Chongqing food – China (Photo credit: Arnoldo Riker)

Food — providing enough of it at acceptable levels of quality and at an affordable cost is shaping up to be one of China’s most challenging problems. Lax quality control, production shortcuts, urbanization and rising consumer spending are all combining to turn the spotlight on China’s food supply chain, creating problems, but also opportunities, for international companies doing business in the country.

Let’s start with the sheer quantity of food the country needs to feed its population. In 1978, China embarked on a policy of achieving self-sufficiency in food. As the country’s economic reform program began to take hold and productivity in its agricultural sector increased, China managed to achieve this goal by the end of the last century. In fact, China surprised many observers when it became a net exporter of agricultural products in 2002, its first year as a member of the World Trade Organization (WTO).

A great deal has changed since then, however. In 2012, WTO said that China had surpassed the United States to become the world’s largest importer of agricultural products. Even with 500 million farmers, China has been unable to meet the country’s growing demand for grains, soy beans and other commodities. And it’s about to get worse.

In January, Chen Xiwen, Director of the Chinese Communist Party’s top policy making body for rural affairs, said that China has decided to stop pursuing its goal of self-sufficiency in food. Chen said that food supplies would come under increasing pressure as incomes improved, admitting that the country could not “turn back the clock” when it comes to imports. In early April, President Xi Jinping told a group of foreign leaders and businessmen that China’s imports of commodities, goods and services will hit a value of $10 trillion annually in the next five years, up from $1.8 trillion in 2012.

Rising incomes and consumption are part of the reason why China is now an importer of agricultural products. Another is urbanization. In the greatest urbanization movement the world has ever seen, approximately 260 million farmers have moved to the cities since 1978, and another 260 million are expected to move off the farms in the coming years.

The safety of China’s food supply is another big concern, with the most recent victim being Yum! Brands, Inc. (NYSE:YUM), the Kentucky based operator of the KFC and Pizza Hut fast-food chains. Yum was one of the first food service companies to enter the China market and is the leading Western restaurant company in the country. China now accounts for 45 percent of Yum’s revenues and nearly a third of its total operating profits.

This week, Yum reported a 26 percent drop in first-quarter earnings, as food safety concerns continued to hurt its Chinese business. Allegations in December that Yum’s suppliers had injected chicken with antiviral drugs and growth hormones beyond food safety limits caused some customers to call for a boycott of the company’s restaurants. The recent outbreak of bird flu will likely lead to a 30 percent decline in same-store sales in April according to the company. As of Tuesday, there have been 108 cases and 22 deaths from the new flu, which has now spread to Taiwan.

Not a week goes by, it seems, without at least one story about the safety of China’s food and water supplies, with bird flu being only the latest. In early April, it was reported that 292 children in Ziyang city, in Southwest China’s Sichuan Province, were sent to the hospital after eating contaminated food in their school canteen and showing diarrhea symptoms, including fever and vomiting. In recent weeks, dead fish and dead pigs found in rivers near Shanghai have prompted safety fears.
Concerns about food safety have caused consumers in China to be much more cautious about what they eat and where it comes from. In January, the first “Prepackaging Nutrition Label Principles” in China were established, providing standard food nutrition information for consumers. Carrefour SA, the French retail giant which now has 200 stores in 60 cities throughout China, launched what it called a “Nutrition Knowledge Promotion Activity” in Beijing in early March to provide food transparency to its Chinese customers.

Reacting to infant formula and milk scares in 2008 and 2011, Chinese consumers have turned to imports. In fact, the demand for imported milk and infant formula in China is so great that Hong Kong recently passed an amendment to its export regulations to prevent an influx of traders who buy milk powder in Hong Kong and resell it elsewhere in China for a profit, mainly to families who have no faith in mainland-produced infant formula. Under the amendment, a person can carry only two cans, or 1.8 kilograms, of baby formula out of Hong Kong, and the person must be at least 16 years old. Violators face fines of up to HK$500,000 ($64,500) and two years in jail.

China’s middle class is increasingly turning to imported products in all food categories, not just milk. At Walmart China’s e-commerce site, sales of imported products increased fivefold in 2012. While imported food used to be rare and expensive, the recent surge in domestic commodity prices, driven by inflation and higher costs, has made foreign food products more affordable. Moreover, the government’s efforts to lower tariffs on imported food has also made such items more accessible to Chinese consumers, said Zhao Ping, Deputy Director of the Department of Consumer Economics at the Chinese Academy of International Trade and Economic Cooperation of the Ministry of Commerce.

With China resolved to being an importer of agricultural products, look for even more favorable policies in the future. Food generally accounts for two-thirds of price inflation in China, and it hits hardest those Chinese who are the least able to afford increases in their food budgets.

In this context, investors will not have difficulty identifying beneficiaries of the food challenges faced in China today. For example, international retailers like Carrefour and Wal-Mart should benefit as consumers place a higher premium on the reliability of the food they buy. Likewise, international food companies will find growing demand in China for their products, at the same time that import tariffs and barriers are being eased. The American farmer will benefit from China’s increasing food imports, as will companies with products, services and management systems that can improve the productivity of China’s agricultural sector. A large and growing market for safe, reliable food products in China is the silver lining in this cloud for international companies.

Geely Gleagle GS (coupe version) concept car, in Auto Shanghai 2011. (Photo credit: Wikipedia)

After respectable — but low for China — growth of 7.7 percent in 2012, car sales surged by 21.6 percent during the first quarter of 2013. Even more surprising was the fact that sales of Chinese brands increased even faster than the overall market. Sales by the local car companies increased by 33.6 percent during the quarter, compared to 16 percent for the global assemblers.

