China’s and India’s Implications for the World Economy by Helmut Reisen, OECD Development Centre

1. China’s and India’s Implications for the World Economy by Helmut Reisen, OECD Development Centre 1. China and India Growth • contribution to global growth • sources & structure • China’s raw material hunger • impact of slowdown 2. The Global Labour Pool Has Doubled: Lower Wages, Fatter Profits • labour & wages • China’s surplus labour • the Lewis model with unlimited supplies of labour • a Krugman-Lewis three-sector model • rich-country wages: a simple Cobb-Douglas function • the Stolper-Samuelson theorem 3. Price and Wage Effects: The Large-Country Case • China’s terms of trade • large-country trade analysis • Implications for investors

2. 1. China and India Growth • contribution to global growth Table 1: China and India’s Contribution to Global Growth, 2000-2004 Percentage share of annual growth rate Source: IMF, World Economic Outlook, April 2005 N.B: GDP based on purchasing-power-parity (PPP) valuation of country GDP.

3. Each year since 2001, their combined contribution to global output growth has been around 30 per cent. Helped to hold global output growth above the 4 per cent threshold which is critical for improving the terms of trade for primary commodity producers. Formula to compute a country’s contribution to world growth: China’s (India’s) growth rate times China’s (India’s) percentage share in world output divided by the sum of China’s growth rate plus the growth rate of the rest of the world, each weighted by their respective share in world output.

4. sources & structure • An analysis of the determinants of growth in China suggests that rapid growth should continue for the foreseeable future, albeit at a somewhat slower rate. • Thanks to capital accumulation (investment growth), potential growth in 2005 has reached 9.5 per cent. It is unlikely that the current savings rate (which has risen to 45 per cent of GDP) can be sustained in the long term. • But considerable room for further institutional and trade reforms to raise efficiency. • The continued re-allocation of labour from agriculture to manufacturing is a further source of productivity growth. Table 2: Sources of China’s Income and Output Growth, 1998-2003 -Percentage points- Source: OECD (2005)

5. Table 3: China and India’s Rising Energy and Steel Use Year-on-year growth rates (per cent) • The current process of capital deepening has spurred the drastic increase in both energy and metal use in China. • China has become the largest marginal consumer of many raw materials and energy products, benefitting raw material, food and energy providers in Africa, Australia and Latin America. • Indian energy and steel use also accelerates in the second period (2000-2003), although at are more moderate pace. Sources: China Statistical Yearbook (2004), International Energy Agency Data Service, Steel Statistical Yearbook (2004), International Iron and Steel Institute

6. FX Reserves and US Treasury Holdings-end 2005-Source: treas.gov/tic; central banks;HKMA

7. impact of slowdown Table 4: Selected Key Country Elements Source: Reisen, Grandes and Pinaud (2004). • The country examples in Table 4 illustrate that the impact of a China slowdown will be uneven; the Dornbusch-van Wijnbergen analysis helps to predict respective outcomes in a general-equilibrium framework, which can be empirically calibrated and tested. It is likely that various outcomes on macroeconomic variables may deviate considerably from what partial-equilibrium analysis would predict.

8. What impact should a slowdown of China’s growth have on the world economy? • Soft landing (to potential output growth, i.e. 9 % p.a.): • a very limited impact on global growth, could even be positiveoverall. • Commodity exporters (Australia, Argentina, Brazil, Russia, South Africa) would be the main losers, raw material importersbenefit thanks to lower prices. Figure 1: China’s Hard vs Soft Landing

9. 2. The Global Labour Pool Has Doubled: Lower Wages, Fatter Profits • labour & wages Table 5

10. Each country is represented by a horizontal line segment, with the length indicating the country’s share in world population (or labour force). • China and India (large populations, low per capita income) appear as a long line along the bottom. • As a look at the graph makes clear, wage and income convergence would be an alarming outcome from the perspective of advanced countries Figure 2: The Global Labour Pool and Real Per Capita Incomes, 1980 and 2000 Source: E. Leamer and P.K. Schott (2005), “The Rich (and Poor) Keep Getting Richer”’Harvard Business Review, Vol. 83(4), April.

