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China Costs Rising

Last week, The Wall Street Journal published an article regarding China's shift to an era of slower growth.  What was more interesting to me were the descriptions of soaring costs.

DASHIMEN VILLAGE, China—In this corn-growing hamlet in northern China, signs are emerging that the nation's supercharged economic growth may be reaching its limit.

A bottomless pool of inexpensive migrant labor has long been one of China's greatest resources, fueling its manufacturing boom. But all the able-bodied workers have left this village already, leaving mostly the elderly. "All the young men have gone out to work," says Wang Shuzhen, 58 years old, whose two sons left town, one to work in construction, the other as a driver.

Fewer migrant workers are heading to China's manufacturing zones along the coasts because villages like Dashimen are tapped out, putting pressure on wages and sparking worries about labor shortages. Job centers in the Pearl River Delta, the manufacturing heartland of southern China, had 9% more vacancies than applicants in the first quarter, according to a survey by China's labor ministry.  ...

The favorable demographics that have supplied manpower for economic growth are changing. China's working-age population, age 15 to 64, has grown continuously. But partly because most families are limited to one child, growth of this working population is slowing, according to the United Nations. The labor pool is expected to peak around 2015, and then decline, according to U.N. projections. In China, manual laborers tend to stop working before age 65, due both to the demands of the work and to employers' preference for younger workers. ...

The most anticipated problem is an end to some 35 years of steady growth of the working-age population, which fueled the expansion when China liberalized its economy. The demographic changes added about 1.8 percentage points of economic growth annually since the late 1970s, according to the Center for Strategic and International Studies, a Washington think tank. But by 2030, the CSIS predicts, the contraction in the working-age population will reduce growth by 0.7 percentage points a year.

In places like Dashimen, in the hills in northern Hebei province, everyone who can physically labor is already working in jobs in the cities. Yin Zhen, the 61-year-old husband of Ms. Wang, says he was a migrant worker himself until employers started passing him over for younger men about five years ago.

With growth of the labor force slowing, migrant workers are in a stronger position to bargain with employers. A central-bank survey this year showed average wages for migrant workers, who traditionally fill the least-skilled slots and have little economic power, rose 17.8% from a year earlier.

Those gains will improve the lives of the poorest urban workers. They also will make it tougher for Chinese exporters of low-end merchandise like apparel and toys to continue to compete mainly on price. Exporters will have to keep boosting productivity to make up for higher wages, and start making higher-end products that are less price-sensitive.

As I detailed a month ago, I believe the massive offshoring of American manufacturing is, if not coming to an end, then about to slow dramatically.  This will have an enormous affect on the composition of economic gains, which have accrued almost entirely to capital over the past decade whereas labour has seen virtually nothing.  I expect gains to labor to outpace gains to capital over the next 10 years and returns on equity to be lower. 

Perhaps I am wrong, I do not know, but seismic shifts on Wall Street usually occur when no one is expecting them.  The consensus is always wrong at big inflection points when articles of faith turn out to be illusions.  Those who see this and have the wherewithal to exploit it make fortunes.

China Update

A few weeks ago, I laid out my thesis on how rising costs are going to create structural headwinds for corporate profitability going forward.  Jeff Matthews reinforces this argument by noting that China's one-child policy is fast creating a shortage of labour.

What is going on is this: costs in China are rising, and they will continue to rise for years to come. In fact, he said, costs will rise the rest of the decade at a rate that places China among the higher-cost manufacturing areas of the world.

And it has nothing to do with the Yuan.

What it has to do with is China’s “One-Child Policy.” ...

the demographics in China are shifting rapidly from a surplus of labor to a shortage. And by “rapidly” he means “the next three years,” when the 18-25 year old population drops by something close to one-third.

Now, the effect of this mind-boggling demographic shift was already felt, early this year.

After the Chinese New Year, a number of U.S. companies reported that an unusual number of factory workers failed to return from their inland homes, reducing their manufacturing efficiency, increasing costs-per-item, and forcing a shift to airfreight in order to get product to markets on time.

What is happening is this: as China promotes economic expansion away from the crowded south, jobs are opening up where none had been before.

To put numbers on it, according to our acquaintance, some factories were 25% short of labor after the Chinese New Year, and thus operated at as little as 75% of capacity.

And this problem for the manufacturing base in China is not going away: in fact, it will get worse as the labor surplus dries up.

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.

 

China's Currency Peg and Bubbles

The global economy is characterized by enormous imbalances, particularly the $2 trillion or so in reserves parked at the People’s Bank of China.  This build-up of reserves is one culprit of the asset-driven economy.

Make no mistake, our problems are not because of China.  Our problems are because of ourselves.  But China’s currency peg has dramatically exacerbated the problems of the global economy.

