China, Inc.: Unleashing or Caging the Dragon?

Apologists for the still state run economy of China like to argue that without the large investment and the guiding hand of favored state owned enterprises, Chinese business would not be competitive.  This logic is used to defend the ongoing channeling of credit to favored firms and the rapid expansion of debt levels in special purpose vehicles backed by local governments.

The Chinese consumer, however, has chosen its preferred companies quite clearly and the winners are not state owned enterprises.  According to a recent study, private brands grew three times faster than state owned brands.  While state owned firms were producing respectable brand returns at 9%, private brands were  innovating, improving efficiency, and building brand loyalty returning 27%.

Private brands are outperforming because to compete with state owned giants, they need to produce a better product, cheaper, and building more consumer trust.  As one of the authors of the study notes, “…consumers are gravitating toward brands that promise them high quality of life and trust.”  Chinese consumers are moving beyond price as the determining factor becoming increasingly discerning shoppers.

Nor is this expansion of brand value limited to high end luxury good makers but rather spread across the consumer spectrum.  The third most valuable brand in China Tencent with its popular QQ chat program and most surprisingly is food and dairy company Yili which is the 15th most valuable, which has tried to carve out a niche as a trusted provider of milk and milk powder.  In fact, 2 of the 5 fastest growing brand values came from private dairy firms.

While there is almost no week that passes without some new public food scandal, both Chinese companies and consumers are rapidly learning about their mutual relationship.  Private firms understand the brand loyalty and consumer trust are valuable assets that take years to build but can be destroyed in a day.  Private firms in China are working to build that trust and provide value to consumers.

Chinese consumers are learning about the power they have over companies.  Companies need to compete for the consumers business and if they are dissatisfied, other competitors are willing to fight for their business.  Chinese consumers have choices and are increasingly willing to exercise the power of the purse to get what they want.  They can find milk producers selling untainted milk and companies that value and compete for their business.

While Chinese brands have not established brand names outside of China, numerous private companies have incredible potential to be the first major Chinese brand overseas.  Lenovo with its line of well priced but top quality smart phones is a formidable competitor with Apple and Samsung given the pricing pressures from populations demanding more for less.  Tsingtao is a great beer and would be a great cultural ambassador if it can find the right international partner with better distribution.  At best it seems unlikely that any state owned firm will be a major player in international markets and none with the product line and price needed to make an impact.

The recent reforms declared a desire to increase the role of the market.  Rather than restricting Chinese economic development and growth, private companies are growing faster, innovating more, providing better product value, and building greater brand loyalty among consumers than the favored state owned firms.  Hopefully, the impact of private firms will be seen as positive unleashing the potential of the dragon and the power of Chinese firms and consumers.

A full copy of the report can be found here in English and here in Chinese.

News on Chinese Debt Problems

China is facing a mounting debt problem as short term debt matures with 2014 seeing $427 billion of maturing bonds or 19% more than 2013.  This has caused the 10 Year AAA rated bond of non-financial companies in China to increase to 6.23% and increasing.  To put this number in comparison, Greece is only paying 8.8%.  In other words, AAA rated Chinese companies are coming increasingly close to the credit quality of Greece.

Nor is this debt explosion limited to Chinese corporates.  According to one Chinese financial news paper, 10 Chinese provinces have increased debt by $3.3 trillion USD or 20 trillion RMB since June! Despite Beijing assurances that there was no grand stimulus package like 2008, Chinese provinces have taken up the slack.  Sichuan doled out a local stimulus package equal to 180% of GDP and no that is not a typo.

Despite the reassuring and inflated GDP, the fire breathing Chinese debt dragon still lurks.

The Difficulty of Rebalancing China

For years, China has publicly professed concern over its slow growth rate of consumption and for years, the investment has continued to grow nearly twice as fast.  Today investment comprises 48% of Chinese GDP with household consumption a relatively miniscule 36%.  Nor does this pattern appear likely to change anytime soon as fixed asset investment growth continues to chug along around 20% annually with various measures of consumption growing in the low double digits between 6-13%.  Despite the public relations campaign of change, this is not economic rebalancing.

Leaving aside whether the government has any intention of rebalancing for the moment, let’s consider the difficulty in rebalancing such a deeply unbalanced economy.  Let’s begin our little exercise by making one pretty realistic assumption: the government plans to keep economic growth about the same rate for the near future.

According to China’s national accounts using World Bank data, Chinese investment is 35% larger than consumption in absolute terms.  The enormity of the disparity presents real problems for policy makers in Beijing.  Though investment growth has significantly outpaced consumption for many years, to rebalance this trend must reverse with consumption growing faster than investment.

This is where the problems begin.  If we assume that growth remains constant, this implies that if investment slows and consumption must grow significantly faster than the slowdown in investment.  Because of the much smaller base from which consumption begins, remember it is about a third less than investment in total terms, consumption has to grow significantly faster than investment declines to achieve the same level of GDP growth.  In other words, to rebalance and achieve GDP growth targets, consumption cannot just grow a little bit faster but significantly faster assuming investment declines even a little.

If Chinese consumption grows 3% faster than investment, it would require 10 years just to return to a level where consumption is equal to investment.    Should fixed asset investment drop much below its 20% annual growth rate, to maintain stable GDP growth, consumption would need rise from about 12% to 18%.  It seems difficult to expect Chinese consumers to increase consumption 18% annually with housing prices rising so fast.

Despite all the talk about rebalancing, the Chinese economy continues to become increasingly unbalanced.  Currently in China, fixed asset investment is growing in China at about 20% annually while retail sales are growing at 13% annually.  Nor is the existing evidence encouraging about rebalancing.  The China Daily recently wrote:

Local governments in China are still relying on increasing investment during the current half tomeet their 2013 GDP growth targets, despite the central government‘s call for a change indirection from investment to innovation and consumption….The shortfalls prompted a surge in local investment that experts warn may exacerbate the localdebt burden and immerse the country again in the consequences of excessive investment.

In other words, the Chinese economy is doing just the opposite of rebalancing but becoming more and more unbalanced.  With disposable income growing at the relatively slow rate of 6.8%, less than real GDP growth, there appears little evidence that Chinese consumers have the ability to drive GDP and rebalance the economy.

However, even this lethargic 6.8% may be overstated.  Research from Columbia University economists Emi Nakamura find that recent Chinese growth is marked by higher than official inflation and overstated household consumption levels.  If the reality of consumption is overstated, this further complicates the ability of China to delicately rebalance its economy.

If Beijing truly wants to rebalance its investment heavy economy, it cannot continue to rely on a government driven fixed asset investment and credit expansion growing at 20% annually while consumption grows at half that level.  Any economic rebalancing is most likely going to require accepting lower levels of economic growth.  Rebalancing the Chinese growth model is going to require all the work of the new leadership.

Note: I would like to welcome my Chinese readers and extend a thanks to Caijing for offering to put  my work on their website.