FEELING THE HEAT (China)

Like hundreds of other CFOs in Asia, Oh Se Kang has spent a good part of this year assessing the merits of a new investment in China. In particular, he's looked at whether or not to build a US$300 million paper mill in Hebei province, 280km southwest of Beijing, to feed the local market with newsprint. Oh's analysis was exhaustive but, in the end, positive. On September 10, his firm, Singapore-based Pan Asia Paper, decided to go ahead. When the plant opens in late 2005, it will make the company the biggest producer of newsprint in China.

The business case behind the investment is simple, says Oh. Once upon a time daily papers in China were little more than drab pamphlets of government propaganda, but economic development has changed all that. A sophisticated and literate urban population has emerged with money to spend, and China's state-controlled media has evolved to meet their tastes. Circulation figures and advertising revenues have risen hand-in-hand and the demand for newsprint has soared - from 1.2 million tonnes in 1998 to nearly 2 million tonnes this year.

As Oh sees it, there's no slowdown in sight. "We expect growth to continue at 8 percent a year," he enthuses. By 2008, when Beijing hosts the summer Olympics, Oh calculates that annual demand for newsprint will reach 3 million tonnes.

Inevitably, though, investing today in expectation of future demand creates risk. "The new mill will give overcapacity in our sector in the short-term," concedes Oh, "but our industry is highly capital-intensive so we have to think and plan for the long-term. We're confident demand will rise quickly and absorb the new capacity." The danger is that it doesn't. If growth fails to materialize then short-term overcapacity all too quickly becomes long-term overcapacity. Price wars kick in and margins sink through the floor.

In China some observers reckon these dangers are already starting to get serious. In sectors ranging from steel, aluminum and cement to cars, chemicals, property and textiles, a growing band of experts claim that China is suffering over-investment on a giant scale. Industrial capacity, they say, is dramatically outpacing demand and it could all end badly as the economy first overheats and then melts down. For companies like Pan Asia Paper, trying to gauge the dangers of an overheating economy is far from easy. In Oh's opinion the risks are small, but not everyone agrees. For those who miscalculate, the consequences could be disastrous..

CFOs certainly seem concerned. In late September CFO Asia polled 66 finance chiefs with operations in China to hear their views on the state of the economy. Worryingly, 50 percent say they are concerned that the economy is starting to overheat, while a further 10 per cent say they are "very worried". In light of these concerns, 10 percent of respondents say they're postponing investment decisions, while 20 percent say they're downgrading growth forecasts for existing projects.

Of course, nobody disputes that the Chinese economy is expanding at a phenomenal rate. According to government figures, for the past ten years annual GDP growth has rarely dipped below 8 percent. So far so good, but look under the bonnet of China's economy, say a growing band of economists, and the engine of China's growth isn't as healthy as it seems. That's because much of the growth is being driven by fixed asset investment (FAI) - the construction of new aluminum smelters, car factories and fridge assembly lines - rather than by consumer demand. Foreign investors have played a part in jacking up FAI, but more important is the state itself. These days, it seems, every one of China's 31 provinces wants to outshine the others by developing its own steel mill, chip plant, and textile industry, so giving rise to serious duplication across the country.

Eddie Wong, chief Asian strategist at ABN Amro, says FAI grew by 16 percent in 2002 to account for more than 42 percent of China's GDP. This year, he says, FAI is growing at an even sharper clip and will account for more than half of China's GDP next year. "The market grossly underestimates China's over-investment problem," says Wong. "More and more capacity is going on stream while consumer demand isn't rising fast enough to soak up the additional capacity."

Some market-watchers have pointed to the fact that inflation in China remains close to zero percent as proof that the economy is far from overheating. However, says Wong, such views fail to grasp the nature of an investment-driven boom rather than one led by consumer spending. Overcapacity tends to produce deflation.

