JP Morgan China Series: Contending with Slower Growth

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JP Morgan Hands-On China Series with perspectives of Chinese and Multinational executives on the growth prospects for the Chinese economy. Includes an interview with Bill Russo on China's automotive industry.

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JP Morgan China Series: Contending with Slower Growth

  1. 1. Contending with Slower Growth: Hands-on Perspectives from Chinese and Multinational Executives Executive SummaryHANDS-ON CHINA REPORT Facing ample evidence of slowing growth in China’s economy, investors haveSeptember 11, 2012 been trying to understand current challenges in the operating environment, and where the silver linings may be found. The government’s limited policy stimulus this year has revealed a surprisingly high degree of comfort with growth deceleration. However, our conversations with executives on the ground clearlyJing UlrichAC show that government support remains very much in place for economic activity that is in line with the 12th five-year plan objectives of transitioning towardsManaging Director, Chairman, higher-value added products and services, and imperatives such asGlobal Markets, China environmental protection. To explore the nuances behind the data, we recently+852 2800 8635 spoke to industry leaders from the property, automotive, luxury retail, diversifiedjing.l.ulrich@jpmorgan.com industrials and chemical industries to seek their perspectives on the current economic climate. We asked whether their companies were bracing for aAmir Hoosain prolonged period of modest growth, how they were coping with inventory issues +852 2800 8641 and margin pressure, and whether the transition in the economy called for aamir.h.hoosain@jpmorgan.com significant change in their business model. The following report presents their views on the current macroeconomic situation in China and outlook for theirMarvin Chen respective industries. The executives we spoke to include Zhang Xin, CEO of+852 2800 1325 commercial property developer SOHO China, Bill Russo, Senior Advisor at Boozmarvin.m.chen@jpmorgan.com & Co. and Chrysler’s former Vice President for Northeast Asia, Shane Tedjarati, President of High Growth Regions at Honeywell, Dr. Martin Brudermueller, ViceLing Zou Chairman at BASF and Sunny Wong, Group Managing Director of luxury+852 2800 8962 clothing retailer Trinity Limited.johnny.l.zou@jpmorgan.com  The unprecedented construction boom of the last 15 years is more or lessJ.P. Morgan Securities (Asia Pacific) Limited over, according to Zhang Xin, CEO of SOHO China. Zhang points out that China’s second and third tier cities are almost as built up as first tier cities, and thus SOHO has strategically focused on Beijing and Shanghai markets since rental yields are considerably higher. While most major cities may already be built, there is however still a need for better urban planning and infrastructure development, according to Bill Russo, an auto industry expertZhang Xin, CEO of SOHO China, Bill with Booz &Co. From the auto industry standpoint, for China to reach aRusso, Senior Advisor at Booz & Co, penetration rate comparable to other Asian countries (~260 per 1,000Shane Tedjarati, President of High people), it will require advances in urban planning - i.e. developing moreGrowth Regions at Honeywell, Dr. parking capacity and traffic management.Martin Brudermueller, Vice Chairmanat BASF and Sunny Wong, Group  While many of the executives we spoke to see China’s growth stabilizing atManaging Director of Trinity Limited a lower rate (BASF plans for an average of 7.3% China GDP growth untilare not members of J.P. Morgan’s 2020) in the coming years, multinationals such as Honeywell and BASFResearch Department. Unless otherwise anticipate that they can grow faster than the overall economy in China byindicated, their views are their own and virtue of their exposure to higher value-added industries benefiting frommay differ from the views of the J.P. policy support. Both Honeywell and BASF have highlighted environmentalMorgan’s Research Department and and energy efficiency, such as clean energy and energy efficient buildingfrom the views of others within J.P. development, as key growth industries going forward.Morgan.  Although the recent deceleration in retail has dampened enthusiasm about the progress of China’s rebalancing towards consumption, Sunny Wong of Trinity points out that following three years of rapid growth, the base is now 50-70% higher for many companies than it was in 2008. The current situation can be characterized as a period of stagnation on a high base, with markets in northern and western China showing some resilience. With Chinese New Year falling very late in 2013, he expects retail sales to remain subdued in the remainder of 2012, before strengthening in 1Q2013. 1
