For decades, China (most notably) has developed its economy by building up its infrastructure and developing export markets. The United States has occupied the opposite position in this unholy economic alliance, acting as a net importer and net debtor. This disequilibrium has a limit. As Credit Suisse investment strategist Daniel Kurz, CFA, argued in a recent paper, which is excerpted below, financial pressures will trigger a reversal in this relationship — and there is ample evidence that this process has already begun. The full-length version of the paper, which includes numerous examples and supporting points, can be downloaded from the CFA Institute website.
—Ron Rimkus, CFA
By Daniel Kurz, CFA
Over the past two decades there has been a persistent and substantial widening of the aggregate current account balance surpluses and deficits of the G–20 countries. This article examines why the pending “rebalancing” could usher in a trend toward selective relocalization of output by net debtor nations, especially the United States.
The growing G–20 current account divergence has brought with it unhealthy excesses in terms of increasingly entrenched net creditor and net debtor nations. Nowhere is this divergence better reflected than in the tenuous relationship between China and the United States. Longstanding imbalances in current accounts have been associated with instability and increasing concentrations of risk. For instance, these imbalances have enabled ever greater outsourcing/single-sourcing of goods and labor, rising business disruption risks, and undue dependence on foreign manufacturing facilities and transportation networks built on cheap fossil fuels.
Chart 1: Current Account Balance — G–20 Countries (USD)
Chart 2: Chinese Working Age Population
After World War II, the United States encouraged its companies to intertwine America’s economy with other industrial nations. The goal was to make the West’s system of production even more efficient to better serve the common struggle against the Soviet Union. Moreover, such an interlinking of industry would effectively make conflict with new allies, especially Germany and Japan, more difficult by all but preventing these nations from rebuilding an independent capacity to wage war.
After the Soviet Union collapsed in 1991, much of the credit went to the great Western industrial system that stretched from Western Europe to North America to Japan. Many were convinced that the highly rational, increasingly specialized, capitalist complex had bankrupted the USSR. However, globalization has left its most ardent supporter — the United States — reliant on a global industrial production system that has whittled away at both economic and national security.
Against this backdrop, China has emerged as an industrial powerhouse. It accomplished this in part by using an aggressive policy of yuan devaluation. Between 1981 and 1994, the Chinese currency declined by 75% against the dollar.
Chart 3: Yuan Devaluation against the U.S. Dollar
The combination of state-led industrialization, very low Chinese wages, solid growth in the Chinese working-age population, and pronounced yuan devaluation resulted in China becoming the “factory to the world.”
While shareholder returns in the developed markets have definitely increased, globalization has reduced vertical integration, and localized value-added has negatively impacted operational stability and, by association, the inherent risk of corporate financial results. Not only has this geographically distant outsourcing framework amplified the supply chain risks of corporations, but it has also enlarged the risk of “cascading societal breakdowns.”
Beyond the deepening logistical challenges related to stepped-up outsourcing, the shift away from the “organic R&D” of erstwhile, integrated manufacturers to “M&A R&D” by companies as diverse as Cisco and GE hasn’t boosted strategic R&D spending. In addition, the low margin contract manufacturers render them incapable of assuming similar R&D budgets. Because strategic R&D spending is what drives technological breakthroughs, it’s absence is a threat to our living standards. However, any discussion of the risks of mounting reliance on globalized outsourcing would be incomplete without considering all-important China. Key issues include increasingly prevalent power shortages, the loss of arable land, pollution, and resource depletion. These very factors call into question China’s business model.
Chart 4: Chinese Share of Global Exports versus Germany, the U.S., and Japan
Chart 5: Trade (Imports and Exports) as a Percent Of Global GDP
Chart 6: U.S. Pretax Profit Margins as Percent of GDP
Chart 7: U.S. Wages and Profits as Shares of GDP
So, what could trigger selective relocalization of output? Continuation of rising coal and oil prices would be pivotal factors. Virtually every economic activity we engage in, from agriculture to transportation to manufacturing to IT to services, is incredibly dense energy dependent (a lot of heat generated per unit volume as exemplified by fossil fuels). For perspective, consider that one barrel of oil is the energy equivalent of 5.8 mn BTUs (British thermal units) of energy or 1,700 kWh (kilowatt hours) of electricity, two common measurements of the capacity to do work. Looked at through this lens, countries capable of producing high GDP per capita with lower per capita energy usage (kWh) should be constructively positioned in a world facing increasingly dense energy scarcity/rising dense energy prices. For example, industry-intensive Japan gets three times the GDP per capita from the same per capita power consumption as China, and both South Korea and Japan produce roughly twice the steel per capita as China (World Steel Association), amidst signs of increasing Chinese GDP energy intensity related to that same nation’s resource depletion challenges mentioned above. Manufacturing powerhouse Germany achieves 3.2 times the GDP per capita from the same per capita kWh as China does. Even the gas-guzzling United States achieves twice the per capita output of China on the same basis, and it is endowed with the world’s leading coal reserves. In other words, in an energy-constrained world, production at the margin is likely to eventually return to countries with higher energy efficiency and/or abundant dense energy assets, i.e., relocalization away from countries with low energy efficiency such as China (see chart 8).
