The  Incredible Shrinking Services Sector

In August 2011 the HSBC services purchasing managers index (PMI) fell to a two year low of 50.6. Ratings above 50 indicate expansion in the sector, while ratings below 50 point to a contraction. Analysts pointed to government efforts to slow the frenzied pace of property development in the country. Anecdotally, real estate agents across China were finding the environment far more competitive than in the past, with fewer properties on the market to sell. However, the explanation does not settle why the index jumped so dramatically from August to September, where it clawed more than two points for a rating of 53. The issue matters to foreign invested enterprises (FIEs) in China, whether they are directly invested in the services sector or not.

Vice Premier Li Keqiang admitted at a Central Committee Meeting in September 2011 that China’s services sector was not creating jobs quickly enough. Between 2005 and 2010, China’s service industry grew at an annual rate of 11.9 percent. However, the industry’s rate of job creation, as well as its value-added growth, failed to meet the government’s targets for the period, he said. The value-added figure of service industry accounts for 43 percent of China’s gross domestic product (GDP), in comparison with about 70 percent in developed nations.

TrendsAsia China Impact™ Watch modeling indicates the country would require a huge, concerted push to develop the services sector on the order of its investment in its transportation infrastructure projects for services to take over the country’s GDP growth from overweening infrastructure development – a truly herculean feat in an economy that has become addicted to the easy money made from building high rises, bridges, roads and railways. The implication of the degree to which a country that does not have a services orientation in its modern history implies tremendous potential for foreign firms to transfer knowledge, experience and even technology to what could prove to be the largest market for services in the world.

However, the leadership’s proclivities toward a command-and-control economy as well as its reluctance to overhaul its education system in favor of the sort of creative, out-of-the-box thinking and problem-solving that services require will present barriers to entry and profitability to foreign companies. The services sector in China may also see job growth stunted for the same reasons.

Job Bank

The services sector is meant to be the reservoir of jobs from which China’s leadership should be able to meet job creation and job replacement figures to stay as near full employment as is feasible in such a large economy with a plethora of industrial controls. Officials at central and local government promote a vision of banks of computers manned by bright young things in China replacing machine operators. The vision is one of the reasons the central government at the turn of the century dramatically expanded the number of students sitting in universities. Fresh graduates were meant to be on the vanguard of a brave new world of technology and service-oriented industries like those that have benefitted in India: services outsourcing, pharmaceuticals development, information technology development, installation, service and support.

The service sector in China has indeed grown – and liberalized – over the past ten years. A decade before services – as was the case in so much of the economy – was the sole purview of State-owned Enterprises (SOEs). The central government’s break-up of the SOEs from the late-1990s to the early 2000s was like breaking open a crypt that had been sealed for a thousand years, allowing oxygen in to would-be entrepreneurial ventures that, if they did not start up small manufacturing operations, would open services businesses to cater to the newly wealthy.

The government-blessed infusion of more than US$2.5 trillion into the economy to ward off impending catastrophe caused by the global economic downturn went predominantly to propping up export-led manufacturers and to infrastructure development. Policies to promote the businesses in services outsourcing hubs like Suzhou, Nanjing and Wuhan were left untouched. Meanwhile, the proportion of university graduates who have been unable to find full-time employment has hovered around 30-percent for the last four years running.

Implications for FIEs

Foreign players in the financial services, internet and, services outsourcing and especially media industries will have a long wait while China’s leadership considers whether and to what extent to open the industries to foreign investment. For instance, despite its obligations as a member of the World Trade Organization (WTO) to open its financial sector to foreign entrants by 2006, the country has prevaricated against the entry of currency payment systems such as Mastercard and Visa in favor of its national champion UnionPay. And, of course, stories of the extent to which Google has been blocked in China and how Yahoo! Was deceived in its business dealings with joint-venture partner Alibaba – with the blessings of the Chinese government – are legion.

The ministries charged with overseeing the development of China’s industry are charged with expanding the Chinese footprint domestically and internationally. The degree to which these cosseted industries will be able through Chinese stewardship to attain international standards of quality and reliability remains to be seen. The availability and capability of human resources within the country will be problematic for the foreseeable future, forcing up acquisition, training and retention costs for talent throughout the sector.

