North Asia and deflation

Andrew Hunt argues that the North Asian Development Model Japan has followed and other Asian nations are looking at needs to be consigned to the history books.

Wednesday, November 12th 2014, 3:41PM

by Andrew Hunt

Japan’s economic recovery from the Second World War was based on four primary pillars, namely enforced import substitution in a number of key areas (such as agriculture); a policy of systematic “financial repression” that lowered the returns to savers but provided corporate and government borrowers with inexpensive credit; the encouragement of exports via a “cheap currency”; and intensive central government development planning.

We suspect that although these policies produced a rapid industrial renaissance and therefore helped immensely to achieve the West’s aim of building a stronger Japan that could act as a bulwark against the feared spread of communism in Asia, we strongly suspect that the adopted policies adversely impacted a large number – if not the majority – of the population over the longer term.

In the grand scheme of things, the initial introduction of these policies was probably justified by the extreme circumstances that Japan found itself in in the post-war period, but the policy mix was already becoming inappropriate by the late 1960s (witness the booms, busts and inflation that Japan suffered in the late 1960s and early 1970s).

Nevertheless, the model was allowed to persist not just through the 1970s but the 1980s, 1990s and even 2000s as well, with few signs of the much-needed reforms that were required. We suspect that the Bubble Economy of the 1980s and the long-running slump that has followed it were partly the result of Japan’s over-long adherence to what has been described as the North Asian Development Model.

Despite Japan’s problems, several other countries within Asia have followed Japan’s lead. Certainly, both Korea and China have followed a broadly similar approach to their development and, in the case of Korea, it does seem that, following its various booms and bust of recent years, the country is beginning to follow what seems to be a similar type of high debt/low growth sclerosis path to that which Japan has endured. In addition, we also suspect that Korea will soon be tempted to follow Japan’s lead by itself adopting a weaker Won exchange rate policy in an effort to revitalise its existing economic model, rather than to change it into something more appropriate for the economy’s stage of development.

It should be remembered that thus far Japan’s much lauded Abenomics has amounted to little more than a competitive devaluation and the promise of some economic reforms but not their actual delivery.

Unfortunately, we suspect that Korea may tend to follow this same path but together Japan and Korea are a very significant part of the global economy and therefore any weakness in their currencies can be expected to be deflationary for global trade prices and global growth. This has certainly been the case in the past and we firmly believe that these economies’ continued adherence to their old models of development and the currency policies that this situation will likely engender will act as a significant bias towards further falls in world trade prices.

We would also argue that China has been adopting “new versions of old measures” to support its economic growth over recent years. Rather than the type of wholesale economic and political reforms that are needed to allow China to move towards “the next stage” of its economic development, China has instead attempted to keep its old model alive by both allowing a massive expansion of local government spending and, rather less obviously, by using its access to cheap credit to subsidise its export prices.

According to China’s official data, around 90%, or perhaps even more, of China’s total economic growth since the end of the GFC has been attributable to an increased level of spending by Chinese local governments, at least some portion of which may not have been “efficient”.

Certainly, there have been significant costs for China involved in this over-reliance on this specific form of public sector spending: the high levels of pollution, weak agricultural sector and areas of excess capacity within the economy are all likely to have been made worse by the surge in local government spending, although many of the world’s commodity producers did gain – if only temporarily – from China’s need for raw materials during this process.

What is perhaps less apparent to many is the extent to which China has subsidised its export prices over recent years – particularly as the Chinese currency has been obliged to appreciate.

According to China’s own data, we find that, over the last 10 years, Chinese average wages have increased by 399% in USD terms (and by 394% in the manufacturing sector). While China has certainly witnessed rapid productivity growth over recent years, we very much doubt that absolute productivity levels have in fact quadrupled in the market economy over the last decade. In addition, we also note that domestic land prices have increased by at least 80% over the same period (where there is no productivity growth), while industrial commodity input prices have increased by 34% and corporate interest rates have increased by around a third or more on average (and the level of outstanding corporate debt has ballooned).

Therefore, we can suggest with some confidence that the corporate sector’s labour, land, capital and material costs have all increased very significantly over the last decade and we would suggest that the increase in effective production costs must have been somewhat more than 50% and perhaps very much more, although the official CPI data (on which many people base their “valuation” estimates) shows Chinese domestic prices rising by only around 30%.

We must also note, though, that over the last ten years, it seems that Chinese export prices have only risen by around 10% in USD terms, according to third party country data. The data is difficult to use but we can suggest that between 2003 and today, China’s effective real exchange rate has risen by at least 40% and perhaps by as much as 100%, figures that would easily explain why domestic profit rates have tumbled and companies have become so addicted to credit. In effect, Chinese companies have increasingly used the cheap credit offered by their still heavily repressed financial systems to avoid passing on their higher costs to their external customers. In a sense, China has been using its banking system to subsidise its exporters and we can say with certainty that the latter can no longer be considered as either profit maximisers or “efficient” in a macroeconomic sense.

Basic economic theory tells us that companies are supposed to make at least a “normal” profit or cease production but China’s companies have been doing neither and this will be reducing overall global economic efficiency.

For New Zealand consumers who shop at The Warehouse, the influx of lower-priced goods courtesy of Japan’s weak Yen and China’s credit-subsidised exports, the fall in world trade prices has appeared beneficial and this has also helped to explain why global inflation rates – and hence interest rates – have been able to remain so low for so long. There are, though, also very important costs for Western consumers.

The fall in import prices has in some cases decimated import-competing industries in many Western countries and therefore “cost jobs” in what were once their most dynamic manufacturing sectors. As a consequence, growth within many Western economies has become overly biased towards the service sectors, but this has implied both more income inequality (service sector employment tends to encompass the highly and the lowly paid with relative few people “in the middle”) and weaker overall productivity trends.

Unlike the manufacturing sectors, the service sector tends to be notoriously bad at generating productivity growth and without productivity growth there can be little or no real wage growth over the longer term. In fact, we would go so far as to suggest that many of the world’s current problems – such as rising inequality, weak productivity growth rates, low real wage growth and the unnatural dependence of headline economic growth on the property markets – are, in part, due to the fact that many of the Western manufacturing sectors are being adversely impacted by North Asia’s attempt to maintain what have become outdated economic development strategies. It would help if Western countries invested more in their capital and human capital stocks, but that is another issue.

For investors, we would argue that Asia’s continued adherence to its existing economic model is likely to continue to bias the global economy towards low inflation, if not deflation. Moreover, we can expect growth in Western manufacturing sectors to remain elusive and this deflationary/weak world trade environment will make it ever harder for current account deficit countries (including those within the Southern Hemisphere) to close their trade imbalances. This may encourage these countries to also seek weaker exchange rates.

Moreover, we can also expect this weak nominal trade growth situation to lead the world’s policy makers to continue trying to support their economies through the greater use of central-bank financed budget deficits of the type that Europe already seems to be erring towards at present. In this environment, we suspect that there will be moments of global growth and “risk on” in financial markets, but there will also be intermittent moments of economic and sharemarket weakness when governments are obliged to reconsider their budget positions, all of which essentially amounts to “more of the same” of what has already been occurring for several years.

Unfortunately, until the North Asian Development Model is finally consigned to the history books to which it now belongs, we believe that it will be very hard to create a lasting global economic recovery and, rather ironically, this failure to generate a recovery may lead to more government spending and innovation in the West – and perhaps more competitive devaluations. We would argue that the West should be careful not to follow the Asian model lest it too ends up in the same muddle that has now engulfed North Asia.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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