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Alaris Commentary: Converting the Downturn into an AdvantageMarch - April 2009chinabusinessreview.com

In tough times, the best strategy is to push forward

By: Francis Bassolino, Michael Deering, and Lyuba Tovbina

For the past five years, many international companies experienced rapid growth in market share and profits in China and have generated savings by improving supply chain effectiveness and efficiency. But as the economic crisis deepened at the end of 2008, executives were having a hard time finalizing budgets that could justify additional investments in China. Earlier that year, companies had been planning to add staff and expand revenue and cost-optimizing programs. But now the mood has changed dramatically, and it seems profane to push for further investment when serious trouble looms at home.

Nevertheless, operating executives and board members at some major consumer goods companies, including Siemens AG and Kimberly-Clark Corp., have chosen to turn the downturn to their own benefit. In 2009, they are pushing forward with a combination of growth initiatives with cost reduction strategies. As Stephen Shao, president of Kimberly Clark ( China), said in a recent China Daily article, "Under the economic gloom, if you spend one yuan on branding, the effect may be the same as if you spend 10 yuan during prosperous times.” The leaders of these firms recognize that although this year will cause some pain for domestic and international companies, an overly defensive or flat-footed stance will only result in missed opportunities--during and after the downturn.

Understand the economic climate

China’s economy expanded by only 6.8 percent in the last quarter of 2008 compared to the same period in 2007. In November, monthly exports declined year on year for the first time in seven years, and imports plummeted as manufacturers purchased fewer foreign production inputs. The trade numbers continued deteriorating into 2009, with exports and imports plunging 17.5% and 43.1%, respectively, in January. Foreign direct investment (FDI) into China dropped 36.5% in November, 5.7% in December and 32.6% in January, compared to the same periods in the previous year. On the ground, factory closures spiked in December and January, resulting in a rise in lawsuits and unemployment. In February, China announced that 20 million migrant workers, 15.4% of the total, were unemployed.

As a result of slowing domestic and international demand, inflation slipped to 1 percent in January, with the price level of non-food goods and services falling by 0.6 and 0.8 percent, respectively, signaling the strong possibility of a deflationary period in the following months. Major economic indicators imply that in 2009 the Chinese economy may fail to meet the government growth target of 8 percent for the first time since 1999. By the end of January, UBS AG had revised its forecast for 2009 GDP growth in China to 6.5 percent, and Morgan Stanley had cut its estimate to an even grimmer 5.5 percent. In either case, the global slowdown in demand will be quite painful for the Chinese economy.

Yet in China this downturn is more of a cyclical trough than a sign of structural weakness. Falling exports are not an easy pill to swallow, but it is important to remember that the dependence of the Chinese economy on foreign trade is often overstated. According to a 2007 estimate by Jonathan Anderson, an economist at UBS Investment Research, exports account for less than 10 percent of China’s GDP. Dragonomics Advisory Services Ltd. research estimates that net trade contributed about 21 percent of GDP growth over the past three years. China is not Hong Kong or Japan – it is a large continental economy, which affords it a degree of independence from global cycles. Even if the global malaise persists and exports continue to suffer, China can revitalize its economic growth through other means.

Encouraging investment and consumption growth

Over the past five years, investment and consumption contributed about 9 percentage points of China’s GDP growth annually, and in the second half of 2008, the PRC government took several important measures to boost both. The People’s Bank of China cut interest rates five times, bringing the benchmark one-year lending rate down to 5.31 percent. In addition, bank reserve requirements were lowered by 250 basis points, loan quotas were abolished, and banks were asked (or rather, strongly advised) to increase lending activity. The result was an immediate surge in bank lending, with loans worth RMB 1.62 trillion distributed in January – a single-month record and almost doubles the amount of January 2008.

To encourage lending to small and medium-sized enterprises (SMEs) – a difficult mission given the banking system’s tradition of serving state-owned giants – the China Banking Regulatory Commission (CBRC) issued a directive that encourages commercial banks to establish special service desks for SME clients. One major obstacle is that lending to smaller clients requires resources and processes that are in short supply at most Chinese banks. To encourage more risk tolerance in the banking system, local governments in areas with high concentration of SMEs – including Dongguan, Guangdong and Shangyu, Zhejiang--have allocated funding to provide interest subsidies to SME borrowers and partial repayment guarantees to lending banks. In response to the early success of these policy experiments, the Ministry of Finance has pledged to furnish {Y}1.8 million to support the local efforts. These steps, as well as positive signs of the development of a corporate bond market, are particularly important in a country where SME owners must often reach into their own pockets to solve enterprise cash flow problems. The government support of SMEs may boost investment spending, which would in turn bolster GDP growth.

