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Private Investment in China: What Could this Mean for China and the Global Economy?

Following a mandate by China’s State Council, China’s Cabinet, to boost private investment into previously state-controlled industries largely dominated by SOEs (State-Owned Enterprises), China’s NDRC (National Development and Reform Commission) has drafted laws to open several industries, namely, the healthcare, railway and transport industries, to investment by private companies.

While not necessarily a watershed moment on the path to a more open China, reforms were attempted in both 2005 and 2010 respectively, it does mark a significant turnabout for China given the state of the economy, with GDP growth slowing to 7.4% in the third quarter, thereby necessitating action from the government and ensuring that legislation will have the teeth required to push previously monopolized industries into reform. This is in sharp contrast to previous versions of the reforms, where economic growth was rapid and the government was trying to bring the economy under control.

Healthcare, railways and transportation are not the only industries slated to open up, however, with the State Council mandating at the beginning of this year that, in addition to the aforementioned industries, municipal administration, finance, energy, telecommunications, and education markets too, should be opened up for private capital.

Domestically, this offers China several advantages, including providing private investment with a place to go outside of the real estate sector, dubbed “the most important sector in the known universe”, not for its vibrant growth, but due to the systemic risk that it presents should a bubble, fueled largely by private capital, burst. Allowing private money to be invested elsewhere ensures that property prices will come more in line with what average citizens can afford, thereby further ensuring stability. Better still, consumers will ultimately receive products offered by what were once SOE monopolized industries, from private companies competing for their business, improving prices and the quality of end-user experiences.

But growth in China is indeed good for the global economy as well. With growth continuing to evade Europe, and the United States still in a tepid recovery, a recession in China could potentially be the straw that breaks the proverbial “camel’s back”. Moreover, by giving private capital a chance to grow, consumers will ultimately be able to better afford goods, domestic and foreign alike, while tax revenues for the government will increase, reducing the necessity of municipal governments to depend on property development for tax revenues alone and further empowering a middle class able to create wealth and invest it accordingly.

While change will by no means be immediate, indeed, this transition could likely take several years, the potential for both China and the world at large look bright as the country proceeds on its march toward more open markets.

 

Where are the Chinese Brands?

With China’s 3Q GDP growth falling the 7.4% year-on-year, the case for the county’s rise up the value chain has never been stronger. As stated in several of our previous articles, China needs to rapidly increase the value of the products that they sell. One way to do this, of course, is to increase the value of the products themselves, through innovation, to be better positioned to compete in the global market. While this mandate has indeed begun to bear fruit, the move up the value chain is hardly this one-dimensional; without brands, China’s companies will remain at a decidedly low rung of the value chain.

This is not to say that Chinese companies are in any way doing poorly abroad, indeed, nearly seventy of China’s companies are members of the Fortune 500, but when you negate market capitalization as a measure of success and replace it with brand equity, fewer than ten of those companies can stack up against their global competitors.

The cause of this problem lies predominantly with Chinese consumers, who, for the majority of the past 30 years, have been relatively uninterested in brands that were not international luxury items such as Mercedes or Louis Vuitton at the high end, and more interested in price and quality at the lower end. This prompted companies to invest heavily in their production in order to drive down costs while improving quality to attract domestic consumers, while investing precious little in their brands.

Also notable are Chinese manufacturers fixed to a strictly OEM model, incredibly adept at making products for others, while less interested in developing their own marketing and sales forces. With sluggish growth and a rising RMB eating at already low profit margins, however, some of these companies are having a rethink, with a modest push by the central government to create their own brands.

But how will a brand make a difference to these stagnating business models? Traditionally, brands have commanded 27% gross margins, in sharp contrast to the 19% delivered to OEM manufacturers, making for a potentially lucrative incentive for any company willing to invest in a marketing team and sales force to build a brand and drive distribution.

While many Chinese brands are making the move toward building their own brands, the opportunity for foreign companies to leverage their own, existing brands to tap a potentially massive market still exists for those companies ready to take a risk and invest in their own marketing and sales efforts within China, while local companies continue to find their feet in unfamiliar territory.

 

Is China Headed for a Slowdown?

In order to counteract what has been bid “the most important sector in the known universe”, China imposed curbs on its property market in order to quell a mountain property bubble that threatened to derail the mounting recovery, a bubble largely a result of the large stimulus set in place to fund infrastructure projects country-wide and give the nation’s economy a “soft landing” ostensibly to prevent a “hard landing”.

