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Is China Becoming Less Competitive?

September 27, 2012

In our view, China is becoming less competitive, which is the main reason for our caution. We are not finding companies that are exciting us when we assess their earnings growth and potential share price returns.
-Dara White, senior portfolio manager of emerging markets equity, Columbia Management

Concerns about the pace of economic growth in China and the imminent change in leadership have continued to escalate. At the beginning of the year, we highlighted the potential for the rate of economic growth to slow significantly. I recently visited Asia to get a clearer perspective on the situation in China specifically, and Asia generally.

I don't expect any major stimulus before the leadership transition (or even after) unless there is a major change in the employment picture which, surprisingly, has remained quite stable. Overtime hours are up and layoffs are stable. However, factory utilization has dropped significantly which raises questions about future data. The housing market has been a surprising silver lining. Since the policy restrictions were lifted for 'real' end demand use (versus speculation) in March, there has been a steady pickup in transaction volumes. Pricing has been flat, inventories have started to come down and new starts have started to pick up. Every housing company I met with indicated that sales volume was above their expectations but they were not looking for price increases. As this pick up in starts to gain traction, it should provide some relief for the economy. A pickup in housing investment would be a positive, but the outlook for exports is still worrisome.

Increasingly it appears the administration views the magnitude of the 2009 stimulus as a mistake. The macroeconomic data points to a soft landing, but our review of corporate earnings points to a hard landing. Increasing inventories which crimps access to working capital in particular has been a real issue. I think part of the problem is that Chinese companies have historically managed for maximum growth in output. Managing in a constrained environment is a new experience and management appears to be having a hard time adjusting.

In our view, China is becoming less competitive, which is the main reason for our caution. We are not finding companies that are exciting us when we assess their earnings growth and potential share price returns. China did dip into a current account deficit in August for the first time in a long time. Wage growth has been one of the reasons we have been bullish on consumption in Southeast Asia. However, the pace is faster than I previously thought. Manufacturing is moving up the value added chain which should help profit margins but the change is simply not fast enough. Russell Napier of CLSA estimates that since the end of 2007 wages are up 70%, while export prices are down 30%, i.e. they have inflated away their competitiveness and destroyed the return on invested capital (ROIC) of exporters.

Napier believes there is a risk the new leadership will look to devalue the currency, the renminbi (RMB), by 15%. Obviously this would be very controversial and has wide implications for the rest of region (do they follow the devaluation?) and for relations with Europe and the United States. However, it will also be controversial in China. Ownership of foreign currency debt has surged as the RMB was viewed as likely to appreciate over time

I am not sure what possibility I would give the likelihood of this magnitude of devaluation happening, but the possible outcome is drastic enough to start thinking through the implications.