Preserving, let alone expanding, profit margins in China are a constant challenge for manufacturers.

First of all, China is by far the most competitive market in the world. All of the companies from around the world that make any particular product are most likely already in China, and when they enter the China market, they are confronted with an army of local manufacturers of the same or similar products. While the products manufactured by many of the local companies may be low in quality and technology, they have the advantage of low price. Moreover, a growing number of the locals are improving their products to the point where they are approaching competitiveness with the international brands.

Secondly, China’s continued economic growth is pushing up prices. Higher per capita incomes are great for workers, but they also mean higher wages for manufacturers. Greater prosperity is creating tremendous wealth in the country, but that wealth also translates into higher rents as cash rich Chinese bid up property prices. Whether it’s wages, rents or raw material prices, China’s increasing level of economic activity is impacting costs across the board.

Finally, the integration of China, India and other emerging markets into the global economy is leading to a higher level of raw material prices. While higher input prices affects all manufacturers, wherever they are located, they are no less of a problem in China.

As I described the highly competitive nature of the China market several weeks ago to a group of INSEAD MBA students who were visiting China, one particularly astute student asked a question that I am often asked: “How does a company preserve its profit margins in China?”

Over the past several years, I have been a regular contributor to the “Opinion” section of BusinessForum China, a bi-monthly magazine published by the German Chamber of Commerce. In 2008, I wrote China’s Manufacturers Move Upstream which addresses the question posed by the student from INSEAD.

To summarize, I gave the readers of BusinessForum China, five ways to counter rising costs and intense competition to maintain profitability:

1. Constantly review your products and customers with an eye to eliminating those that are no longer profitable.
2. Accelerate and intensify lean manufacturing initiatives to reduce waste in your manufacturing processes and business systems.
3. Implement “value engineering” and product re-design to reduce the content of expensive raw materials.
4. Where possible, be aggressive about passing along higher costs to your customers.
5. Implement a comprehensive and continual product development program.

Of the five measures, the most important by far is the vitality of a company’s new product development activity. The reason is quite simple: profit margins are highest at the beginning of a product’s life cycle. As a product matures and more competitors enter the picture, prices and margins inevitably decline.

In a nutshell, stay close to your customers and help them improve their products or services. In doing so, you will stay one step ahead of the competition.

Note to MTD Readers: The following summary overview of China’s stock markets was prepared for one of the clients of JFP Holdings. I thought that our readers might also have an interest in the background information that was prepared.

Background

When economic reforms began in China in 1978, the Chinese government first reformed the agricultural economic system and then followed through with reforms in the industrial sector. In 1986, it began allowing some organizations to convert into share holding companies by issuing shares to employees and the public. In 1990, China facilitated the trading of shares by investors by establishing two stock exchanges, one in Shanghai and the other in Shenzhen.

Shanghai Stock Exchange

Established on November 26, 1990, the Shanghai Stock Exchange is China’s largest Stock Exchange. Securities traded on the Shanghai Stock Exchange include A shares, B shares, Treasury bonds, corporate bonds, corporate convertible bonds and funds.
Initially, only Chinese investors could purchase A shares, which are priced in Renminbi. After the implementation of stock market reforms in December, 2002, however, certain foreign institutional investors have also been allowed to invest in A shares under the system of QFII (Qualified Foreign Institutional Investor).

Conversely, B shares, which are priced in United States dollars, were initially only meant to be purchased by foreign institutional investors. Chinese were not allowed to buy B shares because Chinese law at the time did not allow domestic investors to freely exchange renminbi into foreign currency. With the subsequent relaxation of these rules, however, domestic investors have also been allowed to invest in B shares since 2001.

The Shanghai Stock Exchange has 1,381 listed securities and 879 listed companies. Shanghai’s market capitalization as of May 12, 2010 was RMB 15.2 trillion ($2.2 trillion), resulting in an average price/earnings ratio of 20.16 times. Of the market capitalization on May 12, B shares only accounted for RMB 70.4 billion ($10.4 billion), or less than one-half of one percent of the total. B shares also traded at a lower P/E ratio of 16.07 times on that date.

