Friday, March 14, 2008

China's Inflation and Labour Shortage Problem, It's The Fertility Stupid!

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 the ones 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.


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?".


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Scott said...

Very informative, Edward...thanks! I think a key point you have made is that "there is a shortage of young workers willing to accept the low wages that prevailed in the 1990s." I am fairly certain China's young workers can see that the type of work being done at today's wages isn't rocket science, and that they are aware of what currently employed workers are making. One might say, with tongue in cheek, that the "young workers of China have united" to reject labor arbitrage. Now, workers in other countries such as Vietnam don't have the same leverage regarding wages, which would help explain why electronics production is moving from China to Vietnam, as I mention in my blog.

It seems that now that China has raised the standard of living for a sizeable chunk of its workers, the rest of the work force isn't willing to accept the difficult working conditions that gave China its manufacturing cost advantage. This puts China in the same stage of workforce condition as Western countries. By that I mean that holders of capital can't find workers willing to take jobs at the wage on offer, so the country must either import workers willing to work at that wage as the US has done with agricultural workers, or outsource the work to foreign labor. Since bringing foreigners in is politically and practically nonsensical for China, the work goes overseas.

Given the trend in the size of the 15-19 cohort through 2022, the size of the potential highly educated workforce that China will be able to generate to move its manufacturing sector up the value stack is limited.

Finally, I believe that China's infrastructure outside of the coastal regions is fairly weak, so that even if the low value add manufacturing is moved to the hinterlands where workers might be found, the cost of transporting raw materials to the factories and then the finished product back out to ports for export might eat significantly into labor cost savings.

Overall, this is a lot of food for thought...particularly on how a consensus can miss the boat so drastically on a projection like the idea that China had a bottomless pool of workers.

Anonymous said...

Excellent post. The notion, in the popular press, that China will grow indefinitely at current rates, strikes me as extreme. It seems they have been picking the low hanging fruits, and it will be increasingly difficult to sustain their gains in growth as they move away from heavy industry. But the demographic argument you add to this notion is powerful.

There are other factors, which most fail to consider, that it seems will soon play into a halting of China's growth. Energy needs is an obvious problem. The development of an alternative energy economy should take at least a decade, but world oil demands are increasing with each passing year and production is stagnating. Prices should continue to rise and this will effect growth.

Then, there are food prices. As the price of grain spirals out of control, due to ethanol poduction and increasing dietary variety in the developing world, China is shifting to being an importer of food for the first time. But if ethanol production continues to rise, so will food prices, and the price of imported food will be that much greater. Add to this the decreasing gains in crop production they have been getting and the increases in suburbanization effecting total cropland, and the cycle of rising prices seems further problematic. I would be curious to hear from an economist how this should effect growth.

Then there are the problems in governance which almost always come with increasing development. As the youth enter adulthood, there will be demands for democratization. The big question is whether this will be a peaceful and stable process. If not, how will it effect growth?

But why should it be a peaceful and stable process. China contains within it a pre-industrial peasant economy, alongside an industrial and post-industrial sector. Each is powerful and significantly unrelated to the others. As individuals shift from one sector to another, they must transform themselves to adjust. As the whole society shifts, institution must transform. The problem is that few institutional and cultural arrangements could integrate such massive variance in worldview associated with these differences. China's current government is far too inflexable. A newly democratizing society, at China's levels of education and past participation, is likely to be highly unstable. This seems a recipe for breakdown. But China has been surprising us for some time and may continue to do so.

It is interesting to consider how demographics might play into these factors. Thanks.

Anonymous said...

seems that inflation is expected everywhere. there will be still couple of pools of cheap labor within China but also in India, Pakistan, Indonesia and then there will be a bunch of African countries, should their leaders get a hold of the administrative stability. so the growth story can continue if only based on cheap labour supply.

but as it was mentioned above there will be some problems related with commodities... some are fixable (metals and minerals, coal) some are bound to be a little bit trickier (oil, gas, food staples, wood) and on top will be the whole climate change/wasteland issue.

interestingly enough worldwide the premium on higher education/skills has reached a peak... as the supply of cheap poorly educated labourers dwindles there will be inflation as their negociating position will be stronger. so we might see soon in China stronger labour unions. for that matter this will likely be good for them as they can hope to move from the dormitories to apartments and live a more confortable and healthy life... they are entitled to it as much as we are in the rich countries.

things will then have to move again, as always when human labour is scarce, to technical inovation that will make this more expensive labour more productive.

kurt9 said...

