Will China’s Growth Eliminate Inflation?

By Axel Merk –
PALO ALTO, Calif. (Merk Investments) — 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 whether clients for products, or tenants for buildings exist. One of the side effects is that competition is intense. The prime beneficiary of the intense competition, coupled with a quasi-fixed exchange rate to the dollar, has been the U.S. consumer that enjoys low prices for anything that can be imported from China. Some believe that as a direct result, we do not need to worry about inflation for years to come but more on this later; first, let me share with you my impressions coming back from a 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’s, about an hour flight from Beijing. After lagging in the growth other parts of China have enjoyed over the past 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 taken 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 with 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 as manufacturers in the U.S., with the one difference 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 Hongkong – a dealmaker almost enjoying 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 political leaders, 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 are 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. While long-term, the continued reform process seems unstoppable, 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 do not always make it a low cost country.
Talking about 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 resources in Ecuador were acquired. 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 far away places, often in politically unstable environments. My argument was that it 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 times of crises 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 U.S. savings rate that recently turned to negative 0.6%. Much of the high savings rate in China is attributed to a still under-developed 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 account because of the lack of perceived better alternatives. I had dinner with a high level securities regulator amd I asked the American-trained Chinese 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 help it 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 U.S. economy. There are serious side effects; the over-production with its associated high raw material prices is one of the burdens on the world economy. My concerns notwithstanding, all businesspeople I talked to prefer a stable exchange rate to allow them easier planning for their businesses.
Professor Mundell did say that a shift away from pegging currency from one country to a basket of currencies does make sense should there be fear that the previous reference currency could become unstable. He did not imply that the U.S. dollar would become unstable. Personally, I would not be surprised if historians will point to the foresight of the Chinese as they realize that the U.S. dollar may be at serious risk given, amongst others, the immense current account deficit.
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 sheer unlimited supply of skilled labor, helping to keep a lid on wages (there are some wage pressures in the country side as much of the skilled labor is migrating 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 U.S. 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 invariably fail, setting China up to hit road bumps on its growth path. However, as far as the output is concerned that the Chinese economy generates, we have a recipe for a flood of low consumer prices, keeping a lid on inflation of consumer goods. In the U.S., low interest rates, low taxes, high real estate prices have helped to absorb the flood of goods from Asia. Many analysts stop their analysis here. 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 some 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 U.S. dollar (and now to a basket of currencies) has artificially lowered the price of goods to the U.S. 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 U.S. 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 U.S. corporations that see their margins squeezed. They respond 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 has many spillover effects not easily captured by this model – as manifested most clearly in high commodity prices. In the U.S., just about anything that cannot be imported from Asia has experienced high inflation (healthcare, education craftsmen, to name a few). An anemically low U.S. savings rate is also a sign that the U.S. consumer has not been able to cope with the speed and scale of what is affecting them. One of the reasons why the U.S. savings rate is so low is because 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 to the U.S. economy, the administration is working very hard to keep the consumer spending. Most recently, the government has handed out $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 U.S. consumer when talking about China? Because China’s growth is heavily driven by U.S. consumer spending. With interest rates creeping up; with a real estate market slowing down; with a negative savings rate; with record energy prices; with wage growth that does not keep 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 consumer spending stalls. So what happens to China’s growth if U.S. consumer spending stalls? China would certainly suffer, although the likely reaction there is to work even harder. China may also use its newly found mechanism of setting its exchange rate to promote exports to other trading partners, notably Europe. Separately, intra-Asian economic ties are strengthened especially Korea which is investing very heavily in China. And China’s domestic market may continue to grow unless a severe slowdown in the U.S. leads to a shakeout in China’s economy.
China does see these and other (e.g. environmental) challenges it faces. By continuing on its reform path, China works hard to be ready and is open for business, your business.

Axel Merk is Portfolio Manager of the Merk Hard Currency Fund.
© 2005 Merk Investments LLC