Were Barack Obama, David Cameron or Francois Hollande to announce 7.5-percent growth rates in their countries, they would be celebrated as masterful economic stewards. Yet in March 2012, when Chinese Premier Wen Jiabao announced a 7.5-percent growth target for 2012, it was seen as a gloomy portent of trouble ahead in a country where dictatorial capitalists had targeted (and nearly always achieved) higher growth since the 1980s. In fact, just 12 months before, Premier Wen had targeted 8-percent growth, a figure that he implicitly linked to the maintenance of social stability, against a background of revolution and violence in the Middle East and whispers of a Jasmine Revolution in the Middle Kingdom.
The symbolism of a measly half percentage point indicates that China is entering a major transition period, where the economic tactics that have produced double-digit growth are becoming less and less viable. The country’s leadership is for the first time publicly acknowledging that this cannot continue indefinitely and is working to convince its growth-conditioned populace that this modest slow-down is not only OK, but better for the long-term economic outlook for the Middle Kingdom and its people.
For a country that many view as the modern embodiment of the dynamic capitalism of Andrew Carnegie, China is in fact one of the world’s most carefully managed economies. As Richard McGregor notes in “The Party,” even the economy of the glittering metropolis of Shanghai, showcased as the flower of free market reforms, is approximately 80 percent state run. China’s system is no longer the archaic command economy of old — no one in Beijing decides how many toothbrushes to produce. Nevertheless, contemporary China has retained a “command financial system” where the Party, rather than markets, largely decides which companies and building projects receive bank loans.
The cornerstones of China’s system are the “Big Four” state-owned banks, which control nearly half of China’s financial assets. These banks have the trappings of modernity— ostensibly international governance structures, and successful multi-billion dollar international equity listings. However, they in fact operate at the discretion of Party officials in Beijing, providing cheap loans to corporate champions (40 out of China’s 46 Fortune 500 companies are state owned), public work projects, and many of the politically favored property developments that awe foreign visitors. They also exert a dominant influence on domestic capital markets, providing loans to institutions to purchase equities, and they hold 70 percent of all Chinese bonds. In their book “Red Capitalism: The Fragile Foundation of China’s Extraordinary Rise,” Carl Walter and Fraser Howie liken the Big Four to “finance ministries” due to their scale and subservience to political interests.
This public financial machinery has succeeded in producing investment-driven growth for three decades. Strict capital controls force savers to park their money at very low rates in state banks, which Beijing then directs to invest in infrastructure, real estate or another State Owned Enterprise (very little bank funding reaches private entrepreneurs). This system was dramatically demonstrated during the global financial crisis, when Beijing pumped a two-year stimulus package worth US$586 billion, a vast sum for a government with revenues of less than $900 billion, and proportionately larger than the U.S. or European fiscal stimulus packages. In addition, the government directed the banks to unleash a flood of new loans — China’s loan-book grew 33 percent in 2008-09 at a time when lending levels contracted sharply in the rest of the world. As a result of these historically large interventions, China grew at 9.2 percent in 2009, compared to a 2.6-percent contraction in the United States.
The scale of the post-crisis stimulus investment is staggering. According to The New York Times, the city of Wuhan, for example, has plowed $120 billion into metros, airports, cultural centers and a skyscraper taller than the Empire State Building. This immense sum represents approximately $12,500 per resident, in a city where the average person earns less than $10,000. Wuhan is representative of many municipalities which have relied on leverage from state banks to fund building sprees. Of Wuhan’s $120 billion construction bill for example, as little as 5 percent has been funded by normal municipal revenues.
Creative Finance
Municipalities such as Wuhan have funded the large gaps through bank loans to opaque vehicles known as Local Investment Companies, creatively structured to be hidden from the city balance sheets. Cities have also relied on massive land sales to pay for projects and fund ballooning debt — in 2009 alone, municipalities sold land equaling the area of Jamaica, and some estimate that as much as 74 percent of local government expenditures have been funded by land sales.
Overall, China’s National Audit Office judged that Chinese cities had run up $1.67 trillion in debts by the end of 2010 (and $458 billion in 2009 alone). This pile of municipal debt is nearly as large as that of the American cities, which are set in an economy three times as large. China’s cities, banks and national economy are highly vulnerable to the tightening of credit and a decline in property values.
Post stimulus-China is full of the excesses of top-down investment — half empty bullet trains, skyscrapers without tenants, model cities without people. China has reached a point where it needs consumption, high technology, entrepreneurship and social services more than it needs eight-lane highways. Beijing recognizes this and is quickly moving its policies in this direction but is learning quickly that it is not as easy to dictate economic growth in these segments of the economy.
While many have called for the government to step in with a national-level, top-down stimulus package to bring growth back above 8 percent, as of October, Beijing has resisted such urges, perhaps wary of throwing yet another fiscal party while still hung over from the 2008-09 stimulus. However, the government is determined to engineer a “soft landing” for the economy, and so further rounds of strategic stimulus are expected. This time, however, the government has quietly sanctioned a “bottom-up” approach, whereby the cities initiate massive building-sprees. Chongqing recently announced a $240-billion investment plan, while Tianjin is to spend $236 billion and Changsha $130 billion. If carried out, each of these would rank among the largest urban investment projects in world history. It remains to be seen, however, how much of these schemes will actually be funded, as Beijing loses its enthusiasm for Keynesian largesse.