The most common index measuring the performance of the Shanghai Stock Exchange is the SSE Composite Index which was launched on July 15, 1991. The SSE Composite Index is made up of all stocks (A shares and B shares) listed on the Shanghai Stock Exchange. Other important indices used are the SSE 50 Index and SSE 180 Index.

The Base Day for the SSE Composite Index is December 19, 1990, and the Base Value is 100. The SSE Composite Index was 1,512 at the beginning of 2000, and then traded between 1,000 and 2,200 for the next five years. In June, 2005, the SSE Composite Index began a nearly six-fold increase, hitting an all time high of 5,818 in October 2007. The Index then began a steady decline through the balance of 2007 and into 2008, bottoming at 1,747 in November, 2008. The SSE Composite Index is currently trading at 2,673.

Shenzhen Stock Exchange

The Shenzhen Stock Exchange is headquartered in the city of Shenzhen in the south of China. The companies listed on this exchange are the ones in which the Government of China maintains a controlling stake. Prior to 2005, most (approximately two-third’s) of the stocks listed on the Shenzhen Stock Exchange were not allowed to be traded. After stock reforms were implemented in 2005, however, investors were allowed to trade in these shares.
There are currently 1,332 securities and 981 stocks listed on the Shenzhen Stock Exchange. On May 26, 2010, the market capitalization was RMB 5.9 trillion ($873 billion), and the average price/earnings ratio was 33.77 times.

ChiNext

Fully independent from the main board of the Shenzhen Stock Exchange, ChiNext, likened to NASDAQ in the United States, was launched on October 30, 2009 to provide capital to China’s innovation driven, smaller companies. To date 86 companies have been listed. The total market capitalization of ChiNext listed shares on May 26, 2010 was RMB 366.5 billion ($53.8 billion), and the average price/earnings ratio was 63.7 times.

During the first six months of trading, the 86 companies listed on China’s newest exchange have raised $8.5 billion of capital. However, trading has been erratic and valuations remain very high.

Comparison to The World’s Top Ten Stock Market Exchanges

In 2009, Shanghai was the sixth largest stock exchange in the world, ranking just below the London Stock Exchange and just above the Hong Kong Exchanges.

Rationale For Higher Valuations in China

The price/earnings ratio for the S&P 500 is currently 17.84 times, below all three of China’s stock exchanges. The strength of the China economy and the relatively faster growth of Chinese companies certainly account for part of the difference, but supply and demand for stocks in China is also a factor.

Although the rules governing the ability of Chinese citizens to exchange renminbi for foreign currencies have loosened in recent years, individuals are still limited in the amount of yuan they can convert each year. This restriction, combined with rapid wealth creation in the country, has resulted in a high level of demand for investments in China based assets. Property of all type has been one beneficiary of the imbalance between investment demand and the supply of investments, China’s stock markets have been another. With larger and larger pools of capital chasing a relatively limited supply of listed securities, the stage is set for high stock market valuations on the country’s stock exchanges.

Over the past several years, I have been a regular contributor to the “Opinion” section of BusinessForum China, a bi-monthly magazine published by the German Chamber of Commerce. Founded nine years ago, the magazine’s objective is to inform members of the international community about the latest developments in business and the economy in China. It represents the combined experience and advice of professionals in China and abroad and provides regular updates on the most recent happenings in law and taxes, human resources, WTO, the environment, trade fairs and venues.

BusinessForum China is distributed to all members of the German Chamber of Commerce and other international institutions and organizations in China. The magazine is now available online, making it more convenient for me to pass along my articles in their entirety to MTD readers.

My most recent article, “Don’t Pick Fights in China,” distills into one article some of the advice I have been giving to companies and individuals operating in China over the years. Due to cultural differences and miscommunication, conflicts with partners, customers or government organizations are inevitable in China. While disputes cannot always be avoided, solving them in a friendly manner, with minimal damage to a company’s business becomes an important skill for anyone doing business in the country.

In the article, I cite the recent cases of Google and Danone and provide the following five rules for resolving disputes in China:

Rule No. 1: Keep in mind the age-old axiom that an ounce of prevention is worth a pound of cure. The best way to resolve disputes in China is never to get into them in the first place.

