Changing China
The nation faces challenges on the road ahead

By Mark Robertson, investment manager, emerging market equities, Baillie Gifford

China’s huge surplus of labour and rapid investment growth have given the world a productivity windfall over the last 25 years, in the shape of constantly falling prices of manufactured goods. The world has perhaps become too accustomed to this benign influence, and over the next twenty years some of these benefits may even be reversed. Demographic and environmental issues are already putting upward pressure on unit costs, which could herald a trend change in the global pricing environment.

China’s One Child Policy has been in place for almost four decades. It has been highly effective and China’s demographic structure has already started to change dramatically. The number of elderly Chinese is growing at an alarming rate, but perhaps more worrying is the sharp contraction in the number of young people. Current demographic estimates suggest the number of people under 40 could fall by almost a third over the next 20 years, and the process is already well underway. Since these young, relatively well educated and flexible workers supply the largest part of China’s manufacturing army, their increasing scarcity is posing operational problems for manufacturing companies. Their costs have been rising for some time, and that has also begun to translate into rising output prices.

Shrinking workforce
As China’s workforce stops expanding and ultimately starts to shrink, we may have to get used to Chinese growth rates well below what we’ve seen in the past. An increasingly well-educated labour force can keep generating productivity gains, but harsh arithmetic dictates that the aggregate growth rate will eventually fall. This trend is likely to be reinforced by the aging process, as a greater share of labour and resources will need to be devoted to supporting the elderly. Also, as more Chinese retire, they will stop saving and become net consumers, changing the structure of the economy. A move away from investment towards greater consumption is generally considered desirable at this stage of China’s development, and is likely to happen as a result of the demographic shift as much as any policy. As it does, China’s present vast trade surpluses are likely to fall and latterly turn to deficits, which in combination with rising budget deficits will turn China into a net importer of capital, in stark contrast to its current role.

In addition to demographic change, another structural issue is beginning to affect China’s international competitiveness: the environment. One of the reasons the goods we buy from China are so much cheaper than what we make at home is that the Chinese have tolerated environmental degradation that would be quite unacceptable in other societies. There are four environmental issues that have now become highly political: extreme pollution, the rapacious exploitation of local resources without regard to sustainability, health and safety deficiencies that result in hundreds of thousands of industrial deaths, and the arbitrary confiscation of agricultural land to be provided for industrial use. The political tide has clearly turned, as the Communist Party has recognized that these issues are now generating as much social instability as its traditional concern, unemployment. As environmental neglect becomes increasingly unacceptable, the process of upgrading China’s factories to international standards, and of rectifying past degradation, will also inevitably add another layer of costs to the manufacturing process.

China’s role as workshop of the world has been acquired due to some unique circumstances, but we should be careful not to assume those will last indefinitely. Its days as the originator of global disinflation could possibly be numbered.

To view Mark Robertson's presentation, click here.