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China's industrial profit set to recover
By Shen Lan, Stephen Green and Li Wei |
November 9, 2012, Friday
|
Print Edition
Print Edition
THE slowdown in China's economy has taken its toll on corporate profits, but we see some light at the end of the tunnel.
Profit growth at large Chinese industrial firms declined 3.1 percent year on year in the first eight months of 2012. However, in September, the year-to-date contraction narrowed to 1.8 percent year on year. We see total profit growth began to decelerate in early 2011, slumped in the second half of 2011, turned negative in the first quarter of 2012 (though was shallower than in 2009), and bottomed out in September.
The picture is also better when one looks at the nominal situation: total profits at industrial firms have flattened out since 2011 rather than fallen, according to our seasonally adjusted numbers. Moreover, profits from firms' main businesses have begun to grow again.
Industrial firms' profits from their main businesses are much higher than their total profits. The reason is that many of the costs associated with running their main businesses - such as distribution, administration and financial expenses - are only taken into account when total profits are calculated. Profits from the main business are calculated as revenues minus some limited costs. Total expenses have almost tripled since 2006. At the same time, investment and other non-main business profits have continued to stagnate.
Flattening out
Profits from firms' main businesses have flattened out - while revenue continues to edge up, costs have kept pace. As a result, such profits have stopped rising, and the overall profit margin has moderated to around 14 percent.
Growth in sales revenue generated by companies' main businesses slumped from 30 percent year on year in August 2011 to 7.7 percent in August 2012. It rebounded to 10 percent in September, though this is still at the low end of the trend.
We use the Producer Price Index (PPI) to track the selling prices of industrial companies' products, and industrial production growth to reflect volumes produced. Since July 2011, downward price pressures appeared to have eased. In September 2012, the PPI contracted 3.6 percent year on year. We believe that year-on-year PPI inflation reached a floor in September, as prices of mining products and other raw materials have stabilized.
We also think industrial production growth has bottomed out and looks set for a mild recovery in the coming months. We expect a rebound in prices and an improvement in production to support a mild acceleration in sales revenue growth in 2013.
This is supported by the sales component of Purchasing Managers' Index readings.
Sales growth returned to positive territory in September and October, measured by differences between "production" and "finished goods inventory."
Meanwhile, costs continue to rise at a steady pace. Costs have inched up to nearly 86 yuan (US$13.7) per 100 yuan worth of sales, from 83 yuan in 2010. The two main costs for industrial firms are raw materials and wages.
Commodity prices have moderated from their early 2011 peak, which should help to boost margins over the next six months. One possible explanation for continued high costs is that wages continue to rise.
According to the National Bureau of Statistics, average wages have risen to almost five times the 2000 level; while upward wage pressure has eased in recent months, it remains an issue for some sectors. We believe that wage costs will continue to rise at about the same pace as nominal GDP growth in the medium to long term.
The inventory cycle is also critical, as it determines when companies will begin to increase their profits again, and subsequently restart postponed investment. Sales are still growing, so inventories should be drawn down as long as production adjusts down appropriately, which it appears to have done in many sectors. The inventory ratio (total inventories as a percentage of sales) is still growing, but we believe the growth rate has peaked. Before it starts falling, though, new orders need to pick up. This has not happened yet, but we guess that the turn is not far away.
Similar story
The story for inventories is similar. We've calculated the difference between inventories of raw materials and finished goods in the official PMI series. We have plotted it against the headline PMI reading. A reading below zero indicates that inventories of finished goods are rising faster than those of raw materials, which suggests that companies are drawing down raw materials and cannot sell their finished products. We are still in negative territory, and have been for most of the past year. The situation is not getting worse, but neither is there an obvious turn in the data yet.
Finally, we look at profits across different sectors. Among the numbers released by more than 40 industries, we picked the best and worst for this year. Electricity producers and grid operators performed the best, followed by thermal power producers and consumer sectors like food and tobacco. Metal smelting and processing as well as chemical production did worse. Heavy industry is clearly bearing the brunt of this investment downturn.
China's industrial firms are going through rough times, though 2008-09 was even tougher. We expect industrial-sector profits to have bottomed out in September and October, and foresee a recovery in profit growth in early 2013. As the destocking process continues, enterprises will restart production and resume investment projects.