Increased inventories may account for some of the increase. At the end of March, dealer inventories stood at 40 days, compared to 34 days at the end of January. The additional inventory accounted for approximately 37 percent of the increased unit sales. Had dealer inventories remained at January levels, sales would have increased by 13.6 percent, still a healthy rate of increase by any measure. Interestingly, dealer inventories for both the local and global assemblers at 41 days and 39 days, respectively, are down from their levels during the second half of 2012.

At the end of March, the local brands accounted for 35.1 percent of China’s passenger car sales, up from 32.9 percent at the end of last year. Most of the market share gain came at the expense of the Japanese assemblers, whose market share sank to 15.8 percent from 19.1 percent at the 2012 year end. Sales of Japanese cars in China have been suffering over the past nine months due to the ongoing dispute between China and Japan over ownership of the Diaoyu islands in the East China Sea.

The big winners during the quarter were Chang’an, up 121 percent, Great Wall, up 53.2 percent and Geely and BYD, both of which increased by about 25 percent. In terms of models, the SUV segment outpaced the overall market, with first quarter sales up 40 percent. Sales of low-end SUVs rose 47 percent, due in large part to new model launches.

The strength in China’s car market during the first three months is all the more surprising given that the economy as a whole has underperformed so far this year. On Monday, China’s National Bureau of Statistics reported that the country’s economic growth slowed in the first quarter to 7.7 percent, down from 7.9 percent in the fourth quarter of 2012 and below a widely expected 8 percent rate of increase.

China’s strong auto market is sure to put smiles on the faces of the participants in this year’s Shanghai Auto Show, which is expected to be the largest international motor show in the country’s history. The annual auto show in China, which alternates between Beijing and Shanghai, will officially begin on Sunday, April 21 and will run through April 29. Journalists will get an early look at the new models, however, on Saturday when the show will be reserved for them on Media Day.

And there will be a lot for them to see. China is now the largest auto market in the world, and already accounts for more than 23 percent of the total annual production of vehicles globally. As a result, every major industry participant will be represented in Shanghai in the coming weeks. Nearly 2,000 automobile and component manufacturers from 18 countries and regions will be present at the event. Some 1,300 vehicles will be showcased, including 111 world premieres and 49 Asia debuts. There will be 69 concept cars and 91 alternative-energy vehicles on display.

More than 800,000 people are expected to visit the show, and an estimated 10,000 reporters will cover the show on site.

Apple Store Beijing China (Photo credit: IvanWalsh.com)

Sometimes, too much success in China can create its own set of challenges. Ironically, the very success that Apple Inc. (NasdaqGS: AAPL) has had selling its products to Chinese consumers may be at least part of the reason why the Cupertino, California company found itself at odds with the powers that be in China in recent weeks.

There is no question that Apple products are popular with Chinese consumers. Almost everyone it seems has an iPhone or an iPad, and Apple’s stores in China, like the one in the Village in Beijing’s Sanlitun area, are always packed, with consumers lined up to get inside and black-clad security personnel on hand to ensure orderly queues. Apple’s revenues in China reached $20 billion in 2012, and in the first quarter of this year, China sales increased by 67 percent, accounting for 13 percent of the company’s total.

How can this be bad? It’s not, but Apple’s popularity with consumers may have encouraged the company to take recent criticism of its consumer policies in the country much too lightly, touching off two weeks of controversy that only ended with a public apology by Apple’s CEO last week.

It all started on Friday, March 15, International Consumers’ Day, when state-run China Central Television (“CCTV”) broadcast its “3.15” annual investigative report on how companies operating in China mistreat consumers. In a two-hour special devoted to consumer rights, CCTV targeted Volkswagen AG, the German carmaker, Anhui Jianghuai Automobile Co. (“JAC”), a local auto company, Chow Tai Seng, a popular Chinese jeweler, and Apple.

The CCTV report said that Volkswagen’s direct shift gearbox transmission was causing vehicles to slow down or speed up during driving. JAC was accused of using low-quality steel plates, causing rust to form on some of its Tong Yue brand of cars after just a couple of years of use. Chow Tai Seng, according to CCTV, has adulterated some of its gold with iridium, a metal that is akin to gold but much cheaper. For its part, Apple was criticized for discriminating against Chinese customers, offering them lower levels of service than it offers customers in the United States and Australia.

Like Apple’s electronic products, Volkswagen cars are very popular with Chinese consumers. Last year, 2.6 million Volkswagens were sold in China, the largest selling brand in the country. However, Volkswagen has been operating in China for over 25 years, and it understands that having the support of the media and the government, not just the consumers, is important to continuing success in the country. Rather than crying foul for having been targeted, Volkswagen reacted immediately. After the show, Volkswagen promised action, and a spokesman said the following Monday that the company would recall both locally-made and imported cars using the gear box.

Being Chinese companies that understand implicitly the need to be on good terms with the media and the government in China, both Chow Tai Seng and JAC apologized immediately to consumers and promised remedies. At a press conference the day after the show, JAC management said Tong Yue-brand cars made before 2010 risked developing rust because the company’s “lack of experience in making cars at that time” led to problems in the coating and painting process. Notwithstanding management’s explanation that an upgrade of its manufacturing facilities and technology had eliminated the problem, JAC issued an apology to customers: “Sorry, Tong Yue owners,” it said. “We moved slowly previously, but we are improving. We are mobilizing all of our resources, including human and financial, to solve the problem.” JAC informed China’s quality watchdog of its plans to recall Tong Yue cars at risk.

