Has China's Economic Growth Passed It's Peak?

by Edward Hugh: Barcelona


Is the annual rate of Chinese growth now about to slow, not just temporarily, but may it actually be that the long march of Chinese "catch-up" growth is now finally slowing? This is the question that was asked by the Financial Times earlier this week, and, as they point out, it may well be that behind those headline forecasts for decelerating Chinese output in 2008 there lies a deeper and more significant trend that may mark the arrival of the long-awaited turning point in the trajectory of the Chinese economy.

Certainly both local Chinese and World Bank economists have significantly downgraded their forecasts for China’s 2008 growth in recent weeks – down from 11.4 per cent rate achieved in 2007 to around 9 to 9.5% this year. But more importantly, could the 11.4 per cent expansion in 2007 – the fifth consecutive year of double-digit increase – represent the peak point in headline growth for China's economic development process. That is, after falling back this year, will Chinese growth ever climb back to its previous heights, and even if it doesn't , should this fact be producing concern among us?

On the face of it, it is obvious that noone - not even China - can continue growing at double digit rates forever, and at some stage the cycle of growth will fall steadily back towards the much lower rates traditionally associated with a developed economy. The big question is really, has that point now been reached?

To get an idea of what we are talking about, and of what all this might this mean, perhaps it is interesting to take a quick look at the longer term growth patterns of some other economies who have been through the "accelerated greenhouse" catch-up growth that China is currently enjoying. Perhaps a good place to start would be with South Korea, since South Korea is arguably the South East Asian "tiger" which is most similar to what Chinese economic evolution might look like, since Singapore, Taiwan and Hink Kong are, each in their own way, very special cases.

Now as we can see from the above chart, South Korean was at one point very strong indeed, until growth "peaked" around 1987 (at 11.1%) and since that time growth has followed a more normal cyclical pattern, with the important detail that with each successive cycle Korean growth has slowly and inexorably slowed ("stripping out" the very exceptional sharp decline and rebound produced by the Asian crisis in 1998).

Economic growth for an emerging economy tends to show this kind of profile since in general terms there are both technological and demographic components in "catch up" economic growth - although there may actually be no such thing in reality as a constant steady state rate to catch up with as I try to argue here - and once most of the technological gap has been closed and the benefical momentum of arriving at maximum proportions of the population in the highly productive 25 to 50 age group begins to pass, economies then seem to eshibit a steady loss of momentum rather like air escaping from a pinprick in a gas balloon, as we can see in the cases of the two oldest societies on the planet, Japan and Italy, in the charts below.





Now I have singled out Italy and Japan (the profile for France, or the UK, or the US is really quite different) since they are both late economic developers, and also since their subsequent demographic transition to ultra low fertility has been very rapid, as it is about to be South Korea and China. Hence Japan and Italy have experienced very rapid ageing, and we already know China is about to follow them down this road, at what may well be an even more rapid pace. In fact China may well, thanks to the presence of a forced restriction of fertility, a reasonably high level of life expectancy and a virtually negligible impact from inward migration as we move forward, become the most rapidly ageing society the world has so far seen.

The comparative median age charts for China and South Korea give the general picture. When we get to 2020 China will still be significantly younger than South Korea, but is following the same trajectory. By 2020 Korea will be nearly as old as the three oldest societies - Germany, Japan and Italy - currently are, and will in all probability be older than slower ageing societies like the UK and France. The is a very dramatic change for a newly developed country.




Chinese Growth

So what do we know about growth to date in China? Well, lets look at the longer term chart.



Now when we come to look at this chart, we immediately face a number of important problems. The first and most obvious one is that the further back in time you go prior to 2000 the more unreliable the data is. So the fact that the maximum growth period seems to be in the mid 1980s, followed closely by the mid-1990s burst might, at first sight, seem strange, since it is the growth spurt which China has enjoyed post-1998 which has really been the most convincing. But it should be noted that China's demographic trajectory is virtually unique, and it is the case that it was getting some sort of potential demographic dividend or other well before 2000, so while the earlier data most probably does not give a complete picture, perhaps it would be a mistake to disregard it altogether. Of course, the more credence we give to the 1980s growth, the more we have to reach the conclusion that some significant slowing down or other may well be at hand, since following the trajectory of the line would suggest it. But as I say, maybe we shouldn't give too much credence to earlier data, so we need to be carfeul with this kind of argument.

