The Chinese and Indian Economies and Their Mid Term Impact on Raw Material
Demand
Thomas R. DeGregori, Ph.D., professor of economics, University of Houston

Presentation given at the LNG EPC Construction Management & Construction
Costs: Trends and Issues Seminar, Houston, Texas,  August 11.

The 1997-1998 financial crisis and its after effects are clearly a thing of
the past. Though more uneven than before the crisis, economic expansion has
resumed throughout Asia. Now it is being led by China and to a lesser
extent India. This reflects a significant shift in the underlying structure
of Asian economic activity towards greater regional economic
interdependence. Even before the 1997 crisis, intra-regional trade had
begun to exceed trade with the U.S. and Europe. The post-crisis era has
accelerated this trend. Generally export growth directly to the United
States and Europe from the Southeast Asia economies has been flat during
the recovery period.

Export growth to China has been driving the expansion of the Southeast
Asian economies. This includes exports to China for domestic consumption,
exports of components for assembly and re-export and to some degree,
exports of raw materials. In the case of Taiwan, there was a significant
movement of production to mainland China with a loss of jobs which recently
have been partially recovered by the growth in managerial positions as the
overseas export production expands. The de facto economic integration in
East Asia has been complemented by more formal attempts at monetary and
trade integration with China playing a leading role (though not necessarily
an initiating role) giving it regional influence that it has not had since
European penetration of the region.

2004 for was a year of spectacular double-digit export growth (20% or
better) for the Southeast Asian Tigers - Malaysia, Singapore and Thailand.
The rate of export growth dramatically slowed in the 1st quarter of 2005
but still remained positive raising the question as to whether this was
merely a pause in an expansionary phase or the beginning of a slowdown or
even contraction that might be exacerbated by restrictions on exports from
China whose content is largely (often 90% in electronic goods) from the
Southeast Asian economies.

China has very skillfully used its capital account surpluses and its
increasing demand for raw materials to enhance its diplomatic and political
imprint in Central Asia, elsewhere in Asia such as Australia and South
America.

China's impact on these regions both in terms of the rising physical volume
of raw commodities and the increase in their price has widely recognized
and greatly appreciated. Chinese dignitaries are welcomed with great pomp
and incidents that previously would have been disruptive, such as claims of
an extensive spy network in Australia are simply glossed over and ignored.
China's President or Prime Minister often arrives with promises of major
investments. Unlike the U.S., these countries welcome China's investments.

Even with the alleged expansion of its military (whose budget is
undoubtedly greater than officially given but less than some outsiders
claim), China's power and influence in the world will remain the "soft
power" of diplomacy arising out of beneficial trade relations. I believe
that it is fair to say that these are very important to China so that China
will do what ever is necessary to sustain its economic ties that give it so
much prestige and diplomatic influence.

There are clearly dark clouds on the horizon but there still is some basis
to believe that this massive economy will continue to grow at a slower but
still brisk pace as it has over the past few years, thereby consuming raw
materials, construction capacity and energy. In spite of talk about China
trying to "cool" the economy, actions that it has taken in tightening
credit have only marginally slowed the economy. Even though there is some
minor evidence of inflationary pressures, it is not a cause for great
concern and not sufficient to require any significant slowing of economic
activity. There are any numbers of political and economic forces driving
continued expansion of the economy. China's foreign capital holdings allow
for expansion of domestic investment and consumption to offset any
slackening of external sales. Neither internal forces nor loss of
international competitive advantage is likely to bring China's expansion to
a halt. Any significant slowdown in the Chinese economy is likely to be as
a result of external factors. These potential factors include severe
protectionist responses from the U.S. or even the internal and external
debt correction in the United States that is often forecast but has yet to
materialize. Forces for sustaining China's expansion are:

1 - The growing regional inequalities in China are a cause of great concern
giving rise to a $135 billion infrastructure project for the poorer
interior regions. Benefits are more than political as anyone traveling
about in China can observe the dramatic transformation of rural areas (and
the exports that they generate) along rail lines and elsewhere where there
is adequate infra-structure. Rural infrastructure needs throughout China
will have to address issues of reforestation, de-desertification and water
and soil conservation.

