SPEAKING
FREELY China, inflation and the
yuan By Axel Merk
Speaking Freely is an Asia Times
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When you add
relatively easy access to money to a seemingly
unlimited supply of skilled labor and a sense of
opportunity, you get a dynamite combination ready
to do business - just about any business. We are,
of course, talking about China. You also end up
with real estate and manufacturing projects
mushrooming without consideration for whether
tenants for the buildings, or customers for the
products, even exist. One of the side effects of
such situations is intensified competition. In
China's case, the prime beneficiary of the intense
competition, coupled with a quasi-fixed exchange
rate to the dollar, has been the US consumer, who
enjoys low prices for anything that can be
imported from China. Some believe that as a direct
result, the US will not need to worry about
inflation for years to come, but more on this
later; first, let me share my impressions after a
just-completed trip to China.
I had the
honor of hosting a financial and an economic panel at
the
recently held Shenyang Summit. Shenyang is located in
northeast China, about an hour's flight from Beijing. After lagging in
the growth other parts of China have enjoyed over
the past 25 years, Shenyang is rapidly opening up
and seeking to attract investment; attending the
summit of domestic and international business and
political leaders provided insights to the
microcosm of China's opportunities and challenges.
Many still associate China with a closed,
communist society interested only in know-how and
capital from the West. The fact that just about
any consumer good can be produced in China is
proof that China has made great strides and has
become, in many ways, open. At one of the panels I
hosted, the question was asked why few Chinese
brand names are known internationally. The answer
illustrates what it means to be open for business:
"Because China's economy is open to anyone willing
to do business."
In an environment of
intense competition, if you cannot differentiate
your product or service, your margins will
evaporate faster than you postulated in your
business plan's worst-case scenario - meaning if
pricing pressure on your goods does not erode your
margins, high raw material prices will. Firms
operating in China face similar margin pressures
to US manufacturers, the difference is that in
China, if one firm fails, five others will be
willing to take its place, even if their prospects
are not necessarily any brighter.
Not
surprisingly, Fred Hu, Managing Director of
Goldman Sachs in Hong Kong - a dealmaker
who almost enjoys celebrity status in China - says
the one thing China needs most to achieve
long-term sustainable growth is increased
productivity. Realizing the need, China is seeking
to become more efficient, be it on the government
or entrepreneurial level. On the government side,
no matter whether it was the Director General of
the State Administration of Foreign Exchange
(SAFE), who was on a panel I hosted on the
liberalization of the banking system, or talking
with various officials, it was clear that everyone
is working hard to dismantle bureaucratic barriers
and develop effective markets able to participate
and compete on the world stage. A very consistent
theme was that this transition has to be orderly
and that it has to take place one step at a time;
no one doubted, though, that the right steps will
be taken and that reforms will continue at a
measured pace. This doesn't mean that all is
perfect: a culture of hierarchical rule has a long
history in the country. At any government level,
there is great respect for orders from above, but
also great power is exercised over subordinates.
As local bureaucrats defend their territory,
roadblocks can be thrown in the way of reform or
business activity. Long-term, the continued reform
process seems unstoppable, but both businesses and
reform-oriented government officials are at times
frustrated with how some bureaucrats make their
lives more difficult. When we hear about the
difficulty of enforcing reform-oriented laws, the
same crosscurrents are in effect.
As
businesses feel margin pressures, they are also
working on productivity improvements. China may be
a low-wage country, but China's insatiable and
growing appetite for raw materials and energy -
which frequently causes internal price spikes in
many commodities, not just oil - do not always
make it a low-cost country.
Regarding
China's thirst for oil and energy, I had an
interesting discussion with Peter Cornelius, chief
economist of Royal Dutch/Shell. During the
conference, another acquisition by a Chinese oil
consortium was announced, this time of Canadian-owned resources in
Ecuador. The economist questioned
whether it makes sense for China to acquire the
oil assets when they could purchase the oil in the
open market without taking on the risks associated
with managing oil fields in faraway places, often
in politically unstable environments. My argument
was that doing so would improve China's access to
oil in times of crises; and that hoping for the
spot and futures markets to serve China's needs in
such times would be naive. He countered that if
there truly is an energy-related crisis, pipelines
and ships may not make it to China, no matter
whether China owns the producers or not. He may be
right; however, I believe the Chinese approach to
intensify economic and political relationships
through investment is prudent, as friends are more
likely served than foes during difficult times.
When we think of China, many think of
foreign corporations producing for their home
markets. That picture is rapidly evolving. More
and more corporations are targeting the domestic
market in China, and the middle class is rapidly
expanding. As a percentage of the total
population, the middle class may still be small,
but small percentages in a population of 1.3
billion citizens make for very large numbers. To
illustrate the point, a speaker pointed out that
Chinese tourists are already outspending other
tourists in many parts of the world.
It
may sound contradictory that China's middle class
loves spending, when its citizens currently save
30-40% of their income - especially when
contrasted with the US savings rate, which
recently turned negative at -0.6%. Much of the
high savings rate in China is attributed to a
still underdeveloped banking system. Great strides
are taking place to improve the environment for
both domestic and foreign venture capital. The
number of self-employed entrepreneurs is rising
rapidly. Still, many Chinese put their money into
savings accounts because of the perceived lack of
better alternatives. I had dinner with a
high-level securities regulator, an
American-trained Chinese, and asked why he worked
for the government when he could work for a higher
salary with an investment bank. His response was
that he wanted to help China get ahead and get its
banking system in shape. Again, while there
continue to be great challenges, I had the feeling
over and over again that knowledgeable people are
dedicated to advancing the country.
