Yield outlook depends on policy. In that context, our interest rate strategy team and we believe that ten-year Treasury yields will likely decline slightly further, to 2.25% or so. The Fed wants to depress real yields to support growth while boosting inflation expectations, so the composition of yields between real and inflation compensation matters. With ten-year real (TIPS) yields at 50bp, down 70bp from July, real yields are clearly headed in the right direction. But the trough will depend on how low officials think real yields must go and how long they need to stay there to support growth. In that context, it seems likely that the Fed will keep the funds rate near zero until 2012.
Consensus is too pessimistic on growth, inflation. While QE is coming, we think that the consensus view of 1-2% growth and declining inflation is too dour. There are plenty of well-known headwinds, including the uncertainty around the fate of soon-to-expire tax provisions, as we discuss below. Yet we see four factors that will sustain growth at 2-2.5% in the second half of this year:
• First, we think net exports will rebound in 2H as export growth persists and imports retrace some of their aberrant 33.5% annualized 2Q gain. Quirky seasonal factors for petroleum imports will likely defer that improvement until 4Q, but a one-point annualized contribution to growth from net exports in 2H should partly offset the near-record 1.9% 1H drag from net exports.
• Second, personal income is growing again. Even with modest job gains, increases in the workweek have sustained real wage and salary income growth at a 2% annual rate in the past three months. Ongoing improvements in proprietors' income and the reinstatement of unemployment insurance benefits are providing enough wherewithal to sustain the 2% pace of consumer spending we expect in 2H.
• Third, lower mortgage rates are promoting a modest refinancing wave, despite the inability of many current borrowers to qualify under current GSE guidelines. We estimate that the recent decline in mortgage rates will reduce interest payments and provide a US$10-15 billion windfall to borrowers. That will accelerate the decline in the household debt service ratio - already down from 14% in 3Q07 to 12.1% in 2Q - to a sustainable 11-12% range by late this year, with ongoing benefits to consumer discretionary income and creditworthiness. As evidence of consumers' new capacity to borrow, non-revolving consumer credit - which mostly finances purchases of big-ticket durables - rose for the fourth month in a row in August.
• Finally, lingering fiscal stimulus in the form of rising infrastructure spending will boost near-term growth. Outlays for highways, bridges and other state and local infrastructure jumped at a 20.1% annual rate in the three months ended in August, and double-digit gains in such spending are likely at least through the mid-term elections. That will keep overall state and local spending growth flat in 2H. In contrast, the delay in such outlays and cuts in state and local spending trimmed an average 0.3pp from GDP in each of the three quarters ended in 1Q10.
Will QE2 work? That's not the end of the story, of course, as even the 2-2.5% growth we expect is both unacceptable from the Fed's point of view and unsustainable. It is unacceptable to the Fed because it implies a rising unemployment rate and downside risks to inflation. It is unsustainable because it will not foster sufficient job and income gains and confidence to spend and invest.
We think there's modestly good news ahead: The combination of easier financial conditions and strong overseas growth should help trigger a return to sustainable, slightly above-trend growth in 2011. QE is no panacea, of course, and its bang for buck will be small. Directionally, however, new quantitative easing will help that process; as noted above, the market has already priced some of it in. But QE will work through several channels: It will lower financing costs, boost risky asset prices and household wealth, and continue to weaken the dollar. Freddie Mac reported this week that 30-year conventional mortgage rates declined to 4.27%, and many lenders are offering rates between 3.875% and 4.25%. Even rates on non-conforming mortgages, hitherto uneconomic, have plummeted; lenders are offering rates below 4% on 7-year jumbo ARMs. Since Fed Chairman Bernanke's Jackson Hole speech, popular stock price gauges have risen by 10%. That reversed the 2Q decline and puts household equity wealth up 5.6% (US$960 billion) so far this year. And the dollar on a broad, trade-weighted basis has declined by 5.2%.
Those developments will help support credit-sensitive spending, foster a stable-to-lower saving rate, and help net exports. At the margin, lower mortgage rates will promote refinancing and make housing more affordable. Corporate America is borrowing at historically low rates. Standard models suggest that the rise in wealth, if sustained, will prompt an extra US$44 billion (0.4%) in consumer spending. Likewise, our empirical work suggests that a sustained 5% depreciation in the real trade-weighted dollar will over three years boost net exports by about 1% of GDP.
