As the New Year dawns, one of the biggest domestic issues facing China is the dense smog that hovers over its major cities most days. The country’s most serious international flash point is its ongoing dispute with Japan over ownership of a group of islands in the East China Sea, a dispute that now threatens to entangle other major powers. The country’s largest challenge is implementing a wide range of much needed economic, social and financial reforms, and the biggest development potential for both China and Chinese companies are the opportunities that would be unlocked by the implementation of those reforms.
China is at a crossroads, and the direction it takes has important implications for the country and the global economy. The following predictions provide our views as to the road ahead for China’s economy and the way in which we at Managing The Dragon (MTD) believe the country’s major issues will play out in the coming year.
Prediction #1: China’s Gross Domestic Product (GDP) will grow at between 7.4 and 7.6 percent in 2014.
The message has finally gotten through! China’s leadership has successfully put the country on a long-term, sustainable growth rate of from 7 to 8 percent per annum. For the first time in over three years, no one is predicting economic armageddon for China.
Even Nouriel Roubini, a professor at NYU’s Stern School of Business and a leading China bear, concedes that China will avoid a hard landing in 2014, and that the country’s economy will maintain an annual growth rate above 7 percent. Jack Bouroudjian, Chief Investment Officer at Index Financial Partners, goes even further, predicting a return to double digit growth. “I’m looking for 10 percent by the end of the year from China … With the U.S. dollar going up, look for exports out of China to start picking up,” he said in a recent CNBC interview.
Few economists will go that far out on a limb, but most analysts expect the government to maintain its target of 7.5 percent for GDP growth. Maintaining that growth rate will enable the economy to create jobs, while providing leaders room to deepen reforms. Meanwhile, some private economists like Stephen Green of Standard Chartered expect China’s economic growth to soften a bit to 7.4 percent, but do not see this as cause for concern.
China’s expected 7.6 percent GDP growth in 2013 represents the third consecutive year of a declining growth rate for the country’s economy, but last year was all about the leadership transition and planning for the 18th Central Committee’s Third Plenum meeting in November. This year will be about implementing the economic and structural reforms that will transform China into a healthier, consumption-driven economy.
For 2014, I will go with the consensus and predict that China will grow between 7.4 to 7.6 percent, with any surprises likely to be on the upside. Car sales, a good barometer for consumer sentiment, continued to grow at double digit rates in 2013, and sectors like heavy duty trucks and construction equipment that have been hard hit by China’s slowdown have shown surprising strength in recent months.
Prediction #2: 2014 will be the turning point in China’s battle with air pollution.
According to an old English proverb, necessity is the mother of invention, and there is no question that China is in dire need of a great deal of invention to get on the right side of its battle with air pollution.
Last year, China’s struggle with air quality came into sharp focus. Multinationals began having a difficult time keeping their expatriate managers in China, particularly those with children. There was even speculation that Beijing’s bad air had led Gary Locke, the outgoing U.S. ambassador to China, to leave his post after only two years and take his family back to Seattle. Although Ambassador Locke has denied the claim, the speculation illustrates how serious an issue air quality has become.
The scores of ordinary Chinese citizens who have used social media to harangue government officials on the subject indicate that bad air is not just a problem for foreigners. Although lung cancer cases among children are extremely rare, an eight-year-old girl has become China’s youngest lung cancer patient, with doctors blaming pollution as the direct cause of her illness. Lung cancer deaths in China have increased fourfold over the past 30 years, and cancer is now the leading cause of death in the country’s capital.
Not just Beijing residents are suffering, though. Harbin had PM 2.5 (airborne particles with a diameter of less than 2.5 microns) levels above 1000 in December, and Shanghai and other major cities have been hard hit as well. A hospital in Sichuan province announced in December that it has opened a special clinic for patients with symptoms related to smog. More than 100 patients with sore throats, runny noses and coughs were guided to the clinic within weeks of its establishment in early December.
Beijing announced its Air Pollution Prevention and Control Action Plan in September, which requires PM 2.5 to be reduced significantly in populated regions by 2017. The annual average of PM 2.5 in Beijing is required to drop to 60 by then. Achieving this goal will be expensive.
Wang Jinnan, deputy head of the Chinese Academy for Environmental Planning, said at a conference in Beijing that China needed to invest 1.75 trillion yuan ($290 billion) to clean up its air. According to Wang, 36.7 percent of the investment is needed to clean up industry; 28.2 percent is necessary to develop cleaner energy sources; and 12 percent is required for motor vehicles.
As Wang suggests, China’s battle with air pollution needs to be waged on many fronts. A recent article in the Chinese press said that 24 percent of the pollution in Beijing is caused by the sands that blow into the city from the desert; 22 percent from coal burning for heating; and 16 percent each is contributed by vehicle emissions, urban construction and industrial plants, respectively.