The past decade has been characterized by two of the most deflationary forces of our time – the Internet and the inclusion of China as a major player in the global economy.  The Internet is deflationary because of dis-intermediation – it cuts out the middleman, lowering costs for consumers.  The opening of China is deflationary because its wages are low, effectively lowering the global cost curve for corporations.

In a balanced economy, these deflationary forces should have caused prices to fall.  However, prices did not fall.  The Federal Reserve would not allow that to happen.  To keep prices from falling, the Fed injected money into the economy to keep prices stable.  That money had to go somewhere, and it went into asset markets.

China supplied us with cheap goods and ran a massive trade surplus.  The yuan should have risen against the dollar, but the Chinese government would not allow that to happen, and China built up a ridiculous amount of reserves.  Had the yuan risen, Chinese labor would not have been so cheap, and the deflationary forces emanating from China would have been less.  With less deflation, less money would have been created and less liquidity would have flowed into asset markets.

With trillions of dollars in reserves, China had to put that money somewhere.  Much of China's reserves were recycled back into the US Treasury market, increasing demand for Treasuries which lowered interest rates.  Lower interest rates allowed people to finance purchases of assets cheaply – from homes to CDOs  – fueling the housing bubble.  Had China not pegged its currency to the dollar, it would have had fewer dollars to recycle into the US bond market, demand for bonds would have been less and interest rates would have been higher. Had interest rates been higher (and the Fed could have kept rates higher regardless of what China did) then there would have been no housing bubble, or at least the housing bubble would not have grown as large as it did. 

(This criticism can also be labeled at Japan and other Asian countries whose economies were geared towards exports to the American consumer.  They too ran up enormous currency reserves.)

Over the long run, a floating yuan is good for the global economy.  It will clear out many of the destabilizing structural imbalances.  It is good for China as well.  A rising yuan will increase consumer spending in China as imports become cheaper, re-balancing the Chinese economy away from its heavy (and unhealthy) reliance on exports and capital spending.

In the near and intermediate-term, however, it is bad for our asset markets.  A rising yuan means less demand for Treasuries, which means higher interest rates, which means less support for asset markets such as stocks, bonds and housing.   In our asset-driven economy, less liquidity is bad for our markets.

In the long-run, a floating yuan is positive for the US economy.  Our heavy reliance on asset markets is unhealthy.  Less trading things and more making things is ultimately good for America.

A Scary Thought

On China's stimulus-induced economy, in this morning's Wall Street Journal.

The recovery in China's housing market has underpinned the nation's return to double-digit economic growth, and will become increasingly crucial this year as Beijing winds down its two-year stimulus program. The growing fear of many officials and analysts is that a property bubble that leads to a bust could derail that expansion. How China handles this real-estate boom will have broad ramifications, since its strong demand for the raw materials and equipment needed to build out new housing, infrastructure and factories has been one of the few bright spots in the world economy.

"China's entire growth and investment boom is centered on sentiment in the property market," said Doris Chen, banking analyst with BNP Paribas in Shanghai. [emphasis added] High property prices support local government budgets, she said, and so indirectly finance many of the infrastructure projects that have been rolled out as part of the stimulus.

This usually does not end well.

If China's Property Bubble Bursts, Short Canada

Andy Xie is predicting that the Chinese property bubble is set to burst.

As bank lending slows, “it’s very difficult to see this demand continuing,” Xie, formerly Morgan Stanley’s chief Asian economist, told Bloomberg Television in Hong Kong today.

The Chinese economy has done relatively well during the financial crisis, in part due to an aggressive stimulus program.  However, this has led to an explosion of credit, which has spawned another property bubble in China.  Credit and property bubbles rarely end well.

Growth in China has buoyed commodity markets.  Canada is a large exporter of commodities.  Canada has done relatively well compared to the US economy and the rest of the world, partly because Canada has been good but also partly because Canada has been lucky.  If the Chinese economy stalls because of a collapse in property prices, commodity prices will fall hard as China has been the global marginal buyer of all things coming out of the ground. 

Of course, Chinese demand for commodities is not the only driver of Canadian exports.  More than a third of all products and services made in Canada are exported to the United States.  However, it is my opinion that the recovery in the US will be anemic, and American stock markets may now be in the process of topping. 

(The thesis from which I am currently working is that after a large bounce, the stock market moves sideways for some time, perhaps two to five years.)

If this is the case, demand from the US will not be strong enough to offset the fall in demand for commodities from China.  Roughly half the Canadian stock market is comprised of energy and materials companies.  Canada will underperform in this scenario.

I am short Canada, and am short risk assets in general.  I believe that rallies are now to be sold rather than dips to be bought, and I plan on getting more aggressive on the short side into this rally.  I may be dead wrong, and if I am, I will quickly turn around my portfolio, and I likely won't tell you about it, or at least not in real time.