Unlike Volkswagen, JAC and Chow Tai Seng, however, Apple didn’t apologize, but instead took issue with CCTV’s criticism. Apple issued two statements following the show, denying discriminatory practices in China and saying that Chinese customers enjoy Apple’s highest standards of service and that the warranty policy in China is the same as in the US and around the world. Legal experts in China did not buy Apple’s statements.

Qiu Baochang, legal team leader of China Consumers’ Association, said: “Apple says Chinese consumers enjoy the highest standard of service. This is a false statement. It’s a fact that the company gives brand-new replacements in other countries, but in China the warranty does not cover the outer casing. I think Apple is ducking the issue.” Meanwhile, China’s quality watchdog said that Apple’s policy violates Chinese law, and said that Apple must correct the policy or be severely dealt with.

Apple’s statements, and the reactions from the Chinese press and the government, touched off an avalanche of articles over the last two weeks, many of which called CCTV’s criticism unfair and politically motivated. Some observers said that China had “declared war” on Apple, while other analysts speculated that the continuing media blitz against Apple is aimed at showing what the government can do to successful American technology giants. Some noted that the criticism of Apple coincides with the Obama administration’s pressure on Beijing on cybersecurity issues and the restrictions being placed by some members of congress on Huawei and ZTE from doing business in the United States.

Some or all of these reactions may be true, but they don’t explain why Volkswagen, JAC and Chow Tai Seng were also targeted for criticism. More importantly, they miss the basic point — that companies have to accept China for what it is, not what they would like it to be. China is a big and fast growing market. It is also a country that is under the firm control of the Communist Party and a country whose state-run media has enormous influence as a result. A company doesn’t have to agree or like these aspects of China, but it has to recognize and deal with them if it wants to be successful in the country. A company can’t like China’s market, but refuse to deal with its other realities.

Despite the continued loyalty of Apple’s customers throughout the controversy, Apple finally relented. In an open letter issued last week, Apple CEO Tim Cook offered his “sincere apologies” for Apple’s customer-service practices. In the future, Apple would do to well to follow the examples of companies like Volkswagen, JAC and Chow Tai Seng that have deep experience operating in China.

Image via CrunchBase

Will the Chinese buy A Tesla? The management of Tesla Motors, Inc. (NasdaqGS:TSLA) certainly hopes so.

At the Detroit Auto Show, Tesla announced its plans to open a dealership in Beijing — its first store in China — this spring. George Blankenship, the company’s vice president of worldwide sales, said the store will house an 8,000-square-foot facility, much larger than its U.S. stores, which typically have 2,500 to 3,000 square feet of floor space. “The China market is incredibly important to us,” Blankenship said. “We think our timing is perfect.”

2013 is an important year for Tesla. The maker of battery-powered Model S sedans has a goal of becoming profitable this quarter, with vehicle deliveries forecast to rise to a record 20,000 units this year. In fact, Tesla, which received $465 million in U.S. Energy Department loans to develop and build electric cars, is so confident about its prospects that it predicted it will repay the funds five years ahead of schedule.

Despite the confidence of management, though, the company has its doubters, as evidenced by the 50 percent short interest in Tesla’s stock. Production snags in last year’s second half boosted operating expenses and triggered a wider fourth-quarter loss for Tesla than analysts anticipated. Moreover, a recent New York Times article, Stalled Out on Tesla’s Electric Highway, has sparked a running feud between Tesla and John Broder, the article’s author. Tesla management admits that the article has cost the company $100 million in sales.

With pressure mounting to achieve its sales targets in 2013, where else to look for buyers but China, the largest automotive market in the world? The $64,000 question, though, that will only begin to be answered when Tesla’s Beijing showroom opens is: “Will the Chinese be willing to buy a Tesla?”

Tesla supporters cite a number of reasons for optimism. First, Beijing is enduring an unprecedented amount of smog, which has reduced visibility on many days to a few yards. Electric vehicles are seen as at least part of the solution for improving air quality. Secondly, The Chinese government wants to decrease the country’s dependence on imported oil, and electric vehicles effectively transfer fuel requirements from internal combustion engines that burn gasoline, to power plants that burn coal, which China has in abundance. Third, for these and other reasons, electric cars enjoy many favorable policies from the local governments. For example, Beijing has begun offering free license plates and a $19,000 rebate to private buyers of electrics. And finally, the luxury car segment is one of the fastest growing in China’s large and growing car market.

In considering all of the variables, however, it seems clear that, if Tesla is going to make it in China, it will have to make it as a luxury brand, not as an electric vehicle. At a base price of $59,900, Tesla’s Model S electric sedan already costs up to twice as much as a similar sized conventional car. Optional features can take the price to $100,000, and then a 25 percent import duty, 17 percent Value Added Tax and a Consumption Tax must be added before it reaches the consumer. At that price point, Tesla’s potential customers will be the wealthy individuals that have made China the world’s largest market for luxury brands.
Moreover, Tesla is not likely to benefit from favorable government policies in China because, for the most part, they are reserved for electric cars manufactured in the country. In order to promote sales of its Chevy Volt, General Motors has been urging the Chinese government to extend its electric vehicle subsidies to imported models since 2010, to no avail. Even if subsidies were extended, however, they wouldn’t be enough to move the Model S out of the luxury category.

