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Toward Shifting Wealth Phase II

More than 30 years after the integration of the Asian giants with the world economy has started, it is imperative to disentangle the effects of the initial entry of China and India into world markets (Shifting Wealth I) from the development effects on low-income countries that would arise should they be able to sustain their superior growth (Shifting Wealth II). The major channels through which development effects have operated have been the global commodity markets and the intra-Asian manufacturing production networks, the associated trade and investment volumes and the indirect income effects arising from changes in relative prices (terms of trade and relative wages). Global second-order effects have been generated through the recycling of China’s current account surplus and through the associated exchange rate and interest rate effects. A superb study directed by David Lubin at Citi, just released in its series Citi GPS: Global Perspectives and Solutions[1], provides plenty of analytical and empirical material that documents China’s impact on what they still call ‘emerging markets’. While the Citi economists are quick to call China’s economy unbalanced in view of the country’s high investment rate[2], it is safe to assume that Shifting Wealth II will go along a rebalanced China that produces more sophisticated stuff and consumes more than in the recent past.

Shifting Wealth Phase I defines the initial opening of China and India to world markets which really became felt from the 1990s – a ‘one-off’ event that integrated 2 bn people or 40% of global labour force in the global market economy. China’s economic openess and manufacturing base created international trade, production and investment networks, escpecially with Asia, while its commodity intensive growth created a ‘China-commodities complex’, especially with Africa, Latin America and some OECD commodity exporters. The impact on developing countries was much deeper than just indicated by actual trade flows as higher commodity prices created very large terms of trade gains and real currency appreciations also for countries (such as Nigeria) with small China orientation in their exports. 

China and India opening to trade increased the share of workers with basic education in the world labour force and lowered the world average land/labour ratio. The relative endowments of other countries were thus shifted in the opposite directions, which tended to move their comparative advantage away from labour-intensive manufacturing (Wood and Mayer, 2012)[3]. The initial entry of China into the world markets, especially from when it joined the WTO, has been supportive of raw material prices relative to manufactures, especially manufactures that embody basic skills only.[4]. Resource based economies reaping the benefits of rapidly expanding demand in China for their commodity exports, at the same time, may also be cursed by appreciating exchange rates, rising labour costs, loss of competitiveness in manufacturing industries and other challenges brought about by the commodities boom. The biggest gains in real effective exchange rates during the 2000s (2000-2011) occurred indeed in those countries that have benefited most from China, if not through direct trade links then through gains in their terms of trade (Nigeria, Venezuela).

The counterpart to rising materials prices were drops in the price for basic-skill manufactures, a result of the  Stolper-Samuelson effect of more than 2 billion people with basic skills being simultaneously integrated into the world economy. China’s competitive threat in particular had led to widespread concerns of China deindustrialising other developing countries, concerns that were confirmed in some semi-industrialised countries such as Mexico, Thailand and South Africa while the majority of low- and middle-income enjoyed higher growth thanks to China’s growth engine[5]. However, the crowding out by China is difficult to disentangle from the limited capacity of some middle-income countries, often in Latin America to engage in a structural transformation conducive to higher productivityBy contrast, emerging Asia offers a few examples of virtuous productive transformations. The development of Asian manufacturing production chains, closely linked with Asia’s high and rising intraregional trade, as manufacturing activities shifted downstream from the more developed East Asian countries. Japan, Chinese Taipeh and Korea were the big drivers of this “downstreaming” of manufacturing. Meanwhile, China is at the heart of Asia’s intra-regional trade, with an estimated 56 percent of Asia’s exports to China being used for processing to re-export to other markets, and the rest for final demand in China,  in 2011[6].

Table 1: The Developing World’s Growing China Dependence

- change in growth rate with 1% change in China’s growth rate-

Countries	Low-Income	Middle-Income	Non-Oil	Commodity
Before 2000 After 2000	-0.26* +0.60*	+0.02 +0.64*	+0.22* +0.42*	-0.30* +0.94
------------- Total	-------------- +0.34*	-------------- +0.66*	-------------- +0.66*	------------------ +0.64*

* denotes 99% significance.