However, blockages in the monetary policy transmission channel mean that the direct bang for buck from QE on domestic demand will be limited. Tougher mortgage origination criteria - including ensuring that the loan is no more than 80% of the appraised value of the property, plus verification of the borrower's FICO score and income - have limited the number of eligible borrowers. Originators faced with ‘putbacks' from the GSEs (Fannie and Freddie) on prior loans are understandably skittish to extend credit to less-than-pristine borrowers.
Strong growth abroad will lift US net exports. The influence of strong global growth on US demand and output is a key factor that differentiates us from pessimists. US net exports are poised to add to growth over the next year. While growth in developed market economies is tepid, a modest reacceleration in emerging market growth, especially in capital spending, will help US exports. The surge in non-oil imports has ended, and stable import penetration means imports will grow only slightly faster than domestic demand. In turn, a sharp moderation in US demand and inventories should slow imports dramatically. As mentioned above, if sustained, the dollar's decline will augment those gains.
Global growth slowed in the spring, casting doubt on its potential support for US growth. Even with a slower pace, three global factors are likely to boost US exports: a shift in the mix of US exports toward faster-growing EM economies and Canada, a global capex upswing, and the Russian drought and export ban that will boost agricultural exports.
Moreover, the slowing in global growth may be ending. Qing Wang notes that "while there has been no clear indication of re-acceleration in Chinese growth, forward-looking indicators such as PMIs and the MS China Business Condition Index do point to re-acceleration in the coming quarters. This is in line with our forecast made in July, i.e., the quarter-on-quarter growth troughs in 3Q and stages a modest acceleration in 4Q." Chetan Ahya observes that "in India there was no real slowdown on the ground. The volatile IP number showed a month-on-month deceleration in June but July data released in mid-September came right back with a 6%M rise. Key domestic demand indicators such as auto sales for August and September have been robust."
That pick-up in growth should be good news for the nine industries in the accompanying table, which account for 28% of goods and services exports. The initial surge from recessionary low levels clearly is unsustainable, but the 8-10% pace in volume terms we expect may well be conservative. Many are skeptical about the breadth and vitality of US exports. But comments over the past two months from our industry analysts, while not uniformly strong, are broadly supportive of our upbeat view (see Appendix in full report).
Finally, US QE may indirectly promote faster US growth through an international channel: The Fed's actions are strengthening currencies abroad and forcing policymakers to choose whether to accept currency strength, adopt easier policies, or implement capital controls. Many central banks, in both EM and DM economies (e.g., Australia, Canada) are choosing the second alternative to resolve this ‘trilemma' or impossible trinity, meaning they are choosing faster growth as well as global rebalancing.
Import slowdown has begun. A spring surge in US imports thwarted what we expected to be a moderate contribution from global to US growth earlier this year. Indeed, it seemed that Americans were returning to their time-worn spendthrift ways. But we think the 33.5% annualized 2Q import surge was only a temporary development that restored imports' share of US demand to previous peaks. Swings in inventories magnified the 2Q import surge and dampened recovery in domestic output. Because that inventory leverage works both ways, a slowing in inventory accumulation will depress import growth going forward. Consequently, we think that import growth henceforth will re-sync with the pace of US domestic demand; that will likely promote a deceleration in imports and ultimately a much-needed rebalancing of the US economy. In addition, a slower, more sustainable pace of equipment spending should depress big-ticket-heavy imports. As evidence, we are starting to see a sharp slowing in exports from Asian economies like Korea and Taiwan to the US.
Needed: Job and income growth. Ultimately, the sustainability of the recovery will hinge in significant part on the continued revival of job and income growth. On that score, the moderation in the pace of private job gains and the significant declines in state and local government jobs are both a concern. Average private monthly job gains have slowed to 91,000 in the past three months from 118,000 in the April-June period. The good news is that a rising work week has through most of this year promoted healthy gains in paychecks; the bad news is that private hours stalled in September and growth must improve to restart that process. More ominously, state and local payrolls skidded by a monthly average of 54,000 in the summer. Two-thirds of those losses have been in education, as budget-constrained school districts cut hiring to zero in the new fiscal year. As noted below, a further revival in revenues will be needed to stabilize and ultimately revive state and local government hiring.