China’s reliance on developing a services industry that bootstraps the country’s economic development by opening up nail salons, hair dressers and KTV parlors will sorely miss the mark of the level AND quality of jobs the country really needs to maintain the rapid pace of growth over the next decade. Foreign investors may be able to find a good haircut and massage in China; however, finding an English-speaking customer service representative able to field a customer’s problem in Sheffield, England will be another matter.

The prospect of an NPL portfolio to rival that of the early 2000s does pose the threat of tipping China’s economy into contraction. Tipping points such as a co-incidental price inflation spike in the cost of energy and commodities (as had been seen in 2008 at the threshold of the global economic downturn) and of a BP-sized oil spill or some such large-scale environmental disaster are single-point incidents.

In TrendsAsia’s China Impact™  Watch model, a single-point incident single-handedly morphs the business environment into a contractive state (and, likely, the society into high levels of uncertainty). The SARS incident in 2003 is the perfect example of just such a single-point incident.

The probability of an NPL crisis, however, leans on the coordination of several critical trends to prick China’s economic boom:China’s infrastructure woes compound, forcing huge re-works in the projects that banks are unable or – due to central government sentiment – unwilling to make loans to local governments for. Massively faulty infrastructure affects urbanization plans that create greater stress than ever before between those in the countryside looking to the cities for the good life and current urbanites.

Linked social disruptions force the central government to clamp down on protests with an iron fist, sending business sentiment to lows not seen since SARS.

According to TrendsAsia’s China Impact™ Watch model, though Scenarios 1 and 2 are the more dramatic, they seem more likely to occur than the convergence of critical trends that lead to the development of Scenario 3, especially in light of the central government’s efforts during 2011 to bolster bank reserves and reign in local government access to loans.

Estimated NPL Amounts

Scenario 3 develops as the ratio of non-performing loans (NPLs) of local governments to performing loans is so high as to effect a slowdown on infrastructure and urbanization projects, in combination with a government crackdown on the internet to filter and spin information about the debacle. Estimates vary on the amount of debt local governments assumed during the bank loan binge from early 2009 through 2010.

Dragonomics estimates local government debt could be as high as nearly 50-percent of China’s GDP (WSJ), or an estimated US$2.2 trillion (NYT). Upwards of 70-percent of China’s GDP is derived from infrastructure projects, the highest proportion of any country in modern history. Though China would be able to accommodate high levels of NPLs, the diversion of funds would starve essential infrastructure project development and maintenance, as well as divert government investments away from social services for the elderly, poor and ill who’s medical treatments are to be subsidized to some extent under a nationwide health service.

Increased Tension Between the Have’s and Have Not’s

The marked slowdown in the economy through the exhaustion of infrastructure projects would also throw out of work a great many people who have depended on the projects since the Great Recession of 2008.

A variation on the NPL theme is that Chinese banks have sufficient reserves to cover the bad loans; however, the banks do not have adequate funds to mend the massive infrastructure failings that increasingly plague the country. The run-down of infrastructure projects creates ranks of unemployed workers who are not able to immediately find new employment.

The lack of funds to repair infrastructure problems also fails to provide full employment to those that have developed construction industry skills during the boom years of infrastructure development in the country. Lack of employment on a huge scale generates social discontent as price inflation in food and property exert unmanageable pressure on Chinese who have not crossed the middle class income threshold.

The last time millions of people were thrown out of work was the winter of 2007-2008, when factory sites up and down the east coast closed because of a dramatic slowdown in the export sector. Local governments during the deep winter were managing worker protests everyday. Many of the former employees were upset that bosses had padlocked ates and run off with the workers’ final salaries.

National policy would have to quickly shifted resources toward meeting massed-worker demands. In China, that meant the same sort of carrot-and-stick approach authorities used in protests in Shanghai in the Spring of 2011 when truckers blockaded Shanghai port because of rising fuel and toll prices. Authorities promised a fuel subsidy – which dispersed the crowd – then rounded up the organizers of the protest.

How Much with the Economy Contract?

The China Impact™ Watch model, however, does not see as radical a slowdown in the economy as with the first two scenarios discussed in the Summary, possibly because environmental- and resource-sustainability are already at critical tipping points, requiring a mere “nudge” to set of a cascade effect throughout a society that would squarely pin the blame for an environmental disaster or rampant inflation on the leadership, for instance.

