RE: Morgan Stanley Studies in China
China, a Global Force
Andy Xie (Hong Kong), Morgan Stanley
China is today at the center of attention in the financial community. I usually meet with Asian investment specialists on my tours through Europe and the US. During the last tour, global equity and bond specialists also showed up at my meetings. There is a simple explanation for this phenomenon, in my view: China's export base has become so large that the same growth rate as in the past generates a large enough increase to be felt in the global economy.
For example, China now accounts for over one-fifth of global trade growth. Its export increase this year is equal to its total exports in 1990. China's exports are now equal to 79% of Japan's, compared with 22% in 1990 and 14% in 1980. If it sustains the 12% annual growth rate of the past five years, China's exports will exceed Japan's by 2005 and the US's by 2009.
Nothing I see suggests that China's exports will slow: They have averaged 14.3% annual growth in the past two decades. Yet China's per-capita exports rank among the lowest in the world, at merely 8% of Japan's and 11% of the US's. I see no rationale to suggest that Chinese shouldn't produce for the global economy in the same manner as Americans or Japanese do.
China's export engine is so far limited to six provinces on the eastern seaboard, i.e., those in the Pearl River Delta and Yangtze River Delta. They account for 80% of China's total exports and 89% of the export increase this year. They have a combined population of 338 million, or one-quarter of the country's total. Per-capita exports in these provinces are merely US$762, compared with US$3,500 for Japan and US$2,300 for the US. There are still no limits to this region's export growth in the foreseeable future, in my view.
Further, China is investing massively in developing infrastructure in the middle and upper Yangtze River Valley, where another quarter of the country's population resides. Deep-water ports are being developed in the upper reach of the Yangtze River Valley, as the Three Gorges Dam lifts the water level by 180 meters. Highway and rail networks are sufficiently developed to accommodate rapid industrialization, and electricity and telecom services are in place. China will likely bring another quarter of its population into the global economy in this decade.
The eastern seaboard is moving into high-value-added production such as automobiles, semiconductors, telecoms, and pharmaceuticals. China has arguably the best universities in Asia and is producing over 2 million college graduates per annum. It appears to be in position to establish competitive industries that are R&D intensive. Indeed, multinational corporations are already moving on this prospect by establishing R&D centers in China to remain competitive.
Export industries that require low-skilled labor are moving inland. Even though China has a migrant labor force of about 150 million, the labor market is still not fully arbitraged across the country. The average labor cost in the middle and upper Yangtze River valleys is 30-50% less than in the coastal region. As the infrastructure bottleneck is removed, a significant number of export industries are moving inland.
The middle and upper Yangtze valleys are at a similar stage of development as the coastal region a decade ago. The population density inland allows China to develop infrastructure that will likely eliminate the geographical disadvantage. I expect this region to become successful in the global economy during this decade.
In the next decade, with half of the population in the global economy, China should be able to marshal sufficient resources to bring the rest of the population into the global economy. If the world remains peaceful over the next two decades, China should become a developed economy by 2020, by our estimates. My definition of a developed economy is that 90% of the population have jobs, own their homes, and can afford a vacation every year. In short, I expect China to become a normal economy by then.
There is little doubt that China's development is causing major realignments in global economic activities. It is changing relative prices between goods and services, labor and resources. I estimate that China brings down the relative price between goods and services by one percentage point per annum. Other things being equal, it improves the value of bonds relative to stocks. Typically, it also devalues manufacturing assets outside of China.
Anything that is in scarce supply will likely become scarcer. Something that is plentiful today may become scarce tomorrow. For example, China will likely import more oil than the US in the next decade. Chinese jewelry demand may eventually change the balance between demand and supply of precious metals. The returns on capital for most natural resource industries may finally rise above the cost of capital.
By creating artificial scarcity, a European specialty can often become more profitable. European luxury producers are already benefiting from China's development. Some luxury shops on Paris's Champs Elysee limit each customer's purchases to one item in order to excite demand. The trick seems to work well.
China's globalization is a boon to consumers worldwide. Low prices for consumer goods are especially useful for economies with aging populations. Europe and Japan face such a challenge. China's entry into the global economy fits well with their demographics, in my view.
Of course, China's entry into the global economy will likely cause some dislocation. The extremely low level of national wealth dictates that China integrates at an extremely low level of prices. However, the country's sheer size makes it difficult for the global economy to lift China's price level to the current global level. In many cases, Chinese prices will eventually become global prices, in my view. They should rise with China's wealth accumulation.
However, China's impact is mostly limited to the manufacturing sector, which accounts for about 20% of OECD GDP and is worth about US$5 trillion. The total dislocation will at most be 30% of this amount, or US$1.5 trillion, over the next two decades, in my view. Less than 4% of the total OECD labor force will likely need to shift from manufacturing to services. Most of the adjustment could be accomplished through attrition over such a long span. Absorbing China into the global economy will not be easy, but I see it as quite doable, giving a long enough period of time.
Some economies that now compete against China in third markets will need to adjust more and faster, in my view. The leading export economies in East Asia fall into this category. Their adjustment is being softened, however, by the shipping to China of components or raw materials that it doesn't yet make. For example, Korea has nearly doubled its exports to China in the past five years, even though its market shares in Japan and the US are waning. It has been shipping large quantities of industrial commodities (e.g., chemicals and semiconductors) to China.
For financial investors, China's entry into the global economy means that nominal global GDP will likely grow much slower, as China will charge the world far less than other countries for meeting increasing demand. This secular trend will likely have implications on profit margins for most businesses.
It is becoming popular to attribute China's export success to its currency peg to the US dollar. This is far from the truth, in my view. An exchange rate is a relative price. It typically affects competitiveness only if domestic prices are not flexible. Most economies in the world have price rigidities. Thus, exchange rate policy could alter relative competitiveness.
China appears to have far fewer price rigidities. Its vast surplus labor seemingly makes its labor market quite flexible. China's wages are determined by global demand for Chinese goods. If the exchange rate changes, it affects wages. Currency appreciation just means more bad debts in the Chinese context without changing China's competitiveness, in my view.
For example, China's currency appreciated significantly against other Asian currencies in 1998. This caused domestic prices to decline sharply. China's competitiveness was restored that way. But bad debts in the banking system rose with deflation.
There will likely be increasing scrutiny of China's role in the global economy. Integrating China into the global economy is, in my view, the greatest challenge for the world in this century. The debate on China's role in the global economy will likely only intensify. This debate is now taking place in the financial community. It may get into the political arena next year, as the contrast between a sluggish world and a rapidly growing China becomes sharper.
The debate, however, won't go anywhere, in my view. Multinational corporations have already woven China deeply into a complex global production chain. It is, in my view, already impossible to separate China out as a distinct production base associated with products or Chinese companies. The genie is already out of the bottle. China's globalization is likely to go ahead at full speed.