China's Rebalancing Good for Gold
There is an old saying: "Nobody rings a bell at the top or bottom of a market."
Having said that, anyone reading about the stampede for gold during last month's Chinese New Year celebrations might have heard a faint ringing in their ears.
Here are a few quotations from various press sources:
"Some customers just walk in and buy a bunch of 100g gold bars all at once...Companies come in too to buy gold bars for presents." – branch manager, Industrial and Commercial Bank of China.
"Some companies are giving out gold instead of cash to their employees" –Jia Zhihong, jeweler, Wuhan.
"With customers crowding and rushing in, we did not even have time to eat and drink." – gold counter sales clerk.
"People seem crazy about gold, snatching it up more like a cheap cabbage than such a precious metal...You have to quickly decide whether to make a purchase, or it will be taken away by others." – Beijing shopper
"Think of it like investing in the stock market...Gold maintains its value much better than stocks." – sales clerk, China Gold store.
The classic signs of an investment mania are there. Mass participation, frenzied buying, an established narrative that something is a 'sure thing'. But though this may look like the-mania-before-the-crash, that doesn't mean it is.
China's industrial development is still very much a work in progress. The likely next phase is a rebalancing of wealth away from industry and towards households. Given the demonstrable appetite for gold among Chinese consumers, this should be a major supporting factor for global gold demand.
According to World Gold Council data, Chinese gold consumption totaled 207.4 tonnes in 2003. By 2009 it had more than doubled to 457.7 tonnes. More recently, gold imports from Hong Kong, widely regarded as a proxy for total gold imports, tripled in 2011.
China only began deregulating its gold market a decade ago. Until the Shanghai Gold Exchange opened in late 2002, the government held a monopoly on gold ownership. It is possible that the growth in Chinese gold demand could merely represent catch-up, but this seems unlikely given how rapidly China's economy grew over the same period. Ordinary Chinese have been growing steadily wealthier, meaning more and more people have had the wherewithal to buy gold.
A working paper by economists Guonan Ma and Wang Yi published last year by the Bank for International Settlements, for example, found that household savings as a percentage of gross domestic product (GDP) rose from 16% in 2001 to 23% by 2008 – a period in which GDP itself regularly grew by 10% or more a year.
The authors also found there was a considerable rise in household's average propensity to save – that is, the proportion of disposable income that is held as savings. One possible explanation for this could be that economic growth has raised more and more Chinese to just above subsistence level, as agrarian workers urbanize and take higher-paying factory jobs for instance. As incomes grow, an increasing number can for the first time afford to save. Compared to those on higher incomes, though, these new savers must save a greater proportion of their disposable pay in order to attain a given level of savings.
This is not the only factor likely to have driven Chinese savings higher. Ma and Wang also argue that "precautionary savings motives" also explain the rise in personal savings. They cite the period 1995-2005, which saw a 50% fall in employment at state companies:
'Downsized employees received modest social welfare benefits, while many smaller money-losing state companies were shut down altogether. As a result, the enterprise-based cradle-to-grave social safety net shrank rapidly...The large-scale corporate restructuring and downsizing between 1995 and 2005 increased both income and expenditure uncertainties and weakened the enterprise-based social safety net, thus reinforcing the precautionary motives to save.'
Consider that for a second. Consider how it would have felt from the perspective of a "downsized" Chinese worker. Your socialist government, in power since 1949, has thrown a whole load of people out of work and done very little to help them afterwards.
In this context, it is understandable why people in China started saving more. One only has to think of the long shadow cast by Germany's hyperinflation in the early 1920s, and the pathological fear Germans to this day have of price instability, to see how economic upheaval can have an enduring impact on financial behavior.
China therefore looks set to have a high savings rate for the foreseeable future. Furthermore, the rapid growth of Chinese gold demand suggests that many of those who can afford it choose to use some of their savings to buy gold (indeed, many have chosen to store some savings as gold).
Of course, this is not to say that the Chinese will continue to buy gold in ever greater quantities indefinitely. Indeed, it is impossible to know how a sharp slowdown in growth would affect Chinese gold demand. There may be some safe haven buying, especially if financial institutions collapse or people fear higher inflation as a result of any central bank response. On the other hand though, slower growth would sap the buying power of would-be gold consumers.
This is not an academic consideration. China faces a number of likely headwinds going forward. Most immediately, its export-led growth model means it is exposed to any deterioration in the global economy, for example the ongoing crisis in Europe, with which China has major trade links. It's also probable that China has more deep-rooted troubles brewing. Beijing-based economist Michael Pettis argues that China has for years been misallocating capital "on a grand scale", with state-owned enterprises investing in projects of questionable economic merit.
