Imagine living in the capital city of a major country, and suffering the level of pollution shown in the above photo on a regular basis. We used the photo in chapter 6 of Boom, Gloom and the New Normal when we highlighted how pollution was inevitably going to move up the political agenda in China. Controversial at the time, it warned:
“Recent growth in China and India has come at a price: Poor air quality, chronic water shortages and deforestation.”
By February 2014, the pressure to act was becoming almost overwhelming as:
“The problems have worsened, to the point where almost everyone now agrees that they are creating a major political problem. The new leadership simply has to solve this, if it wants to remain in office. Beijing and the 6 northern provinces have now been shrouded in smog for 6 days, and on Wednesday the US embassy reported that the levels of PM2.5, the small particles that pose the greatest risk to human health, were “beyond index” at 512.”
Guangdong province, close to Hong Kong, had already moved to clean up. But other provinces did little or nothing, as officials worried about the likely impact on jobs. A major part of the problem was that the economy is the Premier’s responsibility, and Premier Li has been more worried about maintaining growth via stimulus programmes.
This year, however, Xi finally lost patience ahead of next month’s 5-yearly People’s Congress – at which he will be renominated for another 5-year term. Having signed China up to the Paris Agreement on climate change in December 2015, he seized control of the economic agenda, as I noted in the Financial Times:
“Xi knows that reducing pollution, rather than maintaining economic growth, has become key to continued Communist Party rule. The recent rapid elevation of Beijing’s mayor, Cai Qi, to become party chief for the city is further confirmation of the high priority now being given to tackling air pollution and stabilising house prices.
“Taken together, these policies represent a paradigm shift from those put in place 40 years ago by Deng Xiaoping after Mao’s death in 1976. This shift has critically important implications, as it means growth is no longer the main priority of China’s leadership. In turn, this means that stimulus programmes of the type unleashed in 2012, and on a more limited basis by Premier Li last year, are a thing of the past.”
Since then, the Beijing area, and surrounding provinces such as Hebei and Henan, have become a centre of the battle against pollution. One key development has been the use of thousands of drones to spot, and measure air and water pollution, and then identify and photograph the culprits. As state-controlled Xinhua reported last week:
“A total of 599 companies, mainly construction materials, furniture, chemicals, packaging and printing, were relocated out of the capital, said the Beijing municipal commission of development and reform. Beijing also closed 2,543 firms and ordered 2,315 firms to make changes. About 73% had pollution issues.”
Similarly, a senior chemical industry executive told me last week:
“I was in/near Cangzhou the other day (another city on the list) where the government have created a large National Level Economic Zone including a dedicated chemical “park” to accommodate the companies that are being cleared out of Beijing and surrounds. This was an otherwise nondescript flatland whose only previous claim to fame was a Mao era collaboration with then Czechoslovakia to make tractors.”
The war on pollution has another side to it, of course, as it marks the end of the “growth at any cost” economic model.
As a result, realism is finally returning to discussion about China’s real growth potential. As last month’s IMF Report on China noted, GDP growth had only averaged 7.3% over the 5 years to 2016 because of stimulus: without this, growth would have been just 5.3%. As a result, the IMF also highlighted an increasing risk of “a possible sharp decline in growth in the medium term”, as well as a need to boost domestic consumption by reducing savings.
This is a welcome development. Too many companies and analysts have indulged in wishful thinking, wanting to believe China had suddenly become middle-class by Western standards. In reality, as the second chart shows, the growth surge was due to $20tn of stimulus lending via official and shadow banking channels.
At its peak, between 2009 – 2013, this lending reached 3.2x official GDP. And GDP itself was probably also over-stated for internal political reasons, as Communist Party officials were routinely judged for promotion on their success in generating GDP growth. Now the pendulum has swung the other way, as the Caixin business magazine has reported:
“In a document jointly released by the Ministry of Environmental Protection and nine other ministry-level bodies, if a city does not achieve 60% of the emission reduction target, the city’s vice mayor will be held responsible. If the city achieves less than 30% of its target, the mayor will be held responsible; and if the PM2.5 level ends up increasing instead of falling over the winter, the party secretary of the city will be held responsible.
“Possible punishment includes party disciplinary or administrative punishments, the document says.”
Large economies are like super-tankers, they take a long time to change course. As I noted nearly 2 years ago, China is now attempting to move in a radically new direction, away from export-driven growth and infrastructure spending – and towards a New Normal economy based on the mobile internet:
“The winners are developing services-led businesses focused on China’s New Normal markets – such as those aimed at boosting living standards in the poverty-stricken rural areas, or for environmental clean-up. The losers will be those who cling to the hope that more stimulus is just around the corner, and that China’s Old Normal will somehow return.”
