Andy Xie, responding to widespread commentary, asks the question as to whether FDI in China is likely to be significantly affected by the SARS epidemic and offers us, barring the worst, worst case scenario, a resounding no. He does, of course, note that the weaknesses in China's political system, and its inability to handle critical information do mid-term pose a different kind of threat.
China maintained its economic momentum in the first quarter. GDP rose by nearly 10% from last year versus 8% for 2002. Exports increased by 33.5% compared to 22.1% last year. Foreign direct investment (FDI) rose by 29.4% versus 12.5% for 2002. China is clearly reaping the benefits of its position as the factory for the world.
As multinational corporations shift their capital expenditure to China, this stimulates growth in the country through increased total investment and exports. In turn, this creates more employment and, hence, increased consumption and bank deposits. The government is able to mobilize the extra liquidity within the banking system to build infrastructure.
We anticipated that China’s economic cycle would peak out in the first quarter due to a higher base but would bottom at a relatively high level. The virtuous cycle described above should continue even in a sluggish global economy. We recently stressed downside risk to our near term outlook (see Downgrading Our GDP Forecast for SARS, April 2, 2003). A significant reduction in tourism and delayed FDI would cut this year’s growth and shift some to next year.
The market is now questioning whether China will be able to sustain current FDI levels in the long term. It is argued that the SARS outbreak demonstrates the need for multinational corporations to diversify their supply sources; too much concentration would increase their vulnerability. While this argument sounds plausible, it is unlikely to work, in our view.
The exceptionally strong FDI flows into China reflect competitive necessity rather than competitive advantage, in our view. The electronics manufacturing services (EMS) sector, for example, reflects this reality. EMS is leading the global capex relocation to China, and deflation in this sector is particularly pronounced. Lower stock markets have decreased businesses’ willingness to pay for these products. Producers that take advantage of China’s low production costs have been gaining market share by cutting prices. As long as prices are set by cost levels in China, it does not make economic sense for these companies to build up capacity elsewhere unless they find locations that have a cost structure to match China’s.
China’s costs are determined by internal competition rather than that with other countries. Surplus labor and high savings rate drive China’s internal cost structure. The competitiveness gap between China and other countries is widening rather than narrowing. Strong economic growth so far has not led to a rise in China’s labor costs relative to other countries. In fact, they are probably declining.
For example, 2.2 million graduates are likely to leave China’s university and college system this year, one-third more than the number of graduates last year. The astonishing fact is that the starting salary for university graduates is declining in nominal terms for an economy that is growing at nearly double-digit rates. This demonstrates how much labor China can bring into the economy all along the quality curve.
Capital supply is rising even faster. In the first quarter of this year, household savings deposits rose by 54% YoY. The nominal value of the increase was $92.5 billion (or 7.5% of 2002 GDP). Capital is more plentiful in China than probably anywhere else in the world. China offers part of its savings to multinational companies to supplement their investment in the country. Semiconductor production, for example, is highly capital intensive. Only in China can multinational companies get bank loans at single digit interest rates for such projects. How can capacity elsewhere compete?
Low labor or capital costs are not the sum of China’s cost competitiveness. The ability to apply the low cost structure up the value chain magnifies China’s competitiveness. For example, developing countries are supposed to import capital goods and export labor-intensive goods. China is actually producing an increasing amount of capital goods for its use while simultaneously remaining competitive in labor-intensive goods.
China has completed the construction of 5,000 km of expressways along the national grid. In comparison, Japan has 8,000 km of such roads in total and the US has about 85,000. Virtually all of the value added in this construction came from local suppliers. China adds capacity of about 18 gigawatt/hour of electricity production every year. China can afford this because it mostly uses domestic equipment. Thus, when multinational companies pay for non-labor costs, these also reflect China’s low labor costs.
The third element in China’s competitiveness is that its size allows foreign companies to explore economies of scale beyond what has been seen before. In China, normal economies of scale are unable to erect sufficient entry barriers to protect profitability. A number of light industries have scaled to a degree that has not been seen before, and it is now virtually impossible to replicate such scales outside of China for these businesses. As more industries start to explore the limits to economies of scale in China, this should lead to more deflation and make capacity outside of China less profitable.
The competitiveness gap between China and other exporting economies is widening. Productivity is rising rapidly in China. Labor surpluses and high savings rate are keeping down prices of capital and labor. The massive development of education is pushing cheap labor up the quality curve, and in my view China’s share in global capex will likely continue to rise over time.
The SARS outbreak is certainly likely to delay many FDI projects, leading to a slower economy this year. More importantly, the outbreak has exposed another risk to doing business in China. Decisions in China must be made by the top guy, who is usually the party secretary at the local government level. Everyone below him tries to anticipate his preference and behave accordingly. This culture, in my view, severely undermines China’s ability to respond to crises like SARS.
If China does not learn a broad lesson from this crisis and doesn’t try to modify its bureaucratic culture, there is a danger that some unforeseen event could cause a bigger crisis in the future. On the flip side, however, China could learn and adapt accordingly as it has done many times before.
Source: Morgan Stanley Global Economic Forum
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