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August 14, 2012

China Watch: Keeping an eye on the Two Chinas

August 14

CHINA WATCH: Keeping an Eye on the Two Chinas

The Chinese economy is in transition, a combination of cyclical changes arising from domestic and international conditions, but also structurally, as a product of its own successes. At the same time, its challenges are increasing. Because business opportunities are, in many respects, on the up-and-up, particularly from a supply-side economy such as that of Canada, counting on continuing Chinese potential makes sense. But for long plays, an awareness of the big picture challenges – structural and governance – in China is also essential if good advice is to be provided, and future problems mitigated. In other words, we want to keep a close eye on the today’s China, all the while knowing that tomorrow’s China will likely be different.

We continue to read about China’s ongoing economic slowdown, and it`s easy to assemble examples at the microeconomic level: the National Bureau of Statistics has just advised that China`s industrial value-added output last month marked the slowest growth since May 2009; at the same time, manufacturing purchasing managers’ index declined to 50.1 in July, the slowest pace in eight months.

At the macro level, GDP rose 7.6% in the second quarter, down from 8.1% in the previous three months.

It is equally easy to come up with indicators of China’s continuing growth and potential.

For example, this, from the China Commodities and Resources newsletter, just in the last few days:

– China’s top three alumina makers are planning to invest a total of $1 billion developing quarries and building smelters in Indonesia to secure stable supply of raw aluminum;

– China’s steel output was up 6.5% year on year in July;

– China’s cement output in July was up 6.1% year on year;

– China’s output of the ten most used nonferrous metals was up 4.1% year on year.

But there is more to it than these cyclical ups and downs, overlying what remains, by any measure, seemingly unstoppable expansion. Inevitably, China’s successful market and policy strengths become, in time, weaknesses, calling for reform and restructuring. The bigger the challenge of reform, the greater the pain, and resistance to it.

An interesting warning has just come from economic guru Andy Xie. Formerly of Morgan Stanley, Xie, to this day famous for predicting asset bubbles around the world and identifying fundamental structural weaknesses in the Chinese economy, and a must-read for China Watchers, published a lengthy analysis of some of China’s fundamental economic challenges. (You can read them on Caixin Online/Market Watch.)

Here and in his other writings, Xie argues that China has seriously overbuilt its manufacturing capacity, leading to falling prices and huge inventories. Local governments however, whose objectives are to maintain employment and tax revenue, pressure firms to maintain production, through policy loans and other subsidies, thereby building further production capacity. This vicious circle can only be broken by a meaningful (not only hortatory) shift towards a consumer economy, with its demand for a broader array of the types of goods and services currently provided by China’s elephantine State-Owned Enterprises. These SOEs however not only play an economic role: because they are controlled by government, as their only share-holder, they provide tremendous opportunities for ‘gray income’, which is only accessible to the political elites and their families.

Meanwhile, in the private sector, many entrepreneurs have been forced to substitute normal business activities with a new business model based on connections with government and SOEs, and the opportunities that they can provide.

“I sense”, Xie asserts, “the deepest pessimism towards the economy in two decades.”

Xie lives in Shanghai, so his criticism of government will necessarily be muted. Also, he is one expert among many. Still, he does describe how such factors behind China’s huge expansion – such as direct government intervention in the economy and dependence on favored ‘Champions’ – are now slowing if not stopping the transition to potentially the even greater consumer economy that China’s Leaders and their fourth and fifth Five Year Plans have promised to build.

Also understated is how such a transition would necessarily dislocate the privileges of China’s leadership class. Big – and sensitive – issues to be sure.

Relevance to Canadian business: in the immediate term, not much. Ongoing Canadian corporate efforts to increase the China business is well justified. Capital – SOE’s, corporate and personal – is flowing out of China, for reasons ranging from strategic national interest to individual opportunity. It’s almost as if we are in both a buyer’s and a seller’s market.

Still, we are wise to think about that other China, the one that will emerge as it works through its built-in contradictions. That too will provide business opportunities, but not before a certain amount of disruption takes place.

Joseph Caron