Most people look at China’s rising military spending – official figures say it will climb 10.7% this year – and first think of growing tensions between China and the US. Or about China’s Asian neighbors that feel increasingly threatened. Or the arms being sold to China’s allies – the country is now a top five arms exporter – that could feed conflicts elsewhere around the globe.
Far fewer think of the money that is being made, and the companies enriched by this rising spending. In part, that’s because the picture of the defense industry in China is hazy at best. The country’s military industrial complex is nearly impenetrable to outsiders compared to the relative transparency of US, European and even other Asian military powers that often give gritty details on defense spending.
What is known about the Chinese defense sector mirrors the country’s state-owned enterprises (SOEs) in other industries. Some military-related SOEs appear to be exaggerated versions of their civilian counterparts, companies that are sprawling yet opaque and generally tightly connected to the government. Defense contractors also face a similar challenge to the rest of the economy: They can’t compete internationally on cheap goods alone and should climb the value chain by producing increasingly sophisticated goods.
Despite these challenges, investors that can break into this little understood industry might be able to ride the seemingly unyielding tide of military spending to high returns. Finding those opportunities to invest isn’t easy, but they do exist.
“China has been expanding its defense budget by double digits for most of the past 20 years … so from that perspective and given that there’s no end in sight, [Chinese defense companies] are in theory not a bad potential investment,” said Dean Cheng, a research fellow at The Heritage Foundation think tank in Washington, D.C. “But the caution would be that even more than your typical Chinese corporation, these guys are opaque. So I guess I would conclude with caveat investor emptor.” In other words, invest at your own risk.
Strategic openings
China will spend US$119 billion on defense in 2013, according to a Ministry of Finance report. That places the country as the No. 2 defense spender after the US, which is far ahead with a budget six times larger.
That figure is likely 50-100% higher than what is officially reported, analysts said. The disparity may just be from variance in accounting methods or issues with the sources of funds, which are generally unclear, Cheng said. Beyond the top-line figure, Beijing does not offer a further break down of how that money is spent.
Ever-rising spending likely goes toward equipment rather than maintaining ground forces, and that equipment is increasingly made domestically rather than imported. The ability to import arms has long been limited: The US and European countries embargoed arms sales to China in the wake of the crackdown on the 1989 democracy demonstrations in Tiananmen, a decision that continues to hold today.
Russia, therefore, has been the primary arms exporter to China, although such weapons deals have grown infrequent. Earlier this year, the Chinese state-owned press trumpeted the largest arms deal with Russia since 2002 in advance of a state visit by President Xi Jinping, but Russia officially denied that the deal took place.
Instead, the military spending is mostly funneled to China’s sprawling defense and aerospace companies. To give some idea of the scale of China’s industry, consider major players including Aviation Industry Corporation of China (AVIC), the country’s main aerospace manufacturer, including fighter aircraft; Commercial Aircraft Corporation of China (COMAC), which makes primarily civilian aircraft; China Aerospace Science and Industry Corporation (CASIC), which makes missiles; and China Aerospace Science and Technology Corporation (CASC), which makes space launchers, satellites and drones.
The comparison to a Western defense company like US-based Boeing, which employs 173,000 people in the making of both civilian and military products, is striking, said Cheng. “AVIC, COMAC, CASC and CASIC probably each have as many people [on staff] as Boeing does, even though each of them produces a subset of all the things Boeing does.” In fact, the companies range from slightly smaller – 120,000 employees for CASC – to much larger – 400,000 for AVIC.
The opportunities to invest are few, however, relative to the size of these companies. Defense falls on a list of protected industries that ranges from telecom to finance and restricts or prohibits foreigners from investing.
As a result, China’s military industrial complex is largely made up of state-owned companies. “The Chinese government owns this industry; they own the complex,” said Yu Maochun, a professor of East Asia and military history at the US Naval Academy in Annapolis, Maryland. That contrasts with the US, for example, where stock in defense contractors such as Lockheed Martin or Northrop Grumman is available on the open market.