What we do know is that from the late 1990s onwards China systematically introduced a very extensive labour and financial market reform process, and this certainly has served to unlease a huge amount of pent-up potential, and it is this which has given us the sustained growth since the early 1990s which has only been accompanied by one small dip between 1998 and 1999 (again the Asian crisis).

Now if we think about the currently rather fashionable coupling-decoupling arguments in this context, it is clear that China was effectively "decoupled" during the 2001 internet bust global slowdown, since it kept growing regardless. That is to say there is evidence that China was much more affected by events in surrounding Asia in 1998 than it was by the recession in the G7 in 2001/2002.

There are of course plenty of reasons for taking the view that things may not be the same this time round. China is evidently much more "locked-in" to global dynamics due to its systematically increased share in world trade. Also China was much more able during to trade increasing its market share for slowing overall world growth during the last recession, by using its price leverage - due to all that pent-up unused labour - but again there are reasons (and especially the domestic inflation ones) for thinking that things may not be quite the same this time. This would be doubly the case if China has been able to extend the post 1998 wave beyond its natural duration by taking advantages of the global imbalances situation, and its own currency and price leverage, to extend its export growth beyond what might be considered the normal sustainable extent. Basically I am very suspicious when I see such extended growth with virtually no humps, like we get in the Chinese case. As we can see for the other charts, growth should be more wave like, so we should at least ask ourselves what it is that has been going on?

The Intractable Inflation Problem

So the big question is when will the current wave come to an end, and when could we expect China to follow in the footsteps of South Korea and show us that steady but constant reduction in annual growth rates. Well... looking at the chart, and sticking my neck out, and also making some sort of back of the envelope estimation about how intractable the inflation problem may turn out to be (and of course recent Eastern European and Russian experience is relevant in this context), my feeling is we may well find China starting to slow this year, and the process continuing next year, and the one after etc - with the normal and anticipated ups and downs. So the Financial Times may well be right when it suggested that Chinese growth may slow and never quite be the same again, but there are grounds for thinking that they may perhaps have only captured part of the picture, and the grounds for thinking this are that they do not appear to have factored in population, labour market and inflation dynamics, and the ineveitable interaction of the three of them.

Certainly Chinese growth from now on is going to be constantly pushing up against limits which are increasingly set by the level of inflation. The inflation problem China has is a very real one, and at this point in time it is hard to see how they can adequately address it. Certainly the popular remedy - unchaining the yuan - could just as easily lead to an acceleration of capital inflows and a further increase in the overheating problem as to any more benign outcome, and I here I would suggest we treat New Zealand (and India for that matter) as the "Canaries in the Coalmine" (or if you prefer "smoking guns"). Conventional monetary policy is up against very clear limits at the present juncture.

And the recent resort to administrative measures seems almost destined to fail - as it is failing in the Russian case - since the problem is not a temporary one produced by high oil and food prices (which are anyway in part a by-product of Chinese growth), but is now becoming more endemic and structural. In the face of the present inflation surge the Chinese government has been gradually widening price controls, and finally took the plunge and froze all food prices last month while at the same time clamping limits on fertilizer prices and raising price supports for rice and wheat. These controls are meant to shield China's poor and working classes, who spend up to half their incomes on food. But the inflation spike is blamed on shortages of pork and grain, and it is obvious that putting a lid on prices simply shifts the hardship over to the farmers, discouraging them from raising output, and thus in the medium term reducing output and putting even more upward pressure on prices.

The recent extreme weather has only exacerbated the problem. In order to ease electricity shortages, thousands of trainloads of coal were rushed to power stations and hundreds of mines were kept running through the Lunar New Year holiday. But with the price of coal now forecast to climb by anything up to 100 percent this year, Beijing has yet to say how power companies will cope.

So I am really not that clear that China has any easy way out of the present inflation dynamic - and remember this is a huge change from the moment when China was reportedly "exporting deflation to the rest of the world", a process which at best has lasted from 1998 to 2007, but is unlikely to continue in the same way. In addition there is now significant evidence of labour market tightening in some parts of the Chinese economy. Wages and salaries of employees went up in the 3rd quarter of 2007 - the latest quarter for which we have data - by 22% (and by 27.2% if we take the private sector alone). And there are significant regional differences, with wages in the private sector in Beijing rising by 36.4% year on year. Even subtracting inflation these are sill very high rates of increase in real wages, and are surely not compensated for in their entirety by productivity increases. So China is steadily losing its competitive edge.