However, stocks are not cheap, the economy is weak, liquidity at best is capped and may soon be tightening, sovereign risk is rising, and the market may be tracing out the top of a range it may trade within over the next several years.

China's Coming Financial Crisis

I would suggest you pop on over to Zero Hedge and read the article published a few days ago from SocGen on the coming crisis in China.

I am currently reading the book, This Time is Different, which details eight centuries of financial crises.  The authors note that financial crises are usually presaged by an explosion in credit growth, like what now occurring in China.  Throw in an antiquated and opaque banking system priced to perfection, enormous imbalances particularly in foreign reserves, overcapacity, too much fixed investment, too heavy of a reliance on exports to the West, and reports of housing bubbles, and this will ultimately not end well.

That does not mean that China is about to roll over right away, nor that the country's future is not bright.  The United States went through many financial crises in its development.  China will as well, and we must be aware of this.

The Effects of Opposition to Globalization in India

From the Cato Institute

As the world approaches the 20th anniversary of the fall of communism, it is worth investigating the costs borne by countries like India that did not become communist but drew heavily on the Soviet model. For three decades after its independence in 1947, India strove for self-sufficiency instead of the gains of international trade, and gave the state an ever-increasing role in controlling the means of production. These policies yielded economic growth of 3.5 percent per year, which was half that of export-oriented Asian countries, and yielded slow progress in social indicators, too. Growth per capita in India was even slower, at 1.49 percent per year. It accelerated after reforms started tentatively in 1981, and shot up to 6.78 percent per year after reforms deepened in the current decade.

What would the impact on social indicators have been had India commenced economic reform one decade earlier, and enjoyed correspondingly faster economic growth and improvements in human development indicators? This paper seeks to estimate the number of "missing children," "missing literates," and "missing non-poor" resulting from delayed reform, slower economic growth, and hence, slower improvement of social indicators. It finds that with earlier reform, 14.5 million more children would have survived, 261 million more Indians would have become literate, and 109 million more people would have risen above the poverty line. The delay in economic reform represents an enormous social tragedy. It drives home the point that India's socialist era, which claimed it would deliver growth with social justice, delivered neither.

The Copper Standard?

Is China buying copper as a way to diversify out of dollars?

China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

Nobu Su, head of Taiwan's TMT group, which ships commodities to China, said Beijing is trying to extricate itself from dollar dependency as fast as it can.

"China has woken up. The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact, and can cover their infrastructure for 50 years."

"The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources," he said.

The SRB has also been accumulating aluminium, zinc, nickel, and rarer metals such as titanium, indium (thin-film technology), rhodium (catalytic converters) and praseodymium (glass).

While it makes sense for China to take advantage of last year's commodity crash to restock cheaply, there is clearly more behind the move. "They are definitely buying metals to diversify out of US Treasuries and dollar holdings," said Jim Lennon, head of commodities at Macquarie Bank.

John Reade, metals chief at UBS, said Beijing may have a made strategic decision to stockpile metal as an alternative to foreign bonds. "We're very surprised by Chinese demand. They are buying much more copper than they will need this year. If this is strategic, there may be no effective limit on the purchases as China's pockets are deep."...

The beauty of recycling China's surplus into metals instead of US bonds is that it kills so many birds with one stone: it stops the yuan rising, without provoking complaints of currency manipulation by Washington; metals are easily stored in warehouses, unlike oil; the holdings are likely to rise in value over time since the earth's crust is gradually depleting its accessible ores. Above all, such a policy safeguards China's industrial revolution, while the West may one day face a supply crisis.

China PMI Signals Expansion

The manufacturing PMI in China came in above 50.  Generally, a reading above 50 signals economic expansion.

The Purchasing Managers' Index (PMI) of China's manufacturing sector rose for the fourth straight month in March to 52.4 percent, up 3.4 percentage points from a month earlier, the China Federation of Logistics and Purchasing (CFLP) announced Thursday.

    It was the first time the PMI rebounded above 50 percent since July 2008, when the index fell to 48.4 percent.

    A reading of above 50 suggests expansion, while one below 50 indicates contraction.

    The PMI includes a package of indices that measure economic performance. The survey, jointly conducted by the National Bureau of Statistics (NBS), covers purchasing and supply managers of more than 700 manufacturers across China.

    March indices measuring new orders, output, purchasing and new export orders all increased more than 4 percentage points from February, according to the CFLP.

    The output index rose to 56.9 percent in March, up 5.7 percentage points from the previous month. The new order index jumped 4.2 percentage points to 54.6 percent.

    The index measuring new export orders rose 4.1 percentage points from February to 47.5 percent. The figure, although still below the threshold of expansion of 50 percent, showed the depth of decline has been narrowing.

    "The continuous rebound of the PMI not only shows the government economic stimulus package has begun to take obvious effect, but also indicates a stabilizing and warming economy," said NBS head Ma Jiantang.