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In a frank admission of the economic challenges facing the country, Chinese Premier Wen Jiabao has acknowledged that Chinese policy-makers “face increasing dilemmas” as they try to rein in growth against the backdrop of a sharply deteriorating global economy.

The comments are likely to highlight the risk to global economic growth as China tries to unwind the stimulus policies introduced in the wake of the financial crisis, and reduce inflationary pressures, without plunging the economy into a sharp downturn.

Wen told an economic forum on the weekend that "China's current economic situation is sound, but the domestic and global economic environment is extremely complicated” according to The Wall Street Journal. He said that China would introduce more flexibility into its existing policies to “solve current significant and urgent problems”, while laying the foundations for “stable and relatively fast economic growth” in 2011 and beyond.

But China is attempting a delicate balancing act, and Goldman Sachs' head of global economic research, Jim O’Neill has warned that we’ll all feel the consequences if China miscalculates.

"What is clear is that a persistently struggling US, in addition to a major disappointment in China, would not be good news for the rest of us”, he wrote in an article in the UK’s Sunday Telegraph.

In the article, O'Neill said that a moderate slowing in Chinese economy was welcome, but he warned of the risks to global economy if China slowed much more sharply. Goldman Sachs has recently cut its forecast for GDP growth in China this year from 11.4 per cent to 10.1 per cent.

"If we are wrong [about estimates for growth in China] especially significantly, then the world will be a very challenged place, particularly for those living on self-imposed domestic austerity," he said.

"What adds to the reality of this situation is that there appears to be growing evidence that China is slowing down."

Since the beginning of the year, Beijing has moved to rein in credit growth by ordering banks to hold a higher proportion of their deposits as reserves, and has introduced much tighter rules for home loan lending. Chinese banking regulators have also signalled a clampdown on bank lending to the off-balance sheet vehicles of local governments. Two weeks ago, China announced that it would stop pegging the yuan to the US dollar, and allow its currency more flexibility. These measures appear to be having some effect. Last week, two purchasing managers’ indexes pointed to a slow-down in Chinese manufacturing activity in June.

But in addition to the weaker global economy which is reducing the appetite for their exports, and tighter domestic credit conditions, Chinese manufacturers must grapple with the even greater challenge of rising wage rates. In recent months, we’ve seen an increasing number of industrial disputes, where Chinese workers have been able to win significant pay rises. Japan’s Honda was forced to agree to wage increases of between 25 and 33 per cent in order to bring an end to two separate strikes at its transmission plant and its exhaust component factory, while the giant Taiwanese contract electronics assembler, Foxconn, has signalled that it was prepared to almost double monthly wages

Andy Xie, the former Morgan Stanley chief Asian economist, argues that these pressures will continue, and that Chinese labour cost are set to increase sharply in coming years.

Xie argues that over the past 20 years, China had an endless supply of labour, which meant that the economy could growth rapidly, while wages were stagnant. But he predicted that this situation would turn around now that the Chinese labour market is moving towards full employment.

“In the past decade, China has had double-digit growth rates, high and rapidly rising property prices, low wages, low inflation, and low interest rates. The next decade may be the opposite: a growth rate of about 6 percent to 8 percent, inflation of as much as 10 percent, and wages rising at 15 percent”, he wrote in a recent article in Bloomberg.

Xie’s prediction of looming wage inflation in China, makes Beijing’s balancing act all the more precarious.

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Ian Rubinstein wrote:

Interesting that Andy Xie's observations are interpreted as support for the idea that China is in trouble. (See A precarious Beijing balance, July 5.)

How about this as an alternate outcome of the Honda/Foxconn/yuan developments?

Wage inflation increases spending power, while price inflation reduces the incentive to save. At the same time, steady yuan revaluation increases the value of Chinese offshore asset holdings, allowing the government to spend more on social security while maintaining the nominal value of their 'nest-egg'.

In this way, the 'global rebalancing' that has been the goal of so many commentators (and President Obama) becomes achievable.

5 Jul 2010 8:31 AM

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