2 - China has lost over 13 million jobs from the closing or downsizing of
obsolete industries and there are more industries that need to be closed.
Without economic expansion to absorb these redundant workers, there is
certain to be political problems. One can reasonably expect that China will
use some of its cumulative capital resources to address this problem should
there be any major slowdown in expansion.

3 - Environmental concerns such as air quality means that China will have
to moderate its dependence on coal and shift to greater use of LNG.

4 ­ Higher oil prices are beginning to have a negative impact upon China's
economy. China has a number of options beginning with improved energy
efficiency in both exploration and use which should have been a high
priority even when prices were lower. China's commitment to WTO requires
its domestic market for refined petroleum products to be opened by the end
of 2006. China's active seeking out of energy sources which the CNOCC bid
for Unocal was only one minor indicator, shows that it is serious about
securing adequate energy supplies.

5 - China is making significant investments in a variety of research areas
which is just one of several indicators that China plans to move up the
technology ladder in its production both for exports and domestic
consumption. To do so will require continued economic expansion.

6 - In spite of China's one child policy, "demographic momentum" will
result in a population expansion of 200 million or more over coming decades
requiring continued expansion to accommodate them.

In India, the Congress Party is well aware of the fact that rapid economic
growth alone does not assure one of remaining in office as they ousted an
incumbent party that was presiding over an economy ("India shining")
growing at 9% a year. The Congress Party coalition came to power on the
promise that they would spread the benefits of this economic growth by
engaging in a program of rural infra-structure development - roads, rail
and irrigation. Given the left-of-center partners in the Congress Party
coalition, the government will have more reasons than just future electoral
success to follow through on its commitment.

India is also continuing the policies of promoting foreign investments in
resource using industries such as automobiles. Needless to say, investment
in IT (including Indian investment in IT in China) continues as India seeks
to be dominant force in this arena.

The long term question is not whether the demand for commodities will be
sustained even with the inevitable fluctuations in the economy. The real
issue is whether there are serious constraints that will complicate this
expansion and drive up prices. For most raw commodities, the likelihood is
that given time, expansion in output will not only catch-up with demand, it
may even surpass it as it too often has done in the past. Resource
producing countries such as Australia are making major investments in
production capability which is often augmented by Chinese firms seeking to
be involved in resource exploration and development. For the investor
seeking to use raw materials in construction or production, it is not
whether prices will moderate in the long run but rather how long prices
will remain high and how far they will fall when the correction occurs.

For those in this audience making investment decisions about trying to
build LNG infrastructure costing $1.0 billion per facility, the
construction cost data presented by others in this seminar are likely to
prevail over the next few years as expanded use is likely to continue and
it will take time for the expanded raw commodity capability to come online.
One exception could be steel. Getting data on capital construction in China
is not easy but there is some evidence that there is considerable steel
making capacity in China under construction that might be able to more than
accommodate their expansionary needs. Speculation is that China may produce
a surplus of steel is just that speculation. Even though the evidence is
strong that there is considerable capacity under construction, trying to
convert this into hard numbers and net production capability is not
possible at this time as China still has production capability that should
be scrapped. And China remains the world's largest importer of steel as
well as its largest producer. And it will soon pass the U.S. in consumption
of steel as it has already done so in other metals.

As an economist I would like nothing more than to give an audience of
decision makers (whether in the private or public sector) the kind of
numbers and forecasts that could be used in making investment or other
decisions. Unfortunately, such calculations at this time would be spurious
as there are too many variables on the horizon. It is best for me to leave
it to others on the program who are following specific resource prices on a
day-today basis.

China's currency revaluation of the Yuan against the dollar is unlikely to
have a major effect on resource prices. It is most likely aimed at slowing
the anti-China protectionist momentum in the U.S. Congress. Since resources
are often priced in U.S. dollars, the revaluation does lower raw material
costs for the China relative to buyers using dollars? If the intended
revaluation or at least the intention of those pressuring China to revalue
is to slow the growth of China's exports then the lower price of resources
to China would be largely offset by a decrease in demand for them by China
and by the Southeast Asian economies whose exports pass through China for
final assembly. Of course, there could be a greater offset both in China
and in Southeast Asia if they take advantage of the lower resource costs to
promote domestic infra-structure development. In my judgment, the current
roughly 2.1% revaluation is unlikely to make much difference either way,
except possibly to put the squeeze on marginal exporters in China.

