Wednesday, June 30, 2010

China’s Next Great Leap Forward: Inflation

Yuan Takes Baby Steps Higher
China Looks to Balance Pressure From G20 Against the Worries of Its Exporters

BEIJING—A week after China loosened its grip on the yuan, the currency is up just 0.53%, a barely visible gain that lived up to the government’s promise to restrict the pace of any appreciation…

—The Wall Street Journal

Thus the Wall Street Journal discussed, earlier this week, the rise of the Yuan in the wake of the long-awaited and much-hyped shift to a flexible currency in a country not much given to flexibility.

And that policy shift preoccupied Wall Street for all of, oh, maybe 15 minutes.

Then, like our dog Charles, Wall Street got distracted by other shiny objects, such as Greek credit default swaps, World Cup Soccer, and yesterday’s Consumer Confidence Index—soon to be renamed the Consumer Anxiety Index.

But having heard more than one company discuss the increasing difficulty of sourcing low-cost manufacturing in China, we sought the counsel of a long-time acquaintance who made a business of manufacturing in China, and who has, over the years, provided a sharp, clear-eyed view of just such issues as the value of the Yuan and what it means for products made in China.

And what it means is not nearly as important as something else going on in China.

What is going on is this: costs in China are rising, and they will continue to rise for years to come. In fact, he said, costs will rise the rest of the decade at a rate that places China among the higher-cost manufacturing areas of the world.

And it has nothing to do with the Yuan.

What it has to do with is China’s “One-Child Policy.”

31 years ago, Deng Ziaoping (look him up, kids), declared a “One-Child Policy,” which is still policy today. And that policy, while not precisely one child (if a couple’s first child was a girl, the couple could have a second child), reduced the number of children-per-females from almost six in 1970 to roughly two today.

Thus, as our manufacturing friend pointed out, the demographics in China are shifting rapidly from a surplus of labor to a shortage. And by “rapidly” he means “the next three years,” when the 18-25 year old population drops by something close to one-third.

Now, the effect of this mind-boggling demographic shift was already felt, early this year.

After the Chinese New Year, a number of U.S. companies reported that an unusual number of factory workers failed to return from their inland homes, reducing their manufacturing efficiency, increasing costs-per-item, and forcing a shift to airfreight in order to get product to markets on time.

What is happening is this: as China promotes economic expansion away from the crowded south, jobs are opening up where none had been before.

To put numbers on it, according to our acquaintance, some factories were 25% short of labor after the Chinese New Year, and thus operated at as little as 75% of capacity.

And this problem for the manufacturing base in China is not going away: in fact, it will get worse as the labor surplus dries up.

After all, as our friend said, “If you could work in an office building near home instead of traveling a thousand miles back to a hot, dark, cramped, noisy factory—and make more money—wouldn’t you?”

We would indeed.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Edgecliff said...

Jeff, kind of a fill in for your information: the last 3rd of this book
Country Driving
A Journey Through China from Farm to Factory
By Peter Hessler
gives a good overview of the process and mindset of the chinese factory, both worker and owner.

PhillipCharles said...

Very insightful and informative article. I was not aware if the significant demographic shift underway in China and its effect on manufacturing's underlying cost structure.

Colin P said...

1/3rd, Jeff? Are you serious? Where can a reader learn more about this?

Jeff Matthews said...

Prince Charles: Thanks. I wasn't aware either, and that's why I published it.

Colin P: I am serious--that's what he said. I am sure there is data out there. I leave it to our loyal readers to help on this one.


Anonymous said...

Hey Jeff,

I will send you the contact details of an expert by email soon, but you're roughly correct here. The "demographic dividend" paid off in the early 90s and is about to be quickly reversed in the next 5 years. I think the numbers you gave are a bit high but in the ballpark. A curious fact: The one-child policy had no measurable effect on birth rates. The drop in births happened in the mid-70s before the one child policy suggestion was publicized. It was natural as there was a large surge in survival as well as a recent surge in bithrates after the hunger period of the late 60s. The population naturally responded. In modern surveys, they find that even if the OCP were lifted, the birth rates would not significantly change. There are plenty of exceptions to the OCP, and the allowable quota across the country is never filled. Economics and opportunities have thrown Chinese birthrates to first-world levels. In fact, some local research institutes have repeatedly raised the issue of declining birthrates only to be ignored.

The reason that you don't hear all this? Standard politics. The people who have been employed by the government to study the population have owed their jobs to fearmongering. If the OCP is repealed, there is fear that the poverty of the 70s would return. They would also have to answer for the fact that the OCP was not needed recently if it is overturned. They would also have to answer for the brutal behavior of the local authorities. Even though the average Chinese couple has no desire to have another child, the brutal treatment of the few who have had multiple children is shocking.

