Mar 2016 COVER STORY: The Paradox of China – Sluggish Growth & Economic Proliferation

Slower economic growth, more intense competition, growing overcapacity, a shift to services, new government priorities, and never-ending anti-corruption drives are just some of the challenges facing business leaders in China today. Gordon Orr, Director Emeritus and Senior Advisor of McKinsey and a renowned expert on contemporary economics of China responsible for establishing McKinsey’s China practice in the early 1990s, illustrates “an increasingly diverse, volatile, US$11-trillion economy whose performance is becoming more difficult to describe as one dimensional”

By Kenny Lau


With the slowest growth in 25 years, China appears to have become a poster-child of the latest global market volatility and synonymous with declines in stock markets, equity prices and demand for commodities. The outlook in 2016 for China, despite having generated more than a third of global GDP in 2015, is far less favorable. The shift from phenomenal growth over a decade earlier to moderate development of recent years, however, is only part of the continuing story of the nation’s economic transformation.

“The absolute scale of China’s economy is still massive – as are its potential opportunities. Regardless of China’s growth rate in 2016, its share of the global economy – and of many specific sectors – will be larger than ever,” says Gordon Orr, Director Emeritus and Senior Advisor of McKinsey and a renowned expert on contemporary economics of China, in addition to serving on the boards of Swire Pacific and Lenovo.

Today, China is “an increasingly diverse, volatile, US$11-trillion economy whose performance is becoming more and more difficult to describe as one dimensional.

The reality is that China’s economy is made up of multiple sub-economies, each more than a trillion dollars in size. Some are booming, some are declining. Some are globally competitive, others fit for the scrap heap. How you feel about China depends more than ever on the parts of the economy where you compete.”

Government plans

There are few surprises in China’s 13th Five-Year Plan in relation to economic development, Orr believes. A challenge is to interpret the plan’s intent clearly in the backdrop of a new “party speak” of centralization now coming to dominate government pronouncements. “The key word here is implementation” as centralized decision-making is generally effective on nationwide issues such as monetary and fiscal reforms while others are more industry- and city-specific requiring precise execution at a local level.

A six percent–plus target of GDP growth target remains, and is the core objective of fiscal and monetary policies. As such, lower interest rates and pressure on the exchange rate against the US dollar in 2016 are expected, while financial reforms aimed at moving the economy towards a market-based allocation of capital will continue, entailing further progress on interest-rate deregulation, on the IPO process (registration rather than approval) and on permitting new entrants into financial services, Orr points out.

“The plan will promote decentralization, but the reality is likely to be greater centralization,” he says. “The Chinese media, especially during President Xi’s increasingly frequent trips abroad, made it clear that economic decision-making has been centralized over the past two years. China will become still more centralized in 2016, rolling back decentralization where it had unintended outcomes.”

Decisions will be “re-centralized” when, for instance, the sustainability of production and profitability of state-owned enterprises (SOEs) in the midst of massive government bailouts are questioned. A case in point is when some 150 new coal-fired power plants – more than three times the number approved in 2013 – were pushed forward in the first nine months of 2015 by local governments upon “higher up” approval, regardless of any realistic demand projection or the question whether new plants should be coal-fired at all.

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Likewise, in Mainland pension funds – controlled largely at the provincial level but covered by the central government in case of any shortfall – there is little incentive at the local level to improve performance as 90 percent of assets are held in bank deposits. “The coming centralization will try to remove perverse incentives and to professionalize the overall approach to investments,” Orr says, noting also the plan for consolidation of SOEs to create fewer but larger companies, each possibly dominating a specific industry.

The central government, he adds, will make big commitments to its citizens on “green initiatives” that local authorities will have to mount a serious effort to deliver. “There will be tougher emissions standards and more spending to support the development of non-fossil fuels. China will explicitly build new export engines in green products. Private-sector and state-owned companies will rebrand their ongoing initiatives as green, and green finance will be available.”

“Increased ideological conformity, as demanded by the Party’s new rules, is almost by definition centralizing; people look to the top for approval of not just what they do but also of what they say and how they say it,” Orr says. “A major test of the effectiveness of centralization is when consumer confidence starts to decline in 2016. Will the central government be able to pull the right levers? No one set of levers is likely to be fit for the entire economy, and it will be one of the greatest test of economic competence.”

China’s labor force

China’s latest plan will shine a light on the success in raising productivity of labor over the past decade and the anticipated acceleration of productivity growth, for both capital and labor, in the coming five years. Over 130 million Chinese workers are directly employed in the manufacturing sector, and increasingly these jobs require technical skills and are better paid, Orr notes.

