China’s impact on global resources, incomes and geo-political trends is now the subject of intense ongoing debates. As always, PIMCO remains cognizant of the investment implications of these critical matters and will continue to offer insights on how we see trends and outcomes developing -- and how our ideas can be expressed in client equity portfolios. In this article, the first of our series, we set a framework for how countries move up the value chain and discuss China’s ongoing transition.
Over the last 30 years, China’s industry has produced a compounded growth rate of 15.6% in value-added manufacturing, from almost RMB200 billion in 1980 to over RMB13,462 billion in 2009. This rapid growth is similar to what has been seen in other parts of Asia but stands in stark contrast to developed markets like Europe and Japan, which have lost market share over the same period (see Figure 1).
During this advancement, Chinese companies have focused primarily on low value-added products. However, we believe this focus on low-cost manufacturing is going to be difficult to maintain due to changes in China’s demographics over the next several years and what many view as the inevitable appreciation of the renminbi.
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This suggests China’s low-cost manufacturing base could face tougher competition and China may have to climb the value chain even further. In fact, the government‘s new 12-year plan calls for a 13% minimum wage increase every year over the next five years, according China’s Ministry of Human Resources. This would likely place severe price pressures on the low-end manufacturing industry, potentially forcing companies to cut labour costs and increase capital per unit of labour.
According to the United Nations, the number of 15- and 19-year-olds in China peaked in 2005 while the 30- to 39-year-old age group has been declining since 2000. This shrinking of the labour pool could lead to a sharp rise in the cost of labour as a percentage of GDP.
If productivity does not improve, we believe growth will likely flounder. As labour demographics change, China could suffer a double whammy of a falling savings rate and a diminishing labour force. In essence, this country of savers could face a smaller savings pool and lower incremental capital to spend -- and this means it would have to spend more efficiently. However, with one of the highest savings rates in the world, we believe China is at a strong starting point.
Factors Potentially Pushing China up the Value Chain
To move up the value chain, we believe countries need four attributes: 1) rapid capital accumulation, typically achieved via a high savings rate that translates into capital deepening, more investment and greater productivity per worker, 2) improved education, 3) technology and 4) time (in that it takes time to integrate capital, labour and technology).
Value added manufacturing refers to activities which make a product or service more attractive to buyers through better utilization of inputs into production. This is expected to result in improved profitability, sophistication and brand creation.
Capital accumulation: With over 45% of its GDP in savings, China has one of the highest savings rates in the world, according to the U.S. Congressional Budget Office. This capital accumulation has likely contributed to a high growth rate and enabled China to move up the value chain. Foreign Direct Investment (FDI) also tends to be a good source of capital. Fixed asset growth in manufacturing more than tripled in China between 2004 and 2009, driven largely by new entrants to the World Trade Organization. FDI has the added advantage of providing advanced skills and management know-how to the Chinese market.
Improved education: Historically, the Chinese culture has tended to emphasize education. But increased wealth has likely contributed to increasing numbers of college students in China over the last ten years. Going forward, not only do we expect China to be in an improved capital position, but we also expect a larger educated labour force with the ability to monetize this capital.
Technology transfer: The size of its domestic market allows China to spend more on research and development (R&D) and so potentially build technology and scale more quickly than many foreign competitors. The Chinese government has been instrumental in promoting the transfer of technology (really, the import of technology) by supporting joint ventures (JVs) with foreign players and providing subsidies. We also expect to see more Chinese companies going abroad to buy foreign technology in the future.
Time: In our view, the more closely aligned these three factors are, the quicker change can occur. Again, this plays into China’s strengths. The sheer size of the domestic market, the available talent pool and high capital accumulation could allow China to move up the value chain faster than its contemporaries.
How Industries Typically Move up the Value Chain
Industries in China usually start in a fragmented market, at the low-price, low-quality end of the product chain, serving mainly the domestic customer base (see progression in Figure 2). Targeted government plans via subsidies, cheap land and utilities, combined with low labour costs, help domestic players gain local and low-end global market share. During this period, technological intensity tends to be low and margins may benefit only due to low and subsidized costs.
