Taking the Heat
Dutch electronics giant Philips contemplates its future in China's overheating economy.
By Abe de Ramos

In the midst of the battle the Chinese government is waging against its overheating economy, Leong Wai Leng stands unperturbed. Early last year, the CFO of Philips China offered an arresting forecast to her bosses in Amsterdam: that sales from its 34 units in the mainland would double by 2007. That would translate to over US$13 billion, which could make Philips the largest multinational in China. The projection, apparently, led to some contagious enthusiasm. CEO Gerard Kleisterlee flew to Beijing to meet with Premier Wen Jiabao, as business leaders do prior to announcing multimillion-dollar deals. Philips soon after unveiled a new subsidiary and announced plans to expand existing businesses in the mainland. Even as China braces for a feared hard landing, Leong sticks to her guns. "This number has been challenged," she says, "and accepted."

The approach is bold. Philips has committed to defying the law of gravity that even the Chinese government itself is trying hard to obey. Leong's projection assumes sales will grow an average of 15 percent every year. That's more than twice the GDP growth rate Beijing bureaucrats believe China must achieve to keep on creating jobs, and far beyond any figure they consider safe. The conventional wisdom is that China is bursting its seams, and since last September authorities have taken a series of steps to deflate the debt-funded bubble developing in some sectors. Many economists are still divided as to whether these measures can be effective, but they agree that the risk of a hard landing grows day by the day. The risk is affecting the market as a whole - China's and the world's.

More than in any other locale, China presents CFOs with ultimate accountability for their company's success or failure. Their recommendations - based on reams of economic data, a feeling for market sentiment, and, ideally, a knack for intelligent observation - will heavily influence how headquarters allocates capital in the world's most promising market. Making sense of the big, confusing picture in China calls for more than a routine balance of strategic planning, budgeting, and forecasting. CFOs must merge the analytical aplomb with a feel for how economic and political forces play out in markets over the long term. They must cultivate a wide variety of sources of information and be able to separate truth from moonshine.

Leong describes the process at Philips as "a consolidation of inputs" from all the company's China units - consumer electronics, semiconductors, lighting, medical systems, domestic appliances, and personal care. "The doubling of the number was decided from the bottom up, with each product division giving input as to how we could leapfrog and double numbers, either by acquisitions, entering new products, or new markets we're not currently competing in," she says. From there, Leong adds, the top brass in China, including herself, worked with Amsterdam to find synergies these divisions could share, from marketing to research and development to manufacturing.

The approach has worked so far. Sales of Philips China - two-thirds of which come from semiconductors and consumer electronics such as television sets and DVD players - grew 20 percent in the first quarter of the year from the same period last year. "From what I've seen, I think we're on target," Leong says with a smile of satisfaction. But while Philips may be, economists wonder if the same is true of China, whose planned economy is now on shaky ground. "We're growing increasingly concerned that our core forecast for a soft landing might prove to be too optimistic," says Desmond Supple, chief economist at Barclays Capital in Singapore.

Fly high, fall hard

A hard landing would occur if China's GDP growth falls significantly below 7 percent. At that rate - just below 9.1 percent in 2003 and 9.7 percent in the first quarter - Beijing thinks the economy would still be able to create jobs and absorb the influx of people from rural areas to the metropolis. As China clamps down on excessive bank lending and investments as a way to slow down its growth, worries have surfaced it could mishandle or overdo the task. Rob Subbaraman, economist at Lehman Brothers, who sees a 7.5 percent growth this year, says there is a one-in-four chance of a hard landing that would deal a severe blow to the fragile banking system. Rumors have been swirling that the central bank, People's Bank of China (PBOC), would raise interest rates for the first time in nine years, and pessimists think it would cut domestic demand.

Donald Hanna, chief Asia economist at Citigroup in Hong Kong, says the probability that China's tightening policies would slow the pace of investment excessively is very low, but admits that the risk is very real. "The risk arises because as all the government economic agencies exercise their muscles, there might be excessive control of investment activities," he says in a report. "As some local officials and bank managers begin to lose their jobs for failing to follow government policies, others may display extra caution in their work." As such, Hanna adds, China must not lose sight of the specific industries on which it must focus its tightening policies.

