Wednesday, August 20, 2008

China Must Embrace Non-Interventionist Energy Capitalism to Strengthen Domestic Demand & Restore Global Trade Balance

China's Energy Woes

by Daniel Ikenson

Daniel Ikenson is associate director of the Center for Trade Policy Studies at the Cato Institute in Washington, D.C.

June 30, 2008

This article appeared in the Far Eastern Economic Review on June 30, 2008.

The process of creative destruction, Joseph Schumpeter wrote, is "the essential fact about capitalism." The old is destroyed by the new and improved. But it is an essential fact that the Chinese leadership is unwilling to accept. Thus for 30 years, with great success, China has harnessed capitalism without embracing it.

But as the economy grows and diversifies, the capacity for success with the old formula is becoming more doubtful. There are too many interests to balance; too many signals to manage. Yet the leadership's response to rising energy prices — the most pressing economic issue of our time — suggests that it has no intention of changing course anytime soon.

China has long provided fuel subsidies, which have been blamed for encouraging wasteful consumption, propping up inefficient industries, degrading the environment, and forcing energy consumers in other countries to pay higher prices. But record oil and coal prices, driven in no small part by economic growth in China, have made it that much more expensive to subsidize gasoline, diesel, and electricity consumption.

Add to that the growing acceptance around the world that taxing carbon emissions is the proper response to inefficient production processes and suddenly the cost of those Chinese subsidies, in direct financial terms, could double. It would seem that now is the perfect time for the government to announce the cessation of subsidies, price caps, and other interventions in energy markets, altogether.

If energy prices and output were determined by supply and demand, progress could be achieved on a whole host of important Chinese policy objectives, from greater energy efficiency and environmental restoration to eliminating economic deadwood and reducing trade imbalances. But instead on June 20 the government announced retail price hikes (subsidy reductions) for diesel, gasoline, jet fuel and electricity, and it re-established price caps on thermal coal, which had already been freed from government control. To prevent coal producers from chasing higher prices abroad, and to hedge against the increased likelihood of coal shortages, the government is expected to ban coal exports (which are already limited) in the near future.

The subsidy reductions are a step in the right direction, but the government is still setting prices without any capacity to accurately project supply and demand. Its overarching goal, of course, is not efficiency or economic rationalization or greater trade balance, but social harmony, which in this context means directing benefits to those interests that are most restive and burdening the relatively quiescent with the costs.

The coal price caps, in conjunction with electricity tariff hikes, are a bid to allow energy companies — in which millions of agitated Chinese hold equity — the opportunity to finally squeeze out profits and to avoid electricity shortages during the peak summer months. Retail prices had been capped in a bid to contain inflation.

But energy price inflation would be more efficiently addressed if the government allowed the market to determine the value of the Chinese Yuan. Most bets are that the Yuan would appreciate considerably, reducing prices in China for imported oil and coal. That policy move alone might encourage more consumption of energy, but not necessarily, if the subsidies and price caps were abandoned too.

More than ever, the Chinese economy needs market signals to allocate costly resources. The government has played a central role in that respect, but as to be expected, it has not allocated efficiently. Unproductive, unworthy state-owned enterprises have squandered resources, while more efficient factories and industries have gone wanting for optimal supplies.

Market-determined energy prices would lead to greater energy use by the factories and industries that can justify their energy consumption — businesses that can cover those costs and make profits — and less consumption by inefficient businesses. Companies that cannot stay afloat without subsidized energy should be allowed to go under. If they can't manage with today's energy prices, they will always be a drag on the economy. And the sooner they exit the market, the sooner the efficient producers will strengthen.

Of course higher energy prices and a stronger currency would likely reduce foreign demand for Chinese exports, and would encourage Chinese consumption of imports. Achieving greater trade balance and shifting the focus of the Chinese economy away from exports and toward greater consumption has been a stated goal of the leadership.