In a move to stimulate domestic consumption, the Chinese Communist Party leadership in December 2008 pledged to increase both urban and rural incomes significantly over the next three years. Urban incomes could benefit from an increase in the personal income tax threshold, but given Chinese households’ high savings rate, the government is likely to channel the cash into government spending instead. Rural incomes will be raised through price controls on agricultural products and oil. Nation-wide subsidies of 13 percent of total cost for rural purchases of certain large-ticket items, such as motorcycles and refrigerators, will help boost rural spending.

The government has also made serious attempts to reinvigorate the residential housing market. To increase demand and address the oversupply of high-end property, the government has pushed for more investment in affordable housing projects. Minimum down payments to purchase a home have been reduced from 30-40 percent of total value to 20 percent. The transaction tax has been waived for acquisition of properties intended for long-term use. Because it was precisely the untimely policies aimed at tightening the booming property market in 2007 and first half of 2008 that arguably initiated China’s economic slowdown, revitalization of the property market is an essential step in ensuring the speedy recovery of the economy as a whole.

An increase in government spending

To show that new policies will be backed with funds, the PRC government has announced a significant fiscal program in hope that more government spending will pick up the slack for declining export growth. The RMB 4 trillion (USD $585 billion) stimulus package rolled out on November 9, 2008 received mixed reviews from the international community, but there is more to it than meets the eye.

First, analysts estimate that infrastructure spending (which accounts for roughly 80 percent of the stimulus budget) could contribute 2 to 3 percentage points to GDP growth in 2009, while indirect benefits, including job creation and better access to inland areas, will provide an additional boost. Second, the national stimulus will act as a top-down directive for local governments to boost their own spending packages. According to the Economist Intelligence Unit, “local governments across China have rolled out some RMB 25 trillion worth of projects to ‘supplement’ the central government’s effort.” With the CBRC encouraging banks to support local projects despite the risks, even the poorest provinces will be able to obtain the necessary loan funding to bring a good portion of the plans to fruition. Finally, the stimulus can be viewed as a confidence-building tactic. In a nation where faith in government power remains strong, such a gesture can boost consumer expectations, thereby raising domestic demand.

Seize the day

What does all this mean for US firms operating in China? It is also a good time to push cost-optimizing agendas such as strategic sourcing and loan programs. A temporary downturn is unavoidable and will be reflected in slower revenue growth for many firms. But with the exception of export-dependent regions such as Guangdong, where fundamental changes to the dynamics of the market are severe, this downturn is cyclical, not structural. In fact, the downturn can bring a number of benefits to firms that use China as a supply base and those that target the evolving Chinese consumer and industrial markets. This is the right time for firms to expand market share through acquisition, brand development or aggressive organic growth.

• Favorable government policies

Companies that stay in China during the downturn can take advantage of favorable government policies intended to keep them from leaving. The government has provided some breathing room for exporters in the form of higher value-added tax (VAT) rebates on a wide range of products, and anecdotal evidence indicates relaxed enforcement of environmental regulations. For companies looking to invest in additional facilities or equipment, VAT credits on fixed-asset investment will offer substantial opportunities for tax deductions this year. According to Robin Ye, chief of the China Finance Executive Council, “the proposed VAT reform … will make it 13-17 percent cheaper to set up manufacturing operations in China from January 1, 2009 [compared to] 2008.” Expanded borrowing opportunities and lower interest rates will also encourage investment, and the government’s employment goals will make it a more accommodating host.

Regional governments will implement friendly policies toward companies that stay, as evidenced by Dongguan’s recent invitation of major companies in its jurisdiction to a meeting about steps the government could take to create more favorable business conditions. Dongguan has also extended an offer to build an additional factory at close to zero cost to a large consumer packaging firm, and likely to other large companies operating in the region. On the other hand, companies that decide to leave or downsize will face more hurdles, as governments could reject liquidation requests and fine employers that implement aggressive layoffs.

• More accommodating suppliers

After years of rising goods and labor costs, companies that expand in China in 2009 will enjoy a buyer’s market. In the face of plummeting orders from major clients, some Chinese suppliers will be more flexible. This is the time for foreign firms to reexamine the supply chain, renegotiate contracts, and ask for greater cooperation from Chinese suppliers. But a word of warning is in order. In industries with historically razor-thin margins, mounting losses may not allow for further price cuts. Instead of demanding lower prices, which could drive suppliers out of business, buyers may want to concentrate on acquiring less tangible advantages. These might include better service, more supply-chain and cost information, and long-term cooperation commitments.

• Availability of good workers

As unemployment rises, new graduates and laid-off workers are having trouble finding jobs. Though the new Labor Contract Law took effect in January 2008, selective enforcement of labor regulations will likely become more common as concerns over unemployment grow, especially in traditional export-oriented manufacturing hubs such as Guangdong. Officials will probably crack down on firms that terminate contracts but simultaneously relax temporary labor restrictions and wage controls. Enforcement of labor laws will be inconsistent, and staying in the government’s good graces will require knowledge and finesse.

