Invisible China - A Review

I said that I would plan to get to more book reviews with this newsletter but due to research and work commitments that has been tricky. Nonetheless I had the time to read Rozelle and Hell’s excellent “Invisible China” which is a culmination of a career of painstaking primary research in China’s labor markets and society. There is a good podcast with Rozelle here, and a more general review in the National Review here. 

The key contours outlined in the book for China’s labor markets today are as follows:

• A rapidly aging population

• Persistent opportunity and achievement gaps between people of urban and rural Hukou constituting a kind of apartheid in the country

• A labor force which is by many measures woefully under-educated: only 12.5% has a college education, and only 30% has a high school education or more.

  

• To put that in context I’ve snapped this image from the book, but more than 70% of children are born in rural areas which are disadvantaged with malnourishment (more than half), developmentally delayed (more than half, IQs may never reach 90) which is often attributable to malnourishment due to intestinal worms and iron deficiency as well as vision issues which are untreated.  

• This at the same time as China is heavily capitalized now by any other measure - high speed trains, empty apartments, sheer stock of materials like steel, cement or copper per capita - you name it.

•  Pervasive and massive wealth gaps:

  The average citizen in urban Shanghai makes twelve times the income of someone living in rural Gansu. In the United States, by contrast, the average income differential between Manhattan and West Virginia is less than a factor of four.

• China today is currently facing issues closer to those of Mexico in the early 90s than Taiwan: a profound weakness in its human capital stock and long term under-investment in education albeit with better external macro conditions (for now). 

  This is the challenge China faces. Based on its stock of human capital, China looks a lot more like 1980s Mexico or Turkey than 1980s Taiwan or South Korea. No country has ever made it to high-income status with high school attainment rates below 50 percent. With China’s present high school attainment rate of 30 percent, the country could be in grave trouble.

• In many respects “average wages” are not helpful measures for competitiveness here: whereas the overall level of wages may still be low in China, the wages for more skilled work are no longer much lower than other places and those for lower end or lower skilled work are not competitive with Vietnam, Bangladesh or similar places. What really matters here are relative prices for the same type of worker, and China is not particularly low for the high end due to persistently high costs of living in major cities and especially real estate, and competition at the low end. On a certain level China represents a flawed monetary union: a hyper efficient exports sector that generates surpluses and could probably bear material currency appreciation and a lower skilled sector comprising most of the country that is already struggling. The lack of fiscal transfers and labor mobility between provinces has only made this worse. 

• BRI has seemed to be something of a solution for this: China can export its surplus low skilled labor to build more stuff where it is actually required and generate remittance inflows rather than fiscal costs. Due to corruption, mismanagement and the age old “they took our jobs” politics this has largely failed. So that is largely out now. 

• The long run solution is quite clear: get better funding for vocational schools, get kids to finish more schooling, make it cheap, ensure they aren’t malnourished. While rural schools facilities and teaching have improved the cognitive problems attributable to intestinal worms and anemia have not even though they are relatively cheap and easy to fix with supplementation and medicine. This stuff is an absolute no brainer and something Taiwan and Korea got right in the 80s as they transitioned from manufacturing heavy models to more technology, IP and services oriented growth. While China needs entrepreneurs and elite business leaders it also needs technicians and managers that will be hard to develop from people who are too tired from anemia to study.

• The short run, however, is hard. China has a surplus population of men due to sex selective abortion who are unlikely to be able to step into technical roles. Without continued growth in construction and other sources of low skilled labor demand how can China absorb this population without significant social safety nets and the associated costs? Throughout the book Rozelle is clearly haunted by the history of Mexico where an export miracle ended and social dysfunction began as crime and the informal economy replaced booming demand for lower skilled labor. 

  More specifically, just like China’s, Mexico’s human capital was highly polarized. Mexico did have a contingent of the population with a high-quality, twenty-first-century education. When the transition came, those people were mostly able to find jobs. A large majority of the labor force, however, had no more than junior high school skills. Even today the distribution of education levels in Mexico’s population has two peaks: one group averages at least fifteen years of education, the other group has eight years or less. That polarization in education led to labor polarization, setting off the exact set of dangerous economic and social effects that may be lurking in China’s future.

