Slow Food?

Pizza Hut store in China
China’s slowing economy is raising concerns at multinational firms. Yum Brands, which runs the KFC, Pizza Hut and Taco Bell restaurant chains has encountered slowing profits, reflecting rising costs in China. Its second-quarter profits rose by 5% to $331 million year over year, representing slowing growth due to higher wage and food costs.

Yun downplayed the missed earnings report, saying that the weaker Chinese performance would be short lived and analysts say that the increased costs faced by Yum are due to its rapid expansion in the country, with restaurant numbers hitting 4,600 nationwide.  Sara Senatore of Bernstein Research said:

The earnings miss is because China margins were a lot softer than people expected, but that’s largely a function of them growing.

Chinese Growth Hits a New Low

China’s economy is growing at its slowest pace in three years with slowing investment and falling demand for the world’s largest exporter in key markets such as the US and Europe.

Gross domestic product rose by 7.6% in the second quarter, compared with the same period a year ago,  down from 8.1% in the previous three months. In March, Beijing cut its growth target for the whole of 2012 to 7.5%.

Since China accounts for about a fifth of the world’s total economic output, the slowdown may hamper a global recovery.  As many of Asia’s biggest and emerging economies are becoming increasingly reliant on China as a trading partner, analysts say that China’s slowdown has been a big factor for the slowdown in Asia this year, and if it does not pick up in the second half of the year manufacturers in this region will face considerable difficulties.

Hard Landing Fears vs. Fiscal Stimulus

A so-called hard landing in China’s economy could have major impacts domestically and on the rest of the world. China’s leaders may be deeply concerned that any further slowdown could lead to rising social unrest. Edmund Phelps, professor of political economy at Columbia University and a Nobel prize winner said that China has a lot of ammunition to counter the slowdown, some of which it has already started using because of the patchy recovery in the US, and the ongoing debt and economic issues in the Eurozone.

The Chinese government has shown a willingness to take strong fiscal measures. It twice cut interest rates to bolster lending and the authorities are also pumping money into public works – such as social housing and reducing fuel prices. A once-in-a-decade leadership change starting later this year provides an opportunity for needed structural changes.
China’s central bank cut the amount of money banks must keep in reserve in order to boost lending, and it cut the cost of borrowing twice in one month.  Earlier this week, Premier Wen Jiabao said that boosting investment would also be crucial for stabilising growth, fuelling expectation that more state-driven stimulus measures would be on the way.
Given these tools, many economists believe these measures will ensure that China’s growth rebounds in the coming months. Yet there are now  calls for yet another stimulus given the slowdown, according to Edward Chancellor, global Strategist at investment management firm GMO.

Out of Fiscal Control?

Despite these measures, analysts warn that China’s growth problems may not be solved by a simple injection of capital and a new round of government spending, especially as many of today’s issues can be traced back to the way the country tried to kick start growth after the global financial crisis in 2008-2009. According to Michael Pettis, professor of Finance, Peking University, China has been “massively over-investing”

During that time, the central government began pumping massive amounts of money into the economy, mainly on infrastructure and construction spending, leading to excess capacity, a surge in property prices and an increase in consumer costs and inflation. Faced with these problems and amid fears that the economy may be overheating, policy makers then see sawed and decided to implement measures to curb lending and slow inflation. These missteps are seen as the major domestic cause of this recent cycle of slowing growth.

In 2011, China’s growth declined to 9.2%, down from 2010’s 10.4%, indications of a long-term slowing  trend.

Bears vs. Bulls

However, China has just released a number of figures painting a more nuanced and mixed picture of the economy: Official figures show:

  • A 13.7% increase in retail sales increased by  in June, little changed from May’s 13.8% figure.
  • An increase in new bank loans from $124.4bn in May to $144.4bn in June.
  • However, electricity output, an indicator many analysts use to calculate current business and consumer activity, was flat in June at 393bn kilowatt-hours.

According to the BBC’s John Sudworth in Shanghai,  the data isn’t a net positive:

Rising stock piles of coal paint a vivid picture of just the kind of indicator the bears will use when arguing that 7.6% is proof of the impending economic catastrophe.

However, bulls can point to a new DHL delivery hub built on the outskirts of Shanghai. Sudsworth says:

For them 7.6% is probably a turning point and they also have their indicators of choice to support the case.

Credit works on an economy like steroids on the body of an athlete: you need ever larger injections to maintain the effect”

“Imbalanced, Uncoordinated, and Unsustainable” – Premier Wen Jiabao

The city of Ordos in Inner Mongolia, is being built to house 1.5 million inhabitants and has been dubbed as the 'Dubai of China' by locals.Edward Chancellor, global strategist at GMO, an investment management firm points out that over the past decade, China is said to have built the equivalent of Rome every two months.
Overbuilding: There has been so much over-building that Beijing is said to have nearly four million empty apartments. Since construction has come to dominate China’s economy, accounting for roughly 25% of all activity and about 15% of all jobs, it is not surprising that China’s property market has slowed over the last year and land sales collapsed, as the engine of China’s economic growth has also sputtered.

Debt Crisis: Meanwhile, China has amassed a huge amount of doubtful debts in recent years. Although there are no sub-prime mortgages or complex financial derivatives at work in China, since 2009, trillions of Chinese renminbi have been lent by state-controlled banks to local government-sponsored infrastructure companies to fund questionable projects, and most of these loans will probably turn bad.