As far as pollution, it’s not clear how large an impact electric vehicles would have on air quality in cities like Beijing. Because Beijing already requires that all cars being sold in the city meet Euro V emission standards, with other cities following suit, passenger cars are not really the problem. By the time a car achieves Euro V standards, emissions of NOx and particulate matter are negligible. The real culprits are diesel burning trucks and buses, many of which are still operating at Euro III emission levels, factories, and the coal fired power plants that will supply the electricity for the electric vehicles. The net result on air pollution of a large population of electric vehicles may well be negligible.

As a practical matter, sales of electric vehicles have been weak in China, and largely limited to government and corporate customers. “The government’s been trying to promote them [electric vehicles], but it’s not an easy sell,” said Tim Dunne, director of Asia-Pacific market intelligence at consumer-research firm JD Power and Associates. “While everyone [who does business with China] would like China to reduce their dependence on oil and reduce emissions,” Dunne said, “EV sales are anemic in most markets around the world.”

In the first three quarters of 2012, only 3,000 electric vehicles were sold in China. Global consulting firm McKinsey & Co predicts the Chinese market will remain mostly unchanged, at least for the next five years, as individual buyers continue to be indifferent to electric vehicles.

That leaves Tesla in competition with BMW, Mercedes, Audi, Porsche, Lamborghini, Ferrari, Bentley and Rolls Royce and other well established luxury brands that provide the “face” that every brand conscious buyer of a luxury car in China desires. Whether Tesla can do the same remains to be seen.

English: Tesla Roadster Sport 2.5, the fourth-generation Roadster from electric carmaker Tesla Motors Inc. (Photo credit: Wikipedia)

Hope springs eternal — and nowhere is it gushing more strongly than with electric vehicle enthusiasts all over the world.

In the United States, investors in Tesla Motors, Inc. (NasdaqGS:TSLA), the U.S. maker of electric sports cars, seem to be shrugging off the fact that the company is losing a $100 million a quarter, the bankruptcy of battery maker A123 Systems, Inc. (OTC Markets:AONEQ), as well as the fact that the Obama administration, one of the biggest proponents of electric vehicles, is already walking back its prediction that there will be 1 million on the road in the United States by 2015. Why else would investors give Tesla a $4.3 billion market capitalization in the face of such question marks?

In China, the government planners have named new energy vehicles (“NEV”) as one of seven strategic emerging industries in its 12th Five-Year Plan which began in 2011. China’s NEV plan is carried out under the country’s “863 Program,” a State High-Tech Development Plan that is funded and administered by the government to stimulate the development of advanced technologies in order to make China less dependent on foreign technologies. In a visit to Lishen Battery, a lithium battery maker in Tianjin, last September, then-President Hu Jintao underscored the government’s enthusiasm for battery and NEV technology when he said: “New energy is a strategic emerging industry with great promise.”

China has two very important reasons for endorsing new energy vehicles. First, the country is looking for every way that it can to reduce its dependence on imported oil. Soaring car ownership and a recent shift to less fuel efficient vehicles, however, are making this an even greater challenge. Secondly, the government sees its NEV plan as a way for China’s automobile industry to technologically leapfrog the existing global automotive assemblers that have one hundred years of experience making cars with internal combustion engines. This objective is also running into important hurdles.

If any country can successfully implement a comprehensive electric vehicle program, it is China. In addition to strong political support, China’s urban infrastructure is still a work in progress with an estimated 270 million people expected to move from the countryside into China’s cities in the coming years. With a virtual blank page on which to draw, there is significant latitude to build in electric charging stations and the other infrastructure needed by an electric vehicle industry. Moreover, China’s car culture is still young, and Chinese haven’t gotten accustomed to those long — and fast — car trips that their American counterparts take for granted. Theoretically, Chinese consumers should be more receptive to the limitations of electric vehicles.

In his recently published, authoritative “Blackbook” (Chinese Autos, Part 1: The Quest for Global Competitiveness — Technology, Competence, Ambition and Politics) on China’s auto industry, Max Warburton, senior auto analyst for Sanford C. Bernstein & Co., LLC, expresses grave doubt that China’s NEV plan is viable. In an interview for Warburton’s research, a senior German auto executive was quoted as saying:

With NEV, they’ve run into exactly the same technical barriers as everyone has faced in the rest of the world—the laws of finance and business may be different here, but the laws of physics and chemistry are just the same world over.

The biggest technical challenge for electric vehicles begins with the battery — they are big and expensive, and can catch on fire, as General Motors found with its Chevy Volt. At today’s prices, the battery pack for an electric vehicle costs $15,000, and that’s before the other powertrain costs of electric motors, converters and inverters for motor control are included. To make a competitive electric vehicle, China’s automakers need to advance battery technology significantly, but according to Warburton’s investigation, Chinese battery technology lags Western standards by a number of years. Despite its claims to the contrary, Warburton does not believe that BYD Company Ltd. (HKSE:1211.HK) has unique technology, and questions whether any other firm or institute in China can develop superior battery technology in the future.

Apart from the technical challenges, electric vehicles are not cost competitive and their performance is inferior to cars powered with internal combustion engines, according to Warburton. At current vehicle prices, oil prices would need to climb to $300 to $500 per barrel for electric vehicles to be cost competitive with gasoline and diesel engine cars in Europe, where gasoline taxes are 70 percent of the price at the pump. In countries with lower gasoline taxes, oil prices would need to be even higher. Oil prices would need to reach $800 per barrel in the United States, and $500 to $700 a barrel in China.

In Warburton’s view, “logical” consumers will only buy new energy vehicles in significant quantities when it makes economic sense to do so — either if vehicle prices fall or become cheaper due to government subsidies. He does not see any evidence that Chinese automakers will be able to produce a significantly less expensive electric vehicle, so the only question that remains is how far the Chinese government will go in supporting NEV technology in the name of achieving greater energy security.