• This segues into the inevitable risks of an economic slowdown in China - crime, and more pertinently for the CCP, political instability and the need for other patriotic distractions from underlying challenges.

  If one of those pillars of legitimacy—continuing fast economic growth—is irrevocably knocked down, what might happen? French predicts that the CCP might feel it has no choice but to bolster its legitimacy by doing even more to whip up nationalist passion. If China really starts to fall and people start to get angry, what’s to stop the CCP from deciding that the time has finally come to make good on a lot of threats with the first overt military move to seize the Diaoyu/Senkaku Islands and thereby risk war with Japan? And if not Japan, then where else? The long-simmering skirmishes in the South and East China Seas might finally erupt, with grave military consequences for us all. These are only possibilities, but we must take them seriously.

• This book outlines the profound bind that the CCP is in around their social contract with the Chinese people: we deliver growth in exchange for power, elite rents and quiescence on political freedoms. Everyone would agree that a better educated public, less debt accumulation and lower fixed asset investment is desirable. It would generate higher and more stable growth, greater financial stability, lower carbon emissions and general welfare. The problem is how to get to this long term goal through the present. In the short term there are growth pressures to export sectors from decoupling and a lack of low level wage competitiveness and shorter term growth boosting measures liberally deployed since 2009 in a decade-plus Keynesian pump are showing materially lower returns not least of all because they are building stuff that generates short term tax revenues for local governments from land sales (real estate) as opposed to things that might allow for decarbonization, greater social services or the like. While spending on childhood malnutrition in rural areas and technical colleges would also constitute expenditure and GDP it needs to be incurred in local areas that may not see the benefits longer term as people move outside of province and won’t see any benefits in the short term in GDP. Short termism, agency problems, free rider issues and the like are very much a feature of the more planned part of the economy as they are elsewhere. 

In light of all this China’s seemingly endless desire for building more stuff makes a great deal of sense if the CCP’s objective function is not GDP but some measure of social stability and thus employment. Pouring more concrete is the answer until such time as the labor force turns over and becomes more highly skilled because in the short term it can do little else. Other options like greater fiscal integration, structural reforms and other politically hard things would be better but remain very challenging in China. This approach is something of a gamble though: you can avoid explicit fiscal transfers and spending and maintain short term high GDP growth but only if your population does not shrink too fast to lead to a massive stock of impaired financial claims and a deteroirating external balance due to lost export competitiveness that could lead to crisis. The problem is that this is where China is today: short term it has excess labor that needs to do what work it can, longer term the population decline is so sharp that in absolute number terms it is not clear that China will have more STEM trained engineers than it does today¹. As today’s bricklayers age out of the labor force and the population shrinks the apartments will be not be 20% unoccupied but worse. The skills intensive export sector will not be able to grow as it has before because while kids born today will have vastly better skills, there’s a lot less of them being born and for the next 20 odd years they are a cost.  

For this reason I expect to see China continue to avoid wholesale structural reforms to finances and hukou and instead engage in kick the can incrementalism. Cramming down creditors to problematic sectors like real estate can be done on a piecemeal basis without triggering a panic and planners can arrange the minimum level of fixed asset investment to keep lower skilled workers employed. Educational spending per child will rise, if only because birth rates are falling so sharply. Ultimately households will take impairments on their portfolio exposure to real estate, but at some point that starts to crimp both birth rates and other discretionary spending and indeed already is according to some studies. The gray malaise is likely to continue and nationalist political distractions are likely to remain expedient and useful onshore as fractured international relations are perceived as lower risk than structural reforms to hukou or the tax system. 

It is not an unfamiliar picture nor a pretty one but Rozelle’s work outlines quite clearly the opportunity - but also the profound constraints - facing the CCP and their social compact with the Chinese people. Lower and higher quality growth with more explicit redistribution and debt accumulation for social spending is an option for a higher quality of life, better international relations and less risk of financial instability but it is not where China is heading today.

1. Total births in 1987 were 28mm, they were ~10mm last year. China could triple college graduation rates and still have only the same number of graduates in 22 years from now. https://vizhub.healthdata.org/population-forecast/