In any case, I wager that within the next decade the official gov't problems in China will be similar to that in Japan and Singapore -- ineffective encouragement of childbearing.

eeeeeekonjohn said...

So, does this imported inflation show up as higher prices or lower margins?

Bryon said...

Jeff, while this shift may be a current positive for Chinese workers in the way of wage increases, I wonder if the ultimate outcome is not defaltion. Who is going to buy all of condo's, homes, etc. in an already "heady" real estate market?

Anonymous said...

Jeff - re a previous post, do you still think this as a Normal recovery?

Jeff Matthews said...

Anonymous asks if this still looks like a "Normal" recovery (see "Meet the New Normal, Same As the Old Normal").

Yes, no, maybe. Temporary employment is off-the-charts positive; current consumer spending is in a slump; overall business is better, but companies and consumers are worried about higher taxes and an unfriendly Congress.

Time will tell.


Anonymous said...

Wrong on a number of significant counts:

1) It wasn't Mao who enacted the one child policy -- he was a proponent of huge populations. It was Deng Xiao ping in '79. PS it's not exactly one child as there are exceptions as in the countryside, for example.

2) The labor content in goods varies quite a bit, but in higher value goods such as electronics, it's about 3% to the final consumer. Don't look for huge price increases in your iPhone due to labor, look for it in commodities price increases.

3) The companies that will experience a labor price "shock" will be those involved in assembly such as Foxconn.

4) The Chinese government wants to move upstream into higher value, less labor intensive manufacturing such as more electronics, alternative energy etc. The lower value stuff such as garments will tend to move to Vietnam and other parts of Southeast Asia and Latin America.

Jeff Matthews said...

Anonymous has provided helpful corrections which we adopted.

Vietnam, however, is barely a partial solution to China's labor squeeze, possessing a somewhat smaller population than China (like 85 million compared to 1.3 billion).

It will be interesting to see how companies cope.

The most obvious first step will be automation, as China's factories are not highly automated. The next step is to move closer to end markets.

It all means higher costs.


nzguide said...

Jeff, I like your blog a lot and have passed it along to many others over the past 3 years or so. I am kind of surprised that you were not fully aware of the Chinese demographic cloud looming out there. Western Europe is of course doomed to demographic upheaval that will shake their social safety nets, but China's policy had not been tried ever before in history and the communist ivory tower may rue the day they came up with such an idea, but faced with a history of starvation outbreaks, desperate men deploy desperate solutions. I confess that rather than an acute labor shortage, I remain more concerned about a largely male population that has no real means of creating a family and settling down. A large contingent of single men with no family prospects due to an incurable bride shortage (imports anyone?) will lead to (in my opinion) a milatarized culture that Taiwan can only be resigned to joining. In other words the surplus male population had better remain employed or China's military ambitions seem destined to grow. Keep up the excellent work. As for the recovery, here in fly-over country the manufacturers seem to be doing rather well right this moment, but housing seems to be stuck in a rut with no real upturn in sight. That's my 1.5 cents worth.

Anonymous said...

Jeff - even Barton Biggs (the permabull) is now worried about a US recession, and has sold all this US tech names. Strangely he was bullish a week ago on another bloomberg story.

Hayseed said...

Jethro, first things first - no one can predict anything on a significant basis, so my points here are only probabilities that are now on the likely side... but given the deflationary forces underway (see virtually all commodities ex gold and almost all world markets), and combine that with unprecedented debt levels across the globe, and you have a perfect storm for a depression. it will look/appear different that the 30's (as new markets never repeat old markets), and you will have CNBC and the other cheerleader types claiming things are getting better, but the probabilities lie now in assets continuing to be repriced downward, which combined with the extreme debt levels, will create a cascade of deflation until some bottom is hit. i have no idea, now does anyone else where that bottom is, but it is continuing and will last for years, maybe decades. point here is that china relies on ROW demand, and that demand is shrinking daily. so will agree that china will reprice its input costs to some equilibrium level, but that demand measure in double digits will now be measured in single digits. you can tradr the market for the short run (6 mos, 1-2 yrs etc) but the only asset long term to hold right now is cash, assuming deflation continues. nothing, no asset, will be spared.

Paul Denlinger said...

This is part of a demographic transition as the Chinese population ages: as factory workers become scarcer, they will also buy fewer things. This is why China is pushing urbanization now.

As this happens, it's likely that factories will move to Vietnam and other nations which have lower costs than China, and the Chinese govt will encourage Chinese workers to train, so that they can move up the value chain.

My prediction is that China will have to complete most of its infrastructure development, including high-speed trains and other stuff by 2015; if it waits longer than that, the Chinese govt simply will not have the tax revenue base to fund the development.