Fundamentals Of How China Makes Its Money (BABA, PFE)

After the United States, China has the largest economy in the world: an astounding $10.8 trillion of economic activity in 2015 and growing by 6.9% annually. If the Chinese economy were represented in PPP, China edges out America as the largest economy. However, with a population of over 1.3 billion people, the Chinese GDP per capita is far behind that of the United States.

How did China go from a poor society in the 1950s to the number two economy only 60 years later? The answer lies in China’s five-year plans. Inspired by the Soviets, the Chinese focused on heavy industry and slowly developed their economy. With each subsequent five-year plan, government improved the country’s industrial and service output and liberalized the economy.

China has faced criticism about how its economy has been able to sustain an average annual grow of almost 10%. Namely, the government has been accused of manipulating the currency to keep Chinese exports attractive and of not disciplining companies that engage in intellectual property theft. (For more, see: U.S. Vs. China: Battle To Be The Largest Economy In The World.)

About 9% of the Chinese GDP is from agriculture. Agriculture in China employed nearly a third of the total workforce in 2013, but that number is expected to drop to 5% by 2020. The main crops the country grows are rice and wheat, Chinese dietary staples which, while not the most profitable crops, are the most needed in a country that still remembers the Great Chinese Famine.

In addition, China grows peanuts, vegetables, citrus and other fruit, oilseed, tea, coffee, corn, and tobacco. The country also catches and breeds fish for consumption and raises chicken and pork. In the east, suburban agriculture produces most of the cities’ needs with farms factory-producing meat, vegetables, fruit, and milk just outside the cities.

Chinese farmers are not the most efficient farmers in the world. The country is scattered with small plots, little irrigation, and almost no mechanization. Although machinery is available to purchase, farmers often don’t have the cash necessary to purchase the tools needed to become more efficient. The Chinese government has vowed to undertake agricultural modernization in its 13th Five-Year Plan. 

Food spoilage is another problem that some provinces face. With no central authority telling farmers what to plant, there is almost no way for the farmers to gage what demand for their product will be at harvest time. By planting what was popular in past years many farmers end up growing the same crop, which leads to overproduction. Overproduction of some crops leads to underproduction of others, which in turn can cause food shortages in the cities. (For more, see: Top Agricultural Producing Countries.)

Like most countries looking to develop their economies, China’s first step was to build up its heavy industry. Today, China is the world leader in manufacturing and produces almost half of the world’s steel.

China’s mining industry extracts coal (3.68 billion tons in 2015), iron ore (1.4 billion tons in 2015), salt ( expected at 70 million tons in 2015), oil (215 million tons in 2015), gas (124.3 billion cubic meters in 2015), and more gold than South Africa. Because of China’s dependence on coal, the country is moving towards more renewable resources and plans to increase its natural gas use in the coming years. China also has multiple oil reserves, as well as natural gas deposits that have yet to be fully explored.

The country is also a good candidate for hydroelectricity production, and in 2012, the Three Gorges Dam was completed and is now a major producer of electricity for the southern cities of China (including Shanghai).

Most Americans know that China is a manufacturing powerhouse. Besides its large textile manufacturing sector, the economy also supplies machinery, cement, food processing, transportation devices (trains, planes, and automobiles), consumer goods and electronics.

Not only does China have many domestic firms that create hardware and software, but the country is also a leading assembler of foreign electronics. The Chinese  software industry grew by over 16% in the first ten months of 2015 generating revenue in excess of $490 billion.

Similarly, China produces automobiles in factories owned both domestically and by foreign companies. However, most automobiles, domestic- and foreign-branded, are purchased by people in China, a country that had 244 million vehicles in 2014. The upward trend in car sales continued with a 4.7% growth in 2015 when 24.6 million cars were sold in China.

The Chinese automobile industry is criticized for IP theft and for a bad safety record with cars produced by domestic firms. The majority of cars manufactured by Chinese companies are exported to Africa, South America, the Middle East or Russia. Because of China’s unique distribution and sales methods, car dealerships and salespeople make a high margin on each vehicle sale. (For more, see: Why Is China Stockpiling Millions of Barrels of OIl?)

The Chinese pharmaceutical industry is, like the rest of China, growing at a fast pace. With 10% growth in 2015 , the Chinese pharmaceutical industry is the third-largest producer of prescription drugs in the world. This industry is, again, plagued with criticisms of IP theft.

China’s drug distribution system is multi-phased: drugs pass through various tiers and expensive middlemen before arriving at hospitals and pharmacies. In China today, hospitals are the main drug vendors, accounting for 80% of pharmaceutical sales.

Domestic firms are the majority of the market but international companies like Pfizer (PFE), GlaxoSmithKline (GSK), Novartis (NVS) and AstraZeneca (AZN) also have a presence. With China reforming and regulating the pharmaceutical industry (increasing OTC access and enforcing patents), there is high potential for investment growth in this area.

While once a country with rationing and consumer good shortages, after economic liberalization, China is a consumer paradise with a love for luxury goods. China is home to some of the largest shopping centers in the world, and, in addition to wholesaling, retail represents 9% of the country’s GDP in the third quarter of 2016.

Companies like Alibaba (BABA) have given a big boost to retail and e-commerce. Alibaba's singles day sale in 2016 saw a record-breaking $17.8 billion of gross merchandise volume in just one day.

In 2015, travel & tourism in China contributed nearly 8% or $854 billion to the Chinese GDP. Other services that are big in China include transportation, real estate, and construction.

While China’s growth seemed unstoppable at one point, there are obvious cracks in the economy that have slowed it down. First off, the country is under fire for the amount of non-renewable resources it burns through each year. With China already considered a large polluter and emitter of greenhouse gases, the expected increase in coal usage is troubling to some.

Next, China is home to rampant corruption. The national government is actively trying to stamp it out in an effort to make the country more business-friendly for westerners and to avoid the economic and business inefficiencies that come from corruption.

Finally, there’s the problem of underemployment and inflation in China. Chinese farmers on small plots of land are marginally useful and, in an efficient market, would be unemployed. Although inflation today is a manageable 2%, the last 20 years have seen the inflation rate vary wildly, a concern for businesses wanting to invest in the country. (For more, see: India Is Eclipsing China's Economy As Brightest BRIC Star.)

China has the first or second largest economy in the world depending on whether you’re looking at GDP or PPP. However, perhaps significantly, the country is not nearly as developed as the other countries in the top 10. Government spending is a key driver of growth which has over the last few years lead to indiscriminate construction. Even with the largest population on earth, China struggled to find buyers for real estate in its ghost towns. But the government's latest agenda focuses on stimulus to reinvigorate economic activity and if that happens the country has huge room to grow.