China: Challenges to Sustainable Growth and Business Implications

By January 22, 2016Uncategorized

By: Julia Mitusova

China has received a lot of media attention over slowing economic growth, the recent stock market crash and increasing concerns about challenges of doing business in China for foreign companies. So what are the business implications of the slowing economy for foreign investors? What can ensure economic growth in China and benefit investors in the long run?

  • Increasing production costs: A steady increase in labor costs over the past decade makes China less competitive as an outsource destination compared so Southeast Asian countries such as Vietnam and Indonesia, as well as US neighbor – Mexico. With manufacturing moving from China to Vietnam or Indonesia, where average wages for a factory worker are 3.5 times lower than in China closing production facilities lay offs are increasing.  Increased crime rates, strikes, and labor actions against employers are plausible.
  • Increasing security concerns: From a security perspective, the challenges China is currently facing such as economic slowdown, growing inequality and pollution affecting the quality of life, might result in growing public discontent. While protests in China are not happening on a large scale yet, social unrest due to factory lay offs is increasing. Unless social issues such as growing unemployment are addressed, crime rates are likely to increase and China could become a less safe place for foreign business. 
  • Decline in sales: China’s trade partners such as Brazil, Indonesia, Russia and Australia, among others are impacted by the decline in commodity demand in China. If this trend continues companies operating in the commodity trading and export business that have China as their main partner might want to consider expanding the geography of their business. 

Current Structural Challenges in China

Limited transparency, high debt and significant government intervention – all together are increasing turmoil in the markets in China.

Over the past few years the private sector in China accumulated significant amounts of debt due to low interest rates. While the official debt to GDP ratio in China is 41%, which is much lower than for example, the 103% ratio in the US, concerns arise in connection with the reliability of data provided by the Chinese government; and analysts believe that the real debt in China is significantly higher. Moreover, the Government owns the major banks and corporations in China, thus both lenders and borrowers are state owned.

In an environment where the state plays a dominant role in various areas of the economy and corporate transparency is limited, it becomes challenging to react adequately to market fluctuations. Thus, financial markets become volatile as investors make their decisions based on limited and sometimes unreliable market information.

For companies operating in China this means an increase in overall market risk and is a signal to protect investments, which explains $59 bn capital outflows from China in 2015.

Economic Growth in China and New Opportunities

A rapidly aging population is a growing concern for Asia as a whole and for China in particular. According to estimates, by 2050 35% of the Japanese, Hong Kong and South Korean population will be 65 and over, while this number for China will be around 24%. In 2015 the percentage of elderly people in these countries was 10.6% on average. With growing life expectancy figures and increasing numbers of retirees, the burden of an economically inactive population will have strong impacts on Asian economics. From the perspective of the financial sector, aging population means that long-term financial instruments will be shaping the Asian financial structure in the future.

Productivity which is measured by the total productivity factor (TPF) is also an important variable to follow in the context of China’s economic growth. The TPF measures the efficiency of labor and capital in a country. China’s growth since the 1990s has been primarily due to the increase of the work force size and growth of capital investment; according to estimates productivity increased by just 1.5% per year between 1997 and 2012. In the long term, low TPF levels won’t be sufficient to drive sustainable economic growth.

For companies operating in China, increasing capital efficiency and labor productivity by taking advantage of innovative technologies is critical, in order to remain competitive globally. While the slowing economy presents challenges, as China is shifting focus to increasing consumption, new opportunities will emerge in other sectors. For example, industries like entertainment, travel and education will continue to grow despite the general economic slowdown.

In the long run however economic growth in China will still require serious structural reforms. The world is waiting to see if China is up to the task.

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