The rapid credit expansion following the 2008 global financial crisis is concerning. China’s stimulus spending has raised its total outstanding debt by around 50 percentage points of gross domestic product over the past few years, and the subsequent weakening of credit growth has exposed the underlying fragility of China’s economy. According to Edward Chancellor, “That’s because credit works on an economy like steroids on the body of an athlete: you need ever larger injections to maintain the effect.”

A Shadow Banking System: The rapid expansion of China’s shadow banking system has caused rapid credit expansion since the 2008 global financial crisis. Much unorthodox lending, often come in the form of trust loans and “wealth management” products that has gone to fund real estate development, have short maturities and are difficult to roll over during times of stress.

Inevitable Decline

Manufacturing’s slow decline: In the last decade, China’s share of the world’s exported goods grew exponentially, making it in 2oo5 the world’s third largest exporter of goods and services behind Germany and the US. However, the trend seems to be slowly but steadily changing. In other parts of Asia, manufacturing and exports are also growing rapidly with South Korea, Taiwan, India and the Association of South-East Asian Nations (ASEAN) increasing their share of global manufacturing from less than 7% to more than 9% in the decade leading up to 2003. Many new factories are being built in other regions of Asia as increasing numbers of companies and foreign investors seek to diversify their country risks and minimize their costs of production.

Experts see several flaws in the current Chinese manufacturing model, including:

  • Highly fragmented domestic markets
  • Industrial growth concentrated in certain pockets, firms, and sectors
  • The prevalence of small, underutilized and poorly-managed firms
  • A serious shortage of skilled workers in the country, resulting in massive poaching among rival companies and huge wage increases being offered to workers.
  • A growth in wages that is only partially offset by the gains in productivity achieved by the factory workers, leading to wage-inflation in the domestic economy.

Other Nations Seize the Opportunity: This situation has created an enormous opportunity for the rest of Asia to become manufacturing hubs like China. Foreign companies are not just driven to minimize their costs, but also to diversify the risks of being overly dependent on a particular country to meet their production requirements. Factories are being set up in other low-cost Asian countries like Cambodia, Vietnam, the Philippines, Singapore and Malaysia as part of the diversification objective.

Social Issues: Many foreign managers are also concerned with the current political situation in China and the growing social unrest among the populations of the economically backward rural regions of the country. In recent years, there have been strong measures taken by the United States and the European Union to make China more accountable for its World Trade Organization obligations, which has created some fears among foreign investors and companies that this might disrupt the current trade system.

Intellectual Property Concerns: Another setback is the lack of protection for intellectual property rights, which has prompted several firms to move to countries like India where the intellectual property rights environment is much better than in China

Exchange Rate: The rising value of the yuan in recent months is another factor which has diminished the competitiveness of China as a manufacturing hub.

Overcapacity: The concern about the calls for increased stimulus, says Chancellor, lies in the potential for  “more industrial overcapacity, more bridges to nowhere, more empty airports and hundreds more miles of ludicrously uneconomic high-speed rail.”

Insufficient Domestic Consumption: Since exports and fixed asset investment have grown faster than consumption,  rebalancing the economy would require a rise in consumption from its current level of just one-third of GDP. However, Beijing’s system of economic management depends on repressing consumers.

Corruption:  Chancellor makes a compelling case supporting Premier Wen Jiabao’s assessment of China’s economy as “imbalanced, uncoordinated, and unsustainable,” pointing out that the imbalances of China’s economy are not accidental but the result of this corrupt polity, with an infrastructure ripe for plundering by corrupt officials, and a series of scandals drawing attention to an endemic problem that poses a  threat to China’s long-term economic prospects:

State-controlled banks earn fat profits while savers suffer deposit rates below the level of inflation. State-owned monopolies charge excessive prices to captive customers. Furthermore, it’s difficult to see Chinese consumption soaring at a time when the property bubble is deflating and construction jobs are being lost. The darkest cloud hanging over China, however, remains public corruption.

While there will be a great deal of debate about the short and mid term prospects for the Chinese economy, it is clear that China faces a downward trajectory over the next few decades as I explained in my article: China’s Economic Time Bomb: The Approaching Crisis.

Stiffer Competition: Several factors remain in China’s favor as far as the attractiveness of its manufacturing sector is concerned. The country has a highly vibrant middle class prevalent in the big cities, has achieved consistently high growth rates over the years and has developed highly integrated supply chains. It also possesses quality transport facilities and infrastructure which are perhaps unparalleled in many other competing nations in Asia. The biggest reason that the Indian manufacturing sector has not progressed as much as China’s is that the country is saddled with huge problems like inadequate infrastructure, a poor law and order situation, a corrupt and tardy bureaucracy, complex tax laws and archaic labor laws.

However, countries like India and Singapore, with their highly educated, skilled workforce are slowly but steadily catching up.  India, in particular has a population of over a billion people and its domestic economy has grown by leaps and bounds in recent times. As the governments of these nations develop their economies even further by taking several steps to strengthen the physical infrastructure and integrate more effectively with the global markets, the mantle of ‘manufacturing hub of the world’ may soon pass on to the next best contender in the race to the top.

Final Words

China’s economy, already unstable, is clearly in long term decline. Its status as the “factory of the world” is declining, and its promise as a market for U.S. goods and services is dimming.

A case can be made that best response for U.S. based multinationals is to invest domestically. Given  current corporate trends, however, it seems more likely that investment will shift to other emerging nations.