Is China’s economy really in trouble? We investigate
A string of sensationalist headlines have suggested that a 2008-09-style crisis awaits China’s economy. Chris Middleton says that the truth is subtler and more complex than that, and the West’s commentators should beware of creating a self-fulfilling prophecy.
China’s economy is widely predicted to grow at over seven per cent this year, yet some analysts have described it as ‘tanking’ or in ‘economic pain’. In comparison, economic growth in the US stands at 2.6 per cent, while in the UK recently announced growth of 1.7 per cent has been seen as a cause for celebration.
Many Western commentators have focused on the rise in China’s debts and the slowing performance of its banking sector, with the Bank of China reporting its second-weakest profit growth since IPO eight years ago, and China’s third-largest bank, the Agricultural Bank of China, posting its lowest profit growth in three years for FY 2013.
These figures are concerning, but China is hardly a narrow economy driven by financial services and sub-prime lending, as some Western economies were prior to the 2008-09 crisis. It is an ancient economy being slowly transformed into a modern one over decades, with an internal migration of ambitious young people out of rural poverty and into fast-expanding cities. Long-term infrastructure programmes accompany those demographic shifts, on a scale that is inconceivable in the West.
In recent months, Chinese buyers have also snapped up a range of British brand names, including the London Taxi Company (via parent company Manganese Bronze), Savile Row tailor Gieves & Hawkes, Weetabix, and, in April 2014, House of Fraser, in which Sanpower took an 89 per cent stake in a deal worth £450 million.
The Chinese economy, therefore, is rich and diverse, but it also owns a great deal of Western debt, which explains analysts’ jitters. In that regard, there is a major problem lurking in the wings: Beijing has set full-year growth targets of 7.5 per cent. With most analysts forecasting lesser growth on current figures – up to 7.2 per cent in 2014 – this raises the prospect of government intervention to avoid missing its own guidance.
So what is really happening in China, away from the West’s focus on financial services?
An alternative view
In March 2014, four very different companies reported full-year 2013 results, in sectors as diverse as plastics/automotive, recycling/energy, housing/land, and pharmaceuticals, which between them offer a momentary ‘snapshot’ of the health of the wider Chinese economy.
One of those, China XD Plastics Co (market capitalisation: $275 million), develops, manufactures and markets high-performance plastics, primarily for use in China’s burgeoning automotive industry. The company is also moving into other high-value niches, such as plastics for high-speed trains and aerospace applications.
“We have recalibrated our R&D direction and are expanding into non-automotive products, in higher-end applications, such as biodegradable plastics, alloys, high-performance fibre material, 3D printing special materials, weather resistance, flame resistance and special engineering plastics, which will cover high-speed rail, ships, airplanes and high-end fuels,” says chairman and CEO Jie Han.
It is an important point. China’s automotive sector is moving out of producing low-grade copies of Western marques and into highly engineered mass-market vehicles, which may, in time, flood into Western markets. The same principles may soon apply to aerospace as well, with the long-term prospect of low-cost Chinese airliners landing on the world’s runways. Meanwhile, China represents the world’s largest greenfield site for high-speed train development, linking its Tier-1, -2, and -3 cities with far-flung towns and rural areas.
So China XD is well placed to capitalise on China’s long-term expansion in a number of key areas. But this poses some short-term challenges for the company.
On the surface, the figures seem stellar. In 2013, China XD became a billion-dollar business by revenue, a year-on-year increase of 75.2 per cent. Full-year 2013 net income was up significantly, at $133.8 million compared with $85.9 million in the previous year. Year-on-year Q4 revenues stood at $384.6 million, an increase of 128.1 per cent from 2012. In East China alone – where the majority of the Chinese population reside in its major cities – year-on-year Q4 growth was up 208.5 per cent.
