socgen - china losing it shine

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11 January 2012


Capital GoodsChina losing its shine NeutralStock selection Preferred

China entering the danger zone.

SiemensLeast preferred

Chinas two main legs of growth, construction and exports, are weakening. Housing demand is slowing, property developers are slashing prices to clear out inventories and pay back their loans and land sales are falling, putting further pressure on already tight local government finances. At the same time, export demand is weakening, reflecting the recessionary environment in developed countries. The debt burden of Chinas local governments and large ongoing deficits should prevent a large stimulus plan similar to that of 2008. Moreover, with gross fixed capital formation representing nearly 50% of GDP, China stands well ahead of other BRIC countries, and we estimate that around a third of the capital stock is not efficient and yields low or even negative returns. Monetary easing could bring some relief, although we believe that Beijing lost some control of the financing system through the recent expansion of shadow banking. China has no choice but to switch from an investment-driven to a consumption-driven economy. Infrastructure, construction and mining-related industries should see their growth rates wane accordingly. On the positive side, we have identified four major long-term themes which could provide a new leg of growth for industrial companies in China: 1) consumer products manufacturing, benefiting from Chinas rebalancing efforts; 2) healthcare equipment, driven by Chinas ageing population; 3) automation, as high wage inflation calls for increased productivity; 4) energy efficiency, becoming one of the governments key priorities, with investments of >$430bn in renewable energies, smart grids and electric mobility planned over 2011-15.

Atlas Copco Do not expect another infrastructure stimulus package.

Four new major themes should drive industrial companies growth in China.

Changing competitive landscape.

Like Japanese industrial companies in the 1980s, the emergence of new entrants from China should significantly change the competitive landscape during this decade. The most at-risk industries include rail transportation, power generation, T&D and construction equipment as well as segments recently added to the Chinese governments strategic priorities such as healthcare. We are underweight stocks with high exposure to the Chinese construction theme, namely mining-related stocks (Atlas Copco and Sandvik, both of which we downgrade to Sell). We are overweight Siemens (Buy) as Chinas accelerated spending in automation and energy efficiency could offset part of the expected slowdown in infrastructure investments. SKF is also rated Buy as it offers a comparably attractive indirect exposure to consumer-related manufacturing activities.Sbastien Gruter (33) 1 42 13 47

Short infrastructure/mining, long automation/energy efficiency.

Gal de Bray, CFA (33) 1 42 13 84

Societe Generale (SG) does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that SG may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE APPENDIX AT THE END OF THIS REPORT FOR THE ANALYST(S)









Capital Goods


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Contents4 8 Investment summary Key recommendations

11 China Entering the danger zone 19 China Rebalancing is key 31 Other long-term themes driving Chinas growth 36 Changing competitive landscape 41 Power generation 48 Rail transportation 53 Transmission & Distribution 58 Healthcare 64 Construction equipment 69 Heavy and medium duty trucks 73 Automation 77 Bearings, cutting tools and compressors 80 Low voltage

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Investment summaryThe purpose of this report is to review Chinas risks and opportunities. 1) We further detail our concerns about the Chinese economic outlook (weakening exports, housing bubble about to burst, local governments debt burden, large shadow banking system) see pages 11-18. 2) We show that China has no choice but to transition towards a more consumption-driven economy, leading to waning growth for infrastructure-related capital goods and greater demand for consumer-related manufacturing see pages 19-30. 3) We show that some companies in our universe should still benefit from some specific mega-trends in China such as the countrys ageing population (driving accelerated demand for healthcare devices), high wage inflation (requiring higher productivity and automation investments) and the growing focus on environmental protection see pages 31-35. 4) The last section deals with Chinese competition risks, which are likely to intensify as domestic demand slows down see pages 36-80.

China entering the danger zoneChinese leading indicators have deteriorated for a number of months with PMI at or below 50. Chinas two main legs of growth, exports and real estate, have shown clear signs of weakness.The export engine has seized up, because Europe and the US, Chinas two key customers, are facing a tougher macro environment. This also reflects the reduced competitiveness of Chinas cost base owing to wage inflation and Yuan appreciation (+22% vs the $ from 2007).

The construction sector, the second leg of economic growth, is also jeopardized. The

construction sector, representing 20% of GDP, has been booming over the past 10 years and has grown well beyond underlying demand in our view. Every year China builds enough new housing to accommodate at least 60 million people a year, while only 20 million people are moving to the cities. Similarly, the Chinese road or railway network is already on par with that of the US. Cement consumption has hit new highs and China is consuming nearly 1,500kg per capita, 5x the rest of world average. A number of warning signals have emerged over the past few months, suggesting that the construction bubble may be about to collapse:Housing prices down. Driven by tightening actions, housing prices are starting to correct

(70% of cities are now showing negative price development).Excess new housing inventory. Among the 75 listed real estate developers, inventories

soared by 41% year-on-year at the end of September 2011. To clear out inventories and pay down their debt, some developers are slashing prices or selling entire residential projects. The situation is unlikely to improve in the coming months, bearing in mind that a lot of properties have yet to come to market, with the number of square metres under construction exceeding the number of sqm completed by up to 6x!Falling land sales. The Financial Times (FT) reported that land sales fell 13% in 130 big cities,

with most of the fall occurring in the last few months of last year. At a time when local governments are already struggling to pay down debt on infrastructure projects, this will put further pressure on their financing since land sales represent 30-40% of their fiscal revenues.


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Ways to prevent a hard landing are more remoteObviously, the Chinese authorities are not just sitting and watching these developments unfold, although their field of action looks more remote than ever. Indeed, another large infrastructure plan looks unlikely given the very low returns on investment yielded by the previous one and the countrys already high level of debt. Chinas incremental capital output ratio is already at a record high, suggesting that any new investment is likely to yield nonperforming loans rather than prosperity. Chinese authorities have started to ease monetary policy (cutting the RRR ratio by 50bps, encouraging lending to SMEs, etc.), although the size of the shadow banking system casts some doubt about the degree of control the Peoples Bank of China has on the overall financing system.

Rebalancing a game changer for capital goods companiesEven if the Chinese authorities miraculously manage to avoid a hard landing and a collapse of the construction bubble, they cannot afford not to re-balance the Chinese economy towards consumption: 1) Benefits of growth have been biased towards corporates and not sufficiently received by households. 2) To boost employment in urban areas, China needs to grow its tertiary sector. 3) Overinvestment and excess capacity in some industries have led to a slowdown in productivity growth. 4) Investment-driven growth is highly energy intensive. The likely re-balancing of the Chinese economy towards consumption will have some major consequences on the growth potential of capital goods. On the one hand, industries like construction and infrastructure-related activities (rail, power or mining), key beneficiaries of the investment boom in China, should see their growth rates wane. On the other hand, consumer product manufacturing industries should see their growth potential materially improve as China enters mass consumption, giving a boost to the automotive, healthcare and civil aerospace sectors for example.Development process Consumption intensity vs GDP per capita

Consumption intensity (per capita)

Investment driven economy Oil Cem ent Steel




BRIC countries

Consumption driven economy