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Inflection Point

ECONOMICS & STRATEGY

May 2012 Sustained US Income Inequality Forces Asia to Boost Domestic Demand
While US retail sales have been robust in recent months, trend growth in household consumption will be depressed by stagnant median incomes and record inequality, with profound implications for the Asian export model. According to the latest OECD report on inequality, the average income of the richest 10% of households in the US is 14x that of the poorest 10%, the highest among developed Western economies. The 2.7 million American households earning more than $250k a year have an estimated $23.3 trillion in assets while the ratio of corporate profits to wages and salaries has increased steadily since 2000 in the US to hit all-time highs, on the back of record price mark-ups over unit labour costs. In a world of stagnating DM mass market consumer demand, it will be impossible for Asia to replicate the mercantilist policies that fuelled export led growth over the past 15-20 years, and the process of rebalancing demand towards the domestic non-tradable sectors via faster household income growth is now underway. Key Points
Consumption accounted for 77% of US real GDP growth while household debt nearly doubled to $13.8 trillion, equivalent to 138% of disposable income or 98% of GDP between 2003 and 2007. American homeowners extracted $2.2 trillion from their homes during this period, a source of economic stimulus that cannot be repeated and more than twice the magnitude of recent fiscal stimulus.. Median US pay fell in 2010 to its lowest level in over a decade while the Congressional Budget Office estimates that 45m Americans or 1 in 7 of the population received Food Stamps last year, a 70% increase from 2007, and forecast that this number would continue growing until at least 2014. The top 1% of households captured 65% of Bush-era aggregate income growth and 93% of Obama-era growth (through 2010). Between 1979 and 2007, the top 1% of US households saw income growth of 275%, and accounted for nearly 20% of total pre-tax income by the start of the financial crisis. By comparison, the bottom 20% had real earned incomes in 2010 that were lower than in 1973. In the first quarter of 2012, the bottom 10% of the work force earned $360 or less a week. Between the end of the recession in mid-2009 and Q1 2012, earnings of Americans in the top income decile rose 7% in nominal terms, versus just 2.5% for the bottom decile. Unless we see a major and very unlikely policy shift say to tax income from capital gains/raise the minimum wage, these inequality trends leave the bottom 40% of American households with limited if any discretionary spending power. The US Congress last increased the minimum to $7.25 an hour in 2009, or $15,080 a year. That amount, when adjusted for inflation, is actually lower than what a minimum-wage worker earned in 1968 and too low to allow even a full time worker to afford basic goods and services. Remarkably, in 2010, nearly 44% of minimum-wage workers had either attended or graduated from college, up from 25% in 1979. To absorb surplus export capacity as DM demand growth remains depressed, Asia will be forced to broaden domestic consumption patterns via accelerating minimum wage levels, more progressive tax systems and greater welfare provision, particularly for healthcare and education. These changes have the added benefit of strengthening social cohesion and sustaining political legitimacy for local elites. A precedent has been set by Brazil (and is now being copied from Mexico to the Philippines) where between 2003 and 2009, the poorest saw income gains 9x higher than for the richest, while the poverty rate fell from 22% to 7%.

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In 2007 23.5% of all American income flowed to the top 1% of earners, their highest share since 1929. In a 2010 paper, economists at the IMF built a model to show how inequality can systematically lead to crisis. Growth in most major OECD economies has boosted household incomes annually on average by 1.9% for the top decile, but only by 1.3% for the bottom decile between 1990 and 2007. Although some developed economies like France have bucked the trend, countries that historically have had more egalitarian systems of income distribution such as Germany have also experienced divergence in income growth, with the richest 10% outpacing the poorest 10% by 1.5 percentage points annually on average. Changes in wages and salaries, which account for 75% of household incomes among working-age adults, have been the biggest driver of the disparity among most countries. Among OECD countries, its ironic that Spain, which faces a brutal round of austerity to rein in a fiscal deficit that reached 8.5% of GDP in 2011, was the one developed country that significantly reversed inequality trends, but largely because of the artificial construction boom in 1997-2007 that soaked up unskilled labour and boosted wage rates.

