FEELING THE HEAT
With concerns mounting over China's red-hot economy, the risks for companies doing business there need careful attention
By Justin Wood

Like hundreds of other CFOs in Asia, Oh Se Kang has spent a good part of this year assessing the merits of a new investment in China. In particular, he's looked at whether or not to build a US$300 million paper mill in Hebei province, 280km southwest of Beijing, to feed the local market with newsprint. Oh's analysis was exhaustive but, in the end, positive. On September 10, his firm, Singapore-based Pan Asia Paper, decided to go ahead. When the plant opens in late 2005, it will make the company the biggest producer of newsprint in China.

The business case behind the investment is simple, says Oh. Once upon a time daily papers in China were little more than drab pamphlets of government propaganda, but economic development has changed all that. A sophisticated and literate urban population has emerged with money to spend, and China's state-controlled media has evolved to meet their tastes. Circulation figures and advertising revenues have risen hand-in-hand and the demand for newsprint has soared - from 1.2 million tonnes in 1998 to nearly 2 million tonnes this year.

As Oh sees it, there's no slowdown in sight. "We expect growth to continue at 8 percent a year," he enthuses. By 2008, when Beijing hosts the summer Olympics, Oh calculates that annual demand for newsprint will reach 3 million tonnes.

Inevitably, though, investing today in expectation of future demand creates risk. "The new mill will give overcapacity in our sector in the short-term," concedes Oh, "but our industry is highly capital-intensive so we have to think and plan for the long-term. We're confident demand will rise quickly and absorb the new capacity." The danger is that it doesn't. If growth fails to materialize then short-term overcapacity all too quickly becomes long-term overcapacity. Price wars kick in and margins sink through the floor.

In China some observers reckon these dangers are already starting to get serious. In sectors ranging from steel, aluminum and cement to cars, chemicals, property and textiles, a growing band of experts claim that China is suffering over-investment on a giant scale. Industrial capacity, they say, is dramatically outpacing demand and it could all end badly as the economy first overheats and then melts down. For companies like Pan Asia Paper, trying to gauge the dangers of an overheating economy is far from easy. In Oh's opinion the risks are small, but not everyone agrees. For those who miscalculate, the consequences could be disastrous..

Over the Speed Limit

CFOs certainly seem concerned. In late September CFO Asia polled 66 finance chiefs with operations in China to hear their views on the state of the economy. Worryingly, 50 percent say they are concerned that the economy is starting to overheat, while a further 10 per cent say they are "very worried". In light of these concerns, 10 percent of respondents say they're postponing investment decisions, while 20 percent say they're downgrading growth forecasts for existing projects.

Of course, nobody disputes that the Chinese economy is expanding at a phenomenal rate. According to government figures, for the past ten years annual GDP growth has rarely dipped below 8 percent. So far so good, but look under the bonnet of China's economy, say a growing band of economists, and the engine of China's growth isn't as healthy as it seems. That's because much of the growth is being driven by fixed asset investment (FAI) - the construction of new aluminum smelters, car factories and fridge assembly lines - rather than by consumer demand. Foreign investors have played a part in jacking up FAI, but more important is the state itself. These days, it seems, every one of China's 31 provinces wants to outshine the others by developing its own steel mill, chip plant, and textile industry, so giving rise to serious duplication across the country.

Eddie Wong, chief Asian strategist at ABN Amro, says FAI grew by 16 percent in 2002 to account for more than 42 percent of China's GDP. This year, he says, FAI is growing at an even sharper clip and will account for more than half of China's GDP next year. "The market grossly underestimates China's over-investment problem," says Wong. "More and more capacity is going on stream while consumer demand isn't rising fast enough to soak up the additional capacity."

Some market-watchers have pointed to the fact that inflation in China remains close to zero percent as proof that the economy is far from overheating. However, says Wong, such views fail to grasp the nature of an investment-driven boom rather than one led by consumer spending. Overcapacity tends to produce deflation.

Take the car sector. A report released in September by consultancy KPMG shows that the number of passenger cars produced in China this year will be twice as many as the market can absorb. The result: between January to June, car prices fell by 7 percent. By 2005, KPMG predicts that overcapacity will account for "a staggering 90 percent of forecast sales".

In CFO Asia's survey of overheating risk, the views of finance executives in China confirm the presence of massive overcapacity. Thirty per cent of respondents believe their own sector suffers from over-investment, while a similar number level the same charge at the wider economy.

Needless to say, in the short-term, over-investment makes for the appearance of healthy growth as banks and investors flood the economy with money. According to the People's Bank of China (PBoC), the country's central bank, the amount of money sloshing around the economy grew by an astounding 21.6 percent year-on-year to the end of August, while local renminbi loans were up 23.9 percent on a year earlier - largely as state banks sought to reduce non-performing loan ratios by stuffing their loan books with new deals. Inevitably, however, a house of cards such as this is unsustainable. Sooner or later overcapacity kicks in, investments fail to generate their expected returns, loans turn sour and the economy stalls.

Trouble-shooting

For its part, the PBoC has recognised that the economy could be in trouble. "All government departments' agreed that money supply is growing too quickly," the bank said in a statement in August. In a bid to curb the growth of credit and rein in the economy, the PBoC has taken several measures. For one it's tried to suck money out of the market by issuing a series of short-term bonds. For another, in September it raised the reserve requirement ratio - the amount of money banks must keep with the PBoC - from 6 percent of deposits to 7 percent. And as of last month, the China Banking Regulatory Commission began on-site inspections of the four big state-owned banks in a bid to cool down reckless lending to certain hot sectors such as real estate.