The United States and Europe share that goal for China. Earlier this month, U.S. Treasury Secretary Henry Paulson, who has been measured and rational in his assessment of the causes of the problems afflicting the bilateral relationship, urged China to abandon its energy market interventions, which he considers a structural impediment to greater trade balance. Mr. Paulson's approach is distinct from that of the U.S. Congress, which is less inclined to think long-term and structural and more willing to countervail the perceived effects of Chinese energy and trade policies through sanctions.

The Chinese government's decision to continue to play a central role in energy markets will continue to be a source of international friction. It certainly strengthens the hand of those who will act if China doesn't.

In its continuing bid to avoid Schumpeter's prediction, the Chinese leadership should sacrifice its interventionist energy policy.

US 110th Congress Must Keep Hands Off China Trade (Protectionism) Before They Screw it Up

Trade, They SED: Credit where credit is due

by Daniel Ikenson

Daniel Ikenson is associate director of the Center for Trade Policy Studies at the Cato Institute in Washington, D.C.

June18, 2008

This article appeared on
National Review (Online) on June18, 2008.

Proponents of a confrontational approach to trade relations have been critical of the deliberative nature of the U.S.-China Strategic Economic Dialogue, which began its fourth semi-annual installment in Annapolis Tuesday. They point to a “lack of progress” on issues that the United States has been advocating since before the first SED in 2006.

These critics believe that since the Chinese government can mobilize the resources to build an Olympic stadium in a matter of months, it can mandate a much stronger currency and a balanced trade account with dispatch, regardless of any adverse economic consequences, even if only to assuage a small, but vocal, set of U.S. detractors. But expecting the Chinese to say “how high?” when told by the Americans to jump is an arrogant and preposterous standard of success.

The objective of the SED from the outset has been to achieve progress on the sorts of structural issues that underlie the trade imbalance: in particular, high savings rates in China and low savings rates in the United States. Toward that end, Treasury Secretary Henry Paulson has been working with his Chinese counterparts to establish health-, life-, and disability-insurance markets, which all serve to hedge against uncertainty about the future. Uncertainty and insecurity thrive in the absence of social safety nets, and they encourage thrift.

Paulson has also been touting the importance of credit markets and credit cards to the Chinese government’s stated objective of shifting the economy’s focus from investment and exports to consumption. American financial institutions will benefit immensely when the use of consumer credit and insurance markets proliferate in China — unless, of course, U.S. policymakers indulge the provocateurs and engage in shortsighted protectionism.

Regrettably, Congress has been too willing to criticize Chinese policies and too unwilling to acknowledge its own complicity in the trade imbalance. By spending far in excess of its receipts, the federal government has played a crucial role in the bloating of the bilateral deficit. The structural changes necessary in the United States, which are far more consequential than any trade policies, concern entitlement spending. Without bold reform to social security and Medicaid, U.S. reliance on foreign capital to cover those expenses will only ensure trade deficits in perpetuity.

But on the occasion of the commencement of SED IV, there are some positive signs on the policy front. Support for the provocative tack in Congress appears to be dwindling. Despite the introduction of dozens of anti-China trade bills in the 110th Congress, none has passed into law. Even sponsors of the so-called currency bills are beginning to have second thoughts, as voters begin to comprehend the central role of the declining dollar on gas and food prices. In effect, the economy is experiencing some of the same consequences of protectionism — higher prices and strained consumer budgets — without protectionist measures having been imposed. An additional layer of real protectionism could constitute the tipping point for consumers.

Accordingly, there appears to be little momentum to move any legislation before the end of the term because, frankly, things are working themselves out. The Chinese currency has appreciated by 20 percent against the dollar since the exclusive dollar peg was terminated in July 2005. U.S exports to China are setting new records every year — in just the first quarter of this year U.S. exports to China rose 25 percent, while U.S. import growth from China slowed to 2 percent.

