Labour shortage could spell inflation and trade deficits for China

Informed researchers are asking what happens to China based on the recent demographic shift from rural labour surplus to rural labour deficit.  The answer may be slower growth and higher inflation, according to a paper released last month by China’s Center for Economic Research at Peking University. But other impacts may also be increased consumption and a deteriorating external balance.

The paper by Huang Yiping and Jiang Tingsong is a very technical and dense work based on macroeconomic modelling. But the results are clear: If China’s rural labour surplus evaporates (as seems to already have occurred), we are going to see savings drop and productivity collapse.

The paper is based on the work of Sir Arthur Lewis, an economist from St. Lucia.

Lewis published in 1954 what was to be the most influential development economics article, “Economic Development with Unlimited Supplies of Labour” (Manchester School). In this work Lewis combined an analysis of the historical experience of developed countries with the central ideas of the classical economists to produce a broad picture of the development process. In his story a “capitalist” sector develops by taking labour from a non-capitalist backward “subsistence” sector. At an early stage of development, there would be “unlimited” supplies of labour from the subsistence economy which means that the capitalist sector can expand without the need to raise wages.

-Entry for Sir Thomas Arthur Lewis, Wikipedia

What Lewis found is that 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. We are seeing those deflationary forces in Greece right now.

From a Chinese domestic perspective, the Lewis Turning Point will crater productivity levels as wage rates rise. The corollaries of this increase in wages and lower productivity are slower GDP growth, higher consumption, lower savings and a deteriorating external balance of payments aka current account deficits.  As I have been saying for a few months now, the whole protectionist fervour directed at China’s currency peg is completely misguided (see Roach: GD II awaits if China bashing rhetoric turns into protectionism). It is not clear that a small increase in the Yuan would have an appreciable impact on the U.S. current account with China.

Within the Chinese economy, there would be dramatically different effects depending on the labour’s share of the value added. Again, it’s not clear which sectors would be worst affected by this labour supply shock.  But, what the Chinese economists are trying to do is figure out how China can avoid the so-called middle-income trap that has afflicted Latin America and the Middle East. After these countries reached their Lewis Turning Point, they failed to move up the industrial ladder and still rely very heavily on  resource-based industries like oil and industrial commodities. If China wants to keep its GDP growth up, it will need to move up the value chain.

At a minimum, however, this study indicates we could be in store for some big changes in China in the not too distant future.


What Does The Lewis Turning Point Mean For China – China Center for Economic Research


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.