It is still fashionable to remark, with an amazed look, on how China has expanded its GDP fourfold since the Open Door policy was introduced – thus beginning the country's march from Communist central planning to market economics. But it is worth bearing in mind that in just two years, China will be marking the 30th anniversary of that famous U-turn, on the eve of celebrations marking the 60th birthday of the People's Republic of China.
In other words, for half of the PRC's existence, Chinese in ever-increasing numbers have been devoted to digging themselves out of the economic rut in which central planning put them in the first half. This is not to dismiss socialism's short-lived health, housing and other benefits, but the beginnings of this reversal were so long ago that CEOs running many of today's successful companies were still in short pants when the Open Door was launched.
In late 2005, the Organization for Economic Cooperation and Development predicted in its first major study on China that the PRC would become the world's largest exporter in five years, and that by the end of the decade its economy could top all but three OECD economies. The contention was reasonable – yet old hat since it has long been assumed that a large economy growing at near-double-digit rate would end up near the top sooner or later.
The more remarkable thing was that it took until 2005 for the rich-country club to conduct its first all-embracing look at China as an emerging economic superpower. But 2005 really was the PRC's year for getting noticed by everyone. China-made clothing piling up at US and European ports as a result of textile export disputes; western politicians griping that the more freely floating yuan wasn't being allowed to float far enough; and China National Overseas Oil Corp's (CNOOC) controversial failed bid for US oil group Unocal – it all made big news. China is now a known commodity: known for buying up commodities (including energy resources) and driving up prices; known for taking people's jobs away with unbeatably cheap, hyper-scale production and export capacity; and known for generally intruding on the comfortable old order.
Just over 50% of China's GDP derives from manufacturing and construction, nearly 15% from agriculture and the remainder from services. But nothing is constant. Each of these sectors is undergoing significant change as participating actors – including dying state enterprises – come to terms with the dynamics of China's evolving market economy.
Start with manufacturing and consider how China's economic transformation is playing out in some industry segments. In mobile phone exports, for example, the foreign brands are dominant, a pattern that is followed in a wide variety of consumer electronics. The exception is clothing, but even here, it is the Liz Claibornes and Ralph Laurens that make the most money thanks to premium pricing.
When China's auto sector takes its first serious stab at exports in the next three or four years, the story is likely to repeat itself. It is Volkswagen, General Motors, Toyota and Hyundai that rule China's domestic market, not the scores of Chinese auto makers who splinter the market so completely that no one local brand has much more than a 1% share – as opposed to 30% for VW and 11% for GM.
So the manufacturing-export juggernaut is not China alone, but China working largely in league with the world's multinationals which helped it evolve into a sophisticated manufacturing center. Chinese companies have to develop strong brands, if only to protect their domestic markets – especially as the economy depends increasingly on domestic consumption rather than exports and infrastructure to drive growth.
Local players overrun
As different sectors have opened up according to China's 2001 WTO accession requirements, domestic players have been steamrolled by the arrival of multinationals. Industry is restructuring across the whole economy, as underperformers either drop out or get absorbed by more successful players. Of over 300 Chinese MP3 player manufacturers that sprang up in recent years, only half remain in business, while 27 of the 96 air conditioner brands in the market at the start of 2005 went under within six months. Twenty of the remaining 69 contenders have 95% of the business – almost ensuring that 80% of the companies in the segment should be gone soon.
The air conditioner market is something of an anomaly, as Chinese companies actually hold their own against strong, more expensive foreign brands such as Hitachi – thanks largely to the presence of a genuinely strong homegrown player, Haier. But it also makes a good illustration of broader trends driving China's economy. These luxury items hardly had a market two decades ago, but even the early movers who counted on the meteoric rise of China's middle class could not make units fast enough. This left the impression there would always be room for more entrants, which was true for only a very short time.