11. China’s Surplus Labour • Much of China’s and India’s rural labour force is underemployed, engaged only in seasonal agricultural work with little earnings. • China has about 2.5 agricultural workers for every hectare of arable land. And many of China’s construction sites and labour-intensive factories are staffed with rural migrants for who the alternative is to survive on one acre per person. • According to the US Department for Agriculture. China’s Ministry of Agriculture estimates that rural China has 150 million surplus workers. • Add to this urban unemployment caused by the restructuring of loss-making state enterprises, estimated at ca. 14% in 2002. • . • With employment at ca. 750 million in China and an estimated annual employment growth of 1 percent (resulting from prospective GDP growth minus increases in labour productivity), we can dare a back-of-the-envelope prediction:

12. China’s Surplus Labour • Over the coming 20 years, China’s rural surplus labour will not be exhausted. • The shape and speed of China’s and India’s integration into the world economy will depend importantly on the transfer of labour from mostly rural low-productivity areas to mostly urban high-productivity sectors. • This process can be well described by a core model of economic development, the Lewis-Ranis-Fei or surplus labour model. The crucial feature of the model is that the modern sector – and by extension the world economy (!) – faces an unlimited supply of labour at wages not far from the subsistence level.

13. Lewis model with unlimited supplies of labour Figure 3: The Lewis Model • The model is a ‘classical’ rather than a ‘neoclassical’ model; the latter would assume that labour is scarce and has to be bid away from other uses, an assumption that can be hardly defended in view of the labour force in China and India. • It is rather realistic to assume with Arthur Lewis that the supply of labour to the modern is perfectly elastic. By offering a wage above the subsistence income level, the modern sector can attract an unlimited supply of labour.

14. In figure 3, labour is available at wage w^ up to L*. As the value of the marginal product of labour in the modern sector exceeds the wage rate, profits are high (shaded area). They are reinvested, raising the demand for labour in the modern sector so that the marginal product of labour curve is shifted to the right from VMPL0 to VMPL1. The model allows us to pose the crucial question now: When and how does the absorption of surplus labour come to a halt? Essentially, there are two possibilities. • Either investment opportunities cease to exist in the modern sector (before L* is reached); for example, this will be the case where the modern sector is based on the exploitation of exhaustable resources. The drying up of investment opportunities leaves a modern enclave in an economy which remains dualistic. This possibility seems to apply more to the African context than for either China or India. Wage differences and inequality between the modern sector and the traditional, informal sector will then persist.

15. Or in China and India, however, the expansion into the modern sector will eventually start to exhaust the supply of labour, and the effective labour supply curve turns positively sloped. • Rising food prices, skills accumulation and rising modern-sector wages will lead to a period (between L* and L**) where the labour supply curve to the modern sector in terms of its own prices is upward sloping. Such a point is reached at L1, where wages rise slightly above the subsistence level to w1. • Finally with the end of unlimited supplies of labour at the subsistence wage, the labour market becomes unified. Real wages rise throughout the economy in a world turned neoclassical again where workers in both sectors receive the value of their marginal products.

16. Figure 4 • Figure 4 suggests that China is still miles away from reaching the point where wages would start to converge between the rural and the urban sector. • In the quarter century from 1978-2003, urban per capita income has risen much faster than rural income; while the ratio of urban to rural per capita incomes hovered around two during the 1980s, urban incomes are now three times higher than the rural average.

17. The Krugman-Lewis Model • How does that China’s wage pressure spill abroad in theory? For an answer, Paul Krugman has offered a useful extension of the Lewis model in a three-goods (low-tech, intermediate, high-tech) one-factor (labour) perspective[1]. • It is assumed that, say, OECD labour is more productive than Chinese labour in all three types of goods, but that productivity advantage is huge in high-tech, moderate in medium-tech, and small in low-tech. • Competition will ensure that the ratio of the wage rate in the OECD area to that in China will equal the ratio of labour productivity in those sectors in which workers in the two regions compete head to head. [1] Paul Krugman (1994), “Does Third World Growth Hurt First World Prosperity?”, www.pkarchive.org.

18. Consider the following numerical example for wages determined by the ratio of labour productivity in the intermediate sectors; hence wages in the OECD area would be five times higher than in China: • If China’s productivity increase occurs in low-tech output, there is no reason to expect the ratio of OECD to China’s wages to change. China will produce low-tech goods more cheaply, and the fall in the price of those goods will raise real wages in the OECD (and Africa likewise). Falling (relative) prices raise the purchasing power of importers and consumers, in other words: their real wages; so surplus labour in Chinabenefits in particular the low-income segments in the importing countries as low-tech products weigh relatively heavily in their consumption.

19. Only under three conditions will higher labour productivity in China translate into higher low-tech prices and reduced real wages abroad: • (i) productivity rises in the competitive medium-tech sector; • (ii) Chinese wages will rise accordingly as China has entered the phase where the labour supply curve starts to slope upwards; and • (iii) productivity has not risen in low-tech production, so that low-tech prices will rise as a result of higher labour unit cost. This potential adverse effect should show up in a rise of China’s terms of trade, or the ratio of her export to import prices. • We will see later that China’s terms of trade have worsened. • So the purchasing power of OECD workers’ wages rises as a result of China’s pressure on low-tech and intermediate goods prices, but that may offer little comfort to workers if their nominal wages drop faster still.