  2. 2. HANDS-ON CHINA REPORT – September 11, 2012  Most of the executives do not expect to see any major policy change in the immediate aftermath of China’s leadership transition. Any sustained improvement in property prices would be considered positive for consumption, while a gradual move from administrative decree towards tax and interest-rate-based means of regulating the housing market was seen as being healthier in terms of promoting an orderly development of the property market.SOHO China: Zhang Xin, CEOSOHO China, founded in 1995 by Chairman Pan Shiyi and CEO Zhang Xin, is a leading developer ofhigh-profile commercial properties in Beijing and Shanghai. As the sales and rental markets forcommercial properties have decoupled this year, with upwards of 20% year-over-year rental growth insome prime locations, SOHO has taken advantage of this opportunity to transition their businessmodel from the “build & sell” model to a “build & hold” model. We spoke with CEO Zhang Xin aboutthe rationale behind this transition and her views on the overall property market in China.What is your current assessment of the real estate market around the country?China’s real estate market underwent a period of unprecedented construction activity in the last 15years, which happened against a backdrop of rapid urbanization. The boom times for urbanconstruction – from buildings to airports and highways – are now more or less behind us. If you visitChina’s second and third-tier cities, you will find that they are just as built up as the first-tier cities.However the demand side is weaker in comparison. This is especially true for commercial real estatewhere you will not find as many tenants as in the first-tier cities.If you consider the basic cost structure of property development, the major items are land costs,construction costs and taxes. Tax rates and construction costs are fairly uniform across China, so themajor difference across regions is in land prices. Land prices are comparable across first-tier cities,so if we take Guangzhou as an example, the cost of developing a building is virtually the same as itwould be in Beijing or Shanghai. However the latter two markets are far more attractive in terms ofrental yields relative to the cost of development. In Beijing and Shanghai, a prime office property cangenerate rental income of RMB10 per day, per square meter. This number in Guangzhou is onlyRMB4-5, meaning that the rental yield is less than half of that in Beijing and Shanghai. This basicallyexplains why we have decided to focus on the Beijing and Shanghai markets.Which segments of the property sector do you expect to outperform and underperform in thenext few years?We continue to think that the most attractive area of real estate in the coming years will be the officesegment in prime areas. The strong rental growth in Beijing and Shanghai during this tough year is aclear indication of robust demand, as well as the basic reality of limited supply. The mid to low-endresidential segment is not attractive because the government’s social housing agenda will essentiallydampen demand. The high-end residential segment in top-tier cities will probably continue to fare well,since new supply has been very limited in recent years.What are your expectations on the policy front? Do you expect the government to change itsstance on home purchase restrictions in the near future?We will have a change in national leadership in the next few months, but it isn’t clear at this stagewhether this will lead to a change in the government’s real estate policy. In the long-run, it certainlywont’ be sustainable to forbid certain people from investing in property, so we think the home 2
  3. 3. HANDS-ON CHINA REPORT – September 11, 2012purchase restrictions are a short-term policy by design. Recently the government has been workingon expanding property tax trials and this is certainly a healthier approach towards regulating themarket than the current reliance on administrative restrictions.From a development standpoint, most property developers are now highly-geared and cannot affordto acquire land and ramp up construction without being able to identify the future direction of policy.Meanwhile, the banks always lend according to policy, so if the policy doesn’t change, their lendingbehaviors won’t change. The banks are, however, developing “bank-trust cooperation” products as ameans to fund developers in the face of lending restrictions.SOHO China recently announced a major shift in its strategy. Can you discuss the underlyingrationale?What we have seen this year is that the sales and rental markets for commercial property havedecoupled. On the one hand, we have seen very strong growth in rental income, with upwards of 20%year-over-year rental growth at some prime locations. On the other hand, the market for strata titlesales has dried up as a result of credit restrictions and slowing conditions in some of the industrieswhere China’s high net worth individuals typically make their wealth. In light of the changing market,we have decided to make a switch in business strategy from the “build & sell” model to a “build & hold”model, meaning that we intend to hold every square