Chart 8: Country-Level Energy Efficiency
While energy efficiency is a key determinant of long-term industrial competitiveness, oil-based transportation costs are also a factor in today’s globalized trade (see chart 5). In a world of triple-digit oil prices, distance costs money; for every 10% increase in transportation distance, energy costs rise an estimated 4.5%. For example, the cost of shipping a 40-foot container from Shanghai to America’s east coast, roughly halfway around the world, soared from US$3,000 in 2000 to US$9,000 in 2008 as oil prices spiked to an all-time high of US$147 per barrel from US$20 in 2000. Transportation costs in 2008 amounted to an estimated 9% tariff on goods going to U.S. ports, compared with the equivalent of only 3% in 2000 (CBIC World Markets of Toronto). This increase shifted some production of such items as appliance motors, metal castings, heaters, batteries, and furniture from China back to the United States and Mexico. The heavier and bulkier the goods, the more sensitive they are to fuel costs, suggesting that if oil prices keep escalating, China and other Asian manufacturers, which often send components to China for assembly and export, will become uncompetitive in a wider range of lower-value goods. When procurement savings fall into the single-digit range, it becomes harder to have work done in distant Chinese factories that take 12 weeks to deliver products and can offer less order flexibility, just as customers are seeking more of that.
In addition to rising energy prices, continuation of the double-digit increases in Chinese wages (see chart 9) over the past decade — increases which output growth per labor hour will be hard-pressed to cut in half — will add further impetus to relocation and relocalization of production away from China. Rising Chinese wages stand to get a further boost from the Chinese labor pool, which is starting to “dry up,” as implied in chart 2. According to statements made by Wang Dewen of the Institute of Population and Labor Economics in September, the Chinese surplus of rural workers has fallen to about 20 million from over 150 million previously. This is linked to decades of urbanization and industrialization, to the widespread agricultural production challenges mentioned, which are “soaking up” more workers, and increasingly to Beijing’s 33-year “One Child” policy. As a result of that policy, China’s old-age dependency — the population aged 65 or over/the population 15–64 years old — is set to explode from 11% in 2010 to 38% in 40 years. This robust rise will not only eclipse the U.N.’s projected global dependency ratio expansion to 25% in 2050, but will also virtually assure a tight labor market and sustained upward pressure on wages. As such, China’s vaunted factory mobilization story, the biggest outsourcing story of all, has likely run its course. Could a generation of outsourcing-based disinflation or outright deflation be set to morph into imported inflation?
Chart 9: Chinese Year-on-Year Wage Growth
Conversely, a straw in the wind comes from structurally high unemployment — “U6” unemployment was 16.5% in September — America, where there are plenty of workers, weak consumption growth, but rising capital spending conviction (see chart 10). While few firms are optimistic about the US economy for the next 12 months, more are going ahead with capital spending projects. In fact, shipments of nondefense capital goods jumped 16.7% in the second quarter, the largest gain in five quarters. In addition, new orders for capital goods increased in the third quarter, implying that business investment will keep growing into 2012. US companies’ capital spending plans and potentially greater relocalization of supply imply an eventual pickup in production and employment, and a possible reduction in US imports.
Chart 10: Less Demand Certainty But More Capital Spending by U.S. Firms
Chart 11: Inverted Value of Trade-Weighted USD versus Global USD FX Holdings
Modern era globalization has lifted the fortunes of many emerging nations, constrained goods-related inflation in developed markets, and enabled a very robust global expansion of product offerings and services, especially in consumables, communications, computing, and transportation. Yet this constructive development has been accompanied by increasing structural current account imbalances, growing supply chain risks, reduced manufacturing and R&D diversity and vitality, growing environmental degradation, and suboptimal energy utilization in an era of rising energy prices. It thus follows that some reallocation benefits are in the cards for corporations and relatively energy endowed and/or energy-efficient nations positioned to benefit from such turbulence. These themes are arguably not on most investors’ radar screens; in fact, greater vertical integration based stability, “just in case” inventories, high energy efficiency, and more local outsourcing are generally either not rewarded or are punished in the stock market valuation-wise. This suggests attractive strategic return potential from appropriate investments for investors willing to engage in some contrarian thinking.
Chinese currency yuan and U.S. dollars illustration from Shutterstock.