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The Coming China Scare

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China's long-term outlook is strong; it's the outlook for the next few months that investors should be wary of. Here's why.

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The single most important thing to understand about China's economic growth in the past five years is that it has been enabled, and to some extent driven, by extraordinarily high growth rates of extremely cheap credit.

The problem is that the credit "music" is about to be interrupted due to well-founded concerns about accelerating inflation. The consequences will likely be quite unnerving for domestic and global financial markets.

China's New Dilemma: Goldilocks No More

For the first time in its history, China faces a dilemma which involves the interplay between wages, inflation, credit and economic growth.

The first aspect of this problem is that the supply of labor in China is no longer as boundless as it has been for the past three decades. While foreign demand for cheap goods was met with a virtually unlimited supply of cheap capital and cheap labor to produce those goods, the result was a "goldilocks" economy of 10% growth with low inflation. However, times are changing.

Labor shortages are already acute in some sectors and wages are rising spectacularly in a few key manufacturing areas on the east coast. These well-publicized wage increases are significant because wages in China have already been rising much faster than average productivity growth throughout the economy, and the trend has been accelerating. At the same time, due to both external and internal forces, prices for everything in China are rising, particularly basic consumption items such as food. Therefore, for the first time in its history, China faces the real prospect of a wage-price spiral.

Let me be clear. China still has considerable labor resources in the countryside that will continue to migrate to the cities. However, due to the increasingly elderly demographic profile of the population that remains in the countryside, the rate of this internal migration will slow. This means that, all things being equal, the non-inflationary rate of economic growth in China must also slow.

Labor shortages are not only a function of slowing internal migration. China's economy is qualitatively transforming at breakneck speed. As a result, mismatches are developing between the skills required by business, and the skill sets of available workers. This tends to create high unemployment/underemployment in some population cohorts while wage inflation becomes a problem in some sectors where compensation is rising faster than productivity.

The fact that China's labor resources are becoming relatively more scarce creates an intractable dilemma. For any given level of demand, the supply will be limited by the growth of productivity. The only way that China can avoid a wage-price spiral will be to enact policies that have the effect of cooling off aggregate demand to a level that runs at or below the growth rate of productivity. Since labor productivity cannot reasonably be expected to sustainably grow at rates of 9%-10% per annum, this inevitably means either or both: 1) Long-term rates of economic growth rates in China will slow, or; 2) spiraling inflation.

What Will the Chinese Do?


Chinese Communist Party leaders have taken due note of the social and political unrest sparked in MENA countries due to steep price rises of basic consumer items. They will be keen not to repeat the same experience.

China's economic model, which has produced steady 9%-10% per annum growth rates for around three decades, has been based on supplying property, plant and equipment to a seemingly endless stream of laborers migrating out of the countryside and into urban areas. It has been a classic case of early-stage investment-led growth, and it has been enabled, and to some extent driven, by extremely cheap debt. This model was capable of producing a goldilocks economy as long as the labor force was unlimited and there were no other supply constraints.

However, as the supply of property, plant and equipment rises in quantity and quality relative to the available supply of labor in some sectors, wages will tend to rise. Furthermore, China's demand for investment goods has driven up the price of all kinds of commodities within China and around the world, creating inflation pressures within China.

Since excess demand for investment goods is largely responsible the inflationary pressures in China, officials there will have to address it. And since China's model of investment-led growth has been enabled, and to some extent driven by, dizzying levels and growth rates of extremely cheap credit, the cooling off of investment-led growth will necessarily involve restricting access to cheap credit.

Chinese officials will have to address excess investment growth for other reasons. First, overproduction in certain sectors is creating dangerous imbalances. For example, commercial real estate investment is creating gluts in some areas. Just as importantly, Chinese industrial capacity in export-oriented sectors face problems of massive overcapacity. This is particularly true since China's export growth is destined to slow. China's major trading partners have warned that they can no longer afford to absorb China's massive current account surpluses caused by predatory trade and currency policies. Thus Chinese investment in export industries, which has been a key driver of economic growth in recent years, will inevitably need to slow.

Whatever way you slice it, China needs to slow the rate of investment growth. And in effect, this means slowing the rate of credit growth.
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