Too Large To Grow So Fast

The Middle Kingdom is still a powerhouse, but the days of runaway growth are quickly coming to an end.

Ruchir Sharma

NEWSWEEK

From the magazine issue dated Oct 6, 2008

Anyone forecasting a hard landing for China's boom is typically met with the same skepticism that doomed the boy who cried wolf. But the lesson of the fable is that the wolf did come, the third time. Now, after two false alarms in 2004 and 2006, the slowdown is at the door. China has simply grown too big to keep expanding at the 10 percent rate it has sustained for 30 years, and is likely to slow to 8 percent at best next year and for the foreseeable future. The decisive end of the era of double-digit growth is here, with major implications for the nation and the world.

Until now, China had defied the traditional theories of how fast developing nations could grow, and for how long. Its economic growth has compounded at an annual average rate of 10 percent over the past 30 years, a record that has surpassed the other miracle economies, such as Japan and South Korea. Japan's growth rate downshifted significantly after 1973, when it reached a per capita income of $3,000—a level China hit earlier this year. Now the law of large numbers is catching up to China: in 1998, to grow its $1 trillion economy by 10 percent, it had to expand its economic activities by $100 billion and consume only 10 percent of the world's industrial commodities. Currently, to grow its $3.5 trillion economy that fast, it needs to expand by $350 billion a year and suck in nearly 30 percent of global commodity production. Even more important, there are clear signs in China's response to the slowdown that the leadership understands that this moment was inevitable—that it is abandoning its old growth-at-any-cost mentality, and will not try to artificially revive double-digit growth.

Until very recently, of course, the China headlines had remained entirely bullish. The red-hot expansion had shown only marginal signs of moderation through the first half this year, and most economists blamed weak growth in Western countries, which are China's best export customers. They had also assumed that sluggish exports could be offset by stronger domestic demand, powered by Beijing's big spending on infrastructure projects and the rising purchasing power of the Chinese consumer. However, the latest signs are that the Chinese domestic economy is not immune to slowdown: it is starting to falter, too, and the property sector is the heart of its troubles, as in many countries.

For the first time since the Chinese housing market was fully privatized in the late 1990s, a coordinated real-estate downturn has set in across all major provinces. The feeding frenzy of rising prices and increasing demand has given way to a vicious cycle of falling prices and slowing demand. Housing is increasingly unaffordable, as property prices doubled between 2000 and 2007, and authorities began raising interest rates last year in an attempt to prevent overheating. Still, for much of this year, developers have continued building with abandon, counting on demand to revive and refusing to lower prices, even as sales began to collapse and inventories mounted. Property sales started to drop in October 2007, turning negative in the second quarter of 2008.

Now there is widespread anecdotal evidence that a price war is breaking out from Beijing to Shenzhen. Discounts of 10 to 20 percent are increasingly common on existing residential projects. New construction activity is grinding to a halt. Auctions of apartments in new buildings are failing to attract bidders even in formerly hot coastal cities like Shanghai.

A bear market for real estate will have widely unforeseen ripple effects across the economy: while the consensus forecast is for still-robust growth of 9 to 10 percent in 2008 and 2009, down from 11.9 percent in 2007, those predictions factor in only falling export growth, which is expected to slip from the 20 percent pace of recent years to single digits next year, stalling a sector that accounts for a third of investment spending in China. Businesses in some of the most energetic export hubs, such as the Pearl River Delta and Yangtze River Delta regions, have been reporting a softening in demand for months now. But real-estate construction accounts for another third of total investment spending, and its collapse should lop off at least an additional percentage point from economic growth.

The downside risks don't end there.

Falling property prices will further discourage consumption, which was weakening anyway. Many Chinese are feeling decidedly less rich because the local stock market has fallen by two thirds from its peak in October 2007. And historically, as consumer confidence wanes, so too do both the real-estate and auto sectors. In a telling sign, passenger-car sales fell in August, down 10 percent from the same month last year.