Cover via Amazon

Anticipation grew in advance of Monday’s 85th Academy Awards, “Oscar Fever” spread throughout the world, including China. Even though the country had no films in the competition, the buzz could be heard before, during and after the annual Hollywood event. Just 30 minutes into the ceremonies, “Oscars” was the top trending topic on Sina Weibo, China’s most popular microblog, as Ang Lee, the director of Life of Pi, received the award for Best Director.

Despite China’s growing importance in the global film industry, having a Taiwanese-American walk to the stage to receive his Oscar was as close as China came to being a real participant in one of the world’s glitziest events. Some thought that Flowers of War, a Chinese film that is set against the 1937 Nanjing Massacre and is said to be the most expensive Chinese film ever made, had a chance, but it wasn’t even nominated for an award. If a Chinese film directed by Zhang Yimou and starring Academy Award-winning actor Christian Bale couldn’t make the list, how does any Chinese film stand a chance?

That is a question being asked in numerous post-Oscar interviews and talk shows in China. The disconnect between the size of China’s film industry on the one hand, and the quality of Chinese made films on the other, is glaring.

In the United States, the world’s largest film market, box office revenues were $10.8 billion in 2012, a 6.5 percent increase over 2011. Led by the growth of the Chinese market, international box office revenues experienced continued growth. Box office revenues grew by 3 percent to $23.1 billion, versus $22.4 billion in 2011, with foreign IMAX and 3-D capable theaters provided a buffer to otherwise softer markets in Europe such as Italy and Spain.

China, now the number two after the U.S., generated box revenues of approximately $2.7 billion in 2012, a 30.2 percent increase over 2011. After years when going to the movies meant sitting in a drafty hall watching a film chosen by a local government committee, Chinese have embraced the idea of taking in a movie as a desirable leisure activity. With an average of nine new screens opening every day, China’s film-exhibition business is growing at a rate that is unparalleled. Since 2002, when there were fewer than 1,300 theaters in China, the industry has grown tenfold. Even with 13,000 theaters, one for every 220,000 people, China’s film industry remains relatively unsaturated. In the United States, there is one screen for every 9,000 people. At this rate, China could top the U.S. film market by 2020.

Despite the growth of their home market, domestic film makers are lagging behind, even after government protectionist measures. To protect the local players, SARFT imposes a quota of foreign movies allowed in China each year — in February, the number was increased from 20 to 34 — and movie theaters are rewarded financially for showing local films.

Notwithstanding these measures, imported movies have historically accounted for a greater percentage of the overall market in China. In 2012, ticket sales for imported movies totaled $1.4 billion, and domestic revenues totaled $1.3 billion, or 49.5 percent of gross ticket revenues, according to data published by the State Administration of Radio, Film and Television (“SARFT”). Last year, U.S. films, including Titanic 3D and Mission: Impossible–Ghost Protocol, comprised seven of the top 10 highest-grossing films in China, according to SARFT. While foreign films accounted for only a quarter of the 303 movies screened in Chinese theaters last year, they took in over half of overall ticket sales.

Why the difference in audience appeal? Many point to regulation and SARFT, the organization under China’s State Council whose main task is the administration and supervision of state-owned enterprises engaged in the television, radio, and film industries. SARFT directly regulates state-owned enterprises at the national level such as China Central Television, China National Radio, China Radio International, as well as other movie and television studios.

SARFT issues mandatory guidelines for media content. In 2009, SARFT issued a directive highlighting 31 categories of content that are prohibited online, including violence, pornography, and other content that may “incite ethnic discrimination or undermine social stability.” In 2011 and 2012, it limited the number of reality television programs and historical dramas, expressing particular disapproval of programs with a plot that involved time travel back to a Chinese historical era. This decree resulted in cancellation of a number of planned films with historical plots. Finally, SARFT is responsible for censoring any materials that offend the sensibilities of the Chinese government or Chinese cultural standards. Prior to distribution in Chinese theaters, all screenplays in China must be approved by SARFT.

Xie Fei, a professor at the prestigious Beijing Film Academy, recently sparked a debate on government control over the film industry when he called for abolishing the country’s censorship procedures in favor of a movie rating system similar to that used in the United States.

“In the past few years, there were so many unwritten laws when censoring movies,” Xie wrote in an open letter. “Unwritten laws such as: ‘ghosts are not allowed in contemporary settings,’ ‘extramarital affairs are not allowed,’ ‘certain political incidents are not allowed,’ etc. The censorship system (in China) is not defined by law, but done according to individuals.” Such rules, Xie wrote, are “killing artistic exploration.”

Officially, Beijing is backing the domestic film industry as part of broader efforts to increase China’s “soft power” to match its growing economic muscle in the cultural sphere. In the 12th Five-Year Plan, the government committed itself to “deepening reform of China’s cultural industries.” Part of the answer may well come from greater cooperation with foreign film partners.

Han Sanping, president of the China Film Group, a state-owned entity that oversees the release of imported films, is known in China film circles as “Master Han” or “the godfather of the Chinese movie industry.” In an interview last year, Han said: “We must try and attract more foreign technologists, expertise, producers, investors, distributors, directors, actors and artists, to come and collaborate with us on high-quality co-productions. And then learn from them.”

