Market outlook: China chemicals move from quantity to quality

06 September 2013 10:09  [Source: ICB]

As the country's economy becomes more diversified, demand for advanced materials will increase, creating opportunities for the chemicals industry

China now accounts for one-third of the global chemical market, with foreign companies accounting for nearly 30% of China's chemical sector. As China's growth shifts toward a more consumption-driven economic model, its chemical industry will likely grow quickly but also increase its value-added chemicals.

 

 As China's economy becomes more sophisticated, the chemical sector will also change

Copyright: Alamy

BOOMING CHINA CHEMICAL SECTOR
China is consolidating its position as the largest global chemical market, with industry output at yuan (CNY) 7.4tr ($1.23tr, €929bn) in 2012. China's share in the global chemical sector rose to 27% in 2012 from around 15% five years ago.

Although the chemical sector is growing quickly, it is criticised as being "big, but not yet strong". The chemical sector raced to expand capacity from a low base in the 1990s to meet demand amid rapid industrialisation as China became the world's factory floor. Clearly, the fast growth has come at the cost of imbalances, such as self-sufficiency or even overcapacity in quite a few intermediary products such as methanol, polyvinyl chloride (PVC), and normal grades of synthetic rubbers. Meanwhile, China still imports a large amount of value-added chemicals such as specialty resins and rubbers, engineering plastics and various fine chemicals.

In the next five to 10 years, the focus of the chemical industry will gradually shift from quantity-driven growth to more quality-driven growth. China is growing fast enough to support the development of a more efficient, greener and more attractive chemicals market, and this is especially applicable for the specialty chemicals sector.

DEMAND TRADE-UP
Since it provides inputs for nearly all other industries, the chemical sector's growth is entwined with China's overall development. Economic growth is bound to slow to 7-8% over the coming years, affecting the growth rates of many industries, including the chemicals sector. China's 12th Five-Year Plan, announced in 2011, is continuing the government's push since the mid-2000s to upgrade the economy away from export-driven growth that relies heavily on traditional industries and that capitalises on its labour-cost advantage. This offers a unique opportunity for the chemicals sector to trade up, increasing demand for higher-grade products.

China aims to have its seven strategic emerging industries (SEIs), announced in 2010, account for 8% of GDP by 2015 and 15% by 2020. All seven SEIs are meant to drive China's broader growth as a competitive economy, facilitating the upgrading of the chemicals sector. As the case of new materials - one of the seven SEIs - illustrates, there is strong demand within the SEIs, but so far China relies mainly on imports due to weak local supply.

TAILOR-MADE DISTRIBUTION SOLUTIONS
Reaching customers presents an on-going challenge. The immature chemicals distribution sector is crowded with many trading companies providing logistics and market access in a highly fragmented market. Some professional distribution companies providing more value-added services such as inventory management, technical support, repacking and labelling are still limited in scale in China.

A tailor-made distribution strategy is all the more crucial and should be driven by the value likely to be generated by the target customer base, available distribution partners and cost-efficiency. The typical approach of pushing small customers toward a distributor is inefficient. It is also important to have a carefully designed responsibility map outlining the strengths of distribution partners. It should be systematically tested in the market during the process of searching for distribution partners. Given the increasing needs of pre-sales and even joint product development in specialty chemicals, hybrids of distribution and in-house technical support are increasingly important.

INCREASING CHINESE COMPETITION
Traditionally, the strongest competition for foreign companies has been from state-owned enterprises that enjoyed government help in terms of market access, preferential policies, approvals and financial support. But new competitive forces are emerging as many private companies become leaders in their niche sectors. Typically, they have dedicated management teams, including founders with self-developed or upgraded technology and are strong in new product development and improvements in processes that achieve both quality and efficiency targets. Investment in research and development (R&D) is helping to drive their success, and the leading companies have invested 3-5% of their revenues in R&D. As such, they are also prepared to take more risks, and speed is one of their secret weapons.

