Companies in China are confronted with a problem that stems from their own success. Profits are dwindling as margins are squeezed from one direction by higher input costs, such as raw materials and skilled labor, and from the other direction by cutthroat competition and rampant overcapacity.
Of the 17 Hong Kong-listed Chinese companies that reported first quarter results, 12 saw a drop in gross profit margins. Worst affected were China's largest cement company, An- Conch, which posted a year-on-year 95.1% drop in profit In the first quarter – and the country's largest chemical fiber producer, Yizheng Chemical, which suffered a 97.5% drop.
These examples herald the imminent arrival of a downward cycle in the world's fastest growing economy.
Investment already makes up more than half of China's GDP and it is rising. The first quarter, fixed asset investment grew 25.7%, despite a 16% full-year target set by Premier Wen Jiabao. Fixed asset growth significantly higher than nominal GDP growth (GDP growth not adjusted for innovation) of 15-16%, which means the share of investment China's GDP is increasing. The question where demand will come from to soak up the extra cement, high-end apartments and consumer electronics.
While most industries in China already suffer from overcapacity, corporations continue their unabated building of excess capacity, assuming it will be their competitors and not them who will lose out in the race grab market share. The auto sector is a prime example with the number of passenger cars to be produced in China next year estimated at roughly double the number of consumers.
One company's investment spending is another's revenue, and as overcapacity, cut-throat competition and rising input costs decimate profits, the effects will be compounded all the way to the banks. Shrinking profit margins mean the number of companies that can no longer service their debt to banks or underground lending institutions is likely to multiply; so too will the number of new non-performing loans (NPL) in a system still dealing with mountains of bad debt from the last economic downturn in the second half of the 1990s. When the economic cycle does pass its peak, as at some point it must, one critical difference from China's late 1990s bust is that private companies now make up a much larger proportion of the economic mix. Unlike last time when most of the economy remained in state hands, corporations today do not have implicit guarantees from the government to ensure their survival. That could mean widespread bankruptcy in a country without functioning bankruptcy legislation.
At some point in the relatively near future, following a sustained build-up of new NPLs, the government will be faced with a choice: either allow the economy to tank or instruct the banks to keep on lending in the hopes that Chinese companies will be rescued, perhaps by exporting excess capacity to the rest of the world. Given the potential for social instability if the economy really headed south, the most likely option is the latter.
But exports are unlikely to be able to take up the slack as investment falls, especially with China's May trade surplus hitting US$8.99bn, the third highest monthly figure ever. Some are predicting the figure will go as high as US$100bn by the end of the year, up from a surplus of US$30bn last year. With volumes as high as this, trade partners like the US and EU, who have long been piling pressure on China to do something about surging exports, are sure to become even more protectionist. Calls for China to revalue the yuan are likely to continue, and at some point, the government will probably decide the easiest way to balance trade flows is to capitulate in some sort of face-saving arrangement.
Will consumers pitch in?
Consumer spending is the other great hope of the government in its plan to offset an investment slowdown. People's Bank of China Governor Zhou Xiaochuan said in a recent speech to a meeting of US, Japanese and European central bankers that China was planning to introduce policies to lift consumption. It remains to be seen what the government can do, besides pushing banks to provide easy consumer credit (credit cards and cheap loans), with all the attendant risks of adding to the increasing new NPL problem. Another option could be lowering income tax in order to boost spending, but Chinese are renowned for having very high savings rates so there's no guarantee they won't just save any money they get from tax breaks. (Besides, how many people do you know in China who pay full income tax rates?)
China's long-term economic prospects are still positive, and as long as the Communist Party remains in power, the economy is unlikely to totally collapse. But since China's capitalist reforms began in 1979, the country has seen four-year up and four-year down economic cycles. Actually, the last down part of the cycle stretched out to six years and ended in 2001. The cause of that last downturn should be quite familiar to anyone paying attention to the financial news in China: government attempts to slow irrational investment and avoid a hard landing.