It was the same experience for handset makers. Bigger players invested in scaling up production, R&D to sustain it, and branding and distribution to fight it out with the likes of Motorola and Nokia, leaving legions of domestic bit players to fall by the wayside. Every new industry ultimately goes through consolidation, but Chinese industries face a particularly brutal form of it because each tends to attract an overwhelming number of participants spurred on by the overall economy's galloping growth.
Going for growth
Few would bet against the Chinese economy galloping on at least 7% a year past 2010, but the exact growth rate within this high-speed bracket is a matter of contention. The government has set a goal to double China's 2000 GDP per capita by 2010, which would require average annual growth of 7.18%.
While attempts to put the brakes on overheating sectors were expected to see a fall in the 2005 growth rate, the OECD raised its projection for the year to 9.3% in November from the 9% quoted in September. It further revised upwards the 2006 projected growth rate to 9.4%, with 9.5% penciled in for 2007, citing an expected boost in private sector investment. The State Council's Development and Research Center was not so confident, predicting GDP growth to fall to between 8.5% and 9% in 2006, with the World Bank settling on a figure of 8.7%.
Underpinning this pessimism – if an 8%-plus growth rate could ever be labeled as such – are fears of overcapacity in industries such as auto manufacturing, steel and aluminum. CLSA's purchasing managers' index dipped to 49.8 in November from 50.1 in October, the sub-50 figure representing the first contraction in the survey's 20-month history. This suggests deterioration in the health of China's manufacturing industry, which CLSA believes is explained by excess supply of key raw materials forcing down prices. Steel, for example, fell nearly 30% between March and November.
In a December research report, Morgan Stanley chief economist Stephen Roach warned that, at the current pace, China's investment-led boom will see the fixed asset investment share of GDP reach 55-60% by 2008 – "a recipe for a monstrous overhang of excess capacity". In his view, 2006 will be about whether the state banks stick to their reformist strategy and stamp out policy lending, or succumb to the demands of companies trying to prolong the investment boom in search of the macroeconomic Mecca that is a "soft landing". China's energy needs will retain a top billing in the year ahead, although the 15% spike in demand experienced in 2004, which played a major role in driving up global oil prices, is unlikely to be repeated. The State Council's Development and Research Center announced in December that crude oil demand would rise by 6% in 2006 over 2005, which in turn showed a tepid expansion of under 4% on 2004. Easing power shortages, rising domestic crude production, increased gas prices which created a subsequent decline in auto sales, and government measures to slow production in oil-hungry industries are seen as being responsible for the slowdown.
But expect China to feel more heat in 2006 over its supposedly undervalued currency. July saw the yuan de-pegged from the US dollar in July, after a decade of the RMB8.3-US$1 configuration, and the introduction of a managed float against a basket of currencies. Further changes took place in November as the yuan's trading range against non-dollar currencies widened to 3% from 1.5%, although its trading band against the dollar of 0.3% per day was unchanged. US critics are likely to continue their calls for a revaluation, with 27.5% being the figure of choice for many of those in Congress who support the imposition of an import tariff of equivalent size if Beijing fails to act.
For their part, the Chinese authorities appear committed to establishing a market-driven forex regime, but only at their own pace. What tends to be forgotten is that capitalism and markets are essentially counter-intuitive to people who grew up drawing up five-year plans, so a pattern of tentative steps towards reform should not be surprising. Even if the results of these five-year plans were woefully off target, the big forward-looking picture implied a level of predictability that markets never could.
China's "paramount leader" and the architect of the Open Door policy, Deng Xiaoping, died in 1997 and was really the last leader of the generation that played a role in the creation of the People's Republic of China. Former President Jiang Zemin and his premier, Zhu Rongji, grew up during the period of communism's peaks and troughs, while the current leadership of President Hu Jintao and Premier Wen Jiabao were children of communism's ultimate trough converging with China's embrace of capitalism and market economics. The next generation of leaders in all likelihood will have grown up in a largely capitalist economy, and these candidates for top government positions are rising up the ranks and gaining influence in policymaking now. So there is every reason to believe China will adopt vibrant market systems.