Rule No. 2: If a dispute arises, listen carefully and make every effort to understand your counterpart’s position.

Rule No. 3: Resolve to settle your differences through friendly negotiations.

Rule No. 4: Enlist the support of individuals and organizations that may act as intermediaries.

Rule No. 5: Always remember that going to court is truly the court of last resort.

In the article, I also introduce my “cold shower approach to decision making.”

In China, it’s always best to resist the temptation to make snap decisions. Just when you think you know enough to make a decision, take a cold shower and think some more before acting.

To learn how both Google and Danone might have benefited from this advice, click here.

The Euro is under attack.

As a result of problems in Greece, the massive relief package assembled by the European Economic Union to bail out the country, and economic storm clouds hanging over Portugal, Spain and others, the Euro is tumbling in value against the U.S. dollar. The Euro has declined 14.7 percent from the beginning of 2010, when it fetched more than $1.43. Some experts believe it is likely to fall further, perhaps to parity with the greenback or lower. Some even question whether the Euro will survive this crisis.

Outside of Europe, the country with the most to lose from an economically weak Europe is China. The European Union and the United States remain China’s two largest trading partners. For the first two months of this year, trade with the EU grew 34.5 percent to $65.53 billion, and with the US, it rose 25.1 percent to $49.32 billion. In order to provide much needed support in this time of crisis, expect China to re-balance its portfolio of foreign currency reserves in favor of the Euro, and to begin allowing the yuan to appreciate against the U.S. dollar in the months ahead.

Although many believe that China’s export growth is the engine driving China’s currency policy, it is likely more complicated than that. In addition to trade, China must take into account the impact any currency policy changes may have on its $2.5 trillion holdings of foreign currency reserves, as well as the relationship between the U.S. dollar and the Euro. China’s past actions with respect to its currency suggest that the country’s leaders like to keep an appropriate balance between the currencies of its two largest trading partners.

Over the past five years, there have been two notable events in China’s currency history—July, 2005 when China released the yuan’s peg to the U.S. dollar, allowing the Chinese currency to appreciate by 21 percent within two years; and July, 2008 when China once again pegged the yuan to the greenback, this time at approximately 6.8 to 1. It may be mere coincidence, but both events occurred when the dollar and the Euro were at high and low points relative to each other.

In the latter half of 2005, the U.S. dollar was at a high point against the Euro, which gave China room to release the yuan’s dollar peg. By July, 2008, when China re-instituted the peg, the dollar’s value in relation to the Euro had fallen by 38 percent from its 2005 high. At its high point in 2005, $1.17 was required to purchase a single Euro. By July, 2008, $1.61 was needed, much to the chagrin of American travelers to the Continent.

At today’s rate of $1.23 to the Euro, we are now close to 2005 levels. Assuming that China has not come to the conclusion that the Euro will be relegated to the dust bin of history and therefore not worth supporting, we are getting close to the point where China’s best interests will be served by tilting its support in favor of the Euro, as it did in 2005.

Geely’s acquisition of Volvo is a watershed event for both the global auto industry and the international mergers and acquisitions business. The acquisition of a global auto brand by a relative industry newcomer from China demonstrates how quickly even major industries like automobiles are being transformed by the development of China’s economy. It also may well prove to be a precursor to a flood of deals from China.

In industry after industry, relatively unknown local companies are growing larger as China’s economy creates unprecedented opportunities for companies that understand its markets. As these local companies gain scale in China, they inevitably set their sights globally. The new class of future global leaders now being created by the continued growth of China’s markets will ultimately reshape the landscape of nearly every industry. Overseas acquisitions of famous companies like Volvo will hasten this development. By acquiring Volvo, Geely purchased an industry leading brand, and all of the technology, engineering, styling and marketing resources and infrastructure that contribute to that position.

If acquiring overseas companies to gain access to technology, marketing and distribution channels in international markets is such an attractive proposition, why has it taken so long for industrial firms in China to venture abroad?

