Selecting China’s Losers From Its Winners

By John Richardson

WE know that:

• China’s Total Social Financing (TSF) was down by 18% in January-April 2015 on a year-on-year basis. TSF is the measure of total credit growth in the economy, from both the state-owned banks and the privately-run shadow-banking system.
• Lending from the state-controlled banks was up by just 14% as shadow banking collapsed by an astonishing 55%.
• There are no indications whatsoever, from key chemicals markets such as polyethylene (PE), that financing conditions are getting any easier in China despite several cuts in interest rates and bank reserve-requirement ratios (the reserve-requirement ratio is the percentages of  money that the state-owned banks have to set aside against their lending. In theory, the lower the percentage, the greater the willingness to lend). For example, despite the cuts in interest rates, deflation is making the real cost of borrowing very expensive. For example, producer prices fell by 4.6% in March, which left real interest rates at 10.8%, according to the Financial Times.
• And financing conditions are going to get a lot worse before they get better.  “The plastic converters, which usually are small and medium-sized enterprises (SMEs), are expecting a very difficult second-half of the year,” a source with a global PE producer said this week.  “The reason is that SMEs source most of their financing from the shadow-lending sector”.
• This is deliberate. Xi Jinping, China’s president, and its prime minister, Li Keqiang, want to try and get, hopefully, the majority of the economic pain out of the way before their “mid-term review” in 2017. This is when they will be assessed on their first five years in office.

But what we don’t know is exactly how much worse things will get before they get better. Are we talking about one or two years of lower GDP growth or even longer?

If you pick up the phone and talk to people in China, they will tell you that turning China’s economy around will take a  long time, as long as 10 years, which would mean that Xi and Li would not have much to show for their efforts in 2017. They might, as a result, have to negotiate for more time. And a few pessimists will even tell you that the reforms won’t work at all. I don’t agree with them.

More immediately, though, back to the here and now. What you must do, if you haven’t already done this, is to start developing a highly differentiated approach to your chemicals interests in China, whether you are an exporter to China or a local producer.

Here four headlines for you to contemplate here to help sort out the winners from the losers:

1. Some provinces will do better than other provinces. No less than 11 out of China’s 31 provinces saw negative GDP growth in Q1. These are the provinces that are, sadly, poor in the first place – and are heavily reliant on now out-of-favour industries, such as real estate, steel, aluminium, and some chemicals, for their growth. They will inevitably continue to struggle.
2. But there will be winning provinces such as Guangzhou. Whilst Guangzhou has big oversupply in some manufacturing sector, it has the compensating benefit of a strong services sector. It also growing higher value industries, which will receive the lion’s share of financing.
3. The same applies at individual company levels. Low-value plastic processors, and other chemicals end-users, will continue to go bust, as I have long been warning. The number of bankruptcies will be a lot higher than some people anticipate. Many of these low-value manufacturers have inflated their profits through misusing letters of credit (LC), according to Simon Hunt, the UK-based copper industry and China economy expert.  He believes that the misuse of LCs, which was widespread in the PE sector, once accounted for as much as 25% of China’s GDP. No longer: As China continues to play its whack-a-mole game, the crackdown on LC fraud will intensify.
4. But the bigger, more consolidated and more sophisticated chemicals end-users will be fine because they have long been adding the kind of value to China’s economy that the government now really, really wants.

The above four headlines tell you that you will need to drill down, you will need to carry out a forensic examination of your customer base in China.

For example, how much PE do you sell to now “laggard” provinces such as Heilongjiang, Henan and Hebei as opposed to Zhejiang, Guangzhou and Anhui. If the answer is “too much”, you must reduce your exposure. Equally, if too many of your customers manufacture, say, cheap plastic buckets, and are based in eastern China, where labour costs have gone through the roof, you are in trouble.