Monday, 8 March 2010
High cost of rebalancing is a necessary evil
In the past two months, the news about wage pressure has been relentless. China’s largest exporting provinces have raised minimum wages. Hong Kong capitalists are desperately worried about labour shortages in mainland factories. Newspapers warn of a scramble for workers in China’s eastern provinces. Everyone seems to be concerned about rising labour costs.
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High cost of rebalancing is a necessary evil
Michael Pettis
01 March 2010
In the past two months, the news about wage pressure has been relentless. China’s largest exporting provinces have raised minimum wages. Hong Kong capitalists are desperately worried about labour shortages in mainland factories. Newspapers warn of a scramble for workers in China’s eastern provinces. Everyone seems to be concerned about rising labour costs.
There are real reasons to be concerned. If an important cause of rising wages is the impact of China’s massive stimulus programme on pulling in workers, this will undoubtedly hurt China’s export competitiveness. If this is happening because workers are being diverted into less productive areas - like building redundant infrastructure, unnecessary commercial and residential real estate, or more factories making products the world doesn’t want - the impact on China’s economy in the short term will be negative.
But higher wages are a necessary part of China’s long-term rebalancing. And, like currency appreciation, it is important to recognise that the long-term benefits will come with short-term costs. Higher wages, higher interest rates for depositors and a stronger yuan are all part of the same process and will have similar impacts on China’s economy. How? The main reason China saves such a huge share of its income, and households consume such a small share of total Chinese production, has been that household income growth for many years has lagged economic growth. As long as the total amount of things China produced grew more rapidly than what domestic households, businesses or governments consumed, its savings rate had to rise.
But this created a dangerous dependency. In order to justify all this excess production, China had to rely on dangerously high levels of investment and on foreign purchases to absorb everything it produced. This cannot and will not change until Chinese households begin to consume a larger share of what the country produces. The most obvious way to do so, of course, is to increase their share of total income. There are other ways of raising consumption. Beijing can subsidise the purchase of certain consumer goods, which it seems to be doing, but since government subsidies have to be repaid by households in the future, this is just an inefficient way of pushing future consumption forward.
The government can also force banks to increase consumer lending. After all, total demand is equal to total income plus the change in debt. And if Beijing can get Chinese households to increase their consumer borrowing, consumption can grow faster than household income.
But here too, there is a problem. Previous attempts by Beijing to force banks to increase consumer lending, something about which they have little experience, has resulted in a surge in non-performing loans. Already there is evidence that rising credit card use in China has been accompanied by a surge in credit card defaults.
Non-performing loans in the banks will ultimately be paid for by households, most likely in the form of very low deposit rates that allow banks to generate the excess profits that pay for these bad loans. This too represents an unfair anticipation of consumption, from tomorrow’s savers to today’s defaulters.
The only sustainable way to raise household consumption rapidly is to raise household income rapidly, especially among the poor. This means raising the value of the currency, raising interest rates, raising wages, or some combination of all three. But this will not come without a cost. Chinese manufacturers are too dependent on low wages, cheap financing, and an undervalued currency for their profits to adjust easily to life without these subsidies. Every move to rebalance, then, will inevitably come with loud groaning.
Nonetheless we need to remember that in spite of localised costs, the rebalancing process, as painful as it might be in the short term, is necessary for China’s long-term development. This should not be done too quickly because it can throw China into a downward employment spiral, but every gradual step in that direction should be welcome.
Michael Pettis is a professor of finance at the Guanghua School of Peking University and a senior associate at the Carnegie Endowment.
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