Clouds on the Horizon

The flow of good news out of China continues, but there are some clouds forming on the horizon which are important to keep in sight.

First, the good news. Last week, we highlighted car sales, which increased by 19.2 percent over last year during the first six months of the year and are likely to register a stunning 87 percent increase in July, as well as the fact that, as of last Wednesday, the Shanghai Composite Index was up by almost 90 percent since the beginning of the year.

Already this week, Andy Rothman, China Macro Strategist for CLSA Asia-Pacific Markets, has reported that:

China’s manufacturing recovery accelerated in July, with the CLSA PMI in expansion for the fourth consecutive month, rising to a 12-month high of 52.8, up from June’s 51.8. New orders expanded at the fastest pace in 14 months, and output prices rose for the first time since last August, suggesting some recovery of pricing power. Manufacturing employment remained in expansion for the fourth consecutive month, and 12.4% of companies said their headcount rose MoM, the highest share in our PMI’s five-year history. A sustainable recovery is well underway in China, driven by domestic investment and consumption in the absence of external demand.

After registering growth of 6.1 percent in the first quarter and 7.9 percent in the, Andy, who has been consistently on target with respect to China’s economy since the global economic crisis began, expects China’s GDP to grow by 9 percent or more in the third quarter. For the entire year, he expects GDP growth of about 8 percent, with the risk now on the upside. Just over half of China’s growth will come from investment, with the balance from consumption and zero (or slightly negative) contribution from net exports. Based on domestic demand alone, China’s GDP should grow at another 8 percent in 2010, according to Andy. If the United States and Europe recover, generating a net export kicker, GDP growth could reach 9% next year.

Now for the clouds, which generally fall into four categories: spotty demand, inflation, profitability, and future growth.

Growth has not been universal in 2009. Unlike in years past, a rising tide has not lifted all boats, making it more important than ever to correctly analyze the near and long-term prospects for individual sectors of the Chinese economy. The obvious soft spot has been in exports. Companies that have relied on exports in the past for growth are clearly having a difficult time in 2009. But there are others.

Take truck sales for example. Like passenger cars, mini-trucks have benefited from the subsidies that are being given to vehicle purchasers in the rural areas of the country as part of China’s stimulus program. As a result, sales of mini-trucks increased by almost 42 percent during the first six months of 2009. However, sales of heavy duty trucks, which are in the middle of a sector downturn, plummeted by 28 percent during the same period. Interestingly, truck sales were also adversely impacted by a falloff in export demand as truck buyers in Russia, the Ukraine and Middle East/North Africa closed their pocketbooks.

Lower truck sales have, in turn, had a knock-on effect on downstream suppliers. For example, Guangxi Yuchai Machinery Company Limited (Yuchai), China’s largest diesel engine manufacturer, reported last week that the total number of diesel engines sold by the company during the first quarter of 2009 was 121,749 units, down by 5 percent from the 127,962 units it sold in the same quarter of 2008.

Concerns about inflation are also now becoming more widespread as price pressures mount. According to a recent article in the Wall Street Journal, “manufacturers in China face rising costs as some commodity prices grow, but economists say producers may not pass on the costs to consumers because of fierce competition.”

The combination of price pressures and competition brings “margin squeeze” back into the China vocabulary as profit margins begin to erode in many industries. Despite exceptionally strong demand, profitability is one of the biggest concerns for China’s passenger car makers. The same is true for China’s truck producers and other manufacturers. In addition to top line growth, China observers would be well advised to keep an eye on profitability measures.

Finally, there are questions by some about growth going forward. Following strong growth in the first half of the year, lending activity is bound to slow in the second. While China’s monetary policy is not about to become restrictive, a slower rate of growth will certainly feel to many as though it is tightening. This has already had an impact on the stock market, as the Shanghai Composite Index dropped 5 percent last Wednesday on fears that the market was outpacing itself, as well as speculation that the government might curb investments and take steps to rein in liquidity .

On a longer-term basis, there is some concern about what slower recoveries in the United States and Europe will mean for China’s export sector and overall growth rate. In particular, Michael Pettis, a finance professor at Peking University and a senior associate at the Carnegie Endowment, wrote a thoughtful piece for the Financial Times whose title, “Brace for a decade of lower Chinese growth,” says it all. Due to lower export growth, Michael believes that the world needs to prepare for a period when “if all goes well, China grows at a still respectable but much lower rate of 5-7 per cent.”

While the numbers coming out of China continue to be very robust, inflation, profitability and balanced, sustainable growth are likely to be the key issues going forward.

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