A Manufacturing Juggernaut Reborn? Not So Fast

Former HSBC Asia-Pacific equity research head William Bratton argues in "China's manufacturing machine powers on" (published on Nikkei Asia, September 14th) that China is still a robust manufacturing hub despite the crackdowns which have impacted its tech and service sectors. He adds that such a trend in the manufacturing sector refutes claims that global supply chain firms are reducing their dependence on China.

His comments have been echoed recently by a few others who are working in China or who look at the China market, regarding their observations that manufacturing is returning to the country.

However, instead of backing up the view with related data, Bratton fails to provide almost any data and includes only a reference to one trade figure over the past two years. Including manufactured export growth as compared to those of Germany, the U.S., and Japan in 2020 is misleading; the COVID-19 pandemic impacted those nations and the rest of the world in very different ways.

Instead, he professes, "And China's momentum is showing little signs of slowing." It is unclear, though, which momentum he is referring to, as in terms of manufacturing, the numbers coming out of China do not tend to support such claims.

More concerningly, Bratton argues: "There are some examples of internationally orientated low-margin production shifting out of the country, but such anecdotes do not make factual trends and they should not distract from the underlying reality of China's unprecedented manufacturing competitiveness." However, he then goes on to provide no facts to make the case for the trends that he says are occurring in China.

Manufacturing PMI: A good place to start

An easy way to provide some facts would be to look up recent purchasing managers' index (PMI) figures, since PMI figures usually indicate manufacturing activity. Unfortunately, though, there have been more than a few months of PMI figures that clearly indicate manufacturing momentum in China is slowing. Caixin's manufacturing PMI figures released at August-end dipped below the 50-point level indicating expansion to 49.2. That followed three months of declines by a respective 50.3, 51.3 and 5.20, with the figure rising only once in the past nine months.

Even today's (September 15th) latest figures are telling: industrial output rose 5.3 percent, missing median estimates for 5.8 percent. At the same time, retail sales growth slowed sharply to 2.5 percent from a year ago and well below the 7 percent economists surveyed by Bloomberg had predicted. The services sector contracted in August for the first time since early 2020, according to purchasing managers' surveys. Such figures both from a manufacturing as well as a services perspective indicate factories are not humming with activity, nor are workers secure enough to spend their paychecks. Rising costs, COVID-19 restrictions, a tight monetary policy by the People's Bank of China, and continued shortages of raw materials, components and semiconductor chips are all weighing on the economy, making it hard to believe the economy is roaring. Instead, most would agree China's economy has been groaning for a few months now.

COVID-19 lockdowns in Southeast Asia; Rising reliance on SOEs

Those who do point out there's been a noticeable uptick in manufacturing orders heading China's way also fail to note that in many cases, this is the result of the resurgence of COVID-19 in Southeast Asia, particularly in Vietnam, Thailand, and Malaysia. Those nations have been the biggest beneficiaries of supply chains moving out of China over the past few years, yet virus lockdowns have halted production across a wide variety of industries, including textiles, technology, and auto parts, among others. Another report out just today in Taiwan's Commercial Times indicated this short-term trend is occurring, with two major industrial-use sewing machine makers from Taiwan sending some of their orders to their plants in China as their factories in Vietnam have been impacted by the pandemic there.

This trend may not be sustainable, however.

First, when those COVID-19 lockdowns begin to ease, it is unlikely that firms will continue to shift their orders from their plants in Southeast Asia to China. Most firms moved their plants out of China for some important reasons, including geo-political tensions, rising costs, unfair competition by local firms in China, increasing involvement by China's government in their operations that included mandating the placement of Chinese Communist Party (CCP) officials in their offices, and the threat of tariffs being levied on their products exported from China to other nations. Those risks have not gone away and, by the looks of the CCP's latest efforts to reform its economy, may instead be increasing.

Second, Beijing's crackdown on a variety of private sector firms has increased the government's support for state-owned enterprises (SOEs). Already, some are arguing investors should consider investment opportunities in China's SOE segment as a way to reduce the risk from possible regulatory crackdowns on private sector firms.

And yet, such reliance on SOEs brings the geo-political tensions that the U.S., Europe and other countries had with China back to square one. Investors will recall that Beijing's backing of its SOEs was criticized by trade negotiators and policy makers in the U.S. and elsewhere given these Beijing-led behemoths had an unfair advantage over foreign, private sector firms doing business in China as well as globally. With private sector firms such as Alibaba, Tencent, Didi Chuxing and others getting tackled by China's regulators, expect their state-owned domestic rivals to see investment and support flow their way from the China government.