Top 1% Income Share a Defining Political Issue

Source: OECD

A raft of new rew research hints at ways in which inequality can precipitate financial instability. Economists at the University of Chicago studied patterns of spending across American states between 1980 and 2008. In particular, they focus on how changes in the behaviour of the richest 20% of households affect the spending choices of the bottom 80%. They find that a rise in the level of consumption of rich households leads to more spending (on credit) by the rest. This trickle-down consumption appears to result from a desire to keep up with the Joneses. Nonrich households spend more on luxury goods and services supplied to their more affluent neighbours, running down savings and leaving themselves financially vulnerable to shocks. The model posits that an investor class may become better at capturing the returns to production, slowing wage growth and raising inequality. Workers then borrow to prop up their consumption. Leverage grows until crisis results. Prof. Robert Frank at Columbia University also writes about this phenomenon, where income inequality drives households to continue consuming regardless of whether they can afford it. In 2010, the bottom 20% of households by income spent more than twice their after-tax earned income, thanks to transfer welfare payments, which are coming under increasing scrutiny as fiscal austerity looms in the US next year.

Inflection Point

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May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

Income Inequality Has Trended Higher Globally

Source: OECD

The explosive growth in technology use across all sectors (including manufacturing) has disproportionately benefited high-earning workers, who also spend far longer at work than do low-earners. Prof. Raghuram Rajan of the University of Chicago has argued that rising inequality was a contributing cause of the global financial crisis. From the early 1980s the wages of working Americans without university education fell ever farther behind those of graduates. Under pressure to respond to the problem of stagnating income, US politicians opened a flood of mortgage credit. In 1992 the government reduced capital requirements at Fannie Mae and Freddie Mac and in the 1990s the Federal Housing Administration expanded its loan guarantees to cover bigger mortgages with smaller down-payments. Finally, pre-crisis, Fannie and Freddie were encouraged to buy more subprime mortgage-backed securities. Other economists have noted that inequality also soared in the years before the Depression of the 1930s, alongside a consumer credit boom unsurpassed until the 2003-7 period, contributing to macro instability. Between 1979 and 2007, the top 1% of US households saw income growth of 275%, and accounted for nearly 20% of total pre-tax income by the start of the crisis. By comparison, the bottom 20% had real incomes in 2010 that were lower than in 1973. Taxes and government transfers help to mitigate inequality, but have declined over the same period the OECD reports that top rates of personal income tax were around 60-70% in the major economies in the 1980s, but dropped to an average of approximately 40% by the late 2000s. In the US, the overall average federal tax rate was 22% in 1979, rose through the 1980s and 1990s to peak at 23% in 2000 before dropping to 20% in 2007 as a result of the recession and tax legislation.

US Housing Bubble Offset Depressed Earned Incomes Until 2008

Source: US Census Bureau

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May 2012

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Research by economists at Cornell University has suggested that income growth for lower to middle class American households may not be as dismal as the Census Bureau numbers suggest by their measure, the bottom 20% of American households did experience real income growth of 2.2% between 2000 and 2007, after adjusting for household size, tax effects and the value of healthcare insurance provided by employers or by the government. However, a closer look at the numbers reveals that the source of that income growth has come mostly from the adjustment from the provision of healthcare insurance the poorest 20% of households gained an additional 7 percentage points of income growth over the period when healthcare was taken into account, but that is not discretionary income that can be spent on Asian merchandise exports.

Including Healthcare Benefits Boosts Bottom 40% Income, But Dubious


Pre-tax Post-transfer Bottom 20% Second 20% Third 20% Fourth 20% Top 20% -5.8% -3.9% -2.0% -0.1% -1.4% Household Size Adjusted -6.2% -2.9% -0.4% 1.0% -1.0% Post-Tax Adjusted -4.8% -1.2% 1.2% 2.3% 1.5% Healthcare Adjusted 2.2% 4.7% 4.9% 5.2% 3.1%

Source: Burkhauser, Larrimore & Simon (2011) 2000-2007 data

This income growth from a higher valuation of existing healthcare provisions misleadingly suggests that soaring healthcare costs have added to the real incomes of households. Although the income data was supposedly treated for inflation, healthcare inflation has far exceeded inflation in the rest of the rest of the economy, meaning that deflating by CPI as was done will not be sufficient. Looking at the size-adjusted post-tax income, which is a better guide for consumer purchasing power, the poorest 20% of American households saw a 4.8% contraction in their incomes between 2000 and 2007, while the second 20% saw a drop of 1.2%. The numbers for the top two quintiles of income supposedly growing at a modest 2.3% and 1.5% over the 2000-2007 period are also underrated. Capital gains form a significant portion of income for the wealthiest individuals, but are not included in most datasets used for the calculation of income inequality. The most commonly used dataset is the Census Bureaus Current Population Survey, and excludes capital gains. Furthermore, capital gains do not count as personal income and therefore are taxed at a top tax rate of 15%, lower than that for personal income, making its exclusion particularly noteworthy. As of 2007, 50.9% of US stock, bond and mutual fund ownership belonged to the wealthiest 1% of individuals, while only 0.5% belonged to the bottom 50% of individuals by income, producing a tax structure that is significantly more regressive than the personal income tax structure implies.

