China’s transition from economic miracle to a normal development, triggered primarily by a rapid rise in factor costs, could send manufacturers packing.
Three important factors that used to support Chinese growth during the past decades – vast labour supply, low production costs and rapid export expansion – are all diminishing rapidly, according to Barclays in a research report released on January 7.
Although the bank is somewhat confident that the change in China’s development pattern or growth model is already taking place, it is less sure that the mainland can avoid the so-called ‘middle income trap’.
“During the past few years, we have witnessed rapid increases in labour costs across the country. We call it the first wave of cost shocks,” said Yiping Huang, chief economist for emerging Asia at Barclays. “It already has had a large impact on labour-intensive manufacturing companies in China’s coastal provinces, and companies are either moving to the west or overseas, moving up the industrial ladder or packing up altogether.”
These companies – either privately owned or foreign owned – have just started to see a second wave of the ‘cost shock’, which is the adjustment of financing costs, notes Barclays.
For example, Hong Kong-based yarn trader Addchance Holdings, plans to shift its manufacturing operations from China to Cambodia due to the Southeast Asian nation’s tax advantages and lower costs.
Although the People’s Bank of China (PBoC) is moving gradually towards market-based interest rates, the rapid growth of non-loan financing is already affecting the structure and cost of funding substantially.
Bank loans used to account for 80% or more of total social financing. In recent quarters, however, this proportion fell below 50%, according to the bank.
Additionally, some investors have recently become concerned about financial risks associated with the shadow banking business, illustrated by the recent default of a wealth management product sold by a branch of Huaxia Bank.
As a result, rising funding costs could have an immediate impact on industries. Funding costs for wealth management products for instance are at least three to five percentage points higher than bank loans.
“Using this type of financing is likely to further squeeze corporate profits, supporting our base case that the recent deterioration of profitability is both temporary and permanent,” said Huang.
In addition to the deterioration of profitability, the other types of changes that the Chinese economy is expected to experience the increase in financial risks and a consolidation of major industries highlights Barclays.
As a result, adjustments to financing costs are likely to reveal misallocated capital in the economy, especially if the PBoC accelerates paces of interest rate liberalisation.
“The heavy industry and chemical sectors, which grew rapidly during the 2000s, will likely be subject to serious restructuring because they are capital intensive and highly leveraged,” said Huang. “However, these companies are also state-owned in most cases, and some investors believe the government would support these companies even if they turn into loss-making enterprises. We disagree. Experience from the late 1990s suggests that if SOEs (state-owned enterprises) become unprofitable, they might be let go relatively quickly.”