Until late 2007, China had in fact been relatively immune to the travails of the U.S. economy, which began to slow dramatically from the middle of 2006. But then inflation started to pick up speed in China, and policymakers responded last November by getting tough, with a strict directive to banks to clamp down on excess lending. The aggressive tightening of monetary policy laid the seeds of the current housing slump in China and dashed hopes of any economic decoupling.

Shakeouts are always necessary to cleanse the system of excesses in prices and spending that accumulate during any bubble. But China's housing excesses are less dangerous than those in the United States and Britain. For one, China's urbanization process is in its early stages, so housing demand is likely to rebound strongly in the long term, and help to swiftly clear unsold inventory. With Chinese household income rising at 10 percent a year, housing will become increasingly affordable if home prices remain flat, even for a year. And unlike Americans, the Chinese are not deep in personal debt; mortgage loans equal 12 percent of China's economy, compared with more than 100 percent of the United States' economy. Banks in China also have relatively small exposure to real-estate developers, who hold just 7 percent of outstanding banks loans. The comparable figure in the United States is 53 percent. The Chinese housing-market-led slowdown poses no systemic risk to its financial system.

The more important questions are how long will the downturn last and where will China emerge at the end of this phase? Some policy help is already on the way. The People's Bank of China recently reduced its benchmark rate by 27 basis points, its first softening in six years. With consumer price inflation slowing, there is further scope for an easing of monetary policy. The government also has ample room to stimulate the economy by raising spending, since its fiscal accounts are almost balanced, and its total debt-to-GDP ratio is very low at 16 percent.

But there is growing disappointment in the Chinese investment community as to why the government is not stepping in more decisively to stabilize growth, particularly in the property sector. The government's reaction reveals a lot about the shifting priorities of the leadership. Following the rapid rise in property prices over the past few years, there was a general feeling in policymaking circles that the average buyer was being priced out of the market and that developers were raking in money like bandits. The government would consequently be happy to see a fall in property prices, possibly a part of its larger objective of achieving a "harmonious society" by dampening the widening income gap.

The government is also wary of turning on the monetary spigots too quickly. It wants to anchor inflationary expectations after the painful experience of the past year, when inflation stayed well above the tolerance limit of 5 percent. The danger with such a strategy is that once a deflationary psychology sets in, it's difficult to turn things around. Consumer price inflation has fallen sharply from a high of 8.7 percent in February to 4.9 percent in August. While the merits of slowly lowering interest rates are debatable, this incrementalist policy does suggest a nuanced shift in the government's growth-at-any-cost approach to a greater emphasis on balanced economic development.

In a way, the commodity-price-led inflation surge of the past year was a message from the marketplace that there are limits to China's growth potential. It is not feasible for an economy to keep growing at a double-digit pace once it achieves a certain critical mass.

The Japanese case is telling. Back in the 1970s, Japan was forced to allow domestic prices and its exchange rate to be more market-determined—all part of an economic evolution process, as larger economies require greater currency flexibility to better tailor domestic money and credit conditions to local needs. Productivity growth in Japan naturally slowed as the exchange rate became less globally competitive, and economic growth averaged 4 percent over the next 15 years.

To be sure, China is not likely to slow to 4 percent growth for some time. China has also moved toward greater exchange-rate flexibility, beginning in 2005, but more gradually than Japan, and it still has a long way to go before it achieves anywhere near the level of modernization that Japan had reached in 1973. China started its modernization drive from a much lower base in 1978, while Japan was already a relatively advanced industrial economy, with modern textile, steel and shipbuilding sectors, at the beginning of its high-growth period in 1955.

Furthermore, China's labor-productivity boom has been driven by the vast migration of rural workers to higher-value-added urban jobs. An estimated 12 million to 15 million people continue to shift from agricultural to manufacturing- and services-based jobs every year. While it is hard to estimate when this labor supply will be exhausted, some early signs suggest that incrementally higher wages are required to move workers to urban centers. This should chip away at productivity growth.

There are also signs that Chinese policymakers are focusing more on shoring up rural infrastructure. Following the food-price shortages of recent years, the government is promoting increased farm growth that will help stabilize prices and—as an unintended consequence—give rural workers less reason to migrate to cities. If that slows factory output, so be it. A further demonstration of the change in mind-set is the recent adoption of a new labor law that, among other things, sets a minimum wage ranging from anywhere between $60 and $110 a month based on the per capita income of each province.