Higher interest rates could also follow, although such steps are less effective in China at cooling economic activity than in other countries because of the fledgling state of the local money markets. In any case, raising interest rates would hurt consumer spending and the PBoC is most interested in slowing industrial investment.

To some observers, the PBoC is acting in good time to avert a crisis. Jun Ma, senior economist for greater China at Deutsche Bank, is confident. "The economy is showing signs of overheating, but mostly it's limited to certain sectors," notes Ma. "We won't see a return to the boom and bust of the late 1980s and early 1990s," he predicts.

Other observers, however, are less optimistic. At ABN Amro, Wong thinks the government response will prove to be too little too late. "The market is looking for fine-tuning but this is wishful thinking," he stresses. "The severity of the problem is already well beyond what fine-tuning can solve." The best that can be hoped for, adds Wong, is that the government can engineer a hard landing rather than a crash. Growth won't disappear but it could drop substantially from current levels as the economy works through its excesses."

Don't Believe the Hype

So how should CFOs react? Robin Bew, chief economist of the Economist Intelligence Unit - part of the same group that owns CFO Asia - cautions potential investors in China to employ good old-fashioned financial sense. "Don't get caught up in the bullishness of the economy," he warns."I suspect that a lot of companies are failing to do their due diligence properly."

That view chimes with stories floating around the market. Ng Wai Lun, CFO of the China operations of AstraZeneca, an Anglo-Swedish drug group, says he often hears of cases in which local managers of multinational companies in China are "bullied by their bosses back in Europe and the US" to be overly aggressive about sales forecasts and to build operations that are too large. "China is the big growth story today and everyone wants a piece of it," sighs Ng. The unavoidable result, he adds, is "overcapacity, missed targets, and painful periods of restructuring."

Even in the pharmaceutical sector Ng says he's seen investment rising faster than demand. Still, that doesn't worry him too much, for Ng believes he has a strategy to combat the effects of overcapacity. "Never compete on price, or you'll end up in big trouble," he says. "We want to compete on things like the quality of our research and development, better technology, and superior drugs."

But there are no hard-and-fast rules when it comes to battling with overcapacity. In the auto sector, different strategies apply, says Wang Jai Pu, CFO of Shanghai-based Torch Investment. Wang's firm specializes in investing in China's vehicle market, a sector he concedes suffers from chronic overcapacity.

Nonetheless, Wang is confident that Torch will make money. The key? First get the strategy right, then go all out for size to kill off the competition. For example, Wang has identified the manufacture of heavy truck parts as a seam of rich profits in an otherwise barren market and is investing in firms he believes have the capability to dominate their niche.

"Smaller players will never make money in this sector," observes Wang. "To be profitable you need to be the number one or two player." Within the next five years, he expects hundreds of smaller firms to fall by the wayside as they succumb to the pressures of dealing with overcapacity.

Another company battling its way into the Middle Kingdom is Singapore-based CapitaLand, a property group that derives 10 percent of its US$1.9 billion in annual turnover from China. Pundits have long claimed that the real estate market is one of the most overheated sectors in the country, but that hasn't held back CapitaLand. The key to managing the risk of overheating, says Boaz Boon, vice president of research at CapitaLand, is to understand the market and to be choosy. While Boon admits that much of the property sector in cities such as Shanghai and Beijing looks dangerously bubble-like, it's still possible to identify profitable niches.

"You need to break the market down into segments," he explains. In Shanghai, for example, CapitaLand is aiming to develop apartments that cost between Rmb7,000 (US$854) and Rmb14,000 per square metre. Apartments above this band, says Boon, have experienced over-development thanks to speculation by foreign investors and the market looks precarious. Flats beneath this band serve the working classes - those most likely to suffer if the government moves to limit mortgage lending in order to cool the property sector. Only the band serving China's new middle class is capable of sustaining the impact of an overheating economy.

Risk Management

Operationally there's much that companies can do too. Given that events could well take a turn for the worse further down the road, finance chiefs in China would do well to re-examine the management of their receivables. Time put in today to review credit terms for customers - especially those in potentially risky sectors - could save much future heart-ache. CFO Asia's survey suggests that finance managers are taking such advice seriously: 58 percent say they have tightened their credit and collections policies in light of current overheating risks.

More immediately, the prospect of shortages could present major risks. Electricity is a good example. While much of the rest of the economy is experiencing over-investment, the power sector suffers from undercapacity. And yet, China's rapid development has seen demand for electricity sky-rocket, especially thanks to the growth of industries such as aluminum and steel, and to the proliferation of cheap air-conditioners. The problem came to a head this summer as whole swathes of China were plagued with blackouts. Power rationing was instituted in many provinces and some businesses had to close for several weeks. The government is working hard to build new power stations but experts reckon the problem will take several years to fix and the situation is likely to worsen before it improves.

Another concern is staff shortages. Iqbal Jumabhoy, CFO of East Asiatic Company, a Danish firm that produces food and industrial ingredients, says he finds it ever harder to hire good quality managers locally and now generally ships in all his senior staff from abroad. He's also experienced logistical troubles as China's transport network has become snarled up with growth. Other sources confirm his concerns - tales of expressways jammed solid with trucks are rife, and the country's rail system is notoriously outdated. Fully 90 percent of respondents to CFO Asia's survey of China report that logistics capabilities are failing to keep pace with economic growth.

Overall, though, Jumabhoy is confident that China will remain a good growth story. "The risks of overheating are serious," he says, "but I think the government has the ability to manage them." Pan Asia Paper's Oh - and hundreds of CFOs like him - are counting on it.

Justin Wood is managing editor of CFO Asia