The impact of a hard landing could be chilling for China's unemployment situation: a cumulative loss of 15 million jobs through 2006, Hanna estimates. China already has a 24-year high urban jobless rate of 4.3 percent. Adding urban workers laid off from state firms brings the figure to 8 percent, according to Supple. Eventually, the number of unemployed would undermine domestic consumption and almost certainly lead to deflation - never a good prospect for companies that rely on both business and consumer demand like Philips. "The impact on consumption would be milder, mainly through an income effect created by lower inflation, but it could be more persistent," says Hanna. "Consumption would continue to diverge from base-case levels until 2008. Deflationary pressure would also escalate over time."

What could avert this trend? China can offset its investment-tightening policies by encouraging consumption. "As investment weakens, we expect more measures to boost consumption - such as encouraging private home ownership and consumer credit, strengthening the social welfare, and raising rural incomes - to cushion the impact on GDP," says Subbaraman. "China's leaders are very sensitive to the risk of social unrest, so they can be expected to do all in their power to avoid a hard landing." So far, says Supple, "private consumption continues to expand broadly with national income," as retail sales saw an average 9 percent rise in 2003, and 9.3 percent in the first quarter of 2004.

Selective Dissonance

That's good news for Leong, who is convinced that Philips would not be affected badly by a hard landing in spite of popular opinion. The CFO weighs most of the arguments that fall on her desk and takes analyses that do not come from the mainland with a huge grain of salt. Leong does not buy into the idea of a hard landing in general, and that domestic consumption would deteriorate in particular. To be sure, she has strong insights of her own, having been a commercial banker with Citigroup and JPMorgan in Singapore for ten years before joining Philips in 1998. And although she has only been in China for four years, it probably helps that she has good guanxi in the PBOC, which is engineering the lending activities of the local banks.

For one, Leong does not foresee excessive tightening as described by Hanna; the Chinese government acts in a far more coordinated way, she argues. "They're not going to have a blanket policy, whereby you raise interest rates or have a major revaluation of the renminbi across the board," she says. "It's going to be on an industry-by-industry basis, and for those where there is clear overheating, the central government, together with the municipal governments and the relevant ministries, will take concerted efforts to target them." Indeed, argues Marvin Wong, analyst at Merrill Lynch in Hong Kong, the recent increase in capital requirements - to 40 percent for property projects and at least 35 percent for steel, aluminum, and cement projects - are nearly the same as raising borrowing rates for companies in these sectors.

Even if the borrowing rate goes up across the board - the PBOC currently puts it at 5.3 percent - Leong says demand would remain stable. For one, China continues to have one of the highest savings rates in the world, and as more middle-income Chinese - the kind who would buy Philips products - aspire for a higher standard of living, they could easily dig into their savings to buy what they need. "The growth in disposable income for urban areas has been extremely high, and with the high savings rate, I think it would take a huge rise in interest rates before disposable income and individual consumption in these urban areas are affected," she says.

Her verdict: domestic consumption in China "will continue to be healthy in the next three to five years", and if there is any price erosion, it would largely be due to the fast cycle of replacing technologies, and the stiff competition. These, Leong have taken as fact. Philips' comfortable market share in all the products it sells in China (its lowest is eighth, in televisions) are currently being shaken, not by other foreign brands, but by local ones that are competing less on price, but more on features. High Stakes and Miscalculations

On the revaluation of the yuan - the argument for which is weakening due to China's soaring trade deficit - Leong did not let the prognoses coming from outside China sway her decisions when she was making her own forecasts for Philips. Investment houses such as Merrill Lynch and Goldman Sachs predicted the renminbi to appreciate by at least 10 percent against the US dollar by year-end. That would make Philips' new investments in China more expensive. That capital would come not from its surplus funds in China, which Leong says she couldn't use because company policy is not to mix finances of subsidiaries. Amsterdam would need to put in fresh funds. A revalued yuan would also make the cost of hedging against foreign-exchange fluctuations more costly.

Leong entertains these as theories, and nothing more. "Outside analysts' estimates are reflected in the non-deliverable forwards markets for the USD/RMB offshore," she says. "We think the onshore view of less than 3 percent, if it happens at all, will probably hold true. Foreign exchange in China is not purely about economics, it's also about political stability."

