China policy shifts could trigger a slide in the chemical sector

17 February 2011 00:00  [Source: ICB]

China's reforms could mean the doom mongers will finally be right, and chemicals will have to adjust to lower growth

Hu Jintao, Paramount Leader of the People's Reublic of China
Rex Features
TEN years ago, Gordon Chang published his book, The Coming Collapse of China, during a time of great economic uncertainty. Major reforms of state-owned enterprises (SOEs) were still taking place, resulting in hundreds of thousands of job losses, and the country was about to join the World Trade Organization (WTO).

The book was a little premature in its pessimism. In the past six years alone, for example, the size of China's economy, now worth $5.8trn (€4.3trn), has tripled, according to Beijing-based online research publication, China Economic Quarterly (CEQ).

But if you predict a disaster for long enough, you might eventually be right. And that could be the case with Chang and all the other China bears - even if it is for the wrong reasons.

A further reform stage is now underway through major policy shifts announced as part of the country's 12th Five-Year Plan (2011-2015). This time around, the bears could be right, but because of changes to China's export growth model rather than a restructuring of the SOEs.

"Since 2001, it has been basically a game fixed in China's favor," says a sales manager with a Southeast Asia-based plastics converter. "Cheap land, cheap energy and great tax concessions have created an unbeatably strong manufacturing industry, which is based heavily on exports."

"There will be a 'demand-growth gap.' As local-for-local sales of chemicals and plastics catch up with losses we are going to suffer from a slower expansion in exports"
Singapore-based sales executive for polyolefins producer 
Add to these advantages the continued flow of preferential loans to the SOEs from the state-owned banks and you end up with huge export-processing zones, such as the one at Daya Bay in Guangdong. A China National Offshore Oil Company (CNOOC) refinery and a CNOOC-Shell petrochemical complex are located next to finished-goods manufacturers.

Export-processing zones, such as the one at Daya Bay, have provided major support for petrochemical demand.

Large volumes of chemicals and plastics have been imported over the past decade for reexport as highly competitive finished goods. Some would say that exports have become unfairly competitive, with the greatest sensitivity around the value of the yuan versus the US dollar.

Growth is under threat as the Chinese government attempts to deal with what academics say are harmful distortions created by all the advantages loaded onto exporters.

Provincial governments have been able to acquire land for industrial development at or near zero cost, argues Yiping Huang, professor of economics at Peking University's China Center for Economic Research. In a paper he wrote in 2010 he says this has limited wealth growth for farmers, thereby holding back the growth in domestic consumption.

Land for new factories can be acquired at low or no cost because of a lack of clarity of land ownership under Chinese law, other economists have long argued.

Another big distortion is the environment. Because Chinese companies have been able to flout what are, arguably, already low environmental standards, their ability to produce cheap exports has been further boosted. According to the World Bank, China is home to 17 of the world's 20 most polluted cities.

The continued flow of preferential capital from state-owned banks to SOEs had left private companies struggling to obtain finance, added Huang in the same paper. Cheap loans had encouraged SOEs to add too much supply in certain industrial sectors, he said. Cheap energy is another distortion, with the economist claiming that SOEs have enjoyed preferential electricity tariffs, encouraging inefficiency and poor emissions standards.

Before the global economic crisis, China had begun to roll back support for the export sector by, for instance, reducing export-tax rebates. But rebates have since been restored and the biggest economic stimulus package of all time, launched in late 2008, led to an even greater flow of lending from the state-owned banks to the SOEs.

"Because the banks were suddenly flush with capital and were told to go out and lend by the government, the most established and, therefore, easiest route to get this money off their books was to lend in huge quantities to the SOEs," says a Beijing-based financial analyst. "The SOEs found that the easiest way to dispose of this money was in new industrial capacity, leading to some overcapacity."

The huge increase in lending has also contributed to rising property prices and a big rise in the general cost of living in major cities.

An anonymous email that went viral in December sums up the growing resentment of Beijingers who have been priced out of owning a home. The email calculates how long peasant farmers, blue-collar workers and prostitutes would have to work to afford a condo in the city. Assuming no natural disasters, a peasant farmer working an average plot of land would just be able to afford an apartment if they had been working continuously since the Tang Dynasty, which ended in 907 AD, estimates the email.

Another popular email describes the misery facing ordinary people in China's increasingly unequal society: "Can't afford to be born, because a Caesarean costs [yuan, CNY] 50,000 [$7,600]; can't afford to study because schools cost at least [CNY] 30,000; can't afford to live anywhere because each square meter is at least [CNY] 20,000; can't afford to get sick because pharmaceutical [costs] are [up] at least 10-fold; can't afford to die because cremation costs at least [CNY] 30,000."

The rise in the cost of living in China has set back the government's agenda of reducing dependence on exports and investment as drivers of GDP growth in favor of greater domestic consumption.

"I am part of the 'sandwich generation,'" says a young Shanghai office worker. "I am too rich to qualify for social housing, but too poor to afford a private home."

Steep rises in minimum wages in eastern and southern China during 2010 and the early weeks of this year show the government is striving to reduce inequality, say economists.

Energy costs have also been steadily increasing over the past two years, in parallel with an improvement in energy efficiency and environmental standards.

"Since 2001, it has been basically a game fixed in China's favor"
Southeast Asia-based plastics converter 

The country's chlor-alkali and vinyls industries are set to undergo major restructuring as a result of higher electricity costs and tougher emissions standards, according to Chemease, an ICIS service in China.

"The value of the yuan against the US dollar will also be gradually increased, which will further remove support from the export sector," adds the Beijing-based financial analyst, "but this will be at a pace that very much suits China."

The question that any chemical industry executive worth their salt has to ask is what impact this great policy will have on the speed of demand growth.

China's apparent demand (local output plus imports minus exports) for polyethylene (PE) rose from around 8m tonnes in 2004 to more than 16m tonnes last year, according to the Chemease service.

It is the same story for polypropylene (PP). Back in 2004, apparent demand was less than 10m tonnes, but by last year it had risen to close to 20m tonnes.

And apparent demand for purified terephthalic acid (PTA) has also soared from less than 15m tonnes in 2006 to approximately 20m tonnes in 2010.

Can these robust growth rates be sustained over the short and medium term as export growth slows?

"Domestic consumption of everything made from chemicals and plastics is booming in China - just look at auto sales," says a Singapore-based sales executive with a North American polyolefins producer. "But in my view, there will be a 'demand-growth gap.' As local-for-local sales of chemicals and plastics catch up with losses, we are going to suffer from a slower expansion in exports."

Recently released government forecasts for the 12th Five-Year Plan support this view.

GDP growth is expected by the government to be lower than the annual average of 11% during the 11th Five-Year Plan. CEQ is forecasting that economic expansion will moderate to around 8%/year.

Perhaps most significant of all, Beijing is predicting that annual export growth will average 10% between 2011 and 2015, down sharply from 27% per year in the five years before the global economic crisis.

Read John Richardson's Asian Chemical Connections blog

By: John Richardson
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