China: Bow to Uncle Sam!
By Khakjaan Wessington
November 17, 2006
"SAN FRANCISCO - China is on the brink of a financial meltdown. Ok, call me a crackhead. Feel better? Now let's talk facts. According to the World Bank, China's profits on capital invested is climbing, not dropping, as an overheating economy might suggest. Whether one is counting on official figures or reverse engineered figures, China's total investment rate is still somewhere between 37%-45%; significantly higher than the 21% average investment rate internationally. When combined with a 5 year Incremental-Capital-Output-Ratio (ICOR) around 4.5% (the % of GDP needed to boost GDP growth by 1%), this seems to paint the picture of a China on the rise: until one looks at US productivity figures.
Graphing durable productivity growth in the US economy over the last four years reveals the US has averaged a huge 6.09% durable productivity growth per year. This has resulted in drops in Unit Labor Cost (labor cost per unit of GDP) significantly during that period: 1.11% per year on average, even as GDP has grown during this period. In fact, durable productivity growth has exceeded GDP growth since the 2000-2001 slowdown: productivity in durable manufacturing is rising so fast, it's making US labor costs even more competitive than they already are. What this means is that the advantage that low labor cost economies have over the US is rapidly shrinking in America's favor.
Now, let's complicate the picture: China is the world's second biggest holder of US Treasury securities, and 70% of its trillion foreign reserves is in US dollars. The popular economic argument is that this huge debt balance is dangerous for the US, because a trade deficit siphons wealth out of the debtor's economy and into the creditor's economy. Eventually, the value of dollar-denominated assets should drop, because US wealth should be getting depleted. This premise is flawed.
A trade deficit can be good if the economy with the deficit is creating more wealth than the cost of imports. The University of Michigan and Florida International University study of US entrepreneurial activity showed it hit an all time high in 2005 with 23 million starting, or managing a business under four years old, and The Economist recently claimed that the US has twice as many entrepreneurs as the EU. This suggests that the US is using the imports of cars and computers (components that make up the US trade deficit) to build businesses.
In economic terms, the value of the goods imported exceeds their cost. The result? Hyper-productivity growth across durable producers and a growth in efficient, small manufacturers. The trade deficit is irrelevant if the imported goods are worth more than they cost. A laptop made in China is more valuable in the US because of the business climate here. Likewise a truck, or most anything else. Who ever heard of the Chinese protecting intellectual property rights? If every jackass with a bank account, connections, or factory is ripping off small business ideas, the value innovator isn't going to get paid for his work and isn't going to add his best use to the economy. Combine this with guangxi networks and party officials demanding bribes, it's no surprise that China's labor costs are rising. There's less incentive to add value if there's a good chance it's going to get stolen - hence low worker productivity growth. This works so long as there are cheap labor inputs, but as labor gets scarcer, wages climb. These factors eat away at China's long term productivity growth and are examples of the way a manufacture's value increases once it crosses the border.
What about the risk of China dumping its dollar assets for other assets? If China does this, it will increase supply of dollar assets and also reduce the demand for dollar assets (since it is a major importer of dollars). A devaluation in the dollar would result in a devaluation of the rest of the dollar reserves China has and put a major dent in its total reserves. It would also make Chinese exports to the US more expensive, and imports from the US cheaper. Dollar inflation would increase and that would hurt everything in the US economy: or would it?
A rapid drop in the Dollar versus the Yuan would result in almost immediate, and major import substitution by US producers. Until inflation is tamped out, it will continue to drop the cost of US manufactures compared to foreign manufacturers. It would be a deathblow to European industries, which would need to respond with even more protectionism. Airbus is already on the ropes - a 20% drop in the dollar would see almost every plane order in the world for the next five years going to Boeing. Multiply this across every industry where the EU is barely competitive with the rest of the world and you can see that a disaster is brewing, not for the US, but for Europe. China would lose its target market for exports and its domestic consumption won't be able to make up for the difference.
China's current investment rate is predicated upon the presumption that for the near future, China will remain one of the world's most competitive manufacturers. With profits where they are right now, it's easy to say that China hasn't over-invested. Still, the trends are telling. Competition with slave economies has unlocked productivity growth in the US economy previously unseen. So long as US durable productivity growth is greater than its GDP growth, the US will continue to get more competitive vs. low-cost producers. Therefore, financing US debt, rather than being a sign of long-term Chinese strength, is a sign of its long term weakness. China's locked itself into a strategy it can't escape. At this rate, the US is going to eradicate the competitive advantage of low labor cost producers in a decade or two. But if China tries to stop subsidizing US trade, it hurts Chinese manufacturers and benefits US manufacturers.
It's just another example of how things aren't always what they appear to be in the international financial game. A strategy can be good in the short term, but lock you into a problem you can't escape. Sorry, China!"
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