Historically, one obvious reason has been cash. When I first came to China almost 20 years ago, a Chinese partner could not be expected to make its equity contribution in a joint venture in cash. Chinese partners might inject buildings, equipment or what may have appeared at the time to be overvalued land use rights, but never cash. Cash, especially hard currency, was very hard to come by. The lack of it was one of the key reasons why foreign investment was welcome.

A second reason that China’s industrial companies have been slow to embrace overseas acquisitions is the daunting challenge of managing operations in countries with unfamiliar markets and vastly different cultures. In many respects, it is even more challenging for a Chinese company to operate successfully in the United States or Europe than it is for an American or European company to be successful in China. After all, the history of foreign investment in China is now entering its fourth decade, while the history of Chinese companies doing business abroad is only now being written. For this reason, the initial wave of overseas acquisitions by Chinese companies has been largely confined to asset intensive energy and natural resource companies.

Finally, the sharp slowdown in Western economies in the aftermath of the global economic crisis has caused Chinese companies to be cautious with respect to entering overseas markets. I have spoken with many Chinese companies that have aggressive ambitions outside China, but have been concerned about the United States and European economies. Despite the attraction of acquiring state-of-the-art technology, no Chinese company wants to be the first to face declining demand in markets it does not understand.

Things change quickly in China, however, and many of the impediments to overseas acquisitions are being removed.

For one, cash is now plentiful. In addition to generating cash through operations, Chinese companies can raise capital on attractive terms in China’s “A” share market; sell off valuable real estate; and/or borrow from Chinese banks. With cash in hand, Chinese companies are expanding aggressively, and in a reversal of the situation 15 years ago, many are buying back the ownership stakes held by their cash-strapped foreign joint venture partners.

In addition to Chinese sources of capital, international banking firms are now more than willing to support Chinese companies with global ambitions as well. Eager to curry favor with the next batch of global leaders, ensuring a future supply of investment banking fees, capital to expand abroad is now increasingly available from international sources.

Global economies are also improving. While the jury is still out on Europe due to the recent crisis in Greece, the United States, at least, appears to have touched bottom. With the worst of the crisis in the past, Chinese companies are now looking more favorably on acquiring operations outside China.

Finally, Geely may set an important example for other Chinese companies. To the extent that it can successfully address the issue of managing a global car brand, Geely’s acquisition of Volvo will encourage other Chinese companies to follow suit.

If Geely can bootstrap its way to the top of the auto industry, one of the largest and most technologically sophisticated in the world, it can happen in any industry — and it will. The rise of local Chinese companies in one industry after another will be the story of the 21st century. Watch for the coming M&A boom from China!

In the mid-1990s, I was frequently asked whether I thought that China would break apart into a number of separate, individual countries. That’s because China bears at the time warned that China was not one country, but many different countries, and that the bonds binding the whole lot together were thin. In their view, China was likely to split into a number of different fiefdoms, each led by their own “warlord.”

As we’ve all learned, however, China is, in fact, one country, despite its many different dialects and regional differences, and nationalism is on the rise. Rather than splitting apart like the former Soviet Union, China has gone the other way, bringing additional territories into its economic and political orbit. Hong Kong was added in 1997, Macau in 1999, and now even Taiwan is drawing closer.

In the late 1990s, financial experts worried that China’s state-owned banks would cause the Chinese economy to go off the rails when they drowned under a sea of non-performing loans. That never happened. In fact, the Western banking giants, which were thought to be bastions of sound lending and banking practices, were the ones that nearly brought down the entire global financial system. Until we see how events in Greece, Portugal, Spain and other European countries play out, they are still not out of the woods, two years after the crisis hit.

Today, many question whether China’s property market might be the Achilles heel in a red hot economy that grew at 11.9 percent in the first quarter of 2010. Certainly, anyone that’s traveled around the country has a story or two about empty office buildings, or new apartment complexes being built purely on speculation. Property speculation may be the Chinese economy’s downfall, but I wouldn’t bet on it. I’ve been surprised too many times over the years.

