We have watched the Chinese economy explode with annual GDP growth in the double digit arena over the past two decades to where China surpassed the U.S. in 2014 to become the largest world economy by producing over $17.6 trillion in terms of goods and services. Just 14 years earlier the U.S. produced nearly three times as much as the Chinese. At the end of the day, China accounts for approximately 16.5% of the global economy versus the U.S. with 16.3%. However, it is important to note that although China’s economy may be the world’s largest it’s still not the richest. GDP per head is still less than a quarter of U.S. levels.

Optimism about the Chinese economy came to an end following a stock market sell off on August 24, 2015 (Black Monday) that saw the Shanghai Composite fall 8.5% (its worst single day performance since 2008). As illustrative of the role China now plays in the global economy, the U.S. Dow declined 1,000 pts., the Tokyo Nikkei-225 recorded its biggest drop in more than two years, falling 4.6%, Britain’s FTSE 100 was down more than 4.5%, the Stoxx Europe 600 index fell 5.3% and the German DAX lost 5%.

Overall, these declines stripped tens of billions of dollars in value from European companies

Following this dramatic negative occurrence, the Chinese economy continues to struggle amid continuing uncertainty, as labor unrest and lagging GDP growth spread throughout the entire country. As businesses, factories and financial services firms grapple with the new economic reality in China, economists disagree on the nation’s fiscal outlook. The IMF feels that China is at “a crucial juncture” in its development path and needs to show more urgency in reforming its economy. The IMF expects China to expand by only 6.0 percent next year (2017) while the majority of other economist predict a continuation of 2016 performance (i.e., 6.5% – 6.7%) – see Figure 1.

Many economists believe that China’s GDP growth is set to decelerate to +6.7% in 2016. Exports most likely would remain a drag on growth this year with a modest demand expansion in the U.S., the European Union and weak new orders from large emerging markets. Private investment will grow at a slower pace limited by a high corporate debt and ongoing overcapacity reduction. Much of China’s economic problems stem from overcapacity in a number of industries combined with high inventory levels.

Against this background, policy support is set to accelerate in the form of a large fiscal stimulus. The monetary stance by the central government will also be supportive but more cautious in order to contain credit risk. Private consumption is expected to pick up gradually thanks to higher purchasing power and improved confidence.

Non-payment risk will likely remain elevated. Insolvencies are expected to grow by +20% in 2016 (from +24% in 2015). Risks are tilted to the downside in the short run and stem from both external and domestic sources. Externally, a prolonged slowdown in exports will weigh on economic activity. Internally, higher credit risks and delayed reforms should reduce overcapacity.

Policy stimulus and a weak yuan have the potential to boost growth throughout the rest of this year. On the downside, a rapid cooling in the property sector could prompt the Chinese economy to slow sharply. In a longer-term perspective, credit-fueled growth has the potential to slow China’s economic transition and exacerbate macroeconomic imbalances.

A bright spot in the Chinese economy has been the housing market. China’s housing frenzy is still very much alive. Credit growth roared back, with medium and long-term new loans to households in August, which are comprised of mostly mortgages, jumping 32.2% year-over-year. That’s the fastest pace of growth since 2010, and suggests homebuyers are trying to get ahead of the game as they expect further tightening of housing and credit regulations.

Investors and speculators shrugged off the government’s cooling measures, boosting property investment growth to 6% in August.

That figure was up 5.4% in January to August from a year earlier, according to data released by China’s National Bureau of Statistics. Property sales also made a strong recovery, growing 31.8% in August compared to a year ago. And on top of that, most Chinese cities saw gains in home prices.

Although China was hit with a major decline in its stock market this didn’t have an overall, immediate impact on the average Chinese consumer. Despite persistent difficulties, some economist believe that an optimistic future awaits China. Fluctuations in the market have not greatly affected average Chinese households due to the fact that domestic wealth invested in stock markets is insignificant as a proportion of Chinese household wealth.