Clearly given the very low level from which Chinese wages started, and the restrained growth in the value of the yuan, it is possible to absorb to some extent such increases. The problem is that they may go on and on, and even accelerate.

And The Growing Difficulties In Finding Young Labour

The reason I say that we should expect worse to come in this regard is due to the underlying strong structural break in the Chinese population pyramid, a break which has been produced by many years of one child per family policy. Looking at those other canaries we have sent down the collective coalmine - Latvia and Estonia (and then, of course, Russia), then it does seem that push-comes-to-shove much sooner than any of us had been anticipating in the question of labour market tightening in the key 15 to 24 age group. In a way these could be thought of as the labour market equivalent of "first time buyers" in the housing market, since they tend to set the rates for others higher up the ladder. And just in case you have difficulty imagining how a country with a 750 million odd labour force could possibly have labour shortages, just remember that this labour force has been growing at an annual rate of 6 or 7 million to sustain the double digit growth rate, and even China can't find the additional people to keep explanding its labour force at this rate forever. And in particular it can't with generational cohorts which will soon be much smaller than those exiting the labour force at the upper age end, and with participation rates in the 15 to 24 age group bound to fall as people go for more and higher levels of education. Maybe it is worth bearing in mind here, that size doesn't mean you have less labour supply problems, au contraire you have more as time passes, and it is no accident in this regard that Russia and the US are the two countries with the largest annual migration needs. In theory we might expect the Chinese economy when it finally becomes the largest in the planet to also be the world's largest consumer of economic migrants, but this scenario hardly seems plausible.

As I say, 2008 could well be the year that inflation really gets a hold on China. Certainly the strong uptick in the latter months of 2007 is evident, as can be seen in the chart below.



Curiously this uptick coincides exactly with the peaking of the 15 to 19 age group, as you can see in the chart, and the decline in this age group from here moving forward is really quite dramatic, as you would expect from the drastic policy measure which was applied.




I have selected the 2022 horizon looking forward based on the fact that this is now known data. We can predict with a reasonable degree of accuracy just how many 15 year olds there will be in China in 2022, since they have now already been born. So we have a pretty good idea of China's new labour supply going forward. Obviously China can still get considerable growth by relocating the existing workforce across sectors to more productive ones. But the end of the labour intensive low economic value growth must now surely be in sight, and the big question is can China sustain inflation-free growth of the order of magnitude we have been seeing in recent years, bearing in mind that much of the recent growth in many of the higher growth developed economies - the US, the UK, Ireland, Spain - has been very labour intensive. My feeling is that it can't, this is why all those exhausted canaries swooning in Latvia have been so useful, and that we will see a slowdown in China which will not simply be cyclical, but rather structural. Possibly the moment of inflection (or tipping point) here will come around the time of the Olympic Games.

So, as I say the 15 to 19 age group has now peaked in China, and from here on in it is essentially downhill all the way, as far ahead as anyone can see. The truth is that no-one at this point in time knows what the consequences of this are going to be. But don't worry, since at least one thing is for sure: we are all just about to find out.

Serbia's Economy Looking Towards Europe..... But Facing Mounting Ageing and Demographic Problems

by Edward Hugh: Barcelona

This post constitutes a brief economic review and report on Serbia to accompany Manuel's election report .

Boris Tadic, the Serbian president-elect, was reportedly hoping on Monday to capitalise on his success in Sunday’s election by pressing ahead with a co-operation agreement with the European Union. At the time of writing, however, it is still unclear whether he willl prove able to secure sufficient backing from Serbia’s fragile coalition government, in which Mr Tadic’s Democratic party shares power with Vojislav Kostunica, the nationalist-leaning prime minister. So on one side there are grounds for at least a bit more optimism as far as Serbia is concerned.

But since in Sebia's somewhat tragic recent history it seems that nothing is ever given without being immediately snatched away, the country also received a dose of cold-shower reality checking, in the form of an observation from credit rating agency Standard & Poor's on Jan. 21 that the outcome of the Serbian presidential elections would have no immediate impact on the country's sovereign credit rating of BB-, which still howevers at a perilously low level, three full steps below investment grade.