Chinese consumer spending rose 22 percent in April, the highest monthly increase in a decade, driving home the point that if Congress is going to worry about the effects of Chinese competition on the supply side, it can also celebrate the effects of China’s growing wealth on the demand side. The downside of U.S. protectionism is accentuated when the world’s economic growth is occurring outside the United States.

Congress is also seeing more evidence that unilateral U.S. actions on the trade front would be, not only self-defeating, but superfluous. The dispute settlement system of the World Trade Organization is proving to be a legitimate and viable venue for resolving trade disputes with China. Out of six WTO complaints lodged by the United States over Chinese trade practices, three have been resolved in favor of the U.S. position, and the other three are pending at different stages of the adjudication process.

A significant casualty of any unilateral sanctions from the Congress could very well be Chinese willingness to honor the verdicts of the WTO dispute settlement system, which would constitute the worst possible outcome of U.S. unilateralism. Regrettably, China need look only to the United States for examples of such disregard for the multilateral system.

The SED was never intended to resolve every last gripe about the bilateral trade relationship. Legitimate trade complaints are working themselves out with the occasional assistance of WTO dispute settlement.

Tuesday, August 19, 2008

Thousands of Chinese Factory Closings Predicted Due to Increased Labor, Energy & Manufacturing Costs, Appreciation of Renminbi & Reduced US/EU Imports


Tuesday, August 19, 2008

By Ian Williams, NBC News Correspondent

Blogging from Beijing

GUANGDONG, China – Once the Olympic party is over, is China heading for an economic hangover?

Ben Schwall, for one, thinks the headache is already setting in for the country's seemingly unstoppable export machine.

"If you are a factory owner here, it’s not like you're being kicked around. Somebody has hit you over the head with a baseball bat," he said.

I met Schwall on a recent visit to the southern Chinese province of Guangdong, where he buys decorative lights for a string of U.S. retailers. "It's the perfect storm," he told me. "You've got a drop in demand. Business stinks. At the same time prices are going up."

‘Perfect storm’

The "perfect storm" is being caused by the soaring price of oil and other raw materials, spiraling labor costs, and the appreciation in the value of China's currency against the U.S. dollar, as well as a sharp down turn in demand as the U.S. faces possible recession.

Factories are closing right across the region where China's export boom began, with the most pain being felt at the low end – lighting and shoe factories, for instance. One of the few businesses still booming is scrap metal, teams clearing the remains of shuttered production lines.

Dong Tao, the Chief Asia Economist at Credit Swisse, just across the border in Hong Kong, calls it the end on an era of ultra-cheap Chinese exports.

"We expect that in the next three years, one third of Guangdong's manufacturing export factories will be closed down," he told me.

There are tens of thousands of factories here. If China is the workshop of the world, then this is its engine. A third of China's exports come from Guangdong, feeding the world's insatiable appetite for everything from shoes to lights to electronic goods.

"The entire world had the impression that the happy party of very cheap Chinese goods could last forever," Dong said. "I thought that. But I think perhaps its coming to an end."

The oil price affects the cost of production, but also the cost of shipping raw materials to China and then shipping the finished product to the U.S.

Cheap labor drying up

China's limitless supply of young cheap labor seems to be drying up too. The minimum wage in Guangdong has doubled in three years, and now stands at around $120 a month. With overtime, workers are taking home more than $200 a month.

The one-child policy is beginning to slow the supply of nimble-fingered young women, favored by the factories. And the new generation of migrant workers from the countryside are more choosy about work – and more savvy.

At one big street side labor market, young migrants work their mobile phones, comparing wage rates between factories. A new labor law has given them more muscle, especially since – to the consternation of factory owners – the government seems determined to enforce it.

Labor turnover is running as high as 75 percent annually at some factories.

‘No profit!’

Many of the factories in this region are owned by Hong Kong and Taiwan entrepreneurs. Men like Philip Cheng, whose company, Strategic Sports, is one of the biggest manufactures of crash helmets, bemoan the sharp downturn. "We don't have any profit now. No profit!" he told me, as helmets snaked along on the conveyor belt behind him, workers pasting on the visors. "The days of cheap labor have gone. No cheap labor. OK?"