Those who have done well under the old regime, like the Party heads focused on job-creation and the opportunities that it created for large-scale corruption, will inevitably fight hard to preserve their way of life. Next month’s Congress will therefore be critical in assessing just how much power Xi will have to pursue his reform policies in his second term.
As I noted a year ago, this Congress will settle key questions. Will Premier Li gain a second term, and continue to be able to obstruct reform? Will anti-corruption tsar Wang maintain his position on the all-powerful Politburo Standing Committee, despite being over the nominal age limit?
The Congress is therefore likely to the most important meeting since 1997, when Jiang Zemin gained re-appointment for his second term as President and led China out of poverty via membership of the World Trade Organisation. Now, as set out in the China 2030 Report (published when Xi became President), Xi has to led China in a new direction.
Otherwise, he will be unable to achieve his twin goals of
□ Making China a “moderately prosperous society” by 2021 (the centenary of the Chinese Communist Party)
□ Making it a “fully developed, rich and powerful nation” by 2049 (the centenary of the People’s Republic), and returned to its historical status as the Middle Kingdom via his ‘One Belt, One Road’ project.
Wishful thinking can be terribly dangerous for company profits. Taken to extremes, it can lead them into bankruptcy.
Recent developments in China thus make it essential for every company to immediately review its strategy for doing business in/with the country, against a realistic outlook for 2016-2018
- GDP growth will likely be zero, and could well go negative
- New auto sales will also remain slow, as growth is cannibalised by the used car market
- Lending cutbacks will mean property and construction markets will remain under pressure
- Major growth will be seen in the supply of basic goods such as $50 refrigerators in rural areas
- The need to clean up today’s pollution means growth in environmental clean-up markets will be turbo-charged
None of this will be a surprise to anyone who has followed the recent development of China’s economy. But it will come as a tremendous shock to those company boards and investors who have believed the myth that somehow China was about to become middle class by Western standards.
Key to this strategy review process will be to ignore published data for China’s GDP. As the world’s media are beginning to recognise, this is completely fictitious. How, after all, could any country possibly present accurate GDP data within 2 weeks of the end of a quarter – and never need to revise it?
Equally, how could its GDP really be growing at 7%, when such critical areas as electricity consumption are now seeing growth of less than 1%, as the chart above confirms. Consumption in January – July rose just 0.8%, and it actually fell by 1.3% in July. As the National Bureau of Statistics highlighted, the data:
“Shows the structural adjustment of China’s economy and power consumption. Sluggish external demand and a slowdown in exports, which dragged down industrial production, as well as the high base data registered last July, all resulted in July’s power consumption shrinkage.”
The slowdown underway in new car sales confirms that this is a long-term structural issue. Passenger car sales fell 6.6% in July, after a 3.4% fall in June, despite price cuts of 30% or more on hundreds of popular models. And worse is to come, with inventories still at 1.7 months. In addition, we can expect Chinese companies to react to the downturn by:
- Producing more “lookalike” models of Western cars – a lookalike LandRover Evoque is now on sale at one-third of the Western price
- Boosting exports by using the currency devaluation to compete with foreign manufacturers
Similar developments are taking place in the property sector, as the government slowly brings shadow lending under control. This means the end of the property bubble which allowed people to buy new cars that they couldn’t afford out of their normal income. Instead, the profitable companies in the future will be those who focus on the used car sector. This is likely to grow four-fold between 2014-2010, from 6m sales to 25m.
Smart investors such as Tencent are now focusing on this sector – aware of the potential profits to be made from used car sales and service, when offered through an integrated online and physical presence. As the China Europe International Business School’s Center for Automotive Research has commented:
“Dealers’ margins are reducing. They are not what they were years ago. Now dealers are not making money by selling new cars, and in fact, dealers in the United States are making more money in after-sales services than selling cars.”
The good news is that the new growth areas for China’s economy are becoming increasingly obvious, as the lending bubble disappears.
The key for those focused on consumer markets is to produce products that are affordable for people on average earnings. This means urban residents with incomes less than $4k, and rural residents with incomes less than $1300. One company I know is seeing excellent growth in affordable bedding sales; everybody values a good night’s sleep.
Another profitable market for the future will be in providing products and services to help clean-up the pollution created by China’s ‘dash for growth’. Even before the Tianjin disaster took place last week, the government was already accelerating its Rmb 9.4tn ($1.4tn) programme for environmental protection, as Securities Daily reported:
“In the next five years, the market for energy efficient, environmentally friendly products will have huge potential. With the government focusing on controlling pollution, the energy-saving and eco-friendly industries will become fast-growing sunrise industries in China.”
Many companies and investors have preferred to believe that President Xi was only paying lip-service to his concept of the New Normal. But it is now clear that he will not repeat the stimulus policies which have created today’s problems for the economy. And as the Chinese phrase says, “if the lips are gone, the teeth will be cold”.
