China seeks reforms that are actually realistic, imagine that

It looks as if the Chinese are preparing to change their economic/social systems and consequently ours will change in tandem. I find it somewhat relieving that such a large nation has a plan for the conservation of natural resources; this will put an end to the many wasteful processes which were used for the generation of profits, they are also in the process of a reduction in lending.

I think that this is yet another example of why governments, such as those in the United States, can do little to avoid destroying themselves and the environment around them, while the Chinese government is perfectly capable of stringent reforms.

The western world has much to learn from China All of humanity would assuredly benefit from a long time approach like that of China; a realistic approach not concocted by individuals hypnotized by the "land of illusion and confusion" that America has become.

China Visit Report
Simon Hunt Strategic Services
By: Simon Hunt
February/March 2006

SUMMARY

This note combines findings from our discussions in Beijing and plant visits with what we see is emerging from the NPC meeting.

Less attention should be given to the detail and more to the thrust of policy, because this government is embarking on a new course for China's economy. The unwary will be caught by surprise.

Past policies have embraced developments that drove industrialisation at any cost, which enabled GDP to grow by over 9% a year since 1995. There were two elements that allowed this extraordinary growth to take place.

First, key input prices, such as land, electricity and utilities, including water, were kept low through subsidies and controlled pricing.

Second, cheap finance was channeled into industry, particularly to large companies and SOEs, often effectively zero cost capital.

Local governments, over which Beijing had limited control, vied with each other to construct plant and infrastructure even if it made little or no economic sense.

What followed was the world's largest ever fixed asset investment binge.

Not only did these policies, which have been in place since the mid-to-late 1990s, create a gross surplus of capacity in so many industry sectors and throughout the manufacturing chain, but also the consequences were a degradation of the environment and a misuse of the country's natural resources, including energy.

This orgy of investment has resulted in so much capacity that there is no pricing power and with costs, both inland and imported, rising rapidly, margins have become under pressure and the foundations for the next round of NPLs laid. Premier Wen Jiabao addressed this issue in blunt language (see below) in his speech to the NPC.

The policy, introduced by Jiang Zemin, perhaps, arguably the correct one at that time, will now be abandoned. In its place, growth will be given a broader interpretation. It will include environmental issues and a better usage of natural resources, which are now viewed as strategic.

In sum, energy intensity and improving air and land pollution are as important as the quantity of growth in the new policy. In other words, it is not so much the quantity of growth that is important, but its quality.

A start will be made this year, the first year of the new 5-Year Plan. The main thrust will be to stop the continued development of duplicated capacity. It will be achieved by banks denying credit to all but their most credit worthy customers; manufacturing, especially in the private sector, will be hardest hit. This has started, as we have heard from friends.

Second, over 100,000 local government officials come up for re-election both this year and next. The election procedure will be quite different; it will not be based on growth criteria alone, as in the past. It will mean that Beijing will end up having more influence over local governments than hitherto. And the change was probably the reason why there was such a jump in reported disturbances in the rural area last year.

A corollary to this change is that Beijing will come down very hard on corruption.

There will be a structural move away from energy and natural resource intensive industries towards the services sectors and IT industries. This is why government is forecasting electricity demand to grow by an average of 7% a year over the next five years compared with 10% a year over the last five years. Perhaps it also implies an implicit slowdown in the growth of industrial production.

Natural resources, including energy, are now considered to be strategic; their use should not be frittered away on silly projects. Where products are exported, which have a high natural resource content, they will be discriminated against via taxes.

A start has been made by imposing a 10% tax on certain copper and copper alloy semis; we suspect that this will become much broader with consequences for global markets. It will mean that more of China's capacity of primary goods, steel, copper and copper semis, aluminum products etc., will be used domestically with a consequential impact on imported materials and goods. It also means that domestic producers will move up the value added chain to achieve this objective.

The second major thrust in policy is to focus on the rural sector. This is not just because 57% of China's citizens live in the rural areas, nor because the income divide between it and the urban community has reached 3.2 times that of the rural sector, but also, because in the last 20-odd years the coastal cities have received the bulk of central government support. It is now time for the rural sector to become the primary focus of attention and for the richer coastal cities to support this development.

Moreover, urbanisation has run its full course. Its development has been taking around 200,000 hectares of agricultural land each year. If these trends persisted, by 2020 China would lose some 25% of its farming land, something which no sensible government would allow.

