Barry Gill
Head of Investments

Barry: The inflation benefit from China – is this coming to an end?
Manoj: In one word, yes. Over the last 30-35 years, there was a shift in production from advanced economies to emerging market economies, particularly China, and there was a consequential shock to global real wages and global inflation. China effectively set the global equilibrium wage and wages in higher-wage economies drifted lower, towards the global equilibrium. This process ended up lowering inflation regardless of what else was going on in the global economy: as Mervyn King – former Governor of the Bank of England – once called them, these were the ‘NICE’ years: Non-Inflationary, Constant Expansion.

However, now things have changed. With a shrinking workforce, China can no longer have the deflationary impact it once had. In addition, we are now hearing more talk of ‘re-shoring’ for geopolitical reasons – moving production back to home markets, which is inflationary.

As we get more siloed economies, they become subject to their own local demographic constraints. And given workforces globally are shrinking, we are entering a period which will likely be in sharp contrast to the previous 30 years where demographics brought inflation down.

Barry: Why don’t investors focus on demographics as much as they should?
Manoj: The problem is two-fold. Firstly, it’s a slow-moving, glacial process. Of course investors are aware that demographics are important - no-one thinks it’s a trivial matter - but it’s something that we think of as happening in 15, 20 years’ time. But we have been at a structural inflection point for quite some time: China’s shrinking population was the beginning, but globally, now the entire manufacturing complex is getting old and the shrinking of the global labor supply has been aggravated by the pandemic. That means we have gone from decades of positive labor supply effects to an end of those positive influences just as the world has gone through some tumultuous changes. Perhaps that’s why we haven’t paid as much attention to them.

Secondly, the reason that financial institutions such as central banks don’t focus on demographics is, how do you put this in a forecasting model? On a two-year time horizon, the change in population will not be enough to impact models; you’d need a mix of a structural and cyclical models. It’s an incredibly hard process to express numerically.

Barry: Is inflation the most palatable solution to the current high debt balances?
Manoj: There are a variety of ‘solutions’. We could grow out of it, but a shrinking workforce means relatively modest growth (since growth is equal to the growth rate of the labor force plus productivity) which will not be sufficient. Productivity will improve but we would be lucky to do better than Japan, which again will not be enough to finance debt.

Then there’s taxation. But no matter how economically sensible the tax is, taxation is never an easy political solution. Thus, trying to use what would otherwise be considered to be sensible economic strategies – increasing productivity, raising taxes, raising retirement ages – are all politically difficult options. Inflation becomes a more acceptable and politically convenient solution.

While we can’t allow 8%, 10% inflation to persist, more modest inflation, say in the 3%-4% range, and you can whittle down the real burden of debt over a period of time. There’s a reason Milton Friedman called it “taxation without legislation”. I think it’s the best we can do.

Barry: Why is Japan a poor model to assess demographic changes?
Manoj: We didn’t start writing the book until we had answered that question. We have an entire chapter dedicated to Japan in our book and it is the first chapter we wrote.

We often hear people say that Japan is the blueprint for the future. However, what we argue is that the change in Japan’s demography turned at a time when the world was swimming in labor.

Looking at three decades of data from Japan’s Ministry of Economy, Trade and Industry, showed that the Japanese corporate sector understood what was going on with global demography much better than we realize. Japan’s corporates understood that China’s integration into the global economic system was not only a massive new market, but also a massive labor supply shock, which was too big to ignore given the problems Japan had at home. Japan Inc. used outbound foreign direct investment (O-FDI) as an ‘escape valve’. They produced in China and other emerging market economies to take advantage of cheap and abundant labor there. They kept high-skilled roles at home and exported as many lower-skilled jobs abroad as possible.

People often point to Japan’s debt as an unique story, but that isn’t true either. Japan’s debt dynamics look very much like other countries: interest rates fell persistently; as a result the debt service ratio fell too, which allowed the debt/GDP ratio to rise dramatically. In a nutshell, Japan ‘happened’ when China was curing all ills. Today, there’s nowhere to hide.

Barry: The dependency ratio (working vs. non-working population) is going up across the world. What are the implications for productivity?
Manoj: Let’s consider workers and non-workers. Non-workers consume but don’t add to supply. On a net basis they tend to be inflationary. The worker, on the other hand, produces a certain amount of supply and out of that supply, the worker is paid a wage that is less than his or her marginal product. Out of that wage, the worker has to save for the future. The gap between the marginal product of labor and what the worker finally ends up consuming is therefore quite disinflationary as the worker produces far more than he or she is consuming. In the last 30 years, while you had this huge surge of labor from China, the dependency ratio was also falling as the baby boomers joined the workforce. Worker numbers grew faster than non-workers and the result was a disinflationary impulse.

Today, as the number of workers continues to fall, the number of elderly is expected to rise. Dependency ratios are rising quite dramatically as a result. As the consumption of the elderly moves into ageing-specific services, this is something that will have to be at least partly financed by governments. The resulting debt numbers we are going to see in the future are enormous. The US Congressional Budget Office ’s1 projections suggest that debt incurred during the pandemic is only going to be a small proportion of the debt we are going to incur over the next three decades.

Financing that debt is going to require a significant amount of inflation to deem it sustainable. So the process of inflation becomes a political story.

Productivity dynamics are inherently intertwined with the ageing process. Without productivity, the sustainability of debt will be seriously undermined – no one wants to own an IOU that is financed purely by inflation. Thankfully there is good news on the productivity front. Once you have a shortage of workers, the private sector is going to try to protect profits by reducing the labor footprint and boosting productivity via capex.

But there will be a limit to what it can achieve. The best-performing country in the last 30 years is Japan. Japan’s output per worker has gone up quite significantly to protect profits, yet we don’t consider them to be a paragon of productivity. It’s nowhere close to what we will need to fight demographic headwinds, but it is a welcome dynamic nevertheless.

About the author
  • Barry Gill

    Head of Investments

    Barry Gill, Head of Investments at UBS Asset Management since Nov. 2019. Previously, he was Head of Active Equities at UBS AM. Barry joined O'Connor in 2012, overseeing long/short strategy. Prior to that, he led UBS IB's Fundamental Investment Group (Americas). In 2000, Barry relocated to the US, rebuilding Equities' long/short efforts post-O'Connor. He held leadership roles in London, including co-heading Pan-European Sector Trading. Barry started his career as a graduate trainee at SBC in '95.

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