From the Chief Investment Officer

Cyclicality is in the nature of capital markets. As the news media careens from one threat-of-the-month to another, we try to focus on long-term opportunities and challenges. Very significant among these is the emergence of China as an economic powerhouse. In this Commentary, I discuss two aspects in particular: the pervasive (and surprising) impact of China on just about everything in the global economy and the recent buying (or bidding) spree of Chinese companies.

The nature of China’s impact on the global economy is similar to the Baby Boom generation on the US economy – massive and pervasive, but sometimes subtle.

At some level, China is behind almost every important trend in the world economy. While politicians in the US are berating China for causing (untrue, anyway) a yawning trade deficit, measuring China's global impact in terms of its exports and its trade surplus misses the profound effects of its growing influence. Everyone knows that most TVs and T-shirts are made in China. But so, in some ways, are our inflation rates, interest rates, wages, profits, oil prices, and even house prices.

China is not the only fast-growing emerging economy, but it looms the largest. China’s contribution to global GDP growth since 2000 has been almost twice as large as that of the next three biggest emerging economies – India, Brazil and Russia – combined. Moreover, China's integration into the world economy is having a bigger impact because it combines a vast supply of cheap labor with an economy that is (for its size) unusually open to the rest of the world. The sum of its total exports and imports of goods and services amounts to around 75% of China's GDP; in Japan, India, and Brazil the figure is 25-30%. As a result, China’s emergence is being felt more by rest of the world.

Richard Freeman, an economist at Harvard, suggests that the huge increase in the global labor pool caused by the entry of China, India and the former Soviet Union into the world economy has, in effect, doubled the global labor force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation, and triggered changes in the relative prices of labor, capital, goods, and assets. With twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labor has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labor and capital, it goes a long way to explain recent trends in wages and profits.

While average real wages have lagged well behind productivity gains in developed economies, profits are grabbing a bigger slice. Last year, after-tax profits in the US rose to their highest as a proportion of GDP for 75 years; the shares of profit in the euro area and Japan are also close to their highest for at least 25 years. This is exactly what economic theory would predict. China's emergence into the world economy has made labor relatively abundant and capital relatively scarce, and so the relative return to capital has risen. Good news for investors, but, lest we salaried types become despondent, we should note that, over very long periods of time, labor has captured almost all of the benefits of increased productivity.

So far, China's main impact on the world economy can be described as changing relative prices and incomes – the prices of the goods that China exports are falling while the prices of the goods that it imports are rising. For a fully developed economy with little excess capacity, this situation would be disastrous. China is coping quite well.

For the rest of the world overall, and, especially for the US, the upward pressure that Chinese imports of raw materials have put on the prices of oil and other commodities has been more than offset by the downward pressure of Chinese manufactured exports. As a result, another important aspect of the China effect is low inflation. A study by Dresdner Kleinwort Wasserstein estimates that China has knocked almost a full percentage-point off the US inflation rate in recent years. China is also partly responsible for the low level of long-term bond yields. To keep its exchange rate pegged to the dollar, China was the biggest buyer of US Treasury bonds over the past year and has supported America's mortgage market by buying vast amounts of mortgage-backed securities.

How long is this likely to last? By some estimates, China has almost 200 million underemployed workers in rural areas, and it could take at least two decades for them to be absorbed by industry. As this process takes place, it will continue to subdue wage growth and global inflation. Profit margins could also remain historically high for a period (though not for ever, as stock market valuations in many countries seem to imply).

The flip side of global capital markets being increasingly driven by decisions in China is that US institutions, world views, and economic models will be less central. We should all hope that the Chinese political and business leadership learn from the painful economic experiences of other countries over the last century.

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