Will China’s bad debt problem affect employment?

The major talking point this morning has been the Chinese bad debt cleanup. Following Yves’ post on China, this post is the second of three on China from Credit Writedowns this morning. Read Michael Pettis’ take and my take on that action here. This post is going to be more about where China and the global economy are headed.

My view is that we are headed for a global growth slowdown at a minimum. Beyond that, we are dependent on the policy responses.

The Present: Labour Shortage

Let’s start with this:

industrial wages rise very quickly when the supply of excess rural labour is exhausted. This is called the Lewis Turning Point and is where China is right now.

This will have major implications for the Chinese domestic economy and the world economy. The first implication is inflation. Without the endless stream of excess rural labour, wages are going to go way up in China and this means inflation will be a problem. Over the last twenty years, the introduction into the global economy of the former Eastern Bloc and China has meant a huge surge in available labour. Despite a flood of money from the Japanese and U.S. central banks, this influx of labour has effectively capped consumer price inflation in developed economies. The result has been the so-called Great Moderation.

If China has reached its Lewis Turning Point, all of that is out the window and Central banks will face a Scylla and Charybdis flation challenge for years. China’s labour shortage will work in concert with resource constraints and likely excess money supply as an inflationary force. These forces are countered by major deflationary forces from the debt overhang resulting from the implosion of the global asset bubble.

Labour shortage could spell inflation and trade deficits for China

Labour is in short supply in China right now, the key phrase being ‘right now’. And China is exhibiting the macro conditions that one would expect: higher inflation, higher wages, and a deteriorating current account.

I used some of Andy [Lees]’s analysis to suggest that China is losing competitiveness in its export markets. While wage rate suppression and capital substitution might make sense on a micro level, these tactics are poison on a macro level since it supresses consumer demand. And increasing internal demand is key to the shift in China’s economic policy. China’s rebalancing toward a more internal demand-focused economic policy is vital because protectionist sentiment is still high, and with the US dollar still relatively weak, the Chinese currency is depreciating on a trade-weighted basis. Translation: if the currency wars break out again, China will get the stick. So wage rates will rise.

Obviously, the right way to deal with the increased labour costs (Lewis Turning Point) is via the increased productivity that comes from moving up the value chain, rather than substituting capital for labour. Let Vietnam have the lower value-added production.

Even so, Michael Pettis suggests that rebalancing through wage increases will not be enough.

More on the China-bearish ‘factor mobilisation story’

The Medium-Term: Non-Performing Loans

Now I happen to be a China (and Asia) bull. I think Jim Rogers has the long-term macro story right. And I agree with China expert Shaun Rein who told me “I’m bullish on real economy not nec investing. Roach underestimates problems. US-China rel. could cause issues”. 100%. The macro picture in China and emerging Asia is better than it is in the US and Europe. If you had to pick regions that will see real economic growth, emerging Asia would be top of the list.

But there are risks. As I see it, the biggest problems are the currency wars and protectionism on the political side. China as the Bad Guy? Yes. On the resource side, demographics, water, and fossil fuels are all big issues. More than that, there is little doubt that China has a malinvestment problem. I am probably less bullish on the medium-term real economy because of it. The Chinese government has tightened monetary policy to deal with this. And as Michael’s latest post attests, over the medium-term, the non-performing loans (NPLs) are going to be a problem as a result. So, I say first come the credit writedowns.

Asia bull Marc Faber think the tightening and the writedowns will lead to a “technical recession” in China over the next year. Basically, he is calling for a growth slowdown – what I have called a hard landing.

(video below)

And hard landings spell labour gluts, not labour shortages.

This is how Michael Pettis put it to me a week and a half ago regarding a post by Michael Shedlock:

Edward, it is not that I disagree with you about the impact of rising wages, I was just responding to Mish’s email and saying that I am very uncomfortable with applying the econometric model to a very different demographic (and institutional) structure, especially since I think the reason for rising wages in China is primarily an (unsustainable) increase in real estate and infrastructure development. My guess is that once investment levels are brought down, we are going to be faced with too many, not too few, workers.