China remains a great economic growth story and is on the path to converging with the industrialized world. But developments of the past year—from commodity-price-led inflation to the slight shift in the government's priorities—indicate that the pace of convergence is set to slow in the years ahead. The 11.9 percent growth rate recorded last year was probably the high-water mark of China's economic miracle; growth could slow to 8 percent or lower in 2009. While that will prompt stimulus measures from the government, it is unlikely that China's growth trajectory will return to the 10 percent-plus rate that it sustained with little inflation from 2003 to 2007. After all, when fixed investment has exceeded 40 percent of GDP for years, there's a limit to how many more new power plants and roads the government can help build.

The $3.5 trillion economy's potential growth rate is probably closer to 8 percent, a rate that hardly detracts from its reputation as an economic miracle. But the shift to a slower growth plane is likely to be painful for many economic agents—from property developers in China to commodity traders worldwide—for whom the idea that anything related to Chinese demand could be bid up to any price had been taken for granted. Although it is starting off as a cyclical downturn, the bigger story is that the law of economic gravity is catching up with China, too.

Sharma is head of global emerging markets at Morgan Stanley Investment Management.

URL: http://www.newsweek.com/id/161234

Get Your Green Motor Running

 

Get Your Green Motor Running

Japan's automakers are zooming ahead in the eco-car race. Their lead may turbocharge their country.

Christian Caryl and Akiko Kashiwagi

NEWSWEEK

Updated: 12:36 PM ET Sep 6, 2008

Honda's new FCX clarity feels like a perfectly ordinary car—which may well be the most shocking thing about it. It looks and drives like a run-of-the-mill four-seat sedan. Slip behind the wheel and press the pedal with your foot, and the car accelerates with satisfying punch. But after a few minutes of cruising, you'll notice that something is missing. The only audible engine noise is a faint whir, so faint that you can actually hear the tires swishing along the asphalt.

That's because the Clarity is a hydrogen-fuel-cell car, one of the most advanced in the world. The once bulky fuel-cell stack that supplies energy to the engine has been reduced in size by half over the past decade while increasing the power output by 50 percent. It's the first to be certified by the U.S. Environmental Protection Agency, and the first to be delivered to retail customers (albeit on a leasing basis). As for CO2 emissions, the only exhaust it produces is a trickle of water. And perhaps most important of all is what stands behind it: A state-of-the-art factory that's ready to produce thousands of the vehicles once the market's ready. Most of Honda's competitors, by contrast, are still bringing concept cars to the auto shows.

The Clarity is also just one of a number of next-generation green automobiles that are beginning to come off assembly lines in Japan. These vehicles, whether powered by fuel cells, long-lasting batteries or renewable biofuels, have been around for years, but almost always as one-off utopian designs or experimental models that were designed mainly to attract good green press. Now Japanese automakers are going to the next level, entering the green-car mass market, in many cases years before their competitors. Nissan plans to introduce an electric vehicle to the United States and Japan by 2010, with a global rollout in 2012. Toyota is road-testing a plug-in hybrid in Japan, the United States and Europe and plans to launch it in 2009 (there's a buzz, unconfirmed by the company, that this hybrid car could use solar power as well). Honda, a distant second to Toyota in the hybrid market, is preparing for the launch of a new car highly anticipated for its innovative green technologies, including its state-of-the-art battery. Mazda will offer the world's first hydrogen-gasoline hybrid in Japan by next March. All of these companies are benefiting from close cooperation with electronics manufacturers, component makers and suppliers that are helping to push Japan to the forefront of green-car technologies. "Globally, Japanese companies are definitely at the top right now, and I expect them to remain No. 1 in the future," says Mike Omotoso, an auto analyst for California-based J.D. Power and Associates. "It's definitely having a positive impact on the Japanese economy."