Source: Garroway, et al. (2012),  “The Renminbi and Poor-Country Growth”, The World Economy, 35.3, 273-294.

Overall, the impact of China on developing-country growth performance has been positive, regardless of the country dimension. Both low-income and middle-income countries have benefitted, as did (expectedly) oil and commodity producers but also non-oil countries. While the China-commodity complex easily explains the positive growth connection for materials-heavy countries, it can be presumed that Asia’s intraregional value-chain trade has produced the positive results for the non-oil countries.

Shifting Wealth Phase II defines a long-term process of sustained and superior growth in populous emerging countries that keep accumulating skills, capital and modern technology, build a middle-income class, switch from investment-led growth toward more consumption and export increasingly sophisticated goods and services. As emerging countries succeed in becoming advanced economies, their success will improve export opportunities for the remaining developing countries, which can lead to accelerating global growth. As countries get richer, they experience a demographic transition with a drop in fertility and young age dependence. If differentials of population growth are small between developing and advanced economies, economic development accelerates over time. Both migration and aid from rich to poor countries can support this process. Once China and India become rich and once their poor share the new wealth, over two billion more people will live in countries that import labour intensive goods and fewer in a countries that export them, opening up opportunities for other countries to fill this niche. Their initial opening may have hurt developing countries in the short term, but their sustained growth improves the long-term prospects of low-income developing countries (Chamon and Kremer, 2009)[7].

The trade patterns of rapidly growing countries tend to be quite dynamic. If factors are being accumulated at differential rates, the composition of output can change quite quickly. Given rapidly growing education and production skills in China and India (Woo, 2012)[8],   the Rybczynski theorem suggests that China and India’s skill-intensive output is rising disproportionately. Unlike low-income countries that do not compete directly with China anymore, advanced and middle-income manufacturing exporters compete directly with China in manufacturing exports. China’s average export prices (unit values) place substantial downward pressure on these countries’ prices; by contrast, there is little and melting evidence for price competition between China and low-income countries (Fu, Kaplinski and Zhang, 2012)[9]. The price competition effect of China’s exports weakened over the time period of 1989–2006, suggesting a gradual change in competition from price to nonprice factors such as quality and variety.

 If China continues to converge towards advanced-country per capita income levels, either higher real wages or real appreciation of the Chinese currency will continue to speed China’s structural upgrading. This would further soften the price pressures on low-skilled goods and on low-income countries. At the same time, technological upgrading in China would move China’s price impact from the middle-income countries to the high-income economies. Prosperity in China and other large emerging countries will improve export opportunities for the remaining developing countries, which can lead to accelerating global growth, supported by a demographic transition with a drop in fertility and young age dependence (see Chamon and Kremer 2009). China’s initial opening may have hurt some developing countries in the 1990s, but its sustained growth improves the long-term prospects of low-income developing countries. Table 2 summarises some possible global development effects of moving from Shifting Wealth Phase I to Shifting Wealth Phase II.

Table 2: The Global Development Impact: From Initial Entry to Sustained Growth Effects

Impact Channel	SW I:Entry Effects	SW I Impact on LICs + MICs	SW II: Ongoing Process	SW II Impact on LICs + MICs
Growth Engine	From G7 to China	Higher growth in LIC and MIC, oil and non-oil	Partial rebalancing of growth engine	Higher trade client diversity, while initial specialisation effects weaken
Agg Demand	Investment-led	Stimulated imports of commodities and skill-intensive	Higher consumption share, less investment	Stimulates low-skill imports, skill imports neutral, structural impact on commodity demand (iron ore, copper suffer; food crop prices stagnant/rising)
Factor Supply	Land-labour ratio lower; Skills-labour ratio lower	Better ToT for commodities and skill-intensive; Lower ToT for low-skill manufactures	Skills-labour ratio gradually rising; Land-labour ratio stagnant	Better ToT for low-skill manufactures with new supply/demand balance; Skill- and tech-intensive manufactures face lower ToTs.

