Thursday, May 06, 2004

The Coming Profit Shock - China

Asia Pacific: The Coming Profit Shock

Andy Xie (Hong Kong)
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China’s slowdown should have a greater impact on profits than on volumes. China’s investment surge has created temporary bottlenecks and inflated commodity prices. Also, the investment bubble supercharged China’s consumption, especially demand for luxury goods, artificially inflating profit margins for such products.

The unit import price for minerals/metals rose by 57% between 1Q02-1Q04, while the volumes rose by 81%. The price change was global and, hence, redistributed income from consumers, and downstream industries to upstream ones. In other words, it has acted as a global tax.

As China cools its investment bubble, most of the price gain in commodities would be reversed, removing the inflation tax and, hence, reversing the profit gains of the upstream industries that we have seen in the past two years.

The Commodity Linkage

China’s imports are one-third those of the US, but grew by more than that last year. About half of China’s imports are raw materials and equipment for capital formation. Another one-third are components for export processing. Thus, China’s slowdown should mainly affect these two sectors.

Because construction of infrastructure, property and factories dominates China’s investment, any investment boom would trigger massive increases in imports of minerals and metals. China accounts for roughly for 70% of the global incremental demand for hard commodities.

As China’s fixed investment accelerated from 13.1% in 2001 to 43% in 1Q04, the demand for such commodities skyrocketed. The greater impact, however, was felt in prices. China’s unit cost of imports for such commodities rose by 57% during 1Q02-1Q04. A similar increase also occurred in 1993.

The main reason for the rapid price rise is that China’s investment occurs whenever there is liquidity and is not sensitive to price, as local governments just want to see capital formation. Thus, a liquidity boom can push up commodity prices very rapidly. However, when the liquidity tide recedes, the process reverses, i.e., the investment doesn’t react to cheap commodities, and, therefore, the price correction undershoots.

There is an argument that the demand recovery in the US, Europe and Japan would offset China’s weakness. This argument does not work for two reasons, in my view. First, the interest rate-sensitive or commodity-intensive sectors (i.e., housing and autos) were never weak during the economic downturn, because the Fed cut interest rates more aggressively than in the past. Thus, the current economic upturn in these economies has not boosted commodity demand that much.

Second, the incremental demand for most commodities has come from China. This is why commodity prices correlate closely with China’s investment cycles. It would be surprising if this linkage didn’t work this time. Further, China’s current investment bubble this is much bigger than the one 10 years ago in absolute volume. Thus, the reversal for commodity prices should only be more dramatic.

The Consumer Linkage

The investment bubble has exaggerated China’s income growth. As income growth in bubbles tends to be concentrated among a few people in the center of the bubble, China’s demand for luxury goods has been rising rapidly over the past two years. While the secular trend is positive, China’s demand for such goods would likely stagnate or even decline in the coming quarters.

Luxury automobiles, for example, have seen very rapid sales growth. While there is a secular growth trend in the size of China’s wealthy class, the bubble has exaggerated its ranks and purchasing power. Hence, auto demand has grown rapidly while prices have been high. As China’s bubble deflates, this industry has to sell to less wealthy people, but with much more capacity. A major price war is looming, in my view.

Another example is the consumption of Chinese tourists in Hong Kong. Shanghai and Beijing account for most of the big Chinese spenders in Hong Kong. But their purchasing power has been exaggerated by the property boom in their cities, partly funded by Hong Kong and Taiwan investors purchasing properties there. Thus, Hong Kong’s retail sales to Chinese tourists partly reflect Hong Kong investors buying Shanghai and Beijing properties. In other words, it is Hong Kong money coming back. When the property bubble deflates, this flow will also diminish.

The Regional Linkage

Asian trade has been reorganized in the past five years with China replacing others in the OECD consumer market, and other Asian economies supplying equipment and consumer goods to China. China/Hong Kong accounted for half of the export increase of other East Asian economies in 2001-03. What it means is that East Asia can only grow when China grows. This change is inevitable as it reflects the relative competitive advantages of the economies. However, it also means that East Asia’s business cycle correlates with China’s and with the US’s only indirectly through China.

Equipment demand is the most obvious linkage. China’s equipment imports, especially from Japan, grew by over 40% in value last year. The growth will likely be in single digits or worse in the coming six quarters.

The most important linkage may be profits from selling goods and services inside China. Korean, Taiwanese and Japanese companies have done an outstanding job of turning China into a market as important as their home markets. In the long term, this strategy could work well. However, their profits in China have been exaggerated by the bubble.

China’s credit surge has been the most important source of profit growth for Asian companies in the past two years, either through higher commodity prices or stronger Chinese consumption. The reversal would come as a negative profit shock. The market still underestimates this effect, in my view. ...Link

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