Wednesday, March 4, 2015

Zen and the art of Chinese economic re-balancing

The latest news out of China is Beijing has set its 2015 growth target at about 7%. Notwithstanding the numerical value of the GDP growth target, one of the key elements of Chinese economic policy is to re-balance the source of growth from credit-driven infrastructure and export oriented growth to the Chinese consumer. My latest progress report on China shows that the country is both re-balancing and not re-balancing.

Read that sentence again. Yes, you read it right. It is and isn't re-balancing.

Let me explain. Last week, China Daily reported that the re-balancing process is progressing well:
Domestic consumption surpassed investment to become the strongest driving force of the Chinese economy in 2014, indicating a new growth model has already started forming as the country enters a "new normal" development era, the National Bureau of Statistics said on Thursday.

Total consumption accounted for 51.2 percent of gross domestic product growth last year, compared with 48.6 percent from investment. Net exports accounted for just 0.2 percent of the GDP growth, said the NBS report.

Xie Hongguang, the NBS deputy director, said: "It means that the consumption-driven growth model has started taking shape, and the economic structure has started improving."

According to the official data, in 2013 final consumption contributed half of the nation's GDP growth and 54.4 percent was from investment, while net exports dragged down GDP by 4.4 percent.
But then, how much can we trust official Chinese statistics?

Does the market believe China is re-balancing?
On the other hand, equity based market indicators are telling a different story. I track the progress of two Chinese ETF pairs that measure the relative performance of Chinese consumer stocks relative to a mainly financial stock basket. The long side on the first pair, PGJ, is heavily weighted in Chinese technology names with heavy exposure to Chinese consumption (e.g. NetEase, Baidu). The long side on the second pair is Global X China Consumer ETF (CHIQ), which is weighted towards direct consumer plays like Great Wall Motor and Vipshop. The short side on these baskets are predominantly Chinese finance and bank stocks, which represents the old model of credit-driven infrastructure growth.

The chart below shows how these pairs have performed in the last three years. When the lines are rising, consumer stocks are outperforming, which is an indication that re-balancing is progressing well. When the line is falling, re-balancing is suffering a setback. As the chart shows, both pairs have been in a downtrend for about a year. This is an indication that the market believes that, despite all the rhetoric, Beijing has gone back to the same-old-same-old model of credit-driven infrastructure growth.

An immature manufacturing base
How can we reconcile Chinese government statistics about rising household consumption and the underperformance of Chinese stocks that are sensitive to the consumer? The most obvious explanation is that China makes up its economic releases. There is also an alternative view, which suggests that both government statistics and market based indicators are correct.

Consider this report from Forbes about Chinese tourists going to Japan to buy high-tech toilet seats:
“World-class toilet seats are not what Chinese manufacturers aspire to make,” the nationalistic Global Times sniffed on Thursday. The Communist Party paper was reacting to reports that China’s tourists were eagerly snapping up Japanese goods, especially electronic personal hygiene accessories, during the just-completed Lunar New Year holiday.

Lunar New Year sales in China were up 11% according to the Ministry of Commerce. That figure seems to overstate domestic spending during the period, but in any event purchases by the country’s tourists abroad evidently increased by a higher percentage. A shift in spending patterns suggests Chinese-made goods are losing favor with China’s increasingly demanding consumers.
The real reason for the Chinese to buying consumer abroad is the perceived quality of foreign made goods (emphasis added):
Why would the Chinese go all the way to Japan to purchase something they could get at home? There appear to be two reasons. First, it was reported that the Chinese goods were cheaper in Japan than in China. But price was not the primary consideration. Second, I think the Chinese believed that Japanese retailers, unlike their Chinese counterparts, would carry only high-standard items.

China’s people, who can often afford the best, are demanding better goods. As the influential Beijing Youth Daily noted, “Chinese enterprises are focused more on producing low-priced products, but they missed the point that more and more Chinese consumers are starting to care more about quality, rather than price.”

Despite years of experience, Chinese manufacturing is not moving up the quality chain as fast as expected. As a result, “overseas trips are turning into regular shopping trips for household items” the South China Morning Post reports.
There have been far too many scandals over the quality of domestic products in China:
Many of China’s producers are apparently unable to bridge the quality-perception gap. Take an item that top Chinese leaders have repeatedly promised to improve: milk powder.

Last month, there were violent protests in Hong Kong as local people there tried to stop “parallel traders” who were emptying shelves of milk and other items. The busy traders often make multiple trips a day to carry goods into Mainland China. Sometimes parents themselves make the trip.

Why is foreign milk powder so valuable in China? Chinese powder is often poisonous and sometimes lethal. About 300,000 Chinese children suffered kidney damage in 2008 because local producers were adding melamine, an industrial chemical, to milk. At least six infants died. Since then, there have been isolated scandals involving milk and many incidents involving other adulterated foods.
In summary, this is the story of how China is re-balancing and not re-balancing its economy. Consumption is re-balancing, but it may not necessarily be to the benefit of domestic suppliers. Chinese manufacturers need to start to develop the right corporate culture and learn to move up the value chain to focus on quality instead of just price. Until that happens, much of the benefits of re-balancing growth towards the Chinese household sector is likely to accrue to foreign firms.

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