HSBC'S preliminary purchasing managers' index (PMI) for November, published last week, was the latest in a raft of recent data that indicate the Chinese manufacturing sector has bottomed. The reading of 50.4 was the first time in 13 months that the index was in expansionary territory.

The positive reading was corroborated by data from the cement industry, which though not always seen as an effective leading indicator, are widely perceived to be a good indicator of real time investment activity.

According to CapitalVue, total cement production in China in the 12 months to September 30 rose to 1.59 billion tons from 1.51 billion tons. During the same period, the sales volume of cement was up from 1.48 billion tons to 1.57 billion tons.

Investors are wondering if the worst is indeed over for the Chinese cement industry. Although the uptick in manufacturing presents lucrative opportunities, cement makers would have to navigate through several challenges in a changing operating environment.

Throughout this period of slowing economic growth, fixed-asset investment in China has remained stable, with a slight upward bias. During the first 10 months, fixed-asset investment increased 20.7 percent, up 0.2 percentage point from the first nine months, according to the National Bureau of Statistics.

Fixed-asset investment is a major driver of cement industry growth. Investments in real estate and infrastructure construction, in particular the railway and highway sectors, are the main sources of cement demand.

Improved sentiment

Notwithstanding cyclical factors, it is, therefore, no coincidence that the cement industry has rebounded as investment sentiment has improved. As of mid-October, the national average cement price had risen 4.7 percent from the end of August.

Real estate investment in China during the first 10 months increased 15.4 percent, year-on-year, unchanged from the first nine months. Sentiment has improved due to recent tweaks in government policies, which sent a clear signal to potential homebuyers that local governments are supportive of the industry, boosting inelastic home demand.

Examples of such policy modifications include Wuhan's allowing housing provident funds to be used to pay off loans taken in other cities, and Guizhou's offer of permanent residence registration for homebuyers. Shanghai made similar adjustments supporting home purchases for owner occupation, allowing the use of provident funds to repay personal mortgages.

Homebuyers did not wait long and responded positively to the policy adjustments. According to China Galaxy Securities, home transactions in 33 cities totaled 61,000 units for the week ended November 10, a surge of 116.7 percent from a year earlier and a significant increase from the 47,400 units transacted for the week ended September 22. Should the rise in home transactions develop into a trend, property developers will be prompted to increase investments, thus stimulating demand for cement.

Another source of cement demand from the real estate sector is the government's ongoing drive to build 36 million units of affordable housing by 2015. Originally conceived as a way to alleviate the woes faced by China's urban working class in climbing the property ownership ladder and to support the real estate sector in the face of strict implementation of property curbs, the affordable housing program has served as a source of stable demand for cement.

In addition, the recent revival of investments in railway construction contributed to the nascent recovery in the cement industry. According to the Ministry of Railways, railway infrastructure investment totaled 69.77 billion yuan (US$11.16 billion) in October, a surge of 240.8 percent compared with the same month last year. This was a huge jump when one considers that total railway infrastructure investment during the first 10 months actually dropped 1.5 percent year-on-year to 361.8 billion yuan, while the amount invested during the first six months fell 38.6 percent to 148.71 billion yuan.

The accelerated pace of investment in railway infrastructure due to pump priming can only augur well for the Chinese cement industry. However, it is not all a bed of roses.

Financing for infrastructure programs remains a problem in some sectors. In this respect, the real estate and railway sectors have an edge. The real estate companies, especially listed companies, could raise funds not only from traditional bank lending, but could also tap the equity and debt markets, including the issuance of Dim Sum bonds. The railway sector could depend on government largesse and debt issuance by the ministry to fund construction.

However, the same cannot be said of highway builders. Although the National Development and Reform Commission approved the building of 2,018 kilometers of roads in September, the onus is on local governments to raise funds and convince private investors to finance highway-building projects at a time when the return on capital is diminishing after the government earlier this year implemented toll-free travel during major national holidays. Another hindrance is the wariness of banks to extend more loans for highway building following the lending binge in the wake of the 4 trillion yuan stimulus program.

Sustainable production

In addition to financing problems potentially constraining demand, the cement industry will have to confront the challenges of operating in an era when environmental consciousness is at a peak. Gone are the days when the Chinese people would acquiesce to having highly polluting plants at their backyard.

To achieve sustainable cement production, Zhang Lijun, the vice minister of environmental protection, announced plans at the beginning of 2012 to introduce tougher standards for nitrogen oxide emissions. Although the standard has not been fixed, there were media reports in September that the government will set the allowance at 300mg per cubic meter - stricter than the international allowance of 400mg per cubic meter and significantly lower than the current allowance of 800mg per cubic meter.

The government opened up another front in the quest for sustainability with the launch of a carbon-trading scheme - the Guangdong Emissions Trading Scheme - which currently has the participation of four cement makers. The first-mover advantage from buying credit for future cement plant projects will help participating cement makers gain valuable experience before such schemes become mandatory.

Although the implementation of emission standards and carbon-trading schemes will lead to higher initial costs, it would also raise the barriers to entry, promote industry consolidation and the elimination of outdated production capabilities. This would help resolve the problem of overcapacity and improve the pricing power of cement makers.

Sustainable cement production is key. Smaller players unable to meet the requirement will have to merge or be acquired by larger players such as Anhui Conch Cement and China National Building Material. This will have the added benefit of raising the industry concentration ratio.

In a race, all runners run, but only one gets the prize. Chinese cement makers must run in order to win. The days of low-hanging fruits are over. To successfully operate in the new paradigm, Chinese cement makers must fight the good fight, stay the course and finish the race. Only by doing so can they cement their place among global industry leaders.

CapitalVue provides China capital market, fundamental and time-series databases. Read more on www.capitalvue.com.