EP, headsup for resource investors ... danger coming this way. I am in agreement with Mr Walker of CLSA.
Some of us in HK are sitting on hands and not doing much, because there isn't much to do.
We see the cost of money rising, especially for mortgages, because our loans are adjusted monthly per latest short rate. We do not see real estate value tempering as yet, but suspect that will come, soon enough.
We figure BurnAndKaput will cause an accident at the margin, and then backtrack. At that juncture, both hands and feet and body in anything gold, but not before.
And so we exit and wait and collect interest. The arena will become quiet, after the screaming starts and then stops.
Asianomics Infofax Publication Date: Monday, 27-Mar-2006
Through the haze
Five days, five cities, fifty beers (or maybe 500), fatter and f... well let's just say "tired". The China Jet Tour finished for me on Friday afternoon, although Andrew Riddick and his intrepid band carried on to Lhasa at the weekend. Country visits are always amazing and endlessly rewarding, especially in places like China. As the week unfolds, general themes sharpen and thought processes clarify. The haze - metaphorically if not literally - clears, at least in part. One simple conclusion from the past week is that China is in the throes (probably relatively early) of the late-cycle consumption boom. It is similar to southeast Asia in 1996.
Spending a week with bright clients, bright colleagues and some bright commentators sharpens one's own thought processes. What can we generally conclude about China today and the progress of its first capitalist cycle?
The easiest conclusion is that China is in the late cycle. It shows all the classic symptoms of that phase - consolidation beginning as the weaker players go out of business; profit margins squeezed on all fronts; wages rising fast; companies finding it increasingly difficult to retain skilled labour; consumption signs picking up and evidence of weaker growth rates in capital goods industries.
This contrasts most markedly with my visits to China over the last four years (it is exactly that period of time since we wrote Gateway to Paradise: The Janus place). In early 2002 the enthusiasm from visits centred on amazing demand growth. Companies reported 30, 40, 50% increases in sales YoY. Banks were lending to anyone. Commodity prices were low and China was the land of 'infinite supply' of labour. Wages would never rise in our lifetime. Expatriate Chinese were returning to take advantage of the riches windfall.
By 2003 the boom was more mature but the story hadn't changed. By that time though the focus had turned to business formation. New competitors were emerging from everywhere. Times were still good, cash flows strong but margins were beginning to erode as competition intensified.
In 2004 many commentators, including the government, started fretting about 'overheating'. We did not share that view (we published China Twenty Questions to outline why the thesis was wrong). Profits were still good, wages were not rising and the current account position was strongly in surplus. Central measures were put in place to curb investment in property, automobiles, steel and aluminium. All were lifted within a few months although the banks have not recovered their confidence since.
But visits in 2004 were characterised by less bullishness and more concern over competition and costs. This is the way that the Schumpeterian cycle (one characterised by massive business formation) develops. In May 2005 we wrote and then there was none..., the theoretical background to how all cycles come to an end - not through government policies (although those often don't help) but through the natural disappearance of profitability among large swathes of new businesses. Our visits last year heard that high commodity prices "were almost killing everyone". Labour costs were rising.
There was no more talk about large numbers of new entrants entering the market. Companies were searching for diversification to ease profit concerns. Everyone had become a property developer.
Our original timing for the downturn in that report was 2007. We became much more concerned about the profit squeeze through high input costs after it was published and shortened the cyclical peak to 2006. After the last five days that timing might still be OK but the main effects of slowdown will be felt next year rather than this year. As we wrote last week, GDP growth in China this year is likely to be at the high end of our 5-7% forecast range.
But while some of our colleagues will take a more positive message from our five days worth of meetings, in particular the booming consumption story, we must point out that that specific feature is bad news for the economic growth outlook in 2007, not good. Certainly it is true that growth is moving inland (although the hotel in Shenyang was empty and the activity in Changsha seems confined to a burgeoning nightlife with little sign of new build or property revival) but that amounts to a different sharing of the pie rather than a bigger pie itself.
There were four recurring themes that ran through our week. The first was consolidation. We wrote about this in last Friday's Infofax and it requires little further elaboration. Companies now talk about how tough business conditions are eg, a top ten steel company said "It will be very tough but if we are not here - no chance". This epitomises the willingness of Chinese companies to cling on and try and ride out tough times. It might work if the next recurring theme did not exist.
The second theme was market share. Some companies we spoke with had good margins and even one talked about an improvement over the last year but most talked about falling margins and the fact that their competitors were worse off than them. According to one car company half to one-third of Chinese car companies are making losses. But everyone was still willing to cut prices to gain market share. There are two problems with this. First, there is only 100% market share available. Most companies' ambitions are going to be thwarted. Secondly, the market share approach involves undermining everyone's profitability to the point of profit destruction. This mentality in China ensures the bust phase of the cycle. Moreover, it intensifies it in that more companies are pushed inexorably towards the edge than would otherwise be the case in a return mentality economy.
The third recurring theme suggests that we are close to that edge.
Labour cost escalation is everywhere. Skilled labour is not easy to get
(indeed some of the comments about skilled labour, and in particular new graduates, were frightening) and double-digit wage and salary growth was commonplace.
Even in the low activity areas of Liaoning and Hunan companies spoke of wage growth between 10-20%. All of them were putting in place retention schemes for skilled labour (although none of them seemed capable of placing a pecuniary cost on these schemes). Yes, the growing power of labour is good for consumption and we saw much evidence for that in the nightlife around China but wage escalation represents a transfer of profits from the higher orders of production (capital goods producers) to lower orders (retailers, bar owners etc).
Which brings us to our fourth recurring theme: the Chinese economy has become more vulnerable to downturn than we had previously thought.
Almost every company we saw was sourcing more machine tools and equipment locally. This sounds like a good thing and, long term, it is. But in the bust phase of the cycle, if backward linkages are strong, more growth destruction takes place than would otherwise be the case. Previously, we had thought that a lot of the coming Chinese downturn would be felt in the machine tool industries of Japan, Germany, Italy and Korea. Now it will take place in China too, especially as the Chinese tool industry is supplying disproportionately the weaker companies. The consumption boom is great for now but increasingly it heralds a bigger bust in the future.
Jim Walker, CLSA
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