Abstract: Real inventory pressure has been increasing in Chinese industrial businesses. Capital goods are under substantially more pressure than raw materials, intermediate goods, and consumer goods. As foreign demand declines, Chinese manufacturers should seek new outlets for their output, and investment in infrastructure and real estate may be the way out.
Inventory is closely related to prices, profits, production decisions, and investment. When the industrial sector dominates economic fluctuations, changes in the inventories of industrial enterprises are often a signal for the market to judge the economic cycle.
China's economy has been recovering over the past year despite twists and turns. As overseas central banks continue to raise interest rates, the pull of external demand on China's economy is waning and domestic demand is becoming more significant to recovery.
Therefore, a comprehensive and in-depth examination of inventories in the industrial sector and clarification of their endogenous linkages with other financial indicators and corporate data can help understand the performance of the industrial sector, grasp the current economic cycle, and prepare the following economic recovery with useful policy implications.
Ⅰ. The industrial sector is under increasing pressure from actual inventories over the past two quarters.
At the end of each month, China’s National Bureau of Statistics announces two indicators related to inventory: inventory and finished goods inventory. As shown in Figure 1, the year-on-year growth rates of both inventories have been declining since May 2022. The annual growth rate of inventory peaked in November 2021 and has been declining since then. Therefore, based on the two indicators alone, industrial companies are indeed "de-stocking". However, both inventory and finished goods inventory are in nominal values, and their movements are affected by changes in industrial goods prices. As Figure 2 shows, the PPI corrected indicator only changed in magnitude, not in trend, and it also showed a de-stocking trend in the past two quarters.
Still, there are three problems with the above observations:
1. Price disturbance. Simple correction by PPI does not allow for better differentiation within the sector.
2. Industrial indicators are often perturbed by change in the samples, leading to a difference between the YoY growth rate calculated by absolute value and the published rate, and both rates are meaningful.
3. Most importantly, the decline in the YoY growth rate of inventory does not mean a decline in inventory itself or de-stocking. Even if a company's inventory is declining, it does not mean that the company's inventory pressure is declining, and it is the actual pressure that is driving the company's inventory adjustment. It is impossible to identify the inventory pressure and de-stocking motivation (active or passive) merely by looking at inventory changes. So a single dimension (inventory change itself) should be avoided in observing the status quo in the industrial sector and determining whether industrial companies are destocking.
What matters is the gap between inventory and desirable inventory instead of changes in inventory growth or in inventory itself.
From the perspective of the decision-making mechanism of micro entities, the desired inventory level is closely related to sales. The higher the sales growth is, the larger the size of inventory to support the growth, and vice versa. Indeed, desired inventory is a theoretical indicator that cannot be directly observed, just like natural unemployment rate and neutral interest rate. Here, we could assess the actual inventory level of businesses by aid of operating revenue and combine the result with its evolving trend to extrapolate the gap between the actual and desired inventory levels.
To demonstrate the inventory of businesses, we design an indicator “broad inventory-to-sales ratio” (broad inventory-to-sales ratio= inventory/monthly operating revenue; the revenue data prior to 2017 is based on the extrapolation from the growth of main business revenue; cumulative revenue from January to February is divided by 2).
The meaning of this indicator is self-explanatory and has at least two advantages compared with the one-dimensional indicator of inventory: first, it can exclude the impacts of price changes on inventory; second, it can avoid the influence of sample adjustment on the indicator’s implication. Meanwhile, based on a moving average of inventory and revenue data, the broad inventory-to-sales ratio is more likely to reflect the evolving trend as it can exclude seasonal effects.
As shown in Figure 3, changes in industrial firms' inventories, as reflected in the broad inventory-to-sales ratio, have corresponded well with the macroeconomic conditions over the past decade. For example, as the macro economy weakened from the second half of 2014 to 2015, the broad inventory-to-sales ratio also continued to rise during the same period. Some market participants may have vivid memories of the overcapacity problems and severe inventory pressure faced by most industrial companies at that time. Likewise, from the third quarter of 2020 onwards, when China’s economy began to emerge from the initial shock of the pandemic and entered the phase of sustained recovery, the broad inventory-to-sales ratio also fell rapidly after a surge, which continued into the first quarter of this year based on its trajectory.
Since the second quarter of 2022, the broad inventory-to-sales ratio of China’s industrial firms has started to rise continuously, implying that the inventory pressure is mounting instead of falling. In other words, the decline in the year-on-year growth of finished goods inventories does not necessarily indicate that industrial companies are really de-stocking since this form of inventory adjustment does not alleviate the inventory pressure faced by businesses. Therefore, although industrial companies seem to be "actively" reducing inventories, they are actually doing so passively in the face of increasing inventory pressure.
II. THE INVENTORY PRESSURE OF CAPITAL GOODS SEGMENT IS FAR GREATER THAN THAT OF RAW MATERIALS AND CONSUMER GOODS SEGMENTS
While the inventory pressure of the industrial sector is mounting, it does not mean the strain is growing at the same rate in all segments. Within the industrial sector, there is a distinct structural feature.
Based on our previous research, industrial businesses are divided into three segments: raw materials and intermediate goods, capital goods, and consumer goods.