20. The entry of China, India and the former Soviet bloc into the global economy cut the global capital/labour ratio by 55% to 60% compared to what it otherwise would have been. • Even considering the high savings rate in the new entrants ( e.g. in China ca. 40 percent of GDP), it will take 30 or so years for the world to re-attain the capital/labor ratio among the countries that had previously made up the global economy. • How much pressure has this placed on wages in advanced countries? The capital/labor ratio is a critical determinant of the wages paid to workers and of the rewards to capital. The more capital each worker has, the higher will be their productivity and pay.

21. Real equilibrium wages down 15% (?) • Multiplied with the intial shock to the capital-labour ratio, a back-of-the-envelope calculation suggests that the inclusion of the Asian giants and of the former Soviet block has reduced OECD equilibrium wages by ca. 15 percent. A reduction of the capital stock by 1% reduces productivity by less than 1%, since capital is only one input; standard estimates put the number at about 0.3%.

22. the Stolper-Samuelson theorem • The Heckscher-Ohlin model - the factor-proportions theory of comparative advantage – also can define conditions under which countries that are richer in human and physical capital than in labour move, as a result of China’s integration, towards a lower wage level. • In the context of China’s emergence, the predictions of the Stolper-Samuelson theorem seem indeed to have been confirmed: • A drop in the price of wage-intensive products causes a reduction in the real-wage rate and an increase in the real return to capital[1]. • If the Stolper-Samuelson theorem is correct and if the emergence of China and India does reduce relative prices of labour-intensive products in world markets, the large reductions predicted above by the calibration of a simple production function will be vindicated. • [1] Edward E. Leamer (1995), “The Heckscher-Ohlin Model in Theory and Practice”, Princeton Studies in International Finance, No. 77, February.

23. Have a look at the Lerner-Pearce diagram which depicts the Heckscher-Ohlin framework Figure 5: China and Stolper-Samuelson in a Lerner-Pearce Diagram • The curved lines are isoquants for labour-intensive toys and for sophisticated cars, i.e. combinations of labour and capital to produce a Euro’s worth of output. • China’s emergence shifts the toy isoquant outward to reflect the fact that, at a lower price for toys, more capital and labour are needed to produce output worth a Euro. • This shift is accompanied by a stretching of the unit-isocost line, reflecting a rise in 1/w and – possibly - a drop in 1/r (as wages drop and capital returns rise). • The Stolper-Samuelson theorem thus predicts pressure on wages (where they are flexible, unemployment otherwise) in those sectors that compete directly with China. This may be achieved through outsourcing or offshoring of wage-intensive elements of production.

24. It is not predicted, however, that wages in the rich world will fall to China’s levels. • First, economic integration of low-wage and high-wage countries should bring worldwide gains from specialisation, which will raise total world GDP and global labour earnings as well. • Second, where wages are high, they partly reflect returns to human capital, not just to raw labour (however, human capital is rising fast in China). • Third, low-wage competition produces strong incentives for advanced countries to move up the value chain; this is confirmed by a wealth of empirical evidence that shows that open economies grow faster than those which respond to low-wage challenges with protectionism.

25. 3. Price and Wage Effects: The Large-Country Case • raw materials Figure 6 Shares in world imports of selected primary commodities, China and India, 1998 and 2003 • China’s and India’s demand for raw materials has been rising since the late 1990s (figure 6). • This exerts a growing upward pressure on prices , especially for those primary commodities that weigh heavily in Africa’s exports. Source: UN Comtrade database

26. Trade theory usually works with the small-country assumption: a country that engages in international trade faces given prices. But China (and for precious stones, India) has monopsony power in some raw material markets – its demand raises prices. Table 5: China and India’s contribution to growth of world imports of selected commodities, 1998 - 2003 Sources: IEA database and UN Comtrade • In recent years, e.g., China has contributed all the world growth in demand for woods and cotton, and a third of global growth for oil and metals.

27. Figure 7: Annual percentage change in commodity import prices, 1994-2004 -US$ per Kg- Source: UN Comtrade No wonder: prices have been rising since 2001. Prima facie, this is good for raw material producers.

