The World Bank released its latest Quarterly Update on China’s economy on Friday (for disclosure's sake: I’m the lead author). At the press launch, there were a lot of questions about the recent wage hikes in several foreign-owned manufacturing companies and the possible concerns these have triggered among many about possible loss of competitiveness and/or a wage-inflation spiral. There were also, as usual, quite a few questions about the exchange rate.
Meanwhile, the People’s Bank of China over the weekend announced the plan to re-introduce more flexibility in the exchange rate regime, after almost 2 years of a de facto peg to the US dollar. This is likely to set the stage for a stronger exchange rate over time.
In this blog post I summarize our main conclusions and views, including our fairly sanguine views on the implications of the wage increases and our quite positive assessment of developments and prospects generally. I would argue that the timing of the move on the exchange rate suggests that China’s authorities broadly agree that, overall, the outlook on exports, growth, and competitiveness in China is fairly good.
In a later post, coming out in a few days, I will focus on the medium term scenario that we did as background work for this quarterly.
In our view, economic developments have largely been favorable. Growth has been strong, with some softening recently. Real estate construction has been an important driver of growth while consumption has held up well, reflecting a healthy labor market. Export volumes have recovered rapidly since the trough in early 2009. Indeed, they have grown faster than world imports, resulting in further market gains, reflecting the strong fundamental competitiveness of China’s manufacturing industry.
In all, growth has become less reliant on stimulus. Government-led investment has slowed substantially and overall investment has also slowed. More recently, leading indicators and industrial production data suggest that activity is decelerating somewhat. Inflation has picked up because of food prices and housing related costs, but core inflation remains low.
One area where the situation is complicated is real estate. Property prices rose very rapidly in much of 2009 and the first part of 2010. That was unsustainable. The government took measures to contain these price rises, emphasizing tightening the access to mortgage financing. The government did not really want to see real estate activity slow dramatically. But that is what some are now afraid of, and that underlines the challenges in this part of the economy.
Looking ahead, China’s outlook remains broadly favorable. Internationally, growth in many high income countries is likely to be subdued in the coming years, as they face fiscal consolidation and skeptical financial markets. However, overall, global growth prospects remain quite good. Projections for global growth done recently are stronger than those done at the start of the year. This is largely because of good prospects for emerging markets, which generally have come out of the global crisis in good shape. And, growth in the core euro zone was never expected to be very rapid in the first place this year, and the downgrades to growth there have been mild.
In China itself, we expect growth to ease somewhat throughout 2010 after the strong first quarter. This is largely because of a further normalization of the macro policy stance and the lagged impact of the measures introduced in mid-April to contain property price rises. Global growth and import demand may also ease, sequentially, after the strong start to 2010. In all, we project 9.5 % GDP growth for 2010 and 8.5 % for 2011. In terms of the composition, we think growth is going to be less driven by investment this year and benefit from more favorable external trade. Consumption is likely to remain supported by a strong labor market, which boosts household incomes and confidence.
We think inflation will remain contained and do not expect an unwarranted wage-price spiral. This is in part because globally there are no inflation pressures. There is still a lot of spare capacity around the world, both in manufacturing sectors and in raw commodity markets. This will continue to dampen price pressures globally for a while. Domestically, the China-specific factors behind the food price increases are not likely to persist. Moreover, core inflation remains very low. Under China’s pattern of growth, increases in supply are large compared to increases in demand. And, as shown in the figure below, despite substantial wage growth in the recent decade, unit labor cost (ULC) increases in manufacturing have remained low, because of rapid productivity growth and upgrading. It is not obvious that this is going to change rapidly.
What about the large wage increases recently? This is in large part a cyclical issue, reflecting the strong rebound in the labor market after an earlier downturn last year when wage growth slowed. When you look at the recent increases in factory wages or the minimum wages over a 2 year horizon, they are not far of historical norms. It is likely that the recent wage hikes encourage higher wages elsewhere. How individual companies will respond will vary. However, given the track record of manufacturing to keep ULC growth under control and the flexibility of the labor market, it still seems unlikely to me that a worrisome wage-inflation spiral will result from this.
What about structural trends? The recent wage increases take place against a backdrop of discussions about the possible exhaustion of China’s surplus labor. When a large part of the labor force is working in agriculture, at low incomes, rising demand for labor from industry can be met without high wage increases. Once all the surplus labor is absorbed, rising demand will lead to larger wage increases. This is the time in a country’s stage of development that we start to see significant sustained real exchange rate (RER) appreciation.
As argued in the companion paper to this Quarterly on medium term issues (527k pdf) looking at the historical patterns in other countries, China does not yet seem to be at the stage where surplus labor is exhausted and this leads to a structural tightening of the labor market and RER appreciation. In principle it is possible that things are different in China, maybe because demographic changes associated with ageing will affect the country at a relatively early stage of development, compared to other countries.
However, looking at the timing and pace of these upcoming demographic trends and observing that there are still large numbers of people working in low productivity activities and receiving low incomes, both in the country side and in cities, this type of sustained tightening of the labor is yet not likely to take place in the coming years.
All in all, in my view, the outlook for China remains largely favorable.
The Quarterly also discusses the implications of this outlook for macroeconomic policy as well as structural reforms, with an emphasis on public finance, social protection, and labor market reforms. It also looks at the role of state-owned enterprises (SOEs) and at a medium term scenario. I will get back to the medium term outlook and some implications in another post.