The growth engine was switched from the G7 countries to China during Phase I; global rebalancing in view of a lower trade surplus in China and a move from investment driven toward consumption driven growth should imply a partial rebalancing of the growth engine for developing countries – back toward OECD countries and more toward other middle-income countries than China. This should foster trade client diversity for poor countries and attenuate hyper specialisation effects witnessed during Phase I.  The shift from investment toward consumption led growth will impact on raw material prices, with prices for industrial metals (steel, copper, zinc) slowing as the initial urbanisation and industrialisation phase comes to an end in China; the winners from this transformation will be those commodities (such as palladium and coffee) with strong linkages to rising living standards and changing tastes, or to the industrial sectors that will outperform such as autos, renewable energy or power investment[10]. The skills-labour ratio is projected to rise gradually as China approaches the Lewis turning point[11], with wage pressure starting to translate into higher prices for basic-skills goods while the evolving supply-demand balance will exert price pressures on skill and technology intensive goods.

Table 3: Spending by the Global Middle Class

- in percent of total, PPP adj. -

World Total, trillion $, PPP adj.	2010 21.9	2025 40,2
North America and Europe	64	41
Asia Pacific	24	45
Central and South America	8	8
Middle east and North Africa	3	3
Sub-Saharan Africa	1	1

Source: Kharas (2010), updated in Kharas and Rogerson (2012).

Another lasting growth driver will be the fast rising emerging-country middle class consumption (Kharas, 2010)[12]. A burgeoning middle class in dynamic developing countries will by 2025 dominate global demand for most goods and services. Using a metric of $10–100 per day in PPP terms, the developing country share of a global middle class of just under 4 billion people in 2025 (compared with 2 billion today) is projected to increase from 55% to 78%, and its spending share from 35% to 60%. The world’s consumption centre of gravity is shifting East by over 100 miles a year. By 2025, it will be over central India, with strong pulls from South-East Asia, as well as from China and India itself.  Favourable demographic trends (outside China) push developing countries to grow faster than developed countries as they are still at an early phase in their demographic transition. Global demographic shifts are inexorably changing the distribution of global economic activity. The reason for expecting an acceleration of global growth is that the share of rapidly growing economies has now risen to almost one-half of total output, while the share of slow growing countries has fallen[13]. India, although poorer than China, has a sizable middle class that could overtake China’s by 2020 (Kharas, 2010), even though India would still be much poorer than China at that time. India has a much higher share of household income in GDP, so its middle class is larger given its income level. As India has the potential to grow rapidly for some years to come, its emerging middle class will strengthen and reinforce its growth.

While the Chamon-Kremer model, the emphasis on the power of beta convergence and the new Asian middle class all emphasise the long-run benefits for low-income countries arising from market expansion in successful emerging countries, there are further channels to consider for Shifting Wealth Phase II that warrant a less exuberant view. As emphasised in Citi GPS (2012), China & Emerging Markets a weaker, more consumer-driven growth in China, linked to the rebalancing process.

The shrinking share of investment  in China’s GDP and  the rising middle class in emerging countries will favour goods and services with high income elasticities, such as tourism, cars and green energy. (Engel’s Law tells us that the absolute spending on goods with low income elasticity must not fall, just their share in overall spending). The new demand patterns in turn determine the future price developments of commodities: aluminium and palladium, heavily used in cars and power infrastructure, will fare better than copper, iron ore and zinc, the metals most leveraged to construction and fixed asset investment. The cyclical dependence – the elasticity of demand to real GDP growth, hence by extension China’s GDP growth – has been highest for metals such as aluminium, copper, nickel, zinc, iron and tin. Metal exporters Zambia and Chile export 19.3, resp. 15.1 percent of their exports to China and may suffer from weakend imports and lower prices that arise from a satiation of the investment-led urbanisationand industrialisation process in China.

