China and its demographics

Dear readers,

This newsletter will be the last one for the year. For an economist who tries to think outside the box, 2008 was a fantastic year. One could compare it with a meteorologist who would get the chance of a lifetime to observe a perfect storm. However the social drama’s caused by the crisis counterbalance the academic joys. 2009 unfortunately will most probably not be any different.

We do have the reputation to be the ‘Waldorf and Statlers’ of the finance industry, but one can not expect that the excesses and imbalances which have built up the last 25 years can be digested by a stock market correction of 30-40 % and a bailout plan of USD 1 trillion. This is the core philosophy of Givanomics. In this dangerous ocean of liquidity some tectonic plates need to be reshuffled and this is going to keep on causing giant waves in the near future. Volatility is going to be something we will have to deal with in the next coming years.

Before we have a closer look at another potential black swan, i.e. China and its demographics, let us for the record make some projections what to expect for 2009. One of the central themes will be further de-leveraging. It is naïve to think the market has de-leveraged sufficiently. Past experience of credit bubbles taught us that they would be followed by a credit contraction. Until now the major banks have only written down apx. EUR 800 bio of a potential EUR 5.5 trio still outstanding. So, we haven’t seen anything yet .

Leading indicators clearly show a contraction of economic growth around the world. As a consequence banks will be faced with write downs of bad corporate debt. Areas that will be hit first are most probably commercial real estate and shipping, two industries which built up huge over capacity. Then given the problems Ukraine, Russia and Hungary are facing, we see East and Central Europe deteriorating. Based upon discussions we have with our contacts with banks that have exposure in the region, we get clear indications that economic activity in e.g. Czech Republic is also coming to a stand still.

All this will in turn cause further funding needs for the banking industry, as further write downs will jeopardize their capital ratios further. Stress tests from Merrill Lynch show the European banking sector could potentially require between EUR 60 – 120 bio of additional new capital depending on how much the economic downside would be.

So far for our 2009 expectations…

In our newsletter on deflation we briefly mentioned the potential thread of Chinese social unrest which could have a major impact on the global economy.[1] For this week we would like to elaborate a bit more on these social issues China is facing.

One would have thought that Europe and Japan and to a lesser extent the US have some serious challenges ahead with the aging of their population. You ain’t seen nothing yet until you have a closer look at China. Their single child policy in the late seventies created a potential monster which is about to be unleashed.

The sociological nature of the Chinese society traditionally preferred male above female children. This combined with the implementation of a one-child policy has triggered a sex ratio imbalance which has caused far reaching damage towards the demographic structure of their society. An interesting paper on the subject was written in 2006, at the University of Michigan [2]

Initially the one-child policy matched its objectives. However after a while it overshot its goal, and it is believed that in the last 20-25 years the policy brought down the population growth by more than 300-350 mio people. This caused a sex ratio (males over females) of up to 1.30 in certain rural areas. Bear in mind that a normal ratio ranges between 1.03 – 1.07 in industrialized countries.

Together with the urbanization of China’s economy, which caused higher or better living standards, this has led to an increasingly aging population. In the beginning of the eighties people older than 65 were only 5 % of the total population. The percentage at this moment has risen to 9%, but will start to rise exponentially over the next 25 years to hit 22 % by 2035. The age group of 0-4 years old dropped from 94 million people to 68 million over the last decade. This together with a drop of the birth rate itself makes the bias of the population age profile moving to the age category of 40. To put this into perspective at the moment 52% of adults are over the age of 40. By 2015 this will rise towards 60 %. Another interesting number is the households who do not have a child younger then 20. This is 37% at the moment. Models forecast a rise to 51 % by 2015 and 71 % by 2025.[3]

All this will have a dramatic effect on the labor force. Models anticipate the labor force already to have peaked this year and will start to decline rapidly. Of course, part of this decline will be offset by an increase in productivity given the improved education and rise in investments, but it won’t be enough. The labor force is declining at a faster pace than increase in productivity and investments can keep up with. As a result this will slowdown GDP growth further, as an aging population reduces the labor force and on in turn lower the return on capital. Investments will fall due to lower returns, which completes the vicious circle: labor falls -> investment falls -> output falls -> living standard falls.