meter of property that we build. We expect rentalincome, rather than sales, will become the major source of our profit. With our current pipeline, we willhold up to 1.5 million square meters in prime locations in Beijing and Shanghai. About 75% of this realestate will be office space and the rest will be retail; 1.12 million sqm of our portfolio will be inShanghai (including the largest portfolio of office property on the Bund) and 380,000 sqm in Beijing.We will also have the largest portfolio of property in Beijing’s Qianmen area.With this change in strategy, we’ve also experienced a shift in our investor base. Some of ourprevious hedge fund investors sold their stakes shortly after the announcement. Howeversubsequently, a lot of US-based long-only funds began to show a keen interest. Many of these fundshave been looking to invest in a pure-play developer in China’s commercial property segment andhave followed SOHO for years, but did not know how to appropriately value a developer focusing onstrata-title sales. Our business model is now one that can be very clearly understood by theinvestment community. Figure 1: SOHO office rents- RMB per sqm per month Figure 1a: China overall building construction (mn sqm) 400 80 360 350 70 GFA new starts YTD 300 300 60 GFA under 255 construction YTD 50 250 222 210 GFA completed YTD 205 40 200 30 150 126 135 20 100 10 50 0 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Oct-08 Oct-09 Oct-10 Oct-11 0 -10 Zhongguancun SOHO Nexus Sanlitun SOHO The Exchange- SOHO Centre SOHO -20 4Q10 2Q12 -30Source: SOHO China, CEIC 3
  4. 4. HANDS-ON CHINA REPORT – September 11, 2012Bill Russo, Senior Advisor, Booz & Co. & ex-VP at Chrysler Northeast AsiaBill Russo is a globally recognized authority on matters related to the Chinese auto industry.Previously an executive at Daimler Chrysler, Mr. Russo has over 15 years of experience in the autoindustry, with over 8 years of experience in China working with industry leaders and governmentofficials on the development of new vehicle programs. In light of the slowing demand, inventory issues,and overcapacity problems in the Chinese auto industry, we ask Mr. Russo for his views on thepossible solutions.How does the current operating environment feel as compared to 2008? Do you expect thegovernment to introduce further measures to boost auto sales?China’s automotive industry has arrived at an inflection point. After a period of breathtaking expansion,the industry is now facing a future of slower growth at a level comparable to China’s GDP growth. Thisfollows a period of rapid growth that was capped in 2009 and 2010 with the Automotive IndustryRevitalization plan, which provided a strong stimulus for new car buyers. Since then, the industry hassharply decelerated owing to this stimulus-driven pull-ahead of demand. Frankly, I think that anothermajor auto stimulus would be worst scenario for the long-term development of the China auto industry.It would be tantamount to “kicking the can” down the road in terms of addressing structuralinefficiencies and might encourage another round of over-optimistic short-term planning on the part ofsome automakers. Some level of stimulus is probably likely to happen, but I think the government istrying to avoid this, recognizing that the last stimulus effort in 2009/2010 resulted in over-investment innear-term expansion and a capacity overhang in the face of slowing demand. Moreover, thegovernment was not able to plan for the immediate impact of the rapid growth if the car fleet, in termsof providing adequate road capacity and parking spaces. The government has some room forstimulus, which may address the supply and demand imbalance in the near-term, however it must notsend signals that would lead auto companies to continue to overestimate their prospects for growth.We should also separate what is happening in the commercial market with what’s happening in thepassenger vehicle market. On the commercial side, the pull-back in demand was largely-policy driven.Businesses that purchase commercial vehicles have less capital available for investment, so demandhas naturally declined. In the passenger vehicle market, there is still healthy growth in the aggregate,in line with GDP growth, but there are also nuances that become obvious with careful analysis.Although the passenger vehicle market is decelerating, there is still a sustainable and healthy growthoccurring in lower-tier regions of the country, as well as in certain hot segments including premiumcars and compact SUVs. As long as the economy continues to expand, passenger car demandgrowth will continue.How would you characterize the current state of demand? Are you concerned about elevatedinventory levels?China’s automotive industry stimulus plan expired at the end of 2010. In 2011 we had a full calendaryear without incentives and I think the fact that there was 2.5% growth (which includes commercialvehicles – a segment which declined by 7% last year) is evidence of underlying demand strength. Themain challenge for the China auto market is on the supply side, where the competitive landscape isextremely fragmented, with a mix of both strong and weak players. In the aggregate, there is acapacity bubble in the market, with companies in certain segments of the market having beenoverambitious in their market share assumptions. This problem is particularly acute in the mid andlower end of the market. An already hyper-competitive market will become even more pricecompetitive as the manufacturers try to under-cut the competition to sell down their capacityoverhang. This is particularly problematic for the local car companies who have over-estimated their 4