Over the past fifteen years, China has shifted from a supplier of parts and components to developed countries to become the core production base for suppliers in other countries, of which mostly ASEAN countries have benefited[14]. As China’s manufacturing wage cost advantage is gradually eroding as a result of higher real effective exchange rates (through either wage inflation, nominal currency appreciation, or a combination) and as other factor inputs – real estate, capital, water and energy – become more expensive as well, it is reasonable to expect (relative, if not absolute) factor relocation away from China. Which countries might benefit? The Citi analysis relates the World Bank’s 2012 Logistics Performance Index to manufacturing unit labour costs relative to China. According to their analysis, Malaysia, Thailand, India, Philippines, Vietnam and Indonesia score well to capture a slice in the fragmented production networks that may leave China. As other developing regions perform worse, Asian regional integration is predicted to further intensify in manufactures.

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[1] Citi GPS (2012), China & Emerging Markets, 16 July: Citigroup. Note that this new Citi analysis is much less exuberant than their former report on Global Growth Generators; see Buiter, Willem, and Ebrahim Rahbari, Global Growth Generators; Moving Beyond Emerging Markets and BRICs", CEPR Policy Insight No. 55, April 2011.

[2] In ealier blog entries, I have argued that China’s growth performance has been driven by Smith-Gerschenkron-Bradford-Summers type of capital deepening, a source of growth that is not necessarily exhausted yet, certainly not in China’s Western provinces.

[3] Wood, Adrian and Jörg Mayer, “Has China de-industrialized other developing countries?”, Review of World Economics, Vol. 147, 325 – 350.

[4] Jankowska, Anna, Arne Nagengast and José Ramón Perea (2012), “The Product Space and the Middle Income Trap: Comparing Asian and Latin American Experiences”, OECD Development Centre Working Papers No. 311, May.

[5] See, for example, Greenaway, David & Mahabir, Aruneema & Milner, Chris, 2008. "Has China displaced other Asian countries' exports?," China Economic Review, Elsevier, vol. 19(2), pages 152-169, June; Kaplinski, Raphael & Morris, Mike, 2008. "Do the Asian Drivers Undermine Export-oriented Industrialization in SSA," World Development, Elsevier, vol. 36(2), pages 254-273, February;  Daniel Lederman & Marcelo Olarreaga & Eliana Rubiano, 2008. "Trade Specialization in Latin America: The Impact of China and India," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 144(2), pages 248-271, July.

[6] Citi GPS (2012), China & Emerging Markets, 16 July: Citigroup.

[7] Chamon, Marcos and Michael Kremer (2009), “Economic transformation, population growth and the long-run world income distribution”, Journal of International Economics, 79.1, September, 20-30.

[8] Woo, Jaejoon (2012), “Technological Upgrading in China and India: What Do We Know?”, OECD Development Centre Working Paper No. 308, Paris: OECD, January.

[9] Fu, X, R Kaplinski, and J Zhang (2012), “The Impact of China on Low and Middle Income Countries’ Export Prices in Industrial-Country Markets”, World Development, 40.8, August, 1483-1496.  

[10] Barclays (2012), “China’s commodity intensity: the dragon’s appetite is changing”, Cross Currents/25 April (not online).

[11] Huang Yiping and Jiang Tingsong (2010), “What Does the Lewis Turning Point Mean for China? A Computable General Equilibrium Analysis” China Center for Economic Research, Working Paper No. E2010005, Beijing: March.

[12] Kharas, Homi (2010), “The Emerging Middle Class in Developing Countries”, OECD Development Centre Working Paper No. 285, January, Paris: OECD.

[13] To be sure, there are many uncertainties surrounding this consumption-cum-demography scenario. Foremost is whether China’s middle class will develop fast enough to sustain rapid growth in China if exports start to falter. Given China’s unequal income distribution and the small current share of the middle class, it is not at all certain that this will be the case. There have been previous examples of large unequal economies failing to grow beyond middle income levels even after decades of strong performance.

[14] OECD Southeast Asian Economic Outlook 2010