US Real Minimum Wage Pegged at 40 Year Lows, as Those in Asia Surge


The US Congress last increased the minimum wage in stages from 2007, topping it out at $7.25 an hour in 2009, or $15,080 a year. That amount, when adjusted for inflation, is actually lower than what a minimum-wage worker earned in 1968 and is too low to allow even a full time worker to afford basic goods and services, let alone discretionary spending. If the Federal minimum wage kept pace with inflation over the last 30 odd years, it would be almost $11/hour now...$9.80 is a pittance. About 10 states are now considering raising the rate, and some Democratic Senators are proposing to increase the federal rate in three increments to $9.80 an hour in 2014 and then tie the minimum wage to the cost of living. Although wages often lag job growth after a recession, the pace of income gains this time around is far slower than in previous recoveries.

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May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

Incomes Stagnant for Bottom 20% of US Households

Source: BLS, Fed

In many cases, minimum-wage work is all thats available, which may explain why such workers are older and better-educated than they were three decades ago. In 2010, nearly 44% of minimum-wage workers had either attended or graduated from college, up from 25.2% in 1979, according to the Centre for Economic and Policy Research. A wave of new economic research is disproving those arguments about job losses and youth employment. The new research looks at micro-level employment patterns for a more accurate employment picture. The studies find minimum-wage increases even provide a small net economic boost, as low income workers immediately spend their raises. A 2011 paper by economists at the Federal Reserve Bank of Chicago found that a $1 minimum-wage increase lifts household income by about $250 and increases spending by about $700 a quarter in the following year.

Margin Over Unit Labout Cost Soars Since 2000

Source: BEA, BLS

Inflection Point

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May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

The ratio of corporate profits to wages and salaries has increased steadily since 2000 to hit all-time highs on the back of increasing mark-ups on prices over unit labour cost. Since 2008, firms have been slow to recreate lost jobs unemployment remains above 8%. Instead, they have ramped up investment in software and equipment, which recovered quickly to a peak of 17.6% y/y in 2010 Q2 before moderating to just under 10% in 2011. Hiring costs due to searching, training and legal compliance have made labour less competitive relative to equipment that has been made cheaper by foreign production, allowing owners of capital to reap more gains from productivity at the expense of workers. The US scores worse in inequality terms compared to other OECD countries mainly because Social Security, unemployment insurance, and other cash benefits in the United States contribute much less to income than comparable programs in other countries. Including the value of government-provided health and education benefits makes the United States look even more unequal compared to other developed countries. In this final comparison the US Gini coefficient (30.3) is still worse than number two Portugal (29.1) and far worse than number three Italy (26.2) and all other developed countries. By this last measure, the most equal countries in the world are the usual suspects: Denmark (19.4), Norway (19.3), and Sweden (18.1). If by income you mean all the money that households get from all sources, including both government transfers and capital gains, then the Gini coefficient for the US is probably around 50 (or pretty much Chinese levels), give or take a point.

US Wage Share of GDP at Historic Lows

Source: BEA, BLS

Economists at the University of California at Davis recently studied 14 advanced countries from 1920 to 2008 to test the relationship between inequality, credit booms and economic crises. They discovered a strong relationship between credit booms and financial crises, a result confirmed by many other economic studies. There is no consistent link between income concentration and credit booms, however. Inequality occasionally rises with credit creation, as in America in the late 1920s and during the years before the 2008 crisis. In other cases, such as in Australia and Sweden in the 1980s, credit booms seem to drive inequality rather than the other way around. Elsewhere, as in 1990s Japan, rapid growth in the share of income going to the highest earners coincided with a slump in credit. Rising real incomes and low interest rates reliably lead to credit booms but inequality in and of itself does not. Consumption remained the key engine of US growth over the last two decades accounting for 77% of real GDP growth between 2000 and 2007 but has been supported by consumer credit as real incomes lagged. Between 2000 and 2007, outstanding household debt nearly doubled to $13.8 trillion, equivalent to 138% of disposable income or 98% of GDP

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Falling Debt Service Costs Boosting Consumption Short Term, But Unsustainable

Source: Fed

The 2008 credit crisis may have marked a turning point in consumers attitude towards credit. Weak job prospects are pushing consumers to pay down debts as much as they can outstanding household debt continues to experience negative growth, while debt service payments as a share of disposable personal income have fallen below 11%, the lowest since 1994. Despite a dip in the personal saving rate between 2000 and 2007, real disposable personal income growth has been trending downwards and real personal consumption expenditure growth has followed suit. Between 2004 and 2006, consumers obtained over $1.5 trillion of home equity loans and cash-out refinancing on the back of fast-rising house prices. Over 39% of home equity extraction between 2001 and 2008 was used for home improvement and personal consumption, while another 17% was used to repay non-mortgage consumer debt thereby allowing more credit for consumption.