“This has been possible due to the double-digit increases in capital and labor productivity that have helped keep so much manufacturing in China,” he says. “However, it looks like that overall manufacturing productivity growth fell dramatically in 2015; a repetition in 2016 would put great pressure on corporate profits, wages and jobs. Although only a handful of sectors – steel, coal, chemicals, etc – were responsible for much of this poor performance, but even more competitive sectors were challenged by continued factory price deflation.”

More importantly, Orr says, are the implications of higher productivity for workers. That is, the disappearance of many traditional well-paying jobs and the need for increased labor mobility and for the lifetime renewal and development of skills. “But I am concerned that implementation will be left to local administrators and that the regions requiring the most help will have the lowest amounts of money to invest in reskilling the workforce and the least impressive actual skills to deliver results.”

The workplace in China, he further points out, is already changing dramatically in ways that will create many individual losers – for example, workers in industries in secular decline (such as steel and textiles) or in industries where technology is rapidly displacing people even as output grows (like financial services or retailing). Government figures indicate a loss of 15 million construction-related jobs and millions more in mining over the past year. The bad news is that these workers, despite being in their prime years, are unskilled for the modern service economy.

“The government must help these workers reskill themselves to deliver on its commitment that all parts of society will benefit from economic growth and to keep people actively engaged in the economy,” Orr stresses. “China must roll out education, training, and apprenticeship solutions quickly and at scale to become the moderately well-off society its leaders aspire to achieve because the state educational system isn’t delivering for the migrant worker or the university graduate.”

“This will be both complex and expensive, but it is simply not enough for officials to visit major local employers, as they did during the global financial crisis, and press them to retain all their current workers,” he adds. “Not everyone can deliver e-commerce packages and, besides, the wages from that kind of work aren’t likely to bring people into the urban middle class.”

The continuing pressure for higher productivity and on jobs overall will lead to lower growth in household income and, potentially, an erosion of consumer confidence in 2016 during which consumer spending was responsible for well over 50 percent of GDP. “If the government doesn’t handle less-confident consumers quite carefully, the kind of behavior the stock market experienced last summer will roil the broader economy,” Orr cautions.

Manufacturing in China

Despite signs of deterioration as indicated in the manufacturing purchasing manager’s index (PMI), China’s role as a manufacturing powerhouse remains intact, with a share of global manufacturing value added reaching 26 percent in 2014 according to McKinsey Global Institute estimates. “Let’s be clear: manufacturing is not about to become irrelevant in China,” Orr says. “Its share will stay well over 20 percent for many years to come. And manufacturing still employs over 135 million directly.”

Instead, Chinese manufacturing is moving towards into two extreme directions of performance: the truly awful and the genuinely competitive. “The fact that many companies – and even sectors – may be voting for a PMI below 50 forever doesn’t mean that the best emergence of internationally capable Chinese manufacturers will do anything but accelerate. Contrary to their historical reluctance to hire functional expertise outside their existing networks, CEOs of Chinese companies now do so incessantly to fulfill their needs.”

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A small Chinese manufacturing sector may be a strong global competitor, while other sectors suffer from massive overcapacity and substandard quality. “By aggressively adopting what we might consider Western concepts – lean and modular design, scaled learning, agile manufacturing, and intelligent automation – many companies are combining low costs with innovation. And their skills are spreading widely across China’s manufacturers,” Orr notes.

On the other hand, it will be a very tough year for low value-added assemblers in China, many of whom “have no viable turnaround options,” he adds. “Multinationals in China are facing up to this double challenge of lower growth and increasing local competition. A few are quietly exiting; some are lowering their cost structures to match; and others will move aggressively on the front foot. In 2016, more multinationals will attempt to purchase Chinese competitors – if you can’t beat them, buy them.”

Noteworthy is the growing number of innovators in industries ranging from construction equipment, consumer electronics and medical devices to solar equipment, moving beyond China and into international markets. The exhibition of the latest annual Consumer Electronics Show in
Las Vegas is an indication of Chinese companies becoming increasingly influential as innovators, Orr says. “Over the last 15 years, they have evolved from naïve exhibitors to hosting some of the largest and highest quality stands that are a must-visit for buyers.”

“The quality of marketing – and of products on display – demonstrated by the leading Chinese companies was of a higher level than in the past,” he notes of his experience in the January show. “They are increasingly seen as quality partners by others in the industry. And hundreds of less well-known Chinese companies, whom I had thought a few years ago would have disappeared from the show, were also there to make sales to global buyers.”

Agricultural imports

Because of a sluggish global economy and a downward trajectory in the prices of commodities including those of raw materials like iron ore and coal, Chinese imports are not expected to rise significantly in 2016. Yet, agricultural imports may be an exception as China’s demand for everything from cereal to beef continues to rise, Orr predicts. And, more importantly, these could be sold directly to middle-class consumers through the expanding online market for groceries.