The measures were effective in the short term, while questions remain as to just how the stimulus measures were funded, particularly at the local level, China dealt swiftly and deftly applied economic levers to avert what would truly have been a global economic crisis.

Unfortunately, these measures would only function so long as they could be paid for, and those funds would have to come from China’s powerful export industry largely responsible for the country’s rapid economic growth of the past 30 years. With developed nations, indeed, the vast majority of the G20 continuing in their economic woes, those export returns have been slow to reappear and are currently in a state of declining growth.

So much so, that China has now released more funds to further promote domestic growth within her own borders, funding more infrastructure projects while slowly relaxing property curbs to more actively engage the “soft landing” and wait for the economic recoveries of Europe and the United States.

China has just released 1 trillion Yuan in its most recent stimulus package, in a bid to further propel waning economic growth due to a dramatic slowdown in export growth, fueled by the continued economic malaise in the U.S. and particularly Europe. The question will be as to whether or not the Central government will be able to control inflation while continuing to release massive liquidity into the market. But therein lies the problem; China’s economy, no matter how much cash is readily available cannot escape the realities of the global financial climate, and while they may be able to temporarily suspend and economic crisis of their own using their hoards of liquid capital, they risk rising inflation and pricing their own burgeoning lower middle class out of the market, which could endanger stability.

Thus, China is working very hard to improve the plight of the common worker in order to both improve domestic consumption, thereby lifting the boat from within, but more importantly, providing economic security to those that may well be negatively impacted as things sour in the face of a continued global slowdown, thereby ensuring stability and buying time in the wait for the global economy to once more finds its feet.

 

Where is China’s Innovation Coming from?

In a previous article, we spoke about how China was rapidly becoming one of the world’s leading innovators, filing more international patents than any other country in 2010. Now, questions remain as to the value of quantity over the quality of innovation and just how that reflects on China’s move up the value chain. This also begs the question: what is China doing to “out-innovate” traditional innovation strongholds like the U.S., EU and Japan, even if that innovation is not matched in technological prowess?

There are several factors that have led to China’s rise up the value chain, beginning with the disruption of traditional supply chains; whereby companies began outsourcing their manufacturing capabilities to China to decrease the assets on their books while increasing productivity and margins; mandated technology transfers, where foreign companies, intent on bidding on government tenders in China were required to contribute their proprietary technology to secure the tender, the chance to get access to China’s growing middle class and the fear that not doing so, would result in significant long-term disadvantages, and finally, China’s nascent engines of innovation, companies that have at first built their businesses as Original Equipment Manufacturers that have since added research and development to their business models in order to compete with competitors, both domestically and abroad in increasingly commoditized industries.

As brands began to outsource their manufacturing capabilities to Chinese manufacturers in the ‘80s and those OEMs became increasingly adept at producing low-end components, the win-win arrangement progressed, with many manufacturers rising up the value chain to take on an increasingly large portion of their partner brand’s manufacturing capabilities. This trend is by no means China specific, but had it not occurred, as with other Asian manufacturing hubs, further steps would have been impossible.

Now armed with a more technically skilled workforce and rapidly improving industrial capabilities, China was set to come of age and invest in what is now some of the world’s most impressive infrastructure, specifically the world’s largest high-speed rail network. Determined to win government tenders, company’s like Kawasaki were encouraged to partner with local Chinese companies, with proprietary technology being part of their contribution to those Joint Ventures. While this won companies like Kawasaki market share in the short term, their Chinese partners would ultimately become their competitors, producing their own trains using Kawasaki’s technology ready for export. This, once more, is not a China-only trend, but akin to the vast majority of developing countries, whereby emerging economies “disrupt” traditional industries with what is often a cheaper labor force, allowing developed countries to adapt and further innovate new products and industries.

While technology transfers are no longer required to bid on Chinese tenders, many companies choose to partner with Chinese companies in order to improve their chances at access to the Chinese market, reasoning perhaps, that the lost opportunity is not worth the technology parted with to secure that access.

An exciting trend is now emerging that is seeing domestic Chinese companies truly out-innovating global competitors. While their numbers remain small, the government has incentivized companies that invest in innovation, ensuring that, while the quality of the gross number of patents filed to date may not yet stand up to global competitors, the future is truly bright for innovation in general, as well as for China.

