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The Global Reverb of China and India

Call it a global twofer. Financial markets have lately recognized that the emerging economies of China and India are boosting global growth, while at the same time helping keep inflation contained in economies around the world. Globalization, through growing imports and outsourcing, is seen as one factor behind inflation and wage growth remaining low in places such as the U.S. As former Federal Reserve Chairman Alan Greenspan once observed, the integration of China and India (along with the former Soviet Union) into world markets would "approximately double the overall supply of labor."

A second, related dimension of this phenomenon has become apparent. The "pass-through" to core inflation around the globe from the run-up in global energy prices has been limited -- in stark contrast to the effects of earlier spikes in crude-oil and natural gas prices. Of course, we shouldn't forget another side to the equation: demand. The surging demand from China and India has contributed to the jump in energy and other commodity prices.

SOARING EXPORTS. But are these trends sustainable? The answer has ramifications for global debt and equity markets. If central bankers believe that growing imports and outsourcing can keep a lid on wages and prices, then they can leave interest rates lower than they otherwise would.

If markets remain confident about the ability to control inflation, this could help sustain the curious flat or inverted yield curve evident today in many countries. If the world can sustain the recent stepped-up pace of growth, this should help support equity markets around the globe.

There's no mistaking the growing presence of China and India on the world scene, together contributing just over a third of total global GDP growth in the past couple of years. As a reflection of 10% annual GDP growth, China saw merchandise exports soar 28.3% in 2005 from the prior year, after better-than 30% growth in the previous two years.

MAJOR PARTNERS. Its status as a major player in many global-product markets is underscored by other countries' data, showing China already neck-and-neck with Mexico in 2005 as the second-biggest trading partner of the U.S. (after Canada). The Middle Kingdom was also the EU's second-biggest trading partner (after the U.S.) in 2004. If Hong Kong is included, China would have been Japan's biggest trading partner in 2004.

India remains a lesser factor in merchandise trade, where its infrastructure shortcomings are more of a handicap. However, it has been able to take advantage of telecommunications advances and its citizens' proficiency in English, to play a bigger role in the outsourcing of services.

Can these emerging giants sustain their dramatic growth, in particular the exports of goods and services, with a restraining impact on global prices? Will they encounter capacity constraints? In both countries, the impressive growth in output is being driven by productivity, helped by a combination of absorbing world technology, along with market reforms and the shift from traditionally rural regions to newly industrializing urban locations.

ROOM TO GROW. Those factors have carried through to key economic measures. China claimed per-capita income growth averaging 8.2% during the 20 years through 2001, with the latest annual data for 2004 showing a year-over-year real increase of 6.8% for rural households, and 7.7% for urban households. This superior performance primarily represents a basic "catch-up" after years of isolation. By all indications, the process should have more than another decade to play out. Data -- admittedly sketchy -- suggest per-capita income, even in the more-developed Chinese coastal provinces, is still only about half of that in Malaysia, and closer to 15% of Taiwan (let alone Hong Kong).

The absorption of new technology is being facilitated by large-scale foreign direct investment (FDI), which in China totaled $60.3 billion in 2005. This was a slight decline of 0.5% from 2004's record level (FDI posted an eye-opening 13% gain in 2004). Foreign-invested companies have fueled the export boom, accounting for about 60% of foreign trade. In particular, outfits from the U.S., Europe, Japan, South Korea, and Taiwan have been shifting much of their low-end assembly to China.

Foreign investment in labor-intensive export manufacturing should continue, though growth can be expected to slow, particularly as China tolerates gradual appreciation of its currency, leading multinationals to seek even cheaper sources of labor in countries such as Bangladesh and Vietnam. However, the domestic market represented by the Chinese population of 1.3 billion will continue to attract growing foreign investment, likely increasingly in the services sector.

COMMODITY PRICE PRESSURES. Further contributing to the growth in average productivity has been the ongoing migration from rural regions to the more-industrialized urban locations. In China, this has happened primarily in coastal provinces, where per-capita income has consistently averaged about three times that in rural regions. Data suggest that a labor shortage will not prevent continuation of the robust economic growth of the past two decades. The urban-registered unemployment rate (available annually) stood at 4.2% in 2004, 0.1% lower than in 2003, with an annual increase of 9.8 million jobs for urban residents.

A similar process is apparently at work on a more modest scale in India, where per-capita GDP growth averaged 3.6% annually during 1980-2001, much of it during the second decade. According to the 2001 census, the ratio of urban-to-rural per-capita income has remained around 1.5 to 1.6 since the 1980s, with the urban population share rising from 23% in 1981 to 28% in 2001.

The discussion is hardly complete without acknowledging the other side of the coin -- growth in China and India is also generating increasing demand on global markets, in particular for commodities. These two economies helped boost world economic growth to 5% in 2004 -- its fastest pace in decades, according to the IMF. Our estimate is of 4.6% growth in 2005 and 2006, tying the third highest reading in data back to 1984. Thus, it's no coincidence that world commodity prices have risen. Prices for metals such as copper, lead, and zinc are all hitting record highs.

THIRST FOR OIL. Most notably, crude-oil and coal prices soared in 2005, as China has emerged as the world's second-largest consumer of oil after the U.S. It's the largest consumer of coal, with power plants burning increasing amounts. In 2004, it was the third-largest oil importer (after only becoming a net importer in 1994), while India was the sixth-largest consumer and ninth-largest importer. China's oil consumption has doubled since the start of the decade, according to the International Energy Agency. This level has accounted for 40% of the global increase in demand.

Chinese and Indian growth has, therefore, played a role in both the run-up in global energy prices in recent years as well as the observed restraint in product prices on world markets. This impact helps to explain the widened gap between overall consumer price index and core CPI increases in many countries.

Considering sustainability, it appears that the underlying process has more than a few years left to play out -- even if the true trajectory is likely to be far more bumpy than the remarkably smooth growth suggested by the available Chinese data.

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