Despite a recent slowing, three decades of growth have elevated China into one of the world's most powerful economies. China's entry into the World Trade Organization in 2001 sparked a repositioning of global supply chains and catalyzed impressive growth in its manufacturing sector as well as its economy overall. However, more recently that growth is slowing as supply chains pivot to other low-cost countries and in some cases even shift back to the developed world. Ironically, this reversal may be happening under the cloak of a protectionist anti-trade backlash in response to the original supply chain shifts that created labor dislocation in countries such as the US and in western Europe.

Against this backdrop, Chinese manufacturers can no longer rely on a never-ending acceleration of finished good exports to fuel demand growth. China's leaders have recognized this. Moreover, the global recession of 2009 has taught them the risks of being overly beholden to exports. As a result, China is now in the midst of a delicate pivot toward a more consumer-oriented economy driven by domestic consumption rather than exports. This shift alone will change the nature of the products demanded and the chemical and plastic components of which many of the goods will be constructed. Because Chinese consumer preferences are quite different than those of the West, product features will ultimately adapt to this reality.

Growth Plus Environmental Stewardship

China faces other conflicting dynamics as its citizens demand higher environmental and safety standards. Meeting this demand will be a challenge, especially considering the nation's reliance on natural resources. Historically, China's chemical industry has largely run on relatively highly polluting, locally abundant energy sources such as coal to supplement limited oil and gas resources.

Moreover, although coal can be production-cost advantaged in some locations, coal-based investments are unlikely to either keep pace with China's domestic chemical growth or offer superior capital returns. With limited natural resources, hydrocarbon-based commodity chemical investments are likely to be marginal uses of increasingly expensive and scarce capital. Lower returns are probably acceptable for state-owned enterprises (SOEs), since basic and intermediate chemical investment remains a strategic imperative and helps maintain a level of self-sufficiency for manufacturing that brings comforts to the country as a whole.

However, the growing local pressure to conserve energy and support green development is creating new challenges for China's energy, chemical, and manufacturing industries. China will need to look beyond coal and begin weighing these macro-level economic and environmental issues in its energy and investment policies and decision making.

To balance these strategic needs with growing environmental demands and slowing economic growth, decision makers will need to carefully evaluate their options, considering issues such as:

• How to most effectively deploy capital
• Using technology advances to reduce CO2 emissions
• Increasing focus on technologies and products that are both market-driven and environmentally conscious

Tips for Sustainable Growth

Chinese energy and chemicals companies need to improve innovation. Companies must transition into higher value-added and technologically-driven manufacturing techniques to ensure market competitiveness and support the call for improved environmental standards. Indeed, these are the goals of both China's 13th five-year plan and its Made-in-China 2025 policies.

Key concerns that China's policy makers are hoping to address include:

• Choosing operational processes that can best meet development goals
• Optimizing the supply chain
• Developing policies that support product innovation
• Enabling organizational efficiency

Looking ahead, China must also reduce both the existing and the future potential for structural overcapacity. In the past, rampant overinvestment has led to lower returns, poor decisions around process technology choices, and reduced competitiveness by capping market prices and sapping reserves for needed investment in other areas, such as innovation and merger and acquisition activity. To strike the right balance, policy makers need to consider steps such as:

• Eliminating so-called 'zombie' companies, by combining market forces with supportive government policies that relieve social displacement and the impact of local protectionism
• Allowing M&A activities that help build scale and optimize the asset base
• Creating better clustering of resources and upgrading the energy portfolio to higher-end products
• Partnering with overseas companies to advance technology and cost position
• Revamping capital investment processes to ensure capital is allocated both appropriately and to the most impactful industry sectors

The combination of the changing nature of China's economy, the increasing focus of its citizenry on environmental stewardship, and the natural shortfall of its energy resources present a daunting challenge to Chinese policy-makers. No doubt the central command-and-control structure can effectively implement the policies once they are decided. The challenge is to maintain the delicate balance in the face of rapidly changing dynamic forces.

Dave Witte is the Senior Vice President of IHS Markit and General Manager of Oil, Midstream, Downstream & Chemical
Posted 4 January 2017