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Chinese transition costs mean world must readjust

*by Hugo Scott-Gall

The costs of growth and transition in China are rising: and that’s hurting the profits and returns of both domestic and international companies. As China progresses, its relationship with the rest of the world changes – and that requires those who supply to, or rely on China, to readjust.

The fact that costs are rising isn’t that surprising, but the breadth of the development is. This goes beyond labour, land and real estate to environmental, regulatory and capital costs. Not just industries need to adjust, also countries will need to adjust as there are effects on savings, capital flows and FX reserves. The multiple consequences of a changing China can be boiled down to two questions - whom does China need? And who needs China?

It may well be that for many companies the sweet spot has passed. Inflation is likely to impact profitability: 2013 earnings estimates for Chinese companies have fallen by 17% since the beginning of 2012, and return on capital is forecast to fall from 20% in 2010 to 14% in 2014. China is clearly trying to go from low-cost manufacturer to fast follower of developed markets, with an aspiration to be a net IP producer.

Winners and losers

Over the past 20 years, China has triggered a massive demand shock for commodities, resulting in a sharp increase in prices. The question is whether supply and technology will bring prices back down. Producers of these commodities that have ramped up capacity could be at most risk here. Goldman Sachs’ commodities team forecasts iron ore prices to decline around 30% by 2015.

Chinese imports of food and other agricultural products from the rest of the world, on the other hand, will probably increase for the foreseeable future. Agricultural surplus countries like New Zealand, Australia, Brazil, Argentina, Thailand, the Netherlands, the US and great swathes of Africa, can benefit here.

China will also need a new set of solutions in power and energy efficiency, especially if and when price ‘incentives’ for energy improve, as fossil fuel subsidies amount to around $20 per capita in China at the moment. The need for more efficient allocation of capital points to higher demand for financial services, insurance and asset management. And lastly, infrastructure solution providers in areas like logistics and communication should remain important as the penetration of online business models rise and economic activity moves further inland.

Benefits and challenges

Some Western companies could obviously benefit from these shifts. In Europe, China-exposed consumer companies have outperformed the market by 3% versus -12% for industrial companies over the past year.

Further development in China is a challenge for all those who rely heavily on its cost advantage. If China were to begin exporting inflation instead of deflation, it would be damaging for the US and most other Western European countries. Countries that owe the bulk of their export growth to China, like the UK, Germany, New Zealand, or Switzerland, will have to watch the development of Chinese industry closely: what current imports can China substitute with domestic produce, like machinery for instance in the case of Germany.

Changing with China

Then there are those who have benefited from China exporting its savings, which has reduced nominal and real rates of interest. This, alongside China exporting deflation, has been a major part of the world’s recent financial history. China potentially saving less and consuming more implies it would buy less Western debt. In the last year, China’s FX reserves have grown by 6%, compared to a 33% CAGR in the previous decade. Some debt-heavy, consumption-driven economies, like the US, Italy and Japan, might need to make some changes, concurrent with China.

China’s rise is a challenge, but the world has seen this development before. The US was a big net consumer of IP in the 19th century, while Europe adopted a lot of Asian IP in the 15th and 16th centuries. If history is a reasonable indicator, then it seems likely China can address some of its challenges - and there are investment opportunities for those who can help it do so.

*Hugo Scott-Gall is an analyst at Goldman Sachs
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