China
The Supply-Side Adjustment
 

By Qing Wang & Steven Zhang | Hong Kong

Industrial ‘Reinvigoration’ Plans

As the global recession deepens, the Chinese authorities have recently announced that plans to ‘reinvigorate’ key industrial sectors including steel, autos, shipbuilding, petrochemicals, textiles, non-ferrous metals, equipment manufacturing, IT, light industries, transportation and logistics would be implemented.

The primary purpose of these plans is to protect ‘advanced productive capacity’ in general and the market share of leading enterprises and brand names in particular. To this end, the Chinese government has vowed to adopt “a combination of well-coordinated measures, including intensifying the technological transformation of enterprises, promoting mergers and reorganizations, shutting down backward production facilities, developing major products, innovating major technologies, and apportioning key development projects” (cited from NDRC’s work report to NPC, March 5, 2009).

Boosting Demand versus Reducing Supply

In our view, the importance of these ‘reinvigoration plans’ appears not to have been fully appreciated by market observers. Perhaps in part being misled by the word ‘reinvigoration’, many market observers have typically associated these plans with the overall economic stimulus plan that aims to boost domestic demand with the objective of offsetting weakness in external demand and absorbing excess production capacity. We, however, interpret these ‘reinvigoration plans’ differently and believe that they are actually supply-side policy adjustments, the primary purpose of which is to effect a government-guided, orderly production capacity retrenchment. Here’s why:

First, the reinvigoration plans apply to almost all key sub-sectors of the manufacturing industry, ranging from upstream to downstream and heavy to light industries. To ‘reinvigorate’ such a wide range of industrial sectors by boosting demand is equivalent to boosting aggregate demand, in our view. However, the Chinese government has already had a separate domestic demand-boosting spending package in place featuring massive investment in infrastructure, affordable housing and so on. So, it is highly unlikely that the primary purpose of the reinvigoration plans is to support the relevant industries from the demand side, in our view.

Second, from the perspective of macroeconomic management, expansionary macroeconomic policies to boost demand are appropriate if the economic downturn is deemed cyclical and thus temporary. If, however, the negative demand shock is large and permanent, demand-boosting measures will only serve to perpetuate the inevitable production capacity retrenchment instead of helping to ‘iron out’ the short-term fluctuations, the conventional objective of discretionary macroeconomic management.

It has become increasingly clear that the negative shocks to the Chinese economy stemming from the current global recession are much more serious and lasting than those experienced during either the Asian Financial Crisis in 1997-98 or the global economic downturn in the aftermath of the internet bubble bursting in 2001-02. We believe that the Chinese authorities have by now appreciated the seriousness of the current crisis. In this context, the ‘reinvigoration plans’ are part of the authorities’ systematic effort to downsize the existing production capacity, as a complement to the demand-boosting measures, one purpose of which is to help buy time for this supply-side adjustment.

Third, we believe that the authorities’ recent adjustment of the spending composition under the original Rmb4 trillion stimulus plan signals a shift in the balance between demand-boosting and supply-reducing measures toward the latter. Compared with the original plan, the revised plan substantially reduces the spending on ‘hard’ infrastructure projects (e.g., railways, highways, airports, ports), which helps to absorb the excess production capacity of heavy industries and boosts the potential supply in the long run, and correspondingly increase its spending on ‘soft’ infrastructure such as medical, healthcare, cultural and education. Of particular note, the spending related to ‘innovative structural change projects’ has increased sharply, a substantial portion of which is earmarked for potential expenses related to sectoral consolidation amid the supply-side adjustment, in our view.

Implications

These plans – when implemented – are expected to create both winners and losers within the same industries and thus likely have profound market implications.

Chinese policymakers – like their Japanese and Korean counterparts – have traditionally given much credence to industrial policies whereby the bureaucrats play an important role in determining resource allocation and strategic development for various industries. The policymakers tend to rely on the ‘visible hands’ to accelerate supply-side adjustment which, in their view, may turn out to be a lengthy and ‘disorderly’ process if the job is left with the ‘invisible hands’ to handle.

In fact, industrial policies have always been an important part of Chinese macroeconomic management, and their purpose is to facilitate a supply-side adjustment, as a complement to conventional monetary and fiscal policy, which works from the demand side. The rationale behind this interventionist approach adopted by Chinese policymakers is that since China is still a developing country that is trying to catch up with the more advanced ones as fast as possible, the government should aggressively implement the policies that have been proven to be a success in other countries (e.g., Japan, Korea, Singapore) instead of adopting a laissez faire approach to allow the market mechanism to work on its own, which tends to be slow.

In practice, the effectiveness of industrial polices in facilitating supply-side adjustment is mixed. During booming years, when most industries are profitable, it becomes very difficult for the authorities to enforce the industrial policies. During downturns, when the profitability and survival of large SOEs are under threat, policymakers tend to be more determined and aggressive in carrying out these policies by forcing consolidation of the industry in general and closure of ‘smaller and inefficient producers’ in particular.

If history is a guide, large, state-controlled companies that have close relationships with and strong influence over policymakers tend to be the winners and will likely emerge stronger out of the supply-side adjustment. Reflecting the official intervention in the context of implementing industrial policies, the supply-side adjustment tends to take the form of exiting the industry by a number of small-scale, non-state-owned enterprises such that the overall industrial profit margins are protected.

The average annual growth rate of overall industrial profits during 2001-02 declined by about 40 percentage points from the peak level reached in 2000. The decline appears to have been mainly due to a slowdown in volume growth, while the profit margin squeeze was rather moderate.

What’s Next

Details of these sectoral ‘reinvigoration plans’ are expected to be released in the coming months. When announcing these ‘reinvigoration’ plans initially, the authorities already provided the general principles and broad elements of these plans. The plan for each sector typically consists of three broad categories of measures: i) boosting demand; ii) consolidating existing production capacity; and iii) upgrading production technology. We believe that production capacity retrenchment is the primary objective that will lead to concrete policy action.

Mergers and acquisitions in the context of industrial consolidation will likely pick up significantly in the near term. While this supply-side adjustment will likely depress investment in the short run, it should help to solidify the dominance of industry leaders in the longer run by protecting their profit margins and market shares.

Source: http://www.morganstanley.com/views/gef/archive/2009/20090313-Fri.html#anchor7568