In large part, Japan's lead in green-car technology is an outgrowth of its old austerity. Japan was obsessed with energy efficiency long before global warming made it a worldwide obsession. For decades Japanese companies have struggled to cope with their oil-poor country's sky-high energy costs by placing a premium on energy-saving technologies, and it has paid off. Even old Japanese industries are cutting-edge in cutting energy costs. Japan continued to make batteries long after U.S. rivals quit, and now makes the most efficient batteries in the world. Japanese steelmakers have ceded ground to cheaper emerging-market rivals but are still unsurpassed in the fine niche art of making superlight steel for car bodies. The hidden strength of Japanese smokestack industries helped create its green cars, and now the success of those cars is pushing more and more Japanese industries—electronic-motor and control-unit producers, all sorts of material companies—to innovate faster.

It's impossible to tally the direct economic effect of the green-car race at this point, but it's huge and likely to grow. The Prius is already the most popular green car in the world, and Toyota plans to raise domestic output of the Prius by 60 percent to 450,000 a year by 2009. By 2015, Goldman Sachs expects the hybrid-vehicle market (including plug-in hybrids) to grow to 2.5 million, up from half a million in 2007, with Toyota and Honda in the lead. Analysts say plug-in hybrids, which run on a battery alone for a short range, are the vehicles that will gradually ease drivers out of the gasoline age and into the electric era. Goldman analyst Kota Yuzawa says hybrid vehicles could account for 5 to 10 percent of operating profits for Honda and Toyota in 2010. And the potential markets look likely to grow as oil prices hit new highs and environmental regulations get tighter.

The focus on green cars reveals the kind of industrial vision that Japan is often criticized for having lost decades ago. Toyota launched the G21 Project, which ultimately produced the Prius, back in the 1990s, when oil prices were low and America's love of SUVs was still growing. The idea was to create a model car for the 21st century, and counter Toyota's reputation for "boring" vehicles. Toyota simply saw the long view before others, assuming that the petroleum-based economy was becoming unviable for a variety of environmental and economic reasons, according to Noriyuki Matsushima, analyst at Nikko Citigroup in Tokyo.

Toyota has since dramatically cut the costs of producing the Prius by achieving economies of scale. Toyota has already reached the break-even point on sales of its hybrids; by contrast, its foreign competitors, like GM, still have years of bleeding red ink ahead of them. Toyota says the parts in its next line of hybrids, due for release next year, will cost about half the current bunch, allowing it to drop prices and raise profits. While the company is estimated to have lost about $10,000 on each car produced when the line was launched back in 1997, "the new Prius is going to be hugely profitable," says Nikko's Matsushima, bringing in thousands of dollars per car. And Toyota aims to cut hybrid production costs over the next decade. With so much more manufacturing experience than its rivals, Toyota will be "the price leader" for the next generation of hybrid vehicles, says Matsushima.

To be sure, virtually every car company in the world is ramping up intriguing green-car projects. Even slow-moving GM plans to debut the plug-in hybrid Volt in 2010, but it is racing from behind against Japanese rivals that work in often exclusive national supply networks, as they have for decades.

Japanese carmakers aim to protect their edge by joining forces with makers of electronics and batteries, the key to the next generation of high-tech cars. Toyota's joint venture with Panasonic (which is majority-owned by the car company) has already made it one of the world's leading battery companies. Similarly, Nissan recently increased its stake in its own battery joint venture with NEC, investing in a big new factory with the aim of marketing its lithium-ion batteries to other carmakers. Japanese battery companies have a big lead in design and mass production, which will make their prices hard to match. A.T. Kearney's Eiji Kawahara says that, even if Japan does not come up with the next big breakthrough in battery design, the technology for putting it into mass production will likely be Japanese.

Mitsubishi's new electric car, the i MiEV, offers another nice illustration of the factors underlying Japan's lead. Until now, many electric vehicles have been limited by range, meager acceleration and long charging times. The four-door i MiEV boasts a range of 160 kilometers per each full charge (compared with 40 for a GM Volt), and, as a recent test-drive around Tokyo demonstrated, its pickup in urban traffic differs in no notable way from a gas-powered car. Other new electric vehicles—like Tesla's much-hyped roadsters—may offer even better performance. But in stark contrast to Tesla—an innovative but tiny start-up—Mitsubishi is reaping the benefits of a tie-up with leading Japanese battery maker GS Yuasa that has the two companies preparing for mass production of state-of-the-art batteries by the end of 2009.

