China: What landing, if any?
November 22, 2004
Simon Hunt been involved in the copper producing industry for almost 50 years.
The financial community at large, with regard to China’s growth, is assuming two fundamental premises. The first is that China had its slowdown in the third quarter with government now intent on reinvigorating the economy. And the second is that the explosive growth of the last two years is the start of a new trend towards faster growth. Both are wrong in my view.
Before saying why, let me set out a piece of background to explain why I have some small insights into the global manufacturing powerhouse of the world.
I started visiting China in 1993. Since then I have spent two to three months each year in the country visiting some fifty towns and cities and around eighty factories each year. As a result, I have seen the changes that have taken place in China’s manufacturing sector from the factory floor. It has been a wonderful surprise to observe how some companies changed from being cradle to grave operations, where profitability was never a factor in decision making, into market orientated ventures, and sad to see those who could not pull themselves out of their own history. Until two years ago, I was consistently bullish about China and its economy. Now I worry. Here’s why.
It is common knowledge that China’s financial sector is fragile, so much so that some policy makers in Beijing believe that the currency is overvalued when account is taken of this fact. Less well known is how so much of the manufacturing sector has been financed, which is a cause of concern for the central bank.
There is, what I call, the unholy triangle of local company, local government and local bank. The company approaches the local government and acquires land cheaply. It then goes to the bank, in which local government has an equity stake, if not wholly owned, and is given 20-30 year money on concessionary terms that in many cases are the equivalent of zero cost capital. The company puts up the factory, installs the equipment, often state-of-the-art, inflates its asset value and repeats the process with the bank.
This is how so many companies have grown from producing just a few thousand widgets of indifferent quality five or six years ago to now having a capacity a hundred times that volume, in some cases millions, depending on the sector.
The problem is that everyone else in the same sector is playing the same game with the result that there has been built a gross surplus capacity at virtually every stage of the manufacturing process. Conversion and product prices have, thus, been driven down to levels that many companies are not, in reality, even covering their operating costs. So the friendly local bank is providing them with working capital in addition to the long-term loans. A month or so ago a senior official from the PBOC stated that as much as 60% of bank loans were for working capital!
The problem for the manufacturing sector is that there is no pricing power, but input costs are rising rapidly from raw materials, to electricity, diesel, water and now even labour. Where are the real profits, as opposed to so many that are published? It is why a senior investment banker in Hong Kong described China as buying expensively and selling cheaply. In fact, on this note I was shocked to be told by the general manager of one Japanese factory that when account is taken of productivity there is now little between the costs of making his product in Japan and China.
In Jiangxu province, a heartland of manufacturing, unskilled wages are rising by 10% a year and skilled by 20-30%. In fact, with rural incomes now rising faster than the urban equivalent, industry will have to raise its basic wage and improve the conditions to attract the much-needed migrant worker. Wage inflation is a mega-trend for the future, in my view.
These developments have global implications. It is one important reason why China’s exports have grown so rapidly, even if, for Chinese companies, margins are tiny if not non-existent. It also means that in some cases, if this trend is allowed to continue, China will have the capacity to provide the entire world with many appliances. For instance, by 2007, China will have the capacity to supply the entire global demand of air conditioners. But, how was this capacity financed?
However, in 2007 China must open up its banking sector to foreign financial institutions for RMB business, which, in turn, means that the banks must be cleaned up by then or else the authorities run the risk of depositors switching to foreign banks. The leadership is determined to keep to this WTO commitment. Hence, action to reform the banking structure is being stepped up. In the process, the authorities must also try to change the Chinese business model, which has been used by these companies that have grown so rapidly, away from the creation of critical mass, with no regard to either profitability or return on investment, towards making real profits.
The PBOC and the Bank Regulator understand the problem and are moving gradually to address the issues. First, they are gaining better control over bank lending, which can be determined more at the local level than in Beijing, as was seen over the past two years. The resignation of ex-President Jiang as Chairman of the Military Commission, which is another story, gave notice to many local governments that his influence had gone.