Elsewhere Pettis draws a parallel with Japan, which he argues underwent a similar phase of overinvestment, making Japan's subsequent stagnation akin to what China might face (and also qualitatively different from the post-consumption boom crisis the US and Europe currently find themselves in):
'This is not the problem that that the US or Europe is suffering from. [The US and Europe] suffer from a typical debt-fueled overconsumption boom, whereas Japan suffered from a typical debt-fueled over-investment boom, and Japan’s period of over-investment was much, much more extreme (centralized investment booms can last much longer and go much further than decentralized consumption booms). This is why I think the Japanese experience tells us almost nothing about what Europe and the US will go through.
'On the other hand, it might tell us a lot about what China will go through. In fact we can make a more general point. Command economies (Japan, the USSR, Brazil and many others during their "miracle" periods) tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments.'
So far, so very bearish for China. But Japan's experience in the years following World War 2 also offers longer term hope. In a working paper published last year, Bank of Japan economists Tomoyuki Fukumoto and Ichiro Muto argue that the high economic growth rates of today's China mirror those seen in Japan between 1955 and 1970, which they say were "initiated by vigorous investment".
After 1970, Japan saw a significant rebalancing of its economy away from investment towards consumption:
Consumption and investment in Japan as percentage of nominal GDP
Fukumoto and Muto find that one key factor behind this rebalancing was the rising share of national income that went to labor, with labor's share of GDP shooting up ten percentage points between 1970 and 1975.
Pettis argues that ongoing rebalancing towards consumption also explains why Japanese living standards have continued to rise over the last two decades despite the stagnant Japanese economy:
'It was the state sector that bore most of the brunt of the slower growth, and this shows up as the explosion in government debt. Households were fine because although the GDP pie was growing at a much slower rate after 1990 than before, their share of the pie was growing after 1990, whereas it shrank before 1990...I think the same might happen, or at least could happen, in China.'
China's rebalancing has barely begun; consumption as a share of GDP has continued to fall in recent years much as it has for the last three decades:
Consumption and investment in China as percentage of nominal GDP
At the start of last year, the Economist Intelligence Unit rated the results of China's 11th Five-Year Plan, which ran from 2006 to 2010. One of the categories was 'Economic rebalancing', a term which includes China's external as well as internal imbalances. China scored poorly in this category, being graded a 'D' for its efforts to address 'external imbalances', another 'D' for 'excessive investment' (see chart above) and a 'C' for 'innovation- and services-based growth'.
There are, however, signs that an internal rebalancing may be starting to get underway. The EIU scored China a B- on 'boosting farm incomes', a B+ on 'social security expansion' and an 'A' on 'reducing regional disparities', commenting that "economic growth has gradually shifted inland".
This may go some way towards explaining the rise in household savings as a percentage of GDP noted earlier, and in particular the rise in the average propensity to save as prosperity spreads and raises more people above subsistence. (As an aside, it is worth pointing out that expansion of social security provision could in time actually lead to a fall in savings rates if it sufficiently weakens the precautionary motive for saving – i.e. to provide for contingencies such as sickness and unemployment in the absence of a social safety net).
There are other signs of nascent change. Recent disputes at Apple and Microsoft supplier Foxconn are the latest in a series of industrial incidents to hit China recently. Fukumoto and Muto find that China has seen a sharp rise in the number of industrial disputes since the global financial crisis began:
Number of labor disputes in China
Industrial action can and does yield results. As CNN reports, Foxconn twice gave its Shenzhen workers pay rises in 2010 following a spate of suicides at the plant.
That this rise in industrial action has occurred in the wake of the financial crisis is unlikely to be mere coincidence. But the example of Japan – which saw a rise in industrial disputes from the mid-1960s, and a sharp spike following the oil price shock of the early 1970s – suggests that concessions, once given, are difficult to reverse, as Fukumoto and Muto note:
'...after the mid-1960s, workers' sense of entitlement to their "fair share" rose...and their bargaining power strengthened. Consequently, it became difficult to restrain the rise in real wages again after the end of the oil crisis, and the rise in the labor share [of national income] became permanent.'
Indeed, China's government announced this week that the minimum wage should grow by an average of 13% a year between now and 2015. It remains to be seen how this plays out in practice, but it suggests the authorities are aware of a need to raise household incomes.
China is yet to undergo significant internal rebalancing of real incomes away from industry and towards people, such as that experienced by Japan in the postwar era. There is good reason to assume that, sooner or later, such a rebalancing will occur.
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