The investment avenues for foreigners amount to partial plays on rising defense spending. Among listed firms, investors will find some military-related operations mostly hidden in largely civilian companies.
Aerospace manufacturer AVIC is among the most promising targets for investors. The company has roughly 23 listed units, including three in Hong Kong. The reason AVIC, which makes both civilian and military aircraft and components, has so many listings compared to other aerospace and defense companies is “historic,” said Xu Zhiguo, an analyst at state-owned Sealand Securities in Beijing. “The proportion of military products business in AVIC is relatively smaller, and many of its aviation assets are for civil use, which are not quite sensitive. Therefore, AVIC initialized asset securitization sooner than other firms in Chinese defense industry.”
Hong Kong-listed unit AviChina Industry & Technology may be the best target for foreign investors, for whom investing in the mainland-listed companies is limited. Military demand drives a small but significant part of AviChina’s business. Approximately 17% of AviChina’s revenue was ultimately related to military demand in 2011 and 33% of the firm’s profits, according to a March report by investment bank Citi.
Increased military spending should contribute directly to the company’s growing bottom line in the future. Citi estimated that every 10% increase in the national military budget would translate to a 2.9% rise in AviChina’s estimated 2013 profits. Taking positive prospects for AviChina’s civilian lines of business into consideration as well, Citi initiated coverage of the company in China with a “buy” rating in March.
Many other opportunities to invest appear to be more slimly related to military spending. For example, China North Industries (Norinco), the import-export arm of China’s largest arms maker that shares a similar name, has a Hong Kong-listed unit called Norinco International. Wh
ile Norinco International isn’t in the arms trade per se, they do sell some related items, such as air surveillance and control system project, according to a recent contract with Laos.
Funds that are licensed under the Qualified Foreign Institutional Investor (QFII) to buy mainland stocks may find far more options as there are dozens of domestically listed aerospace companies. Regulators are also considering a similar program for individual investors. However, investors would need to dig into a company’s Chinese corporate filings to determine if and how much of the demand might be related to military spending.
The lack of transparency on defense spending may make the exact nature of a company’s military ties difficult to discern. Investors will likely need to come to terms with a degree of uncertainty whenever investing in such companies. But that may not stop experienced China investors – misreporting and outright fraud in Chinese financial filings is thought to be widespread among companies on mainland exchanges.
Building better bombs, etc.
As military spending rises, already gigantic Chinese defense contractors won’t necessarily grow larger. Instead, they will likely move into more sophisticated goods which could boost arms exports to developed countries. China currently sells to mostly poorer countries that buy small arms and less expensive equipment, Cheng said. China could sell more to countries like South Africa, rather than Zimbabwe, for example.
China seems well positioned to do that and is already climbing the defense industry value chain. The military’s emphasis is already shifting from the army to the navy, air force and space, areas that require more expensive goods, said Yu of the US Naval Academy. The shift is evident in an increasing number of naval and air force officers being appointed to the Central Military Commission, Yu said.
That move up the value chain may help China climb the ranks of arms exporters, but it is admittedly unlikely to challenge the US as the top arms exporter anytime soon. US military equipment will remain the most in demand because it has been battle-tested, which is appealing to buyers, Cheng said. China simply hasn’t been in a war since 1979 so lacks that ability to test equipment.
For now, rapidly rising demand from China’s military alone appears set to drive high growth among defense contractors. That will undoubtedly sustain growth in the industry for years to come. But whether these companies can pull off a transition to making more sophisticated goods that are internationally competitive will determine whether the industry can grow quickly for decades to come.
With the lack of transparency on China’s military industrial complex, it’s difficult to judge to what degree defense contractors will be able to make that transition. But with ever more spending being poured into the industry – and a military dependent on its success – those that can stomach the risks may find investing in the sector to be well be worth the rewards.