For instance, gross capital formation reached 42% of GDP last year, compared with an average of 38% in the past twenty years. Such a level is unsustainable and, is, interestingly at the same level as the crisis year of 1993. This must be brought down for it is an integral part of the misallocation of capital that has created this duplication of capacity.
Second, local governments will be forced to sell off their equity stakes in local banks to the private sector with bank supervision then being tightened. Thus, the unholy triangle will be broken over time.
Third, the 0.27% increase in interest rates was an important signal. But, the real change was the central bank notifying the banks that they could charge up to 14% on loans. Thus, banks can begin to price in risk. Prior to the lifting of interest rates, the PBOC, the Ministry of Finance and the Bank Regulator issued a joint notice to the banks warning that if inappropriate loans were issued, the banks and lending officers would be severely punished and, if necessary, referred to the judicial authorities. More loans, as a result, are being given to the large SOEs who are unlikely to go bust so starving the smaller SOEs companies and the private sector of funds.
Future interest rates rises, which might be as much as 200-300 basis points next year, will be driven more by the need to attract deposits back from the “Kerb” market than the level of the CPI, which is likely to fall further with the expected continued decline in food prices. With deposits earning around 2% and CPI running at around 5%, it is hardly surprising that funds have moved out of bank deposits into this grey market, where rates of up to 20% can be found. Semi-official sources estimate that some US$17bn over the last eight months has been shifted from bank deposits into this unofficial market with most going into the real estate sector. In fact, we have been told that non-performing loans outside the official banks are as much as $200bn.
These measures and, others that the PBOC and bank regulator will introduce, mean that monetary policy is becoming more restrictive. Bank lending will slow with banks tightening their lending standards and not before time. Already, around half of car loans have had to be written off with mortgage delinquencies already at a high level. The fear is that as the authorities move to bring order to the financial system there will be a lot of casualties in the manufacturing and real estate sectors.
In summary, by implication, reforming the financial system implies a massive restructuring of the manufacturing sector. The next two years will be interesting to see how these changes play out and whether the authorities are prepared to take them to their ultimate conclusion.
It is not just the repercussions from reforming the financial sector, which will cause problems for the economy, but domestic and export demand.
Domestic demand is slowing for many goods. This is hardly surprising after we learnt of the huge increase in household debt over the last five years. The Chinese Academy of Social Sciences, a government think-tank, has just reported that household debt to disposable income is at 155% in Shanghai, 122% in Beijing, 95% in Qingdao, 91% in Hangzchou, 85% in Shenzhen, 79% in Ningbo and 44% in Tianjin. Five years ago, household debt was virtually zero. This is a staggering change; it questions the rapid growth being assumed by so many analysts.
October’s car sales were 16.5% (provisional figure) lower in October than a year ago. In fact, the pent-up demand has now been satisfied. Future demand will be more pedestrian and constrained by tighter lending standards by financial institutions, crowded roads and lack of parking facilities. On the manufacturing side, there will be a lot of casualties as many projects were based on rapid growth in demand. Prices will fall sharply. China will become an important exporter of cars.
The growth rate of mobile phones is slowing rapidly.
We estimate that aircon sales into the Chinese market peaked last year with sales being 9% lower this year and not regaining their 2003 level until 2008. This is because the market is saturated in the large cities with high temperatures and incomes are not high enough in the rural areas, where owning an aircon is considered a luxury rather than a necessity because most housing units are single homes with more space.
Chip sales peaked in April and are expected to be 20-30% lower in the second half than in the first. There is no sign of recovery yet. Of course chips are an imbedded component to every type of consumer electronic and appliance, suggesting that a slowdown will be seen across this sector.
Property sales are slowing. Both commercial and residential grew by just 2% year-on-year in September compared with sales of over 40% early in the year. Shanghai’s sales rose by 8.8%, but Beijing’s fell by 20%. On the other hand, the supply of new property continues to grow rapidly – in fact by over 20% in September. There is a 2-3 year time lag between the start of a new project and its completion. To absorb the new supply, prices will have to fall sharply, causing difficulties for lenders, developers and mortgage holders.