Shen Lan, Stephen Green and Li Wei are economists with Standard Chartered Bank. The opinions expressed are their own.
Profit growth at large Chinese industrial firms declined 3.1 percent year on year in the first eight months of 2012. However, in September, the year-to-date contraction narrowed to 1.8 percent year on year. We see total profit growth began to decelerate in early 2011, slumped in the second half of 2011, turned negative in the first quarter of 2012 (though was shallower than in 2009), and bottomed out in September.
The picture is also better when one looks at the nominal situation: total profits at industrial firms have flattened out since 2011 rather than fallen, according to our seasonally adjusted numbers. Moreover, profits from firms' main businesses have begun to grow again.
Industrial firms' profits from their main businesses are much higher than their total profits. The reason is that many of the costs associated with running their main businesses - such as distribution, administration and financial expenses - are only taken into account when total profits are calculated. Profits from the main business are calculated as revenues minus some limited costs. Total expenses have almost tripled since 2006. At the same time, investment and other non-main business profits have continued to stagnate.
Flattening out
Profits from firms' main businesses have flattened out - while revenue continues to edge up, costs have kept pace. As a result, such profits have stopped rising, and the overall profit margin has moderated to around 14 percent.
Growth in sales revenue generated by companies' main businesses slumped from 30 percent year on year in August 2011 to 7.7 percent in August 2012. It rebounded to 10 percent in September, though this is still at the low end of the trend.
We use the Producer Price Index (PPI) to track the selling prices of industrial companies' products, and industrial production growth to reflect volumes produced. Since July 2011, downward price pressures appeared to have eased. In September 2012, the PPI contracted 3.6 percent year on year. We believe that year-on-year PPI inflation reached a floor in September, as prices of mining products and other raw materials have stabilized.
We also think industrial production growth has bottomed out and looks set for a mild recovery in the coming months. We expect a rebound in prices and an improvement in production to support a mild acceleration in sales revenue growth in 2013.
This is supported by the sales component of Purchasing Managers' Index readings.
Sales growth returned to positive territory in September and October, measured by differences between "production" and "finished goods inventory."
Meanwhile, costs continue to rise at a steady pace. Costs have inched up to nearly 86 yuan (US$13.7) per 100 yuan worth of sales, from 83 yuan in 2010. The two main costs for industrial firms are raw materials and wages.
Commodity prices have moderated from their early 2011 peak, which should help to boost margins over the next six months. One possible explanation for continued high costs is that wages continue to rise.
According to the National Bureau of Statistics, average wages have risen to almost five times the 2000 level; while upward wage pressure has eased in recent months, it remains an issue for some sectors. We believe that wage costs will continue to rise at about the same pace as nominal GDP growth in the medium to long term.
The inventory cycle is also critical, as it determines when companies will begin to increase their profits again, and subsequently restart postponed investment. Sales are still growing, so inventories should be drawn down as long as production adjusts down appropriately, which it appears to have done in many sectors. The inventory ratio (total inventories as a percentage of sales) is still growing, but we believe the growth rate has peaked. Before it starts falling, though, new orders need to pick up. This has not happened yet, but we guess that the turn is not far away.
Similar story
The story for inventories is similar. We've calculated the difference between inventories of raw materials and finished goods in the official PMI series. We have plotted it against the headline PMI reading. A reading below zero indicates that inventories of finished goods are rising faster than those of raw materials, which suggests that companies are drawing down raw materials and cannot sell their finished products. We are still in negative territory, and have been for most of the past year. The situation is not getting worse, but neither is there an obvious turn in the data yet.
Finally, we look at profits across different sectors. Among the numbers released by more than 40 industries, we picked the best and worst for this year. Electricity producers and grid operators performed the best, followed by thermal power producers and consumer sectors like food and tobacco. Metal smelting and processing as well as chemical production did worse. Heavy industry is clearly bearing the brunt of this investment downturn.
China's industrial firms are going through rough times, though 2008-09 was even tougher. We expect industrial-sector profits to have bottomed out in September and October, and foresee a recovery in profit growth in early 2013. As the destocking process continues, enterprises will restart production and resume investment projects.
Shen Lan, Stephen Green and Li Wei are economists with Standard Chartered Bank. The opinions expressed are their own.
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