Recently, global oil prices have strengthened, largely on the back of more positive economic statistics from the world's second largest economy -- China.
Export growth and capital investment statistics have shown positive trends suggesting that the economic slowdown experienced by the country may be ending and more historical economic growth rates are returning. In fact, Standard Chartered Bank (SCBFF-Nasdaq) economists have recently upgraded their forecast for China's growth rate to 8.3% this year and 8.2% next, although other estimates for 2014 are much lower. This upwardly revised estimate is meaningfully better than the government's official projection calling for 7.5% growth in 2013. While this may be good news for China and the global economy, a new paper from researchers at the International Monetary Fund (IMF) suggests the country's economic miracle may be about to end.
This new paper chronicles a demographic trend that has not received much attention from economists but which portends serious labor shortages for the country in coming years. The paper "Chronicle of a Decline Foretold: Has China Reached the Lewis Turning Point?" says that the army of Chinese peasants looking for work peaked in 2010 at around 150 million. That number is now collapsing. The surplus labor situation will disappear after 2020 and within a decade after that China will face a labor shortage of almost 140 million workers. According to the IMF, "This will have far-reaching implications for both China and the rest of the world." No doubt.
It was only about half a dozen years ago that a Chinese demographer shocked his audience at the World Economic Forum in Davos with the warning that his country might have to resort to mass suicide in the end, having to push pensioners out on their own. He was describing the demographic problem of too many old people to be supported by a rapidly shrinking younger, productive population.
The graying of the world is quickly becoming a topic of increased interest and importance for understanding which economies on the planet will thrive and which ones will shrivel up. In China's case, its massive labor surplus of farm workers migrating to the coastal cities with their manufacturing jobs has powered the Chinese economic miracle for the past several decades. This cheap labor was the raw material of the Chinese manufacturing sweatshops and the low cost of manufacturing drove the country's economy. This labor force migration was carefully regulated by the societal and governmental structure of the country in order to keep the migrants' families tied to their villages and hopefully keeping a lid on social unrest.
The problem now is that the government's one-child policy and the populations' low fertilization rates are baked into the country's demographic and it will take nearly a half a century to turn around this shift in the labor pool.
The IMF paper points to the challenge of the Chinese economy as it meets its Lewis Point. The Lewis Point is named after St. Lucia's Nobel laureate economist Sir Arthur Lewis. The turning point marks when the supply of migrant laborers dries up and city wages soar. In effect, labor turns the tables on capital and the end result is that profits crash. The Boston Consulting Group reports that "productivity-adjusted wages" were equal to 22% of U.S. levels in 2005, but they will reach 43% by 2015. By that time, Chinese wages will reach 61% of wages in the American southern tier states, the region where manufacturing growth has been the most rapid in recent years. It supposedly is this turning point in China's labor market that has led a number of America's leading manufacturing companies to begin "on-shoring" manufacturing jobs. The phenomenon is being helped also by cheap energy from the shale revolution, a weaker U.S. dollar and lower shipping costs.
The Lewis Point is a critical point in the development of economies. It is when developing economies no longer can rely on cheap labor, copied technology and export-led initiatives to drive their growth. Instead, they need to evolve into economies driven by the rule of law and the free flow of ideas. Unless they evolve, they are likely doomed to fall into the "middle-income trap," and most do. The list is long of countries that through their history reached the Lewis Point and succumbed to failure -- the Soviet Union, the Philippines in the 1950s, most of the Middle East and much of Latin America in the 1960s and 1970s. The jury is still out on whether Argentina and Brazil can avoid falling into the middle-income trap. And certainly we don't know yet where China is headed.
The Chinese government is attempting to revive its slowing economic growth by turning on the credit spigot. Railway investment almost doubled in the second half of last year. The government recently has pledged $2 trillion of stimulus spending to help pump up growth. What this credit growth looks like is a reversion to the economic stimulus of earlier periods, which means more steel and cement.
According to some economists, "investment" made up 55% of all growth in 2012, and it may soon need to reach 60% in order to help keep up the pace of growth. Economists call this pattern of growth stimulus a giant Ponzi scheme with a bad outcome. What is not seen, however, is that the center of the investment-driven growth is moving westward into the interior of the country and the Upper Yangtze and away from the coastal areas.
If you read various articles on the interior's new growth you learn about the construction of the world's tallest buildings and those being built in record time. It is this ramp up in growth in the interior that is driving the recently upwardly-revised Chinese economic growth rate forecasts. The growth is being financed by the rapid expansion of Chinese bank balance sheets that had been growing by 30% of GDP per year since 2008 and are still growing at 20% a year now. According to Fitch Ratings, the credit rating agency, fresh credit added to the economy over the past four years has reached $14 trillion if you include shadow banking, trusts, letters of credit and offshore vehicles. This credit stimulus about equals the size of the entire U.S. commercial banking system.
Fitch estimates that the output generated from each extra yuan of lending has fallen from 0.80 to 0.35. If true, it means the Chinese will need to accelerate their lending pace in order to keep the economy growing. With estimates that credit in China now represents 210% of GDP, far higher than any other developing economy, one has to wonder how and when the cycle ends. When the credit bubble pops, as all bubbles eventually do, it will probably be a result of the clash of the labor shortage and the credit expansion hangover. Is it likely to happen in the next decade? If so, China may experience the Japanese phenomenon of being forced to sell the many assets it has accumulated in recent years, and continues to acquire, at fire-sale prices. Does anyone remember Pebble Beach and Rockefeller Center?
From the perspective of the energy industry there are two aspects of this scenario that are worthy of attention. First is the implication for energy consumption growth. A last gasp of investment in new buildings and infrastructure projects means a spurt in energy consumption, much like what was experienced in the early years of this century as China prepared for the Olympics, which caught energy forecasters flatfooted. After this last wave of investment, energy consumption growth will drop, and probably precipitously, unless the country can build a consumer-based economy.
The second implication is what happens to all the global energy investments Chinese oil and gas companies have made in recent years? Will these assets be pumped dry and then discarded, or will they be dumped on the market driving down asset values as the companies engage in a wild scramble to raise cash to repay their debts? The former scenario suggests we may be looking at higher oil, gas and even coal prices as easily recoverable resources are depleted rapidly and investment in more expensive resources is ignored, while the latter points to collapsing energy asset values, which should drag down energy company share prices.
If you are ExxonMobil (XOM-NYSE), Gazprom (OGZPY-PNK) or Saudi Aramco, what should your corporate strategy be? Examining their policies and investments in recent years along with what they do this year could signal how they see the China bubble ending. Our current reading suggests they see a shifting in the driver of global economic growth away from Asia and back to western economies.
G. Allen Brooks is Managing Director of Houston-based investment banking firm Parks Paton Hoepfl & Brown. This article originally appeared in the Feb. 19, 2013, issue of PPHB's newsletter "Musings from the Oil Patch."