by Bill O’Grady
Last week, we discussed China’s power structure and how the suspension of term limits changes recent precedents. We examined President Xi’s actions in his first term to consolidate power and prepare for the next phase in China’s adjustment. We concluded with the reasons for moving now and what it potentially signals about Xi’s view of his power and political capital.
This week, we will continue this topic by analyzing China’s challenges while shifting from the world’s high growth/low cost producer to a slower growth, “normal” economy. We will show how these challenges fit into China’s overall geopolitics and Xi’s response to these constraints. From there, we will offer an analysis of America’s policy toward China in the postwar era with specific discussion on the critical assumptions regarding democracy and markets that have clouded policymakers’ expectations toward China. Finally, we will conclude with market ramifications.
China is in the process of making the adjustment from being the world’s high growth/low cost producer to a slower growth economy. Since the industrial revolution, the world has seen a number of nations make this transition. The British carried the high growth/low cost producer role from the onset of the industrial revolution in the early 1800s until around 1870. After 1870, the U.S. and Germany both played this role. Following WWII, Germany and Japan were high growth/low cost producers, with a parade of nations succeeding them in this position, including South Korea, Taiwan and, now, China.
In general, the high growth/low cost producer engages in a set of policies designed to boost the industrial capacity of the economy. This usually requires policies designed to increase saving. Saving can be domestic and/or foreign. The U.S. did attract a good deal of foreign saving from Britain after the Civil War but still exported saving (which is running a trade surplus). Most other nations followed a policy mix to generate most of the saving domestically. That required a specific policy mix that boosted domestic household saving. This was usually accomplished by an undervalued exchange rate, a weak or non-existent social safety net and low interest rates on retail bank deposits. All of these policies combine to curtail consumption. This saving funded domestic investment by allowing for low interest rate loans.
In the postwar period, with the U.S. providing the reserve currency and acting as importer of last resort, all of the high growth/low cost economies have been export promoters. They all built excess capacity to not only meet (admittedly constrained) domestic consumption but global consumption as well. In most cases, these nations have large rural populations that could migrate to cities and provide low-cost labor.
No nation that has accepted this role has maintained it indefinitely. Usually, three factors develop that undermine a country’s ability to continue as the high growth/low cost producer. First, costs rise over time as the “Lewis tipping point” is reached. Named after the Nobel Laureate economist Arthur Lewis, this occurs when all the excess labor from the countryside is exhausted and wages begin to rise. This increases costs for the high growth/low cost producer and opens up the global economy to another competitor. Second, the country reaches sufficient size that the rest of the world finds it burdensome to continue to absorb the high growth/low cost producer’s exports. Trade barriers are implemented which leaves the high growth/low cost producer with excessive productive capacity. Third, the accumulated debt that fostered industrialization becomes unsustainable and increases the odds of a debt crisis.