China's exports: Is the golden age of cheap labor coming to an end? (Part 6 of 6)
(Continued from Part 5)
China’s GDP slows
The below graph reflects a slowdown in China’s Gross Domestic Product (GDP) growth rate. The Chinese economy has grown dramatically from a low base level over the past 30 years, and is now the second largest economy in the world, after the United States.
Though soft global economic conditions and low interest rates since late 2008 may have played a role in slowing the appreciation of the Chinese yuan, the continued high growth rate of China will nonetheless continue to put upward pressure on the yuan. The Chinese government has targeted an 8% per annum growth rate in exports, with a 7.5% growth rate in the overall economy, and it continues to post large trade surpluses—$27.1 billion for July 2013. These trade surpluses will continue to contribute to domestic price inflation, including wage inflation and continued pricing pressures for Chinese manufacturers.
The Japanese yen appreciated from 250 to 125 from 1980 to 1988 during the Reagan administration, amid a hollowing of the U.S. manufacturing industry. Like the Japanese manufacturers, Chinese manufacturers will also have to invest in productivity-enhancing technologies, such as robotics, to maintain their competitive advantages. Without an offsetting increase in productivity, a continued appreciation of the yuan will make Chinese goods and services more expensive, and growth could continue to decelerate in the coming years.
Will China avoid the Japan experience?
China’s growth deceleration raises concerns as to the banking system’s ability to manage itself through a potential credit shock. In Japan, the central bank began to aggressively raise overnight interest rates in May 1989 from 2.5% to 3.25% in order to cool an economy that was growing about 4% per year, while money supply was growing at a rate of around 10% per year. The unstoppable Nikkei Index had reached a high of 38,916 in January 1990, while the overnight rate had reached 4.25%. However, the Nikkei subsequently began to collapse in the face of higher interest rates and tighter monetary policy. By September 1990, 16 months into the tightening campaign, the overnight interest rate in Japan had reached 6.0% and the Nikkei had declined from nearly 40,000 to nearly 20,000. The Nikkei subsequently fell to the 15,000 level by the middle of 1992—a 60% decline. In the case of post-1990 Japan, the time between monetary tightening and equities finding a near-term bottom took approximately three years.
In China, the Governor of the Central, Bank Zhou, would not like to repeat the asset bubble collapse of the prior Bank of Japan Governor Mieno. However, the rapid acceleration of private and public sector debt in China has many worried that a similar pattern could emerge. As such, investors focused on China’s iShares FTSE China 25 Index Fund (FXI) will need to closely monitor the following developments related to the various issues discussed in this series.
- China’s cost of labor and associated inflationary pressures
- China’s appreciating currency and potential impact on export growth
- China’s tightening of monetary policy, debt levels, and banking system stability
For investors that are wary of China’s equity markets, China’s iShares FTSE China 25 Index Fund (FXI) may appear less attractive than both U.S. and Japan markets as the moment. Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) have performed well over the past year—up 37.8% and 20.4%, respectively. China’s iShares FTSE China 25 Index Fund (FXI) has been up only 3.7%.
In the United States, the S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV) have been up nearly 17%, with the State Street Global Advisors SPDR Dow Jones Index (DIA) up 13.6% over the past year. These broad-based indices with significant exposure to global blue chip companies may outperform indices with greater exposure to more domestic economy–sensitive shares, such as the Blackrock iShares Russell 2000 Index (IWM), Blackrock iShares Russell 1000 Growth Index (IWF), and smaller market capitalization companies found in the State Street Global Advisors SPDR S&P MidCap 400 (MDY). Should challenging economic conditions worsen, companies with smaller market capitalizations may find credit conditions more challenging than large companies with larger and more diversified sources of cash flow. Blackrock iShares Russell 1000 Value Index (IWD) may also provide a more defensive exposure to U.S. equities should valuations remain attractive and stable in the face of softening economic data. In either case, investors in both U.S. and Asian markets will need to remain cautious should monetary tightening in both the United States and China cool economic growth faster than expected.