Home Equity Spending Boost Cannot Be Repeated

Source: Fed

Peaking Educational Attainment Exacerbating US Inequality Trends


Over the past 25 years, inequality has widened at similar rates to the US in many developed countries. The percentage of workers earning less than 2/3 of the median wage has increased from 22% in 1979 to 28% in 2009, a level which compares to 15-20% in Europe and Japan. A quarter of all workers in the US earn $10/hr or less that is about $22K or less, if fully employed on a 40 hour week, versus a national average wage of $23/hr. Massive government transfers to households are not a temporary situation, but something that is going to be consistently
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Inflection Point

May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

required as a greater share of Americans can no longer subsist on wages offered by employers in a high cost of living country. Across countries in the OECD, the income of the richest 10% is on average 9x greater than that of the poorest 10%, compared with 14x more in the US. These disparities are undermining social mobility because parental income is a reliable predictor of childrens income. Rising inequality in America is partly due to the rise of productivity enhancing IT in the service sectors with a supply shortage of workers with the skills to adapt to this structural change in the labour market. The supply of skilled American workers (as measured by a completed third level education) has been relatively flat for about 30 years. In the US, the average number of years of completed schooling has been stuck at roughly 12. The US was once the world leader in secondary-school graduation rates but it now ranks near the bottom of OECD nations on this count. At the university level it is still a leader in attendance but completion rates have fallen behind. Only half of students who begin university ultimately receive a degree. These weaknesses in education are a major cause of widening income inequality. Thirty years ago, full-time workers with a university degree earned 40% more on average than those who had only completed secondary school. In 2010, according to the US Labor Department, the difference was 83%. A postgraduate degree now leads to 300% higher earnings on average. When baby boomers born in 1955 reached age 30, they had about two years more schooling than their parents, according to a Harvard University study economists. In contrast, when Americans born in 1980 turned 30 in 2010, they averaged only about eight months more schooling than their parents. This development already has profound implications in an economy demanding ever higher cognitive skills: those with only a high-school diploma had an 8% unemployment rate in March, roughly double that of college graduates. In todays highly automated factories, many manufacturers demand the equivalent of a community-college degree, even for entry level workers. Among Americans who turned 25 in the 1970s, only 5% had less education than the parent of the same sex. Among those who turned 25 in the 2000s, 18% of men and 13% of women had fewer years of school than their parents. Thirty years ago, the US led the world in the percentage of 25- to 34-year-olds with the equivalent of at least a two-year degree. As of 2009, the U.S. lagged behind 14 other developed countries, on OECD data. The fraction of 25-29 year-old men who had earned four-year degrees began a long slide around 1975 and while the fraction of men in their late 20s with four-year degrees has been climbing since 1994, hitting 27.8% in 2010, that is barely above the late 1970s level, according to the Census Bureau. In 2010, 36% of women in their late 20s had earned at least a bachelors degree, up from 20% in 1976. Men drag down the average, and the net result is that a supply of educated workers is rising much more slowly than apparent demand. The soaring cost of tuition is one factor; over the past decade, for instance, average published tuition and fees at four-year public colleges rose by 72% in real terms to $8,240 from $4,790, adjusted for inflation, according to the College Board, while Ivy League board and tuition fees are typically $50-60k a year. Today, student debt outstanding now exceeds Americans total credit-card debt at about $1trn.

Unemployment Decline Flattered by Surge in Economically Inactive Population

Source: BLS

Inflection Point

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May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