Take the car sector. A report released in September by consultancy KPMG shows that the number of passenger cars produced in China this year will be twice as many as the market can absorb. The result: between January to June, car prices fell by 7 percent. By 2005, KPMG predicts that overcapacity will account for "a staggering 90 percent of forecast sales".

In CFO Asia's survey of overheating risk, the views of finance executives in China confirm the presence of massive overcapacity. Thirty per cent of respondents believe their own sector suffers from over-investment, while a similar number level the same charge at the wider economy.

Needless to say, in the short-term, over-investment makes for the appearance of healthy growth as banks and investors flood the economy with money. According to the People's Bank of China (PBoC), the country's central bank, the amount of money sloshing around the economy grew by an astounding 21.6 percent year-on-year to the end of August, while local renminbi loans were up 23.9 percent on a year earlier - largely as state banks sought to reduce non-performing loan ratios by stuffing their loan books with new deals. Inevitably, however, a house of cards such as this is unsustainable. Sooner or later overcapacity kicks in, investments fail to generate their expected returns, loans turn sour and the economy stalls.

For its part, the PBoC has recognised that the economy could be in trouble. "All government departmentsÉ agreed that money supply is growing too quickly," the bank said in a statement in August. In a bid to curb the growth of credit and rein in the economy, the PBoC has taken several measures. For one it's tried to suck money out of the market by issuing a series of short-term bonds. For another, in September it raised the reserve requirement ratio - the amount of money banks must keep with the PBoC - from 6 percent of deposits to 7 percent. And as of last month, the China Banking Regulatory Commission began on-site inspections of the four big state-owned banks in a bid to cool down reckless lending to certain hot sectors such as real estate.

Higher interest rates could also follow, although such steps are less effective in China at cooling economic activity than in other countries because of the fledgling state of the local money markets. In any case, raising interest rates would hurt consumer spending and the PBoC is most interested in slowing industrial investment.

To some observers, the PBoC is acting in good time to avert a crisis. Jun Ma, senior economist for greater China at Deutsche Bank, is confident. "The economy is showing signs of overheating, but mostly it's limited to certain sectors," notes Ma. "We won't see a return to the boom and bust of the late 1980s and early 1990s," he predicts.

Other observers, however, are less optimistic. At ABN Amro, Wong thinks the government response will prove to be too little too late. "The market is looking for fine-tuning but this is wishful thinking," he stresses. "The severity of the problem is already well beyond what fine-tuning can solve." The best that can be hoped for, adds Wong, is that the government can engineer a hard landing rather than a crash. Growth won't disappear but it could drop substantially from current levels as the economy works through its excesses."

So how should CFOs react? Robin Bew, chief economist of the Economist Intelligence Unit - part of the same group that owns CFO Asia - cautions potential investors in China to employ good old-fashioned financial sense. "Don't get caught up in the bullishness of the economy," he warns."I suspect that a lot of companies are failing to do their due diligence properly."

That view chimes with stories floating around the market. Ng Wai Lun, CFO of the China operations of AstraZeneca, an Anglo-Swedish drug group, says he often hears of cases in which local managers of multinational companies in China are "bullied by their bosses back in Europe and the US" to be overly aggressive about sales forecasts and to build operations that are too large. "China is the big growth story today and everyone wants a piece of it," sighs Ng. The unavoidable result, he adds, is "overcapacity, missed targets, and painful periods of restructuring."

Even in the pharmaceutical sector Ng says he's seen investment rising faster than demand. Still, that doesn't worry him too much, for Ng believes he has a strategy to combat the effects of overcapacity. "Never compete on price, or you'll end up in big trouble," he says. "We want to compete on things like the quality of our research and development, better technology, and superior drugs."

But there are no hard-and-fast rules when it comes to battling with overcapacity. In the auto sector, different strategies apply, says Wang Jai Pu, CFO of Shanghai-based Torch Investment. Wang's firm specializes in investing in China's vehicle market, a sector he concedes suffers from chronic overcapacity.

