China – Rising Costs, Lower Returns

I am seeing all sorts of commentary regarding the de-pegging of the RMB to the dollar as being positive for risk assets.  And it is, long-term.

Over the long-term, a floating Chinese currency is enormously positive as it will help alleviate the enormous imbalances in the world economy.  Simply put, the imbalances are that the US consumes too much and China produces too much, which has led to an unstable build-up of foreign currency reserves in China.  China must consume more and the US must produce more.  A rebalancing of the Chinese currency will help do both by making imported goods into China cheaper while making exported Chinese goods more expensive, leading to lower growth in Chinese currency reserves.  But over the short and intermediate term, this could produce headwinds for US stocks.

There will be pressures on businesses other than a rising Chinese currency, however.  Labor costs are rising in China, which means labour costs will start rising again in the developed world.  Because Chinese labour costs are rising, offshoring will become less ubiquitous and profitability will fall.

I believe that we are witnessing an inflection point in the construct of the global economy that could have enormous ramifications for how the spoils are divided up between capital and labour.  Over the past decade, those spoils have accrued primarily to capital whereas labour has lived off crumbs.  I believe that we are shifting to a more equitable distribution of wealth. And though I doubt we will see a reverse of the past decade such that all the gains accrue to labour and capital gets little, the gains will be more evenly distributed.

More to labour, less to capital

The biggest benefactors of the opening of China over the past decade have been the owners of capital.  The opening of China has shifted global cost curves down.  Companies have been able to shift productive capacity overseas, which has increased profitability and returns on equity.  Many measures of corporate health during the 00s hit either all-time highs or multi-decade highs – profit margins soared, return on equities skyrocketed, profits as a percentage of GDP exploded, etc.

Labour, on the other hand, experienced stagnant income growth, at least in the developed nations.  Productive capacity shifted offshore, pressuring wages.  Consumption growth was often financed by debt and home equity extraction, not by growth in income.

Even in China, which has seen enormous gains accrue to labour over the past decade, there is widespread discontent amongst the have-nots as income disparities have raised significantly over the past 10 years.  There have been several high profile reports coming out of China lately about worker discontent at plants and factories.  Workers have gone on strike and have received significant wage gains.

Wages are going to rise in China relative to capital as Beijing attempts to create more internal consumer demand within the country to rebalance the economy and to keep the social peace.

This cannot be overstated enough – if the cost structures of global corporations are rising, as accelerating wages in China and a higher RMB implies, there will be headwinds for corporate profitability growth, and gains to the owners of capital will be lower.

Rising costs in China will mean fewer options for corporations to lower costs by moving production offshore.  Costs for corporations are going to rise at the expense of profitability as companies pay their employees more domestically.  Profit margins are going to fall, return on equities will be lower and the percentage of profits to GDP will decline.  Good for labour, bad for capital.

Over the long-term, the developments in China are extremely positive as they assist in the rebalancing the enormous imbalances in the global economy.  Over the short and intermediate-term, however, they will slow aggregate profitability growth.

Less demand for dollars

Perhaps the most destabilizing imbalance is the enormous amount of currency reserves held by the People’s Bank of China.  Over the past decade, the Chinese currency peg has kept interest rates in the United States lower than they otherwise would have been.  To keep the RMB low, the PBOC purchased US dollars and used those dollars to buy US debt, primarily Treasury and agency bonds.  This demand for US government bonds kept a lid on interest rates.

A rising RMB means there will be less imperative for the PBOC to buy US bonds to keep the RMB low.  Less demand for US bonds will mean higher interest rates.  Higher interest rates means lower valuations for risk assets, which means lower returns for equities.

Less liquidity

The downward shift in global cost curves kept interest rates low as the opening of China was deflationary.  Central banks don’t like deflation, they like price stability.  To counter deflation, central banks created money, which is inflationary.  The money supply grew at a faster rate than economic growth. 

Much of this liquidity found its way into asset prices, particularly real estate prices but also commodities, credit and other more esoteric assets such as wine and sports teams.  A rising cost structure in China will reduce deflation, which means there will be less money creation to counteract deflation, thus less liquidity.  Less liquidity will mean less fuel for assets.  Less demand for assets will mean lower returns for risk assets.

The end game

The effects of a rebalancing Chinese economy towards more consumption will mean lower aggregate profitability growth, higher interest rates and less liquidity in the financial system, all of which are negatives for stocks over the intermediate-term.  This does not mean that stocks are going to fall but it does mean that returns to equities will probably be substandard.  Over the long-term, the effects will be positive as they will strengthen an unhealthy global system.

Of course, over the intermediate-term, there will be winners and losers.  Obviously, corporations selling to the burgeoning Chinese consumer will benefit.  However, companies that relied on offshoring are going to see lower profitability.  Profit margins are likely to be lower over the next decade than the past decade as less offshoring will mean less pressure on wage growth in the developed world.  This will alleviate (though not eliminate) the pressure on the American consumer caused by deleveraging, thus benefiting the American consumer.

I believe this shift in trend will occur over the next 10 years, and will happen slowly and subtly.  The opening of China has been and will continue to be one of the most significant economic events of the past 100 years.  However, the composition of wealth distribution caused by the opening of China is changing, I believe, which is going to have a significant effect on asset returns.