Chinese Economy – Macroeconomic Analysis for Tesla’s Investment Decision

Economic Structure & Transition

The Chinese GDP has grown remarkably over the past few
years. The CAGR has been 8.5% from 2012-2017.
Traditionally government expenditure & investment have
been major contributors to the GDP. The share of investment
in GDP has risen to around 44% in 2017. However, the credit
fueled investment growth model is running out of steam due
to lower returns on investment, negative investor sentiment
due to US-China trade war and sizeable excess supply &
capacity. The government is now focused on raising the
domestic consumption rate. Recent policies include
boosting incomes and higher spending. Amidst the slowdown
due to US-China trade war, the next phase of growth will be
consumption driven.

GDP Analysis –Growth, Forecasts & Components

The Chinese GDP has grown by 6.5% in 2018. The World

Bank forecast for GDP growth in 2019 at 6.2 percent. The
projections reflect several factors. On the upside, there was a
positive surprise in actual GDP growth in the first quarter and
a larger-than-expected fiscal stimulus announced in the 2019
Budget. Higher US tariffs on exports worth US$200 billion,
heightened uncertainty from the escalation in trade tensions,
and weaker global growth are expected to have a negative
effect on China’s outlook. In 2020, growth is expected to
slow further to 6.1 percent, down. In addition to the negative
impact of the new US tariffs on exports, the escalation in trade
tensions and weaker business confidence, as well as slower-
than-expected global trade growth, are projected to weigh on
investment in the near term. Forecast GDP growth of
around 6% in 2020 on slower investment and industrial
activity. But it is expected that there will be relatively healthy
consumption and service sector growth. The government
also puts a lot of emphasis on improving the industrial
structure and moving up the value chain. Overall, we GDP
growth is expected in 2019-20 to average just around 6%,
roughly meeting the government target of doubling GDP and
per capita income by 2020 (the objective set in 2010).
Government expenditure & consumption will be the
major growth drivers. From the production perspective, the
GDP growth contribution of industry was stable at 2.4 pp in
Q1 2019 compared to Q4 2018, while the contribution of
services increased by 0.4 pp to 4.0 pp. The growth
contribution of construction, transportation, and real estate
declined further, while that of financial intermediation
increased. Software and IT services continued to rise at
double-digit rates, contributing 1.0 pp to growth in Q1 2019.
Services will contribute approx. 3.7% to the GDP growth rate
from 2019-2021.
US- China Trade War Impact & Outlook: Rising tariffs and high uncertainty has taken toll on China’s exports and investment.
China’s exports and imports both fell in June, as higher US trade war tariffs blitz Chinese economy. In June 2019, exports fell by
1.3 per cent year-on-year to US$212.8 billion, after tariffs on US$200 billion of Chinese goods were raised from 10 per cent to
25 per cent by the US administration. This was down from 1.1 per cent growth in May. The trade war has led the government to
undertake fiscal stimulus which will expand the fiscal deficit. Chinese government heightened infrastructure spending to prop
up slowing economy. The fiscal stimulus may prop up the economic growth however the risk attached with higher debt to
GDP ratio is likely to increase. Even though outlook on a truce to the U.S.-China trade war is improving, a US-China trade deal
remains unlikely any time soon. Corporate investment is being held back by the elevated uncertainty surrounding the trade
war with the US.

Disposable Income & Savings

Consumption continues to drive economic
activity, in China but its contribution to growth
declined to 4.2 pp yoy from 4.5 pp in Q4 2018 and
5.3 pp in Q1 2018. According to household survey
data, growth in real consumption expenditure has
been generally weaker than real disposable income
growth in recent years. This trend has been driven
by urban households, while for rural families
consumption growth has been, on average,
higher than income growth.

The saving rate of urban households continues to rise, while that of rural households has gradually decreased. The recent
decline in China’s national saving rate has been the result of lower saving by corporations, the government, and rural households.
A decline in the urban household saving rate and higher consumption will be important for rebalancing from investment to
consumption and sustaining growth in the future.

Consumer Price Index (Inflation)

Consumer Price Index (CPI) increased from 2.1% in

2018 to 2.4% in 2019. Strong food price growth
contributed to higher inflation in March and April.
Food prices are volatile and, during this period, were
driven by a supply shortfall caused by bad weather
and an outbreak of swine flu (which raised prices of
Pork). Also due to quantitative easing, tariffs on
imports and fuel supply shocks, the CPI is
expected to reach 3% by 2024. The CPI inflation
rate is within the Central Bank’s target of 3%. The
global oil price increase will be a big driver of the rise
in China's CPI inflation. Inflation changes are in line
with consumer’s average income.