Forget about single-causation theory

Other factors also help refute the argument that rising manufacturing and export figures indicate China's manufacturing and export juggernaut is back to stay.

Rising inflation brought about by easing monetary policies has produced asset inflation in around the world as well as in China. Continued supply chain reshuffling has led to shortages and bottlenecks, which means figures that portray higher export figures must be examined with rising inflation in mind. Prices of everything from transportation to raw materials to tariffs to labor costs have meant the COVID-19 pandemic-era figures are often being compared to a lower base that was seen before the pandemic and even the trade wars.

Add to that the China government's moves to improve its environment. This is impacting its economy in two ways.

First, it is reducing its exports of low-priced products which rely on highly-polluting methods to produce them. This is being seen in the steel industry in particular, where low-priced steel output is shrinking while higher quality, more expensive steel is being favored. That has also led to continued support for higher steel prices in China and globally.

At the same time, the move to more environmentally friendly methods of production means low-end production orders are not likely coming China's way, at least not over the long term. China's latest unemployment level stood at 5.1 percent in August, unchanged mom, while that of people aged 16 to 24 declined slightly, albeit at a still-high level of 15.3 percent. While the government should be applauded for having the resolve to improve its environment by scaling back inefficient and polluting production, the downside is that manufacturing jobs are going to be less plentiful until China moves up the value chain to produce high-end products using less-polluting methods.

One can look at other markets for insight into China's economy, too, to understand whether China's manufacturing is undergoing a unique rebirth or if it is feeling the same effects its peers are enjoying.

The outlook for manufacturing sector activity in nearby Taiwan indicates that the phenomenon going on in China is being felt elsewhere, too. Taiwan's industrial output has consistently been on the rise, with industrial production in July rising 13.93 percent yoy while manufacturing production rose 15.02 percent yoy, up for an 18th straight month. Job prospects in the sector are set to again be positive in fourth quarter this year and higher than a year ago. Meanwhile, revenues at Taiwan's three major science parks has surged at the fastest pace in eight years during the first half of 2021, with exports from the parks climbing by 22.6 percent yoy. The rise is in part due to Taiwanese firms having moved production out of China over the past few years, and the current figures support the idea that those firms are not going back to China to produce.

The jury is still out on the currents of trade in China

It should be expected that more reliable data on how to read the tea leaves that can predict the future of China's manufacturing sector will take time. The sudden crackdowns by its president, Xi Jinping, and the CCP on the tech industry, private education sector, billionaires and other parts of the economy are still being understood by firms and investors.

It is unlikely many businesses or investors have given these efforts a confident "thumbs-up" and have pledged to either stay in China or return their production there, despite some survey findings done by business associations in China in 2020 or early 2021, or before the recent waves of crackdowns began. Moreover, firms that have made huge investments over the years in China may be less willing to throw in the towel until there is no doubt on which direction Beijing is going. For now, it is more likely that any increased manufacturing activity in China is the result of short-term effects, such as those created by the pandemic's resurgence in Southeast Asia.

In that regard, it is unlikely those who are trying to hang a sign over the China economy as being "Open for Business" will not be basing their claims on solid data or sustained confirmation that Beijing's attitude toward the private sector have been reversed. Business sentiment will likely still be unclear until after Xi is able to secure an unprecedented third term in 2022. To do that, he will continue to announce policies that try to win over the masses who are clearly hurting from rising prices, COVID-19 lockdowns, and rising unemployment, with both factors shown by the falling non-manufacturing data. "Common prosperity" will be in vogue; letting a hundred polluting manufacturing industries bloom will probably be out of favor for now as Xi urges the billionaires to donate their wealth while he tells the rest of the population to prepare for tough times ahead.

Beijing says things are changing in China. Believe it.

Rolling out the usual bromides of the greatness and allure of China's economy - as the author does in his article - these days seem horribly out of place. The COVID-19 pandemic has hurt nearly every economy around the world, and China is no exception. For example, right now, manufacturing in Fujian Province is under pressure as a new cluster of infections is forcing understandably concerned officials there to close down some areas, such as in Putien. We are aware of this first-hand since Taiwan firms are operating there and are updating investors on the status of their production. This is but one case of how COVID-19 is making any widespread manufacturing resurgence in China problematic.

Instead, the popping up of voices on social media and other outlets trying to suggest manufacturing is both returning to China and charging ahead, albeit with the providing of no data to even refute the actual figures that are coming out, such as PMI, only suggests that the painful debate that is going on between two groups - those who are supporting Beijing's policies and crackdowns, and those who are hoping to avoid becoming a target of those crackdowns - is escalating. As always, investors should be asking for real numbers, not cheerleading.