I am also not sure that it is important for China to remain competitive in the export market. As i think we both agree strongly, a large continental economy like China’s should focus primarily on developing the domestic market and the real purpose of productivity growth should be to increase household income, not to stay competitive in international markets


He makes a fair point. China is an aging society that has none of the demographic hallmarks that one traditionally sees in higher-growth emerging markets. Read Claus’ last piece on Russian demographics and you could substitute China for Russia in many instances – and add in the one child policy to boot. So when we look at the so called BRIC economies of Brazil, Russia, India and China driving global growth in this recovery, the demographics are starkly different between Brazil and India on the one hand and China and Russia on the other.

Since monetary policy acts with a lag, I speculated in April that the hard landing is already happening. China is slowing right now. We shall see by how much and what the policy response will be.

The Longer-Term: Demographics or continued growth?

My response to Michael was:

Michael, yes we agree wholeheartedly here. On some level, the overhang from resource misallocation is so large, it probably doesn’t even make sense for policy makers to worry about moving up to more value added production since there may soon be an excess of labour.

Here’s what I said to Mish:

"I think my view on the Lewis Turning Point is that it could be real, meaning that right now the malinvestment-stimulated economic growth has left China with a labour shortage much as the U.S. had a 3.9% unemployment rate in the late 1990s. The problem is the bubble and how its end will play out. The prospect of labour surplus is very real in the near term.

That said, if China overcomes its bubble by successfully socialising losses, it can resume growth and then you might face the same problems again."

The immediate problem is the excess capital investment and the costly maintenance of the projects it has spawned. If the Chinese ratchet back this cap. inv., problems will come hard and heavy for housing, commodities, employment, NPLs, etc, etc.

I might write something up on this and quote you (if you don’t mind). Let me know if you have any other thoughts.



So, that’s what I am doing here.

A slowdown is coming. But how will this affect employment and what will the currency and policy responses be?

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com


  1. alex

    Ed Harrison,

    Referring to the video (which I know is a few months old, but current enough): how can you call Schumer’s (and others) calls for revaluation “protectionism” when the US has such a large trade deficit (both bilaterally with China and multilaterally)? I understand the need for other countries to hold some USD (since it is the international reserve currency) but how can China possibly justify holding USD reserves equal to 50% of their GDP? What purpose can such large reserves serve other than currency manipulation?

    P.S. Some countries are even worse. IIRC Taiwan has USD reserves equal to 100%/GDP! Nevertheless their sheer size makes China the biggest problem.

  2. Jorge Shubya

    The solution to higher labor costs is to truck in laborers from South Asia to compete head-to-head against the Chinese. Duh!

  3. Stelios Theoharidis

    There are a couple of negatives to add to your scenario:

    1) Rising commodities prices (food and fuel). This will likely continue unless a speculation in these markets is brought to a halt. Based on conditions in the US breadbasket for planting we can expect an upward trend in food and increasing instability amongst developing and emerging economies.

    2) Environmental Hazards: pollution and related health issues in most major Chinese cities is going to have a downward effect on long term GDP growth.

    3) Inequality, social and civil unrest, both in China and abroad, the latter instability affecting their commodities prices, with the exception of Australian coal, most of their fuel inputs are from unstable regions.

    4) Double dip in most developed (Japan, Europe, USA) economies decreasing demand for Chinese goods. There is going to be a feedback loop.

  4. DP

    Exports were 30% of China’s GDP before trade collapsed in the fall of 2008. Fearing a worker revolt when unemployment soared, China’s central government pushed the local governments to make the state owned banks loan massive amounts of money on a massive building spree for roads and trains to nowhere and excess commercial and residential buildings to employ workers. The demand for materials to produce those projects helped reinflate the commodity bubble and Australia’s natural resource economy.

    Now, less than 3 years later China allegedly has a labor shortage? As Yves comments, this is almost certain to be replaced by a worker glut in the near future.

    Let’s see, we’ve got the Greece/Ireland/Euro mess, questions about the sustainability of China’s economy, oil is over $100/barrel, wrangling in the U.S. Congress over raising the debt ceiling once again, the yield on the U.S. 10 year has just gone through 3% like a hot knife through butter. This looks a lot like 2008 again, just trillions of dollars in debt and a lot of near worthless China infrastructure later.

    1. MyLessThanPrimeBeef

      Arab Spring

      Ero Summber

      China Fall

      South America Winter.

      Viva the Four Seasons!

