Financial Times Jan 10 2011
Who has survived the global credit crisis in the best shape? As Chou En Lai said about the impact of the French Revolution, it’s still too early to judge. The snap verdict that China is the big winner and the US and rest of the old G7 are big losers is already looking questionable.
True, China has continued to register turbo-charged growth while many of the debt-laden economies of the West have struggled to emerge from recession. No surprise, then, that a tsunami of financial capital has surged eastward, or that European politicians are scrabbling for trade deals, despite China’s extraordinarily aggressive posture over the Nobel Peace prize and other diplomatic issues.
The financial markets, however, have taken a rather different view. Currently the Shanghai market is languishing at less than half its all-time high, significantly underperforming the other three members of the BRIC group. More surprising, since the start of the US-originated subprime crisis in August 2007, Shanghai’s total return in dollars has been beaten by the American S&P, the UK’s FTSE100, and even the Japanese Topix.
The message is clear. As numerous academic studies attest, economic growth has little if any relationship with investment returns. The China “macro story” that has been sold so skilfully and relentlessly to investors all over the world is simply another version of the new era thinking that has characterized every investment mania from the South Sea bubble to the dotcom frenzy.
After the extended period of disappointing performance, Chinese shares no longer look so expensive in terms of the current price earnings ratio. But this may be deceptive. On the cyclically adjusted “Shiller PER” – which uses a 10 year average of earnings – the China market is even now almost as expensive as the US stock market was in 1929. In other words, the current level of earnings is exceptionally high compared to recent history.
In a dynamic emerging economy recent history may be a poor guide to the future. Yet there are good grounds for concern about the direction of Chinese profits. A significant increase in the profit share of national income, as we have seen in China this century, implies a significant decrease in the labour share – meaning that wages fail to keep up with the pace of economic growth. The other side of this mismatch is apparent in the GDP numbers – a decline in the contribution of personal consumption and a ballooning dependence on investment.
We’ve seen this movie before – forty years ago, to be exact. In the 1960s Japan’s developmental state was achieving year upon year of double digit GDP growth, fuelled by government-directed investment into infrastructure projects such as the bullet-train network and the build-up of heavy industry. Throughout this period, workers were flooding into the cities from the countryside, depressing wages and setting off a virtuous cycle of rising profitability and rising investment.
In the mid 1950s,Japanese labour had taken 60% of total value added. In the miracle years this ratio fell to 50%, then started a V-shaped recovery in 1970 as the labour market tightened. Ten years later it had soared to a plateau of 68%. These gains had to be fought for. In the 1970s, Japan’s now dormant union movement was in its marching chanting heyday. Inevitably profit margins were squeezed, and in real terms the stock market went nowhere for a decade.
Can workers grab a bigger share of the economic pie before the urbanization process is complete? In Japan they did. In 1970 Japan’s urbanization ratio (the proportion of urban population to total population) was still just 53%. Currently the Chinese urbanization ratio is 45% , roughly where Japan was in 1964. However Chinese statistics are notoriously unreliable. The floating population of unregistered urban migrants is variously estimated at between 50 and 140 million people. So China’s true urbanization ratio may already be close to Japan’s in 1970.
If China were to follow the Japanese template, the next stage would be labour strife and inflation. The best way to avoid that outcome would be a radical tightening of the currently super-easy monetary policy. But that would risk a serious slowdown and probably necessitate a revaluation of the yuan – both of which are anathema to Beijing.
There is no good way out of the corner into which China has painted itself. Rebalancing the economy is absolutely necessary. It is also a long-term project fraught with risks – not least for investors who have bought the story of inevitable Western decline and unstoppable Chinese ascent.