  5. 5. HANDS-ON CHINA REPORT – September 11, 2012market share growth prospects. This will raise the level of urgency for China to begin to consolidatethe fragmented landscape of car companies.However, I don’t think inventory levels of 2 or 3 months are necessarily something to panic about,since the supply side will gradually readjust to a lower level of market demand. In the meantime, wewill see elevated inventories, and discounting to get vehicles off the lots. These are just symptoms ofa problem that can be fixed with some adjustment. The underlying problem is that there are too manycar companies that have been too optimistic about their prospects, particularly in the entry-level andmid-market segments. On the other side there is a premium segment that has grown to account for 8%of the market. Current market conditions for luxury vehicles are not as challenging as exist for theentry-level and mid-market segments.Recently some local governments in China have adopted license restrictions as part of effortsto relieve traffic congestion. How is this affecting the behavior of prospective car buyers?The introduction of these restrictions has shifted the mix towards higher end products – it’s a fact thatwe’ve seen in Beijing, Shanghai and Guangzhou. When the cost and difficulty of obtaining a licensegoes up, people who are fortunate enough to have the opportunity to buy a car want to get as muchcar as possible. I think this pattern will be repeated – already Xian and a few other cities areconsidering implementing similar policies. While this puts some constraints on growth, at the sametime, there are seemingly countless number of highly populated cities in China that have notimplemented restrictions, so automakers will try to shift their focus to other cities. The trafficcongestion problem in China is only partly due to the number of cars – the car ownership rate inBeijing is only 60 per 1,000 people (compared with New York which has over 400 cars per 1000) butthe city has some of the worst traffic conditions in the world. The root cause of the problem is actuallylinked to the ability for the transportation infrastructure to keep up with the rate of urbanization. Betterurban mobility planning, additional parking capacity and traffic rules enforcement would actually helpease the problems of traffic congestion. The government needs to provide ample parking and providealternative mobility solutions (including public transportation), so that people who own cars will chooseto use them when they really need to. License restrictions treat the symptom of the problem ratherthan the root cause.Many analysts suggest that China’s passenger vehicle penetration has a long way to go,based on a comparison against ownership rates of 400 per 1,000 in the US or ~260 S. Korea,etc. Do you think this type of comparison is valid?I certainly don’t think that a comparison to the US ownership rate is valid, given the densely populatednature of China’s cities. The capacity of Chinese cities to handle traffic is limited and the demand forurban mobility in China is also different. When a buyer purchases a car in China, what they’re usingthem for is often different from what you would see in the US. Driving distances are typically muchshorter, so a more relevant comparison would be against a place like Taipei where the ownership rateis upwards of 220 per 1,000 people. I certainly think that China will achieve a significantly higher levelof ownership, but this will require advances in urban planning – i.e. developing more parking capacity,managing traffic congestion and enforcing traffic regulations.Which homegrown Chinese automakers do you believe have the brightest long-term prospects?The Chinese automakers all know how to create “commodity” cars, but the transition from “reverseengineering” to an independent development capability is one that only a few domestic car companieshave been able to cross. The three that stand out are Great Wall, which has excellent managementand very good capabilities in terms of body assembly, body structure, and putting together a car thatcan meet crash standards. They also have a logical platform strategy that allows them to efficiently 5