Coming resolution to tax uncertainty. Policy gridlock in Washington has created economic uncertainty, which is a drag on growth. If this gridlock is not resolved soon, expectations of fiscal drag will become reality, perhaps trimming three-quarters of a percentage point from growth in 2011. The fate of the expiring tax cuts is a key uncertainty for the outlook. If the tax cuts expire, households will be hit with US$175 billion in higher taxes on January 1. The uncertainty surrounding the expiring tax cuts should prompt some taxpayers to accelerate income into 2010 at the expense of 2011. In July we thought Congress would extend the expiring tax cuts, at least temporarily for a year. We now expect that Congress and the Administration will resolve that uncertainty by early next year with a one-year extension of all tax provisions.
Fiscal drag: Less than feared. Three sources of fiscal drag could hold back growth: Stimulus enacted in 2009 under the American Recovery and Reconstruction Act (ARRA) will continue to fade, unemployment benefits may not be extended, and state and local governments could cut spending further. The largest source of drag is from the winding down of ARRA transfers and grants; between this calendar year and next we estimate transfers (including Cobra assistance and other transfers) will decline by US$68 billion. Grants in aid to state and local governments will fall by US$27 billion. And the Making Work Pay Tax Credit, which cost about US$60 billion, will not be extended past 2010.
However, we expect that Congress will extend UI benefits, at least for a while. And rising tax receipts mean that the drag from state and local restraint will be modest. Total state and local tax revenue gained 1.7%Y in 2Q, a third straight small gain after the worst decline on record last year. The turn slightly higher recently should lead to a modest rebound in spending in the current fiscal year. State and local governments have deeply rooted fiscal problems in pensions and healthcare that will take years to fix. But cyclically, we continue to think that the causation mostly runs from the economy to state and local government spending. States and municipalities are under enormous pressure to supply needed educational and public safety services. So, the combination of a modest rebound in revenues and federal stimulus funds for infrastructure seems likely to support renewed spending growth.
Treasury yields plummeted over the past week except at the long end of the nominal market - to a series of record lows for the 2-year, 3-year, 5-year, 7-year, 5-year TIPS, 10-year TIPS and 30-year TIPS - as the move accelerated to price in resumed quantitative easing by the Fed and, increasingly, expectations of easier monetary policy across the world, partly as a result of broadening efforts to fight the dollar weakness that has been driven by the rising QE expectations. The past week's rally was the biggest in the run of four straight weekly gains, with the accelerated gains driven by a very dovish interview with Chicago Fed President Evans in the Wall Street Journal in which he not only strongly advocated a major resumed quantitative easing policy immediately but also said he thinks the Fed should consider an intermediate inflation target above its long-term goal near 2%, aggressive new easing measures announced by the Bank of Japan that included plans to ramp up buying of a range of assets including ETFs and REITs, and a weaker-than-expected employment report after a run of somewhat better data earlier in the week. The employment report showed another sluggish gain in private sector payrolls that was in line with lowered expectations after the soft ADP report, but the plunge in state and local government jobs, which was not expected in consensus expectations, was a lot bigger than even our pessimistic forecast for a 50,000 decline in teachers, and softness in private sector hours and earnings offset the modest gain in jobs.