Purchase Manager Index: The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in
the manufacturing and service sectors. The official Chinese Purchasing Managers' Index (PMI) rose to 49.8 in September 2019,
slightly better than expected and advancing from 49.5 in August 2019. But it remained below the 50-point mark that separates
expansion from contraction on a monthly basis. The PMI is expected to improve with the government’s fiscal stimulus
programs.
Rising Wages & Impact on FDI
While China remains among the top FDI
recipients in the world, FDI inflows have
declined in recent years due to factors of
both temporary and structural nature. In
2015, a weaker domestic growth outlook,
equity market turmoil, and Renminbi
devaluation lowered business
confidence and contributed to an
investment slowdown. China’s share of
global FDI fell to an average of 8.6
percent in 2015-17. China has seen the
highest amount increase in its wage rate,
60% from 2010-2017. Relocation of
plants to other low-cost economies is a
major economic risk.

Fiscal & Monetary Policies: The Chinese government has been following expansionary policies to prop up the slowing down
economy. There has been a reduction in Corporate VAT for industries such as manufacturing from 16% to 13% and from 10%
to 9% for sectors including construction and transportation. In addition, small and micro-enterprises with monthly sales of less
than 100,000 yuan have been exempted from value-added tax. Furthermore, since the start of this year, six special deduction
policies for personal income tax related to children’s education and continuing education have benefited around 48.8 million
people. In the investment-oriented Government Fund Budget, the limit for local government special bond issuance was raised by
RMB 800 billion (0.8 percent of GDP) to RMB 2.15 trillion. The People’s Bank of China cut banks’ reserve ratios by 1%,
unleashing cash of $1.15 trillion to help banks lend more. Local governments are allowed to sell 2.15 trillion yuan of so-
called special bonds in 2019 to raise funding for infrastructure projects. Fiscal policy and measures implemented due to prop up
the economy will enhance the risk a of further debt build-up. The government debt to GDP ratio is expected to become
70.3% in 2023 from 50.5% in 2018.

The PBoC also revamped the interest framework to reduce cost of borrowing that will support government bonds and create
room for central bank to loosen monetary policy. PBoC has asked lenders to price their loans based on a monthly prime rate.
This move is an effective interest rate cut. The US fed Bank rate cut has would increase gap between US and China interest rates
so that Chinese securities would have a higher return compared to US equivalent bond. This would give investors less incentive
to move out of China. It will provide a timely window for China to reform its lending rate mechanism, as it will ease external
obstacles in terms of the yuan exchange rate and capital flows.

Currency Fluctuation: The CNY has weakened against the US$ amid renewed trade tensions with the US. There is no major
depreciation pressure envisaged given that policymakers would not be comfortable with major weakening of the CNY as the
concerns about triggering large financial capital outflows persist. In the medium term, it is expected that the CNY will
appreciate modestly against the US$ due to US fed Bank rate cuts and revamped interest framework by PBoC. The policy stance
on capital outflows will be relaxed only gradually, given that net financial outflows remain sizeable.

Unemployment: According to IMF, the unemployment rate in China has continually decreased from 3.4% in 2009 to 3.8% in
2018. It is expected to remain at the same level.

Political Stability: The 19th Party Congress in October 2017 marked the beginning of Xi’s second five-year term. The various
developments do not suggest a shift in the direction of economic policy, which remains characterized more by stability rather
than a drive for accelerated change and reform.
EV Market in China

China is the world’s biggest market for electric vehicles (EV) with more
than 47% of global market share. As of January 2019, there were roughly
2.6 million electric vehicles in China. In 2018, the total sales of EV in China
was around 1.2 million, up 61.7%. EV contributed roughly 4.5% of light
passenger vehicles sold. The electric vehicle market of China is made up of
several local players. The HHI index (as of 2017) is estimated to be
around 1600 indicating a moderately competitive market.

The players compete on price and this leaves considerable room for a
differentiated product to own in a fast-developing nation with rising
disposable incomes.

The market is expected to grow by CAGR of 33.3% from 2019- 2024

Government Policies

As part of its ‘Made in China, 2025” plan China is taking aggressive steps to become the market leader in EVs. currently, electric
cars in China enjoy a significant degree of exemption from acquisition tax, along with the excise tax, normally based on engine
displacement and price. The value of the incentive ranges from around CNY 35,000 to CNY 60,000 (which is around USD 6,000
to USD 10,000) to purchase electric cars. A higher degree of incentive level is directed toward the procurement of pure electric
vehicles. Additionally, EVs in China are exempted from circulation/ownership taxes, further encouraging the adoption. In
2017, the City of Beijing announced plans to transform its entire taxi fleet to electric propulsion. Recently, some revisions
were made to its policy: subsidies were ceased for vehicles with a driving range of under 150 kilometers, while vehicles with
300km of driving range will continue to receive the current level of subsidies. Those with driving ranges of over 400km are
entitled to even higher subsidies. Due to these favorable policies the growth in the Chinese EV market much faster than
other developed markets.