  6. 6. HANDS-ON CHINA REPORT – September 11, 2012introduce new models. Another potential leader is Geely. This is probably not as evident in terms ofcurrent market performance, but more in terms of the company’s ability to open new segments of themarket, implement a platform strategy, develop a brand strategy and acquire automatic transmissioncapabilities. This is entirely separate from the Volvo Deal, which should help them accelerate theirdevelopment capabilities. SAIC is also further developed in terms of in-house capability whencompared with other local OEMS, having acquired the MG and Roewe brands, but also having afunding source to expand from its very profitable JVs. Most of the remaining companies pretty muchmake products that target the low end of the market, so I don’t think their longer-term prospects arevery bright. They will have to slug it out in the commodity space. Figure 2: Global passenger vehicle penetration (car ownership per 1,000 people) 600 500 400 300 200 100 0 Germany China USA UK India Indonesia Thailand Taiwan South Korea Japan FranceSource: CAAM, CEIC, WDI. For India, Indonesia, USA, UK and France, the penetration is based on 2010 statistics and the rest are 2011.Honeywell: Shane Tedjarati, President & CEO of Global High Growth RegionsHoneywell invents and manufactures technologies linked to global macro trends in areas such assafety, security and energy. Honeywell’s history in China dates back to 1935, when it established itsfirst franchise in Shanghai. This year, it is expected that China will represent about 6% of Honeywell’ssales, but about 20% of Honeywell’s growth. We spoke with Shane Tedjarati, President & CEO ofGlobal High growth Regions at Honeywell. Mr. Tedjarati has been on the ground in China for over 20years, and has been leading the transformation from “Made in China” to “Made for China”.How does the current operating environment feel as compared to late-2008?Honeywell has exposure to multiple industries as well as long and short cycle businesses and eachindustry segment has seen a varying degree of slowdown in China. On the whole, the global economyis not in a good position. If the situation in 2008 can be described as “open heart surgery,” the currentenvironment can be characterized as “stage 1 cancer.”The world is more than ever looking at emerging markets or what we call high-growth regions forsigns of growth, however even these regions are not immune to the slowdown. Certainly someindustries in China, such as the residential property market and automotive sector, have seen growthslow tremendously. On the residential side, we see mid to high end residential demand being themost impacted. In the auto sector we see commercial vehicle growth slowing the most. This is due tothe sluggish demand from the construction, mining and other transportation sectors. So the residentialand auto market give us the most concern. 6
  7. 7. HANDS-ON CHINA REPORT – September 11, 2012On the other hand, we have seen no slowdown in the aerospace sector. Companies are not timidabout continuing to invest in this sector, and we have even seen some acceleration in project activity,such as the development of the C919, a single aisle airliner. We have also seen no deceleration in ourrefining and high-end petrochemical business. It is no longer just large SOEs investing and benefittingfrom the petrochemical business, as we have seen a growth in smaller private enterprises alsoinvesting in this sector.As a diversified company serving a range of industrial sectors, what are you seeing in terms ofthe current inventory situation in China?We have seen quite a bit of destocking amongst our customers and distributors. They havesystematically destocked inventories from about 3-months to 1-month of inventory, mostly in thesecurity safety and commercial controls products. We are beginning to see some inventories beingbuilt back up, but it is not phenomenal as confidence is still quite low. Many people are concernedabout whether the export sector will rebound, although we do not really depend on the export marketthat much. Inventory rebuilding is more prominent in the western and central areas of China, as it isharder to get inventory to those regions and they don’t want to lose the ability to serve customers.What are your current expectations in terms of central government policymaking? Are youexpecting any near-term change in the economic policy direction?We don’t expect any significant economic policy changes until we have the leadership transitionlargely behind us. One thing I think the government can and will probably do is provide more supportfor private sector growth. The direction that the SOE sector has taken over the past 7 years or so hasbeen very deliberate, and there have been good and bad consequences. SOEs have become verypowerful, accounting for around 50% of GDP. We all know that they are not the most efficient indeploying capital, nor are they the most entrepreneurial organizations. If we want to unleash thepower of entrepreneurs, the government must go back to the basics with SOEs and focus on how toget the private sector to drive growth.As for some short-term measures, we continue to see positive developments in energy efficiency andsectors related to environmental