I can remember standing in the middle of Pudong in 1996, surrounded by newly-built, totally empty office buildings, wondering what the developers could possibly be thinking. If Pudong wasn’t the ultimate field of dreams — build it and they will come — I didn’t know what was. Yet, a year later all the buildings were filled and the rest is history. Pudong has to rank as one of the most successful real estate developments of all time.

Whenever I encounter economic issues regarding China that seem to defy logic, I turn to Andy Rothman, my good friend who is the China Macro Strategist for CLSA Asia-Pacific Markets. Andy always seems to have done his analytical homework, which enables him to provide logical explanations. Since I am getting many questions about China’s property market these days, I was thankful to read Andy’s recent article, PERMA-BEAR MIGRATION, published in Sinology, his research newsletter.

In his opening comment, Andy expresses a similar sentiment regarding the China bears:

The annual migration of China perma-bears is underway once again. In past years, the migration was triggered by a wide variety of misguided fears: pork prices, export-dependency, non-performing loans, SARS or trade war with America. This year, the perma-bears are queuing up to proclaim that China is on the precipice of a housing market collapse paralleling the recent U.S. property meltdown. One day the perma-bears will be right, and China will suffer the long-predicted economic crisis, but this isn’t coming soon, and China clearly is not suffering from the housing finance bubble that crashed the US economy.

As Andy points out:

It is a mistake to look for the old American property problems to reappear in China. … The Chinese housing market is very different from America’s because:

• The loan-to-value ratio for mortgages is very low in China, while it was very high in the US. China buyers must put at least 20% cash down, and most buyers are required to put down 30% or more.
• China has almost no securitisation, no subprime mortgages and option ARMs, and .U.S-style home equity loans are not available.
• China’s housing boom has not been accompanied by a sharp rise in debt. The ratio of consumer lending to GDP in China is 17%, in contrast to 95% in the U.S. and 72% in the U.K.
• Household leverage in China is 39%, well below the 55% level in the U.S. in 1960, and far from the U.S. peak of over 130% in 2007.

Andy also clears up a number of misconceptions, which I will only paraphrase here:

• China’s housing market is driven by owner-occupiers, not investors. Only 22% of buyers are investors.
• Housing is affordable for many middle-class Chinese.
• The market is not primarily Beijing and Shanghai. 150 cities with a population of at least 1 million account for the vast majority of sales.
• Prices are much lower outside of the four tier-1 cities of Beijing, Shanghai, Guangzhou and Shenzhen.
• Investors are not highly geared. Of the middle-class families in our study who own a second property, only 39% used a mortgage. Of those who did use a mortgage, more than one-third paid a cash down payment of 50% or more.
• Low financial sector exposure. Mortgages remain a very small part of China’s financial system. The ratio of mortgage loans to GDP is only 14%, compared to the US peak of 79% in 2007.

If you are an institutional investor, I encourage you to call CLSA and get on Andy’s list for Sinology. It’s the best research piece I know of on China and its economy. In any event, I will continue to pass along Andy’s comments as I have in the past.

It began with direct flights between the Chinese mainland and Taiwan. As a result, flying from Beijing or Shanghai to Taipei is now as easy as flying to Hong Kong. Travelers must still pass through immigration, as is the case with Hong Kong, but there’s no longer the need to get to Taipei indirectly from another city in Asia. When I visited my client in Taipei last week, I boarded the Air China flight in Beijing at 8:00 am and was on the way to my meeting in Taipei by noon. A 1:00 pm Air China flight two days later returned me to Beijing in plenty of time for dinner.

In yet another sign of improving relations between China and Taiwan, Beijing and Taipei are now make it even easier for residents of the PRC and the island of Taiwan to visit each other and see what life on the other side of the Taiwan Straits is like.

On Tuesday, May 4, the Taiwan Strait Tourism Association unveiled a 10-employee office in Beijing, the island’s first official presence in China’s capital since the two sides split in 1949. According to an agreement reached between the two countries in 2008, China reciprocated by opening an office in Taipei three days later. On Friday, China’s Cross-Strait Tourism Exchange Association opened its first office in Taipei with three employees. Two or three more employees are expected to be added by the end of the year.

