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China--investor chaos or opportunity? Considering everything that is happening in the world today is China still the land of opportunity?

Every investment has two possible outcomes (Positive or Negative). When it comes to placing that investment in a foreign country it can be impacted by any number of events outside of the control of the investor. These country risks can and do influence the eventual outcome of the investment (i.e. such country risks include but are not limited to political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of capital being locked up or frozen by government action). There is also the risk associated with civil unrest. For the past couple of decades we have seen thousands of foreign companies rushing into China to make an investment, assume the risk of that investment in order to become a part of China's future. For some that has proven to be a wise decision while for others it didn't turn out exactly as planned.

Today, China is the second largest economy on the globe with a lot of experts predicting that it will surpass the U.S. in the next few years. It has enjoyed an unprecedented growth of its GDP over the past two or three decades. So, with that thought in mind, the question posed by this article is simply "considering everything that is happening in the world today is China still the land of opportunity, is it still worth the assumption of country risk by future investors?"

Unless you have been asleep for the past few months or isolated on some deserted island you are very much aware of the numerous global crisis that are evolving around us. Everything from the Russians saber rattling in the Ukraine; the rise of ISIS in the Middle East; rumors about a possible change in leadership in North Korea; protesters in Hong Kong exercising civil unrest. If you recall, Hong Kong was returned from a century of British rule to Beijing on June 30, 1997. So far it's been a fairly peaceful movement.

This particular protest in Hong Kong would seem to be mostly about the city's special status based on the agreement the city has with the Beijing government. Hong Kong is largely autonomous from the rest of China, has greater freedom, and even has a promise from Beijing to have free elections in 2017. Although the Hong Kong protest is getting all the headlines this protest is not just about Hong Kong. If we look at history, mainland China has had a long history of public protest. That history impinges directly on what's happening in Hong Kong today. As we have seen, protest in China tend to come and go with some solved using military force while others end somewhat more peacefully with a simple compromise. This particular protest is being looked at carefully by the foreign investment community since how it eventually gets resolved could be a sign of how the central government will act in regards to other situations that might impact on foreign investors. It's possible that this whole issue may be resolved prior to the publication of this article.

As a bit of history, some of the great, most celebrated protest actions in China's past began with student activism. If the state uses repressive actions against students, even if the official press chooses only to denigrate the students, then it normally leads to large numbers of sympathizers joining with the students on the streets. This is something that happened in Beijing, and many other cities, in 1989. But it also happened as far back as 1919, when there was an initially student-led movement that led to a general strike in Shanghai.

The irony of this protest is that the residents of Hong Kong didn't like life under the British rule and they now equate life under Beijing to be no better than what they experienced under the British, hence Beijing has become the New British.

The question that everyone is wondering about is "What is the potential long-term economic and business impact of the massive protests sweeping Hong Kong"? Not surprisingly, no so called "China expert" appears ready to make any definite predictions about this matter, at least not yet. That's mostly due to the continuing uncertainty about how exactly how long the demonstrations will continue and the larger question about what actions Beijing may take to contain the unrest. If we assume that the protests will continue for some time, such action would definitely hit the tourism and retail industries of Hong Kong, which added together yield about 10 percent of the territory's total gross domestic product. These two sectors would be "harshly impacted" due to the fact that most tourists would avoid going to Hong Kong. In addition, overall business confidence in Hong Kong would likely take a nose dive. After Hong Kong's economy contracted last quarter, a prolonged bout of protest or a heavy handed Beijing response to the protest could easily push Hong Kong into a recession. To this writer, the worst-case scenario would materialize if Beijing were to decide to end the protest using force by sending in the army or armed police. That sort of action would most likely have severe repercussions far beyond Hong Kong's borders and send shivers around the globe thus jeopardizing Hong Kong's status as an international financial center. Such fall out would impact negatively on China's own economy thus creating a "lose/ lose" situation for all involved.

It appears that the main casualty of the protests (so far at least) is the often referred to policy of "one country, two systems." When China took back Hong Kong from Britain in 1997, Hong Kong became what is known as a "Special Administrative Region" (SAR) of China under a unique set of conditions, called "one country, two systems." This rather cumbersome sounding policy was put together to win over support from the residents of Hong Kong for the takeover by China. This policy granted Hong Kong a defined range of freedoms that was far greater than what was (and still is) allowed on the Chinese mainland. Hence, the recent decision taken by the central government in August to renege on parts of that agreement signals that Beijing cannot be trusted in this matter.

It's important to point out that both Britain and the U.S. offered themselves as guarantors of the 1997 transition agreement that established Hong Kong as a Special Administrative Region (SAR). I strongly suspect that this is a responsibility that neither country wishes to take today. Should there be a violent crackdown of the protesters initiated by Beijing it's highly unlikely that any country would do much to be of assistance to Hong Kong. Military action by any outside groups is out of the question, and economic sanctions would come into the picture only if the level of violence is deemed extreme. Obviously, there would not be any Russian proposed sanctions levied on China.

So the Hong Kong movement of today is actually linked to long-term traditions and history within China, it's also connected to things happening in other parts of the world, and it's connected to quite different but simultaneously occurring challenges around the territory that the Chinese government wants to claim authority over. Needless to say the Hong Kong protest is probably connected to some political actions being played out within the Beijing power structure. Somewhat coincidentally, the Communist Party's Central Committee will convene in Beijing in October for their annual plenum to plot and steer the country's economic, political and social path. Anything that would make President Xi look weak or indecisive will benefit his detractors.