Leong had better hope that her judgment is on the money, for much is already at stake. Since setting the revenue target, Philips last July announced it was boosting the capacity of its joint-venture semiconductor manufacturing plant in Shanghai with a new US$687 million production line. The new line is expected to produce 30,000 chips a month. In November, it set up a joint venture in Jilin city to develop and manufacture chips used to control electrical voltages for a range of electronics and appliances. These moves reflect the risk Philips is willing to take in China's consumer market, as the bulk of the semiconductors it makes end up in consumer gadgets such as mobile phones.

By the end of June, Philips is also expected to formalize its latest joint venture, with Neusoft Digital Medical, which would manufacture mid-range medical-imaging systems, a US$1.2 billion market in China that is growing at 10 percent a year. The joint venture embodies Philips' ambition, as it expects to generate annual revenues of US$400 million by 2009. That would give the venture a 20 percent share in the market, if current growth rates are applied, and a platform to compete with current leaders General Electric and Siemens.

Philips' expansion plans in China go beyond selling to a market of 1.3 billion people. In fact, they are crucial to the restructuring of its global operations. Following a restructuring program initiated three years ago, the Dutch company has been moving many of its small production facilities scattered globally to China in a bid to leverage on scale and generate cost savings. CEO Kleisterlee has said that productivity per labor cost was five times higher in China than in Europe (versus three times higher in India - another strategic location). Moreover, Philips has been building up its R&D presence in China to develop products not just for the local market but for global rollout as well. Leong says plans are also afoot to "better use China for sourcing of raw materials for Philips' other factories overseas."

The wages of growth

For Leong, the risks that these investments face are not so much the consequences of a hard or soft landing, but the rising cost of doing business in China, a result of the rapid economic growth the country has seen in recent years. Her foremost concern: the rising cost of skilled labor, which Philips finds it needs more as some of its low-end manufacturing is outsourced. "Particularly in the big cities, indirect labor costs are going up - your finance folks, your human resources managers, your engineers, your purchasing managers," she says. Their salaries have gone up "tremendously", she says, estimating an average of 7 to 8 percent a year. "And you will see that they will continue to rise, because of the shortage of trained and experienced people."

The impact on Philips, to be sure, will be substantial. "I see [the rising salary levels] very strongly in the semiconductor sector, with more firms developing and demanding higher levels of technology and managerial skills," says Hans Kothius, executive compensation leader for Greater China at Watson Wyatt in Hong Kong. Although not a new phenomenon, it was accentuated in the last 18 months, he says, as local companies, who were used to a flat pay structure, adopted market-driven practices.

Particularly rare are managers who have had some form of international experience. "It's safe to say that there is not enough supply of people in China who can manage and focus on efficiency, productivity, cost control, and bottom line," says Kothius. Also a threat to Philips' sourcing strategy is the reduction of value-added tax refund, which effectively reduced the refunds on exports by four percentage points across a handful of sectors, and most adversely affected companies in light manufacturing industries such as electrical appliances, according to accounting firm Deloitte & Touche. The move also has the effect of making sourcing of raw materials from China - for goods that are for export - more expensive. "The regulation basically means that you should try to source for your raw materials from outside China rather than locally, which doesn't quite make sense," says Leong.

Leong's interpretation is that China imposed the measure to indirectly address its bloated foreign exchange reserves. "By buying overseas, you would then convert more RMB into US dollars, so that would reduce the foreign reserves and reduce the pressure from the US, which is lobbying very hard for China to revalue its currency," she says. It's a bilateral issue that squeezes businesses in between. Says Russell Brown, managing partner at accountancy firm Lehman Brown in Beijing: "For companies like Philips, which pay VAT here and on goods arriving on the next destination, if they (get less refunds) it would affect their margins or increase their pricing on the next destination."

Another concern is the stability of power supply in China. The summer of last year saw a massive shortage of electricity that resulted in rationing, which continues to this day and should get worse this summer. A CFO of a foreign-invested company has said they needed to shut down a plant every four days; for the CFO of another company, every Sunday. Philips, which has cumulative investment of US$2.6 billion in China, has yet to suffer. But Leong wonders how long they will be spared. "We'll definitely look into the situation when we're bringing in new investments."

Philips isn't alone in facing these concerns. The difference lies in the level of optimism - based in large part on Leong's own reading of China's medium- and long-term economic prospects. In the end, she sees a success story - for Philips and for China. No wonder she's smiling.