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Chinese whispers


After a week in China's hinterland, Lead Portfolio Manager and Head of Hermes Emerging Markets Gary Greenberg, talks about how he saw every stage of development whilst on his travels…

We travelled on amazing five-star highways in remote areas, landed at almost empty but brand new regional airports and marvelled at a global power tool manufacturer's countless quality control labs. But we also endured a distressing level of air pollution, and toured the insalubrious central kitchen of a listed noodle chain (and then, inexplicably, sampled the food).

It would be disingenuous to claim that in five days we discovered things that no one else knows. And yet each visit to the country, over a period of 20 years, brings new impressions and insights; visits to the hinterland, where conversations are fresher and more open than those in the major cities, the aspirations of the people less guarded, and the personalities less calculating are particularly rewarding. Importantly, we learned what kind of things will matter in China over the next few years.

China has enjoyed huge advantages in the past two decades: cheap labour and currency, a huge domestic market, and a government prepared to engineer a draconian transfer of resources from the private sector to the public/corporate. These combined to produce a modern economic miracle.

Now, as with all miracles (certainly all financial ones), peeking behind the curtains reveals a lot that needs to be fixed. The old story of breakneck growth at any cost is certainly over. Real business acumen will be necessary; connections and an MBA from a top university will not be enough.

To be optimistic on China these days requires believing that the government will get the spiral of debt-fuelled investment under control, which will lead to a near-term growth slowdown. By contrast, a China pessimist thinks the government is either clueless or cynical or both, cannot get debt and investment under control, and therefore will keep pumping up short-term growth until the inevitable crash finally arrives. We have arrived at a through-the-looking-glass moment where an upturn in the credit cycle and an acceleration in growth are bad news, while cautious lending and slowing growth readings are good news. Recent readings have built the case for a slowdown in credit, so good news.

Despite the over-investment in roads and airports, logistics continue to pose a major challenge for Chinese companies. Railway infrastructure remains inadequate, especially in the interior of the country. New railroads are being built here, but at great expense. Whether the economics will bear out China's modernisation remains to be seen.

Goods distribution through retail is also immature: retailers are often unwilling to offer goods on anything other than consignment (power tools for instance), and the warehouse infrastructure throughout the country is immature. The lack of a distribution network for Techtronics, the power tool company we visited, represents a big hurdle.

Despite the challenges, national industries are growing, supply chains are well established, especially in the South, and no one we spoke to seemed to be in a business that was experiencing stress. Macroeconomic predictions of a sharp slowdown in growth may prove to be accurate but the business community is not planning for it yet. This may translate into a build up of inventories, but sell through this year seems healthy. A slowdown thus is manageable at the business level, at least anecdotally.

Things had slowed considerably at Kweichow Moutai, a Chinese liquor distiller, located at the site of a historic battle between Mao and Chiang Kai Chek. Here, wheat, sorghum and the area’s special soil are fermented giving rise to what we are told are 1000 different types of microbes. This special mixture is then distilled and left to age for five to 30 years to produce the "Champagne of China" also known as Moutai, which sells for USD150 to USD50,000 a bottle. To me it tasted like liquorice, but then I am a barbarian; for my hosts it must have been like hosting a tasting of 2002 Chateau Lafitte for a Wal Mart shopper.

Overall, greater efficiency was the order of the day. Labour cost escalation was a recurring theme, and automation is on everyone's mind. One company plans to reduce the labour force by 90% in the next year. Others are busy fitting robotic arms to help in manufacturing. Consumer product companies were talking about market segmentation, others had put in enterprise resource planning, and still others were on a mission to keep cost growth at zero (a big challenge given 10% a year wage growth).

This is precisely what one would wish to see when visiting Chinese companies: an awareness that the boom times will not continue forever and that they must create an edge in business processes, rather than low labour cost and externalities. China's labour cost is 20% of that of the US, but its productivity is also only 20%. Labour costs will continue to climb, by high single digits in my view, over the next five years, so Chinese companies must improve their productivity”.

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