The top 1% of earners got 93% of all growth in after-tax personal income in 2010. That reflects, among other things, low effective tax rates for much of this group, which are largely explained by the high percentage of their income that consists of capital gains and dividends. Undoubtedly, there is a strong case for deep tax reform. With the personal tax cuts introduced in 2001 and 2003 expiring in December, there is a golden opportunity to do this next year. In 2010, 93% of the income gains went to the richest 1% of households. No one below the richest 10 per cent saw any gain at all. In fact, most of the bottom 90 per cent lost ground. Their average adjusted gross income was $29,840 in 2010. Thats down $127 from 2009 and down $4,843 from 2000 in real terms. Meanwhile, employer-provided benefits continue to decline among the bottom 90%; the share of people with ever soaring health insurance from their employers dropped from almost 60% in 2007 to 55.3% in 2010, according to the Commerce Department. And the share of private-sector workers with retirement plans dropped from 42% in 2007 to 39.5% in 2010. The value of financial assets held by American households increased by $1.46tn in the fourth quarter of 2011; since 90% of those financial assets are owned by the richest 10% and 38% by the top 1%, the wealth effect of a rebounding equity market boosts sales at Tiffanys, not Wal-Mart, and retail sales growth has been driven in the US (as in Asia) by the luxury segment. For the bottom 90%, their biggest asset is their home and home prices are down over a third from their 2006 peak and still dropping, albeit at a moderating pace. An estimated one in three homeowners with a mortgage are now in negative equity. The top 1% got 45% of Clinton-era economic growth and 65% of economic growth during the Bush era. So far in the Obama recovery, the top 1% has accounted for 93% of income gains, exacerbating underlying inequality trends, which played a key role on both the supply and demand sides in driving the bubble and subsequent chaos in US credit markets.

US Savings Rate Depressed by Weak Income Growth

Source: BLS. BEA

Does Brazil Offer a Mass Consumption Template for Emerging Asia?


To some extent; in Brazil, household consumption has been spurred by a conditional cash transfer to the poorest households that has expanded the middle class. Between 2003 and 2009, the poorest in Brazil recorded income gains 9 times higher than that for the richest, while the poverty rate fell from 22% to 7%. The Bolsa Familia cash transfer program in Brazil only costs 0.4% of GDP annually, and recent IMF analysis on China and Korea argues that a comprehensive minimum social safety net can be provided at relatively low cost. So at least in some cases, policies to promote more inclusive growth need not be prohibitively expensive. The introduction of a conditional cash transfer program in the Philippines, which is budgeted to cover 60% of the countrys poor by year end, is an encouraging precedent likely to be followed across the region. Few emerging Asian economies have unemployment insurance schemes and many have low pension coverage rates; less than 20% of the working age population
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Inflection Point

May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

is covered in most of emerging Asia compared with an average of 60% in OECD countries. Enhancing such safety nets would help reduce precautionary motives to save, hence increasing consumption and facilitating global rebalancing.In policy terms. Brazils economy has benefitted from rising commodity prices and strong capital inflows boosting its terms of trade; this has allowed it to pursue domestic-consumption-oriented economic growth, while investment has been neglected. Following the financial crisis in 2002, Brazil experienced an acceleration of economic growth. Initially, tight monetary and fiscal policies were offset by a massively depreciated exchange rate, providing the impetus for export-driven growth. Later in the decade, Brazils terms of trade began to improve on the back of accelerating global commodity prices driven by Chinese demand for primary products, allowing further expansion in terms of final consumption. Brazils growth rate almost doubled in the 2000s compared with the 1980s and 1990s. Rising export prices allowed Brazil a far more significant increase in domestic consumption than would otherwise have been the case but domestic consumption itself was supported by rising social transfers and the greater availability of domestic credit due to various reforms (e.g. in the bankruptcy code) and the decline in domestic interest rates in the wake of economic stabilisation. In order for consumption-driven growth to continue, however, its terms of trade would have to continue to improve, which seems unlikely.

China Consumption/Investment Divergence Extreme

Source: World Bank

Ironically, Brazil now needs to shift its growth model in the opposite direction to China. The government predicts that investment will rise to 20% of GDP in 2012, a very low by emerging economy standards (exceeding only the Philippines within Asia). The household savings rate amounts to 5% of GDP and the corporate savings rate is 10% of GDP. A major cause of Brazils low household savings rate is the existence of a pay-as-you-go pension system which provides individuals and families with little incentive to save. Raising savings, especially government savings, would help fund increased investment and help raise productivity, making it easier for domestic industry to cope with a strong real exchange rate. After achieving remarkable success in reducing income disparity and dragging millions of households into its middle classes, Brazil needs to consume less and invest more or risk failing to break the 3.54% growth speed limit over the medium-term. China is affecting investment and labour markets in Southeast Asia in ways that are complicating efforts to moderate widening income disparities, increase productivity, and possibly escape the middle-income trap. Real wages have stagnated over the past decade in Southeast Asian economies as a result of relatively low productivity growth and pressure to stay competitive with Chinas labour costs. ASEAN countries have also struggled to boost private investment rates closer to pre-Asian crisis levels in order to sustain long-term growth. Starting in the mid-1990s, real wages in China surged by over 12% annually (see table below). Breaking this down by sector, growth ranged from around 8 to 10% annually in manufacturing up to 15% in financial services. By contrast, real wage growth for
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China Finally Pulling Emerging Asian Minimum Wages Higher


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May 2012

SALES CONTACTS Guy Stille Tel: +852.2217.2853 Email: guy.stille@quamgroup.com

Thailand, the Philippines, and Malaysia was in line with GDP growth for much of the 1990s but then fell off sharply and either declined or stagnated over most of the past decade.