English: great wall hover ???????: ????? ???? ????? (Photo credit: Wikipedia)

The timing of Spring Festival must always be taken into account when analyzing vehicle sales in the first two months of the year in China, but by any measure, passenger car sales were very strong in January. In the first month of the Year of the Snake, passenger car sales surged to 1.49 million units, a 53 percent year over year increase.

While the hefty percentage increase can be attributed at least partially to the “Spring Festival” effect — most businesses close for at least a week during Spring Festival, which this year fell in February rather than January as it did last year — monthly sales of almost one and one-half million units were the highest ever recorded in China, exceeding the next highest month by nearly 200,000 units.

By type, medium-sized cars and SUVs registered some of the largest increases. Medium sized cars accounted for 57.7 percent of the market in January, while SUV’s increased their share to 15.5 percent. Small cars accounted for just under 20 percent, and luxury vehicles just over 3 percent, of the market during the month.

China’s passenger car market remains highly fragmented with a total of 27 separate companies making cars. Volkswagen (Frankfurt: VOW.F), with joint ventures in both Shanghai and Changchun, continues to be the leading brand in China, increasing its total market share to 21.8 percent, while General Motors Company (NYSE:GM) follows in second place with 12.2 percent. At 5.6 percent, Nissan was the only other brand to have greater than 5 percent of the market. All of the 24 other brands are below this level.

By country, Chinese local brands now account for 32 percent of the total, their highest ever, with Geely, BYD, Great Wall and Chery all finishing on the top 10 assembler list for the month. European brands are second with a 25.8 percent share; the Japanese third with 16.7 percent of the market; followed by the American brands at 14.3 percent and the Korean brands at 11.0 percent.

The largest market share shift over the past several years has come at the expense of the Japanese car companies. In 2008, Japanese brands accounted for about 31 percent of the Chinese car market, almost double their share today.

China is now the world’s largest auto market and it is impossible to imagine a set of circumstances that would cause this to change. “Who is winning?” and “Who is Losing?” in China’s auto sweepstakes, therefore, are two of the most frequently asked questions by investors.

As far as winners, Volkswagen has been a consistently strong performer and has led the international assemblers with its convincing market share. With respect to the local players, several of the Chinese car companies have had their moments in the sun over the past several years. In 2007, Chery received a great deal of attention with its international push. In 2009, BYD gained notoriety when Warren Buffet, arguably the world’s most famous investor, bought a 10 percent stake in the company for $230 million. And in 2010, it was Geely’s turn when it bought Volvo for $1.5 billion.

Today, however, Great Wall Motor Company (HKSE:2333.HK) is receiving all of the buzz. The company has carved out an important niche in the profitable SUV segment and is far and away the leading local player in that category. Some industry experts say that Great Wall may be the only one of the local car companies to ultimately survive as an independent company. That may be too dire a prediction, and whether it proves to be true, only time will tell. In the meantime, though, Great Wall is the poster child for all Chinese car companies.

Clearly, the big losers in the China market have been the Japanese car companies. Although Chinese consumers love Japanese technology and styling, the ongoing dispute over the Diaoyu islands in the East China Sea has created a negative environment for all Japanese goods in China, including autos. Chinese feel very deeply about this issue, and it will take time and a great deal of positive public relations efforts to reverse the negative sentiment.

Winter Haze Blankets China (Photo credit: NASA Earth Observatory)

The ink on the paper with my predictions for China was barely dry when what may become “the” story of 2013 came onto the scene—air quality. If I knew then what I know now, I would have had to have included a discussion about air quality.

In the run-up to the Beijing Olympics in 2008, particularly in the three or four months before August, Beijing’s air quality was in the news on a daily basis. While air pollution has remained a nagging problem since then, Beijingers have learned to live with the situation, and there have been enough blue sky days in the capital city to keep the Air Quality Index (AQI) out of the news—until last week that is.

Particulates less than 2.5 micrometers in diameter (PM 2.5) are referred to as “fine” particulates and pose the greatest health risks because they are small enough to directly enter the lungs and the blood stream. The U.S. EPA has developed a formula to convert PM 2.5 readings into an AQI value that can help guide health-related decisions. For example, an AQI value of 50 represents good air quality with little potential to affect public health, while an AQI value over 300 represents hazardous air quality. The U.S. Embassy in Beijing publishes AQI values for Beijing and other cities in China, and the Chinese Ministry of Environmental Protection provides its own air quality data for cities throughout the country.

I’ve lived in Beijing for 20 years, and am generally unaffected by bad food, water or air. Even I noticed it last week, though, when the PM 2.5 AQI approached 900 micrograms per cubic meter. I read somewhere that it was like being in a forest fire — an apt description based on my experience. Hospitals reported increases of up to 30 percent in the number of patients reporting breathing problems; visitors to China received warnings from their risk management departments; and everyone hit the app on their iPhone to check the latest AQI from the U.S. Embassy.

The recent bout of air pollution was exacerbated by weather patterns where the air simply did not move for days on end. Nonetheless, high levels of PM 2.5 particles are in the air due to rapid industrialization, more vehicles, coal burning for heat and power and lax enforcement of environmental regulations.
This was one story that could not be hidden from the public. “How can we get out of this suffocating siege of pollution?” the People’s Daily, the official Communist Party newspaper, asked in a front-page editorial. Newspaper headlines, as well as the public’s ability to spread information through social media, are putting enormous pressure on the government to take action. What can it do? Stricter enforcement of environmental regulations is one obvious answer, but officials are reluctant to enforce standards for fear of holding back economic growth.