There has been a dramatic slowdown in the rate of floor space under construction this year. Compared with the average of the first two months, the decline was almost 70% in August and 65% in September, the last reporting month. Once the existing projects are completed, for which banks extended finance after the mid-year clampdown rather than take an immediate hit on their balance sheets, we will see a significant slowdown in the real estate sector.
Growth in consumer expenditure will be constrained in future years for one simple, but, largely, unconsidered reason. The elders, aged 60 years or older, will increase from today’s 11% of the population, or some 140 million, to 15% in 2015, or around 200 million. These are extraordinarily high absolute numbers. The social system is not yet designed to cater for these retirees. Their children must help them. This is one reason why savings will always remain high, apart from the need to pay for education and medical costs.
Therefore, we should expect to see some moderation in consumers’ spending on durables over the next two years or so.
Nor does the export picture offer much hope, despite the strength of recent years. This has been a product of the unprecedented boom in world trade and the flood of multinational corporations moving to China as an export-manufacturing base.
There are a few comments worth making. First, talking to component suppliers to the foreign companies in China producing the full range of consumer electronics and appliances for the export market, a key part of China’s export trade, exports of these goods will fall by 20-30% in the fourth quarter versus the first nine months of 2004 with a budget for 2005 of exports being 10% below that of this year.
Globally, too, most analysts are forecasting some sort of slowdown in trade, with our own Road Map showing a recession in the USA by end-2005 and in most countries in 2006. Exports from China will be especially hurt. Moreover, there remains a risk that relations between Washington and Beijing will deteriorate over the year with Washington retaliating to China’s measured move to float the RMB by imposing more duties on imports from China.
Multinational corporations (MLCs) tend to move like sheep. Since China joined WTO, any MLC worth its stock market quote has had to be in China. But, some, we hear, who are there and who need to expand their capacity, are choosing to build their new capacity elsewhere, partly for infrastructure reasons, with Eastern Europe a favourite destination. Moreover, plants in the West are learning to compete with China by a total reconfiguration of their product lines. Add in the increasing costs of freight and insurance, port congestion and the political consequences of the hollowing out of manufacturing in the USA and the EU, the cost saving of being in China starts to look rather marginal.
In addition, China’s economy is awash in inventories of finished goods. Car inventories are around 600,000, at least at the last count. Mobile stocks are well over 70 million. Aircon stocks will be close to 9 million by year-end. And inventories of most appliances are 30-50% higher than a year ago, according to official data. With sales growth slowing, both in the domestic and export markets, and credit getting tighter – not easier as is generally being assumed – there will have to be an output adjustment. This will last a couple of quarters next year when industrial production will take a severe knock. Slower growth will then follow.
In our view, the rapid growth of the last two years (IP grew by 17% in 2003 and probably 16.5% this year) is an aberration. Aberrations consist of excesses. Excesses must be purged to return to stable growth. This will take around two years. Thus, we should see below trend growth in 2005 and 2006, followed by slower but more sustainable growth than seen in these last two years.
A question that I am frequently asked is how does such an outcome square with the country’s need to remain socially stable. There are two areas where employment can be improved to offset the losses from manufacturing, which a restructuring of the sector would involve. They are services and agriculture: both are getting a great deal of government attention.
There is another way, one on which I must tread gently and diplomatically. Despite the public signals, relations between Washington and Beijing are becoming quite tense, especially over trade, N Korea and Taiwan. Any move by Taiwan towards independence, or even their insistence of more trappings of Statehood, would be met by immediate military activity by China. Under the umbrella of nationalism that would ensue, Beijing would be able to take a sledgehammer to its domestic problems and do in two years what would otherwise take three or five.
Finally, it is for these reasons that I have become cautious of China’s growth over the next two years or so, whilst maintaining my long-term faith in China’s ability to grow faster than the West. For it is a fact that the centre, or powerhouse, of the world is inexorably shifting back to where it was prior to 1850, in Asia led by China. Demographics, savings and history are driving this shift of power. Herein, lies the real problem.
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