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Letter from China, 2019

 
 

It’s 2019 already, here in China. The PRC is getting ready to celebrate it’s 70th anniversary, and as usual everything is being cleaned up and made presentable. The mood is generally positive, and skies are a shade bluer in Beijing and other large cities compared to 2009, or 1999. It seems like 2009, with the world in recession and globalization itself even in question, was a long time ago. Looking back, the attitudes in that period seem a bit strange- such as talk of deflation, with the world just now getting over another major run of inflation. Hindsight certainly helps.

Many things are quite different since 2009, but others very similar. Let’s take a brief look at how things stand now, especially in comparison to that period 10 years ago. We’ll look at this in four areas: the economy, political risk, foreign companies in China, and key trends. We’ll skip anything cultural, sporting, etc. After all, we know what has happened, some of which - like Brazil and Germany winning recent World Cups- one did not need a crystal ball to predict.

The China Economy- 2019

The unofficial race for national GDP preeminence is like a yacht race- with a range of boats chasing the US and EU, and making progress at a slow rate. For China, the US and EU yachts are in sight, though still a ways ahead, and tail winds are not as strong in 2019 as they were in the years running up to 2009. China’s onward climb to GDP preeminence has slowed somewhat, though otherwise is on track. China’s GDP is close to USD 8 trillion, and per capita GDP (absolute) nearly USD 5,000, and almost USD 9,000 when measured by PPP.

Looking back, economists now believe that years around 2005 represent China’s peak growth period, with growth rates between 10-12%. Since the Great Recession of 2008-9, growth rates have slowed to the 6-9% range, due to several factors. For one, exports slowed in 2009. While these bounced back, this was never to the pre-2009 levels. More importantly, there are several key embedded issues that have kept China from going over 10% again: high commodity prices, especially oil, higher wages, a persistent shortage of managerial talent, and the continuing inefficiency of many SOE and reformed stock firms, and still inefficiencies in the banking system and allocation of capital. China is finding that while these are serious issues and do drag, they are part of the growth bargain, and can to some measure be addressed. In more open industries, for example, a new generation of private firms has started to overtake the SOEs, a good number of which are being officially or unofficially dismantled- which would have been harder to do in 2009.

Despite fears to the contrary, China has found that growing by as low as 6%- below the benchmark rate of 8%- is not so bad. Due to high agricultural prices, more farmers have remained on their farms, and there has been less migration to the cities than projected, so China does not have to create as many jobs as before. Moreover, agriculture has become much more efficient, not only with adaptation of GM crop technology for seeds on a widespread basis starting in 2011, but through improved methods as well. The fu xiong cha ju- the gap between rich and poor in China has steadily increased, but the poor are smaller as a total group, and somewhat better off in 2019 than 2009. This has not gone down so well in China’s middle class, as the hourly rate of domestic workers has nearly tripled in the past 10 years, making ayis and the like increasingly affordable only for the upper middle class and wealthy. Inflation has not been good to the shi min or city dwellers as it has to the farmers, though the former benefited to a much greater extent from China’s initial reform period, in the 1980s and 1990s.

Moving to money, China still has the largest foreign reserve currencies in the world, though the amount has decreased to USD 1.4 trillion (all currencies- nominal) since 2009, as China has found that it needs to spend a good amount of its current account surplus on imported energy, oil in particular. Thus the current drive for energy savings. The Chinese government has allowed the Yuan to appreciate somewhat, now to USD 1:RMB 6.1, though still will not allow for a full float, as the priority is still to protect and augment export-producing jobs. Many economists see the real value of the RMB at around USD 1:RMB 5.6, so the difference is not as stark as it used to be, but there is still a gap. Due to this, and because China only issues limited treasury bills, the Yuan is not as close to becoming a reserve currency as foreseen in 2009. There is speculation about a free float in the next 5 years though.

In foreign investment there was a trend away from investing in China starting around 2009 for several years, in which investment was diverted into other countries such as Vietnam, Thailand, Mexico or Latin America, and to some measure India. In most cases this was done to reduce costs, wages in particular. In other cases this was done just to diversify, and not to have all one’s eggs in China, or for IP issues. Thus FDI dropped by over 20% for about 3-4 years. However, the trend has now partially reversed, as wages grew significantly in these other locations, and by cost arbitrage FDI is now increasing in China at the expense of these other markets. On the other hand, Chinese firms invest much more overseas than in 2009, mainly to gain access to these markets.