Nonetheless, Wang is confident that Torch will make money. The key? First get the strategy right, then go all out for size to kill off the competition. For example, Wang has identified the manufacture of heavy truck parts as a seam of rich profits in an otherwise barren market and is investing in firms he believes have the capability to dominate their niche.

"Smaller players will never make money in this sector," observes Wang. "To be profitable you need to be the number one or two player." Within the next five years, he expects hundreds of smaller firms to fall by the wayside as they succumb to the pressures of dealing with overcapacity.

Another company battling its way into the Middle Kingdom is Singapore-based CapitaLand, a property group that derives 10 percent of its US$1.9 billion in annual turnover from China. Pundits have long claimed that the real estate market is one of the most overheated sectors in the country, but that hasn't held back CapitaLand. The key to managing the risk of overheating, says Boaz Boon, vice president of research at CapitaLand, is to understand the market and to be choosy. While Boon admits that much of the property sector in cities such as Shanghai and Beijing looks dangerously bubble-like, it's still possible to identify profitable niches.

"You need to break the market down into segments," he explains. In Shanghai, for example, CapitaLand is aiming to develop apartments that cost between Rmb7,000 (US$854) and Rmb14,000 per square metre. Apartments above this band, says Boon, have experienced over-development thanks to speculation by foreign investors and the market looks precarious. Flats beneath this band serve the working classes - those most likely to suffer if the government moves to limit mortgage lending in order to cool the property sector. Only the band serving China's new middle class is capable of sustaining the impact of an overheating economy.

Operationally there's much that companies can do too. Given that events could well take a turn for the worse further down the road, finance chiefs in China would do well to re-examine the management of their receivables. Time put in today to review credit terms for customers - especially those in potentially risky sectors - could save much future heart-ache. CFO Asia's survey suggests that finance managers are taking such advice seriously: 58 percent say they have tightened their credit and collections policies in light of current overheating risks.

More immediately, the prospect of shortages could present major risks. Electricity is a good example. While much of the rest of the economy is experiencing over-investment, the power sector suffers from undercapacity. And yet, China's rapid development has seen demand for electricity sky-rocket, especially thanks to the growth of industries such as aluminum and steel, and to the proliferation of cheap air-conditioners. The problem came to a head this summer as whole swathes of China were plagued with blackouts. Power rationing was instituted in many provinces and some businesses had to close for several weeks. The government is working hard to build new power stations but experts reckon the problem will take several years to fix and the situation is likely to worsen before it improves.

Another concern is staff shortages. Iqbal Jumabhoy, CFO of East Asiatic Company, a Danish firm that produces food and industrial ingredients, says he finds it ever harder to hire good quality managers locally and now generally ships in all his senior staff from abroad. He's also experienced logistical troubles as China's transport network has become snarled up with growth. Other sources confirm his concerns - tales of expressways jammed solid with trucks are rife, and the country's rail system is notoriously outdated. Fully 90 percent of respondents to CFO Asia's survey of China report that logistics capabilities are failing to keep pace with economic growth.

Overall, though, Jumabhoy is confident that China will remain a good growth story. "The risks of overheating are serious," he says, "but I think the government has the ability to manage them." Pan Asia Paper's Oh - and hundreds of CFOs like him - are counting on it

China's currency: Renminbi and ruin? - Sep 30, 2003
By Hussain Khan

TOKYO - Protectionist pressures similar to those visited on Japan in the 1970s and 1980s are growing in the United States to force China to float or revalue its currency. But those advocating a revalued yuan should be careful what they wish for, because they might get it.

Certainly, the world's currency and equities markets have been roiled dramatically since September 22, when the administration of US President George W Bush dragooned the Group of Seven finance ministers into issuing a statement that exchange rates needed to be flexible to reflect economic fundamentals. That statement caused currencies all over Asia to suddenly begin to gyrate.