Aramid fibre, a high value-added material used in many applications including fire-retardants, fibre strengthening and aeronautics, is an interesting case. Chinese companies took less than 10 years to replace imports of meta-aramid fibres, or aramid 1313, with local products. China still imports significant amounts of para-aramid, or aramid 1414, but Chinese companies are aggressively investing in R&D and might move quickly in the future given their close cooperation on product development.

POSITIVE FDI TREND
In the past 10 years, the chemicals sector has been a main target of foreign direct investment (FDI) in China. Overall, the amount of value per investment case has also increased over the years, demonstrating confidence in the potential for larger-scale operations in China. The investment portfolio covers not only intermediaries, but also various specialty chemicals, including those with pioneering technology.

The outlook for slower GDP growth might cloud investors' confidence in the short term. However, many chemical companies are confident about their medium- and long-term development in China. Many chemical companies with a footprint in China already earn 5-10% of their global revenue there, and this percentage is likely to increase at a much faster pace than in other global markets. Giants such as BASF, Bayer and DuPont have announced aggressive investment plans in both production and R&D. Medium-size companies are perhaps even more aggressive.

INCREASING M&A
As with other sectors, the chemicals industry will shift toward a broad consolidation process in the future. Macro-level issues such as overcapacity, fragmentation, low profitability and environmental and social pressures are driving the shift in China's economic growth model. Meanwhile, capital markets, listed companies and investors will help drive the consolidation process.

Over the past 10 years, inbound deals and greenfield chemical sector projects have a combined value of nearly CNY300bn. Of that total, 70-80% came from greenfield investments (including both wholly foreign-owned enterprises and joint ventures). The trend towards greenfield investment is partly due to a lack of suitable acquisition targets, but is also related to many large greenfield investments by multinationals such as BASF and Bayer, among others.

Given such high fragmentation, with over 30,000 companies in this sector, we anticipate increased mergers and acquisitions (M&A) activities in specialty chemicals. We expect that 20-30% of those 30,000 companies may disappear in the next five to 10 years. Foreign companies can step up acquisitions to accelerate their expansion, especially medium-sized companies with minimal or limited prior presence in China.

STRATEGIC IMPLICATIONS
Chemical companies must adapt to a more quality-driven, rather than quantity-driven, growth model in China in the next decade as they face more intense competition. China will remain the main global opportunity and its domestic demand will continue to grow, but the market will become more sophisticated and more demanding. Distribution will remain a key challenge and competition will not be limited to large state-owned monopolies, but will increasingly include privately owned, and intensely competitive, niche players. At the same time we expect that faster consolidation will offer many opportunities for expanding companies, while others might consider focusing on core businesses and disposing of non-profitable assets

The two traditional success factors in China, namely operational excellence and staff retention, will remain as relevant, if not more so, than in the past. Chemical companies also will have to refresh their understanding of the China market, continually reviewing their product portfolios while also upgrading their list of products and creating new products. Companies will need good customer relations, but also must understand that the needs of their customers' own customers offer significant opportunities for creating extra competitive advantages in this sophisticated demand structure. In distribution - one of the main problem areas - solutions will remain difficult. But at least some opportunities are opening up to rationalise and optimise distribution of products.

Lastly, consolidation is likely to change the dynamics of many subsectors within the chemicals industry and it will offer more opportunities for foreign companies to rapidly enter or expand through M&A, or to dispose of non-performing assets and focus on core business.

All things considered, the next 10 years will provide a world of opportunities in China's chemicals sector, but the way foreign companies approach the market is likely to change considerably. What worked in the past will not work in the future. Understanding this, and putting it into practice, will determine who will be successful in the next decade.

Simon Zhang a Chinese national, is managing director of InterChina Consulting's Strategy Practice and is based in the company's Shanghai office. He currently leads InterChina's Chemical Sector Group and its Clean Tech Sector Group. Email: Zhang.yi@InterChinaConsulting.com


Author: Simon Zhang



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