Q4 net income was $57.5 million, up from $17.3 million in 2012. Gross profits for the year were $223.4 million, an increase of more than 55 per cent, although margins were down by three per cent. However, the company said that it expects gross margins to improve in 2014 as the company moves into higher-end niches.
However, there was grit among the financial pearls – figures that do reveal recent shifts and tensions in the Chinese economy. Accounts payable increased by 1,625.4 per cent, due to the extended payment terms for raw materials, according to company CFO Taylor Zhang. Shipping volumes rose by 30.5 per cent in 2013, but shipping expenses grew massively to $16 million from $2.1 million in 2012. Short-term bank loans increased by 94.1 per cent, in support of capacity expansion in south-west China. Accrued expenses and other current liabilities ballooned by 62.2 per cent.
In short, although this supplier to emerging, high-growth sectors is shifting up market in the long term, it is seeing a significant short-term increase in its debts and costs as it does so. This is similar to the challenge facing many Indian companies: any move up-market into higher-value niches needs to be funded from somewhere.
Stories like this are the main reason for the rise in China’s debts to 230 per cent of GDP: it is mainly corporate borrowing, and from other parts of the Chinese economy.
So what are China XD’s prospects for 2014? Here, the company sounds a note of caution. “We expect revenues to range between $950 million and $1.05 billion,” says Zhang, “and net income for fiscal year 2014 to range between $100 million to $120 million.”
After a healthy 2013, therefore, the company is expecting a flat to negative 2014: grist to the mill for the doom-mongers? “We always speak conservatively at the beginning of the year,” says Zhang, “and second, we do not have any additional capacity coming online. So the capacity is pretty much the same as 2013, and in 2013 we had pretty much already reached full utilisation rates.”
In other words, the company has hit an internal buffer on its expansion plans – indeed, it admits that in Q3 and Q4 2013 it was operating at above-optimal capacity to hit aggressive performance targets. The conclusion is clear: before climbing higher up market in terms of value, the company needs to add new rungs to its operational ladder, just to help it grow in its existing markets.
One of those rungs is being added now: in December 2013, the company broke ground on the construction of a new production base in Nanchong City, Sichuan Province, with completion due by the end of 2015. This will add an additional 300,000 metric tons of annual production capacity across an additional 70 new production lines, but payback is unlikely until 2016 – hence the forecast cooling period in 2014 and 2015.
While one Chinese company has been thriving in plastics, another, China Recycling Energy Corporation (CREG), is recycling and obtaining energy from them, and other materials.
China is often seen in a light of investing in fossil fuels and increasing its carbon footprint, but that perception is unfair. According to a report produced by the National People’s Congress and the Chinese People’s Political Consultative Conference, the budget of China’s central government will increasingly be focused on energy-saving and environmental-protection measures.
Investment in those areas is already a pillar of China’s power industry, according to CREG CEO, Guohua Ku. “The value added [by the sector] is about two per cent of GDP and the annual growth rate for the output value of the energy-saving and environmental protection industry will be over 15 per cent,” he says.
Worldwide, the market size of the environmental protection industry increased from $250 billion in 1992 to $600 billion in 2013, by some estimates – an average annual growth rate of eight per cent.
At $285 million, CREG has a similar market capitalisation to plastics maker China XD. Describing itself as “the first mover” in its sector, it recycles energy and provides energy-saving and recycling products and services – a volatile market within China for investors, judging by swings in the company’s share price during 2013.
But that hasn’t deterred a major investor from the West. In 2013, the company secured the backing of blue-chip investment house the Carlyle Group, whose board members have included George HW Bush, Fidel Ramos, and Thaksin Shinawatra. The group is investing roughly $25 million in the form of convertible notes and share purchases.
CREG is certainly building fast. During the financial year ended 31 December 2013, the company completed phase two of a 12-megawatt biomass power generation system in Pucheng, phase two of a 12-megawatt biomass power generation system in Shenqiu, two units of three-megawatt-plus furnace pressure recovery turbine in Shanxi Datong project, and a 25-megawatt waste-heat power-generation system in Jitie.