The increasingly aggressive Fed rhetoric and the soft employment report results seem to have investors rapidly setting their sights higher for how much buying the Fed will do and how big its initial announcement, expected on November 3, will be. Our base case is that a more incremental approach will be adopted this time, in line with remarks on Monday from Brian Sack, head of the New York Fed's markets group that implements policy, with buying targets announced from FOMC meeting to meeting and adjusted depending on market moves and economic data. The Fed may also announce a medium-to-longer-term purchase goal but probably while reserving more flexibility to adjust this target than in the 2008 and 2009 QE. We're expecting about US$100 billion in Treasury buying to be announced as the target to be bought between the November 3 and December 14 FOMC meetings, perhaps also with an announced initial target of about US$1 trillion in buying in the first year, which would account for most of the net issuance needed to fund the expected F2011 budget deficit of US$1.2 trillion. But with the unusually strong policy comments from some Fed officials recently, especially President Evans, and the soft employment report, market sentiment seems to be shifting more in favor of a ‘shock and awe' than an incremental approach. And these rising expectations for more aggressive Fed buying are having increasingly major market impacts. In the past week, the pre-QE trend of falling real yields and rising inflation expectations substantially accelerated, the latter seen in both big further increases in TIPS inflation breakevens from their August lows (though not so far to elevated levels), a spike in 10s-30s to a record high, and an accelerated depreciation of the dollar. Indeed, the Bank of Japan's initially well received plan to conduct the equivalent of US$60 billion in asset purchases was quickly swamped by rising expectations for how much more in liquidity injections the Fed might do, sinking the yen to a new 15-year low on Friday and raising the pressure on the BoJ already to adjust up its buying plans. Meanwhile, the surging AUD contributed to the Reserve Bank of Australia's surprising decision not to raise rates Tuesday, many emerging market economies continue to struggle with heavy capital inflows seeking higher returns as US rates plummet driving up their currencies, which Brazil's finance minister decried as an "international currency war", political pressure on China for revaluation continues to grow, and the ECB seems to be becoming increasingly uncomfortable with the surging euro. Even without actually doing anything yet, the Fed's talk of resumed QE has already led to a significant easing in US monetary conditions through plummeting US yields, including a move to new record-low mortgage rates in recent days, the weaker dollar, and the pressure the weaker dollar has placed on other countries to pursue easier monetary policy, though at the cost of rising international tensions.
For the week, benchmark nominal Treasury yields fell sharply at the short end and in the belly of the curve, but the long end lost a bit of ground. The 2-year yield fell 8bp to 0.35% - only 21bp over the 4-week bill yield at 0.14%, which can probably be fully accounted for by a term premium - 3-year 11bp to 0.52%, 5-year 17bp to 1.10%, 7-year 17bp to 1.74%, and 10-year 14bp to 2.38%, while the long-bond yield rose 2bp to 3.75%. These 2-year, 3-year, 5-year and 7-year yields were all record lows after declines of 21-49bp in the past four weeks, led by the 7-year. Longer-end yields weren't at record lows, but 10s-30s were at an all-time high after surging 16bp on the week to 136bp. As strong as gains along much of the nominal curve were, they fell well short of an extraordinarily strong performance by TIPS, as investors priced in an extended period of extremely low real rates coupled with some upside in inflation. The 5-year TIPS yield fell 31bp on the week to -0.47%, 10-year 32bp to 0.39% and 30-year 22bp to 1.40%, all record lows. This lifted the benchmark 10-year inflation breakeven 18bp to 1.99% and benchmark 30-year breakeven 25bp to 2.35%, four month highs, and the 5-year/5-year forward breakeven based on constant maturity yields about 20bp to near 2.45%, high since May. The medium-term path priced into the Treasury market of extremely low real rates and some upside in inflation from current below-target levels is just what the Fed would like to see with QE. More worrisome to us, however, is that while the market is priced for inflation to keep trending higher over the years to come, there is little market hope for an improvement in growth, with the 5-year/5-year forward real rate at only about 1.25% suggesting very low growth continuing all the way out to between 2015 to 2020.
The drop in yields on expectations for QE is already feeding through in a substantial way to consumers, with a strong showing by the MBS market dropping mortgage rates to new record lows. Even as Treasuries continued to richen versus swaps on QE expectations, with the benchmark 10-year spread up 3bp on the week and 14bp the past month to a four-month high of 10.5bp, mortgages managed to solidly outperform Treasuries, with current coupon MBS yields falling about 20bp to near 3.15%, a new record low below the prior low of 3.2% hit at the end of August. On average for the week ending Thursday Freddie Mac reported that the national average 30-year mortgage rate was at a record-low 4.27%, and late in the week rates being offered by the largest mortgage originators were no higher than 4.25% and as low as 3.875%, so the national average rate should fall significantly further in next week's survey to another new low. Helping mortgages the past week was the slower-than-expected response to these rates, as MBS prepay speeds in September rose less than expected after the surprisingly sharp increase in August, and the MBA's mortgage refi series extended a recent pullback in refi applications. With mortgage rates breaking to new all-time lows, however, it seems likely that the refi wave should gather steam in the coming weeks. We expect this will help the consumer debt service burden, which has already fallen from the peak of 14% hit in 2007 to 12.1% in 2Q, fall into the 11-12% range that we consider to be a long-term sustainable level within the next couple of months. Already historically high housing affordability will also receive a boost from the further drop in mortgage rates, providing support to home sales and helping to contain downside in prices as the huge inventory of unsold and distressed homes is worked through. Clearly it is not needed now, but eventually if rising mortgage supply starts to put upward pressure on MBS/Treasury spreads, we expect that the Fed would add MBS buying again to its quantitative easing program.
