China’s Communist Party has just kicked off a third wave of economic reform. It is an effort to push the mainland’s manufacturing platform up the value chain, to contribute more to domestic growth and create higher-paying jobs.
The first wave of restructuring saw the end of the communes and the arrival of foreign-invested factories in the 1980s, while the second wave, which took place during the following decade, resulted in the transfer of economic power from state-owned enterprises to entrepreneurs.
Now, China is teetering on the brink of a new era of industrial consolidation. The goal is to shut down small export-processing manufacturers that pollute, use scarce resources and abuse workers. China will not go high-tech quickly, but Beijing no longer wants to be the world’s sweatshop for junk.
In the short term, these policy changes and rising raw material costs will squeeze manufacturing margins, resulting in bankruptcies and job losses. Beijing believes it can accept this short-term pain as part of a longer-term restructuring process.
It is a risky strategy, but then so were the first and second waves of China’s restructuring. These changes delivered double-digit economic growth, turned China into the world’s second-largest manufacturing nation and helped the party consolidate its political power.
The last 17 years have seen a level of political stability unmatched in modern Chinese history, and the party hopes that the third wave of economic reform will produce similar results.
Beijing is relying on a multi-pronged approach to push manufacturing up the value-added chain.
Back during the first wave of economic restructuring, the government established a long list of subsidies designed to promote exports. Thousands of goods – largely low-valued-added processed products – received rebates on the value-added tax (VAT). In some cases, producers got back all of the 17% VAT they should have paid.
Over the past year, many of these rebates were abruptly cancelled. The impact was quick and significant. Almost overnight, tens of thousands of companies found once-profitable export businesses had become unviable. In many cases, factories not only lost large rebates – payments that had been the only profit source for small producers – but were also facing stiff new taxes.
Additional taxes have been imposed on many dirty industries, including coke and metals processing. The intention is to put an additional burden on smaller factories with low cash-flow. Beijing believes such firms are the main violators of laws to protect the laborforce and the environment.
These firms are also being targeted through specific legislation. The new Employment Contract Law, which obliges firms to consult with workers, and places limits on an employer’s ability to fire workers or be overly reliant on temporary staff, is already having an impact.
The changes, combined with widespread promotion of the new law, mean workers themselves are now far more willing to fight for their own rights. Labor arbitration cases filed in every province rose by at least 50% year-on-year in the first two months of 2008.
For all firms, but particularly smaller, labor-intensive operators, the new law means added costs.
On the environmental front, no new laws were required – it is a case of enforcing existing ones properly. The party has made two key policy decisions that facilitate this: It has acknowledged the extent of China’s environmental disaster and pledged to do something about it; and it has warned local officials that promotion will not be forthcoming unless they reduce pollution, even at the expense of short-term employment.
The impact of the anti-pollution campaign has been greatest on smaller firms, particularly those engaged in export processing.
All of the measures the government is taking are having an impact on manufacturing margins, but an even heavier source of margin pressure is the rising cost of everything that comes from the earth.
In CLSA’s latest Purchasing Managers’ Index (PMI) survey, 60% of manufacturers reported that their input prices were up in April, three times higher than one year ago. Output prices have also been rising, but not as fast. Only 37% of manufacturers reported higher selling prices, up from 14% a year ago.
The results are clear. Gross margins at small- and medium-sized enterprises fell from 14.6% in the first quarter of 2007 to 12.5% in the same period of 2008. The margin squeeze is set to worsen during the next few quarters. More firms will be going out of business in China, with small, low-end, low-margin manufacturers, particularly in the processing sector, most at risk.
These closures will have an impact on China’s unemployment rate, but thanks to the rise of the services sector, not a dramatic one. Neither will they have a major impact on macroeconomic growth – largely because the sector has already been in decline for some time. Furthermore, domestic investment and consumption are the primary drivers of China’s economic growth, not exports. It is only in the past three years that exports have accounted for a significant share of GDP growth, rising from 2.4% in 2004 to around 16% last year. In 2008, expect the figure to return to a more “normal” level.
The firms that emerge from the industrial consolidation can add capacity, improve productivity and regain pricing power. They can also count on domestic demand. First-quarter retail sales were up 21% and home prices rose 11%.
Given that about 60% of total fixed-asset investment is financed by firms’ retained earnings – which is a reflection of the limited fundraising options in China’s immature financial system – a capital expenditure slowdown is inevitable. However, the government is poised to make up for the shortfall through increased investment in infrastructure. With a spending of US$1.2 trillion, China will account for 48% of all infrastructure spending in Asia ex-Japan and the Middle East between 2008 and 2012.
This means China’s overall fixed-asset-investment growth will continue at about the same 24-28% year-on-year pace that it has experienced since 2003. It also means continued pressure on global resources.
Never mind the US recession. A US slowdown is less important in a world where a still-growing China accounts for one-fifth of global consumption of wheat, corn, rice and soybeans. Between 2004 and 2007, China accounted for 35% of global oil-consumption growth and 107% of copper-consumption growth. The US figures for oil- and copper-consumption growth over the same period were 10% and minus-36% respectively.
The upshot of this is that Chinese demand will be an increasingly inflationary factor in global commodity prices. But the effects don’t end there. By virtue of Beijing’s third wave of restructuring, the prices of everyday goods, as well as wages, will rise the world over.
Over the past 20 years, global consumers have benefited from low-priced goods made by Chinese factories that paid low wages and that often polluted at will. Now they will have to cover the cost of minimum wage and overtime limits, social insurance and pollution-control regulations. It is time to start paying the true cost of producing goods in China.