The End of the China Love Affair

The End of the China Love Affair
FEER - May 2005

source: http://www.feer.com/articles1/2005/0505/free/p020.html
by Jonathan Anderson

It's probably safe to say that the world rediscovered China in the latter part of 2002. Since the previous bubble came to a screeching halt in the mid-1990s, the mainland economy had been essentially lying fallow: subpar growth, widespread layoffs and unemployment, banks left with a crushing bad loan hangover, farmers with stagnant incomes and state enterprises shutting their doors. Most analysts and pundits spent their time worrying about whether it would all end in tears, and you could sense the zeitgeist in the most popular bestsellers of the period: The Coming Collapse of China and (the ironically titled) The China Dream.

As it turns out, however, the government had done a good job quietly laying the groundwork for the next upturn. They churned out new infrastructure spending on roads and communications, privatized the housing stock, created from scratch new mortgage and auto-finance instruments, and all the while kept the doors flung wide open for foreign investment and export outsourcing. In fact, one could argue that they did too good a job—by 2002, the economy had gone right through full-fledged recovery into an outright boom. The property-development sector was red hot, and banks fueled the fire by pumping out credit to nearly every project that walked through the door. Profits skyrocketed in steel, cement, autos and other housing- and transportation-oriented industries, and soon so did new investment in plant and equipment. By my estimate, the Chinese economy grew around 10% in real terms in 2002 and nearly 12% in the following year.

As the economy boomed, so did returns, and foreign investors who had been complaining for half a decade about moribund sales and excessive competition were suddenly recording very impressive earnings growth rates. Most important still, in the second half of 2002 the demand recovery began to spill over into global commodity markets. China's voracious appetite for primary products, industrial materials, and machinery and equipment drove import volume growth to 40% year on year, and seemingly overnight the mainland became the key marginal buyer of flat steel products, crude oil, copper, soy beans, construction equipment and a host of other goods and services. This demand also kick-started the Asian trade recovery; by mid-2003 shipments to China accounted for more than half of export growth in neighboring Asian countries—even when we exclude those goods that went for processing and re-export.

It wasn't long before the adoring hordes starting descending on the mainland. Last year it became virtually impossible to walk into any of the seemingly endless supply of business-class hotels in Beijing or Shanghai and expect to get a room; the conference halls were filled with private equity firms, commodity analysts, consumer salesmen, investment bankers or just tourists who flocked to "see it all happen." Every business school in the U.S. and Europe was suddenly adding a mainland study program to their curriculum; every multinational firm suddenly needed a corporate off-site in the Middle Kingdom; and brokerage houses everywhere were overwhelmed with requests for one-on-one client trips to rural hinterland provinces. In short, the world had embarked on an ardent, budding love affair with China.

The Breakup

As with most romances, however, this one had no sooner begun than the ardor began to cool. Actually, that's perhaps too harsh; the world's affair with China managed to carry on for a full two years, from late 2002 through the end of 2004. But over the past few quarters events have moved in another direction, and from the vantage point of mid-2005, things now look very different indeed.

No, we're not talking about the collapse of the Chinese economy. In fact, real growth is still above 9% and will probably average 8% or so over the next five years. Banks aren't going under, but rather improving; the supposed armies of unemployed are shrinking; farm incomes are rising; urban households are buying homes, and mainland goods are flooding shelves everywhere. This is still a phenomenal, vibrant growth story—China is here to stay.

So what's the problem? To begin with, although mainland demand is very strong, it is nonetheless showing the effects of two years of macroeconomic tightening. In real terms, investment growth is now only half what it was during the 2003 peak. Residential and commercial construction activity have visibly come back down to earth from the dizzying heights of only a year ago. Banks are far from closing their doors, of course, but new bank lending has also cooled off since the authorities began applying administrative pressures. So we still see a vibrant China, but we no longer see rampant overheating.

What's more, after three years of overinvestment, supply capacity is coming in much faster than demand in a number of key industrial sectors, such as autos, steel, aluminum, cement, certain chemicals, etc. The government may have successfully stemmed the flow of new "white elephant" investment projects in these areas, but the economy is still dealing with a heady rush of large and small producers who are opening their doors to business.

The situation is precisely the opposite in upstream primary products sectors such as fuel, mining and agriculture. China is running out of new production potential in nearly every commodity category, which, given voracious mainland demand, has meant an upward spiral of primary commodity prices and imports. Macroeconomic tightening has helped cool that spiral down a bit—but has not stopped it, and this is adding additional strains to the rest of the economy.

This sharp change in the Chinese economic environment has had three specific implications for the rest of us:

* Global investors are no longer pulling out super-profits from China. Look no further than the automobile sector for a "poster child" of China's economic shift: from mid-2002 to mid-2004, sedan sales grew at an astonishing pace, by more than 50% per year; however, after gorging themselves on cheap auto finance, consumers have decided to take a break, and sedan purchases actually fell in the first quarter of this year. Meanwhile, the euphoric supply build-out continues unabated; by the end of this year, the mainland auto sector will have installed capacity for six million sedans, compared to end-demand of only three million.