It was a somewhat mixed week for risk markets, with stocks not showing as much enthusiasm about QE as other risk or rates markets at this point. The S&P 500 did manage to gain a decent 1.6% on the week to reach a five-month high, but Tuesday's 2.1% rally after the BoJ easing moves was the only notably positive day. Cyclical sectors did notably better, with the materials, energy, industrials and consumer discretionary sectors gaining about 3% on the week, but this partly offset by only small gains in more defensive areas and underperformance by financials and technology. Credit markets had a more persistently positive trend through the week to extend a recent run of outperformance versus equities. The investment grade CDX tightened 7bp on the week to 97bp, also the best close, with the prior series 14 version closing at 91bp, its best level since April. The high yield CDX index gained about 2%, for about a 40bp tightening on a spread basis to near 510bp, also the best close since April. The subprime ABX market lagged, with the AAA index gaining 1%, as widespread problems with mortgage foreclosure procedures led to a broadening move to impose foreclosure moratoriums, including a freeze on all foreclosures announced by Bank of America, the country's biggest mortgage originator, on Friday. The commercial mortgage CMBX market, however, had a great week, with the AAA index rising 2% to its highest level since the current series began trading in May 2008. Lower-rated CMBX indices are still well below their 2008 highs but they posted bigger gains on the week, 6% for junior AAA, 9% for AA and 7% for A. There has been increasing optimism that the recent healing in the CMBS market could allow some start to a revival in issuance going forward, which these latest gains should continue to support. Meanwhile, the muni bond CDS market extended its recent strong performance, breaking the previously close relationship with still struggling peripheral EMU government bond markets, on improving fiscal fundamentals as tax revenue has started to turn around and strong demand for taxable Build America Bonds. The latest week saw California finally approve a budget more than three months into the current fiscal year and New York City see record foreign demand for a sizeable BAB sale, as the 5-year MCDX index tightened 16bp on the week to 204bp, the best level since early June after a nearly 30bp tightening from the recent wides seen in mid-September.
The employment report was weaker than expected, as the drop in state and local employment was larger than the 50,000 drop we had expected (and little change expected by consensus), private sector job growth remained sluggish, and underlying hours and earnings details were disappointing. Non-farm payrolls fell 95,000 in September, with temporary census jobs at -77,000 (to only 4,000, so this is the last month this will be a significant distortion), private sector +64,000, and state and local government -83,000. Private sector job gains were led by leisure (+38,000), healthcare (+32,000) and temps (+17,000), with partly offsetting weakness in construction (21,000) and private education (-15,000). Weakness in education at the start of the school year also accounted for most of the near-record drop in state and local jobs. The unemployment rate held steady at 9.6%, but other details of the report were softer. The average private workweek was flat at 34.2 hours, which combined with the only minor gain in jobs left total hours worked in the private sector little changed. Total hours worked in the manufacturing sector declined 0.1%, pointing to only a 0.2% gain industrial production in September. Average hourly earnings were also unchanged, leaving aggregate weekly payrolls, a gauge of total private sector earnings, up only 0.1%, pointing to sluggish growth in personal income in September.
The larger-than-expected plunge in state and local jobs in September and sizeable downward revisions to prior months pointed to a significantly worse outlook for state and local government spending in GDP. The construction spending report has shown a big pick-up in state and local government construction spending in recent months that should keep overall S&L spending from declining, but based on the weak employment numbers, we now see spending ex construction falling 1.6% instead of 0.8%, which would be the biggest drop since 1952. We see state and local construction spending gaining 11%, however, which should leave overall S&L spending about flat, down from our prior estimate of a bit less than +1%. This reduced our estimate for 3Q final sales (GDP ex inventories) to +0.8% from +0.9% and for final domestic demand (GDP ex inventories and trade) to +1.1% from +1.2%. This was more than offset for overall GDP growth, however, by a further 0.5% jump in wholesale inventories in August on top of an upwardly revised 1.5% surge in July. We now see inventory accumulation adding 1.3pp to 3Q GDP growth instead of +1.1pp, which offset the 0.1pp lower outlook for final sales and boosted our 3Q GDP estimate marginally to +2.1%.
