November 2012

CHINA: China’s export myth

Made in chinaWith its Western trade partners poorer than ever, no wonder slowing exports has caused concern about China’s growth. But Stefanie Eschenbacher finds domestic consumption plays a bigger role in GDP than many realise. There is little doubt that the 18th National Congress, scheduled for November 8, will be the most influential ever. Every five years since chairman Mao’s death in 1977, the National Congress of the Communist Party of China gathers delegates in Beijing to discuss party politics. This year it is as anxiously awaited in the West. “There may be no better time than today to observe how China will change in the future,” Xinhua, the official press agency of the People’s Republic of China, notes in the state-controlled English newspaper China Daily. “After more than three decades of rapid growth thanks to the reform and opening-up drive, China has ushered in an important era of transition in which the country must transform its economy and make it more sustainable.” Distortion
John Vail, chief global strategist at Nikko Asset Management, says social stability and empowering the middle class economically have become a priority of the Chinese leadership, particularly after the Arab Spring. Other issues are clamping down on corruption, tackling pollution and limiting rising house prices. The economy underpins much of this and in recent years it has become obvious that China’s growth model, which over-emphasises manufacturing and exports, is no longer viable. China’s economy is “hugely distorted” as a result of its export-led development strategy, says John Greenwood, chief economist at Invesco Perpetual. Chinese policy-makers have kept the exchange rate for the renminbi low, offered tax incentives to exporters and imposed restrictions on the import of consumer goods. “The Chinese economy has long emphasised exports at the expense of domestic consumption,” Greenwood says. “Shifting to domestic consumption will take a long time.” Export growth slowed in recent months and data suggests that the manufacturing sector’s long slowdown is now also impacting the services sector. The HSBC Purchasing Managers’ Index fell to 47.9 in September, with everything below 50 indicating a manufacturing contraction. This was the longest reading of below 50 in the eight years the survey has been conducted. Even the official manufacturing purchasing managers’ index, released by the National Bureau of Statistics and which tends to be more cautious as it reflects the larger state-owned companies, has been below 50 for two consecutive months. The services sector, which had previously held up well amid a global slowdown, has also reached a low. This is somewhat contradictory as one would expect the services sector to do well as China’s economy is rebalancing. Manufacturing is – and has long been – the dominant sector. In fact, as Greenwood points out, China only started measuring services a couple of years ago. The consultancy, IHS Global Insight, has compiled data that indicates China became the world’s largest manufacturer two years ago, taking over from the US, which had been number one for 110 years. China’s manufacturing base remains dominated by cheaper products – textiles and appliances – which account for roughly a quarter of the overall output. Meanwhile, foreign companies dominate the electronics sector. Stimulus
With the global financial crisis, demand for products made in China slumped. Vail says the crisis had a “tremendous impact” on China, despite several trillion renminbi in economic stimulus. Today, the consensus is that China needs to move up the value chain, away from value-added manufacturing. “Many companies, such as shoe manufacturers, disappear or decline gradually,” says Vail. “They move the lower end of production to places like Vietnam.” Greenwood warns it is “naïve and simple to measure exports on face value”. Last year, he says, exports accounted for 26% of Chinese GDP on paper. Yet roughly one third of those were in fact components bought from abroad that went into manufacturing exports. He highlights one study by the Hong Kong Monetary Authority, which shows that Asia’s dependence on exports to China was roughly half of the headline figure because of the re-export factor. “There are many studies that have been done on this,” he says. “These also show the dependence of Asian economies on China is smaller for that reason. For example, 40% of Thailand’s exports go to China, but half of it is re-exported. Thailand is, therefore, less dependent on China than superficial studies led one to believe.” There is not one figure to rely on and it varies on methodology, Greenwood says. But he adds that China remains significantly dependent on external demand. Opinions differ when it comes to assessing just how dependent the Chinese economy is on exports. One problem is that GDP is measured in value-added terms while exports are gross revenues. To compare like for like, value-added exports would have to be stripped of imported components. The remaining domestic components would have to be converted into value-added terms by taking out inputs purchased from other domestic sectors. Consumption