Figure: Global electric market sales, 2013-2018

Strengths

Tesla’s Gigafactory in China could be a game changer for Tesla. The plant could have an initial annual capacity of 250,000
vehicles. That capacity is set to double to half a million vehicles after the factory’s second phase. With the local manufacturing
unit, Tesla will be able to save on logistics considering the US-China trade war. These savings could be passed on to the customer
bringing down the price of Tesla cars and position them as a differentiated value offering compared to the local alternatives.
The Lithium ion battery is a major cost in an EV. Innovation in battery
technology has brought down the per unit cost of an EV battery 80%
from $1000 in 2010 to $200 in 2017. Through its extensive R&D, Tesla
is confident of bringing the cost of battery to $100 per kWh by 2021.
At this crossover point internal combustion engines cease to be more
cost effective making the EV even more attractive to the price conscious
customer whose decision will now be based on preferences.

Challenges

Collecting rare earth metals for synchronous motors will be a major challenge for Tesla. Limited EV infrastructure will serve as
a bottleneck for demand growth. The government provides subsidies for local EV companies providing a competitive edge.
Through this protectionist move, companies like BYD and BAIC can provide EVs at a lower price in the Chinese market
with high price elasticity of demand. There is a dearth of EV charging infrastructure which has proved to be a bottleneck for
adoption.

SWOT Analysis

Strengths
- Differentiated product
- Low battery cost due to extensive
R&D
- Top EV manufacturer in the world
- Strategic manufacturing plant in
construction in China
Weaknesses
- High priced offerings
- Extremely competitive market
- Limited charging infrastructure
- Limited raw material for production
factors
- Long hours for charging

Opportunities Threats

- Chinese government withdrawing - Trade war escalation

subsidies for local manufacturers
- Charging infrastructure presents
new revenue streams
- Countries shifting towards green
mobility solutions
- Consumer perception
- Price war by competitors
- New entrants to intensify
competition
- Rising wages in China to increase
costs

Recommendation:

 Tesla’s focus market has been the United states. Tesla is struggling to stave off a potential dip in demand in the U.S., its
biggest market, after reductions in federal tax credits for EVs. The company cut the price of all its models by $2,000 to
partially offset the loss of the subsidy. A local plant in China is crucial for Tesla to expand its presence in China and
diversify its geographical portfolio.

 Though China has a seen a slowdown in car sales in the recent quarters, the EV market in China is expected to grow by about
CAGR 33.3% from 2019-2024. This provides immense opportunity for Tesla to expand its presence in the biggest &
fastest growing EV market of the world by setting up a production plant there.
 Currently China imposes 25% tariff on car imports & 5% tariff on auto parts & components. Domestic production would
help shield Tesla against import duties as the U.S. and China find ways to wriggle out of the tariff quandary. Also, there
would be cost benefits due to cheaper wages & raw materials in China compared to USA. Thus by setting up the Gigafactory,
Tesla can significantly reduce prices in China and capture a major market share.

 The Gigafactory set up in China will be the production centre for sales in China & other Asian countries like India, Japan etc.
The Chinese plant will be the core of Asian supply chain for Tesla. The cars manufactured at the Chinese plant will be
subject to high tariffs in the US. So, the demand for US markets cannot be sourced through China. Thus, Tesla should
operate on a multiple production centre model where the US & European market demand will be met through
production centres in US and Asian market demand will be met through the Gigafactory in China.

 The biggest challenge in EV adoption in any economy is the EV infrastructure. It is reported that only 40% of households
having EVs in China can find convenient charging points. This opens opportunity for Tesla to partner with the Chinese
government to set up EV infrastructure and create an EV ecosystem in China. Tesla earns $10 per car charge on its EV
infrastructure (charging points). Along with the EV car sales, EV infrastructure can be a major business opportunity in
China.

References

https://economictimes.indiatimes.com › Industry › Auto › Auto News

https://asia.nikkei.com/Spotlight/Electric-cars-in-China/Tesla-leads-foreign-charge-into-China-s-electric-vehicle-market
https://marketrealist.com/2019/10/auroras-growth-initiative-update-drives-its-stock/
https://cleantechnica.com/2019/10/03/china-tesla-demand-is-spiking/
https://www.forbes.com/sites/sap/2018/09/06/seven-reasons-why-the-internal-combustion-engine-is-a-dead-man-walking-
updated/#3f0e384b603f
https://www.bloomberg.com/opinion/articles/2019-04-12/electric-vehicle-battery-shrinks-and-so-does-the-total-cost

Group 31 Niket Chauhan (117) | Taniya Kamakar (152) | Vrajesh Chitalia (158) | Aanchal Chopra (161)

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