Thursday, April 4, 2013

China's Breakout: McKinsey's Thoughts

McKinsey partner Gordon Orr has written a piece for the McKinsey Quarterly on issues for the Chinese economy in 2013. We recently posted on Ruchir Sharma's "Breakout Nations," which has a longer-run perspective about emerging markets, but Orr's article tangentially touches some issues of longer-run concern.

In the short run, McKinsey expects Chinese banks to underperform. As a result of the post-2009 economic stimulus and programs in prior years, the Chinese banking system has a a large volume of underperforming loans which need resolution.  As the banks looked for new income streams, they sold wealth management products to well-heeled customers and small savers.  These products, McKinsey says, have to right-sized on bank balance sheets.  The net effect, McKinsey says, is that the system will need 1.3 trillion renminbi ($208 billion) in new capital within the next five years.

Even if this problem comes to light in 2013, its resolution will take years, and the initial extent of the banking system's problems should prove, as in the case of every other other national banking crisis, to be understated.

China consumes 50% of all pork produced globally, and its internal food production, storage and distribution system is already pushed beyond its limits. Pork and chicken prices have risen 100%.  In July 2011, prices rose by 57% year-over-year driven by herd thinning due to high grain prices and by disease.  Foreign imports can't fill the gap, especially because of an "extremely rudimentary cold supply chain."  If the Chinese government wants to see a shift towards consumption, shortages of consumer electronics will not be the issue, but shortages of food and packaged food products may very well be the Achilles heel.

Local protests are said to be rising in frequency and intensity, McKinsey says.  The government is reluctant to begin visible clampdowns in a Twitter and SnapChat-filled communications world.  There is, the author says, a growing resistance to building more pollution-generating projects like mining and chemical ventures in the countryside.

As the push for infrastructure spending increases, the issue of capital efficiency will come to the fore.  Efficient use of capital, some research has shown, is a key for countries to breakout from emerging market status to that of a developed economy.  Chinese capital utilization has been splashy and visible, but not necessarily efficient.

Online retailing may turn traditional Chinese store retailing on its ear.  A particular model being used by Chinese-American entrepreneurs in the U.S. may work very well in China.  The model produces frequently changing designs of consumer textile products on small runs, which encourages new orders and established customers to frequently check the offerings.  If this model were exported to China where labor rates are lower, it might work.  The point is that traditional big box retailing might not have a future in China apart from the super-cities.

Middle class parents are said to be hedging their bets by enrolling their young students in foreign boarding schools, as their parents also acquire property in these countries, from Switzerland to the United States.

Foreign investors, McKinsey says, are increasing their investment in the Chinese Super League, as football club prices in England's Premier League are at relatively stratospheric levels for the top clubs.  This would be a good sign and a potentially good way for foreign investors to indirectly play the rise in consumer income and wealth.  It remains to be seen how, and if, foreign investors can make money and achieve liquidity.

China is increasingly looking to take stakes in foreign agriculture, as it is already the second largest importer of rice and barley, and among the top ten importers of corn.  The country already leases hundreds of thousands of hectares of crop land from Australia to Kazakhstan for growing soybeans. Moving large volumes of grains, seeds and oils is probably one factor in the interesting venture recently announced among Cargill, private equity and Chinese shipbuilders.

Smart, agile traders will have some money making opportunities in the next few years as the Chinese economy adjusts to longstanding imbalances and begins a different stage in its economic development.

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