So, with this bit of history and introduction, let's revisit the question posed by this article. Is China the right place for offshore companies to make a significant investment today?

To answer this question I propose that we assume that the Hong Kong issue will be peacefully resolved. How that will actually happen is open to speculation. China has far more to lose by incorporating force to resolve this protest that it has to gain. A number of China experts feel that in the end, the protesters will gain some of their demands but probably, not all of them.

To address the primary question at hand, it's important to look at key parameters. Investments are generally made in areas that offer a good return and pose good growth opportunities. How does China stack up in this regard? Looking at the past few years (2000-2013) one thing is for certain, China's GDP growth has been unmatched by any other country (See GRAPH # 1, next page).

Most economist feel that the amazing growth in GDP achieved so far by China will start to slow down over the coming years. However, even with China slowing, its economy is still expanding at double the pace of America's. So growing at 7 percent literally means that the Chinese economy will double in size in the next ten years. Such growth would bring the Chinese economy to about the same size as America's is now. With the U.S. growing at only around 2-3 percent per annum (see GRAPH # 2), speculation as to when China takes the crown is gaining momentum daily. However, no one is picking an exact date for this to occur, not just yet. What ultimately matters more than absolute size is the income earned by the people within a country. And it will be many more years before per capita GDP in China will overtake that of the U.S. under any of these measures.

So, are foreign companies still investing in China? The short answer is "yes." According to the United Nations, annual Foreign Direct Investment (FDI) flows to China grew from $2 billion in 1985 to an estimated $121 billion in 2013 (see GRAPH #3), and may have actually reached $127 billion in 2013. The U.N. further estimates the stock of FDI in China through 2012 at $832.9 billion. This is a strong indicator of investors' confidence that the world's second-largest economy can keep growing at a solid pace while retooling its growth model.

As indicated in GRAPH #4, China was the world's second-largest destination for FDI flows in 2013 (after the United States). You might wonder where this FDI is coming from. Asian companies are by far the biggest investors in China, with investment from the top 10 economies in the region including Hong Kong, Thailand and Singapore rising annually by 7.1 percent in 2013 to $102.5 billion.

Investment from the European Union rose 18.1 percent year-on-year in 2013 to $7.2 billion, while investment from the United States climbed 7.1 percent to $3.4 billion.

China's service industries were the biggest draw for foreign investment, pulling in $50 billion, up about 14 percent. Not surprising, given rapidly rising labor and other costs, investment in manufacturing fell by 5.2 percent, to $38 billion, making up just over two-fifths of the total. Investment in agriculture, animal husbandry, and fishery businesses dropped by 2.6 percent, to $1.4 billion.

At the same time this FDI is coming into China, Chinese companies are expanding abroad. China's outbound direct investment by non-financial firms jumped 16.8 percent to $90.2 billion in 2013 versus 2012. This growth in external investment has experts predicting that China's outbound investment could exceed foreign direct investment in China sometime in the near future. GRAPH #5 displays China's investment history in the U.S.

When you look at the data, the history and forward looking estimates it appears that compared to other locations China is a reasonably safe place for foreign companies to invest. This is especially true for those companies involved in the Coatings industry (i.e. raw material or formulated coatings supplier). China has become the world's largest producer and consumer of coatings. As the paint, coatings, adhesives and sealants industries continue to grow in China, leading foreign companies will continue to invest heavily in this region.

However, it's fairly important to point out that China's leaders want to reduce the economy's reliance on foreign investment, while expanding household consumption, which now accounts for around 35 percent of the economy, about one-half the 70 percent rate in the U.S. Beijing wants to unlock the power of the middle class to consume. Unfortunately, there is still not a lot of evidence China is making that economic transition. Fixed asset investment, for example, still appears to be the main economic driver. The so called 'mini-stimulus,' which involved ramping up public spending on railway, energy and infrastructure projects, did in fact drive a sharp acceleration in steel output, and also supported cement and metals production. The central bank also eased monetary conditions. To most China observers it appears the Chinese government has reverted back to the old investment playbook. The consumer sector is important to the future of China, but today it's too small and growing too slowly to be a key driver of the broader economy. Looking ahead, the Key Issues in China for International Investors seem to be:

* Deregulation of Interest Rates

* Liberalization of the Currency

* Improving Market access for foreign companies

* Less tension between Beijing and various mainland sites (i.e. Hong Kong).

Bottom line, all financial investments contain an element of risk. Investing in China or any other foreign location simply adds more elements of risk that needs to be analyzed and managed accordingly. This writer still views China as an opportunity but not for the faint hearted.

Dan Watson, Contributing Writer

GRAPH #1
CHINA--% GDP BY YEAR

2000    8.4
2001    8.3
2002   10
2003   10.1
2004   11.3
2005   12.7
2006   14.2
2007    9.6
2008    9.2
2009   10.4
2010    9.2
2012    7.7
2013    7.7

Note: Table made from bar graph.
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Title Annotation:FEATURE: China Report
Author:Watson, Dan
Publication:Coatings World
Geographic Code:9CHIN
Date:Oct 1, 2014
Words:2298
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