Economic slowdown due to a diminishing number of infrastructure projects would affect the interior of the country more than the coastal region: most of the largesse for infrastructure projects went to the interior from 2009 through 2010. Most of the workers who would be out of work without sufficient time to retool for new occupations would be in the interior, since infrastructure works along the coast are more mature, with fewer construction sites (and therefore, workers) than in the interior.

Conclusion

Magnitude 2-to-3 shocks simultaenously applied to each of the critical trends in Scenario 3 – urbanization, infrastructure development and national interests – would be sufficient to bring the business environment into a contractive state, presenting slightly more threats to foreign businesses doing business in China than opportunities. Given, though, that the central government has been working for the better part of a year to ensure bank lenders have sufficient financial cushions with which to handle large NPL losses as well as inevitable maintenance and upkeep costs, the investment environment should remain relatively congenial to foreign-invested enterprises. Should the country, however, suffer a perfect storm of any combination of the scenarios in this discussion, the leadership will have to contend with challenges beyond the scope of its current set of tools.

The tragic subway accident on one of Shanghai’s lines injured nearly 300 people. Fortunately, none were killed, as had been the case when two bullet trains collided on the high-speed rail line connecting Hangzhou and Wenzhou in Zhejiang province. The Wenzhou train accident, however, had far greater repercussions for China society and the overall business environment than did the Shanghai incident.

The Shanghai subway incident made it plain to China’s freshly minted middle class that issues with China’s economic development approach are not confined to the countryside, but are now an integral part of a system upon which their livelihoods and lives depend.

Companies doing business in China must consider the implications of infrastructure put in place that does not meet international standards for quality and safety. Logistics companies, in particular, which rely heavily on transport infrastructure to move client goods throughout the country, need to review contingency plans in the event of future mishaps and reconsider insurance plans for staff and goods.

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At the end of 2010 Shell Oil produced two future scenarios of how the world might revert wholesale to renewable energy sources – Scramble and Blueprint – both of which take account of China’s new-found role as energy heavyweight. TrendsAsia extended the Scramble scenario into a third, grittier scenario called Skirmish

The first, called Scramble, sees countries in a grab-fest for energy resources they stake out with gusto, cordoning off supplies for their own society’s consumption and perhaps – if there’s enough to go round – for their allies, as well. A lack of inter-governmental coordination and unfettered use and abuse of fossil fuels leads to a global slowdown around the year 2020, which catalyzes governments to place public and private strictures on the use of energy until, ten years on, the world has become green.

Blueprints, Shell’s alternative reality, sees governments coordinating responses to energy shortages and climate change by shared mechanisms for carbon and CO2 emissions taxes. The developed world in particular licenses energy saving and energy efficient technology to China in return for the country’s participation in global frameworks to make the transition to cleantech. China’s energy consumption peaks by 2055, at which time the world is using 30% less energy per capita than it was in 2010.

Though the Scramble scenario seems the more draconian – and therefore, most realistic – it can still be extended further into yet another scenario. A third scenario might be called Skirmish, in which China in its own scramble to secure energy sources presses Vietnam, Cambodia, Laos and Thailand to blockade the export of natural resources to China in retaliation for China siphoning the once heavy flows of the Meikong River southward and for its navy blockading the oil and natural gas fields discovered in the South China sea – territory claimed by Vietnam, Thailand, Brunei and the Philippines.

Pushing the envelope on the fantasy, China has also moved into Arunachal Pradesh with several divisions of the People’s Liberation Army. The region’s provenance has been in dispute between China and India for several decades, ever since the Indian army was thrashed during a brief skirmish there in 1962. China needs the region to secure the glaciers that feed the rivers that power its great hydroelectric dams.

Meanwhile, Japan’s Self Defense Force is on high alert after a Chinese submarine sinks a Japanese frigate patrolling the Kurile islands off Japan’s coast. The islands sketch another mineral-rich deposit claimed by Japan and China. A fit of democracy and China-bashing in Kazakhstan forces China’s hand as the Middle Kingdom consolidates its hold on the oil fields into which it has sunk hundreds of billions of dollars over several decades cultivating the dethroned autocracy.

