John Mauldin -- "This week we look at China. Simon Hunt is one of the smartest China hands I know of. He has been visiting the Middle Kingdom for many years and has numerous contacts throughout government and industry. If you read the official releases, it looks like things in China will stay on the same path as recent years. Simon has been saying privately and now publicly that there are some very significant changes happening in China that will affect a number of markets over the years, as China changes its focus from growth at any price to one that might be a bit more rationalized. This is a very important point. I suggest you put your thinking caps on as we take advantage of Simon's insider knowledge."
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China Economic Service
Simon Hunt Strategic Services
By Simon Hunt
NOVEMBER REPORT
China's leadership held important closed-door meetings last week on economic policies for 2006. Whilst official reports suggest that policies will continue to be implemented that produce fast, stable growth in 2006, the reality is that a different economic model will be pursued.
The model of the last few years, at least up to 2003, was growth at any price. The legacy of that policy has been a serious misallocation of capital, the building of gross surplus capacity at every point in the manufacturing chain, the lack of pricing power, a manufacturing industry that is mired in losses, the inefficient use of energy a horrific environmental legacy.
Commentators have largely ignored these outcomes as they continue to push China's growth story, but the leadership is less impressed. A new economic model is or has been formulated. It is based on growth that adds value to the population and brings value to the economy. More attention will be paid to narrowing the income divide between the rural and urban sectors, to attracting industry away from the coastal cities into the rural areas and to the establishment of a more stable society.
The implications of these goals are far-reaching and they contradict many of the accepted wisdoms of economic policy.
The first crucial hurdle to overcome is the mounting losses in the manufacturing sector and declining profitability in other key sectors such as auto, steel and cement. As we reported in October, the National Bureau of Statistics survey of 200,000 companies in the manufacturing sector showed a combined loss of US$15.1bn in the first seven months of this year, a 55% increase on 2004. Not even China can sustain losses of this magnitude in perpetuity.
The reason for these losses is very simple and it harks back to the late 1990s, when the concept of growth at any price became rooted policy. Cheap capital, with invariably zero cost financing, cheap land and favourable tax treatments by local governments encouraged both local state and private sector companies to go on an investment spree which has ended in there being this serious surplus capacity at every point in the manufacturing chain.
As a result, there is no pricing power as every company seeks a piece of the same pie. In fact, in many sectors, conversion and end product prices have fallen by some 50% over the last three years.
Unless stopped soon this cycle of high fixed asset investment will have a serious negative impact on the economy. It is also likely to be the platform for the next round of NPLs.
China's leadership has recognised this problem over the last few months; they will now confront the problem head-on. Fixed asset investment will be cut significantly. The method of doing so will be through the banks. Those that are being privatised will have to lend on a commercial basis, no longer being the conduit for state or local government demands. Other banks will be issued with strong window guidance on sectors that they should not lend to.
The result will be two fold: first fixed asset investment will fall sharply and, second, since construction is an integral component of the former, it will lead to slower growth in this sector's major inputs - steel, glass, cement, aluminium, copper and so on.
This development will have far-reaching consequences. Demand for imported raw materials should slow and prices weaken. But, since each of the major inputs to the construction sector is energy intensive, the policy will also slowdown the growth of electricity demand.
And this has consequences for Power Supply Bureau orders for power cable, since after three years of rapid upgrading and expansion of the electrical grid network, distribution capacity will be in some surplus next year.
The issue facing policy makers is not just this serious surplus of manufacturing capacity. It is rising costs, both domestic and imported, the latter through raw material and energy prices. However, homegrown costs are rising rapidly too, whether for wages, land, water, electricity, diesel etc.
The very sharp increases seen in imported raw material prices have aggravated an already deteriorating margin situation. China is suffering from the uncomfortable position of buying expensively and selling cheaply, ultimately, if allowed to continue, a recipe for bankruptcy.
The impact of these tightening measures on manufacturing will lead to restructuring, bankruptcies, mergers and bailouts. The recent bailout of WorldBest, a Shanghai conglomerate, at a cost of some US$620M, is probably a forerunner of others to come.
Over the last 20-odd years, growth has focused on the coastal cities, leaving most other parts of the country behind. There will now be far less focus on these cities. Industry will be encouraged to move into the rural sectors where transport systems have been optimised, where land and wages are at least one-third less and where labour is plentiful.
Redeveloping towns and cities in the rural areas of China at the expense of more urbanisation of coastal cities is a sensible policy. Costs in these areas are rising too fast and there is always a problem in coping with the migratory workforce, who is often treated as second-class citizens. It means also that the need for homebuilding in these cities will be less, though there will be more upgrading of existing dwellings in rural areas.
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