There are already signs that Beijing wants to breathe life into the country's moribund stock markets. In August, the government announced an end to non-tradable state-held shares, the financial framework which made two-thirds of listed Chinese companies off limits to the public market. The arrangement effectively silenced shareholders in China's A- and B-share markets, Chinese retail investors and qualified foreign institutional investors respectively, making a nonsense of transparency and corporate governance.
Reform comes in the shape of G-shares, a pilot program launched earlier in the year that is now the vehicle of choice for around 250 companies on the Shanghai and Shenzhen stock exchanges looking to convert non-tradable shares into tradable ones. It remains to be seen whether a piecemeal pace and compensation for existing shareholders will be sufficient safeguards in dismantling the overhang without crashing the market, but the long term effect should be a therapeutic one. Investors will have the power to demand more of the companies that market forces decide can survive and the best Chinese companies, which opted to list offshore in the past, will start moving in. As the process matures, and liquidity piles up, Shanghai can look ahead to taking its place among the leading global markets.
But effective stock markets will be of little use to China without brokers that know how to use them: 114 of the country's 130 or so brokerages managed to lose a collective US$1.85 billion in 2004. Here, again, the government has woken up to the need for change, closing down the worst offenders and opening up the market to foreign involvement. UBS' investment in Beijing Securities came with the added rider that the Swiss bank would take management control and knock the underperforming brokerage into shape. Other global players are looking for the same kind of deal.
Nursing sick banks
A similar pattern is emerging in the banking sector with 19 foreign institutions taking stakes in 16 domestic banks at a total cost of US$16.5 billion. Bank of America paid US$2.5 billion for 9% of China Construction Bank and then spent a further US$500 million on equity in CCB's US$8 billion initial public offering in October. In return for its investment, Bank of America gains a ready-made China platform from which to launch its own services. Hard cash aside, for CCB it's all about getting access to American expertise in corporate governance, auditing and risk management.
The Chinese banks' thirst for knowledge is understandable. The banking system, comprising four large state banks and hundreds of regional and city banks, remains a mess, a legacy of the days when banks were used as communism's fund transfer agents and not as lenders in the conventional sense. We are now far from the days when they lent money to state enterprises simply to service earlier loans. The Big Four are all making the transformation into commercial entities – CCB has listed, Bank of China and Industrial and Commercial Bank of China are expected to follow suit this year – and with this comes a tightening up of lending policy.
Work is still required in scrutinizing credit on a smaller scale if the banks are to effectively develop their consumer businesses. A national credit bureau system is essential if banking is to keep up with an increasingly mobile China, where businesses and people roam from province to province. Until very recently, credit was only available to locals, so the prospect of borrowing to set up a branch of an SME in another province was out of the question.
Despite the numerous regulatory hoops that foreign banks must jump through and the inbuilt competitive advantages of domestic lenders, the international contingent will pose a new challenge when the market makes significant steps toward liberalization in December. HSBC and Citigroup have both launched dual currency credit cards through their tie-ups with Bank of Communications and Shanghai Pudong Development Bank respectively, while investors in the Big Four state lenders are expected to do the same.
The foreigners are pursuing business from high-net-worth people and businesses as well as upscale consumers looking for more enticing services and products, most of whom are to be found in cities along China's more affluent eastern seaboard. Chinese banks must reform at speed if they hope to retain better-paying clientele, but it is the old customers who are likely to create the most problems. Consider auto finance: when dealers repeatedly slashed prices to move piled-up inventories after sales sank from year-on-year 40%, 50%, 60% and 70% growth to 0%, borrowers still financing their purchases suddenly quit payments, seeing that they could get a new car for a lower price than what they had paid for the car they had purchased earlier. But even this is small fry compared to the SOEs themselves. Should China's reported excess capacity send company earnings tumbling, the state will face the tough choice between allowing market forces to pass judgment on the underperformers or telling the banks to bail them out. A new generation of non-performing loans is waiting to be born.