initiatives, such as smart grid and smart city projects. We are excitedabout urbanization and infrastructure development in China. We see China moving to develop betterand more energy-efficient commercial and residential buildings. Pollution monitoring and also safetyand security will be important going forward. We just had another coal mine accident recently, and thegovernment certainly does not want accidents like these to become front and center.What pace of economic growth are you anticipating in the next several years? Do you seeChina’s slowdown as a temporary situation or a structural shift?Structurally, China has some strong fundamentals and I still think there are some very promisingindustries for Honeywell to benefit from. We are certainly planning with the assumption of 6-7% GDPgrowth in the next few years, not the 8-9% growth we have seen previously. We believe 6-7% growthis very healthy for China and that China does not need 8-9% growth, as there are also consequencesthat come along with such a fast growth rate. Government officials that I have spoken to are veryconcerned with issues such as corruption, inflation and the widening wealth gap that come as aconsequence of rapid growth. It used to be that China needed a higher growth rate to maintainemployment, however we have seen that employment can be maintained with a 6-7% growth rate.We started to align our business 6-7 years ago to be more in line with China’s macro trends. We areon track to deliver around 15% growth this year, which is roughly twice the GDP growth rate. Weanticipate delivering 1.5-2x GDP in the coming years. 7
  8. 8. HANDS-ON CHINA REPORT – September 11, 2012How is your business in China faring relative to other high growth regions?India definitely has been the worst hit, largely due to issues with economic policy execution. Investorsand multinationals have also noticed this, as Brazil overtook India as a recipient of foreign directinvestment last year, which is quite startling. In this respect, the Chinese government has performedwell as they have executed and enacted policies in response to changing macro trends.We are very bullish on regions such as Mexico and Brazil. We believe that we can deliver 2x GDPgrowth in Brazil. Overall, high growth regions represent about 20% of Honeywell’s revenue. Theseregions however contribute to over 50% of Honeywell’s growth. In 2012, we expect China alonerepresents around 6% of Honeywell’s sales, and about 20% of Honeywell’s growth. As you can see,China represents a large part of our growth and China is especially important for us. For example,while we work on projects with Sinopec around the world, the decision making is still made in China.BASF: Dr. Martin Brudermueller, Vice ChairmanBASF is the world’s leading chemical company and with accumulated investments over the last 20years of more than €4 billion, and €6 billion including JVs, BASF’s presence in China is unmatched.BASF is a material supplier to all key manufacturing industries in China, which gives the company agood pulse on the changing macro environment in China. Dr. Brudermueller is responsible for thecompany’s Asia Pacific region, as well as its global Performance Polymers and Polyurethanesdivisions, and is uniquely positioned to provide insights on China’s chemicals industry and the macroeconomyDo you see China’s slowdown as a temporary situation or a structural shift?A lot of macroeconomic KPIs [key performance indicators] are looking south. However, China still has7.5% GDP growth, so signals are a bit mixed. What is evident is the fact that industrial KPIs acrossthe board have weakened, whether this is industrial production or whether it is the PMI.However, BASF is thinking long-term. We do not change our long-term plans because China’s growthis somewhat weakening at the moment. I also think that some of the growth rates have beenextremely high in the past and are normalizing to become a little bit more sustainable. We use a long-term horizon for strategic planning for the simple reason that we build assets for 30 years and more,so we have to think about the long-term demand pattern. Hence, our picture until 2020 in terms ofannual GDP growth is a solid 4.8% for Asia Pacific, 3% worldwide, and for Greater China ourexpectation is for 7.3% between 2010 and 2020. And our assumption for the Chinese chemicalmarket is at 8.5% growth, which is higher than our forecast for GDP growth.Could you discuss the differentiated performance and outlook for the downstream industries,where you are seeing strengths, where you are seeing weakness?In effect, BASF is a material supplier to basically all manufacturing industries and our sales correlatewith industrial production. We are strong in the major markets and part of our risk management lies inserving multiple industries because industry-specific peaks and troughs will differ, as will regionalones.If you take the automotive industry, the Chinese market is still a reasonable contributor to our growth.In 2010, after the crisis, China overtook the US and Europe in terms of car demand. And in 2020, weexpect that China will have as much demand as Europe and the US put together. With regards to carproduction, the average Chinese car contains only about half as much plastic material as a Europeancar. This is a potentially huge growth market for us as we can grow our market quite strongly even ina somewhat slower market by putting more plastic material into each car made. 8