Is China the culprit it is made out to be? Certainly, powered by cheap labor and an undervalued currency, the People's Republic has been transformed from relative isolation to major global exporter in fewer than 20 years. Because of its flourishing export trade, sniping from competitors has grown, with Western manufacturers accusing the country of remaining relatively closed and cheating on its World Trade Organization (WTO) obligations after becoming a member almost two years ago.

In fact, China, driven under the lash of the former prime minister, Zhu Rongji, has borne a good deal of pain and opened its markets faster than anybody thought possible. Nick Lardy, senior fellow at the Institute for International Economics, told his audience at a recent Merrill Lynch seminar in London that China is "very deeply integrated into the global economy" and "more importantly, deeply enmeshed in the global supply chain".

Import tariffs came down by two-thirds before the country joined the WTO, Lardy said. By 2005, tariffs on manufactured goods will be 9 percent, far below Argentina's, for example, which are in the 20-30 percent range. Import quotas and licenses have all but gone and will be zero by 2005. Moreover, the number of Chinese companies authorized to conduct foreign trade has risen rapidly in the past two years. On Lardy's criteria, China is three to five times as open as Japan. And, while China is running a monumental trade surplus with the United States, its current-account balance is fairly close to even because of its exports from other nations.

The problem with the US manufacturing sector is that it has lost jobs for 37 months in a row - nearly the entire tenure of the Bush presidency - totaling about 2.7 million since July 2000, dragging down the labor market and creating a critical issue in the 2004 presidential race.

Alarm bells have begun to peal in Washington, DC, where both Democrats and Republicans are ever willing to exploit any issue that will give them traction with the voters. Three bills are currently under discussion that are aimed at what is described as China's "currency manipulation", despite the fact that the yuan, known internally as the renminbi, has been firmly pegged at 8.28 to the US dollar for several years. In fact, the United States was eternally grateful during the Asian financial crisis of 1997-98 for China's steadfast refusal to devalue the yuan and kick off a round of competitive devaluations in Southeast Asia.

But China is a big, visible and happily overseas target for US politicians on both sides of the political aisle. More than a decade after US politicians were taking Japan to task almost daily for its then-huge trade deficit, China has shifted into the gunsights. As politicians once bashed Japanese cars on the steps of the Capitol in Washington, it is in the realm of possibility that something Chinese is about to be bashed today.

Since Saudi Arabia set out to punish Western countries for their support to Israel by suddenly raising oil prices by more than 400 percent in the 1970s, the economic growth rate of industrialized countries has dropped significantly, to about 2 percent level on the average. China is the only major country that has posted gross domestic product (GDP) growth of about 8 percent over the past two decades.

The industrialized countries have therefore found trade and investment in China enormously attractive. Industry ministers, prime ministers and presidents have led delegations to China, made agreements and competed with each other to acquire an ever larger share of China's investment market. Various US governments held their noses over China's human-rights record, all the while continuing to accord the country most-favored-nation status, made permanent by the administration of Bush's predecessor, president Bill Clinton. Instead of imposing sanctions, China's human-rights violations have been forgiven in the drive to gain better access to Chinese markets.

As a result of these investment recommendations, China has emerged as a manufacturing giant. The availability of cheap labor has hollowed out some labor-intensive sectors in the industrialized countries and given a competitive edge to all those goods manufactured in China. Labor costs are so cheap that no country in the world can compete with it in export markets. This has caused the rapid growth of capital inflows in China as well as of exports and of foreign-exchange reserves.

Now the time has arrived to suffer the consequences despite the fact that those consequences are going to come back to haunt Western manufacturers. Some 65 percent of Chinese exports are manufactured by Western and Japanese factories, often with components imported into China and then re-exported. Cheap Chinese manufactured products have invaded industrialized countries, resulting in the closure of domestic manufacturing factories.