China’s air quality problem has not come into being overnight, and it won’t go away overnight. Therefore, China has to take as many steps in as many different directions as possible to begin addressing the problem. While the growing number of passenger cars is cited as an issue, environmental regulations for cars are already strict. Beginning this January, all gasoline powered vehicles manufactured, imported or sold in China are required to comply with Euro V emissions standards. Europe currently operates according to this standard and is not scheduled to implement Euro VI until 2014. The fact that 70 percent of the cars made each year in China are made with foreign technology makes implementation and enforcement of emissions standards for passenger cars less problematic.

The real culprits in China are the diesel engines for commercial vehicles like trucks and buses that must rely on local technology due to cost considerations. For this reason, the implementation of emissions regulations has lagged passenger cars and is currently at Euro III standards. While Euro IV standards for commercial vehicles are due to be implemented in July of this year, many doubt that enforcement will be effective throughout the country.

Fortunately, there are solutions to even this problem. Take the City of London, the site of last year’s Olympics. In 2008, London created its Low Emission Zone (LEZ) to encourage the most polluting heavy diesel vehicles driving in the city to become cleaner. The LEZ covers most of Greater London, and to drive within the LEZ without paying a daily charge, vehicles must meet certain emissions standards that limit the amount of particulate matter coming from their exhausts. In January, 2012 the LEZ emissions standards became more stringent, and tens of thousands of trucks and buses were retrofitted with filters and other systems to enable them to comply. Other cities all over Europe, as well as the State of California, are on a path to implementing similar programs.

Starting with buses, which operate in areas with the greatest population density, China can do the same. There are over 190,000 big buses operating in China’s cities, more than one-half of them diesel. As London has found, it is not enough to simply mandate higher emissions standards for new vehicles. The problem lies with the older vehicles that may be in service for many years to come. While it can be expensive to retrofit existing vehicles, China’s Central Government and its cities have been willing to subsidize the purchase of expensive CNG and electric powered buses because of the direct impact that heavily polluting buses have on the country’s city dwellers. Retrofitting existing diesel powered buses is a much less expensive alternative than replacing a bus that may still have some years left in its useful life.

China should follow London’s lead and have its existing, diesel engine powered bus fleet retrofitted. Huss Inc., a German company, and Clean Diesel Technologies Inc. (NASDAQ CM: CDTI), an American company, participated in the London program and have proven retrofit filters and systems that can do the trick. These past few weeks make it critical that China begin taking action to address the air quality in its cities.

Greater China. Note the oval Tarim Basin, the dryer area separating Inner and Outer Mongolia and the projection of steppe into Manchuria (Photo credit: Wikipedia)

In December, I had an opportunity to speak about China to audiences in such diverse cities as New York, Philadelphia, Anchorage, Cincinnati, Pittsburgh and Reno. The audiences represented a wide range of occupations—from hedge fund and investment managers to ordinary investors, business men and women, students and government officials. As a result, I received a pretty good sampling of the latest “view from the States” as far as China is concerned, providing useful background for this year’s predictions.

As might be expected, questions about China’s leadership transition, the state of China’s economy and the prospects for the shares of Chinese companies traded in China and elsewhere were raised at every stop. I feel compelled, therefore, to include my views on those issues in my predictions for the upcoming year. Unlike in past years, not many had questions about the exchange rate between the renminbi and the U.S. While the exchange rate issue does not appear to be front and center — at least for now — there are other important developments on the currency front which I do address.

Prediction #1: China’s new leadership will accomplish a smooth transition of power in their first year of governing and will largely continue on the same path as their predecessors.

Throughout much of last year, the Bo Xilai affair dominated the headlines and tended to cast a pall over the leadership transition that occurred in October. The actions of Bo, his wife and the Communist Party seemed to suggest that there were deep divisions within the Party and that the leadership transition would be anything but peaceful.

While only true insiders can categorically say whether such divisions are present, the transition has been uneventful thus far, and all signs point to the fact that Xi Jinping and Li Keqiang will largely continue down the same path as their predecessors. Both were understudies to the outgoing leaders — Xi to Hu Jintao and Li to Wen Jiabao — and both were selected for their new positions by their mentors. Xi Jinping, as Hu Jintao’s number two, and Li Keqiang, as deputy to Wen Jiabao, have already played a large role in setting policy over recent years.

Stephen S. Roach, a member of the faculty at Yale University, former Chairman of Morgan Stanley Asia, the author of The Next Asia, and a well-regarded expert on China, is very positive on the new leaders. According to Roach:

Xi Jinping and Li Keqiang – the top two officials in China’s new governing council (the Standing Committee of the Politburo) – are both well educated, well-traveled, and sophisticated thinkers who bring a wealth of experience to the many challenges that China faces. As so-called Fifth Generation leaders, they continue the steady progress in competence that has marked each of China’s leadership transitions since the emergence of Deng Xiaoping in the late 1970s.

From all appearances, China seems to be in good hands.

Prediction #2: China’s Gross Domestic Product (GDP) will grow faster than it did in 2012, ending several years of a declining growth rate.

“Will the decline in China’s growth rate continue in 2013?” was one of the most frequently asked questions on my travels through the United States.
After increasing from 9.1 percent in the post crisis year of 2009 to 10.4 percent in 2010, China’s GDP growth rate declined to 9.3 percent in 2011 and will most likely fall to somewhere between 7.7 percent and 8.0 percent in 2012. China’s GDP growth rate has slowed in each of the past seven quarters, reaching a low of 7.4 percent in the third quarter of last year. The National Bureau of Statistics (NBS) will announce the growth rate for the fourth quarter and the year on January 18, so we will see if this downward trend reversed itself in the past three months.