Skirmish is the scariest of the scenarios as little is known of the domino effect in which one country’s actions inadvertently set off a cascade of unintended consequences for other countries.

Though all three scenarios are fanciful, they bring to mind two important points: 1) the world is increasingly interconnected through energy usage; and 2) energy politics will increasingly become the centerpiece of domestic policy and of geopolitics for developing and developed countries. All the scenarios agree that fossil fuels that are still economically accessible are finite in amount: oil, coal, even natural gas.

The zero-sum world view of fossil energy sources has already motivated countries – especially China – to set off around the world to stake their energy claims. International trade, as well, is warping at an accelerating rate toward greater movement of oil, natural gas and, in the last two years, coal. Though China’s goals to reduce energy intensity as a proportion of GDP growth is a step in the right direction, all of the same construction technologies the West used fifty years ago to (re)build its post-war societies are and will continue to be in use for at least the next twenty years.

The technologies themselves and the kinds of energy-intensive infrastructure projects to which they are being put to use are increasing China’s appetite for energy exponentially. Increased energy usage as urbanization becomes more deeply seated in the country is adding to the high-speed momentum.

In no way can China’s leadership show it is truncating promises to its citizens for access to the middle class by reducing access to energy sources – whether gas to power automobiles or coal to power plants that produce electricity that run wealth-creating factories and office buildings: those waiting in line for the good life would not stand for the policy sleight-of-hand. And as many of China’s foreign policy actions of the past two years have illustrated, the country’s leadership plays almost exclusively to a domestic audience, for whom a scrappy China is the kind they like to see performing on the world stage.

China-border skirmishes over energy and water may be a more likely scenario than the West would prefer to consider.

Image credit: World Energy Technology Outlook 2050 study published by the EU Commission, 2007

©2011 TrendsAsia Ltd. All rights reserved.

Southeast Asian nations may benefit from China’s full-on development of its domestic market for solar photovoltaic (PV) power. Countries like Indonesia, the Philippines and Malaysia, which have the difficult task of administering territories separated by ocean, are not easily connected to massive electricity grids as one finds on large, contiguous land masses like China.

The geography of some Southeast Asian nations also makes connecting the many disparate communities difficult, as well. Vietnam, Thailand, Cambodia and Laos are all marked by mountainous terrain blanketed by forest. One inexhaustible resource all the Southeast Asian countries share, however, is sunshine. Xu Renhe, the general director of the Economic Development Board of Singapore, stated, ”Southeast Asia is close to the equator and these areas have abundant sunshine. It’s hard to connect the may islands with electrical lines. Solar off-grid power generation has an inherent advantage, then.”

What most solar power plans for Southeast Asia lack, though, is a cost-effective means of bringing electricity to millions of citizens across the varied lands. China’s recent decision to implement feed-in tariffs in its domestic market may bring down the cost of implementing solar power throughout the Association of Southeast Asian Nations (ASEAN).

On August 1, 2011 China’s National Development and Reform Commission (NDRC) introduced a unified standard for the on-grid price of solar power. According to the notice, solar power projects that were approved before July 1st, 2011 and that are constructed and put into operation by December 31, 2011 will have on-grid power pricing of RMB 1.15 per KW-Hour (including tax). For projects approved after July 1, 2011 that are unfinished by the end of December 31, 2011, the on-grid power price will be RMB 1 per KW-Hour, except in Tibet. (The on-grid price in Tibet is RMB 1.15 per KW-Hour.)

The effort is a shot-in-the-arm for a manufacturing industry in China that is suffering from overcapacity and primary markets that have narrowed the windows of opportunity into their countries. As recently as 2008 about two hundred PV manufacturers in China were able to take advantage of subsidies to power producers in Germany, Italy and Spain to support solar power generation on their electricity distribution grids. Three years on and those subsidies have all but been phased out and the number of Chinese PV producers has exploded to nearly a thousand.

