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Economics: China: Hype or Happening?
New York: August 10, 2004
By John R. Stephenson

With all the talk these days about the price of oil surging, the decline of the US dollar and the huge current account deficit, one country appears to be pretty central in all of these discussions — China. But is China's dramatic growth really a miracle or is it just hype that analysts have trucked out to explain the many dramatic changes we have seen in our own economy over the last several years?

The growth in the Chinese economy over the last few years has been dramatic to say the least. Between 1995 and 2002, China's industrial productivity growth expanded at a 17% annual rate which compares with an average annual growth of 4% in the US. How much is Chinese labor producing? Lots. Chinese labor is producing three times what it did a mere nine years ago and there appears to be plenty of room to increase production in the future. The unemployment rate in China is 23% or 169 million people (equal to the entire US labor force) and Chinese agriculture employs half of the working population, versus less than 3% in the US and 4% in Europe.

As China rapidly industrializes, this dramatic growth is occurring in the context of an overtaxed domestic infrastructure. Of the 31 Chinese provinces, fully 24 are reporting shortfalls in electricity and within the coastal manufacturing regions, the government has described the electricity shortfall as "acute". So strained is the nation's electricity grid that Bejing has announced that 6,000 factories will be closed for one week each in observance of "high temperature holidays" (electricity demand soars as temperatures increase). As well, hotels in the major cities have taken to limiting their thermostats to spare the air conditioning system in the summer. Not only is the thermostat set so that the air conditioning will only come on at a rather toasty 26-degrees Celsius, but hotels are requesting that staff use the stairs in order to avoid overtaxing the elevators.

But is all of the growth the result of a shift away from an agriculturally based economy and towards an industrial economy? No. China is growing economically in the same way as the United States and Europe have, by both increasing production through a shift

towards industrialization and by increased productivity. Of the thirty-eight industries in China, twenty-seven have seen average productivity growth over the last year in excess of ten percent. Indeed a substantial portion of this productivity miracle is the transfer of ownership of bloated state-run factories to private hands where the new owners have successfully managed to down-size the employee rolls, yet produce more. This trend is part of a global manufacturing trend and as Steve Wieting, the senior economist at Citigroup, has noted: "Real manufacturing output has risen 77 percent even though the number of manufacturing workers has fallen 22 percent since the 1979 peak."

The Chinese are successfully transitioning to the big leagues with both increased production and soaring productivity. The Chinese success, while in part dependent on low wages, is increasingly dependent on increasing productivity. This helps to explain the fact that although the US dollar has fallen 20 percent on a trade weighted basis over the past few years, US import prices are stable (or in some cases falling). In short, those who export to the US are making their products cheaper and more efficiently than ever before.

But for the Chinese production miracle to continue, China will need to stimulate domestic demand for its products and services. The miracle has been fueled in large part by the American consumer. In the 1996 to 2001 interval, the United States accounted for fully 96 percent of the cumulative increase in world GDP. This economic growth has occurred because the US has been borrowing massive amounts of money (roughly $500 billion per year) from foreigners to support the consumption habits of its consumers. With the US trade deficit at six percent and approaching seven percent of GDP, the United States is becoming tapped out. The US dollar will have no where to go but down and if US consumers retrench in response to weak economic prospects at home, emerging economies will have to look internally or towards Europe for increased demand.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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