So where is Sebia likely to be heading in the coming months? Well in this brief note I will be arguing that unfortunately Serbia seems to have and to be about to receive the just about the worst of both possible worlds. While still locked outside the European Union it nevertheless faces many of the inflation-ridden, remittances-driven consumer-boom problems - severely aggravated by out-migration and long term low-fertility-provoked labour shortages - which also bedevil most of the existing members of the EU10 European Union accession group.

Long Term Population Decline

It is impossible to understand what is currently happening in Serbia, and what is most likely about to happen next, if we lose sight of the fact that Serbia's population, like that of many othercountries in central and Eastern Europe, is both ageing rapidly and declining. The official population of the Republic of Serbia - as monitored by the Serbian statistics office - has been falling since the late 1990s.




At the same time Serbia's population median age is rising quite rapidly, and has now passed the sensitive 40-year-old barrier.



This is significant, since what experience we have with ageing tends to show us that as median ages move up beyond 40 the momentum of internal demand starts to slacken, and a country's economy comes to depend increasingly on exports for growth. This is significant, of course, in Serbia's case, since Serbia currently runs a sizeable trade deficit.





The reason for Serbia's rising median age is threefold: low fertility, increasing life expectancy, and substantial out migration of people in younger age groups.

If we look at fertility we can see that it is presently around 1.6TFR, and while this is still somewhat above the general norm for East and Central Europe countries - which are normally hovering in the 1.2/1.3 TFR range - it is nonetheles well below replacement levels, and looks set to fall further yet awhile as the birth postponement process gathers pace.



The impact of this steady decline is that the annual number of live births also declines, at the same time as the annual number of deaths rises since the number (and proportion) of people in the older age groups also rises. I don't have long term data for Serbia alone, but the pattern for Serbia and Montenegro (with Serbia at the time in question including Kosovo) is revealing enough.



And then if we look at the balance of births and deaths for the Republic of Serbia alone from the turn of the century, we can see how the natural rate of increase has turned negative, regardless of out migration.




At the same time male life expectancy - at 72.49 - while being quite high in an East European context, is still comparatively low in developed country terms (it is more or less in the same range, for example, as countries like Tunisia, Mexico and Paraguay), so this age is likely to continue rising steadily, thanks to the arrival of better medical technologies and medicines.




But here is just where we find a problem for a country like Serbia, since most of this increase in life expectancy will come from improving the outlook for the over 60 group, and this will have a significant on-cost (in health and pensions) with little positive economic (as opposed to human) benefit.

So the basic picture to take away from all of this is that Serbia, which is still a comparatively poor country, is going to face the possibility of increasing labour shortages as she grows, while at the same time having fiscal strains produced by the weight of the elderly population group, and productivity issues in trying to replace the "missing" people in the 20 to 30 age groups with more workforce participation from those over 55, many of whom may have little work experience (rural women), poor education, or may have been through an extended period of long term unemployment. None of which are evident "plusses" when it comes to the nitty gritty rapid catch-up economic growth.

GDP Growth and Inflation

Economic growth in Serbia has been pretty strong in recent years, and Serbia's economy has grown at an annual rate of over 7 percent for the last three consecutive quarters (up to Q3 2007) for which we have data. But in a pattern which is now becoming increasingly common across emerging markets across Central and Eastern Europe this strong growth has sparked widespread inflation and overheating concerns, problems which make Serbian government attempts to bring the economy into line with European Union criteria increasingly difficult.





Indeed, due to the steady increase in the value of the Dinar against the US dollar, the rise in the dollar value of Serbian GDP has been little short of spectacular.




Gross domestic product in fact grew by 7.2 percent in the third quarter of 2007, and this followed growth of 7.7 percent in the second quarter and 8.4 percent in the first three months of the year. Policy makers at the central bank have become increasingly nervous and concerned that this swift growth, which is more than twice the pace of the 15 nation eurozone, will destabilize the economy, and especially since they have been keeping a weather eye on capacity constraints and what has been happening elsewhere in Eastern Europe.