This sounds like a recipe for disaster, and sure enough, Ford, GM, Volkswagen and others are having a perfectly miserable year, with prices falling, inventories building and profits collapsing. Mind you, the situation is not nearly as bad in the rest of the economy—but as we will see below, this still marks the end of the upward profit cycle in China.

* China's imports from the rest of the world are no longer growing. Actually, they are now falling; just look at the chart nearby, which shows real import growth by category. Two years ago the mainland was snapping up everything in sight, and overall imports were increasing at 40% year on year. Over the past six months, however, the combination of slowing domestic demand and rapidly rising excess capacity has pushed Chinese imports of processed basic materials down sharply. The situation is better in other manufactured goods categories, but only slightly; imports of machinery and equipment are now virtually flat, again reflecting the deceleration of domestic investment spending.

There are only two areas, in fact, where China is still actively buying in increasing amounts. The first, as noted above, is primary products; as you can see from the chart, raw material imports have also slowed, but not by nearly as much as in other categories. The second is intermediate inputs for re-export, such as motherboards, connectors and ic products in the electronics sectors.

* The reason intermediate imports are still growing is that exports are still very strong, as the second chart shows. Not only is the mainland no longer buying—it's selling a lot more than it did before. Textile manufacturers are taking advantage of the elimination of the decades-old global quota system to increase market share. Electronics shipments are jumping as foreign players pour into China to locate production and assembly facilities. But that's not all. For the first time, we are seeing a strong uptick in exports of steel, aluminum, machinery and other heavy industrial products.

What does it all mean? The upshot is clear: China may still have a strong, growing economy, but that growth no longer looks very friendly to the rest of the world. In the words of Simon Ogus of DSGAsia, "The Chinese customer is turning competitor." And this means that world's late, great love affair with China is now turning sour.

What to Expect

Will it be an amicable parting? Alas not. There are good reasons to believe that the relationship with China could take a much testier tone, at very least for the next year or two. By far the most important or those reasons is the simple fact that the rest of the global economy is not in great shape. Yes, the U.S. economy is still powering ahead, but growth looks increasingly fragile, with soaring trade and current-account deficits, bond and currency markets propped up by ever-greater amounts of foreign borrowing, overheated housing prices, and an itchy investor base scanning the news daily for signs of trouble.

Outside U.S. borders, it's hard to find new sources of stimulus. Europe remains stuck in a profoundly unexciting 1% to 2% real growth rut, unable to fully resolve deep-seated structural problems. Japan is (once again) coming out of recession, but (once again) no one is very enthusiastic about its near-term economic prospects. This time last year, China's other Asian neighbors were abuzz with talk of renewed confidence, "delinkage" and the rise of the regional consumer; however, the recent steady deterioration in GDP and production data have shown precisely how dependent Asia still is on exports—and how important China was for the recovery story over the past two years.

Against this backdrop, fading Chinese demand and growing mainland exports will not go unnoticed, to say the least. Here are the trends to look for in the next 12 to 18 months:

* Falling profit margins. We've already seen a shakeout in a few headline sectors like property development and auto manufacturing, but this is not the end of the story; heavier industrial sectors like steel, aluminum, chemicals and other materials are almost certainly next, as higher input costs, rising excess capacity and slower end-demand take their inexorable toll. Downstream sectors such as light manufacturing and services have seen less new capacity investment and thus should be spared the worst, but margins will nonetheless come off as higher producer prices get passed through the system.

As discussed above, the only area with an unabashedly positive outlook is upstream primary products, where short Chinese supply will keep prices buoyant—but again, this just means continued cost pressures on the rest of the economy. And as profit margins subside from the current astronomical levels, so will foreign investors' euphoria at the "China Boom."

* Rising trade tensions. Growing Chinese market penetration in textiles, furniture, electronics as well as practically every other known consumer goods category has raised hackles across developed markets. G-3 imports grew at an average pace of 13% year on year in the first quarter of this year; meanwhile, Chinese exports to the G-3 economies (which already account for one-seventh of total import purchases) increased 35% year on year over the same period, with no sign of a slowdown whatsoever.

Indeed, quite the opposite; excess industrial capacity at home is adding new product categories to the list. In the last few quarters China swung from a very large finished steel and aluminum importer to a net exporter of the products; the situation in chemical industries is not quite as dramatic, but net import volumes are still falling at a pronounced clip. And while the mainland is far from a major player on global auto markets, industry analysts have been surprised by skyrocketing exports of Chinese vehicles and parts (albeit from a tiny base) over the past two years.

The prospect of Chinese manufacturers unexpectedly taking over heavy industrial markets the way they have done in labor-intensive industries is unlikely to win the mainland new friends abroad. The good news, if you will, is that this is a temporary phenomenon driven by cyclical overcapacity and macroeconomic tightening, and mainland trade patterns should return to normal over the next few years. But for the next 12 to 24 months, look for rising tensions with China's main trading partners.