Columbus Day on Monday is a government holiday, and most US markets are closed (though the stock market is open), but there are a number of important economic releases through the remainder of the week, highlighted by retail sales and CPI Friday. Fed Chairman Bernanke will also be speaking Friday morning at the end of another heavy calendar of Fed appearances. He will speak at a more theoretically focused conference hosted by the Boston Fed, but the his speech, "Monetary Policy Objectives and Tools in a Low-Inflation Environment", is clearly exactly what markets are most focused on right now, so investors will probably be expecting him to provide more clarity on how he thinks the Fed should approach the reintroduction of QE. Earlier in the week, supply will probably be the main focus in the Treasury market, with 3-year, 10-year and 30-year auctions Tuesday to Thursday. The minutes from the September FOMC meeting will be released Tuesday. A couple of weeks ago it seemed that these might be an important avenue for the Fed to signal its thinking on renewed easing, but those signals have been clearly sent by the numerous Fed speakers recently, so the minutes' significance is smaller. In addition to retail sales and CPI Friday, data releases due out this week include PPI and trade Thursday and business inventories Friday:
* We forecast a 0.1% rise in the producer price index in September, overall and excluding food and energy. A rebound in quotes for food items should be about offset by a slight pullback in the energy category. Meanwhile, the core is expected to show a fractional rise in September under the assumption that the often volatile motor vehicle sector holds relatively steady.
* After the sharp swings the prior couple months, we look for the trade deficit to hold steady at US$42.8 billion in August, with exports gaining 0.8% and imports 0.7%. Exports should be led by food, with agricultural export prices showing a huge gain. Industrial materials should also see some price-supported upside, but a pullback in aircraft after a big gain last month should lead to a modest decline in capital goods. Most of the import gain is likely to be in petroleum products, with Energy Department figures pointing to upside in volumes and prices. Other goods imports should flatten out, in line with slowing growth in inbound port volumes as domestic demand growth has been muted.
* We see the core CPI just barely rounding up to +0.2% in September (our point estimate is +0.16% on an unrounded basis) and the headline rising 0.3%. Industry data point to a rebound in hotel rates following the surprising dip seen in August. Also, declining apartment vacancy rates and rising effective rents point to the resumption of at least some mild upward drift in the key residential rent and OER categories. In addition, the bizarre deceleration in medical care costs seen over the course of the past couple of months seems unlikely to continue, based on widespread anecdotal reports. On the downside, we look for a modest pullback in new car prices. If our estimate for the core is realized, the year-on-year rate would just barely round up to +1.0%.
* We forecast a 0.6% gain in overall retail sales in September and a 0.3% gain ex autos. Sales should get a boost from a solid gain in the auto dealer category and a price-related jump at gas stations. Otherwise, we look for only fractional advances in discretionary categories, such as general merchandise and apparel, based on the mildly disappointing chain store results. This implies a modest 0.3% rise in the key retail control gauge that flows directly into the calculation of personal consumption. In 3Q, we now see real consumption up 1.9% - about the same pace as seen in the first two quarters of 2010.
* We look for a 0.6% gain in August business inventories. A sharp jump at the wholesale stage, together with some expected elevation in auto dealer stockpiles, should push up overall business inventories in August. Meanwhile, the I/S ratio is expected to tick up to 1.27.
Introduction and Overview
What are the megatrends that could define the Chinese economy through 2020, in terms of both growth trajectory and the structure of the economy? To what extent can we extrapolate China's economic success of the past three decades to the coming one? What are the potential pitfalls and risks down the road? How should investors best position themselves for the potentially profound transition and transformation of the economy?
We aim to address these issues in a series of reports under the umbrella Chinese Economy through 2020. They include several key topics such as the outlook for growth and structural evolution of the economy, demographic and labor market trends, the rise of the Chinese consumers, China's demand for commodities, the outlook for China's property sector and wealth creation; the role of Hong Kong and the global influence of China.