The constantly widening US trade deficit reached the second-highest level of imported goods on record in July. The trade deficit rose by US$40.3 billion as imports of consumer goods from China and oil hit record highs.

"Big-spending consumers, with refund and refinancing checks in hand, helped push the US trade deficit wider in July as higher imports, largely of consumer goods, outweighed export gains," said Leslie Preston, an economist at CIBC World Markets in Toronto.

Imports of goods and services to the United States rose to $126.5 billion in July while exports also rose, to $86.1 billion, the strongest showing since May 2001. These deficits made the dollar weaker despite the US administration's desire to keep it strong. Sherry Cooper, chief economist at BMO Nesbitt Burns in Toronto, pointed to the 18 percent decline in the US dollar against major currencies such as the euro.

These deficits have resulted in large dollar surpluses in the hands of China, Japan and other Asian countries (see ).

China's foreign-exchange reserves alone now exceed $357 billion. The only way these Asian countries have been able to use this surplus is to invest it in US government securities.

"Asia's largest economies are aggressively sinking the spoils of their trade surpluses with the United States into the purchase of US government securities, financing much of the widening US federal budget deficit," Peter Goodman of the Washington Post reported from Shanghai.

If the yuan were to be significantly revalued upward against the US dollar, US Treasuries would suddenly become considerably less attractive to Asian central banks, which could go looking for other places to invest. Then the US economic dilemma would rapidly become a whole lot more complicated. The US Federal Reserve would have to raise interest rates to continue to attract foreign investors, who pour $1.5 billion a day into US securities.

So would cutting China's exports by floating or revaluating the yuan create broad-based prosperity or employment growth in the US? Since World War II, the United States has constantly lost industries to overseas competition. US jawboning resulted in the Plaza Accord of 1985 in an attempt to cut Japan's trade surplus. After the Plaza Accord, Japan floated its currency. The yen appreciated, to little effect. US industries, primarily car makers, discovered that now they were competing on quality, not price, and they continued to lose market share.

But it did have one major effect. The Japanese, in a matter of months, transferred much of their industrial plant to the rest of Asia and ultimately provided China with the opportunity to replace Japan as the No 1 exporter. As the Japanese industrial diaspora continued, other Asian countries also made inroads into the US market.

US manufacturing costs and quality problems continued to cost manufacturing jobs. But instead of facing up to their weaknesses, the manufacturers are now replacing Japan bashing with China bashing. A yuan revaluation by as much as 40 percent is being suggested as the competitive tipping point.

But even if that wish materializes, it may be a temporary phenomenon. It is more likely that the same story will be repeated. Japan grew vastly richer on endaka, or high yen, as it was known, exporting the same goods on a higher level of revalued yen until the situation became untenable and Japan endured a crash that it is only now tentatively digging out of.

If under US pressure China floats the yuan, it will have more dollars in its hands and US manufacturers will be unable to reverse the 20-year-old trend of losing to foreign competition. And, because the cost of manufacturing will rise on the upwardly floating currency, the 65 percent of exports produced by Western-owned factories in China will become more expensive and less competitive. Western and particularly US industry would inevitably suffer.

"What an upward revaluation of the yuan could do, however, is firstly make goods more expensive for the heavily indebted American consumer and, more importantly, pull the rug from under China's economic development and integration into the international community," said William Belchere, chief economist at JPMorgan Asia Pacific.

"It could do this at a time of global economic fragility and with serious weapons of mass destruction crisis on its own doorstep, in the form of North Korea's announced nuclear-weapons program."

Beijing's currency conundrum - Sep 9, 2003
By Francesco Sisci

BEIJING - Despite world headlines indicating heavy pressure, US Treasury Secretary John T Snow in his visit to Beijing last week actually pressed the yuan-revaluation issue quite softly. He returned to the United States with a promise of a future liberalization of exchange rates and with a cut of tax rebates on exports, which whittles down Chinese commodity competitiveness by some 5 percent.