Serbian inflation which had been declining over recent years abruptly started to accelerate again towards the end of 2007, reaching an 11.9% rate in December, a level which prompted the bank to raise the benchmark rate by three quarters of a percentage point at the end of December and by a further half a point today (6 February), in the process bringing the rate up to 10.75 percent, which is the highest current rate in Europe, amid accusations from the central bank governor Radovan Jelasic that the Cabinet is not doing enough to calm inflation. In particular, and ignoring advice from the IMF, instead of aiming for a surplus the Serbian Parliament last December adopted a 2008 budget that includes a deficit of 0.5 percent of GDP and an inflation target of 6 percent.




"Only a deaf man cannot hear inflation knocking at our door" central bank Governor Radovan Jelasic said in a press conference recently. "Today's passivity will be paid for dearly in few months." December inflation rate soared to 11.9 percent in December from 10.4 percent in November.



Remittances and Migration

Given that the present median age is fairly high (40.6) and since fertility has been low, but not disastrously so, while life expectancy is not especially high it would seem to be a reasonable deduction that there has been a fair amount of outward migration in the 20-40 age range over the last decade or so. I say reasonable assumption since unfortunately, in a manner which is all too common in East European societies, the situation is complicated by the fact that the Serbian government has not made migration figures public since publishing the results of the last census in 2002. What appear to be reasonably accurate figures for the period up to the census are available on the statistics office website, so it is perfectly possible that the administration themselves have no real idea of what the numbers actually are, as this paper on migration in the Serbian context makes clear).

Some indication of the extent of Serbian out-migration can be obtained from the remittances flows, which were estimated by the World Bank to be running at a rate of 17.7% of GDP in 2006. Now this is a very large share in GDP value, and has lead people to use the expression "labour export" driven development in the case of countries like Moldova and Serbia. But this view misses one important feature of the situation, and that is that - unlike high fertility socities like Pakistan or the Philippines - Serbia is not resource rich in labour. Labour is a precious and potentially scarce resource in a low fertility society, and far from exporting, Serbia needs to hang onto what it has, and even attract back many of those who have left.




Back in 2002, according to the statistics office, there were roughly half a million Serbs working abroad, about 100,000 of those being in Germany. In that year there were 2 billion dollars worth of remittances coming back. In 2006 there were roughly 4.7 billion dollars coming in, so we could estimate that the number of those working abroad has more or less doubled to near the million mark over these years. In a country with a labour force in the 3 to 4 million region, this is a lot of people.

The whole issue of Eastern European migration is a complex one, and has been the subject of a recent World Bank report. Basically we are witnessing a systematic east-west migration process taking place across Europe at the present time, driven mainly by the existence of a substantial wage gradient.

So Serbia has, along with most of the rest of Eastern Europe, a substantial problem in retaining its young native-born human capital. Indeed, according to the above cited paper, a staggering 70% of Sebian students indicate that they would like to leave the country on completing their studies. But on top of this Serbia - along with a whole swathe of other Eastern European countries (Croatia, Macedonia, Moldova, Ukraine, Georgia, Armenia etc.) - faces the problem of being excluded (at least in the short term) from the European Union. Unfortunately with the current climate towards enlargement inside the EU this situation is unlikely to change much in the near future, and these are likely to be critical years in the demographic history of these countries as the full weight of the second stage of the demographic transition - low fertility and medically driven extensions in life expectancy - comes increasingly to exert an effect.

Perhaps the final bucket of very cold water is thrown on all this by the most recent authoritative statement on the state of the Serbian economy: the October 2006 IMF selected issues Serbia paper, from which I now freely quote:

Serbia has made significant economic progress since 2000. Output is up 40 percent and the share of the private sector in non-agricultural non-budget employment has almost doubled to around 60 percent. These advances have reversed the decline of the previous two decades. In light of this progress, these notes aim to shed light on the challenges ahead.

