China's downturn will do it - and the world - some good

Guest observation

China's economic slowdown is for real.

However, we may find this slowdown could be the one we have to have to provide the foundation for long-term progress.

China's problems are known: the consumer, internet and casinos are crowded trades with clear risks.

Here are four trends which reveal the pressure on China's attempts at rebalancing growth.

1. Crackdown on corruption hits casinos and residential property
   
   The corruption crackdown is affecting some major casinos' ability to turn a profit.
   
   Take Macau: VIP and junket-rolling chip value declined 3% year-on-year (year-on-year) and 14% quarter-on-quarter (quarter-to-quarter). The supposed saviour, mass market gambling, saw revenue growth slowing to 16% year-on-year in the first half of 2014 and further to 13% year-on-year in July 2014, as compared to 32% last year.
   
   Table yields (the amount of money a casino makes per table per day) had risen from US$4,600 in the first quarter of 2010 to US$12,900 in the first quarter of 2014, but have since fallen marginally in the second quarter.
   
   We recently met SOHO China, a developer and landlord of office properties in Shanghai and Beijing. It confirmed recent reports that the residential property market has cooled, particularly the luxury end.
   Apart from slowing demand, luxury apartments are sometimes offered at 20-30% discounts to some insiders.
   
   An initiative to make ownership records transparent as China prepares to levy property tax also has the unintended effect of revealing people who own multiple properties disproportionate to their income.
   
   
2. Online retail a double-edged sword; prices are down but reach grows
   
   The top 10 offline retailers had 9% share of total retail in year 2007, rising to 11.2% in 2012. Compare this to online retail as a percentage of total retail, which went from 0.2% in 2007 to 6.3% in 2012. Online retail is a double-edged sword for consumption.
   
   For 'old economy' asset-intensive businesses the online channel is a serious threat that puts downward pressure on pricing. At the same time, it dramatically increases the reach and access for suppliers and brands to cities and towns that earlier could never justify a mall or physical presence. This will lead to an enlarged pie of total retail sales.
   
   Over time, if income levels in less developed parts of China do increase, retail sales can see a boost due to the reach of online retail formats.
   
   
3. Major developer abandons retail malls
   
   Retail sales at department stores are falling. China Vanke, one of the largest property developers, has taken a strategic decision not to build any more retail malls. This trend is compounded by the rise of e-commerce, but also reflects lower demand for high end products.
   
   Virtually every department store in China is witnessing negative same-store sales. Luxury brands are resigned to use flagship stores as mere adjuncts to brand building, as opposed to outlets where they can sell their goods.
   
   According to a report from Bain Consulting, Chinese consumers accounted for 29% of global luxury goods spend in 2013. Recent trends in value-added tax refunds in Europe for Chinese customers show a marked slowdown to just 9-10% year-on-year growth.
   
   Just like the slowdown in China GDP growth affected commodity producers across the world, so too this crackdown has ramifications across the world.
   
   
4. Hypermarkets disappoint as employee benefits cease
   
   Hypermarkets and supermarkets in China have fared worse at a time you would normally expect them to do relatively better.
   
   Sun Art Retail, one of the largest hypermarkets, recorded flat same-store sales this half. Combing through the accounts of department stores and hypermarkets, one analyst pointed out the big drop in Business to Government (B2G) pre-paid cards. State-owned enterprises in China had a practice of buying pre-paid cards at these stores and gifting them to employees or customers. That practice is now frowned upon in China.
   
   This last point is worth pondering upon. Even supermarkets and hypermarkets were deriving sales from customers who did not earn that spending money but were gifted that money.
   
   What does all that tell you about the rebalancing? I have marginal exposure in consumer, casinos and the internet. The rest of 'poor quality' cyclical China is cheap and that is where I have invested my attention.

Samir Mehta manages the BT Wholesale Asian Share Fund of JO Hambro Capital Managed Funds.