  9. 9. HANDS-ON CHINA REPORT – September 11, 2012Or take renewable energy. Many people dont know that China has the largest installed wind energycapacity worldwide. You might ask what a wind turbine has to do with chemistry. The rotor blades of astate-of-the-art wind propeller weigh ten tons, and they are getting bigger and bigger. So you have tomake them lighter, stiffer, and protect them against corrosion. All these elements can only work withnew materials created from chemistry. This is why wind energy is a huge market for BASF. China isalso the leader in solar cell production to which BASF supplies a range of innovative chemicalsolutions for wafer processing and UV-stable systems for the frames of photovoltaic and solar panelsto just name a few products. So not only are a lot of these future markets actually in China, it is alsowhere the technology is increasingly being developed. Chemistry plays a key role in these innovativeindustries.Construction, on the other hand, is a bit slow. I think we all know that there are a lot of finishedapartments that haven´t been sold. In the consumer goods markets, whether its appliances orfootwear or textiles, there is a much slower pace than in recent years. So it is pretty much a mixedbag, with automotive at the higher end, and construction at the lower end.How is the inventory situation in China from your point of view?I think we are currently observing some de-stocking effects. Its not so surprising that this happens intimes of uncertainty. I think a lot of companies have learned that in a crisis situation you need toensure low inventories. Also with a weakening world economy, with oil prices going down andchemical prices weakening, its very natural to de-stock.Can you give us a timeline for demand recovery?I think there will be improvement in 2013 but its maybe a little bit too early to tell. Looking forward,where will the growth come from? If you look at Europe, I don’t think we will see a quick turnaround.Regarding the US, the situation might improve after the elections, but not all of a sudden. If you lookat China, we might see some action by the new government in October. And India is politically prettymuch paralyzed at the moment. So looking at the global picture overall, I think you will only see slowimprovement, and thats our hypothesis for the next quarters to come.Can you elaborate a little bit more on the competitive threats of operating in China?I am very often asked who is our main competitor in China, is it Dow, DuPont or Bayer? Its actuallynone of the multinationals; rather it’s the Chinese companies. There are hundreds and thousands oflocal companies, bigger and smaller ones, very good ones, of course also bad ones. But all in all, Ihave to say that there are increasingly more powerful Chinese competitors. They are applying state-of-the-art technology, learning to be more reliable, and they are improving their quality. For theindustry as a whole, this is good as it makes us more innovative.The local companies are quickly upgrading their marketing strategies. Value can be destroyed by justselling products as cheaply as possible to increase sales. But more and more local competitors arelearning that they have to earn money more sustainably and to draw long-term value out of what theysell. So as a matter of fact, we have very tough competitors in China in some areas. But this is alsothe reason why we are ourselves are focusing more strongly on innovation, addressingmultidisciplinary challenges. We are running more or less ahead of the field, but we have to be evenfaster with new offers to the market.I have a very strong interest in seeing that the whole industry becomes more responsible and thateveryone lives up to the rules, minimizing emissions and ensuring safe operations. A lot of ourChinese competitors, at least in the past, have not had to operate under these circumstances, so it’sno surprise that they could offer cheaper products. But the Chinese government has done a good jobin improving regulatory standards. And they are also putting more emphasis on the actual compliancewith these rules and regulations. We have seen a lot of companies being shut down or relocated. Sothe overall regulatory environment is going in the right direction. This improves our position as we getmore of a global level playing field, with our Chinese competitors having to play by the same rules thatapply to us. 9