“Agricultural products are different because of the increasing demand for stock feed and for high quality fruits and vegetable in China,” he explains. “This is largely due to a rising middle class whose appetite for international products of premium quality from countries regarded to have high health standards has multiplied exponentially. It is not easy for China as a country to meet the demand nationwide through domestic means.”

In 2016, China’s growing needs for food will drive agricultural imports to record highs in both volume and value, and more countries than ever before will find agricultural-export opportunities there. Russia is one example: Chinese imports of grain and oilseed from Russia reached 500,000 tons in the first nine months of 2015, compared with just 100,000 for all of 2014, Orr points out. Even large volumes of corn from Ukraine are pragmatically finding their way across Russia and into China.

Even as Russia’s reorientation towards China, following the imposition of Western sanctions, has taken some time to play out in agriculture amid a lack of infrastructure including border inspection points, this is nonetheless very significant. It is a direction, although in a slower fashion, similar to what happened with oil imports for which China reduced its reliance on the Organization of Petroleum Exporting Countries (OPEC) from more than 65 percent to roughly 50 percent by increasing imports from Russia.

The free trade agreement between China and Australia is due to take effect in 2016, and there will be rapid growth in trade, particularly in meat and dairy products, Orr expects. And a more economically stable Argentina will compete with Australia to provide beef to China and with Ethiopia to provide alfalfa at scale to feed China’s dairy herds.

“The recent decision of Australia to turn down an investment on national-security grounds will only have a temporary effect on deterring Chinese investors from putting more money into Australian agriculture,” he says. “Several had previously made approved investments, and others are sounding out international partners to invest jointly in new Australian projects.”

Meanwhile, after a pause in 2015, US farmers should be able to increase their exports to China not just in soybeans (historically more than 40 percent of US agricultural exports to the country by value) but also in cereals, intermediate goods and, especially, branded processed foods, Orr believes. “Food safety will remain a theme that benefits US and other international producers of branded foods.”

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State of investment

On the macro level, China’s outbound investment will accelerate in 2016 mostly due to “One Belt, One Road” initiatives and the need for distressed-asset acquisitions in basic materials and related sectors, Orr anticipates. “Chinese acquirers may plan not to extract the assets in the near term but simply to stockpile them as long-term insurance. Secondly, a growing share of the acquisitions will come from private companies that aspire to global leadership.”

The volatility in the property and stock markets in 2015, he says, has also driven Chinese investors to diversify their investments into more stable vehicles. “Today, they still remain dependent on bank deposits and property. The need for wealth managers has increased dramatically. Often, their challenge is not about finding clients but rather credible products to sell. The challenge for investors is to find advisers they can trust; most simply push the products that give them the largest commission.”

Wealth managers in China are moving online to deal directly with investors, and online lending sites are becoming broader wealth managers and are acquiring mutual-fund distribution licenses, Orr notes, citing Credit Ease, East Money, Jupai, Jimu, and Lufax as prime examples. “Whatever happens, sinking money into a second, third, or even fourth property will no longer be a major way of investing in China.”

Opportunities for foreign fund managers and brokers are growing in China as well: Aberdeen Asset Manager and Fidelity have both received approval to open wholly- owned investment
management operations; and HSBC for the first majority foreign-controlled brokerage. Likewise, global asset managers will be asked to serve Chinese insurance companies and pension funds for a diversification of assets – many still hold as much as 25 percent of their assets with banks in the form of negotiable deposits.

The launch of the Mutual Recognition of Funds (MRF) – initially through several Hong Kong-based funds with JP Morgan, Hang Seng, and Zeal – “will be good news not just for Chinese middle-class consumers who historically have had very few options to diversify their investments into assets outside China,” Orr says. “MRF is a two-way process. A number of Mainland funds are being made available to non-Chinese investors for the first time.”

“While this is all quite exciting and positive, there is of course a risk that this openness to cross border investing goes away again during 2016,” he cautions. “Why? Because China’s exchange rate continues to weaken and is seen by many now as very much a one-way bet in the
Mainland today. Somewhere between US$100 and $200 billion left China in December, and it is still an ongoing trend.”

“And don’t forget the volatile mindset of Chinese investors. If a product makes a loss, they still expect to be bailed out,” he adds. “Taking personal responsibility for bad investment decisions isn’t the norm. Foreign fund managers will have to deal with anger online and in person when a product they sell doesn’t live up to expectations. The progress of allowing bad investments to fail will only be incremental.”

“Nevertheless, China’s financial system is experiencing an increasing pace of change that is more market-based. While there’s still a long way to go on the journey towards a fully modernized financial sector, we should not ignore the positive changes that are underway. It is a new challenge for China’s leaders to guide this more complex, more diverse, and more globally connected economy.”

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