Ongoing projects include a new 15-megawatt waste-gas power-generation system and a Coke Dry Quenching (CDQ) waste-heat power-generation project – a technology that substantially reduces air pollution and energy consumption during the production of iron and steel, and is touted as the future of the industry.
So how is the company performing financially? “We had a number of operational highlights in the fourth quarter of 2013,” says CFO David Chong. “Total sales increased by $12.98 million, compared to $0.2 million for the fourth quarter of 2012. Net income grew by 169 per cent, or $4.21 million, as compared to $1.57 million for the fourth quarter of 2012.
“For the year ended 31 December, we also had a number of operational highlights. Total sales increased by $61.95 million, compared to $1.25 million for the year 2012. Net income grew by 359 per cent to $15.63 million, as compared to $3.41 million for 2012.”
The figures suggest that some parts of China’s economy are thriving, and challenging Western perceptions.
A property bubble?
However, one area that has been uppermost in the minds of many commentators – alongside banking and manufacturing – is China’s property sector, which is widely thought to be overheating. Certainly, the internal tensions brought about by the expansion of China’s cities and the growing wealth and house price disparities that this creates are distorting the domestic economy in a way that isn’t sustainable for long.
New house prices in Tier-1 cities, such as Beijing, Shanghai, Guangzhou, and Shenzhen, soared by over 20 per cent in 2013, including nine months of sequential rises, according to the BBC. This presents a strategic challenge to the Chinese government; while rising prices may be good for investors in the short term, a property bubble risks destabilising the national economy, obliging Beijing to strike a new-style balance – in China’s terms – between regulation and free-market laissez-faire.
In that sector, China Housing & Land Development (CHLN, market capitalisation $78.4 million) develops, constructs, and sells residential and commercial real estate units, as well as develops land in mainland China. Its financials present a muddy picture, partly because of the distorting influence of a handful of major programmes that are being completed in stages.
“Our financial performance in Q4 2013 was better than our original estimates,” says CEO Xiaohong Feng. ”Fourth-quarter revenues totalled $56.1 million, which was a 126% increase from $24.8 million in the third quarter, but a decrease of nine per cent from $61.5 million in the fourth quarter of the prior year. Fourth-quarter 2013 contract sales totalled $40 million, compared with $18.6 million in the third quarter of 2013 and $22.9 million in the fourth quarter of 2012.
“We are making progress, balancing our unit inventory more effectively so that we can offer a broader array of apartment units to prospective low-, mid- and high-end buyers. Ensuring greater unit availability in each of these tiers is important, as overall market demand appears to be softening.”
The company’s figures suggest a complex, ever-changing market within China. For example, it said that average residential sales prices in Xi’an increased to RMB 7,772 ($1,252) per square meter in Q4, compared to RMB 7,552 ($1,216) in Q3 2013. However, that was a decrease year on year, from RMB 7,820 ($1,260) in the fourth quarter of 2012.
But overall, CHLN said that it experienced average residential sales prices of RMB 6,600 ($1,063) per square meter compared to RMB 6,369 ($1,026) in the third quarter of 2013 and RMB 5,137 ($827) in the fourth quarter of 2012, supporting the BBC’s figures and analysis: an overheating market.
But despite this, the company is upbeat about prospects. “Looking at our potential first-quarter performance and expectations for the full year, we expect that 2014 will be a better sales year than 2013,” says Feng.
Pharmaceuticals is another key sector in the Chinese economy. China Pharma Holdings manufactures and markets drugs and medicines, but its small market capitalisation of just $20.57 million reflects the company’s poor share price performance in recent months. According to the company, increased regulation in a previously poorly monitored sector is impacting its business.