Chinese companies will be allowed to hold more cash, and thus surrender less of it to the central bank, and Chinese tourists will be able to take, and spend, more money abroad, removing some steam from the present revaluation pressures. Most important, the Chinese will buy more US Treasury bonds.

This is a high prize. Next to Japan, China is the United States' largest purchaser of bonds, but in the past couple of years China had been dreaming of a strong euro and strong ties with Europe and thus had been buying more euros. However, this could be a good time to sell into the euro's strength, which is diminishing, at least temporarily. The Chinese purchase of US bonds can guarantee that interest rates are low and China's continuing economic expansion will be financed. The cheap yuan also guarantees that Chinese imports won't become expensive and thus trigger perhaps a new round of inflation in the United States.

On the other hand, many US economists are clear that the US jobs lost to China won't be recovered with yuan revaluation: they are lost forever. If they go anywhere, these jobs will go to India, or Mexico, or Myanmar, if and when the yuan makes these exports uncompetitive. In the present situation, despite the official populist rhetoric, the United States has no real interest in a short-term revaluation of the yuan per se that could create more problems than it solves. There is long-term interest in the free exchange of the yuan, but this is a different and more complicated kettle of fish. In any case, once the exchange is free, it is not certain that the yuan will be revalued upward.

It is true that in the past decade China had higher growth, lower inflation, larger trade surpluses and more labor productivity increases than the United States. Prima facie these are all arguments leading to upward yuan revaluation, but would that really occur? Possibly not. The opposite is actually more likely.

Once the yuan were freely convertible, foreign companies could invest in the Chinese stock market, which would be dangerous. Many of the worst companies are listed and most of the best are not. In a nutshell this is the problem with the Chinese stock exchanges, making them a honey pot for world speculators. They could plunge in, arguing that China's fundamentals are good, create a bubble, reap fat profits, and then run away saying the Chinese companies did not perform.

And it would all be true: the strength of China's economy is not paralleled by the performance of listed companies. However, coming in and running out could be the equivalent of beating China's fragile economic institutions with a sledgehammer. That could kindle an economic, then a social and political crisis. It could be the end of the Chinese dream and the beginning of the Chinese nightmare. Do we really want to see this movie?

Even short of that, the response of Chinese retail investors to a free currency exchange could be hard to predict. Whoever has money in China is always subject to possible retaliation by the state, which can claim they are tax evaders who made their money through corruption, seize property, fine them or even lock them up. In recent decades the only guarantee against such a future has been taking money abroad and bringing it back as foreign investment.

As little as 20 and as much as 70 percent of the foreign direct investment in China is probably laundered Chinese cash. To stop this phenomenon, China should provide more guarantees to Chinese entrepreneurs and absolve all past mistakes. But this can't be done for domestic reasons: many in the Communist Party would rebel against it, saying that it would acquit all the past corruption.

Besides, ideologically it would be hard to explain why for the same acts some were put in prison or even executed, others will be anointed as the new wealthy Chinese aristocracy. Moreover, many big speculators still want to gain some more, and hope the system will carry on being as murky as ever, to make even larger profits.

An amnesty for past economic crimes would clear the slate, gear the state better against new economic crimes and prevent future economic ones. But some big potatoes still want to make money out of state control. And, while only the ones with big connections can manage to take their money abroad, if the exchange rate were freed, every salary man could end up with a bank account in the Bahamas. This capital flight would drop the yuan exchange rate, not increase it.

Therefore there are plenty of reasons to view yuan revaluation with great caution away from the fads inflaming the popular press and the demagogues in the West. The US government is doing it, but the international press is moving in the opposite direction, which betrays a different and possibly a larger problem: China's difficulty in communicating with the rest of the world. Here the government counts only as long as it has popular support. For many reasons China is now better at improving government-to-government relations, as the recent Korea talks proved, but is much less apt at talking to the common people of the world who day after day are growing more concerned and attentive about China's moves.

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