Across Asia, the richest 1% of households account for 6-8% of total income. Close to 20% of total income went to the

wealthiest 5% of households in most countries, according to the Asian Development Bank. The Gini coefficient, a key measure of inequality, grew in the regions three largest economies - China, India and Indonesia. Even in Singapore, with its technocratic focus on equitable growth, the ratio of median income for the top and bottom 20% of wage earners has risen from 10x a decade ago to 13x recently. From the early 1990s to 2010, it increased from 32 to 43 in China (almost certainly a significant understatement, given the poor quality of local income statistics), from 33 to 37 in India and from 29 to 39 in Indonesia. For the region as a whole, the Gini coefficient has leapt from 39 to 46 in the last two decades. Technological progress, globalization and market-oriented reforms drove high growth in Asia but FDI led export growth favoured capital over labour, and cities over rural areas, resulting in a widening income gap. Growth in Real Wages (% annual increase) 2000-2005 2006-2009 12.6 12.7 3.5 1.1 -1.1 -0.7 -1.0 1.2
Source: International Labour Organization

China Malaysia Philippines Thailand

The most extreme case of rising inequality in Asia remains China. Income inequality measured by the Gini index rose from around 0.3 in the early 1980s to approaching 0.5 in recent years. Such a change marked China as having the fastest income-inequality increase of any large country over the last three decades. The rising capital intensity of production over the last decade should have reduced the returns to capital, so that the total income accruing to capital should have declined enough to reduce capitals share of income or keep it unchanged. But in fact, capitals share of income went up substantially; total wages fell 10 percentage points of GDP in China in 2000-7 before recovering slightly since, and profit share rose by a similar amount. Excess profits from the 2001-7 export boom have been directed into ever more investment rather than being redistributed as wage rises or dividends.

Real Income Growth Lagging GDP and Negative Real Rates Have Suppressed Chinese Consumption

Source: Wind Information

Since 2002, fixed investment and exports in China have grown their combined share of GDP by 24 percentage points versus household consumption. Even allowing for a likely on-going understatement of top decile incomes and therefore overall consumption share of GDP, the trend shift has been destabilising. The bulk of Chinas rapidly rising national income over the past decade has been directed to the corporate sector, which in turn has directed its

Inflection Point

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rising surpluses not to wages or dividends, but further investment. Wage growth in China has lagged productivity growth until very recently, which has constrained households ability to consume, even if their precautionary savings were reduced by better social provision. According to the Boston Consulting Group, Chinas wages in the Yangtze river delta region have risen from 72 cents an hour in 2000 to $2.79 in 2010, with a forecast rise to over $6/hr in 2015, though wage rates in other parts of China, especially the western, inland regions, remain cheaper.

Asia Boosts Credit Growth/Domestic Demand as Trade Surpluses Shrink Since 2009

Source: IMF, ADB

Wages are rising in Vietnam and India at an even faster pace than China, albeit from a lower base. Malaysias cabinet has recently approved the countrys first-ever minimum wage, to be set at levels between US$264 and $297 per month. Thailands government introduced a higher minimum wage this month that will push wages up about 40% in many parts of the country. The new Thai government is introducing a nationwide minimum of 300 baht ($9.75) a day. However, that wage will only apply to Bangkok and six surrounding provinces. Other provinces will also get a 40% rise but the minimum will not reach 300 baht. In the northern city of Chiang Mai, for example, it will be 251 baht. Taiwan is considering hiking the minimum monthly wage to NT$20,000 (US$678) from the current NT$18,780, and hourly wage to NT$115 from the current NT$103. Indonesia raised the minimum wage by 20% in March, and Vietnam is raising its minimum wage by 220,000 dong (US$10) this month. In China, at the start of the year, Beijing raised its minimum wage by 8.6% while Sichuan province raised it by 23.4%. Shenzhen, with the highest minimum wage in the country, raised it by a further 15.9% this year to RMB 1,500 a month. With social inequality a rising political concern for the Beijing leadership, more moves to support the aspiring middle-class are likely to emerge. Aside from China, investment rates never fully recovered in Southeast Asian economies after the Asian financial crisis, remaining about a-third lower than in the late 1990s at around 20 to 25% of GDP. Stagnant real wage growth and relatively low investment rates have been viewed as largely the result of country-specific conditions. But the regions production network has played a significant role in enabling China to pull away from its neighbours. With multinational firms managing decisions about where components are produced, location is influenced by the relative productivity of labour and wage costs along with the logistical advantages that Chinas size offers. That means China both attracts the dominant share of investment and sets the bar for labour costs. Chinas exceptional investment rates have contributed to industrial productivitys estimated 13-15% annual growth since the mid-1990s (although now sub 10%), far higher than its neighbours have experienced and exceeding manufacturing wage increases so that unit labour costs fell continuously. High labour productivity growth added to the advantages China could provide for labour-intensive assembly lines after its WTO accession in 2001. And there was also ample room for importing medium-tech components from Southeast Asia, which was supported by investments from multinational firms that were driving production-sharing arrangements. Chinas declining unit labour costs since the late 1990s have put pressure on countries like Malaysia to limit wage increases in order to maintain
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competitiveness, but that pressure is now abating as just 5m new workers enter Chinas workforce over this decade and domestic political imperatives shift. While weak productivity growth/investment remains a structural wage constraint across the smaller Asian economies, real wages can be expected to increase at maybe a third to a half of Chinese rates over the next few years.

