Presentation by Tony Cole - China and the Lewis Turning Point Tony Cole is a CDU University Fellow and a Senior Partner, Mercer, based in Sydney. Over recent years he has led the Asia Pacific investment consulting business. Tony recently moved to a new role centred on key client consulting, thought leadership. Before joining Mercer in 1996, he was executive director of the Life Investment and Superannuation Association of Australia. Earlier, he served the Australian government in various senior positions, including Chairman of the Industry Commission, Secretary to the Treasury, and Secretary of the Department of Human Services and Health. Tony has a bachelor's degree in economics from the University of Sydney. In 1995, he was awarded an Order of Australia for service to government and industry. Tony was the Chairman of the Advisory Board of the Melbourne Institute of Applied Economic and Social Research for 10 years to 2011. He is a member of the minimum wages panel of Fair Work Australia and of the Advisory Board of the Northern Territory Treasury Corporation. He was a member of the Abbot Government’s Commission of Audit. Tony is also a Trustee Director of the Commonwealth Superannuation Corporation which manages retirement savings for Australian Government employees and a director of Australian Ethical Investors Ltd. China - at a turning point? As the world's largest trader with the world's largest foreign currency reserves and soon to be the World's largest economy, China's economic performance is vital to the world economy - especially during a period when so much of the world economy is in the doldrums. For Australia, China is even more important: it takes 30% of our exports and supplies 18% of our imports. I have argued previously that China's continuing strong economic growth should not be seen as a cyclical boom that would inevitably be followed by a bust. It is instead a long term structural change which is likely to continue for decades to come. While there will almost certainly be periods of less strong growth and bursts of very rapid growth this will reflect cycles within a longer run growth path. As long term investors need to focus more on the opportunities provided by long term trends rather than short term cyclical ups and downs. Because the economic outlook for China is so important to us all it gets enormous scrutiny from economists around the world. While some of this is well informed, much of it is frankly alarmist nonsense. The alarmists have predicted hard landing after hard landing but none of them have occurred. And it is the alarmist nonsense which is most likely to be reported prominently in the press. Stephen Roach (Yale University, formerly Chairman of Morgan Stanley, Asia) has observed that "the China Crash Syndrome is a malady that seems to afflict economic and political commentators every few years, never mind the recurring false alarms over the past couple of decades". (1) Roach describes the current China hard- landing debate as "Just another false alarm". Whilst I agree with Roach's conclusion, there are some new arguments being put by several of the doomsayers (and some who have not previously been in that group) which need to be given some attention. The new arguments postulate that while there has been a multi-decade growth trend in China, the conditions that made that possible have now disappeared. China is therefore unlikely to enjoy such rapid growth in the future. It needs to engineer a transformation of its economy to focus on domestic consumption if it is to maintain trend growth at around the slower 7% or so it has recently canvassed as a target. Implicitly, if its future trend rate of growth is around 7%, there will be times in the economic cycle when growth will dip well below that. The Lewis Turning Point (2) A common theme of these commentaries has been that China has reached, or will very shortly reach, the Lewis Turning Point. The Lewis Turning Point is a concept created by Professor Arthur Lewis in 1954 to explain and predict the growth path followed by labour surplus economies in their initial stages of development. The model assumes a dualistic economy, with a highly productive modern sector and a large rural or village sector with productivity that is barely above subsistence. A very simple path to a burst of very rapid economic growth is to transfer workers from the low productivity subsistence sector into the much higher productivity modern sector, which typically exports the extra production. This is profitable and can be sustained because the modern sector is able to keep wages low while there is a surplus of labour in rural areas willing to migrate to the modern sector. The uneven distribution of income - profits high, wages low - results in a high savings level, and high profitability leads to high levels of investment. The larger economy provides higher revenue for government, which enables it to invest in education and physical infrastructure which also helps growth to accelerate. Over time, the surplus of labour declines as a large proportion of rural workers have moved to the modern sector. The migration from the farm sector has typically forced modernisation and efficiency gains within the sector so that the disparity of incomes between the traditional and modern sectors has narrowed. At this point, wages in urban areas begin to rise as competition for jobs from migrant workers diminishes. If they are to remain competitive in export markets, employers must improve their factories' productivity or seek to move up the scale of quality or complexity in what they produce. Businesses may also attempt to re-focus their production on local demand as the population has become progressively better off as the wages share of income has risen. The issues I am going to address are:- (1) whether China has reached the turning point or is approaching it? (2) if it has, what are the implications for China? And (3) what are the implications for the rest of the world, including investors? Has China reached the Lewis Turning Point? The Lewis model seems to fit the Chinese experience very well. China has had very rapid growth fuelled by migration of workers from the rural sector to the cities on the Eastern coast. Labour costs have been low so that Chinese manufactured goods have been super- competitive in international markets. Income distribution has been very uneven and saving and investment rates have grown to extremely high levels. Government has invested massively in infrastructure and education, further enhancing competitiveness of industry. In various parts of the country, industrial activity and wages have been rising and there have been reports of simple manufacturing activities such as toys and textiles migrating to Western provinces in search of lower wage costs or to other less developed economies such as Bangladesh or Vietnam. Industry (with encouragement from government) has responded by attempting to move up the scale of complexity and quality where wage costs are not so determinative of profitability. The turning point concept seems pretty straightforward so that it should not be too difficult to assess whether China has reached it or is rapidly approaching it. Unfortunately, this is not so. Economists are still debating when Japan passed the turning point. Fei and Ranis (3) postulate that the turning point in Japan occurred around 1917. This was based on the view that agriculture had modernised (so having no labour left to free up) and there was a burst of wage increases around the end of WW1. Most economists (even Japanese economists) believe Japan's farm sector remains extremely backward to this day (4) so the story does not fit the model. Arthur Lewis himself suggested the turning point in Japan was somewhere in the 1950s. The increases in wages around the end of WW1 were a false indicator. Minami (5) has estimated that the point was passed sometime in the early sixties. His analysis is based on real wages in the subsistence sector (in which he includes textile workers as well as rural labour). He concludes that, measured over appropriate time periods, real wages in the subsistence sector were almost constant in the pre-WW2 period but showed a strong increase in the postwar period, especially since the end of the fifties. Minami argues that the turning point is not an event that occurs at a particular time or even in a year. It is a major development for an economy that takes place over several years. The timing and speed of change will vary across regions and industries. It is important to carefully distinguish between the demographic/economic trends and the business cycle or even longer periods of higher than usual economic activity. Following his work it has become more common in the literature to refer to a turning 'period' rather than a turning point. Ross Garnaut first wrote about China nearing the Lewis Turning Point in 2006. (6) He was reacting to reports of labour shortages and sharp increases in wages in the Guangdong area in 2004. The wage rises led to a fresh burst of migration into the region. Shortly afterwards the global financial crisis erupted, which resulted in many migrant workers having to return to their home villages. These developments took attention off the topic for some time. Garnaut returned to the topic in 2010. (7) He picked up the concept of a turning period rather than a turning point. He noted that, in a very large and diverse country like China, with very differentiated regional labour markets, the pace and timing of change will vary considerably.