  5. Three Wickets

    “..industrial wages rise very quickly when the supply of excess rural labour is exhausted. This is called the Lewis Turning Point and is where China is right now.”

    How does this happen exactly in a developing nation with a population of one trillion.

    1. MyLessThanPrimeBeef

      Someone once said that you don’t solve a problem using or thinking the way that got you there the first place.

      Except technology. When the problem is caused by technology, the solution is always more technology. The one time that was not the case was the nuclear cold war, which was not resolved by making more nuclear bombs but through Soviet folly and perhaps Rock ‘N Roll and decadent Western pop culture.

      So, the solution to the Lewis Turning Point is definitely not more rural Chinese babies.

      1. alex

        “Someone once said that you don’t solve a problem using or thinking the way that got you there the first place.”

        Tell that to Helicopter Ben.

  6. paper mac

    “The macro picture in China and emerging Asia is better than it is in the US and Europe. If you had to pick regions that will see real economic growth, emerging Asia would be top of the list.

    But there are risks. … On the resource side, demographics, water, and fossil fuels are all big issues.”

    I appreciate that economists are people who have contracted a severe neuropsychological disorder that causes them to believe that the endless gyrations of numbers arbitrarily assigned to imaginary entities accurately describe the real world. That is fine, and I wish you all the best with your recovery. That said, being “bullish” about “emerging Asia growth” while describing “demographics, water, and fossil fuels” as “risks” and “big issues” is beyond glib and bordering on pathological.

    China is in the midst of the worst drought in at least 50 years, possibly in a couple of centuries. The most thorough NCAR analysis of the effects of climate change on drought conditions predicts that much of southern China will be a more-or-less permanent dustbowl by mid-century. The Huang He and Yangzi, cradles of the Chinese civilisation, are running dry. Desertification claims a couple percent of Chinese arable land every year. While you watch a bunch of imaginary numbers go up, the China which nurtured and supported one of the world’s oldest extant civilisations is literally dying. That’s not a disembodied “risk”, something that arbitrarily impinges on the economic sphere, it’s a direct consequence of the economic model the Chinese gov’t is pursuing. “Growth” and “increased domestic consumption” under the CCP’s paradigm are literally not possible without extracting horrific tolls from the health and wellbeing of the Chinese people. And that’s just water- I think we can set aside fossil fuels and demographics for now.

    There is no such thing as infinite growth in a finite system. Whatever is overgrown will inevitably wither and die. Laozi knew that 2500 years ago. The sooner you stop cheerleading “growth” and just-so stories about emerging Asian markets (Vietnam is the next source of our slave labour! China’s gon’ be fine if they get “policy” right! Whee!), the sooner we can start paying attention to outcomes that matter- the health and wellbeing of people and the landbases that support them.

    1. MyLessThanPrimeBeef

      Zhuangzi, Laozi’s spiritual descendent, so they say, though he was an oringial in my book, and the world’s first known anarchist (maybe), said, beside the butterfly dream, Life is finite while knowldge is infinite; to pursue the infinite with the finite, how dangerous that is!

    2. alex

      “China is in the midst of the worst drought in at least 50 years, possibly in a couple of centuries. … much of southern China will be a more-or-less permanent dustbowl by mid-century. … it’s a direct consequence of the economic model the Chinese gov’t is pursuing.”

      AGW is continuing because of the policy of almost every country (IIRC Germany may be an exception). A kilo of American GHG’s warm the planet just as much as a kilo of Chinese GHG’s.


      Draconian though it may be, China has one of the most effective population control policies.

      1. paper mac

        “AGW is continuing because of the policy of almost every country (IIRC Germany may be an exception). A kilo of American GHG’s warm the planet just as much as a kilo of Chinese GHG’s.”

        No argument there. In addition to the major rivers running dry, parts of them are so polluted that the increased concentration of chemicals renders them caustic and unusable as a water supply, etc. It’s pretty fucking grim, and although there are some big crash programs underway to mitigate the worst of it, they need to keep an arbitrary and imaginary number “GDP” getting larger in order for the CCP’s cronies to continue making mad bank, so they’re not going to stop building coal generation and chemical plants.

        1. alex

          “they’re not going to stop building coal generation … plants”

          Unfortunately not. The sad thing though is that China is doing more with renewable energy (wind, solar, etc.) than the US is.