Frank Yao, vice chairman for Asia at Neuberger Berman, says over the past five years, net exports as a percentage of GDP contribution has been “in low single digits”. Yao says between 45% and 50% of China’s GDP is, in fact, investment and between 35% and 40% domestic consumption. This has been the average for the past five years, with the exception of 2009 when the share of investments soared to around 60%. “The share of net exports as a percentage of GDP is much lower than people expect,” Yao says. Greenwood adds that a large proportion of investment is focused on exports. Last year, he says, 34.4% of China’s GDP was consumption and 48.4% was investment. “GDP figures in the second quarter of this year were 7.6% in real GDP terms, but many of us question whether the estimates of GDP is based on reliable data.” Greenwood’s own estimate is based on three factors: electric consumption; freight traffic, including air traffic, ports, rail, roads; and deflated real loan volume. Using these measures, he says GDP growth is closer to levels in 2008. Vail says: “One thing that does not get coverage is operational leverage. Chinese companies are operating on a thin profit leverage so they are more exposed to slowing external demand.” The tremendous stimulus boosted employment, but Vail says the Chinese are aware they have to get out of the value-added industry. One example industry experts like to cite when they illustrate China’s manufacturing is that of Apple’s iPhone. It is designed in the US, the chips are manufactured in Taiwan or Korea and the circuit board is made in Taiwan. It is assembled in China, but sold almost everywhere. Nevertheless, the slowdown has affected China. Yao says exports have not recovered and export growth had been around 20% year-on-year for the past five to ten years. This year, however, China worked hard to achieve export growth of 10% year-on-year. Robert Horrocks, chief investment officer at Matthews International Capital Management, says China’s economy is export-driven, mostly in the sense that the civil war and turning towards communism had “caused a generation or two of Chinese entrepreneurs to be abandoned. “When China wanted to remember how to do capitalism, exports were a way of learning the market, building the institutions, promulgating the law, and reinstilling the culture of business that had been vibrant in the past but suppressed by ideology. “Quantitatively, domestic demand has been far more important. Qualitatively, export industries were vital to relearning capitalism, but their job has been largely done.” Horrocks says the whole point of China’s modernisation is to make people richer, increase their skills and knowledge, allow them greater freedom in their economic lives, and enjoy greater spending power. “It is the course that every successful economy has taken and is the course that China is following,” he says, adding that rising wages are key. Rising wages
One problem with the export-led growth model is that rising wages make goods more expensive and therefore less competitive in the world market. Horrocks, however, says rising wages will provide greater resources for savings that will be invested in education and capital goods. “Ultimately, if people are getting smarter and have more machinery or software to work with, they will produce more [and] that will cause wages to rise,” he says. This, in turn, will allow for greater spending on healthcare, consumption, financial products and leisure. “However, the ultimate driving force will be the incentive to better oneself, to achieve a new life, to make money and be able to keep a large portion of your earnings.” BMW is another example industry experts like to cite. The car manufacturer reported a 40% increase in sales in China over the first eight months of this year. Elsewhere in the world, including in its home market, Germany, sales hardly grew. “Demand for many high-end luxury goods is increasing in China while it is stagnating in Europe or the US,” says Yao. The Chinese consumer market is attractive for many companies, given the sheer size of the population – more than 1.3 billion – and the growing middle class, even though it remains a poor country. Wages have been rising, especially in the past five years, which is the main prerequisite for encouraging consumption. In the absence of a social welfare system – where people save to pay for retirement, healthcare and education – it appears unlikely that consumption will pick up rapidly. Yao says: “Encouraging domestic consumption is definitely a viable strategy; it will take some time, but China has been trying hard to provide a better social security net.” It recently emerged that the Chinese government has been considering a pension system similar to the 401k corporate pension scheme in the US, where companies are obliged by law to pay social security employment contributions. Top of the political agenda, if the official party line is anything to go by, is the healthcare system. Yao says in Shanghai, for example, this is already well established. Spreading it to the second and third-tier cities will be the next challenge. “China started two years ago to spend 300 billion renminbi ($60 billion) in five years and has established a national social security card already, costing 700 billion renminbi,” Yao says. “Based on a lifetime focus on income and savings, it is possible that it could increase consumption,” Greenwood says. “But, fundamentally, China is still a poor country. Most importantly, it needs to raise per capita income using whatever means.” ©2012 funds europe

Executive Interviews

INTERVIEW: Put your money where your mouth is

Jun 10, 2016

At Kempen Capital Management, they believe portfolio managers should invest in their own funds. David Stevenson talks to Lars Dijkstra, CIO of the €42 billion manager.

EXECUTIVE INTERVIEW: ‘Volatility is the name of the game’

May 13, 2016

Axa Investment Managers chief executive officer, Andrea Rossi, talks to David Stevenson about bringing all his firm’s subsidiaries under one name and the opportunities that a difficult market...


ROUNDTABLE: Beyond the hype

Oct 13, 2016

The use of smart beta investing continues to grow. Our panel, made up of both providers and users, discusses what the strategy actually means, how it should be used and the kind of pitfalls that may arise when using this innovative investment technique.

MIFID II ROUNDTABLE: Following the direction of travel

Sep 07, 2016

Fund management firms Aberdeen and HSBC Global meet with specialist providers to speak about how the industry is evolving towards MiFID II.