The feed-in tariffs the NDRC has announced for the Chinese domestic market are meant to provide access to what could potentially be the largest market in the world for PV products while also meeting burgeoning electricity consumption demand in the country. In addition to energy production constraints, the central government has also set the country the task of reducing its CO2 emissions per unit of GDP by as much as 17 percent by 2015 during its 12^th Five-year Plan. The NDRC sees a muscular solar power program as an important means of meeting consumption, market and emissions goals. The Ministry of Finance has announced it will increase funding for Golden Sun Roof-project capacity by one-gigawatt annually from 2013 to 2015,” Meng added.

China’s more assertive thrust into solar power implementation will continue to push down the price of solar panel manufacture. Chinese manufacturing activity the last three years has already driven the cost of PV manufacture to below RMB 0.73 per kilowatt. Coal-generated electricity sets the benchmark for market competitiveness at RMB 0.50 per kilowatt. Competition between China’s PV makers will continue to deflate PV production costs and increase the efficiency of the technology to convert sunlight into electricity.

The Southeast Asian market, with nearly 600 million people, will certainly benefit from the cost-efficiencies gained from market competition within the Chinese marketplace. Already, Chinese solar technology companies have been positioning themselves for the development of Southeast Asia’s market for solar power. China Guangdong Nuclear Power Company (CGNPC) intends to invest more than US$50 million in a biomass solar power station in Singapore. Changzhou-based Trina Solar is teaming up with Solar Energy Research Institute of Singapore (SERIS) to develop high-efficiency silicon wafer solar cell using Trina Solar’s monocrystalline wafers. And Sichuan Han Long Group plans to invest US$100 million to set up its international headquarters and R&D center in Singapore.

As Southeast Asian countries find the cost of fossil fuel subsidies onerous, disparate communities become more anxious for electricity and urbanization requires greater levels of energy, solar power technologies imported from China will become an increasingly attractive complement to more nuanced energy portfolios.

©2011 TrendsAsia Ltd. All rights reserved.

The weakening of China’s services sector runs counter to the central government’s professed desire to re-balance its economy away from infrastructure development and export manufacturing and more toward domestic consumption. The HSBC  purchasing managers’ index (PMI) for the services sector dropped to 50.6 from 53.5 in July, according to a statement issued by HSBC Holdings Plc and Markit Economics. It is the second lowest score for the sector the bank has seen since records began in 2005. A reading greater than 50 implies sector expansion, while one below 50 implies sector contraction.  Analysts believe the slight contraction in the real estate construction industry caused the down-tick.

TrendsAsia believes the downward trend in the services PMI is broader based, and reflects the government’s reluctance to wean itself from tangible projects like bridges, railways and widgets. Without the development of services sector “infrastructure” the economy may find it difficult to pick up the slack of unemployed as infrastructure projects wind down from the beginning of 2012 and as export manufacturing continues to slow due to rising costs and weakened consumer spending in the West. Services sector infrastructure involves further development and opening-up of digital communications technologies, professional services training and other soft skills service workers around the world require.

Of greatest concern to the Chinese leadership, however, is job creation, especially as it works to cool the economy…

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The largest group of job seekers to be impacted by the contraction of the services sector are university graduates. At the end of 2009, nearly 50 percent of all college graduates that year had not yet found jobs. Nearly three million students each year since then have not been able to find full-time work within a year after graduation. The number may increase in future unless local governments – at the direction of the central government – develop practical training programs for graduates and incentives to business to grow the services sector in China.

The development of the services sector in China will also provide a cushion for the migrant workers who find themselves without work as the round of infrastructure projects kicked off at the beginning of 2009. Then, banks pumped funds into the domestic economy as part of the central government’s fiscal stimulus package to stave off the contagion of the global economic downturn. Many of the local government infrastructure projects – roads, bridges, buildings – will conclude construction toward the end of 2011 and the beginning of 2012.

The slowdown in export manufacturing as well as the contraction in the services sector will have a deflationary effect on salaries, despite consumer price inflation. The overhang of unemployed university graduates and migrant workers who have finished projects will provide a greater supply of labor than the services market is able to absorb for at least the next two years – unless government intervention increases the number of companies and positions available to the labor pools.

TrendsAsia continues to rate the overall business environment at “4″, “Richter Scale” above as light-green. The rating has dropped from “5” at the beginning of August as inflation has gained greater footing in the Chinese economy and an overall slowdown in the economic output of the country has become more evident. Despite the slight contraction in services sector opportunity, the overall rating essentially remains the same.