Air pollution in China is not limited to remote parts of the country, but rather severely impacts major cities like Beijing and Shanghai where the country’s government and corporate elite reside. Furthermore, the human and financial costs of air pollution are mounting each year that China delays taking serious action. Every long journey begins with a first step, and 2014 will be the year in which the government takes the first step and aggressively begins to address air quality.
Prediction #3: China’s ongoing dispute with Japan over the Diaoyu Islands in the East China Sea will increase in intensity during 2014 and threaten stability in the region.
China’s battle with Japan over the disputed islands is not getting any better, and both sides seem more dug in than ever. Moreover, the islands are a contentious issue in the foreign relations between Japan and the People’s Republic of China (China), as well as between Japan and the Republic of China on Taiwan (Taiwan). Japan does not officially recognize Taiwan as a sovereign state and does not acknowledge either China’s or Taiwan’s claims. Japan considers the islands to be part of Okinawa.
In November 2013, China raised the stakes when it declared that it had imposed an “air defense identification zone” over part of the East China Sea and the islands. The Chinese Defense Ministry warned that any noncommercial aircraft entering the zone would need to submit flight plans in advance and maintain radio contact with Chinese officials, or else face unspecified “defensive emergency measures.” The vast zone covers territory claimed by China, Japan, Taiwan and South Korea.
The U.S. has clearly given its support to Japan. U.S. Defense Secretary Chuck Hagel has assured his Japanese counterpart that the defense pact between the two nations covers the islands, and commended Tokyo “for exercising appropriate restraint.”
Meanwhile, the United States has visibly defied China’s demand by flying two unarmed B-52 bombers over the islands without informing Beijing. Japan’s main airlines have similarly ignored Chinese authorities while flying through the zone. Japanese airlines have stopped giving flight plans and other information to Chinese authorities upon request of the Japanese government.
Planes are flying; China’s national pride and “face” is at stake; Japan is not backing down; the U.S. is becoming involved; and no one is talking. Sounds like a nightmare scenario to me.
Prediction #4: China will begin to implement a wide range of economic, legal, and social reforms in 2014.
The Third Plenum meeting culminated in a sweeping 60-point blueprint for economic, social and legal reforms to launch China on the road toward President Xi Jinping’s dream of accomplishing the “great rejuvenation of the Chinese nation.”
Highlights of the reform package include the loosening of China’s one-child policy, the end of labor camps, a declaration that the market plays a “decisive function in resource allocation,” financial and fiscal reform, greater land rights for farmers, the reform of the “hukou” household registration system, and changes to the judicial system. The question now is: “How serious is China about implementing these reforms?”
Some reforms are already underway, but the financial markets are waiting to hear the specifics of those involving the economy and the financial markets. One area of particular interest for investors is the timetable for new initial public offerings (IPOs), which have been suspended since October 2012 due to concerns about the integrity of the IPO process. If IPOs resume in 2014, the backlog will include the 600 companies that have already filed, as well as an additional 800 companies that are expected to file.
China needs to develop robust capital markets in order to circulate the substantial amount of capital that has already been amassed in the country. Getting the right amount of capital to the right companies and entrepreneurs is necessary for the country to transition to a market-driven, consumption-led economy. Serious economic and financial reforms will begin in 2014.
Prediction #5: Cross border M&A, both inbound and outbound from China, will increase significantly in 2014.
This year may be an investment banker’s dream. Beyond the large natural resource and energy deals that have characterized China’s merger and acquisition (M&A) activity in recent years, inbound and outbound China deals in the industrial and consumer sectors may increase significantly in 2014.
Three forces will drive inbound deals. First, companies that already have a large presence in China realize they are underweight in their exposure to the country.
These companies have China experience and personnel, the financial and human resources to expand and are hunting for acquisitions to increase market share. Secondly, China’s consumer markets are growing rapidly, and acquisitions are one way for international companies to gain scale and distribution quickly. Finally, the lack of an IPO market for over a year has left Chinese private equity and owner entrepreneurs searching for alternative liquidity options.
As far as outbound acquisitions, the Chinese market is becoming increasingly competitive, and Chinese companies that acquire advanced technology will have a decided edge in the marketplace. Also, recovering economies in the U.S. and Europe have made these economies more attractive to enter. Finally, China’s State-Owned Assets Supervision and Administration Commission (SASAC) will now begin focusing more on profitability, not sales, in evaluating the performance of the state-owned enterprises (SOEs) that it supervises. This shift opens up the possibility of making minority investments as SOEs contemplate overseas deals.
In many cases, owners of overseas companies may be willing to take on a minority investment by a Chinese company, but may not be ready to sell the entire company. In other cases, an overseas acquisition may be too large for many Chinese companies to consider acquiring outright. With a need to have majority ownership and management control so that sales can be consolidated, the burden—and risks—of taking on the management of an overseas acquisition falls completely on the Chinese acquirer, and this has been a big deterrent for many cross border deals. If minority transactions are on the table, financial and management partners can be found to share the risk.
For these reasons and more, the dream of a large China M&A market may finally become a reality in 2014.