As evidence of this fact look at the robust nature of the Chinese automotive market. China is now the leading manufacturer of automobiles in the world. They produced over 24 million vehicles in 2015 compared to the combined output of the U.S. and Japan at slightly over 21 million vehicles. Automakers in China rolled out 1,990,500 vehicles and delivered 2,071,000 in August 2016, according to CAAM. Production and sales jumped 26.6% and 24.22% respectively over a year ago. Passenger car sales grew 26.34% to 1,795,500, including 916,200 sedans (up 20.12%), 654,100 SUVs (up 43.86%), 180,400 MPVs (up 35.93%), and 44,800 micro-vans (down 36.88%). Although on the surface this performance appears to be good news for the Chinese economy it is worth noting that various Chinese cities (i.e., Beijing) are pursuing options to limit the number of automobiles on their streets as a means of combating the air pollution that chokes most large cities. Beijing has put forth proposals to have an upper limit of 6 million automobiles in Beijing. It will be interesting to see how this approach works out. Overall, most economist believe that auto sales will decline in the latter half of 2016 with a further cooling off expected in 2017. As such, the expected growth in 2016 versus 2015 has been projected by the government backed China association of automobile manufacturers as 7.3% compared with the 10% growth in 2015 versus 2014.

Most economist feel that China is expected to keep its deep pockets open to both protect and boost its economy. China has done this before with positive results. However, if they choose this method now it will cost them (i.e. fiscal deficit will surpass budgeted target).

The central government’s fiscal deficit will surpass the target of 3 percent of gross domestic product set for 2016, according to economists surveyed by Bloomberg News. The broader shortfall that wraps in revenues from land sales, policy banks and other channels will also sink deeper into the red.

Here’s a snapshot of what the Bloomberg survey of 18 economists conducted Sept. 9 to 13, 2016 revealed.

• 17 expect this year’s budget deficit will be deeper than the government forecast, with nine forecasting 3.6 to 4 percent and four projecting above 4 percent
• 16 expect the broader augmented fiscal deficit will be 10 percent of GDP or more
• 16 expect a higher fiscal deficit next year too, with nine forecasting 3.5 to 3.9 percent, 6 seeing 3.1 to 3.4 percent, and one expecting 4 to 4.5 percent of GDP.

The fiscal tap in China is viewed as remaining well and truly open, in part to compensate for an on-hold monetary stance as policy makers shift from all out stimulus to reigning in asset bubbles.

Although there is a lot of uncertainty about the Chinese economy, there have been some recent bright spots. China’s factory output and retail sales grew faster than expected in August as a strong housing market and a government infrastructure spending spree underpinned growth in the one of the largest world economies. Industrial output grew the fastest in five months as demand for products from coal to cars rebounded, though analysts do warn that the outlook is a bit clouded by overall weakness in manufacturing investment and lack of spending by private firms. Some economists have said “it is very clear that the data is improving mainly because of the property market and this area is not sustainable”.

All things considered, looking beyond 2017 a number of economists feel that China will continue to see a decline in its GDP growth such that by 2020 that growth could be down to about 4.8%.

As China moves forward with its economic reforms, it will have to confront a possible imbalance between its strengths and weaknesses.

CHINA PERCEIVED STRENGTHS

• Strong FX reserves and external surpluses
• Large domestic marketHuge industrial base
• Solid growth prospects
• Low public and external debt
• Improvement in macro-prudential management

CHINA PERCEIVED WEAKNESSES

• Ageing population
• Difficult business environment, lack of transparency
• High corporate debt
• High inequality, low share of private consumption to GDP regarding the economic performance
• Competitiveness erosion
• Key sectors with overcapacities especially steel and solar
• Continued geopolitical tensions with key countries in the region
• Increasing market orientation

Most economists believe that in order to create a long term sustainable and stabilized economy that China needs to back away from depending so much on its exports. In other words, develop a thriving internal market. This is indeed a two edge sword since China’s Export growth has been a major component supporting China’s rapid economic expansion over the past few decades. In the last 2 years, China’s exports have declined due to weaker global demand but even so, China’s proportion of global exports rose to 13.8 percent in 2015 from 12.3 percent in 2014. China’s major exports are: mechanical and electrical products (41 percent of total exports), high tech products (20 percent), labor-intensive industries like clothing, textiles, footwear, furniture, plastic products and ceramic (16 percent), motors and generators (5 percent) and integrated circuits (5 percent). China’s main export partners are the United States (18 percent of total exports), Hong Kong (15 percent), the European Union (16 percent, of which Germany, the UK and the Netherlands account for 3 percent each), ASEAN countries (12 percent, of which Vietnam accounts for 3 percent), Japan (6 percent), South Korea (4 percent) and India (3 percent). The following graphs depicted in Figure 2 and Figure 3 were last updated in September of 2016 and are based on actual data through August of 2016.