Down the road, Dongguan Shan Hsing Lighting has just moved into a new factory, but is now operating at fifty percent capacity. It’s been hit by the crisis in the U.S. housing market, its biggest customer. The company's president, Tim Hsu, said profits have dried up.

"With constantly rising prices, we have to raise our quotes to survive. American consumers will have to pay higher prices," he said.

Dong at Credit Swisse agreed."Watch out," he said, "the prices in Wal-Mart, Home Depot, Motorola, they're going up."

Other factories are chasing lower labor costs elsewhere. Dong told me forty percent of factories he surveyed recently are looking to move – either to inland China, where costs are less, or out of the country.

Cheng of Strategic Sports is looking at Vietnam, where labor costs are now around half of those of China; Schwall, the lighting buyer, is planning a visit to India.

For Schwall, there's another headache. His company, Aliya Intenational, also monitors quality, making sure manufacturers aren’t cutting corners in the production process or using sub-standard or dangerous materials, a task made all the more important following last year's spate of product recalls.

He said that even before the latest surge in costs, factories were operating on wafer-thin profit margins, and now some may be more tempted to take short cuts as a way of cutting costs.

"The devil is everywhere," he told me as he examined the fittings on an elaborate chandelier he'd plucked from a busy production line. "And of course there is temptation."

He said he feels much happier when the factories he's dealing with are at least making some money, since the temptation to cut corners then is not as great.

What does it mean for China Inc?

All of which begs the question of what this means for China Inc. The pain seems most acute in the export manufacturing heartlands of the south, and doesn't appear to have yet dented China's overall growth rate, which remains above 10 percent – though many economists are skeptical about the accuracy of the official figures.

The Chinese media has carried stories pointing to a slowdown, but they have tended to follow the official line of keeping bad news off the presses during the Olympic Games. Officials in Guangdong have also played it down, describing the closures as just a normal transition away from low-end production, of the kind that took place in Taiwan, Korea or Japan. Which may well be good in the long term.

The problem is the meltdown is happening so quickly. The head of the Hong Kong Small and Medium Enterprise Association, whose members are big investors, warned in late June that 20,000 of the 70,000 Hong Kong-owned factories in Guangdong could close this year. He said the region is no longer competitive.

Economic ups and downs are not new to the rest of the world, but China has known little but boom for nearly thirty years. Breakneck double digit growth has become the norm. No other major economy has grown like China over that period.

Moreover, China's communist leaders, presiding over one of the world's most rapacious capitalist economies, have traded on their ability to deliver economic growth to dampen demands for political change.

The massive Olympic rebuilding – with its $40 billion price tag – also provided an economic stimulus, which will soon be over. The Games have given a big "feel good" lift to Chinese, about what they've achieved and where they are going.

This, and the seemingly unstoppable boom, have set expectations very high about the future, which could make a post-Olympic economic slowdown all the more difficult to manage.


Don't Bet on the Renminbi

by Calla Wiemer

Far Eastern Economic Review

July 30, 2008

Rumor has it that hot money is betting on a sharp appreciation of the renminbi. China’s official reserve assets seem to accumulate at ever increasing rates, and recent increases are not accounted for by the trade surplus and net foreign direct investment. It appears there’s money coming in, but why would speculators be betting on a big-time revaluation? It doesn’t fit with macroeconomic fundamentals.

The fundamentals rest with the domestic relationship between saving and investment. The difference is the trade imbalance since saving not channeled into domestic investment becomes a capital outflow and a capital outflow is financed by export revenues not spent on imports. In a span of just six years, China's national saving rate rose by a dramatic 12 percentage points of gross domestic product, from 38% in 2000 to 50% in 2006 (see nearby graph). From an already high level then by international norms, it went stratospheric. The investment rate was also high and rose in parallel until 2004. During this stretch, the saving/investment gap ran at about two and a half percent of GDP. Then the investment rate flattened out at around 43% while the saving rate pushed inexorably upward, and correspondingly the trade surplus soared.