In the first installment, we established that China's potential economic growth rate is set to slow but should nevertheless average 8% per annum through 2020, with a profound structural evolution that leads to rising shares of consumption-GDP, service sector-GDP, and labor income-GDP (see China Economics: Chinese Economy through 2020 (Part 1): Not Whether but How Growth Will Decelerate, September 19, 2010).
This report is the second installment and aims to assess the evolution of China's demographics and labor market and its implications for the sustainability of China's economic growth over the next decade.
The debate over China's demographic transition and the attendant implications for the labor supply has been in the spotlight since 2003-04 when the shortage of rural migrant workers initially emerged. The concerns seem to be becoming a real threat as the demographic total dependency ratio is poised to bottom and working-age population growth to decelerate over the coming years. Indeed, the expectation of a precipitate decline in the growth rate of working-age population appears to have become one of the most powerful arguments for a sharp slowdown in China's economic growth over the next decade.
A deceleration in the growth of the working-age population is unlikely to be a headwind to the overall economic expansion in China, making an average GDP growth of 8% per annum through 2020 quite achievable, in our view.
1) While China's working-age population is set to decelerate significantly over the next decade, the effective labor supply will remain abundant. Several long-standing distortions in the labor market have driven a wedge between the working-age population and the effective labor supply, as shown both by the distinct disconnect between GDP and employment/working-age population growth over the past two decades and the current disproportionately high share of the rural population and employment in the primary sector.
2) The removal of these distortions - which is taking place in a profound fashion - should ensure an abundant labor supply through to 2020. We forecast that while the working-age population is expected to only increase by 20 million, urban and rural non-farm employment will increase by 80 million from 2010 to 2020.
3) In the meantime, strengthened human capital investment and continued capital deepening - the other two key sources of labor productivity gains - are likely to persist.
4) More specifically, given the high percentage of the working-age population living in rural areas and the disproportionately high share of primary sector employment, a significant boost in labor supply and labor productivity is, in our view, eminently achievable, especially with proper policies in place. Some such policies have already been implemented in recent years, including the gradual deregulation of controls over rural-urban labor mobility that have been impeding rural-urban labor mobility for over half a century, the acceleration of urbanization, the ‘Go West' inland investment program, an aggressive social housing program, and improved provision of education. Moreover, China should continue to be one of the most important manufacturing bases in the world, as it remains internationally competitive, given its relatively high labor productivity, strong logistic infrastructure and economies of scale.
What Is the Recent Debate?
China's demographic transition has been at the centre of discussion since 2003-04 when a shortage of rural migrant workers became evident in the Pearl River Delta. This was later reported to have spread to the whole country. It called into question the sustainability of the business model adopted by the ‘world factory', which relies on a seemingly unlimited supply of migrant workers at very low cost to churn out more and more goods for exports. The subsequent increase in wages was considered strong evidence of labor shortages, arousing concerns that China has already reached or crossed the ‘Lewis turning point' and, as a result, the era of unlimited labor supply would come to an abrupt end.
These concerns appear to be becoming a real threat, as the total dependency ratio (the number of dependents, i.e., children and the elderly, compared to the working-age population), is poised to bottom out in the next few years according to United Nation forecasts, casting serious doubts on China's ability to remain the dominant manufacturing base. Moreover, the continual increase in wages, coupled with the much-anticipated appreciation of the renminbi, are additional hurdles, squeezing an already thin margin and hurting Chinese exporters' international competitiveness.
The pessimism is so widespread and deep-rooted in the minds of some China observers that upbeat comment from the Minister of Commerce Chen Deming in March 2010 was met with considerable skepticism - Mr. Chen was quoted as saying that China could still enjoy another 10 years of "demographic dividends" based on the analysis done by the Ministry of Commerce specifically on the labor shortage issue. And it is our understanding that a key working assumption made by the Chinese authorities in their preparation for the 12th Five-year Plan (2011-15) is that demographics will continue to work in China's favor over the next decade.
What causes the disconnect? Will demographics in general and labor supply in particular be a headwind or tailwind to the economic growth? This is key issue in forming China's economic outlook through 2020.
First Up, How Do We Get to Where We Are Today
From High Birth Rate, Declining Mortality Rate...
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