  10. 10. HANDS-ON CHINA REPORT – September 11, 2012 Figure 3: BASF GDP growth forecast (USD Bn) 21,800 4.8% CAGR 7% 6% 17,300 8% 6% 13,600 7% 13% 8% 7% 12% 7% 24% 8% 11% 29% 34% 41% 37% 32% 2010 2015 2020 Greater China Japan South Asia ASEAN ANZ Korea Source: BASFTrinity Group: Sunny Wong, Group Managing DirectorTrinity Group, a retail arm of the Li & Fung Group, is a leading luxury menswear retailer serving theGreater China region. Trinity manages six international menswear brands in China, namely Kent &Curwen, Cerruti 1881, Gieves & Hawkes, D’URBAN, Intermezzo, and Salvatore Ferragamo. Trinityoperates approximately 458 stores in the Greater China region, with over 374 retail stores in MainlandChina. We spoke with Sunny Wong, Group Managing Director at Trinity, about his views on thecurrent retail operating environment in China.How does the current retail environment feel as compared to 2008 and why?The situation is similar to late-2008 in the sense that the western and northern parts of China areshowing more resilience in retail sales growth. The inland provinces in China are benefiting from anemerging middle class, so business there seems to be more sustainable. We should take into accountthe fact that the base in northern and western China is now much bigger than it was 3 years ago,following three consecutive years of high growth. We are not falling off a cliff now and the situation ismore like stagnation on a high base – for many companies the base is now 50-70% higher than in itwas in 2008. Consumer sentiment in China has been dampened by the clampdown in property, so arecovery in property prices would be good news for us.Naturally, the retail industry has a stronger focus on second tier cities today than it did in 2008. It usedto be that first-tier cities accounted for 60-70% of distribution, but because of the magnitude ofproperty development occurring in second tier cities, there are a lot of malls opening that give us anopportunity to open new shops. As the economy began to decelerate, people started out thinking thatthe luxury goods segment would be more resilient than the rest of the industry, but it is turning out tobe about the same.Do you see China’s slowdown as a temporary situation or a structural shift?The current slowdown is more structural in nature. The Beijing administration has been talking aboutstimulating domestic consumption for the past 5-10 years and I think they’re aware of the importance 10
  11. 11. HANDS-ON CHINA REPORT – September 11, 2012of having a bigger domestic market. But for the time being, exports continue to be very important,especially with the eastern and southern regions of China heavily exposed to external demand. So thestructural transition will still take time. The export picture is quite poor, and manufacturers are finding itquite difficult to cope with labor shortages and rising labor costs, especially along the coast. At thesame time, taxes have generally been on an uptrend. We must not forget that China removed a lot ofexport VAT rebates, which particularly hurt the larger industries.Would a cut in the luxury goods import tax have a major impact on the sector?Some people point out that many Chinese shoppers are spending their money on luxury goods inEurope, America and Hong Kong. So long as there is a differential between domestic and offshoreprices, high-end customers will prefer to shop abroad since they plan to travel anyway. People havelong talked about a reduction in the luxury tax, but you can’t guarantee that this will prompt brandowners to reduce prices.Do you believe we are on course for an improvement in sales conditions in the remainder ofthe year? Are current inventory levels high, low or normal?We are not forecasting a recovery by the end of the year – we are hoping that things will stay aboutthe same. The summer season has not been very strong so far and, looking forward, the comingChinese New Year will fall very late on February 10. This means that sales in December might not bevery strong, since there won’t be a spillover into the Chinese New Year season. But we think the firstquarter next year will be good.Our company now has about 400 days of inventory. We can cut our inventory quite easily, since theapparel that we sell is more fashionable and less seasonal. We don’t rely on other intermediaries, so ifour inventory is reduced, it means that a customer somewhere is wearing our product.What is the likelihood that retailers in China could engage in the level of discounting seenduring the previous crisis?In 2008, the level of discounting was very fierce, but this time it is very isolated. The main thing thathigh end brands have done is to extend the length of their sales period. Now in September, most ofthe discounted summer products are all gone, except for some isolated cases. China retail sales value (rhs) vs. China retail sales YoY growth (lhs) 2000 Rmb, Bn (%) 25 1800 1600 20 1400 1200 15 1000 800 10 600 400 5 200 0 0 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Sep-06 Dec-06 Jun-07 Sep-07 Dec-07 Jun-08 Sep-08 Dec-08 Jun-09 Sep-09 Dec-09 Jun-10 Sep-10 Dec-10 Jun-11 Sep-11 Dec-11 Jun-12 Source: Bloomberg,NBS, Jan-Feb 2012 retail sales not available 11
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