My own research shows that most of the increase in the saving rate can be explained by China's extremely high GDP growth rate in the post-2000 period ( When countries experience breakneck growth in income, consumption as a general rule tends not to keep up. Also contributing to China’s rising saving rate is a falling dependency ratio as saving is higher among those in their working years versus the young or the elderly.

The exchange rate has played a passive role in this story. The peg in place at the outset of the post-millennial growth surge dates essentially to 1994. Exchange rate unification at that point established a rate that was in line with market forces, yielding a small, arguably prudent, surplus in the trade account (i.e., a small gap of saving over investment as visible in the nearby graph). Indeed, in the wake of the Asian financial crisis a few years later the Chinese government made much of holding the line against devaluation. For a decade, the pegged exchange rate was a boon to trade and investment because it provided stability, not because it distorted the market. To have prematurely revalued the currency would have choked off exports and stimulated imports at a cost of slower income growth and job creation.

The growth spirt post-2000 was stupendous, beyond what the official figures reveal (a claim that is empirically supported in the paper referenced above). But with growth of this order came the saving rate increase and hence, when investment was administratively restrained in 2004, the gaping trade imbalance. Until the 2004 juncture, a peg at 8.3 had been credible. With the mounting trade surplus though, the exchange rate came under pressure. The Chinese government’s response to that pressure has been to move gradually away from a peg and develop the institutional structure for market-based exchange rate determination. In that context, the central bank has been caught holding the bag, absorbing surplus foreign exchange inflows as the trade surplus widened and private investment inflows stepped up. There was not a deliberate policy stance to run up the trade surplus by leaps and bounds and accumulate massive foreign reserves. It just turned out that way given the existing peg and phenomenal GDP growth.

Growth momentum was sustained through a feedback loop to the U.S. economy. The accumulation of forex reserves in China had its counterpart in a capital inflow to the U.S. Such an inflow tends to push up the value of the U.S. dollar which undermines U.S. exports and boosts U.S. imports. This slows down the U.S. economy. The ready antidote to a threat of slowdown is monetary stimulus which there was in full and which found an outlet in rising asset prices. This made Americans happy to go on consuming. The bottom line was the U.S. kept growing and buying Chinese goods and China kept growing and lending money to the U.S. For awhile both sides enjoyed strong growth and increasing wealth. The problem, we found out belatedly, was that the U.S. financial system was not capable of allocating burgeoning investment funds effectively, and the fallout from that spells the end of the cycle.

There are Chinese observers who blame U.S. monetary policy for the imbalances and the whole upward spiral which bore the seeds of its own collapse. And Americans of course blame China's "artificially low" exchange rate. Actually, the forces were symbiotic and both sides enjoyed the boom times while they lasted.

The inevitable slowing of China’s growth rate will only gradually contribute to a decline in the saving rate. But there are policy measures that can be brought to bear with very substantial prospects for pushing the saving rate down, and these measures are worthwhile for intrinsic reasons as well. Such measures include: building the social welfare system; improving the financial system; and absorbing profits from SOEs in the fiscal budget.

Increased fiscal spending on social welfare programs has an expansionary impact, and this at a time when the economy is already showing signs of rising inflation. This is where the exchange rate finally comes in. There is a role for currency appreciation within the broader scope of macroeconomic policy now where there had not been previously, in my view, strictly for purposes of reducing the trade surplus. In combination with expansionary fiscal policy used to stimulate domestic consumption, currency appreciation acts to divert resources out of tradable goods production (less exports and import substitutes) and into social welfare service provision. In this way inflation is kept in check despite the increased fiscal spending. However, the appreciation called for in this context is modest and gradual, and as such should not be cause for any onslaught of speculative capital.

Ms. Calla Wiemer, a Ph.D. in economics and longtime specialist on the Chinese economy, lives in Los Angeles and is writing a macroeconomics textbook for Asia.