China’s emergence as a middle-income country and shift to lower (though still high) growth has major implications for foreign corporations operating in China. Profitability is being squeezed across the corporate spectrum. Goldman Sachs found that in the second quarter of 2012, the earnings of China’s A-listed non-financial companies declined 17.6 percent year-on-year. This figure primarily reflects years of inefficient overinvestment by Chinese SOEs, but should serve as a cautionary figure for Western multinationals. A cooler market will increase competition among companies for strong local talent. The next decade will witness the intensification of the talent war, where multinationals will compete for managers who can raise profits in an environment of slower growth. Quality local talent will continue to become more expensive. According to Towers Watson, while local junior managers still earn less than 60 percent of comparable expatriate staff, Chinese executive pay is already on par with the generous packages of expatriate executives. As companies increasingly focus on improving efficiency and clawing away at market share, talented local staff will command a premium. It will not always be worth it. While China has its share of talented global executives, the layer of experienced, competent managers is usually not very deep. Western companies frequently hire expensive Chinese senior level managers and executives only to find that they lack the managerial competencies to add value to the organization. Moving ahead, the process of hiring, retaining and firing staff will be more and more critical to operational success in China.
While China is becoming more competitive, it is still a game worth playing for most global businesses, both as an investment destination and market. Even at just 6-percent growth (and many believe the 7.6-percent growth reported in Q2 of 2012 is overstated), China is on track to become the world’s leading economy by 2030. Moreover, a strengthening currency (up 24 percent against the U.S. dollar since 2005) will make China a more attractive export destination. U.S. exports to China now exceed $100 billion, a five-fold increase in 10 years, and more than any other country outside of neighboring Canada and Mexico.
Just as the fortunes of some industries will be stronger than others, economic growth will vary greatly by geography. The National Statistics Bureau estimates the country’s urban-rural disposable income gap to be at 2.77, which, though high, has fallen below 3.0 for the first time in a decade. The coming decades may see an income convergence between rural and urban communities as well as between first- and second-tier cities, which are enjoying the benefits of state infrastructure spending and where growth has begun to exceed that of Shanghai, Beijing, Guangzhou and Shenzhen.
Expiration Dates
Industry is shifting along with China’s economic landscape. If the previous economic model consisted of ever-growing Marshall Plans directed to fixed asset investment, the traditional industrial model has consisted of large-scale export-industrial clusters, fed by abundant migrant labor, and centered in and around Shanghai and the Pearl River Delta, which formerly served as efficient oases in a backward country. Just as the old boom-era economics are not sustainable in the long run, the old industrial model is increasingly outdated. First, the Eastern industrial provinces are now middle-income geographies, a product of their own successes, which has led to intense wage pressure. In the southern Guangdong province, industrial wages have been rising at approximately 20 percent per year. The impact of the One Child Policy, implemented 30 years ago, has reduced the supply of workers in their twenties, and especially in the most urbanized areas, where the policy is most strictly enforced.
These trends are causing China to move up the value chain and prompting companies to evaluate new strategies. China is increasingly too competitive and too pricy for manufacturers of low margin or undifferentiated products. Lower value-added production has or is considering relocating. Neighboring Vietnam has been favored for over a decade as the “China +1” play. Bangladesh and Cambodia are now favored for garment production, while Indonesia and India offer promise for other industries. Myanmar, with its extremely low incomes and relatively high population, is attracting a hard look from major companies as the country opens its political system and economy.
However, for the majority of businesses in more complex industries, China is still a promising and attractive market in which to operate. First, China is no longer primarily a location from which to source goods but increasingly the world’s most important market in which to sell them. The advantages of producing goods from within such a critical market will only grow. The American Chamber of Commerce in Shanghai determined that the most successful Western firms operating in China are those that sell a majority of their products to the domestic market rather than export. Secondly, China’s vast interior is opening up to viable manufacturing. While the post-crisis round of stimulus will create a financial overhang for decades to come, China has made impressive gains in transport infrastructure, rising to 48th in the World Economic Forum rankings, above all other BRICS as well as middle-income countries such as Turkey, Mexico and Brazil. The improved infrastructure has been particularly pronounced in inland provinces such as Sichuan, where export manufacturing is increasingly viable. The improved national infrastructure has also cemented the country as a truly national market, much as the federal highway system did in mid-century America.
Third and finally, firms with technical advantages will continue to prosper in China. As international PV manufacturers discovered, companies using widely available technology are quickly rendered obsolete by Chinese companies able to marshal resources and people at a dizzying pace. However, those firms that retain proprietary technology or operate in niche parts of the value chain can not only succeed in China but thrive.
China’s youthful, high-growth economy is maturing; its 30-something work force is looking for stability and middle-class comforts. As the country enters a sustained period of slower growth, it still represents attractive investment and market opportunities for most global businesses, particularly those who can most effectively guide their in-country operations and management in an environment of heavier competition. And as any Western politician would attest, growth of just 5 or 6 percent is a nice problem to have.
John Evans (john.evans@tractus-asia.com) is a co-founder and Managing Director of Tractus Asia Ltd., where Kent Kuran (kent.kuran@tractus-asia.com) is a Consultant. Tractus Asia is a leading Asian FDI advisory firm.