* More currency pressures. From late 2003 through the beginning of this year, we didn't hear much vocal pressure on the exchange-rate issue. Most foreign governments held their breath and watched the diverting spectacle of China's domestic economy, from overheating to tightening and back again, and any official dialogue was generally carried out behind the scenes.

But not any more. Over the last months the markets have virtually erupted with official statements and actions aimed at the yuan. The U.S. Senate recently endorsed a measure imposing a 27.5% tariff on all Chinese exports to the U.S. if China doesn't revalue its currency. The U.S. House of Representatives introduced a bill that would define exchange-rate manipulation as a prohibited export subsidy and allow U.S. agencies to sanction China in order to protect U.S. industries.

The last G-7 meeting of finance ministers and central bank governors narrowly escaped issuing a direct call for Beijing to take immediate action on the exchange rate (only the Japanese representatives deferred, for political reasons). Since then, U.S. Treasury Secretary John Snow has pounded on the table on nearly a weekly basis, and markets are speculating that the Treasury will also re-include China in its annual list of foreign countries that manipulate their currencies—a move which would force bilateral negotiations between the U.S. and China on the exchange-rate issue.

Why now? In part because of rising confidence in a "soft landing" in China (if macro worries are fading, there's no longer an excuse for the global community to put off action), and in part precisely because of the recent cycle of rising exports and falling imports. In the past, the Chinese authorities could easily deflect calls for currency adjustment by pointing to a relatively balanced current-account position, but after the radical trade adjustment of the past few quarters the current-account surplus is now running at nearly 10% of GDP on a seasonally adjusted basis—in other words, future discussions are going to get more and more difficult as the numbers come out. This will be particularly true in the U.S., where external deficits are rising without respite; the U.S. Treasury had been a voice of moderation in the past, but clearly could not hold out against rising populist sentiment.

What Can China Do?

A final question: Is there anything China can do to make things better? Open up its import markets? Cool down export growth? Revalue the currency?

Sadly, the answer is ... no, not really. Despite common complaints in the press about market access and intellectual property rights, the fact is that over the past decade the mainland has undertaken one of the world's most rapid and widespread market liberalizations. In 1990, annual import value was just over 10% of GDP; by last year, the ratio had rocketed to 35%.

Under the terms of WTO accession, China is relentlessly opening sector after sector to foreign trade and investment, along the way becoming one of the largest global importers of raw materials, machinery and equipment. Of course the process is not yet over, with much opening to come in service sectors such as media, finance and distribution—but most of the heavy lifting is already behind us.

On the export side, the government has been quietly trying to dampen growth over the past few quarters, taking away vat rebates for overseas shipments (despite the fact that under standard global practice, Chinese producers should receive a full vat refund on all export transactions), and imposing voluntary restrictions on key sectors such as textiles in order to avoid frictions with trading partners. But China is far from the "Japan Inc." or "Korea Inc." of old, where a few cozy meetings between bureaucrats and business leaders could decide the issue.

The mainland export sector is mostly private, highly fragmented—and more than 50% of exports come from foreign-owned producers. In this environment, it's hard enough for the authorities to keep up with current trends, much less implement an effective clamp-down. And with new foreign investment money rushing in unabated, China's exports are just going to grow and grow.

Then there's the currency. To listen to U.S. lobby groups, the Chinese yuan is the root of all evil, giving a massively unfair advantage to mainland exporters and taking away jobs from American workers. Is the yuan too cheap? Absolutely yes, in a near-term sense, and the exchange rate should appreciate over time once China begins the move to flexibility. However, it's devilishly difficult to show that the yuan is "fundamentally" undervalued over the longer term, i.e., that the exchange rate is providing a large structural subsidy to Chinese workers.

But the more salient point is this: Even if the yuan were to strengthen significantly tomorrow, we doubt very much that the U.S. economy—or Europe, or Japan—would reap any sizeable benefits. I went through the details a few months ago in these pages ("How I Learned To Stop Worrying and Forget the Yuan," December 2004); the key conclusions are as follows: First, there are precious few industries where Chinese workers compete "head-to-head" with their developed-country counterparts. Not toys, not textiles, not low-end appliances. In fact, the only area of substantial overlap is the electronics sector. Second, the domestic value-added share of China's electronics exports is laughably small, around 15%, as most of the input components are produced in other countries. This means that even a 25% revaluation of the yuan would only raise the factory-gate price of a "Chinese" PC or DVD player by 3% to 4%—hardly an earth-shattering rise for the U.S. consumer. Instead, the real beneficiaries of a stronger Chinese currency would be its low-income neighbors, who compete in the same labor-intensive export industries (toys, textiles, etc.) where the mainland makes its money.

This doesn't mean that China should abandon its plans to move to a flexible currency regime—in fact, there are plenty of good domestic reasons to go. But given the arguments above, any political benefits of moving the yuan are likely to be short-lived and insufficient to offset rising disillusionment with Chinese growth. Better settle in for a bumpy ride ahead.

Mr. Anderson is chief Asian economist at UBS.