This article was originally published in the October 2012 edition of The China Analyst.
Is China about to have a “firm landing?” China’s economy is often viewed as having the binary choice of experiencing either a soft or a hard landing. A soft landing is always preferred and is usually – when viewed as highly probable – enough of an assurance for most China watchers that all will be fine. A hard landing – according to its predictors – is almost always analogous with severe repercussions, including fallout that could potentially threaten social cohesion. However, interpreting China’s economic future as having only two possible paths is an oversimplification. China’s economy is complex and, with an uncertain global backdrop, several in-between scenarios are possible.
China, after all, is in the midst of a number of delicate transitions: it is undergoing an unstoppable structural shift from a low income to a medium income economy; there is a somber move from a rapid growth rate economy, to a moderate (and hence more sustainable) growth rate; and a complex shift is underway from being a low/medium-tech (and low/medium-cost) producer to a medium/high-tech (and medium/high-cost) producer. This implies waves of change across all areas of the economy. In fact, the entire socio-economic superstructure and growth model are evolving. Due to these adjustments – and the weak global backdrop – it is necessary to interpret China’s current cyclical adjustments with care. What is sure is that it is not simply an absolute choice between a hard versus a soft landing.
It may be time to look for a China “landing” somewhere in the middle of the two extreme scenarios. We take the view that China will experience a “firm landing” over the next 12 months. In short, a landing which would be less than comfortable – even painful at times – but still manageable.
There are increasing visible signs of the much-vaunted slowdown in the Chinese economy, a slowdown that has been the subject of intense media speculation in recent weeks and months. Global fallout from the Euro-area crisis and China’s softer first and second quarter GDP growth numbers of 8.1% and 7.6% respectively, along with the Bo Xilai debacle, rising tensions with neighbors in the South China Sea, and downward revisions in GDP projections for the second half of 2012 all have the makings of a perfect storm. This has led many analysts to predict a so-called hard landing for the world’s second-largest economy.
So how bad is it really? The data shows a weakening economy – and the slowdown is severe – from a peak of 14% GDP growth in 2007, 10.4% in 2010 and 9.2% in 2011, to most likely around 7.7% for 2012. This means that current growth has effectively halved against the 2007 peak and has dropped by around a quarter from the average of 10% over the past 30 years. This marks a big change – there are mounting stockpiles of scrap, coal and iron ore at stockyards all over the country’s ports; large numbers of unsold vehicles sit in dealership parking lots; and empty malls dot certain parts of the country. Recent trade, manufacturing, bank lending and retail spending data support this, and convincingly illustrate the latest downward shift for the second quarter – and July-August indicators are weak as well. Also, widespread property price reductions and slower car sales growth hint at a level of aggregate demand that is probably consistent with GDP growth for the third quarter of close to 7.5%, below the 7.6% and 8.1% registered in the first and second quarters. Clearly, no rebound yet from the second quarter’s level.
A New Model
Nevertheless, this is not necessarily a hard landing. China is large and complex, and one must be wary of ignoring a piece of the jigsaw puzzle. While China is certainly slowing, especially in certain sectors and regions, it is also true that a growth rate of close to 8% for the full year will still outpace that of any large economy. This year, China’s economy will grow by some USD $700 billion, thereby adding another Switzerland or Turkey to global output. Moreover, Beijing views its economic future in a very different light from just three to eight years ago. The future entails more moderate but sustainable levels of growth – quality growth – as opposed to the breakneck growth of the past. This new growth pattern is aimed at shaping a new economic structure, and with it a new set of rising strategic industries and new areas of competitiveness.
Inevitably, this new growth model will see some sectors recede, even traditional ones that served as the battering ram to bring China onto the world stage with record-breaking exports. However, this does not make the transformation less necessary nor avoidable. The growth model must adapt – and this implies slower but higher quality growth.
This also means that excessive stimulus measures, as the economy slows, would be far more dangerous than seeing the growth rate fall below 7.5% or even reach 6%. The view that China needs 7%-8% growth to maintain social stability is an outdated and baseless article of faith; today’s China is already socially transformed to the point where it can remain stable and continue its long term trajectory even if the growth rate dips to around 6%. Of course a protracted slowdown would be problematic, but the ‘bicycle view’ – that China will fall over if it grows too slowly – does not hold in the same manner that it did in the past.
Cushioned but Firm Landing
Beijing will not stand back completely as the economy slows. Banking and real estate, China’s twin liquidity engines, have been revved down for the last two years, impacting consumer spending that has enjoyed lofty double-digit growth in the last decade. Meanwhile, exports have slowed to become a drag on the economy in the second half of 2011, and more so in the first half of 2012, as Europe and other developed markets continue to struggle. Hence, the recent slowdown in China’s industrial production and the associated downside risks to growth leave policymakers little choice but to further ease policies over the next few months.
