China’s changing demographics will dramatically impact the world economy

The International Monetary Fund (IMF) just released a fascinating paper entitled “Chronicle of a Decline Foretold: Has China Reached the Lewis Turning Point?” The paper explains that Chinese population controls will cause the number of Chinese working adults to peak between 2020 and 2025.  At this point, a “precipitous” drop of working age population will occur, which in turn will create a labor shortage in China.

The IMF paper summarizes its findings as follows:

“China is on the eve of a demographic shift that will have profound consequences on its economic and social landscape. Within a few years the working age population will reach a historical peak, and then begin a precipitous decline. This fact, along with anecdotes of rapidly rising migrant wages and episodic labor shortages, has raised questions about whether China is poised to cross the Lewis Turning Point, a point at which it would move from a vast supply of low-cost workers to a labor shortage economy. Crossing this threshold will have far-reaching implications for both China and the rest of the world.”

The “Lewis Turning Point” in the paper’s title and the preceding paragraph refers to 1979 Nobel laureate W. Arthur Lewis. The IMF paper summarizes this concept as follows:

“China’s large pool of surplus rural labor has played a key role in maintaining low inflation and supporting China’s extensive growth model. In many ways, China’s economic development echoes Sir Arthur Lewis’ model, which argues that in an economy with excess labor in a low productivity sector (agriculture in China’s case), wage increases in the industrial sector are limited by wages in agriculture, as labor moves from the farms to industry (Lewis, 1954). Productivity gains in the industrial sector, achieved through more investment, raise employment in the industrial sector and the overall economy. Productivity running ahead of wages in the industrial sector makes the industrial sector more profitable than if the economy was at full employment and promotes higher investment. As agriculture surplus labor is exhausted, industrial wages rise faster, industrial profits are squeezed, and investment falls. At that point, the economy is said to have crossed the Lewis Turning Point”

With a limited labor supply, the Chinese will be motivated to invest in greater amounts of labor-saving equipment and machinery, much as the rest of the world’s developed countries have already done. Future growth of the Chinese economy would then change to depend upon increased capital investment and increased consumer spending. This is a change from recent past economic growth, which primarily occurred through increased manufacturing capacity driven by cheap labor from its population moving away from agrarian production.

This affects the entire world, which has come to depend upon Chinese cheap-labor exports for certain manufactured goods. Productive areas with competing cheap labor will become more important to world production, with an overall price increase in those (largely Western) nations that import/consume these less expensive goods.

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