Author: SEAN MAHER Consultant Strategist Quam Securities s.maher@globalalliancepartners.com Tel: +852.2847.2270 .

Quam Group is a founding member of Global Alliance Partners (GAP), an international network of local financial institutions with offices in 25 countries, a total of $40bn in AUM and which has completed $22bn in corporate finance transactions. GAP aims to leverage cross-border capabilities covering private equity, stock broking, research, fund management and investment banking. Other leading members include Reliance Capital (India), KT Zmico (Thailand), Seymour Pierce (UK) and Capital Partners (Japan).

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SALES CONTACTS Guy Stille Tel: +852.2847.2243 Email: guy.stille@quamgroup.com

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Quam Ltd. (Quam) via its subsidiary companies Quam Securities Company Ltd and Quam Capital Ltd holds a license from the Securities and Futures Commission, Hong Kong and is a participant in the Stock Exchange of Hong Kong and the Hong Kong Futures Exchange. Our holding company, Quam Ltd, is an investment banker and an underwriter of securities via its subsidiary companies. As a group Quam has Investment Banking, Advisory and other business relationships with a variety of companies covered by our research analysts. Our research professionals provide important inputs into the Groups Investment Banking and other business selection processes. Recipients of this report should assume that our Group is seeking or may seek or will seek Investment Banking, advisory, project finance or other businesses and may receive commission, brokerage, fees or other compensation from the company or companies that are the subject of this material/report. Our Company, Group companies and affiliated corporate members of the Global Alliance partners (GAP), their officers, directors and employees, including the analysts and others involved in the preparation or issuance of this material and their dependants, may on the date of this report or from, time to time have long or short positions in, act as principal in, and buy or sell the securities or derivatives thereof of companies mentioned herein. Our sales people, dealers, traders and other professionals may provide oral or written market commentary or trading strategies to our clients that reflect opinions that are contrary to the opinions expressed herein, and our proprietary trading and investing businesses may make investment decisions that are inconsistent with the recommendations expressed herein. We may have earlier issued or may issue in future reports on the companies covered herein with recommendations/ information inconsistent or different those made in this report. In reviewing this document, you should be aware that any or all of the foregoing, among other things, may give rise to or potential conflicts of interest. We and our Group may rely on information barriers, such as Chinese Walls to control the flow of information contained in one or more areas within us, or other areas, units, groups or affiliates of Quam. This report is for information purposes only and this document/material should not be construed as an offer to sell or the solicitation of an offer to buy, purchase or subscribe to any securities, and neither this document nor anything contained herein shall form the basis of or be relied upon in connection with any contract or commitment whatsoever. This document does not solicit any action based on the material contained herein. It is for the general information of the clients of Quam. Though disseminated to clients simultaneously, not all clients may receive this report at the same time. Quam will not treat recipients as clients by virtue of their receiving this report. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Similarly, this document does not have regard to the specific investment objectives, financial situation/circumstances and the particular needs of any specific person who may receive this document. The securities discussed in this report may not be suitable for all investors. The securities described herein may not be eligible for sale in all jurisdictions or to all categories of investors. The countries in which the companies mentioned in this report are organized may have restrictions on investments, voting rights or dealings in securities by nationals of other countries. The appropriateness of a particular investment or strategy will depend on an investors individual circumstances and objectives. Persons who may receive this document should consider and independently evaluate whether it is suitable for his/ her/their particular circumstances and, if necessary, seek professional/financial advice. Any such person shall be responsible for conducting his/her/their own investigation and analysis of the information contained or referred to in this document and of evaluating the merits and risks involved in the securities forming the subject matter of this document. The projections and forecasts described in this report were based upon a number of estimates and assumptions and are inherently subject to significant uncertainties and contingencies. Projections and forecasts are necessarily speculative in nature, and it can be expected that one or more of the estimates on which the projections and forecasts were based will not materialize or will vary significantly from actual results, and such variances will likely increase over time. All projections and forecasts described in this report have been prepared solely by the authors of this report independently of the Company. These projections and forecasts were not prepared with a view toward compliance with published guidelines or generally accented accounting principles. No independent