The only way to quickly lift growth would be via stimulus measures; however, China will not rush to achieve “quick wins” in this manner. The risks are well understood. Nevertheless, we do anticipate at least a degree of stimulus. While many provinces have already signaled their intention to support investment levels, the central government has yet to unveil an integrated plan. While we do not expect a massive central push for investment as seen during 2008-09, we do anticipate the carrying out of ongoing policy initiatives and signals from the central government that it will ensure adequate demand in order to support employment and business confidence. Given Europe’s malaise, this is understandable. Measures will be limited and will not prevent a moderation of growth. It will just cushion what is likely to be a fairly firm landing.
For the longer term, the question is when exactly a new consumer-driven growth model will kick in and whether it can fully offset the effects of a prolonged global slowdown. Over the long-term, this looks probable. Unfortunately, China’s transformation is still underway and for the economy to pull up decisively over the short term, it cannot yet count on the Chinese consumer.
So this is where policymakers will need to show resolve. They must resist the temptation to provide short-term stimulus – even as the world and China slows – and instead focus on enacting the difficult reforms that would bring forward the consumer-led demand economy that will form the core of a new growth model. Pressures are mounting and consumer demand can only be expedited by so much, so it will be a close call. However, we believe that the long-term considerations will win out. So expect the slowdown to continue and only a mild stimulus to avoid the worst bumps.
As a result of this new phase in the country’s development, China watchers that are used to lofty growth rates over the past 20-30 years will need to sit through the inevitable volatility of the next 6-12 months. The key is to remember that China’s long term fundamentals remain strong. It will continue to transform, industrialize, urbanize, modernize and reinvent itself. Over the longer term, China will remain a key market for hydrocarbons, metals and minerals, high-end manufacturing, services and technologies. Society is transforming in a profound way, and despite facing key challenges and a significant slowdown, China’s relentless ascent is not in question.
Upshot & Strategic Implications
- The landscape is changing and CEOs of Chinese firms and MNCs alike will have to think and anticipate differently. We offer a few general ideas in this regard:
- China will become a more “normal” economy after decades of rapid growth. Changes are occurring in cost structures and differentials, technology, household and national debt, company leverage, etc. A very different landscape is unfolding
- China is partially transformed – it must be viewed for what it has become – a USD $8 trillion economy that is more emerged and more developed but still on a path of change
- Entering China for the same reasons as ten years ago is a mistake. Ignoring China is also a mistake. It is necessary to be perceptive and to assess how the macro transformation will impact the business landscape of your industry
- China is becoming a very competitive terrain; companies will need to work hard to identify and claim addressable markets (that are less contested)
- Mature (developed) and immature (less developed) industries and segments will co-exist in the economy with very different patterns between regions, industries and companies
- Exemplary strategic intelligence is imperative in scoping the opportunities
- It is now more important to have a solid China team than ever before – there are many “China hands,” but not many good ones
- Strategy implementation will require more careful management to calibrate and fine-tune market positions
- It will be necessary to operate in China with very different cost structures
For the mining and resources sector
- Despite lower demand growth, China remains the most important driver of commodities demand
- Lower demand growth, lower prices, higher volatility and variability (some commodities will perform better/worse) must be understood and managed
- Marketing is now a far more important function in the industry than before
- There must be an emphasis on strategic marketing
- Direct management of end-user relationships is key
- Branding, after-sales service and support will become hallmarks in resource marketing
- Resources is now a “competitive” industry – mining marketing managers will increasingly compete in the same manner that say Procter & Gamble (P&G) and Unilever compete
- Companies that get this right will attract a premium
For procurement managers
- Supplier health checks and supplier selection become very important
- Auditing and pre-qualification processes are crucial
- Deeper due diligence will pay off in the end
- Management of Chinese suppliers needs to be elevated – a difficult task if you do not have an on-the-ground presence in the country
- Appreciate suppliers’ cost structures in order to pre-empt pricing decisions on their part; solid cost/price index tracking is needed
- It is necessary to remain cognizant of cost increases as a part of global category management (i.e. identify future alternative markets and develop an initial intelligence on them)
- Exchange rate risk will rise, but more hedging instruments are available than in the past
- Leverage the internationalization of the renminbi to manage exposures and complete settlements
China’s overall transformation remains intact. However, the nature of that transformation is changing. The next several months will be turbulent and a firm landing could be uncomfortable. Do not underestimate the complexity and challenges that must be faced to manage effectively through this phase. Brace for some bumps that will hurt but do not spell the end of China’s rise. In fact, China’s economic march has only just begun. The main story of how its population, burgeoning middle-class, productive capacity, rising income and wealth, aspirations and global participation and influence will impact the world has yet to be written. In many ways, this is just the end of the beginning.