The TrendsAsia China Impact™ Watch critical trends analysis model does not see a hard landing for the Chinese economy as a high-probability proposition. The China Impact™ Watch framework reviews Political, Economic, Social, Technological, Legal, Environmental and Demographic (PESTELED) trends that impact companies doing business in China.

However, three scenarios could trigger a hard landing and severely impact the operations and marketplace of businesses in China:

- Scenario 1: Energy and Commodities Price Inflation Spike

- Scenario 2: Environmental Disaster Leading to Large-scale Protests

- Scenario 3: Local Government Non-Performing Loans (NPLs)

Environmental disaster is difficult to predict. The pressure China has been placing on its ecosystem for sixty years is unsustainable. A lack of transparency, concern for safety, lack of experienced professionals (inspectors, engineers, designers, et al) across a host of manufacturing and infrastructure development projects – coupled with powerful currents of collusion – make a disaster on the order of the British Petroleum Oil spill of April 2010 almost inevitable.

Scenario 2: Large Scale Protests over Environmental Poisoning

Pollution and its impact on a large community’s livability provide another potential tipping point for a seizure in the economy. The scale of the environmental disaster, however, would have to be immense – of the size of the BP spill – larger even than the oil spill in the Yellow Sea, in July 2010, when an explosion ripped two main crude pipelines and a nearby crude depot in Dalian, spilling 1,500 tons of crude into the sea to leave a slick covering 183 sq km (71 sq miles).

By contrast, the British Petroleum spill off the coast of Louisiana that began in April 2010 was 130,000 times larger than the Dalian spill, destroying 150 miles of shoreline and attendant ecology and commercial interests.

The consideration, however, has not been lost on China’s leadership, which has been expressly appalled with the slow leak of oil from an offshore rig in the Bohai sea. A joint venture between the State-owned Enterprise (SOE) CNOOC and ConocoPhilips manage the rig. The rig has been leaking a few hundred barrels of oil a day since spring 2011, and, as of this writing, has still not been completely corked.

China Impact Watch Trends "Heat Map", Scenario 2

Current State

In contrast with Scenario 1, popular discontent would result from the environmental damage and the impact on livelihoods of a BP-sized spill. Also, the extent of the incident would likely been under the stewardship of a single or multiple State-owned Enterprises (SOEs), ostensibly led by the Chinese Communist Party (CCP).

In the same way the central government, China’s railway ministry and the CCP came under fire during the rail disaster of July 2011, which killed 40 and injured another 200 passengers, the authorities would once again be in the people’s cross-hairs. As had been the case with the rail disaster, digital media channels – blogs, twitter-like weibo messages, and even state-run publications – would be the conduit for citizen ire.

Censorship authority in this event, however, would come into play, deleting internet-based criticisms and suspending user accounts to a much more dramatic degree than had been the case during the July 2011 train incident. Greater pressure on the internet – though not a prerequisite in the environment scenario for tipping the economy into a hard landing – would almost certainly lengthen and deepen the negative effects of an economic slowdown.

The scenario also suggests the same effects on the economy in the event of a SARS-like public health disaster, as the country had experienced mid-2003.

Alternatively, a major rupture in the Three Gorges Dam engineering project would be the culmination of sixty years of testosterone-driven centrally planned engineering and manufacturing projects meant to leap-frog the West’s technological and economic development. Just as in the BP-like spill scenario, Chinese citizens would ban together through the use of digital media to condemn the project and all mammoth brain-children of the Chinese Communist Party (CCP), lump the issue together with other grievances they have with the leadership, and seek major reforms.

It would remain to be seen whether the event would be sufficient for the CCP to reform its system of governance; however, it would most likely reform the approach and speed with which it is modernizing the economy: an effect similar to that seen in the aftermath of the July 2011 high-speed rail accident in Zhejiang province.

Implications for Business

The SARS event shows the most likely outcome for businesses in the event of a major environment-related incident: business ground to a halt – domestic and foreign-invested – factories lay idle, and expats and their families were called home at great expense and with little coordination.