28. Table 6: Volatility in Commodity Import Prices* • The benefits of China’s and India’s rising global demand (net imports) are, nevertheless, attenuated by the volatility of demand of the Asian giants, partly due to cyclical variations but importantly also to arbitrage between home production and imports. • Moreover, as about 70-80 per cent of manufacturing exports from China is produced by multinational corporations, high raw material demand partially reflects relocation of raw material demand from production sites elsewhere. • Such relocation does not occur without friction, which further fuels demand volatility. Consequently, rising raw material demand from China and India is not necessarily an unfettered blessing for Africa. Note: * Standard deviation of annual percentage changes Source: Own calculations based on UN Comtrade data

29. China’s supply side has weighed as well on prices. • The rapid export growth of low-skill and labour-intensive manufactures has increased the market competition for these goods and hence exerted a downward pressure on their prices. • Focusing on the major product-groupings (classified at the 8-digit level) imported into the EU where developing-country exporters were prominent and reporting the proportion of the sectors for which the unit-price of imports from different income-groups fell between 1988 and 2001, Raphie Kaplinsky (IDS Sussex) shows that in almost one third of these sectors the price of Chinese-origin products dropped. He concludes that the greater China’s participation in global product markets, the more likely prices will fall[1]. • [1] Kaplinsky, Raphie (2005), “Revisiting the Revisited Terms of Trade: Will China Make a Difference?”, mimeo, Institute for Development Studies. • manufactured goods Figure 8: Declining World Manufacturing Export Price, 1986 – 2000 Source: Kaplinsky (2005)

30. China’s terms of trade • Terms of trade is defined as the ratio of the price a country must receive for its export commodity to the price it pay for its import commodity. • Terms of trade can be calculated using a Laspeyres index. • Where price of exports in the current period quantity of exports in the base period price of exports in the base period price of imports in the current period quantity of imports in the base period price of imports in the base period • The net barter terms of trade is the ratio (expressed as a percentage) of relative export and import prices when volume is held constant. • The gross barter terms of trade is the ratio (expressed as a percent) of a quantity index of exports to a quantity index of inputs. • The income terms of trade is the ratio (expressed as a percent) of the value of exports to the price of imports. • The single factorial terms of trade is the net barter terms of trade adjusted for changes in the productivity of exports. • The double factorial terms of trade adjusts for both the productivity of exports and the productivity of imports.

31. Terms of Trade: The Large-Country Case • Monopsony (buyer) power means that China and India often do not face an infinitely elastic supply curve, such as Sw, for its imports. Their demand rather pushes the curve up to SChina. Similar effects occur with exportables, where a large country’s export supply pushes up the world demand curve • from Dw to • The existence of world market power for the large country means that the difference between pre- and post-trade terms of trade is smaller for China • (Pa- P China) than for a small country (Pa- Pt). • Gains from trade are depicted by the triangle under the autarchy supply/demand curves for exportables/importables and above the post-trade supply/demand curves; these are horizontal for a small country, but upward sloping for a large country. Hence, gains from trade are smaller for the large country as the triangle is smaller.

32. Is China’s Growth “Immiserising”? • Immiserising growth arises when an increase in economic activity isassociated with a fall in real living standards. The increased economic activity may be reflected in greater inputs of labour (people; labour hours), capital, land or any other resources which have an opportunity cost. • Bhagwati (1958)[1], who is responsible for the modern-day discussion of immiserising growth, began by examining circumstances in which declining [barter] terms of trade outweigh the benefits of growth. • Also, in a world of trade distortions, growth of production can induce a net loss of output. For example, tariffs could induce FDI targeting the domestic market, but with such inefficiencies that the result would be less favourable than a world free of tariffs (and of tariff-hopping FDI. This provides an intellectual underpinning for the neo-classical critique of market interventions underlying industrial policies. [1]Bhagwati J. N. (1958), “Immiserizing Growth: A Geometrical Note”, Review of Economic Studies, No. 3, pp. 201-5. Bhagwati, J. N. (1987), “Immiserizing Growth”, in The New Palgrave: A Dictionary of Economics, (J. Eatwell, M. Milgate and P. Newman, eds.), London: Macmillan .

33. Figure 9: Commodity import price, export volume and Terms of trade (Index: 2000=100) • A rapid increase in commodity imports as a share of merchandise imports means that the price of total imports is largely affected by volatile commodity import prices since non-commodity import prices are fairly stable. • However, the deterioration in net terms of trade is compensated by the volume of exports which expand at 25.2 per cent a year (2000-2004) against 10.3 (1995-1999). This is illustrated by steady rise in the purchasing power of exports at 22 per cent a year (2000-2004). Source: UNCTAD (2005), Handbook of Statistics

34. Implications for Investors • Improvement in trade-off inflation & growth • Equity risk premium = dividend yield + dividend growth ./. return on risk-free asset • Ex. US: 2.8% = 1.8% + 3% (=GDP growth); UST = 2% • Post-China => 4.6% = 1.8% + 4.5% ; UST = 1.7% www.oecd.org/dev/reisen