China's Competitive Threat
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China's Competitive Threat

A weaker currency is not the only driver of competitive risk.

The decision by China's central bank to devalue its tightly-controlled currency last month left shockwaves across global financial markets. While the People's Bank of China stated that the move reflected the authority's switch to a more market-oriented valuation, other interpretations - including delivering a much needed boost to their faltering export market - have been made. Though it is certainly true that the country's exporters may benefit from a weakened Yuan, the recent currency move only underlines a number of existing drivers that are helping Chinese companies to improve their competitive edge, especially in the higher value product markets. This article provides a closer look at some of those key drivers.

Excess Capacity

First, there is the risk of China exporting its excess capacity and further disrupting pricing. The country retains an anomalously high investment share of GDP - standing well above the peaks seen in Japan and Korea's during their respective industrial expansions. Weaker industrial production in China, combined with a diminished demand from domestic consumers, will inevitably lead to lower prices. Chinese companies will therefore face pressure to look overseas for new markets, and as ongoing currency weakness is expected in the year ahead, this only compounds this risk of continued low pricing.

Moving up the Value Added Curve

The steady penetration of industrial markets by Chinese companies has been readily apparent for a number of years, with 40-50 percent of their exports now made up of machinery or transportation equipment. What is equally significant is that the import intensity of such exports has collapsed. For example, the percentage of imported computer components required to produce computer exports has fallen from 40 percent in 2000 to 15 percent in 2013.

Importantly, the devaluing of the currency isn't just a boost for low cost manufacturing products, it also provides its assistance in plenty of areas of higher margin territory and this is where the Chinese corporate sector is heading.

Profitability Gap

Chinese companies have consistently operated at lower margins and returns compared to their Western counterparts. Access to cheap funding and a far lower cost of capital have helped sustain this, alongside arguably an inherent desire to take market share to establish national champions, rather than maximize profit in certain industries. The desire to compromise profitability to achieve strategic ambitions in specific industries - and increasingly high value products - will mean that Western companies will struggle to continue to play the "quality over value" card as before.

"Made in China 2025"

Indeed, improving market positioning in a range of higher value add industries appears to be front and center in the minds of Chinese policy makers. "Made in China 2025" is the first of three 10-year plans aimed at transforming China into a leading high quality and value added manufacturing power by 2049. 10 key sectors have been prioritized to be at the center of China's transition from a low end, volume, labor based production economy to a cutting edge, integrated, digitalized manufacturing base at the forefront of global and technical innovation, no longer dependent on imported components, machine tools and international know-how. China has already climbed the quality curve in consumer goods, telecoms and areas of capital goods/machine tools. We are unlikely to have to wait for 2025 to witness more of this.