The key to forecasting China’s auto demand since 2008 has been the level of bank lending, as the chart above shows. This was critical in making China the world’s largest auto market. Official data shows average disposable income was just Rmb 10k ($1600) in H1 2014, making it impossible for most people to buy a car out of income:
- Purple period, 2008, saw auto sales of ~600k/month and lending of Rmb 400bn/month ($65bn)
- Blue period, 2009, of panic stimulus saw auto sales increase 50% and lending almost treble at one point
- Black period, 2010-2013, was more stable with auto sales at 1400/month and lending Rmb 600bn/month
- Brown period, 2014, has seen auto sales stabilise at 1600/month, and lending at Rmb 900bn
Since 2005, total auto lending has thus risen 4700% from just Rmb 6bn to Rmb 282bn by Q1 2014. Direct retail loans to customers grew 15000% from Rmb 1.3bn to Rmb 195bn over the same period.
This highlights how China has seen the auto industry as being key to maintaining employment, and thus a priority area for support.
However, there are increasing indications that the nature of this support is changing. Past performance may well prove an unreliable guide to the future.
One sign is that many more cities are introducing purchase restrictions on new car sales to reduce pollution. Beijing, for example, will only allow an extra 400k cars on the road between now and 2017, for a total of 6m.
At the same time, the auto association has warned that demand for commercial vehicles slumped in HI, adding:
“We believe the economy hasn’t shown obvious signs of improvement in the second half. It’s hard to say whether more local governments will issue restrictions this year but this is definitely one of the risks we have to take into account.”
A second sign is the decision to strip most officials of their government car, and replace it with an allowance of $80-$210/month, depending on rank. This will be bad news for overseas brands, which have held 80% of this $675m market. Audi will be badly hit as it supplies around a third of the volume.
A 3rd challenge is that China now has 137m cars on the road, as a result of this hectic sales expansion:
- Used car sales will start to become more significant for the first time
- Their volume will double from just 5m/year last year to 10m next year
- Equally, of course, new domestically-oriented markets for servicing and maintenance will also develop
There are also signs that dealers may gain power versus manufacturers – at the moment, they can often be forced to hold vast inventory. China Daily reports this has been rising rapidly in recent months, with some dealers now holding more than 5 months stock.
The final challenge also relates to pollution. The government currently plans to take 6m high-polluting cars off the road this year, and we can assume it will subsidise their replacement – thus helping to maintain volumes. But it is likely that much of this support will be tied to the use of electric cars, with refuelling costs set to be 30% below gasoline prices.
Urban areas with fixed routes for official cars will now have to buy electric cars, whilst those suffering extreme cold can buy hybrids. And subsidies (including exemption from the 10% vehicle tax) will only be offered for cars costing up to Rmb 180k ($29k).
International car companies, and their suppliers, will need to move fast to realign themselves with this new direction. In the past, the money was made by selling high-priced cars to government officials and those benefiting from the property bubble.
In future, as GM have confirmed, growth will focus on the low-cost market of cars selling for $7k in poorer areas outside the major cities, where car ownership is still relatively low. Electric and hybrid vehicles will be the other main growth driver,
Chapter 6 of Boom, Gloom and the New Normal in October 2011 was one of the first detailed analyses to highlight the way in which pollution was rapidly moving up the political agenda in China. Controversial at the time, it warned:
“Recent growth in China and India has come at a price: Poor air quality, chronic water shortages and deforestation.”
Since then the problems have worsened, to the point where almost everyone now agrees that they are creating a major political problem. The new leadership simply has to solve this, if it wants to remain in office. Beijing and the 6 northern provinces have now been shrouded in smog for 6 days, and on Wednesday the US embassy reported that the levels of PM2.5, the small particles that pose the greatest risk to human health, were “beyond index” at 512.
The World Health Organisation recommends day-long exposure levels of no more than 25. Yet Bloomberg reports that the level has been above 150 since 19 February. And next week, of course, sees the start of the annual meeting of the National People’s Congress in Beijing, where the problems are certain to receive major attention.
Of course, these problems are not unique to China at its stage of development. As the blog noted a year ago, pictures of the its smog today mirror those seen in the West until the 1960s, when governments finally began to recognise that economic growth was unsustainable if it meant millions of people died as a result.
This highlights how policies have to change. Shanghai’s Academy of Social Sciences yesterday reported that Beijing is”almost uninhabitable for human beings“. Whilst Beijing has established an official body to co-ordinate the emergency response to severe air pollution as China Daily reports:
“The agency advised children and the elderly to stay indoors and to wear masks when going out. It also urged residents to take public transport and reduce driving. The agency urged middle schools, primary schools and kindergartens to reduce outdoor activities.”