          What the hell happened to the US as the ultimate “can do” country? Need to build a railroad across a continent? No problem – we’ll figure out how to deal with a few deserts and mountain ranges. Want to put a man on the moon? You came to the right place.

          Nor was this limited to “big spectaculars”. Back in the 1960’s and 70’s the US was very much in the forefront of the environmental movement. We both enacted regulations and implemented the necessary technology to eliminate such curiosities as flammable rivers.

      2. Edward Harrison Post author

        I didn’t go into the serious environmental problems that China’s strategy is having because it’s not the main focus of the post. But I agree with you it could be a disaster. You look at every single energy source and China is going all-out.




        Bad things are going to happen there. This is the problem with the capitalist infinite growth paradigm really. While the Chinese are way ahead of the US in alternative, they sill have so many resource demands that they are doing some very nasty things to the environment.

        And note, Brazil is ow building the third largest dam in the world. So they are at it too.

        P.S. – India is going full speed ahead on nuclear:

        So they are at it too. Again, isn’t that what high growth in large economies means?

        1. paper mac

          Thanks for the response, Ed. I’m glad you’re concerned about this as well. I guess what I don’t understand is when I see guys like you who are acknowledging the “problem with the capitalist infinite growth paradigm” and you’re still interested in seeing economic growth assessed under that paradigm. At the end of the day the question seems to be “how long can the elites keep the wheels on the cart by playing jiggery-pokery with economic data and monetary policy instead of mending the axle”. It’s certain this endeavour is doomed to failure, and whatever replaces it is going to be far worse for a lot of people. It’s also certain that the longer the status quo continues, the worse the end state will eventually be. So why are we supposed to be interested in clever monetary policy which will keep the top spinning, instead of, say, repudiating a system which is guaranteed to eventually destroy us? When you’re in a hole, stop digging kind of thing?

  7. Stelios Theoharidis

    While I mentioned the environmental/resource crisis earlier, the water issue has huge implications internationally. It has very real consequences for local populations but under an international regime it takes a strange form. China faces both a quality and quantity concern locally.

    We must remember though that countries do import water, embodied in food imports. Water consumption in general for human beings is generally not for subsistence but rather for waste. A large majority of the embodied water in our lives is not for drinking but rather for showering, laundry, flushing, etc. Hell we also trash about 2/3s of the food we produce, water waste in animal husbandry, and poor irrigation practices is massive. While we face very real resource restrictions there is a huge amount of waste in the system.

    Food prices strangely enough are at the same time artificially low due to subsidies and high due to speculative behavior on the market. Honestly I don’t know how that plays out as far as accurate pricing goes. Water and land poor countries are actually engaging in land grabs with foreign investment vehicles all over the world with the tacit approval of domestic elites. In many places biofuels, cash crops, and livestock are replacing staple food production.

    What you are more likely to see is an international food production regime where the emerging and developed countries will take the lions share while the poor are left with the crumbs. This will play out within and between countries. There is a concommitant instability as the poor are slowly squeezed more and more, but the results of that is not clear. But, the Chinese will subsidize food production, acquisition, etc in order to ensure that their populations are adequately fed and stave off impending instability. Why you may ask, because they can afford to do it. It is the condition of the poor as well as stability in many other countries of the world that I am more concerned for to be honest.

  8. Philip Pilkington

    Yeah, I think people are really over-thinking this one a bit. Pettis is on the money: the real estate bubble is key. Once it bursts it’ll drag employment into the dirt.

    I tried a quick Google-fish for the number of Chinese employed in their construction sector, but no gold (if anyone else succeeds, your input would be appreciated). However, consider what happened in Ireland — where we ran our economy off the construction sector:


    Back at the peak of the bubble there was around 240,000 people employed in the construction sector. That’s out of a labour force (at the time) of around 2.1m. So, that’s what? 11.5% of the labour force (est.)?

    Well, according to that Irish Times article the amount of jobs in the sector has shrunk to 80,000!

    That’s a tremendous drop in employment. But that’s what happens when you tie your economy to the property balloon.

    1. Philip Pilkington

      It should be noted that you can probably safely double that figure again — around 23% — to get a very conservative estimate of the percentage of the labour force directly employed BY the construction sector at the time of the boom (i.e. through manufacturing of construction goods, retail, services etc.).

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