 

What Happens When China Becomes the World’s Largest Importer?

China’s economy has grown largely on the crest of a wave of exports fueled by foreign direct investment over the past 30 years, but as the global market changes and China adapts to new realities, what are some potential opportunities that arise from companies with an existing presence in the export industry in China and how might they leverage that experience to benefit from the changing domestic economy?

China’s export industry is indeed changing, while it is by no means going away, physically or metaphorically, there are certainly some challenges that will present themselves over the coming years. But like any challenge, there also comes opportunities; as China’s imports rapidly increase, despite the ebb and flow effect of global markets, the trend is clear, China will become both the world’s largest importer and largest economy in the world in the not-too-distant future.

In a previous article, we spoke of about how China, in an effort to maintain economic growth and offset the effects of a decrease in exports, while at the same time attempting to close what has been an increasingly larger wealth gap and create a more robust (and happy) middle class. In so doing, we may be seeing a shift in the China model, one that is increasingly more consumption, and therefore import-oriented than only foreign direct investment and export-oriented.

Businesses currently exporting from China are in a marvelous position to take advantage of this trend. In the process of offsetting rising costs as a result of the changing global economy and China’s pivot to adapt to it, these companies can use their existing production capacity, experience on the ground and/or human capital to make sales on the mainland and capture a part of what will be the world’s largest consumer market.

While traditional imports, often components ready for tertiary production and future export, as well as luxury goods and status symbols such as wine will remain, there is nary an industry that will not be touched by this development, while some more readily or imminently accessible markets exist such as those that cater to China’s aging populous, professional services, design and medical products, a nascent middle class will ensure that the market for quality goods will only grow for the foreseeable future.

While, as with any pivot, timing is essential to ensure that these products come to a market that is ready for them, the future is bright for forward looking enterprises that see the opportunity when it presents itself.

 

China’s Industrial Base – Moving Inland?

In one of last month’s articles, we cited China’s rapidly increasing labor costs, one of the lynchpins of the country’s economic growth of the past 30 years. One of the many reasons that labor is becoming increasingly difficult to find, is often tied to China’s migrant workers, by far the globe’s largest migratory workforce, leaving for home during Chinese New Year, with increasingly fewer returning to their positions at factories along the coasts.

This begs a couple of questions, the first: why (perhaps how), in a country of 1.4 billion people is there a labor shortage? And the second and perhaps more important going forward: How will this affect China’s manufacturing and export industries?

The reality is that both the labor shortage and the resulting solutions are related. Over the past 30 years, as coastal cities have rapidly developed and been the primary beneficiaries of foreign direct investment and government assistance, they attracted massive numbers of migrant workers from elsewhere in the country. The best example of the scale of this migration is perhaps, Shenzhen, formerly a fishing village just 30 years ago, is now home to some 14 million people and is one of China’s primary economic hubs. Migrant workers will traditionally leave for home, bringing with them the majority of their savings to provide for family back home. As this trend has continued in tandem with increase government investment into China’s interior, the infrastructure required to facilitate industry has developed.

Rather than travel to far flung factories on the coast leaving their family behind in search of work, many former migrant workers are opting to find work closer to home; and industry has begun to follow.

This has resulted in massive competition for workers between factories along the coasts resulting in increasing wages both instituted by the factories themselves, as well as the municipalities in which they are located, with regional manufacturing hubs such as Beijing, Shanghai and Guangdong looking to attract migrant labor to their regions with mandatory minimum wage increases. So, while some of China’s industry has begun its own migration, other, higher value manufacturing remains near the coast due to intricate supply chains and more advanced infrastructure. This has not, however prevented some advanced manufacturing from moving.

Foxconn, with its massive workforce and plethora of clients has the ability to support much of its own supply chain, and while this has allowed them to move some manufacturing into the hinterland, to cities such as Zhengzhou, Chengdu and Wuhan, they have also added nearly one million robots to supplement their labor force in Shenzhen, to mitigate the increased cost of labor.

So what does this mean for businesses in the export industry? It will largely depend on what is being exported; while lower labor costs further inland may be attractive to manufacturers whose products lie lower on the value chain may move to benefit from these savings, those higher up the value chain in IT and more specialized industries derive much of their competitiveness from a robust supply chain, fueled by an experienced and skilled labor force currently beyond the reach of smaller inland cities.