International businesses for the most part did not have policies in place for their managers to be able to decide whether to travel to China on business – in many instances, for negotiations with Chinese counterparts – directly affecting the operations of home offices, as well.

Chinese leadership’s proclivity for cover-up and information blackout merely added to the confusion corporate headquarters around the world experienced.

Companies still have no assurances the Chinese government has mended its uncooperative ways when it comes to managing disasters that reflect poorly on the country.

Corporations must have strong, clearly-written (and even rehearsed) contingency plans in place to break the cascade of setbacks for their own companies promoted by cultural and political climates.

China is still open for business, despite much-weakened Western markets in Europe and the United States. The Chinese economy may be slowing – as is the general consensus between journalists, analysts and factory managers in China; however, the property development sector is still building apace, despite the central government’s best efforts to moderate the sector.

Though the Chinese Communist Party (CCP) could have shut down online and traditional media channels through which citizens and Chinese journalists criticized its handling of train wreck of July 23, 2011, it has been rather staid in its response: it has only seen a handful of journalists suspended from their publications.

The most ominous presentation of its displeasure came with a visit of the Beijing CPC leadership to the offices of Sina.com – the most popular channel through which citizens “tweet” their thoughts through a Twitter-knock-off service Weibo – to impress upon the company’s executives its ability to shut down Sina.com if Sina.com cannot shut down dissonant voices that use its service.

Though the possibility exists for China to have a “hard” landing – especially in light of the central government yet again tightening bank requirements for reserves in the face of mounting debts accumulated by local governments since 2009 – the likelihood is small, based on the TrendsAsia China Impact™ Watch model. However, should China experience a energy- or commodities-inflation spike or environmental shock before the end of the year, the economy could tip into recession.

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Source: Thompson Datastream, OECD, West Texas Intermediate

The TrendsAsia China Impact™ Watch critical trends analysis model does not see a hard landing for the Chinese economy as a high-probability proposition. The China Impact™ Watch framework reviews Political, Economic, Social, Technological, Legal, Environmental and Demographic (PESTELED) trends that impact companies doing business in China.

However, three scenarios could trigger a hard landing and severely impact the operations and marketplace of businesses in China:

- Scenario 1: Energy and Commodities Price Inflation Spike
– Scenario 2: Environmental Disaster Leading to Large-scale Protests
– Scenario 3: Local Government Non-Performing Loans (NPLs)

The first scenario is remarkable in that a single, dramatic jolt in the negative (red) direction of the Sustainability-Natural Resources trend will drive the Overall China Business Environment from the positive “opportunity”-strong side to the red “threats”-strong side (see “Heat Map” sidebars) -  the very definition of a tipping point.

A major threat to China’s oil import sources or lines of transportation – for instance, continued viral destabilization of political unrest and social turmoil in the Middle East; or, a catastrophe in the constricted oil shipping channel the Malacca Straits, through which more than half China’s oil travels – would have substantial repercussions for the economy. Coupled with the inflation that is already affecting the average consumer’s basket of favorite foods in China – pork, rice and vegetables of every sort – Chinese workers, consumers and businesses would suddenly find themselves in a recession, seemingly overnight.

China Impact Watch Heat Map, Aug 29, 2011

Scenario 1: Energy- and Commodities-Price Inflation Spike

Though China’s economy is weakening in sync with the rest of the world’s, TrendsAsia Critical Impact™ analysis indicates a soft landing that would see inflationary pressures for food and property as still a major burden to Chinese consumers; however, the inflation would not in and of itself create malign conditions in the business environment for FIEs.

Should the pressures persist and energy- and commodity-resource costs increase by a dizzying 80-percent within a year, then the stage would be set for wholesale closure of thousands of factories in China as had been seen in the run-up to the Global Economic Downturn of 2008. The closures contributed to the unemployment of millions of Chinese migrant workers who simply remained in their hometowns after Spring Festival 2009.

The central government’s fiscal stimulus package that eventually amounted to US$2.5 trillion by the end of 2010 contributed heavily to the development of infrastructure projects that generated many of the jobs the workers still have as of this writing.

With Brent Crude at this writing priced at US$115 per barrel, a spike in the price of Brent Crude oil upwards of US$200 per barrel would be sufficient to reel the economy in. Escalating protests throughout the oil-producing region of the middle east would provide just such an ignition to a radical acceleration in the price of oil.