Built on that, we investigated the changes in inventory pressure facing different segments and determined the source as well as the trend of the pressure via a combination of indicators.
As demonstrated in Figure 4, since the second quarter of 2022, the broad inventory-to-sales ratio in the three segments has all increased, implying that the inventory strain has been rising. However, the relative level diverges significantly in the three segments, with the capital goods segment facing the greatest pressure, which is manifested as follows:
The broad inventory-to-sales ratio of raw material providers has increased, but still lower than the pre-pandemic average (in 2019). That of consumer goods makers is slightly higher than the pre-pandemic average but lower than the peak back at the early stage of Covid (Q3 2020). And that of capital goods makers has risen above both the pre-pandemic average and the peak at the start of Covid, now reaching a new height since 2014.
Such structural difference is also seen in profit margin and export fluctuations. We have calculated the profit margins of the three types of producers using total profit as a share of operating revenue, both 1-year moving average. As shown in Figure 5, the profit margins of all three have experienced cyclical movements since the onset of Covid, and all have declined since Q2, 2022. However, the profit margin of raw material/intermediate goods providers has just decreased slightly, and is still much higher than before Covid. In comparison, that of the other two has basically returned to the pre-pandemic level.
Similar phenomenon is also observed in recent export situations. China’s export has been growing at a much slower pace since Q2, 2022, largely owing to the reduced export volume of capital goods.
As Figure 6 exhibits, the quantity effect of capital goods on export has been much lower than that of raw material/intermediate goods and consumer goods since Q2 this year and also lower than the average of last year, plunging from 9.4% in July to -1.8% in August. Decomposed figures indicate that the negative growth in the export volume of capital goods in August has directly dragged China’s monthly export down by 5.5 percentage points.
III. CONCLUSIONS
In conclusion, Chinese industrial companies have been stocking up, not destocking. Capital goods makers are even more so than raw material/intermediate goods and consumer goods providers.
This seems different from what past experience suggests. Over the past decade, every time the macro economy went down, it was the raw material/intermediate goods providers that led to stock up, such as iron and nonferrous metal producers. But China’s supply-side structural reform in 2017 substantially reduced overcapacity once widely seen among raw material/intermediate goods providers； In recent years, supply-side constraints have become a bigger problem concerning the market instead.
While the Chinese real estate sector has gone through a year of deep adjustment, related industries have not been significantly stocking up as evidenced by micro inventory statistics. In fact, the supply of these industries has been much more elastic, enabling them to adjust flexibly based on actual needs and avoid overstocking.
Capital goods makers, while under higher stock pressure, have managed to maintain faster fixed asset investment growth than the other two types of producers. As seen in Figure 7, capital goods providers have outpaced the other two in terms of fixed asset investment growth since 2021, scoring an average monthly year-on-year growth of 21%. This, while explaining why they have a lower profit margin than consumer goods producers (i.e. more of their profits have been spent as capital expenditure), also means that the effective supply capacity of the sector, after two years of continuous investment growth, has remarkably increased. And this could secure Chinese businesses at a better place with a greater share of the global market amid external demand boom. However, once external demand cools down, they have to find new demand to consume their heightened producing capacity; otherwise they would come under mounting stocking pressure.
Structural differences within the industrial sectors are already manifested in the stock market. This year, though the stock market has remained in a state of fluctuations, the performance of capital goods index is obviously worse than that of raw materials and intermediate goods, and consumer goods (Figure 8). It is especially the case in September. Correction of the capital goods index was as much as nearly 20% compared with its end-August level, while that of the raw materials and consumer goods indexes less than 10%. (Note: The basic data are from SWS Index. Among them, raw materials and intermediate goods indexes include basic chemicals, iron and steel, coal, non-ferrous metals. Capital goods index includes machinery and equipment, electric power equipment, light manufacturing, electronics and computers. Consumer goods index includes textile and apparel, automobile, household appliances, food and beverage.)
Capacity expansion of the capital goods sector is a foregone conclusion, a trend that conforms to the general direction of China’s industrial transformation and upgrading. In the next stage, it’s highly possbile that China will experience a continuous decline in external demand. A new challenge we face will be finding new demand for the capital goods sector to maintain effective production capacity. Starting from the definition, since it is capital goods production, the output must serve investment, so only by increasing investment demand can we boost the effective demand for capital goods. Specifically, promoting investment in infrastructure and real estate sector is the most crucial, as investment in these two industries can more dramatically drive the demand for other industries, especially the capital goods sector than investment in manufacturing.
In contrast, investment in manufacturing does not require special attention. On the one hand, investment in the sector has already recorded a rapid growth, and excess production capacity may become a problem in the next stage. On the other hand, the demand for consumer goods fundamentally depends on the overall macroeconomic conditions. At this time, stimulating investment in consumer goods may get half the result with twice the effort, while production capacity of raw materials and intermediate goods is basically in a locked state.
In summary, the focus of macro policies should still be placed in "expanding infrastructure investment and stabilizing real estate investment". Recently, a number of policies were rolled out to stabilize the real estate industry, which has helped to bolster the confidence in the real estate market. In light of the current and future realities, whether from the perspective of short-term or structural adjustment, more supporting macro policies are still needed.