A
discussion on China these days would not be
complete without talking about the Chinese yuan
and its exchange rate versus the dollar or a
basket of currencies. It was difficult to find
anyone who was not in favor of a fixed (or very
stable exchange rate). Nobel Laureate Professor
Robert Mundell gave a presentation in which he not
only favored a fixed exchange rate versus the
dollar, but ideally a world currency (Mundell was
influential in structuring the euro). His view is
that a stable exchange rate facilitates business
planning, and money will flow to the region with
more favorable conditions. My concern, as I have
expressed on numerous occasions, is that these
money flows may create imbalances too great to
handle. A trade surplus with the United States of
$17 billion for the most recent month reported is
a great deal of money for China, an economy that
is still a fraction of the size of the US economy.
There are serious side effects; overproduction,
which forces raw material prices higher, is one of
the associated burdens on the world economy. My
concerns notwithstanding, all the businesspeople I
spoke with prefer a stable exchange rate, to allow
them easier planning for their businesses.
Professor Mundell did say that a shift
away from pegging the yuan to a single currency
(such as the dollar) to a basket of currencies
does make sense, should there be fear that the
previous reference currency could become unstable.
He did not, however, imply that the US dollar
would become unstable. Personally, I would not be
surprised if historians will point to the
foresight of the Chinese as they appear to realize
that the US dollar may be at serious risk given,
amongst other factors, the immense current account
deficit in the US.
How is inflation
impacted by China's rise? To understand the forces
at work, let us examine different supply and
demand factors. In China, with 600,000 engineers
graduating from college each year, we have a
virtually unlimited supply of skilled labor,
helping to keep a lid on wages (there are some
wage pressures in the countryside, however, as
skilled workers migrate to the cities). We have a
lot of money looking for investment opportunities,
from foreign direct investments, to government and
domestic investments. Then we have a currency
that, while now tied to a basket of currencies, is
so far still de facto pegged to the dollar. In
addition, China's enormous trade (and current
account) surplus with the US leaves it awash with
money. If you swim in money, odds are you are not
going to always put it to its best use, as many
investments inevitably fail, setting China up to
hit speed bumps on its growth path. However, as
far as the output of the Chinese economy is
concerned, we have a recipe for a flood of
low-priced consumer items, keeping a lid on
consumer goods-price inflation. In the US, low
interest rates, low taxes, and high real estate
prices have helped to absorb the flood of goods
from Asia. Many analysts stop their analysis here.
However, in my view, an inflation analysis
must take into consideration the side effects as
well because these are of unprecedented
proportions. Never before have so many people
joined the global workforce; as a result, the
strains on resources are felt globally. And not
only is the scale unprecedented, so is the speed.
China's growth is not only a result of decisions
made by the Chinese central government; it's a
combination of a number of factors, both internal
and external. In China, the pegging of the yuan to
the US dollar (and now to a basket of currencies)
has artificially lowered the price of goods to the
US consumer in recent years, leading them to
consume more than they would have in a floating
exchange rate environment. External factors
expediting China's growth include US monetary and
fiscal policies that have, over the past years,
fostered consumption. The speed and the scale has
left its marks not only on high commodity prices,
but also on US corporations who see their margins
squeezed. They have responded by accelerating
their outsourcing to Asia to remain competitive.
Mundell says that a fixed exchange rate is
not inflationary as long as there is demand to
absorb the increased money supply. In my view, the
unprecedented speed and scale of China's entry to
the global economy has many spillover effects not
easily captured by this model - as manifested most
clearly in high commodity prices. In the US, just
about anything that cannot be imported from Asia
has experienced high inflation (health care,
education craftsmen, to name a few). An anemically
low US savings rate is also a sign that the US
consumer has not been able to cope with the speed
and scale of what is affecting them. One of the
reasons why the US savings rate is so low is that
the consumer believes that elevated energy prices
may only be temporary. I believe energy prices are
likely to remain elevated; I also believe that the
lackluster employment growth and the
unsatisfactory income growth are part of the
"spillover effect". As the consumer plays a very
important role in the US economy, the US
government is working very hard to keep up
consumer spending. Most recently, the government
has handed out US$2000 to many victims of
hurricane Katrina in the form of prepaid debit
cards. While the motivations are honorable, this
is very much akin to throwing money out of
helicopters, as Federal Reserve Chairman
Greenspan's potential successor, Ben Bernanke, has
promoted as a possibility to boost an economy at
risk of deflation. More importantly, the
administration has announced a stimulus package on
top of an economy that is already running at its
limits - at least when measured by the price of
energy. The recent surge in gold comes as no
surprise to us; we also believe that pressure on
the dollar will increase, as the government will
fight any slowdown mostly by printing money.
Why do I always end up discussing the US
consumer when talking about China? Because China's
growth is heavily driven by US consumer spending.
With interest rates creeping up; with a real
estate market slowing down; with a negative
savings rate; record energy prices; wage growth
that is not keeping up with GDP growth; with
producer price inflation and with consumer price
inflation indices picking up, to us it is a
question of when, rather than if, US consumer
spending stalls. So what happens to China's growth
if this occurs? China would certainly suffer,
although the likely reaction there would be to
work even harder. China may also use its newfound
mechanism of setting its exchange rate to promote
exports to other trading partners, notably Europe.
Separately, intra-Asian economic ties will be
strengthened, especially with South Korea, which
is investing very heavily in China. And China's
domestic market may continue to grow unless a
severe slowdown in the US leads to a shakeout in
China's economy.
China does see these and
other (for example, environmental) challenges it
faces. But by continuing on its reform path, the
country is working hard to be ready and is open
for business - your business.
