Home > The Merk Perspective > Merk Insights > November 28th 2004

China meets Europe - Motivation and Implications for the World Economy

Axel Merk, November 28th 2004
This article was written by Merk Investments before the Merk Hard Currency Fund was launched.

Over the past couple of days, we attended the Hamburg Summit, a forum of international economic and political leaders discussing Sino-European relations. We were most interested in the topic, as we wanted to gain a deeper understanding of how the goals and challenges China faces influence the world economy. Conversely, we wanted to gain a better understanding on the inroads China has made into Europe, and how perceptive Europe is of these influences.

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The enlarged European Union is now the world's largest economic region; while it is hardly a homogeneous area, China has taken note. More importantly, China is keenly aware of the fragile nature of the over-extended US consumer that its economy depends on, and desperately is seeking ways to diversify, i.e. to find new distribution avenues for its goods.

It was a delight to see the highly energized Chinese political and economic leadership. Aware that China has been cited for the explosion in commodities prices, Zeng Peiyan, Vice Premier of the People's Republic of China, was eager to point out that China is still a small player in the world, only consuming about 5% of the world's oil (China relies heavily on domestic coal for its energy needs; he did not mention that China last year consumed 40% of the world cement production, and more than 20% of each of the world's traded aluminum, zinc, stainless steel, iron ore, to name a few). Business leaders present from some of China's largest private enterprises were convinced that the political leadership would be able to continue to keep China on its steady growth path and master the formidable challenges ahead.

One of the highlights of the conference was wisdom shared by Lee Kuan Yew, Minister Mentor of the Republic of Singapore, who gave insight into how a small Asian country such as Singapore was surviving and thriving in the midst of brutal competition through innovation and flexibility. When asked what advice he would give to Germany, one example he gave was that Singapore each year invites the trade unions on a tour of manufacturing plants in India and China, pointing out that this is most effective in taming their demands.

A persistent message was that China's leadership continues to put political interests ahead of economic interests. Social stability with in the country is paramount, which in turn means that job creation (China each year has to find jobs for 15-20 million people) is more important than profitability of enterprises, or indeed the strength of the banking system. Emboldened by the success of the past decades, the Chinese leadership believes it can steer its economy with a strong hand, carefully controlling what sectors are to be supported or reigned in.

When asked whether China will continue to peg its currency to the Dollar, Zeng Peiyan responded by asking why Europe didn't do more to keep its currency stable, pointing out that China has been most responsible with its currency, especially by not devaluing the Yuan during the Asia crisis in 1997.

The major side effect of the Chinese economic model is that it does lead to inefficient capital allocation. On numerous occasions, we have discussed the overinvestment taking place in China due to a 'subsidized' exchange rate, that it imports inflation into China, in addition to lowering the price level of goods abroad (the US in particular where China and Asia export most to). The margins of US manufacturers are squeezed as overproduction in China (and the rest of Asia that also clings to 'competitive' exchange rates) causes a rise in raw materials prices, while at the same time finished goods sell at rock bottom prices as the markets are flooded with an overproduction of cheap imports. US based manufacturers lower their only remaining variable cost, labor, by accelerating outsourcing to China and other low cost countries.

While China experiences the same margin pressures, China has an unlimited supply of cheap labor and, as mentioned, puts profitability behind political interests. In the US, the administration counts on the flexiblility of the labor force, transforming the society into a service society. What the US administration ignores, however, is that the service sector these days is also prone to outsourcing, not so much to China, but to India and other even lower cost countries such as the Philipines, and that the transformation is taken place at a highly accelerated pace due to the imbalances that are fostered both in the US and abroad.

It is not fair to blame the high commodity prices exclusively on China. China recently told the US to get its own house in order (the twin deficit, low domestic savings rate). And indeed, it's the much larger US with an economy about 9 times larger than that of China, that has emphasized consumer consumption growth at any cost over the past couple of years. Or maybe one should say, growth at no cost as interest rates have been kept artificially low, causing US consumers to take out record debt and drive real estate prices into the stratosphere (upon which even more cash can be taken out of real estate and spent on cheap imports). Obviously, this exposes the US economy to very serious risks should interest rates rise and income not keep pace; as discussed above, the spiraling outsourcing game will ensure that income cannot keep pace with inflation that is building up in the system. One factor that may tame the outsourcing game may indeed be exploding commodity prices: as commodity prices rise, the cost of labor has a reduced impact on the cost of finished goods.

China must diversify away from the US consumer. It can do that by stimulating consumption at home, by fostering intra-Asian growth, and by finding new distribution channels in Europe for its goods.

At home, China's consumers have the world's highest savings rate, and the number of people spending money on goods and services is growing rapidly - the sheer size of the population makes this a very attractive market. The rest of the world would like China to open up more quickly and get its banking system in order, so that the rest of the world can sell to the Chinese consumer -- this is in progress, but at a pace and subject to rules imposed by China.
Intra-Asian trade is expanding rapidly -- while China has a major trade surplus with the US, it's overall trade balance is relatively flat as it is a major importer, mostly of raw materials, from other Asian countries. It will be some time before intra-Asian trade can sustain the region's economy and be less dependent on the US.

And finally, China is very interested in a closer relationship with Europe, the focus of the conference. A major difference to the US is that Europe is not interested in competition based exclusively on price. Greenspan and Bush are advocates that only price should matter, as otherwise a trade war may result when other interests are taken into consideration. Europe, on the other hand, is keenly aware of the cost of its environmental regulations and high labor standards. Just as China rightfully puts its own interests first, Europe is not interested in the "accelerated transformation" that the US has engaged in, and has made that clear to China. Given that Europe has significant expertise with environmentally friendly technology, Europe considers this one of many export opportunities.

Lance Browne, Chairman of Standard Chartered Bank China provided a realistic picture of the state of the Chinese banking system. He provided insights into the political dynamics that contribute to continued substandard credit standards being applied to loans. A side effect of the weak banking system is that it is extremely difficult for foreign banks to compete, as they cannot hope to be bailed out by the Chinese government. In our view, the current efforts by the Chinese government to slow the economy should be used to become more pro-active in getting the banking system in order. The problems are only getting bigger, and China has to compete with other developing countries with more robust credit environments.

We are entering a new phase in the development of the global imbalances. With Bush re-elected, the same economic policies continue to be pursued. At the same time, inflation in China has not only caught the attention of the leadership, they have started to do something about it. In the US, inflation is rapidly building up in the production pipeline. Disruptions will be more common - be it only something as neglected as the bottlenecks at US ports, where stringent union practices have lead to capacity constraints (and Wal-Mart e.g. starting their holiday imports months ahead of schedule, and many businesses giving up just-in time delivery because the transportation sector cannot cope with the flood of imports). The US election has proven to be a catalyst for the latest wave in dollar devaluation, and gold has reached $450 an ounce.

Given its location in Hamburg, many German business leaders attended - in a time when there seems to be mostly gloom in the press about Germany, it was most refreshing to meet and talk to many successful German enrepreneurs. China's growth path will continue, although we expect a number of speed bumps. As the contrarian analyst Marc Faber pointed out during one of his spirited presentations, history has shown in related situtations (e.g. the rise of the the US in the 19th and early 20th century), that it is quite possible for the world economy to experience substantial shocks, yet have China be an economic powerhouse at the end of the road.

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