The so-called labor "shortage" is simply that the excess labor capacity has dried up enough that people no longer take the jobs with the s**t wages and conditions like they did before. Its about time that Chinese workers get a better deal.

Employers in the southern delta (Guangdong Province) are especially notorious for not paying their employees on time. Of course their employees will leave on holiday and not return to work. You would do the same if you were in their situation.

Also, the interior parts of China are still cheap to live in (like regular 3rd world countries). So many workers from these area make their money on the coast, then return to their villages when they have enough money to retire or do something else.

If China does actually run out of workers, they will simply have to innovate and start using automation and robots to do things instead. They will have to improve the working conditions, not to mention income, to get employees. This is no bad thing and will actually improve productivity and, thus, economic growth in China.

Anonymous said...

One aspect related to China's inflation problem that I think is important to note is the political implications. When prices (specifically food prices) rise in China, social unrest has historically broken out and we are already seeing this happen. Significant social unrest could disrupt the economy and significantly cut into growth.

Not surprisingly, given the rise in food prices and China's demographic situation that you laid out, workers are demanding wage hikes, which you point out. Anecdotally, I just heard a NPR radio story on factories closing in southern China because labor costs have become so high they can no longer turn a profit.

Given inflation's historic links with social unrest in China, the government, as would be expected, is more bothered by high inflation. As you point out, it looks like China could be headed for a tumble.

Another interesting aspect to the China inflation story is its impact on the rest of the world. Rising labor costs in China should filter through to their exports, which should further inflationary pressure in the US and Euro Zone. Meanwhile, resource demand in China has helped fuel the worldwide commodities boom we are now experiencing. So I would argue that unlike eastern Europe, China has a starring role in the global inflation pressures we are seeing. A popular saying is that if the US economy sneezes, the world catches a cold. It will be interesting to see what happens when China sneezes...

Anonymous said...

The Greatest Demographic Blunder in the History of the World

I have been warning of the perils of China’s one child per couple restriction for about ten years. The utter stupidity of this policy points up a short sidedness on the part of the Chinese government of epic proportions. This is not just stupid, this is scary stupid. The Chinese government has not just shot themselves in the foot they have blown their foot off. According to a New York Times article of February 29, 2008 by Jim Yardley, it is estimated that China has managed to prevent roughly 400 million births in the last three decades. And as if that is not enough, culturally Chinese couples have overwhelmingly favored male children. I don’t even want to discuss gender driven abortions or what they did with the female infants that did come to term. I do thank God that some made their way to the U.S. and other countries through adoption.

But wait, let’s just think about this. China, the country on the fastest track in the world to economic development and modernization has carved out 400 million people from its population thirty years old and under. Moreover this anemic under thirty population is predominantly male. In the book “Bare Branches, The Security Implications of Asia’s Surplus Male Population” Valerie M. Hudson and Andrea M. Den Boer point out that high male to female ratios often trigger domestic and international violence. Duh! Who are they supposed to marry? “Bare Branches” is dead on. It gets worse. According to the Times article: “China’s fertility rate is now extremely low, and the population is rapidly aging, especially in urban areas. Experts have warned that China is steadily moving toward a demographic crisis with too many old people in need of expensive services and too few young workers paying taxes to meet those bills.” There is more. China’s single biggest economic advantage is cheap labor, nearly at the slave level. However according to the Times article “China’s biggest manufacturing centers are already facing labor shortages.” A labor shortage means higher wages. Higher wages mean the loss of China’s competitive edge, their only competitive edge. China is a country that has sealed its own economic doom. We need to watch the attractiveness of higher price Chinese goods as labor costs escalate along with higher shipping costs because of higher oil prices. China’s economy is headed south. So, what is the world going to do with a country of 1.3 billion people when they get hungry?

What is the answer here? I don’t think there is one. I think we just wait until the demographic time bomb explodes. The world is going to be an interesting place.