Their one-child policy also has some indirect socio-economic effects. Since it almost became a privilege to have a child, parents start to adore and spoil their children which turned into a mass psychological disorder. Among sociologist they are talking about the ‘Little Emperor Syndrome’. These children carry high expectations for the future and lose their Chinese cultural values. They grow up in a more Western oriented atmosphere and falling victim of the negative influences of the fast food culture. Studies expect by 2010 one in five children in China will be coping with obesity. This is rather dramatic given the fact that the Chinese culture was known for good health and gastronomy practices.[4]

Another socio-economic effect ofto the sex imbalance is that it becomes increasingly difficult for men to find a partner. This has triggered a huge kidnapping campaign and is increasing crime and violence.

Next to an aging population, Chinese officials face another demographic challenge. The rush from the rural areas to the coastal cities of China. This urbanisation already started in the early eighties, but it accelerated when the Chinese government started to experiment with capitalism in some of their provinces near the coast. People from the country heard about the success stories of people who left and became overnight a millionaire and decided to throw the dice and try their luck out in the city next door. This has triggered an exodus from the inland towards the coast. This rush is even expected to accelerate.

In the next 15 years Chinese cities expect to add 350 mio people who all will be looking for a better future. By 2030 the total amount of people living in cities is expected to hit the one billion mark.

All this is going to put a lot of pressure on resources such as water and energy, but the government will need substantial amounts of public funds to offer social services. Apart from that the economy will have to keep up growing by 8-10 % annually for the next 20 years in order to offer employment to those people.

There are already social unrests in many cities, because the difference between the expectations they have for a better future and the real outcome of it once they arrive in a highly polluted and super competitive city is extreme.[5] One can imagine what is going to happen when growth is falling back to 3-4% levels and millions of people keep rushing into those cities…

One can wonder what this has to do with the current crisis. In the short term probably not much. China has enough of financial reserves to manage these social unrests for now. However in the long run it might be, given the huge exodus that is still expected ( 350 mio people even outpaces the total population of the USA!!!) they would have to dig very deep in their reserves to keep this situation under control. As indicated in our previous newsletter it might very well be possible that at a certain stage the Chinese government might be forced to unwind their strategic investments to buy off social unrests. This would trigger huge changes in exchange rates and interest rates.

To give you an idea what the impact could be, just look at the recent move in EURUSD in the last 3 weeks. The EURO rallied sharply from 1.28 to all the way up to 1.46. One of the major drivers behind this move was the Peoples Bank of China who was diversifying at least a minor part of its reserves away from the USD. During that period they bought about USD 60 bio of EURUSD starting from the 1.25 area. A big chunk of that came from emerging market bonds denominated in USD which came to maturity and which were not rolled over. If a move of USD 60 yards can trigger this kind of volatility in the market, imagine what it would trigger when they would have to use only 20-25% of these reserves. For the record, the reserves of China’s central bank are estimated at USD 1.7 trillion at the moment.

The Chinese government is aware of these developments and is anticipating to that in a way you can only expect from totalitarian regimes. At this very moment they are modernizing and expanding their army. This is not for the purpose to conquer the world but to maintain domestic order. One can compare it with the military of Saudi Arabia. To support this thesis, in March 2007 the Chinese government announced they would increase their military spending by 18 % annually. This was the biggest increase in more than 10 years. This is also called the ‘Dark Theory’ which goes around in the highest Japanese intellectual circles nowadays.[6]

[1] http://givanomics.blogspot.com/2008/12/its-all-in-curve-or-scary-story-on.html
[2] C. Chan, M. D’Arcy, S. Hill and F. Ophaso : “Demographic Consequences of China’s One-Child Policy”, April 2006, University of Michigan
[3] Research numbers JP Morgan 2006
[4] Dr. Philip James, chairman of the International Obesity Task Force, quoted in “Study Foresees Soaring Rate of Childhood Obesity,” March 6, 2006. Xinhua News. http://news.xinhuanet.com/english/2006-03/06/content_4263297.htm.

[5] Thomas Lum, “Social unrest in China”, may8, 2006
[6] For more insight we refer to D. Smick “The World is Curved, 2008 Marshall Cavendish
www.theworldiscurved.com