We hear a great deal about the “imbalance of Trade” between China and the rest of the world. In fact, historically speaking, China exports more material/value than it imports. In August of this year Imports to China unexpectedly increased by 1.5 percent from a year earlier to USD 138.54 billion, following a 12.5 percent decrease in July while markets expected a 4.9 percent fall. It was the first increase in 22 months. In yuan-denominated terms, inbound shipments went up 10.8 percent year-on-year, compared to a 5.7 percent decline in the preceding month. Imports in China averaged 483.67 USD HML from 1983 until 2016, reaching an all-time high of 1830.94 USD HML in March of 2013 and a record low of 16.60 USD HML in July of 1983. China’s main imports are mechanical and electrical products (34 percent of total imports) and high tech goods (23 percent). The country is also one of the biggest consumers of commodities in the world. Among commodities the biggest demand is for crude oil (6 percent of total imports), iron ore (2 percent), copper and aluminum. Agricultural products account for 5 percent. China’s main import partners are: The European Union (12 percent of total imports, of which Germany accounts for 5 percent), ASEAN countries (12 percent, of which Malaysia accounts for 3 percent), South Korea (10 percent), Japan, Taiwan and the US (9 percent each) and Australia (4 percent). All data reflected in the Imports into China are reported by the General Administration of Customs.

The following data provides a brief overview of the current trade structure that China has with the rest of the world.

Using the prism of the Chinese Economy let’s take a look at the Chinese Coating Industry. In many respects the Chinese coatings market resembles the microeconomic model of “perfect competition.” In other words, there are over eight thousand paint producers in China with nearly identical business models based mostly on third party formulation knowledge. More importantly, no single firm has pricing power, no one profits and as prices and other types of sensitive information from the West are discussed, players can and do act very quickly in their search for a competitive advantage. Not surprising, participants in this market view the industry as anything but perfect. Neither producers or customers are happy with the current situation. China has yet to evolve a PPG or AkzoNobel type entity. As such the coatings industry has no major local leader and is so fragmented that no one is happy. China’s coating industry is ripe for a major consolidation of participants.

Given the apparent slowdown of the Chinese economy it may be possible to “reform” the coatings industry. Commencing in 2015 we have witnessed severe headwinds in virtually every area of the coatings market. The Chinese government has decreed that they will deal a heavy hand in combating over capacity and non-sustainable businesses. The coating industry is well positioned for such an undertaking. If there is a consolidation within the Chinese coating industry this will be a win/win for producers and customers. Such a consolidation should give rise to a greater investment in R&D by local producers. At the moment, local R&D efforts by other than multinational participants are essentially nonexistent.

Obviously, you can’t ignore the Chinese coating market. Some estimate has the total coatings market at 7.1 million tons valued at USD$137 billion with ink production at 500,000 tons. It’s important to note that although there has been significant growth in waterborne systems the majority of paint production remains solvent-based. In total it represents the world’s second largest coating market. As I mentioned, even today this market is dominated by solvent-based systems. In recent years there has been a marked increase in the switch to water based systems both in the architectural and industrial coating segments. The move by Chinese authorities to reduce air pollution has been one of the major reasons for such a switch.

As mentioned elsewhere in this report, China is now the leading global producer of automobiles. The 2016 value of the coatings used in the OEM automotive market is estimated to be about USD$ 1.44 billion. Future growth rates are variable but most experts believe it will exceed 7%/annum. Of course, that growth rate depends on the overall health of the Chinese Economy.

China will most likely continue its infrastructure spending spree. As such, China’s market for anti-corrosive coatings (ACC) for marine, container, bridge and oil platform application will continue to exhibit robust growth in the face of weakened economic activity. Application areas in this market include bridges, containers, drums, maritime anti-corrosion, etc.

With a growing housing market, an expanding automotive production forecast and continued infrastructure spending you would think that China offers a genuine growth option. Unfortunately, this isn’t that type of market. There are many competitors and the market isn’t well developed. Additionally, for non-multinationals there is genuine concerns about raw material availability, paint quality, paint specifications and routes to market are confronted with formidable obstacles. The Chinese coatings market is presents many challenges to those that wish to participate. It will take enormous commitment, resolve and patience to build success. There are no quick wins in the Chinese coatings market. However, the long-term gain from investing in China more than justifies the sacrifice demanded in order to achieve success. Given the recent slowdown of the Chinese economy and the likely pressure from the central government to cut back on overcapacity and seriously look at the long term sustainability of various companies it may be possible for a new entrant to acquire success by mounting an aggressive acquisition strategy. However, if this is your chosen route to market I encourage you to focus on quality, not quantity in your pursuit of possible candidates.