China Consumer Inflation February 2008

China's inflation accelerated to its fastest pace in 11 years in February as the worst snowstorms in half a century disrupted food supplies, adding to pressure on the government to step up administrative measures to try and slow the economy and on the central bank to raise interest rates. Consumer prices climbed 8.7 percent in February from February 2007 following a gain of 7.1 percent in January, according to the statistics bureau in Beijing earlier today.

This is obviously very bad news indeed, and makes the Chinese problem look ominously like what we have been seeing in some East European economies and Russia. Obviously rising living standards which produce pressure on restricted global food prices don't help, nor does the strong flow of speculative funds entering China in the expectation of yuan revaluation. But to the discerning eye there is obviously a much more profound process at work here. The problem seems to be that China - despite its enormous size - is chewing up its labour reserves faster than new labour market entrants are arriving, and this is happening in large part due to the structural population break which has been produced by several decades of one child per family policy.




The issue is simply that China cannot continue to grow at anything like the double digit rate it has become accustomed to in recent years, in particular due to the growing constraints on labour supply. It should be remembered here that China has so far been focusing on low value work which is hugely labour intensive.

If you want some idea of what this means in practice, just look at this opening sequence from Jennifer Baichwal’s documentary "Manufactured Landscapes". And notice, apart from the scale of the enterprise, and the types of activity engaged in, the comparatively young age of most of the workers.




The New York Times's Keith Bradsher was in China last summer, and he pointed out that while there are no really reliable figures for average wages in China there is widespread evidence that factory owners and experts who monitor the labor market are noting how that businesses are having a hard time finding able-bodied workers and are having to pay the workers they can find ever more money.

For decades most labor economists saying that China’s vast population would supply a nearly bottomless pool of workers. So many people would be seeking jobs at any given time, this reasoning went, that wages would be stuck just above subsistence levels, probably for decades. As recently as four years ago, some experts estimated that most of the perhaps 150 million underemployed workers in the countryside would be heading to cities. The reality however has been quite different. Instead, from 2003 onwards sporadic labor shortages started to appear with growing intensity at factories in the Pearl River delta of southeastern China. Now those shortages seem to have spread to factories up and down the Chinese coast.

Only this week the Economist reports - in an article entitled Where is Everybody - that the vast annual migration of around 20m people that has been fuelling the manufacturing boom in southern China over the past two decades is rapidly diminishing.

The Guangdong Labour Ministry is reporting that 11% of the workers did not return after the January holiday period, and independent estimates put the number as high as 30%. Whatever the exact details, many factories are reeling. Wages were already rising (according to government figures by around 20% y-o-y) now they will surely go up further. Meanwhile, revenues are falling due to slowing demand from America and a reduction, following pressure from other countries, in China's complex system of export subsidies.

The Federation of Hong Kong Industries have also produced some gloomy looking figures. Members estimated 10-20% of the 70,000 factories in Guangdong province had closed in the past year, and they expected a similar number to close within the next two years. Two-thirds of those polled said they were unsure whether to invest more in the region; one-third planned to cut investment. Only one respondent was optimistic. As the Economist notes, not all of this is bad news by any means since to some extent the closures are the objective behin a recent government plan to force dirty, low-paying industries out of business or into poorer interior regions that have so far missed out on the country's growing industrial wealth. But then we have the inflation data, and we can see that there is more at work than a simple "facelift" operation.

When pressed Chinese officials are quick to say that there is no overall shortage of labor — rather, there is a shortage of young workers willing to accept the low wages that prevailed in the 1990s (see again the video clip above). Factories in cities like Guangzhou advertise heavily for young workers, even while employment offices consider it a success if someone over 40 can find any job in less than a year.

Keith Bradsher quotes Jonathan Unger, director of the Contemporary China Center at Australian National University in Canberra, to the effect that “Now they’re taking workers into their early 30s, but anything older than that and they think they can’t take the conditions, the 11-hour days.... as well as work on weekends, and a tedious life in factory-owned dormitories". and as Brasher says "Plant owners’ refusal to hire blue-collar workers over 35 or 40 is colliding with the demographic reality of China’s one-child policy". And on his vists to villages from tropical Gaoyao in the southeastern corner of the country to dusty Houxinqiu in the northeast, what he found most striking was how few young adults remained after so many had left for the cities. He cited a recent government survey of 2,749 villages in 17 provinces and autonomous regionswhich found that in 74 percent of villages, there were no workers fit to travel to distant cities. Of course this is what they are now noting in Guandong.


The Real Issue is Inflation and Rapid Growth


The big unknown in 2008 in China is what is going to happen happen to inflation. Most analysts are assuming that the application of a traditional set of policy measures - letting the yuan rise, raising interest rates at the central bank - will produce a very gradual slowdown in China. Having seen what I have seen in Eastern Europe, and looking at what is now happening in Russia, I have my doubts abou this.

The inflation problem they have is a very real one - as we are now seeing month after month -and at this point in time it is hard to see how they can adequately address it. Certainly unchaining the yuan could just as easily lead to an acceleration of inflows and an increase in the overheating problem as to any more benign outcome, and I would treat New Zealand (and India for that matter) as the "Canary in the Coalmine" (or if you prefer "smoking gun") here. So I would just like to put up a question mark on this count, and I would do this especially in the context of the underlying and strong structural break in the Chinese population pyramid which has been produced by many years of the one child per family policy. Looking at those other canaries - Latvia and Estonia (and then Russia) push-comes-to-shove time does seem to arrive a lot earlier than we had all been anticipating. As I say, 2008 could well be the year that inflation gets a hold on China. In which case the whole thing could simply continue overheating till it simply cannot anymore, and then we could see a quite severe slowdown, a slowdown which given China's size and growing economic importance could have an impact across the entire global economy.

The danger is that a feedback mechanism is created whereby rising wages (according to data from the statistics office Chinese wages are now rising at something like 20% year on year) feed into producer prices, which then feed into consumer price inflation, and so we go on. Certainly this weeks producer prices data was hardly reassuring, since producer prices climbed 6.6 percent in February, the fastest pace in more than three years, giving us yet one more indication that the "cheap Chinese labour" global disinflation process most likely has now come to an end.



What we really need to be noting here is the fact that China's demographic trajectory is virtually unique, especially in terms of economic growth and China's demographic transition, since it is surely the case that China was getting some sort of demographic dividend or other (in terms of having an increasing proportion of the population in the workforce) well before the recent growth wave really took off in the late 1990s.

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 both interms of labour supply and sectoral shifts in economic activity, and it is this which has given us the sustained growth since the turn of the century.

What is interesting to note is how the recent uptick in inflation coincides almost exactly with the peaking of the 15 to 19 age group, as you can see in the chart below, and it is important to note that the decline in this age group will now continue as far ahead as the eye can see, and especially over the next several years is really going to be quite dramatic, as you would expect from the drastic one chile per family "torniquet" policy 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.

Postscript

Those interested in a more growth-theoretically oriented explanation of the argument in this post may find my "Has China's Economic Growth Passed It's Peak? post well worth reading.

And for a fuller explanation of the inflation dynamics problem in another context see my "Inflation in Russia: Too Much Money Chasing Too Few People?".