Moreover and very importantly, foreign suppliers now understand better that China represents a large market on the sell side, and is much more cohesive as a market compared to SE Asia. Jiangsu Province, for example, has a larger population than Thailand- 80 Mn compared to 65 Mn- and has nearly surpassed Thailand in per capita GDP, especially with the appreciation of the RMB. Jiangsu, however, is much more integrated with its neighboring provinces, by every measure (transport, language & culture, legal & tax structure), especially Zhejiang, Shanghai, and Anhui (combined population & GDP150 Mn, USD 960 Bn : ) than Thailand is with Burma, Laos, and Cambodia (combined population & GDP: 60 Mn, USD 32 Bn). In fact just this Hua Dong or Eastern China market has become larger than the markets of all but about 20 countries in the world. In ten more years, there may be only about 8-10 countries with larger economies.

The China economy still depends to a good extent on exports and investment for growth, though not as much as in 2009, especially in regard to investment. The Chinese consumer now accounts for a larger stake in the economy compared to 2009, though this still needs to grow. Property is also less of a focal point of the economy than it used to be, and growth in this industry has not duplicated the rabidly high growth periods of the 2000’s. All in all, growth is not as strong as before, but more balanced. More balanced, but there are still risks…..

Political Risk

Regarding political risk, China in 2019 has yet to take over the world, let alone Asia, and has not yet imploded, or approached something even close to this. Curiously, the two best selling books on China now are Why China is About to Implode and Dragon Unbound- How China Will Take over the World- the same two as in 2009. Apparently the dates for this implosion- or conquest- keep getting put off, though new reasons for this are offered in each updated version of these books. Maybe one of these can be put into the next 5 Year Plan.

There are certainly indications in either direction- conquest or implosion. Since 2009, for example, Chinese firms have been more aggressive in purchasing overseas corporations- the acquisition of Dell Computer, which had fallen on hard times, being the latest example. Even more remarkable is that this was by a company, Jiangsu Dazhen, which did not exist in 2009. The number of overseas resources China has acquired since 2009 are also too many to count, and Chinese brands are getting noticed more overseas, albeit from a very small presence before. However, any objective eye would see this as a modest expansion that would seem in order with an economy of China’s size, rather than a full or partial conquest. On another tack, the launch of another Chinese air craft carrier has some in Washington and other capitals wringing their hands, though on balance China’s ability to project force is still not nearly at America’s level, and maybe not even at Japan’s.

On the other side, there has been an increasing mumble of complaints, online and in visible protests, about the healthcare system China is trying to implement, which seems to be falling short in delivering what it had promised. Protests over environmental issues, even in smaller cities, have become more organized, though with this and other protests no one in China is really questioning the authority of the central government. The online environment has in fact developed greatly, from its large but chaotic status in 2009, and has in fact been given greater recognition at all levels of government. This is not just an outlet for steam, but an increasingly constructive platform.

None of these indications though indicate a country that is about to implode or even take over the block. Otherwise, there has arisen a more contentious legal environment compared to before 2009, with more Chinese firms locked in disputes with foreign ones. However, Chinese firms are also suing each other to a greater degree, especially over the traditional litigious focus of foreign companies, intellectual property. Having now developed some IP, leading Chinese companies are loath to let others just copy this, and are fighting back against the IP pirates, which don’t have as much support among local governments as they used to. According to a recent poll of foreign business in China, China has made some progress in IP protection, though they would like more.

In short, China is not as stable as say Switzerland, but extreme risks continue to be minimal, and it remains an environment that one can do business in. Now how much profit a foreign company can actually make in China is another issue, and here the changes are both good and not good.

Markets: Foreign Companies in China?

The past ten years have been very good to some foreign companies and cruel to others. Some companies- such as DuPont and Emerson for example, have seen exponential growth, and now find that China accounts for over 10-20% of their global revenues, and even higher in profits. Many other companies, however, have found their penetration of the China market reversed, or have even been bounced out of the market- not by the government but by market forces. In general, larger foreign companies have done better, but this is not a steadfast rule, as many SMEs are also in this first group of success stories.

In short, what happened is that one set of foreign companies went down market, and a set of Chinese companies went up market, sometimes to great success. To understand this further, let’s first focus on Chinese markets for a moment. Before 2009 or so, in many markets in China there evolved a certain order: simply stated foreign companies sold to the top of the market, leading Chinese firms to the middle, and lower end Chinese firms to the low-end. The size of these market segments could vary- for example, the top end may be up to 30% of the market or more (as in a high performance market such as aerospace), or as low as 3% or less (in a wide range of markets with low barriers to entry). However, starting well before 2009, and accelerating after this, many of these leading foreign and Chinese firms actively set out to break this mold.

These foreign companies wanted greater penetration, into the middle tier or the market, which often represented a larger segment by volume, if not by revenue. So they started to enact a comprehensive strategy including: bigger and deeper channels, lower priced and more functional offerings through “China-products” and local acquisitions, greater local R&D/ D&D in general, expansion of applications and solutions, extensive local sourcing, and other strategies and tactics. This has meant serious investment, but has in many cases paid off, meaning not only greater penetration and sales, but also making it more difficult for leading Chinese companies to compete against them. Moreover, this trend has not fully played out, and may accelerate or mutate further.