Side-effects of the medicine
“China provides a unique opportunity to its pharmaceutical industry,” explains president, CEO and interim CFO Zhilin Li. “However, the real challenges remain, from compulsory new GMP [good manufacturing practice] upgrading requirements and rising pricing pressure to extended regulatory review time for new medical production applications, which temporally impacted our performance negatively in 2013.
“We have maintained a conservative stance in general sales and credit policies in 2013 in order to ensure the capital requirements for new GMP upgrading requirements, and control and improve the condition of our accounts receivable.”
The Chinese pharmaceutical industry has been “the key contributor” to China’s economic growth, he says. The market was valued at RMB 926.1bn ($149bn) in 2012, according to the Medicine Blue Book [published by the Chinese Academy of Social Science in December 2012]. The compound growth rate of China’s pharmaceutical market was over 20 per cent from 2005 to 2010, and the Blue Book forecasts that it will continue its rapid expansion at an average rate of 12 per cent between 2014 and 2020.
“The Blue Book pointed out that the Chinese pharmaceutical market is showing features of rapid expansion, fierce competition, lower concentration, and is greatly influenced by the government’s policies,” says Li. “The Blue Book further mentioned that the pharmaceutical market’s expansion was supported by the increased demand for medicine associated with the population ageing, improved social welfare, and residents’ enhanced purchasing power.”
Despite this, the company has had a rough ride. Annual revenues fell 40 per cent year on year to $32.8 million in 2013, while net losses in the same period were $20 million. This was the result of falling sales throughout all product categories, according to the company. Gross loss margin was 1.5 per cent in 2013, against a gross profit margin of 25.8 per cent in 2012. For fiscal 2013, the company also reported bad debts of $10.8 million, compared to a bad debt expense of $0.9 million in 2012.
So why is this happening? “The healthcare reform instituted by the Chinese government since 2009 contains pricing controls, which have resulted in margin compression in most pharmaceutical products on the market today, especially in the generic space where many of our products are sold,” says Li. “Going forward, we expect to see continued pricing pressures on most products, while new products could help to support overall gross margin once they are launched.” However, that means increased R&D expense.
Although these four companies’ results can present only a glimpse of an economy that supports one billion people, the sectors in which they operate connect with many other parts of the economy – among them transport/aerospace, energy, technology, healthcare, and engineering – not to mention social mobility.
The picture that emerges, from these results at least, is not that of an economy that has superheated and is now in decline, but rather a snapshot of an economy with massive potential that is carefully repositioning itself for the future. Many of the observations, such as shrinking margins and increased regulation, are partly attributable to China’s increasing openness to play in a global market. But it is also conceivable that if the economy does begin to contract, Beijing may decide to reduce its exposure to the US money markets.
At present, the West should be wary of treating China’s moderating growth as indicative of a 2008-09-style catastrophe. China is dealing with the short-term results of a successful few years during its rapid expansion. Now, as companies identify new opportunities in higher-value markets, they are finding that they have pushed their internal capabilities to the limit in order to reach a new point of departure. Another note of caution lies in China’s burgeoning housing market. Any widespread downturn in property prices could create a domino effect within the country, given the rapid expansion rate of its cities.
Western commentators should also beware of applying Western cultural norms to Chinese business leaders. The unbridled chutzpah and showmanship of some US CEOs may sometimes be able to talk up share prices by force of will, but the Chinese way is to be more conservative in their corporate guidance. That moderation should not always be interpreted as a warning.
There is a further dimension to fears about China’s economy. Some commentators, including the FT, have warned of the excessive influence of the shadow banking sector within China. While this criticism applies even more to Western economies and their own reliance on under-regulated (usually offshore) finance, it is true that speculative, non-bank investment in major construction programmes becomes a much higher-risk strategy if nervous investors take flight.
Sensationalist headlines about a 2008-style meltdown in China do little to help, therefore, and only increase the likelihood of investors getting out of the country. In the short term, Western analysts should be more worried about creating a self-fulfilling prophecy. TS
The Strategist says
Signal, not noise.