Already the i MiEV's battery weighs in at a mere 204 kilograms (compared with 454 for Tesla's model), and the effect on cost is palpable. Mitsubishi plans to start selling i MiEVs in Japan at the end of next year for a price of about $28,000 after planned subsidies of about $10,000—compared with a cool $100,000 for a Tesla. Meanwhile, thanks to its work with Japanese power companies, Mitsubishi says it's close to perfecting "quick charge" devices that would bring the battery up to 80 percent of capacity in half an hour—thus opening up the prospect that you could recharge your car in the supermarket parking lot while picking up the groceries, for example.

Japanese companies have been plugging away at the green-car challenge for years, in a slow and steady way that plays to the strengths of their manufacturing tradition. While U.S. automakers have spent as much on R&D as top Japanese makers do, the former have been pursing totally different priorities—still sticking money into bulky SUVs while the Japanese were already well down the hybrid road. That money is filtering into other areas of Japanese industry, reinforcing technological progress. "We are now seeing the result of numerous companies' ferocious effort to innovate technologies" to meet carmakers' demands, says Masahiro Ohta, analyst at Fuji Chimera Research Institute.

The secret to making better batteries lies less in blazing transformations than in incremental innovation—something the Japanese are traditionally good at. Japanese battery makers and automakers have been collaborating since the late 1990s. Both sides use the word suriawase, meaning "coordination and integration." Indeed, car-industry observers took note last year at the Detroit Motor Show when Toyota president Katsuaki Watanabe adorned his company's stage with a huge PANASONIC sign (Panasonic supplies batteries for the Prius). The fact that car manufacturers and suppliers have such close relationships in Japan facilitates speedy experimentation and innovation. "It's not like assembling personal computers," says Tatsuo Yoshida, analyst at UBS Securities. "When you're making cars, you just can't put a set of components together to make a perfect product. A car is made of tailor-made parts and tailor-made components."

Slowly but surely, these relationships come together to give Japan an edge. Nissan is also working to develop a next-generation battery, partnering with NEC in an effort to begin mass production next year. A.T. Kearney's Kawahara says, "Those [Japanese] manufacturing technologies are the most confidential of the confidential." Though Ford and GM have been loudly touting hybrid vehicles of their own, those are estimated to be much more expensive, and U.S. manufacturers are already finding themselves compelled to turn to the Japanese for batteries that offer the necessary staying power.

Since the batteries that power cars could also someday be used to heat homes, a lead in the area has vast implications for the broader Japanese economy. Nobuaki Yoshioka is a senior executive at Automotive Energy Supply Corp. (AESC), a joint venture between Nissan and NEC. His company has been pushing the envelope of battery technology by developing lithium-ion batteries with manganese components—something NEC has been working on since 1990. "I think [the potential of this technology] is enormous," says Yoshioka. "We know that oil is going to be depleted, and that's going to make it indispensable to somehow store energy that is generated. Today we're focused on cars. But it's clear that the number of possible applications as storage of energy is huge."

For example, superefficient batteries might store electricity generated at times of low demand for use during peak hours. Batteries could be used to change the infrastructure of the energy industry not just in Japan but also throughout Asia. Fumikazu Kitagawa, an auto-sector consultant at Nomura Research Institute, believes that combining the new generation of batteries with solar-power generators will completely revolutionize household energy systems. "This sort of system will be available at reasonable cost, and fairly soon," says Kitagawa.

Batteries are only one part of a green automotive-components industry, including electric motors, inverters and the like, which Japan already dominates. Nomura estimates that the market for hybrid components alone could triple to $5 billion by 2012, and reach $9 billion by 2015. "Japan now has a huge potential to become a world supply center," says Yozo Hasegawa, author of the book "Clean Car Wars," which details the competition for green-car technology among Japanese carmakers and their foreign rivals.