For their turn, leading Chinese companies- meaning not just large (and often not the large SOEs) but in particular advanced ones- have made even greater gains. One reason is that as a group, these companies have been pursuing more advanced products and customers the top end market segment for a long time. As the standard is set by others, they do not need to innovate this standard, just to meet it, or come close. Moreover, many of these companies are very strong in continual cost reductions, and abstractly-put are delivering 80% of the value at 60% of the price- or 70% of the value at 55% of the price- and so on. If customers demand that 95% level of quality, then foreign suppliers will not have a problem. But if only 70% or 80%, then competition will be tougher than it used to be, and will not get easier. On the other hand, more complacent Chinese firms who thought they owned the middle segment of the market may also be in for a surprise from foreign firms that have localized well, and other domestic firms that have expanded aggressively. Leading foreign and Chinese companies in some markets are meeting and clashing in the middle, whereas in other markets there is less competition- at least relative to China.

The big losers then have been: less advanced Chinese firms, some of which have been acquired by more advance ones, and many of which have just folded; and the set of foreign companies whose value propositions have been lost in the shuffle, and have been squeezed tight, or squeezed out. The markets of course have not been static. Aside from growing larger, most markets have also exhibited a trend to quality- with customers expecting more and being able to pay at least some premium for this. This is contra-intuitive to those who do not know Chinese markets well, but to those who do makes sense. This means a smaller low-end market segment, and the definition of quality being redefined slowly upward.

Overall, Chinese companies have gained somewhat at the expense of foreign ones, but most markets keep expanding significantly, and it is certainly not a zero sum game. Moreover, with the wide range of acquisitions and alliances made in the past 10-20 years, thinking just in terms of foreign v. Chinese is a bit dated- like those strange hair styles they had back in 2009.

Key Recent Trends
Are there any trends in China that were not at least latent or started on a small level in 2009? The short answer is, not really. They were all there, in some form and some level of momentum. Let’s look at a few significant ones.

Workshop of the World? China is much more thought of now a market to sell into, more so than as a production base for export- or at least the combination. As mentioned, costs in China have become higher, and while there has been some movement to lower cost locations in Western China, in many cases these locations have been found wanting, especially for products requiring greater value added or precision. And foreign companies are finding it just as hard as in 2009 to compete for top talent. On the other hand, with GDP doubled since 2009, the value of China as a market has become increasingly clear- and not just for niche items, but for anything that can common some price premium. China still has massive industrial capacity, but its consumers are much more in focus now.

Going West. There has not been a big movement to Western China, but there has been to smaller cities. Smaller is relative, so we’re talking 3-10 million rather than 10+ million. This can also be called the movement from Tier 1 and Tier 2+ to Tier 2-5 cities, in terms of investment, consumer marketing, and general emphasis. One economist recently predicted that in ten years, these cities will represent over 60% of China’s GDP, compared to 10% in Tier 1 and Tier 2+ cities.

All things Green. Green in China has not totally lived up to the promise and hype it had in 2009, but serious work has been done here. Energy efficiency is greatly improved, especially in factories. Green buildings are a growing trend. Most promising has been China’s embracing of electric vehicles, which accelerated after 2012, driven by affordable models produced by local manufacturers. There are still significant air and water quality issues, which are taking much longer to resolve, and China seems to be perpetually in the planning phase to cut carbon emissions. To date, “green” in China is more focus on energy than environment, and lowering energy costs has become an urgent task.

Big Projects. Since the Great Wall and Grand Canal, China has loved big projects, and these are still in vogue. China is still focused on landmark projects, with strong focus on energy, such as oil & gas pipelines, new LNG ports, etc. The Moon mission is also gaining speed, and the plans to build a jumbo jet are nearing fruition, though with many issues still needing resolution. If we count social projects, then the national healthcare project is the biggest of all, though the effort to make this complete is making the Great Wall look more like a yard fence.

 

Looking Ahead to 2029
So what will China be like in 2029? Let’s not go there. Things in China can change fast, and we may be starting with some false assumptions. Maybe we’ll see a World Cup Final in 2024 between China and the US…now we’re moving from projection to fantasy. Let’s revisit this again in 10 years’ time.

 

About GCiS China Strategic Research

GCiS (www.GCiS.com.cn) is a China-based market research and advisory firm focused on business to business markets. Since 1997, GCiS has been working with leading multinationals in sectors ranging from technology to industrial markets, medical, chemicals, resources, building and constructions and a few others.

 

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