China's Economic Miracle Is Over

China funded the largest economic stimulus programs in world history from July of 2009 through June of 2010. As a percentage comparison to the U.S. stimulus plan; the Chinese spent twice the amount of money in half the time. China focused their stimulus on encouraging production, whereas America’s stimulus went to consumption. It now appears that the Chinese produced a huge portion of the consumer goods Americans bought with their stimulus dollars. Consequently, China’s unemployment rate fell to 4.2%, whereas the U.S. unemployment rate rose to 9.6%. Unfortunately for China, their stimulus success has also sown the seeds of their economic demise. A vicious combination of inflation and a strengthening currency is about to end the Chinese economic miracle.

China’s economy is only a third as large as the U.S. economy, but the total amount of goods and services traded are similar. China exports $2 trillion and imports $1.5 trillion; the U.S. exports $1.5 trillion and imports $2 trillion. But as shown below, in the Great Recession, China achieved high growth and employment; but the cost of success is high interest rates and raging inflation.

Int. Rate Growth Rate Jobless Rate Inflation Rate Food % GDP Food Inflation

China 5.56% 9.60% 4.20% 4.40% 34.0% 10.8%

US 0.25% 2.00% 9.60% 1.10% 12.4% 1.4%

To understand the Chinese “miracle” it is important to be aware of China’s history. President Nixon may have opened China to the outside world in 1970, but it was the collapse of the Soviet Union in the 1980s that forced China to abandon communism and flirt with capitalism. From 1981 to 1993 China devalued its currency six times, from 2.8 Yuan to 5.3 Yuan to the dollar. Facing economic crisis and famine in 1994, China embraced capitalism as “Socialism with Chinese Characteristics”. The exchange rate was devalued to 8.7 Yuan per dollar and tax rates were set at a 40% discount to the U.S. and Japan.

The combination of a 68% devaluation of the currency and dramatically lower tax rate fueled China’s economic boom.

Over the last fifteen years, China’s economy quadrupled; while the U.S. doubled and Japan had no growth. The graph below demonstrates China has not taken advantage of its success to develop competitive domestic manufacturing. The Chinese export “miracle,” as shown in yellow, is still due to U.S. and Asian manufacturers outsourcing their low-tech “processing” of component assemblies to benefit from China’s low effective wage rates. China continues to run a small deficit in “ordinary” finished goods manufacturing and a larger deficit in the “other” category of services.

Consequently, the success of the Chinese economy remains very susceptible to changes in China’s costs of production. Until recently, China could count on millions of impoverished peasants leaving the farms in the countryside each year to head to the cities for low tech jobs and a better life. This seemingly “endless pool of labor” kept worker wages low. But the stimulus program was so successful that the economy has now reached full employment. To get more workers, companies are forced to offer higher wages to convince workers to switch employers. The higher employment and rising wage rates have increased the demand for food, which is over one third of Chinese personal consumption. The higher demand for food has created rampant food inflation. With food prices up almost 11% this year, farmers who might have considered moving to the cities are staying on the farms and getting rich. Workers in the cities are being squeezed by consumer prices that are rising faster than wages.

China’s labor force is 800 million versus the U.S. labor force of 154 million workers. Currently China’s unemployment rate is 4.2%, or 33.6 million versus the U.S. unemployment rate of 9.6%, or 14.8 million workers. Chinese exports amount to a massive 45% of their economy versus 11% for the U.S. economy.

China could put an end to this domestic demand-pull and cost-push inflation by allowing its currency to float up in value; but any increase in currency exchange rate would directly increase the cost competitiveness of Chinese labor. Since over two thirds of Chinese exports are process manufacturing for corporations in other countries, changes in the exchange rates with China would have a direct proportional relationship to the willingness of corporations to out-source their low tech processing work to China.

Several recent academic studies have determined that, every 10% appreciation of China’s currency, would result in a 17% reduction in China’s processed exports. Estimates of how much the Chinese currency would rise in value if the Chinese government allowed it to float, range from 10% to 40%. Therefore, a free floating currency could increase China’s unemployment by 40 to 160 million!

China’s economic miracle allowed the country to become the second largest economy and the largest exporter in the history of the world. This miracle continues to be grounded on the third world economic model of providing foreigners impoverished peasant labor at the lowest effective cost. High unemployment in the rest of the world is driving labor costs down, whereas full employment and high demand are driving China’s labor costs up. Rapidly growing inflation will soon force the Chinese to allow their currency to appreciate. China is not prepared to handle hard economic times. The government has kept its tax rates very low by not providing social services. As inflation and unemployment rise, China’s economic miracle will be over.