Life in the fields
Agriculture, post-Open Door, has become one of China's real success stories in production terms, all the more impressive as farmers are working with less land as environmental erosion and urbanization eat into the overall farm plot. China now tops the world output in grain, cotton and oilseed. Addressing a seminar late 2005, Agriculture Minister Du Qinglin said China accounted for 20% of increased global agricultural output over 25 years.
But production is improving on the back of higher efficiency and adoption of world practices in areas such as soil enhancement, and it is said that China will need only 10% of the estimated 400 million farmers it has now, i.e., half of China's overall workforce. This broadly fits in with China's plan to accelerate urbanization to the point where it doubles what it is now, to 800 million, by 2020. Getting there will be painful, though, as more migrants flood into the cities, mostly to take up unskilled jobs or do on-demand construction work.
For most small plot holders, life is still a misery. Despite the government canceling all agriculture taxes, the OECD was critical of Beijing in an agriculture study published in November. The study claimed that barriers to rural-urban migration and a lack of clarity over land ownership rights were key contributors to the country's income disparity. In addition to recommending better education and healthcare in rural areas, the OECD called for large-scale peasant organizations to market farmers' products. The latter reform is unlikely to be forthcoming given the government's fear of allowing independent groups to become too strong.
Money from overseas
Foreign investors continue to be excited by China, though foreign direct investment showed signs of slowing over 2005 after the previous year's record of over US$60 billion, which made the PRC the world's top FDI destination. In the first eight months of 2005, actual FDI totaled US$38 billion, a 3% decline year on year – the first time that had happened since 1999. The slowdown was in part blamed on Beijing's imposition of macroeconomic measures to slow down growth in overheating sectors. But 2005 trends also hinted some of the big players had made their big investments and established their footprints. According to Taipei's Chunghua Institution for Economic Research, Taiwan investment growth in the mainland dropped 18.3% over the first eight months. One reason for that, The Taipei Times surmised, was that all Taiwan industry suitable for relocation had already been relocated.
Like any FDI destination, China has its plusses and minuses. But the degree to which China has changed is well illustrated by a conversation Singapore Prime Minister Lee Hsien Loong had with The Hindu newspaper in October in which the PM suggested India would see much more investment if it followed China's example. "In India, which is not a communist country, when will we be able to hire and fire workers?" Lee asked. "In China, a communist country, the labor commissioner is not a problem in regard to the flow of FDI."
China has indeed come a very long way in a very short time, but it still has a long road to travel. The WTO trade talks in Hong Kong in December were held shortly after the fourth anniversary of China's entry into the organization, and on the whole foreign companies have responded well to reforms.
Import tariffs were cut to an average of 9.4% from 15.5% in 2001, while the ongoing liberalization of the financial sector has been more than matched by progress in insurance, where foreign-invested companies are attracting a growing number of Chinese clients. Beijing has also agreed to talks on opening up its procurement system to allow foreign companies to compete for government purchases.
Needless to say, intellectual property rights remain a black mark in China's report book, with a US Chamber of Commerce report published in October citing it as "the most visible area of WTO non-compliance." The report said 70% of pirated goods seized at US borders in the first half of the year originated from China and Hong Kong.
Further complaints fall under the purview of transparency and reliability. Foreign firms have spoken of long waits before receiving distribution rights, frustration over Beijing's practice of publicizing regulations just before they take effect, and bitter feelings at how China is supposedly developing its own technology standards in violation of WTO competition rules.
Clearly there is much to be done for the world to have full confidence in China as a trading partner. If 2005 was the year when the country got noticed, in 2006 Beijing needs to make sure this happens for the right reasons.
The year ahead: domestic economy
Eddie Wong, chief Asian strategist at ABN AMRO
The coming year is going to see questions asked of China's commitment to economic reform. The country's GDP growth should be fine, maybe somewhat slower than 2005, but I don't expect a major slowdown. However, the quality of growth will decrease. In 2005, as for the last few years, growth was driven by investment, particularly manufacturing investment. There has been massive expansion in capacity and, as a result, a lot of companies have found that their margins are being squeezed.