Tuesday, July 15, 2008

China is On the Cusp of Industrial Agriculture

China faces agricultural revolution

By Richard McGregor

The Financial Times

May 8, 2008

China, a small net exporter of rice and largely self sufficient in wheat, has been something of a spectator in the global food crisis of recent months, with Beijing’s role confined to tightening scrutiny of exports to prevent profiteering.

“There is no grain crisis in China at the moment, and there won’t be for some time into the future,” says Cui Xiaoli, a researcher at the development research centre, a think-tank under China’s cabinet.

The country’s inflation hit 11-year highs in recent months, almost entirely because of an increase in food prices, but the government and many economists argue that these rises are a temporary phenomenon.

But the short-term calm of analysts such as Mr Cui belies the long-term pressures on Chinese agriculture, which are on the verge of triggering revolutions in the way China trades and farms its food. Those pressures could even send it offshore in search of arable land.

The Chinese are getting richer and, like their western counterparts, eating more meat, which in turn is spurring a surge in demand for foodstuffs to feed a growing population of pigs and other livestock.

With 21 per cent of the world’s population, 9 per cent of its arable land and below-average and poorly distributed water resources, China is already unable to supply enough homegrown animal feed.

Soyabean imports have tripled in the past three to four years and now make up 60 to 70 per cent of local demand, compared with 20 to 30 per cent in 2002.

This year Beijing began restricting the export of corn and its domestic use in making ethanol, to prevent supplies from running out. Eventually, however, China will inevitably have to import large amounts of corn, as well as soyabeans.

Although analysts disagree on the timing of China’s emergence as an importer of all grains, few doubt that Beijing will be forced to modify its longstanding policy of self-sufficiency in basic foodstuffs to meet demand.

“We have already seen what a ‘perfect storm’ of high demand, tight supply and market opening does for other commodity imports and, sooner or later, the same factors will necessarily drive food imports as well,” says Jonathan Anderson, an analyst at UBS.

Any rise in Chinese imports of corn, for example, would immediately have an impact on global prices. With ethanol demand high worldwide, “nobody has any corn to sell” on international markets at the moment, says a Beijing-based agricultural analyst.

But just as important, and largely overlooked, in a debate on food that concentrates on trade is another revolution in Chinese agriculture happening at grassroots level among 700m-odd farmers and their families.

Liu Yonghao, the chairman of the Hope Group, based in Chengdu, in western Sichuan province, made his first $1m, and more, in the 1990s from feeding pigs.

After dabbling in other industries, the entrepreneur says he is returning to his roots to take advantage of the coming upheaval in Chinese agri­business.

Mr Liu, who along with his brothers topped China’s first rich lists in the late 1990s, says China’s fractured system of tiny farms, each selling its output separately, will inevitably die.

“The gap between the modern industrial and urban economy and the small peasant economy is getting larger and larger. We need to modernise farming, and that means scale,” he says.

“All the recent problems with inflation and food safety relate to our working system. How can we supervise a system with 200m production units that each raises four or five pigs?”

The top three producers of pork in the US supply about 80 per cent of the market. In China, the top three would be lucky to have a combined 10 per cent market share.

Mr Liu is now putting his entrepreneurial energy into building a single, vertically integrated national feed business. If he succeeds, such is the scale of Chinese consumption of pork and other meats that he will inevitably have the largest feed business in the world.

Instead of just selling feed, Mr Liu wants to control the whole process, from breeding stocks to product processing. To do so, he will have to contract, and help finance, potentially millions of farmers.

Quite apart from recent food inflation in China and more recently around the world, Mr Liu says, farm costs at home will continue to rise, in order to compete with urban wages, and will translate into higher prices.

“Fewer farmers now want to raise pigs, and over 70 per cent of middle and younger men have left the countryside,” he says. “When the market is in such an imbalance, prices are sure to go
up. I think they will stay high for a while.”