The China syndrome: economic challenges ahead

In late 2008, the Chinese Government introduced a RMB4 trillion stimulus package aimed at stabilising the local economy in the aftermath of the global financial crisis. In early May, we visited China and Hong Kong to assess the impact of this initiative as well as the continued development of China’s manufacturing industry.

In essence, the stimulus package achieved the Government’s goal of providing equilibrium to the economy and concurrently allowed a return of confidence among the public and business communities. In a global environment where doomsayers held the upper hand, the importance of creating domestic confidence and facilitating a re-emergence of economic momentum cannot be underestimated.

Indeed, as domestic liquidity improved and confidence returned, economic activity recovered sharply, with both property market transaction

levels and retail sales on the rise. Most recently, some major cities have seen record land sale prices at auctions.

In addition to its economic impact, the Government’s decisive and timely implementation of such significant fiscal spending has also benefited the public perception of the authorities.

It should be noted that the package merely stabilised the economy and restored liquidity levels within the financial system to pre-crisis levels. It has provided no additional stimulus; that will need to come from the export sector, as before.

Its impact is both direct and indirect: the income gap between the coastal cities — where the export sector is the driving force of economic growth — and rural areas remains significant, and private consumption on an overall level is therefore very dependent on consumption patterns in the economic hubs.

With encouraging signs emerging from the developed world and industrial production as well as consumer confidence in Japan and the US appearing to recover, the combination of the domestic impact of the Chinese initiative and the possible return of global growth will undoubtedly have a beneficial impact in China and the Asia Pacific region.

Structural change

During the trip, we also noted some encouraging structural changes in China’s manufacturing industry. We visited a group of companies in the auto, machinery and technology sectors for the purpose of assessing the quality of Chinese factory management relative to that in Japan, which remains the benchmark in terms of competitive manufacturing, particularly in the auto and machinery sector.

We believe China’s future development will depend on how well and how fast its manufacturing industry can move up the value chain by offering higher value-add products while increasing productivity. Over the last few years, large purchases of advanced ‘heavy industry’ equipment from Europe have dramatically expanded China’s production capacity in a relatively short time period.

However, going forward, such investment is unlikely to continue as companies are becoming more focused on quality enhancement rather than capacity expansion and will seek to more efficiently utilise the acquired equipment to produce a higher quality product.

While this development may ultimately pose a threat to many global capital goods companies, it is a positive and necessary step in China’s industrialisation process towards the creation of globally competitive companies.

We expect that in coming years, many Chinese companies will generate higher free cash flows as productivity improves and capital investment becomes more controlled. This will concurrently translate into higher domestic consumption.

A second beneficial element in the pursuit of this global competiveness is China’s flexible employment system. It is more flexible than Japan’s in our opinion and, particularly among private companies and listed state-owned enterprises (SOEs), this system has emphatically facilitated the profitability focus of management.

A significant proportion of the workforce of many Chinese companies is made up of part-time workers with performance salaries. While this is a positive for many companies, particularly listed ones, it also puts the onus on the Government to control employment practices, often the first casualties of an economic downturn.

The speedy adjustment in production made possible by this employment system went some way to insulating Chinese companies from lasting damage when the financial crisis hit the global economy in 2008.

This is in stark contrast to Japan, where many blue-chip companies saw earnings evaporate completely within a period of a few months. As China continues its move into the second stage of industrialisation and begins exploring the potential for productivity improvement, we consider the most promising long-term investment opportunities will be found in the steel, auto and technology sectors.

Economic cyclicality

While the points raised above are very positive for China’s long-term growth, they also highlight the cyclical short-term issues. As China has expanded its capacity over the last few years, particularly in the material and auto industries, many in those industries are still experiencing low utilisation rates.

And while the employment system described above provides industry with some flexibility, it also instantly transfers some cyclicality to private consumption. That is why the Government’s measures to stabilise domestic demand are crucial until global growth re-emerges and export activity (and its impact on consumption in the coastal cities) recovers.

The wealth effect of the domestic equity and property markets must also be taken into account. This is of relevance to many consumers, with the financial benefits of government officials, private entity entrepreneurs and SOE factory workers, among others involved, directly or indirectly linked to these assets’ prices.

The recent recovery in China’s A-share market is an indication of the return of confidence, which in turn will play a role in supporting retail sales and property transactions over the months to come.

While structurally China’s long-term growth prospects are sound, economic activity will remain to some extent at the mercy of cyclical patterns in the short term, both domestically and globally.

Diane Lin is the senior portfolio manager for the Pengana Asian Equities Long Short Fund, Pengana Capital.