A consensus seems to be building, though, that China’s economy bottomed in the third quarter. Lu Zhongyuan, deputy director of the Development Research Center under the State Council, or China’s Cabinet, said recently that China’s economy has bottomed since June, buoyed by the country’s “economic restructuring, innovation incentives and the market’s self-stabilizing forces.” Lu went on to say that this momentum will continue to drive up growth in the year ahead and that there is no doubt that China’s economy will grow by more than 8 percent in 2013.

Likewise, the World Bank recently predicted that China’s economy will grow by 8.4 percent, and Andy Rothman, China Macro Strategist for CLSA, believes that 8 plus percent growth is on the horizon for the coming year. Add to that the fact that the new leadership will be determined to get off to a good start economically, and my prediction that China’s GDP growth rate in 2013 will exceed 8 percent appears relatively safe.

Prediction #3: The Shanghai Stock Exchange Composite Index (SSE) will register a double-digit increase in 2013, rewarding investors for their patience.

The third time is a charm. After being flat out wrong in 2011 when I predicted a 25 percent increase in the SSE, and only partially right in 2012 when I again predicted a similar increase, I predict that the SSE will continue its December momentum and register a double-digit increase in the New Year.

Since its high water mark in late 2007 when the SSE reached 6036, China’s stock market has been plagued by concerns as to how China would be impacted by the global economic crisis, the property bubble and the credit tightening that followed, the weak economic prospects for the United States and Europe, China’s two largest trading partners, and lately, uncertainty about the leadership transition. The SSE declined by 11 percent in 2010, 22 percent in 2011, and was down another 10 percent for the first 11 months of 2012, making it one of the worst performing stock markets in the world for most of the year. The SSE then came alive in December and gained almost 16 percent during the month to finish 2012 at 2269, up 4 percent.

While not all of the concerns regarding China’s economic and political situation have eased, many of them have, so stock market sentiment should be much more favorable in 2013. A continuation of the momentum established in December, and a double-digit increase in the SSE in 2013 seems to be in the cards. A more positive sentiment with regard to China will also have a favorable impact on the shares of Chinese companies that are traded in Hong Kong, the United States and other overseas markets.

Prediction #4: China will continue to slow its purchases of U.S. Treasury securities.

From the end of 2003 to the end of 2010, China’s holdings of U.S. Treasury securities grew from $159 billion to $1.166 billion as China’s currency reserves increased and the U.S. debt doubled from approximately $7.0 trillion to $14.0 trillion. In other words, purchases of U.S. Treasury securities by China accounted for just over 14 percent of the new debt issued by the U.S. government during that period.

Since then, however, the pattern has been much different. Over the past two years, China’s holdings of U.S. debt have been flat to declining, despite the fact that the U.S. government debt has increased to $16.4 trillion. In essence, China has not financed any new bond issuances by the United States since the end of 2010. As noted by Thomas Donlan in the December 8, 2012, issue of Barron’s: “Between September 2011 and September 2012, China reduced its holdings of U.S. Treasury debt 9 percent, from $1,270 billion to $1,155 billion…”

While the policymakers in Washington may not understand economics and the basic laws of the capital markets, the legions of U.S. trained economists that advise the Chinese government understand full well that when you have more supply of something than demand, prices will fall. While the additional supply of Treasury notes and bonds is currently being taken up by the Federal Reserve, and to a small extent by Japan and other countries, they know that this cannot last and that the value of China’s holdings will ultimately decline.

Like any prudent investor, China has been diversifying its holdings away from an asset class where prices are likely to fall. While China is unlikely to “shoot itself in the foot” by dumping its holdings of Treasuries, as many fear, it has not taken up any new supply for several years now.

Look for this pattern to continue in 2013 as China continues to wean itself from the U.S. dollar and to diversify its holdings to include a larger basket of currencies, as well as hard assets in Europe, the United States, South America and Africa. China is currently the second largest holder of U.S. Treasuries, but Japan has been increasing its purchases and is just $26.8 billion behind. Many analysts expect Japan to take over the number-one spot sometime in 2013, a distinction that China will be only too happy to relinquish.

Prediction #5: China will continue its efforts to internationalize the yuan in 2013.

While full convertibility of the yuan is still several years away, China has been quietly building demand for its currency outside China and internationalizing its role in the global economy.
China began this process in November 2010 when the Russian Prime Minister Vladimir Putin and Chinese Premier Wen Jiabao announced that Russia and China had decided to use their own national currencies for bilateral trade, instead of the U.S. dollar. The yuan started trading against the ruble in the Chinese bank market in Shanghai immediately, and in December 2010, began trading on the Moscow Interbank Currency Exchange, marking the first time that the yuan has traded outside of China and Hong Kong.

A year later, China agreed to a deal with Hong Kong that will give the territory more access to the Chinese currency, enabling Hong Kong to access 400 billion yuan ($63 billion) from the Chinese central bank, and at the end of 2011, the Japanese government announced that Japan and China will promote direct trading of the yen and yuan without using dollars.

A string of trade/currency deals followed in 2012. In March, China struck a deal with Australia that allows for an exchange of local currencies between the central banks of the two countries. In June, a similar deal was struck with Brazil, and in August, German Chancellor Angela Merkel and Chinese Premier Wen Jiabao announced in a joint statement from Beijing that the two countries plan to conduct an increasing amount of their trade in euros and yuan. In addition to deals with its largest trading partners, China also concluded similar arrangements with the United Arab Emirates (UAE) and Turkey in 2012.

Look for more of the same in 2013.