The good news is that the smog is expected to finally lift over the next few days as a cold front comes in to clear the air. But Beijing residents know it will not be long before the problems re-emerge. And as the blog noted in its recent Research Note, the problems will get worse, not better, until the polluting factories are closed down and vehicle pollution reduced.
Even more worrying is new research from China Agricultural University‘s College of Water Resources and Civil Engineering, which suggests that if the outbreaks of smog are allowed to continue, Chinese agriculture will suffer conditions “somewhat similar to a nuclear winter”. They suggest this is a further threat to China’s food production, and claim to have:
“Demonstrated that air pollutants adhere to greenhouse surfaces, cutting the amount of light inside by about 50% and severely impeding photosynthesis, the process by which plants convert light into life-sustaining chemical energy”.
Thus it is no surprise to find that President Xi has now decided to take up the subject personally. Speaking after a well-publicised tour through the smog yesterday evening, he called for strengthened efforts to control it saying:
“The priority is to limit PM2.5 by reducing dependence on coal, strictly controlling vehicles, adjusting industry structures, and other measures.”
China is clearly now preparing to shift away from its current ’growth at any cost’ model of economic growth. This must result in a major slowdown, as it will take time to build the new, less-polluting, factories and power stations. Car ownership must also move down the priority list.
Average incomes in China are very low by Western standards, and certainly not “middle-class” as the blog discussed yesterday. It is also easy to forget that almost half the population still lives in rural areas. Official data shows their incomes have shown major growth over the past 20 years, but are still less than a third of urban incomes today.
The chart above shows the percentages in terms of 2012 incomes, in Rmb 1000 segments ($158)
- Half of the rural population have incomes less than $1267/year
- An income above $1901/year places someone in the richest 25% of the population
- Only 6% have incomes above $3168/year
Consumption patterns for food, housing, transport, education etc follow the same patterns as for urban areas. But absolute values are much lower.. Average total consumption expenditure in 2012 was just $936 per capita. In terms of durable consumer goods, this means:
- Every household has a mobile phone and a colour television
- 2 out of 3 households now own a washing machine and refrigerator
- 2 out of 3 households now own a motorbike, whilst bicycle ownership has halved since 1995
- But only 1 in 5 own a computer
By comparison in urban areas:
- Every household owns a mobile phone, colour TV and air conditioner
- Everyone owns a washing machine and refrigerator
- 1 in of 5 households own a motor bike and the same proportion own a car
- Bicycle ownership isn’t recorded
- Almost every household owns a computer and water heater
This comparison identifies the real markets for companies aiming to target the 642m people living in rural areas.
Of course there are wealthy people in rural areas. But there are not enough of them to form more than a niche opportunity. The real market is thus for $50 refrigerators and similar very basic appliances.
In addition, however, there will be a growing market for environmental improvement. As Goldman Sachs have noted, most water in N China is not fit for drinking or for agricultural use. Similarly, the Ministry of Environmental Protection has published a new book warning that:
“One-sixth of China’s arable land — nearly 50 million acres — suffers from soil pollution. More than 13MT of crops harvested each year were contaminated with heavy metals, and 22m acres of farmland were affected by pesticides”.
The situation is particularly acute in Hunan province, which produces one-sixth of China’s rice and is also a major producer of nonferrous metals. Pressure to maintain economic growth means that the province is also China’s leading polluter of cadmium, chromium, lead and nonmetal arsenic.
Companies who look through the middle class myth, and focus on these opportunities will be the major winners for the next few decades.
Pollution is, unfortunately, one of the downsides of industrial development. Luckily for us in the West, it is mostly a distant memory. But as the BBC picture on the left reminds us, Britain was paralysed by ‘smog’ (a lethal mixture of fumes and fog) only 50 years ago in December 1962.
Now it is Beijing’s turn, as the Financial Times picture on the right shows. As the paper writes, it has been “a winter of terrible pollution in Beijing“. Levels of the most toxic types of smog reached 40 times that recommended by the World Health Organisation (WHO). Whilst a new joint study between the WHO and leading universities found that “outside air pollution contributed to 1.2m premature deaths in China in 2010, almost 40% of the global total”.
Unsurprisingly, pollution has therefore shot up the government’s agenda in recent months. It is a major factor behind the limitation of auto sales in the major cities. But clearly more needs to be done, including the closure of the most polluting factories. In turn, of course, this will have a major impact on economic growth.
But doing nothing, and allowing people to die unnecessarily, is simply no longer acceptable to the general population. As co-author John Richardson summarised the situation last month:
“Just imagine bringing up your kids in a world where you worry every day that they might be breathing in noxious air and eating contaminated food. OK, your apartment might have tripled in value since the early 2000s, but what’s the point of money when you cannot guarantee the safety of your children? As countries get richer it always happens that the quality of life becomes as important as material wealth.”