Given that this is a managed revaluation however much one may talk about a
float, it is not clear how much further revaluation China will allow. Given
that they hold over 600 hundred billion in U.S. notes, the initial
evaluation has already cost them over $12 billion loss in depreciated value
of their holdings. How many of us who bought notes would appreciate it if
those who issued them asked us to unilaterally make a major reduction in
their value. There are clearly limits to how far China will allow
revaluation to proceed without taking other actions such as switching out
of dollar holdings at a rate that does not precipitate a dramatic fall in
value. Even using their surpluses to buy other currencies or make other
investments could hurt the U.S. economy far more than any presumed gain in
the U.S. balance of trade.

More important to the issues under consideration is not what happens in
China but what happens in the U.S., particularly the U.S. Congress. No
reputable economist believes that a Yuan revaluation, even one larger than
that already taken, is going to bring lost jobs back home. Textile exports
that China loses would likely be picked up by Bangladesh, Cambodia and
Vietnam among others. In fact, African countries that have seen their AGOA
textile mills close with the ending of the Multi-fiber Agreement, are
unlikely to have any of them re-open. In any number of areas, Vietnam is
beginning to challenge China on exports and is ready to try to take
advantage of any opening in export markets. The best that one can expect
for the U.S. economy is to slow the outsourcing of production in areas such
as electronics which would have the ironic effect of hurting Southeast
Asian economies more than it would hurt China. Most estimates are that the
revaluation would close the deficit gap by only about $10 to $12 billion
which is next to nothing. Should Congress be dissatisfied with this outcome
and seek to force more restrictive protectionist measures, we could be in a
trade war with dire consequences for the U.S. and world economy. Such an
outcome would undoubtedly lead to lower resource prices from circumstances
which nobody desires.

Even apart from protectionist moves by the U.S., there still is the
question of both U.S. and China working their way out of China's financing
our twin deficits and engineering a "soft landing." As the late Herb Stein
used to say ­ that which can't go on forever, will have to stop someday" ­
and our current and continuing deficits can not continue indefinitely nor
can we expect China to finance them indefinitely if we are successful in
limiting their exports to us. Most everyone has seen the various scenarios
on trying to transition from our current situation. All involve an increase
in interest rates beyond the measured increases currently being carried out
by the Fed and a slowdown in the U.S. economy. Any slowdown in the U.S.
economy would result in reduced imports from Asia slowing their economies
(subject to the qualifications given above) taking the edge off the
commodities price boom. China with its large capital balances and its
internal unmet infra-structure needs would be better able to negotiate a
soft landing than either the U.S. or other Asian economies except possibly
India.


  What are the likely scenarios for Chinese and Indian growth for the next
five years?  Can we expect a correction?

Overall, I am foreseeing continued growth in both the Chinese and Indian
economies though at a slower pace. Their demand for resources should
continue strong. Predicting commodity prices remains tricky but I see a
least a three year horizon for investments in commodity extractions to
begin to have an impact upon prices would not be surprised at a five year
horizon. This becomes moot if there is any significant correction in the
U.S. economy in trying to navigate out of the twin deficits. I am decidedly
pessimistic about this issue but the reader or listener could have
different interpretations of the data. With the 1st of the baby boomers
turning 65 in the next five years, some actions will have to be taken to
start initiating a change otherwise we will be just digging ourselves
deeper in the deficit/debt hole.

Of course, this would also affect energy prices.

For awhile, increases in energy prices were higher than raw material
prices; might we see that day again?

The short answer here is yes because in the long run most material
resources are quite abundant needing only the infra-structure investment to
make them available and to drive down their costs. Energy resources may be
more difficult to expand and there fore continue to command a premium but
not necessarily at current levels as there are elements of political risk
and uncertainty built into today's prices. The longer answer concerns the
time frame in which this all plays out and for a five year horizon, there
are to many uncertainties for a macro-economist to provide a definitive
answer, long or short.