like South Korea begins to develop, it is quite reasonable to assume that its prices (e.g., wages, property prices, or the cost of a haircut) will rise to the same levels as in developed economies. South Korea has a population of fewer than 50 million. If it invests to join the global economy, global demand will be met by Korean supply at the margin. As South Korea’s labor force is less than 5% of the OECD labor force, it will reach full employment quickly -- and the extra global demand will pull up its wages to international levels. Rising wages will cause inflation, and asset and goods prices will also converge towards international levels.
The price trends in China will be very different from those in Japan or South Korea at similar stages of development, in my view. China’s labor force is bigger than the OECD labor force. When it can make a product more cheaply than others can, even if all the production of that item relocates to China, its wages will not increase. China has developed remarkable strength in light manufacturing. Already, many products are made mostly in China (e.g., shoes, toys, PCs). China’s exports have quintupled in the past decade and reached 35% of GDP last year. But the wages at the coastal export factories have barely changed in the past decade.
The challenge is that the size and growth of China’s underemployed labor force limit its bargaining power. China had a population of 1.3 billion and a labor force of 760 million in 2003, according to official statistics: 256 million were employed in cities, 153 million were employed in non-agricultural activities in rural areas, and 325 million worked in farming. I believe a conservative estimate would put excess labor at 150 million. China created 9 million jobs last year when the economy was overheating. The labor surplus is likely to remain for the foreseeable future.
Furthermore, official statistics may not tell the whole story. First, China’s population or labor force could be significantly understated. The stringent population control policy may have caused many rural areas to understate births in the past two decades. My observations on family sizes in several provinces (e.g., Sichuan, Hunan, Hubei, and Henan) would support this.
Second, self-employed workers totaled 50 million in 2003. In China, many of these people are earning subsistence income and may prefer salaried jobs where available. I estimate the number of salaried workers at 150–160 million. Only this group of workers is comparable to those employed in OECD or ex-Asian Tiger economies, in my view. (The balance of the labor force comprises farmers and temporary workers.)
Third, about 20 million people turn 18 and join the labor force every year. It is unclear how many people retire each year. However, with no pension in the rural sector and little pension for many urban workers, the number who voluntarily retire is unlikely to exceed 10 million (or 2.4% of non-rural employment), in my opinion. This implies that the current pace of job creation cannot even digest the new inflow. The official statistics show that the number of people employed in agriculture has not changed since the mid-1990s.
There are widely disseminated reports of shortages of migrant workers in some coastal provinces and rapidly rising wages in certain professions. The shortage of migrant workers is due to: 1) the bad working conditions at the coastal export factories (often 10 hours of hard work per day for US$70–100 per month); and 2) wage stagnation despite rising living costs. Migrant workers tend to work for surpluses -- the difference between wages and living costs that they can send home to support their families. The prices of basic items have risen sharply since 2002 (chicken up 35%, rice up 30%, flour up 23%, water up 16%). Wages have not kept up with living costs. This is why migrant workers are often less eager to go to provinces with high living costs for the same pay.
Experienced middle-level managers have seen double-digit increases in their income in the past two years. Multinational corporations have stepped up the pace of relocating to China and have been competing for seasoned managers. The relative scarcity of such managers has contributed to their wage inflation. However, as time goes by, a lot more people should acquire these skills and experience, and the wage inflation in this segment could become deflation in five years. We saw the same pattern emerge for IT professionals during the Internet bubble: Their relative scarcity during the demand phase elevated wages in this industry to international levels, but their income has fallen by 70–80% in many cases as universities have turned out more such professionals and demand growth has slackened with the bursting of the bubble.
Indeed, a skilled labor surplus is developing in China. Enrollment at higher education institutions increased to 3.8 million in 2003 from 924,000 a decade earlier. About 40% of graduates could not find jobs that required a college education. The upside from this is that MNCs are likely to relocate more production to China to tap into this pool of cheap educated labor.
If Chinese workers are not enjoying higher wages from the economic development that increases labor production, who is? The MNCs that control distribution channels and brands are the principal beneficiaries, in my view. The rise of the big-box retailers has fundamentally altered the relative bargaining power between production and distribution players. The companies that produce goods cheaply in China and export them to rich consumers have benefited most from China’s productivity gains. Of course, these consumers benefit, too, by paying less for the same products. This has been the big investment story in relation to China, and the story is unlikely to change, in my view.
The fact that Chinese workers benefit little from their productivity gains has profound implications for China’s property market and commodity prices. Property values tend to rise in line with labor income in the long term. Property speculators assume that China’s economic growth will deliver rapid wage growth, and, hence, that they are just front-running Chinese workers in pushing up the prices first, i.e., Chinese workers will buy from them at higher prices with their higher wages in the future. I believe this is an illusion.
The justification for high commodity prices is based on the same illusion. The prices that China can afford depend on wage levels more than the overall size of the economy. The Chinese economy has been expanding rapidly on employment rather than wage growth. In the end, the burden for bearing the costs of raw materials comes down to the income of each consumer. Chinese consumers are just not becoming rich fast enough to catch up with the rapid increase in commodity prices. However, the impact of high raw material prices has so far been covered up by a property bubble.
In summary, the global financial markets are speculating in China-related assets, in the belief that Chinese prices will rise to OECD levels. I believe that OECD prices are more likely to fall towards Chinese levels.
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