As these products are sold, engineers can use customer feedback to improve the products, saving R&D and shortening the product cycle. Chinese players have historically become dominant in markets where there is limited demand in the developed world and/or local Chinese characteristics are different. For example, in the wheel loader industry where technology intensity is tends to be low, local players such as Lonking and others quickly became dominant, gaining the majority of the market.
In higher value industries, technology transfer is often necessary to gain an entrance into the market. For example, the Chinese railway market has effectively become a duopoly between China state rail and China national rail and their foreign partners, with the foreign companies maintaining a technology and market share advantage only at speeds above 300km/hr. The Chinese government was instrumental in requiring JVs to access this attractive, large global market.
Local companies must typically increase their own R&D spending to help erode the high price discounts they have versus foreign players. This can often be accomplished efficiently with low-cost local engineers. Initially, these Chinese manufacturers start out
as gloried assemblers of imported parts. But as the cycle progresses, localisation tends
to occur, support industries grow, and the company can start to use locally produced or in-house parts. This is when domestic companies can start gaining an edge over their foreign rivals because higher margins tend to be found within the components of the product.
As the local market expands, domestic M&A and growth can lead to the emergence of significant economies of scale in local leaders. This allows not only more efficient manufacturing but also a significant expansion of the distribution network and the company’s brand image. However, this sudden market expansion often creates overcapacity and domestic price wars. The wind turbine market is a good current example of this price war stage of progression up the value chain. Although it has significantly eroded domestic profitability, it also forced out most foreign players (the very high-end producers survived), as most competitors cannot compete at these low price points. Consolidation may come, but likely after foreign players permanently lose market share and their domestic rivals become larger and stronger.
Success in the local market pushes companies to look for export opportunities. This usually starts with a look at emerging markets, where cost is a more important factor than it is in developed markets. In many cases, however, local companies are using acquired foreign technology to directly compete against their foreign rivals in emerging markets. This is the case in coal-fired turbines, where the Chinese state-owned enterprises have successfully entered many of the fast-growing emerging markets, limiting the market share of foreign players. Here, companies tend to compete on quality and price, while also providing “softer” offerings such as service and distribution networks.
Finally, domestic leaders can attack developed markets via foreign M&A or significant R&D spending. In the market for wind turbine gearboxes, for example, according to company data, China High Speed Transmission (CHST) has captured roughly 70% of the domestic market and is now looking to take share away from the European leader, Hansen. Initially, this is being achieved by becoming qualified by foreign buyers. However, with similar quality and lower pricing, the domestic player can use current periods of market weakness to significantly increase global market share at the foreign players’ expense.
Investment implications
Based on our top-down view of the market, we are convinced that certain Chinese manufacturers can not only overcome the impediments of labour shortages, an aging population and currency appreciation, but could indeed benefit from the changes and emerge as world leaders within their sectors over the next five to ten years.
In particular, we have identified wheel loaders and excavators as two sectors where we expect specific Chinese companies to successfully migrate up the value chain. In the medical equipment and automation equipment markets, where global multi-national corporations (MNCs) still enjoy high domestic market share, we expect certain Chinese competitors to continue to squeeze margins and chip away at market share. In the telecom equipment business, Chinese leaders such as Huawei have started to export more products and appear to be gaining global market share, initially via price competition (according to company data, Huawei currently has a 35% domestic market share, while Chinese vendors have nearly 32% global market share). And in the wind turbine industry, new Chinese players have interrupted a global supply/demand balance and altered the competitive landscape.
We believe China’s absolute advantage in many industries may be fading and investors should attempt to carefully isolate and identify companies that appear to have competitive advantages, demonstrate the potential to steal market share away from foreign competitors, and have the wherewithal to start exporting value-added goods globally.
Finally, when translating this assessment into an investment strategy, we remain mindful of cyclicality and valuation. Stocks trade within cycles, so there will be certain periods when it may be beneficial to own certain stocks and other times when it may prove prudent to watch from the sidelines. Because China’s macroeconomic changes may have a much more pronounced, long-term effect on some sectors and companies than others, our goal is to identify the most attractive companies and then wait for the appropriate valuation point to acquire their stock at attractive prices.