For foreign firms with long-term ambitions in China, and indeed globally, the growing pool of available labor presents the opportunity to reshuffle existing human resources and hire better-qualified workers at a lower cost. Since Chinese workers have become adept at job hopping, firms should also reevaluate employee loyalty programs to ensure that quality labor hired during the downturn stays after the economy improves.

• Acquisition opportunities

For firms that have held on to a significant amount of cash through the recent boom years, the downturn will offer a host of growth opportunities, including acquisition of assets, competitors, and new product lines. Indeed, in an environment of mounting losses and factory closures, many business owners in China will need to sell, and valuations will be much lower than even just a few months ago. Financial and operational due diligence will be as tricky as ever, but opportunities to capture market share, extend product lines, and acquire capacity will present themselves in abundance.

In addition, the China Banking Regulatory Commission in December 2008 issued guidelines for commercial banks to provide loans for mergers and acquisitions (M&A) of both public and private firms. These guidelines effectively changed the government position on M&A lending from “restricted” to “encouraged,” making way for the state-owned Industrial and Commercial Bank of China to become the country’s first M&A lender by signing an agreement on January 6 to provide loan funding for Beijing Capital Co.’s future acquisition projects. Although all companies registered under PRC law, including WOFEs and JVs, can in theory take advantage of these loans, it will take time for this type of lending to transition from policy-centric to strictly commercially motivated. Still, the change is likely to lead to more M&A activity, strengthening the Chinese economy in the medium term.

Risks to consider

Although companies will likely benefit from maintaining a firm course in China, there are several short- and long-term risks. In a country with an immature legal infrastructure and underdeveloped rule of law, an economic downturn often leads to a spike in illegal and unethical practices. Therefore, it becomes even more critical to perform thorough due diligence when evaluating potential suppliers or acquisition targets and to keep a close eye on existing suppliers and partners. To avoid losing important assets and being confronted with disgruntled workers, increased vigilance is prudent. Companies should also diversify their supplier network to insure against supply disruptions.

From a macroeconomic perspective, despite government efforts to stimulate the economy, a slowdown in domestic demand is likely, particularly through the second quarter, while people wait to see whether global and domestic markets have bottomed out. Indeed, faced with tenuous employment prospects, workers are likely to save even more than their current 25 percent. And as long as the savings rate is driven by a lack of state protection from the financial burdens of job loss, healthcare, education, and retirement, measures to stimulate household consumption will have a muted effect. The medical reform plan that passed in January earmarked RMB 850 million to be spent by 2011 on the provision of affordable universal medical care. This is a welcome step, but long-term effort is required to alleviate the many shortfalls and inspire citizens’ confidence in the medical system.

Another potential hurdle on the path toward economic recovery is misplaced nationalism and protectionism, in China and globally. In 2009, nationalism and a lack of enlightened leadership on the business and political fronts could be disruptive in certain sectors. A recent example is the 87 percent tariff the European Union placed on fastener imports in December 2008. In China, this protectionist move will likely result in factory closures, an estimated loss of 400 million Euro (USD $305.5 million) of annual revenue, the loss of tens of thousands of jobs, and a corresponding fall in consumer spending. With all major national economies interconnected in a global web, it is important for political leaders to recognize the impact of protectionist decisions not only on the targeted country but also on the global economy.

The final and most worrisome issue has to do with the relationship between the current downturn and China’s long-term development. In the second half of 2008, the PRC government reversed or undermined several policies it had pursued earlier in the year that sought to move industries up the value chain.

Specifically, enforcement of labor and environmental regulations seems to have been relaxed. This attitude may provide benefits in the short run, but the long-term costs to the economy, the environment, and the rule of law could be significant. Likewise, renminbi appreciation has come to a halt, which will help exporters but hurt Chinese investors and consumers.

Now is the time

Despite some concerns, China has the potential to emerge from the crisis in better shape than before. With the appropriate strategic planning on the part of business leaders and apt use of the policy arsenal on the part of the PRC government--neither of which is guaranteed--the country could experience healthier development, consolidate fragmented industries, build a more mature financial system, and expand domestic demand. Companies should take advantage of the current economic environment and seek to benefit from favorable government policies, more accommodating suppliers, availability of skilled workers, and M&A opportunities. Capitalizing on these advantages to reduce costs and expand market share may well be the key to surviving the downturn.

Francis Bassolino is managing partner, Alaris China, based in Shanghai. Michael Deering is managing partner and CEO, Alaris Consulting, based in Chicago. Lyuba Tovbina is associate, Alaris China, based in Shanghai.

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