However, it is more feasible that governments of the world – including China – would draw down on strategic oil reserves to moderate the rise in oil prices.

Scenario1 does not require greater internet control by central authorities to tip the economy into recession. The commodities pricing shock is something that would be transmitted and felt throughout the economy without digital technology to communicate grievances.

The internet and other digital communications, though, would provide an echo chamber in which discontent would mount in an exponential fashion, each grievance feeding off others to create a cascade of ill-feeling toward the leadership. If censors were to tighten control of digital media channels to stamp out criticism, the result would be a further deepening of economic malaise than the basic scenario would see.

China Impact Watch Trends "Heat Map", Scenario 1

The government would likely resort to price caps on fuel, pork and rice – main inflation drivers – which would cause industry disaffection as companies would be unable to make profits, and may even see losses. Producers may seek buyers outside the domestic market, or simply stop selling their offerings at a loss.

2010 through the middle of 2011 saw just such industrial disaffection with coal mines simply refusing to ship coal to power producers as long as the price at which they could buy coal was capped by government mandate.

The result was that power plants either went offline in provinces that had the additional cost of having to import their coal from other provinces, or of power plants forcing factories to operate on reduced production schedules. Power producers also asked retail outlets in Shanghai to turn off lights and heating, or – better yet – to close their doors to business when the summer temperature was above 37-degrees C.

Implications for Business

In the Spring of 2011, Foreign Invested Companies (FIEs) invested in the manufacturing sector were already struggling with rising fuel prices, and food inflation as expressed through local domestic salary inflation.

However, Western markets wanted and were able to absorb products made in China, keeping Chinese manufacturers in business. The economic doldrums of the summer of 2011 in the West, though, will see a prolonged malaise of consumption, just as had been the case at the end of 2007, when the housing bubble in the United States and Europe had burst.

Energy price caps plus the slowdown in the export sector created worker frustration that boiled over when workers were unable to return home either because they had not been paid their salaries before factories had closed or because of blizzard conditions during the historically harsh winter.

Companies will have greater room for maneuverability if they see the pace of China’s urbanization slowing: China’s urbanization is taking upwards of half the world’s copper and aluminum imports, a quarter of its coal and oil imports, as well.

In the mean time, inflation-sensitive producers would do well to begin researching production platforms in other countries, especially if they are export driven: rising commodity prices began eating into their margins as long ago as 2009.

Companies that are selling into the China market would do well to beef up their marketing and sales efforts to differentiate their products against domestic producers and to bolster the fact that theirs is a foreign brand, implying quality and accountability where many domestic players are unable to follow.

The Fukushima Nuclear disaster and China’s desire to diversify its energy portfolio away from fossil fuels sees natural gas as a natural alternative energy source.

Total consumption of natural gas in China in 2010 was 106 billion cubic meters – with growth of nearly 20-percent over 2009. However, China’s use of natural gas is a relatively thin slice of its energy pie, representing only 4% of overall consumption in 2008. China National Petroleum Corporation (CNPC) predicts natural gas consumption to grow to 230 billion cubic meters by 2015. Industry analysts expect China may consume 300 billion cubic meters of natural gas by 2020, accounting for eight-percent of China’s total energy portfolio at that time. Imports will continue to make up 20-percent of growing demand for natural gas, increasing to 25-percent of the mix by 2030.

Natural gas consumption at the provincial level varies widely; however, the majority of Chinese regions still underdeveloped, with Beijing as the greatest consumer of natural gas at less than a 70% penetration (as measured by populations with access to natural gas). Consumption levels in China’s southwest, north-central and southeast-interior provinces provide the greatest opportunity for growth in natural gas markets, with relatively low penetration levels of 1% to 12%. While the national average of penetration is 20%, increased urbanization and industrialization of China’s hinterland will drive annual double-digit growth of gas consumption through 2020.

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Format: PDF
Length: 13 pages; 9 charts.
Published: August 20, 2011

Topics covered include:

• China’s Natural Gas Market
• Consumption – Natural Projections
• Production – Domestic
• Import Projections
• Consumption – Provincial Supply & Penetration