And costs of doing business in many of these cities have got out of hand. In fact, some say it is cheaper to relocate back to Singapore for many sectors.

The corollary of slowing down urbanisation is to bring industry to the countryside, though no longer industry that is energy intensive – that trend has finished. This means also that the migration of rural workers will come to an end. China's surplus rural workers, which are probably, anyway, mostly in the age bracket of over 40 years, will stay at home as jobs will come to them.

Farming will be restructured to improve its yield and in so doing labour productivity.

China will persist with its step-by-step approach to the RMB; for the next few years it should appreciate by no more than 2-3% a year against the US$.

Where do these factors leave the economy? Two factors point to a slowdown, apart from the cyclical forces. First, a slowdown in the growth of bank lending will lead to slower growth in many sectors.

In our factory visits, nowhere did we find that business was robust or booming, except for some companies that had niche markets.

Second, Beijing will attack fixed asset investment. Both will be done via the banks; the credit spigots will be stopped for many companies and local governments, as we can attest to after talking with friends.

This will establish the crisis environment from which restructuring will emerge. In the short term, there will be some pain, which will lead to lower output. Bloated inventories, which are seen in some sectors (and remarked upon by Premier Wen Jiabao), such as compressors, electrical appliances etc, will have to be liquidated.

Moreover, government wants to see further price adjustments in the real estate market, especially in Shanghai. Here prices have fallen by some 15-20% since the peak, but need to fall another 20-25%. It is expected that this price adjustment will not be completed until end 2007.

Other parts of the economy should continue to blossom, such as consumption, but not enough to prevent a significant slowdown.

And should the US economy slow in the second half, as we expect, due to issues related to housing, exports of goods will fall more than government is now forecasting.

How much of a slowdown is difficult to forecast. But, in our view, real GDP will fall to under 8% this year and around 7% in 2007; manufacturing will be hit harder as so much of industry will be restructured and this sector accounted for 41% of GDP last year.

Against this background, it is interesting to note that our friends in Shanghai are very positive on China's stock markets.

For the longer term, what we find is worrying is the large increase in costs. Skilled wage rates are rising by 30-40% a year and unskilled by 10-20%, depending on location. But all other cost inputs are rising and are threatening to do so at higher rates – electricity, fuels, water, land etc.

We hear of companies quietly leaving China for other shores, but some like Flextronics, have publicly aired their concerns. A combination of these cost increases together with a modest revaluation of the RMB over the next five years could accelerate this trend out of China.

Once industry has been restructured, say in 3-5 years, pricing power will return. Profitability will be the motto, not critical mass. Then, China will no longer be exporting deflation. And then, the rest of the world will need to watch out for a different set of dynamics, because other countries will not go down the route of creating critical mass at the expense of profits.

Global consumers will find that prices for so much of what they buy now will be rising. 2010 may see the start of this period of rising prices for goods like appliances.

The annual National Peoples Congress is almost half way through its sessions. Enough has been said to know the drift of future policy.

The debate between the conservatives, who want to roll back many of the reforms, blaming them on the growing economic and political divide between the rural and urban communities, and the reformists, who respond by saying that reforms have not yet gone far enough, is all but over.

The reformists have won, despite having to postpone the introduction of the new property law. Premier Wen Jiabao stated, "The decision to implement the reform and opening up policy constitutes a major decision on the destiny of our country...Reform is now going through a very difficult period, and we must strengthen our resolve to accelerate all reforms and continue making progress in major reforms."

What does this all mean? We set our conclusions out in a brief "In" and "Out" balance sheet.

Out:

• Economic growth at all and any cost
• Central government focus on the development of coastal cities growth
• Degradation of the environment
• Wasteful use of energy
• Misallocation of capital.
• Duplication of capacity
• Corruption
• Dependence for growth on trade

In:

• Growth that adds value to the economy and its people
• Narrowing disposable income between rural and urban households
• Deploying funding to the rural sector, not just this year, but over the longer term
• A focus on the intangibles of growth, such as education, Health careand the creation of a social security network. None of these can be implemented as instant policies but have to be thought through over the next couple of years to produce a coherent set of initiatives.
• Industry restructuring
• The environment
• Husbanding the country's natural resources
• Profitability, not the creation of critical mass
• Bank lending to be based on proper risk assessments
• A balanced economy with greater emphasis on consumption
• Increasing focus on technology, in the process moving away from low technology industries.