accountants have expressed an opinion or any other form of assurance on these projections or forecasts. You should not regard the inclusion of the projections and forecasts described herein as a representation or warranty by or on behalf of the Company, Quam/GAP, the authors of his report or any other person that these projections or forecasts or their underlying assumptions will be achieved. For these reasons, you should only consider the projections and forecasts described in this report after carefully evaluating all of the information in this report, including the assumptions underlying such projections and forecasts. The price and value of the investments referred to in this document/material and the income from them may go down as well as up, and investors may realize losses on any investments. Past performance is not a guide for future performance. Future returns are not guaranteed and a loss of original capital may occur. Actual results may differ materially from those set forth in projections. Forward-looking statements are not predictions and may be subject to change without notice. Quam does not provide tax advice to its clients, and all investors are strongly advised to consult regarding any potential investment. Quam/GAP and its affiliates accept no liabilities for any loss or damage of any kind arising out of the use of this report. Foreign currency- denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of or income derived from the investment. In addition, investors in securities such as ADRs, the value of which are influenced by foreign currencies effectively assume currency risk. Certain transactions including those involving futures, options, and other derivatives as well as non investment-grade securities give rise to substantial risk and are not suitable for all investors. Please ensure that you have read and understood the current risk disclosure documents before entering into any derivative transactions. This report/document has been prepared by Quam/GAP, based upon information available to the public and sources, believed to be reliable. No representation or warranty, express or implied is made that it is accurate or complete. Centrum has reviewed the report and, in so far as it includes current or historical information, it is believed to be reliable, although its accuracy and completeness cannot be guaranteed. The opinions expressed in this document/material are subject to change without notice and have no obligation to tell you when opinions or information in this report change. This report or recommendations or information contained herein do/does not constitute or purport to constitute investment advice in publicly accessible media and should not be reproduced, transmitted or published by the recipient. The report is for the use and consumption of the recipient only. This publication may not be distributed to the public used by the public media without the express written consent of Quam. This report or any portion hereof may not be printed, sold or distributed without the written consent of Quam. Neither this document nor any copy of it may be taken or transmitted into the United States (to US persons), Canada, or Japan or distributed, directly or indirectly, in the United States or Canada or distributed or redistributed in Japan or to any resident thereof. The distribution of this document in other jurisdictions may be restricted by law, and persons into whose possession this document comes should inform themselves about, and observe, any such restrictions. Quam nor its directors, employees, agents or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information. This document does not constitute an offer or invitation to subscribe for or purchase or deal in any securities and neither this document nor anything contained herein shall form the basis of any contract or commitment whatsoever. This document is strictly confidential and is being furnished to you solely for your information, may not be distributed to the press or other media and may not be reproduced or redistributed to any other person. In particular, neither this document nor any copy thereof may be taken or transmitted into the United States, Canada or Japan or distributed, directly or indirectly, in the United States, Canada or Japan or to any US person. The distribution of this report in other jurisdictions may be restricted by law and persons into whose possession this report comes should inform themselves about, and observe any such restrictions. By accepting this report, you agree to be bound by the fore going limitations. No representation is made that this report is accurate or complete. The opinions and projections expressed herein are entirely those of the author and are given as part of the normal research activity of Quam Securities Company Ltd and are given as of this date and are subject to change without notice. Any opinion estimate or projection herein constitutes a view as of the date of this report and there can be no assurance that future results or events will be consistent with any such opinions, estimate or projection. This document has not been prepared by or in conjunction with or on behalf of or at the instigation of, or by arrangement with the company or any of its directors or any other person. Information in this document must not be relied upon as having been authorized or approved by the company or its directors or any other person. Any opinions and projections contained herein are entirely those of the authors. None of the company or its directors or any other person accepts any liability whatsoever for any loss arising from any use of this document or its contents or otherwise arising in connection therewith. 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