Japan's push for the ultimate green car will also spill over into the materials sector. Consider the steel industry (steel is the main ingredient in automotive bodies). Amid intensifying global competition and consolidation, Japan's steelmakers have kept their edge, increasingly focusing on high-end innovative products coveted by the auto industries (about 80 percent of Japanese production is in this area, which yields the highest profit margins). Yasuhiro Daisho, a professor at Waseda University, says Japanese steelmakers have been leaders of ultralight and high-strength steel for years. "Nippon Steel and JFE Steel have the technologies that ArcelorMittal is very anxious to have," he says. Asian makers, in particular the Chinese, are also trying to catch up with Japan's lead in steel innovation.

Other materials makers are also scampering to develop new products for high-tech cars. Toray, a pioneer of high-tech materials like the carbon fiber it puts into aircraft wings and into the fuselage of the Boeing Dreamliner, too, is just one of them. The company recently set up a new automotive research-and-development center for advanced materials in Nagoya, just down the road from Toyota and suppliers. Toray holds 34 percent of the world carbon-fiber market, and aims to develop a carbon fiber cheap enough for use in car bodies. It hopes to more than double its sales to the auto sector to $3.5 billion by 2015. Teijin, another high-tech-materials maker, aims to "cut the weight of a car by half" by using a variety of new materials like polycarbonate resin, and a bubble-shaped prototype is on display in its Tokyo showroom. Meanwhile, a superlight sports car produced by Ken Okuyama Design is set for sale this fall in Japan. Using carbon fiber and aluminum generously, the model weighs only 750 kilograms.

Another potential growth industry: bioplastics, which have been attracting R&D money from Mazda and Toyota, among others. Because these materials are derived from plants rather than from petroleum (as most plastics are today), bioplastics are carbon-neutral and require much less energy to make. These companies are experimenting with a range of items, including installment panels and floor mats.

Of course, by betting heavily on all the green-car technologies, Japan could easily find itself getting a couple of calls badly wrong. It's certainly missed forecasts in the past—when, for example, Japanese mobile-phone companies ended up backing the wrong standard in the early 1990s, largely shutting themselves out of the global cell-phone boom that followed. The lithium-ion batteries that Japanese companies are investing in right now have plenty of limits, and it's always possible that nimble non-Japanese entrepreneurs could figure out an even better technology.

So far it's unclear which of the new green-car technologies will triumph in the race for "sustainable mobility." Hydrogen-powered fuel-cell vehicles like Honda's Clarity still face some serious challenges if they're ever to break though into the market: not only are they costly, but the fuel stations and infrastructure to power them would have to be built from the ground up. While electric vehicles have the huge advantage of being able to tap into existing power networks, they, too, remain costly, and even the best batteries still don't offer the same range as a full tank of gasoline. Lithium-ion batteries hold some safety concerns. The batteries have a tendency to overheat, potentially causing fires; some manufacturers have had to recall lithium-ion laptop batteries for just this reason. Don Hillebrand, director at Argonne National Labs in Chicago and a leading researcher who has testified before the U.S. Congress on battery technology, warns: "This is a time of great potential and huge risk. Those leaders today may not stay leaders, because rules are going to change quickly."

Even the popular hybrids are still a niche product. But as far as Japanese carmakers are concerned, gasoline is no longer where the action is. Hillebrand believes that green technologies are changing the industry in an unprecedented way. If Ford invented modern car manufacturing when it built the first assembly line for the Model T, says Hillebrand, then the emerging green technology represents "the second invention of the auto industry. And it's the Japanese who are leading the charge."

Ecofriendly cars are leaving the auto shows and the design exhibitions and taking to the streets. Honda, for one, has already started leasing the FCX Clarity to a select group of high-profile customers in southern California. As American actress Jean Harris, one of those chosen as a Clarity user, says: "I love that it's not a huge leap from what we're already used to. It feels like a space-age regular car." If Japanese managers have their way, that simple phrase could well provide the key to a new economic boom.

URL: http://www.newsweek.com/id/157508

©  2008