“Four cities, five days, 14 companies: we made the most of our trip to China and it confirmed our concerns and reaffirmed our decision to downgrade our economic assessment for the country.
“We also picked up several key insights into China’s development,” said Nathan Lim who runs the international equities fund.
China has settled into a lower gear
We were able to conclude that the slowdown in China has already happened and it appears the economy has settled into a lower gear. Amongst the weakest sectors right now are steel, coal and chemical refining. The strongest include automobile manufacturing, shipyards and the logistics sector. In a broader sense, the weaker companies are those with a mix of customers leaning more towards the government or construction. There is a general view that the second half of 2014 will be roughly flat or only modestly higher than the first half as there does not seem to be another major stimulus program on the horizon. A near term risk we see are reports of broad inventory destocking. Running warehouses so thinly can have a chilling effect on sentiment as it represents a lack of confidence. We worry that excessive pessimism could be a self-fulfilling prophecy.
Monolithic stimulus programs are a thing of the past
The Chinese government has recognised that its previous rounds of stimulus were excessive and lead to massive misallocations of capital that has resulted in excess capacity in numerous industries. As one local manager put it “China is no longer building ghost cities”. The lessons learned from these prior experiments means stimulus will be far more directed and, at this time, is going into rail, offshore drilling, renewable energy and anything to do with pollution abatement.
China is redefining its economic playbook to be less dependent on fixed asset investment. It is trying to transition to an economy that is more balanced between investments and domestic consumption while simultaneously dealing with the legacy of unproductive capacity and their attached loans. Balancing the need for short term growth while allowing the excesses to wash out of the system will take time and constant vigilance, but at this time the authorities seem to be doing a good job.
Lean manufacturing has arrived in China
In those meetings where we had a chance to visit the factory floor, it was insightful to see lean manufacturing being rolled out. China may have lost its low wage advantage but its move into advanced manufacturing will be a wake-up call for all European and US manufacturers and their workers. In some factories it was reported that the products being made in China exceeded the quality standards overseas and were amongst the most efficient factories anywhere (a US multinational with 100 manufacturing facilities globally said of the five that had achieved silver certification, three were in China!). The move to lean manufacturing is seeing a dramatic impact on productivity as Chinese divisions of multinationals are making the investment into advanced equipment and bringing even their most sophisticated components and products into the country. Granted that implementation had clearly achieved varying levels of success, it demonstrates yet again the competitive forces emerging from this country.
The corruption crackdown is real
The corruption crackdown is real and will have a long lasting impact on doing business in China. Everything from the way government tenders are awarded to ensuring pollution regulations are enforced has taken a massive step forward since the appointment of Premier Li Keqiang. In the short term, this has had a chilling impact on the economy as government related economic activity slowed down due to arrests and officials taking excessive care; however, as tendering activity has resumed we heard from two companies who won tenders despite not being the cheapest bid for the first time ever because their solution better matched the requirements. Merit based competition will favour foreign multinationals as they have a generational lead on salesmanship. The typical local competitor competes almost exclusively on price and when faced with annual national wage inflation of between 5-10%, they will struggle to maintain margins.
People are fed up with the pollution
It is no exaggeration that the pollution in China is bad. The air, soil and water is under such stress that we could finally be at that point the US and UK found themselves following the Cuyahoga River fires and London ‘pea soup’ disaster in the 1950s that a generation finally takes responsibility for the environment.
While pollution it is being addressed, a concern we have is the rate of improvement is insufficient to offset public unrest as even ‘clear’ days with PM readings in the low triple digits is still well above the World Health Organization’s recommended level of 25. Enforcement of industrial discharge standards and waste disposal is an area we hope will benefit from the government’s crackdown on corruption.
Conclusion – China looking more closely at itself and its peoples’ need
“Reflecting back on our trip, China continues to grow as an economic force but its new found focus on human capital. Looking to its people’s needs/abilities will surely be its most powerful move yet because just imagine what its populous will achieve when they do not have to fight through choking smog and corrupt officials to earn a living,” said Mr Lim.
Nathan Lim CFA
Portfolio Manager
Australian Ethical Investment
(02) 6201 1971
0400 300 819
nlim@australianethical.com.au