All the numbers that have come out of China in the past few weeks – whether they relate to GDP growth, corporate earnings, or the health of the manufacturing sector – add up to the same conclusion: the Chinese economic machine is slowing. And it is happening faster than most China watchers expected.
The headline figure is GDP growth, which fell in the third quarter of calendar 2008 to 9%, its lowest since since 2003 and a steep decline from the second quarter of last year when it peaked at 12.6%. And diminishing demand for China's exports was not the only factor to blame. In the domestic economy, there has been less investment in property, which in turn has affected other key sectors such as commodities, utilities, and construction.
GDP may be the number that grabs the most attention, but the earnings reports for the same period compound the picture of slow growth.
According to data provided by J.P. Morgan, third-quarter earnings growth for 1,005 companies listed in Shanghai or Shenzhen that had reported by October 28 dropped by an average of 20.8% year-on-year.
With a global financial storm in full force, earnings in the banking sector have attracted particular attention.
“While most banks still achieved very strong year-on-year profit growth for the first nine months in 2008, the third quarter alone has seen significant profit growth slowdown," says Frank Gong, J.P. Morgan’s head of China research. "On a sequential basis, profits in aggregate for the nine banks were down 9% quarter-on-quarter, modestly below our expectation."
Industrial and Commercial Bank of China (ICBC) reported third-quarter earnings that were down 10% quarter-on-quarter. The decline was largely the result of a decrease in its net interest margin and losses on investments, such as exposure to Lehman Brothers and collateralised debt obligations (CDOs), that exceeded expectations. China Construction Bank's earnings were down 4% quarter-on-quarter.
The pain is being felt across most sectors and especially by companies involved in commodities. The net profit of China's largest copper company, Jiangxi Copper, fell 26.9% in the third quarter versus the same period in 2007 due to huge drops in the price of copper. Meanwhile, Aluminum Corporation of China (Chinalco) reported that its net profit was down by a whopping 92% in the third quarter compared to the year prior. Other sectors to be badly hit are property and machinery manufacturing.
The energy sector – including oil, gas, and coal – was the only sector to provide good news in the form of margin expansion, according to a recent report by CLSA. “Thanks to falling oil prices and a 10% rise in wholesale prices of diesel and gasoline since July, margins of refiners recovered from the lowest level in the second quarter. Although coal prices softened during the quarter, the average price was still robust and miners managed to push their margins to a new high,” the report says.
PetroChina, China's largest oil and gas producer, and Sinopec, the largest petroleum and petrochemicals company, both beat expectations with their results.
Growth, which for years has been the main attraction of China to investors, is becoming a less important characteristic. “The next two years is going to be more a story of balance sheet, not earnings," says Nicholas Yeo, investment manager at Aberdeen Asset Management. "The focus will be on companies with enough cash to weather the storm."
The other economic indicator that has raised eyebrows is the Purchasing Managers Index (PMI), which consists of factors such as inventory levels, employment, deliveries from suppliers and new orders. A score above 50% suggests that the economy is expanding, while anything under 50% points to a contracting economy. In October, China's PMI fell to 44.6%, the lowest since publication of the series started in 2005.
A key driver of the decline in the PMI was a drop in new orders and a mounting product inventory.
“We are seeing a fast deterioration at the micro level,” says Lan Xue, Citi's head of China research. “In particular, October has been a horrible month for demand, which not only has shown no signs of recovery after the Olympics but actually has slipped more quickly. We believe both external and domestic demand is disappearing fast.”
A report from Morgan Stanley, released on Tuesday, says that not all sectors were affected in the same way. “The consumer sectors generally showed stronger anti-cycle capacity by occupying three out of the four [sectors with a PMI score below 50% – the three being food, garments and pharmaceuticals], but heavy industries like metals and machinery topped the loser list.”
Despite all the bad news spilling out from the mainland, BNP Paribas last week upgraded China to overweight on the belief that China will outperform the other large emerging markets. In the future, growth will play a new role, the bank argues.
“China's super-high growth era (driven by low input costs, a young population, inward foreign direct investments, benefits from globalisation/WTO entry, that resulted in rapid industrialisation, urbanisation and an export-oriented economy) is behind us. We are now entering into a medium-growth rate (5% to 6%) era for the next two decades,” BNP Paribas says in a report. This medium-growth era will be driven by structural reforms such as rural land reform and healthcare reform, and also a natural shift towards a services-oriented and domestic consumption-driven economy.
With all the indicators pointing downward, now might seem a strange time to get bullish on China, especially considering that many believe the next quarter is going to be even tougher. But if BNP Paribas has got its strategy and timing right, then this may be the time to give China the benefit of the doubt.
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