If an earnings contraction starts to develop, the government will find itself called upon to support loss-making companies and it will be left with two options: either let the companies go bankrupt and deal with rising unemployment while retaining market discipline; or forget about banking reform and ask the banks to lend more money. It comes down to policy choice between enduring an economic hard landing and increased bank lending, leading to increased non-performing loans. I suppose what we are most likely to see is a combination of the two.
The root problem of the Chinese economy is its excessively low cost of capital. Borrowing is still cheap and this prompts excessive investment. This is the case with basic materials, particularly the steel industry where there is severe excess capacity. But a variety of sectors have the same problem: aluminium, petrochemicals, textiles, auto manufacturing.
The government's commitment to consumption-led growth rather than investment-led growth has been there for a couple of years and if they had increased interest rates two years ago, it would have helped. Money would have been taken out of the corporate sector and this excessive investment might have been stemmed. But if they increase interest rates now, there is the chance that corporate earnings could completely collapse. Timing is important and they missed their best opportunity.
The year ahead: banking
Lance Brown, chairman of Standard Chartered China
Will it be business as usual or a year of great change for China's banking sector in 2006? Improbably, the answer is both. Business as usual because banking reform and bank restructuring will continue apace. As in 2005, more Chinese banks will receive capital injections, negotiate strategic partnerships and list on stock markets. We will also see more bickering over China's exchange rate and, if interest rates remain low, a continued improvement in bank profitability is likely.
On the other hand, for foreign banks, 2006 will bring the biggest change to China banking since 1949: access to the retail market. Under the terms of China's WTO accession, from December 1, foreign banks will enjoy the same market access as Chinese banks, enabling them to provide local currency retail banking services to Chinese citizens for the first time in over 50 years. But there will be no "Big Bang:" December 1 will not suddenly see all foreign banks providing a complete range of banking services to everyone throughout China. The regulators are committed to opening up and competition, but the top priorities are stability and an orderly market.
The jury is still out on whether we shall see the creation of a Special Banking Zone, in which foreign banks would have further freedom in a controlled environment. If successful, these reforms could then be rolled out nationwide, as happened with the early RMB licenses. But maybe all of this is really just business as usual. When Standard Chartered opened in India and China in the 1850s, those two countries were the largest economies in the world. We are still there 150 years later, the largest foreign bank in India and the oldest foreign bank in China, so watching the resurgence of these two economies really is a case of "deja vu."
The year ahead: foreign policy
Nicolas Chapuis, Minister Counsellor, French Embassy in China
Facing the risks entailed by its rapid development and internationalization, China will continue to place internal stability coupled with sustainable growth as the main objective of its foreign relations. Hu Jintao and Wen Jiabao will persist in promoting their country's renaissance as an opportunity for business, not a threat. In the same spirit, they will probably strive to accommodate concerns over the valuation of the yuan and IPR enforcement. Chinese diplomacy will furthermore try to gain additional ground in raw material producing countries, notably in Africa and South America.
At global level, the Sino-American relationship will confirm its prevalence over all other bilateral links. Despite the largely negative views on China emanating from the US Congress, Beijing will seek to capitalize on America's description of China as a growing stakeholder in the international community, as the Chinese mediation on North Korea has demonstrated. In that context, European countries will have to boost efforts to catch China's attention. For its part, China wants significant ties with the region, as these relationships guarantee what Beijing sees as a necessary balance for its own stability and growth. The European Union has to respond by defining its own political objectives.
At the regional level, the relationship with Tokyo will be the highest on the agenda, after 2005 ended with the suspension of high level meetings. Friction over Japanese Premier Koizumi's visits to the Yasukuni shrine is only the tip of an iceberg heavy with mistrust on both sides. Beijing rejects categorically that Tokyo and Taipei may have common security concerns, while Tokyo is bitter about China's opposition to a Japanese seat on the UN Security Council and rejects China's supposed ambition to rule over East Asia. How this tension is defused is likely to set the shape of things to come in the Beijing-Tokyo-Washington triangle.