Of course it is important to remember here that back in 2000 the Serbian economy was virtually in ruins, so climbing back up was not so difficult, it is what comes next which is important:

With capital formation rates regionally low and employment reportedly falling, much of the economic recovery since 2000 has reflected growth in total factor productivity. In part, this is the dividend of corporate reforms which have increased efficiency. But even with the exceptional steel investment in 2004, Serbia’s investment ratios are well below those in other transition countries. Even allowing for data quality uncertainties, these investment patterns raise questions about the sustainability of Serbia’s recent economic growth. The note infers that these investment patterns indicate that a significant further reform agenda—ranging from improved business and political climates, to bankruptcy and privatization—still lies ahead.

and on employment:

With the unemployment rate at 21 percent and rising, employment reportedly in trend decline, and future restructuring set to result in further layoffs, the issues are challenging. The note is exploratory, suggesting lines of enquiry rather than firm conclusions about the way ahead. It reports that the employment structure has shifted to the private sector, but cautions that data are not yet conclusive as to whether this is re-classification due to privatization or whether private firms are creating new jobs. It suggests that Serbia’s labor institutions could be reassessed in view of the high and rising unemployment, including the complex wage setting mechanisms in the public sector inherited from the Yugoslav era.

Also note the rapid growth of credit, especially to unhedged borrowers (shades of the Hungarian disease):

With rapid credit growth one of the consequences of earlier reform, notably of the banking system, the 2005 FSAP pointed to the need to strengthen banking regulation. Given that the 2005 banking law brought the legal regulatory framework largely in line with Basel Core Principles, this note emphasizes that the key challenge now is implementation. It notes that credit, which is largely fx-indexed lending to unhedged borrowers, requires strengthened regulatory capacity to monitor and manage indirect credit risk arising from foreign exchange exposures.

And note these two points from the Main Findings section:

In Serbia, the large current account deficit has been associated with relatively low investment ratios compared to other CEECs (except Bulgaria)—although data doubts remain.

Given Serbia’s large external debt, financing its large investment needs will require achieving higher national savings and attracting larger non-debt creating flows.

and this:

Given these caveats, Serbia’s data suggests surprisingly high external deficits given lackluster fixed investment ratios. Such delinks are not without precedent—after 2001, the Czech Republic and Hungary both reported continued high external deficits while fixed investment ratios declined, in both cases reflecting weakening domestic savings rates. But overall, Serbia’s performance is unusual in degree—reporting large external deficits alongside low investment ratios.

I think the very last sentence really says it all. Capital has continued to flow into Serbia in recent years, but less in the form of foreign direct investment and more as external, including off-shore, borrowing. External debt has continued to increase. In particular, private debt rose to 38 percent of GDP at end-September, more than double its end-2004 level, and at the same time there has been a very rapid growth in euroized credit. So we have very much the same combustible mixture we have been seeing all over Eastern Europe, with the only distinction that the intensity and degree in Serbia are just that bit stronger.

The Serbian average wages increased by nearly 30 percent in the 12 months to November 2007, while during the same period retail prices rose by only 10.4 percent. That means that in November 2007 the average wage bought about 20 percent more goods or services than in November 2006! In manufacturing, real wages rose by 20 percent. While this was the smallest increase of all sectors, it still exceeded by far the estimated 13–14 percent rise in industrial labor productivity. Thus, industrial labor became less competitive. This is all clearly unsustainable.




It is highly probable that under these circumstances foreign direct investors will find Serbia less attractive, and privatization and restructuring of enterprises with skyrocketing wage bills will become more difficult. The problem is at its worst in the public sector. Real net wage growth in public sector in the 12 months to May 2007 was 30 percent, while productivity increases were relatively small. A few examples: Health workers received an average 42 percent salary increase. At the same time, the health sector is busy taking out additional loans to finance necessary maintenance and capital expenditures. Somebody will need to repay the loans. Real wages in the electricity sector went up by 30 percent in the year to April, while EPS received a 15 percent increase in electricity prices in May. It also consistently requested more price hikes to cover its expenditures.

Higher wages increase consumption and imports, thus further deepening the current account deficit. They also increase inflation in the non tradable sector and thus make the job of the National Bank more difficult.

So Serbia seems to be caught in a kind of trap, where out-migration produces remittances and an increase in consumer and loan demand, and this increase in demand fuels a wage price spiral which seems to be hurtling out of control (remember that euro denominated loans carry a much lower rate of interest than dinar denominated ones, thus effectively circumventing the central banks monetary tightening), and all of this while unemployment - according to official data - runs at over 20%. What happens next? This is very hard to say, since no-one really has ever been here before, but the result will certainly be worth watching, if only to see what can be learnt from the experience.

Some further explanation of the theorectical logic that lies behind this argument can be found in:

Inflation in Russia: Too Much Money Chasing Too Few People?

and

Catch Up Growth and Demographics - Evidence from Eastern Europe