According to data from the Taiwan government, approximately four million people from Taiwan visit China annually, while about one million from China visited the island in 2009. Along with improved business ties between China and Taiwan, tourism will now benefit further from Republic of China President Ma Ying-jeou’s active campaign to improve relations with China since taking office in May 2008.

The improved cross-straits relationship is important for Americans doing business in China, because Taiwan, and its relationship with the United States, has always been a flashpoint for the Sino-American relationship. With China and Taiwan coming together peacefully, as many predicted they would if left alone to resolve their differences, one more issue is taken off the table as a point of contention between the world’s two leading economic powers.

I haven’t seen many headlines, but make no mistake about it, the relationship between the Republic of China (“ROC” or “Taiwan”) and the People’s Republic of China (“PRC” or “China”) has never been better.

I spent the last few days in Taipei, the capital of the ROC, speaking to financial and business leaders, and the mood there is decidedly upbeat. The main cause for optimism is the constructive relationship that has developed between Taipei and Beijing, as evidenced by the imminent signing of the Economic Cooperation Framework Agreement (“ECFA”), which will eliminate many tariffs and encourage investment flows between China and Taiwan.

Unlike Hong Kong, a former British colony, and Macau, a former colony of Portugal, whose fates were decided by treaties between Great Britain and China, and Portugal and China, respectively, the ultimate fate of Taiwan has been uncertain. While no one knew what life in Hong Kong and Macau would be like afterwards, there was no question that Hong Kong would officially become part of China in 1997, and that Macau would follow two years later. In the case of Taiwan, economic forces have been drawing it closer to China since China’s opening in 1978, while political forces have tended to pull in the opposite direction.

Between 1895 and 1945, Taiwan was a Japanese colony. As its first overseas colony, Japanese intentions were to turn the island into a showpiece “model colony,” and much effort was made to improve the island’s economy, industry, public works and change its culture. After the defeat of Japan during World War II, however, Taiwan was surrendered to the Allies, and the ROC, which was established in 1911, proclaimed the “retrocession” of Taiwan to the Republic of China and established the provincial government at Taiwan.

Unfortunately, events in the post World War II period caused Taiwan to become a source of contention between the United States and China. Ever since President Harry S. Truman pledged to protect Taiwan against a possible PRC invasion during the first year of the Korean War, Taiwan has been a strong ally of the United States. Taiwan has provided a valuable Pacific base for U.S. missiles and has benefitted from massive American aid and trade. For its part, the PRC has always regarded Taiwan a part of its sovereign territory and has had full reunification as its objective.

Under the leadership of Taiwan President Ma Ying-jeou, Taiwan is moving in that direction — at least economically. Over the past two years, President Ma and his government have concluded 12 agreements with China on flights, food safety, opening Taiwan to tourists from the rest of China and mutual judicial assistance in the past two years. “All these agreements contribute to prosperity and stability in Taiwan and nothing in these agreements compromised Taiwan’s sovereignty or autonomy,” President Ma said in an exclusive interview with CNN’s Christiane Amanpour which was aired last Friday.

In that same interview, President Ma told Ms. Amanpour that “We will continue to reduce the risks so that we will purchase arms from the United States, but we will never ask the Americans to fight for Taiwan. This is something that is very, very clear.” President Ma added that the risk to the United States of a conflict between China and Taiwan is the lowest in 60 years as a result of his government’s efforts to build a rapprochement with Beijing.

Direct flights between major cities in China like Beijing and Shanghai and Taipei are one sign that the two economies are drawing closer together, and tourism in both directions is flourishing as a result. For example, flights between Taipei and Shanghai are full as Taiwan tourists flock to the Shanghai Expo. The flow of capital from China to Taiwan which is expected as a result of ECFA will further strengthen economic ties.

The practical impact of the improved relationship between Taiwan and China is a big economic boost to Taiwan companies. Less cross-straits tensions will reduce the risk of investing in Taiwan and should lead to higher stock market valuations. Moreover, Taiwan companies will benefit from increased sources of capital, and the elimination of many tariffs that will better enable them to integrate their factories in Taiwan with those in China.