Falling prices, not markets, are the real headache for Chinese firms

Manufacturing has been stagnating, wholesale prices sliding in the last three years

The dramatic collapse of China's stock markets has shaken global investors, but for Chinese factory executives the real problem is a decline of another kind - the remorseless erosion of profits thanks to nearly four years of price deflation.

While the stock market rollercoaster of the past 12 months has hogged headlines, Chinese manufacturing has been stagnating slowly but inexorably for more than three years, with wholesale prices sliding continuously as legions of small companies compete desperately to stay above water.

Producer prices hit their lowest point since late 2009 in July.

"Business isn't good, the economy isn't doing well, so I'm not planning on expanding the business," said You Zhenming, 39, whose factory, which sits amid fish farms outside the coastal city of Ninghai, makes small rubber components for cars.

Falling wholesale prices mean that the real cost of borrowing for companies remains high, despite a series of interest rate cuts, while shrinking profit margins discourage firms from investment that would generate growth.

Like many of the mid-sized private enterprises that form the backbone of China's real economy, You's factory is hurting, slammed by increased domestic competition, rising factor costs and falling exports, all of which mean less profits.

China's central bank has attempted to shore up the slowing economy and stabilise plunging stock markets with a surprise currency devaluation and aggressive monetary easing.

But that means little to the majority of private firms such as You's who have done without access to traditional financial markets for decades.

Like many other business owners who spoke to Reuters, You's company isn't in a state of collapse, nor is he knee-deep in debt like many bigger state-owned enterprises.

But, like most Chinese manufacturers, he has seen a steady erosion in his pricing power due to intense competition, which forces him to pass on any savings that might come from cheaper commodity prices or a lower exchange rate directly to the customer.

"The price of rubber's been falling but that doesn't help us since our orders are falling too," said You, noting his sales volume has fallen 20% this year from 2014. As a result, he has cut prices 10% from a year ago.

The weakness of export markets has made things worse, he said, because it has forced all his competitors to concentrate their pricing competition in the domestic market.

You wants to sell half of his product overseas, but he can only sell 10% at present and overseas customers are growing increasingly finicky, only making small hit-and-run orders instead of buying in bulk.

TOO MUCH COMPETITION

While much criticism of the Chinese economy focuses on the protected monopoly status of major state-owned enterprises, seen as suppressing competition and discouraging efficiency gains, the challenge for China's legions of medium-sized private companies is not too little competition, but too much.

"China has a bad disease," said Richard Gong, CEO of the Wecan Group, speaking from his factory on the outskirts of Shanghai, where lines of robots in various states of repair stare blankly at rows of corn in the adjacent vegetable garden.

"Competition within industries is too intense, it's irrational."

Wecan started manufacturing automated production lines, and recently launched a lucrative sideline in refurbished foreign robot arms, which Gong resells to Chinese car makers.

Outside of China the robotics sector is dominated by around four major brands, but Gong estimates he faces more than 1,000 competitors in China, many of them start-ups sponsored by local governments as part of a nationwide push to automate Chinese factories.

Gong says he's doing well, adding capacity and raising profit targets, but the fact that he is able to outprice domestic producers selling used foreign machines shows the automation sector overall is not healthy.

As many insiders warned when governments started encouraging the development of domestic automation brands, a swarm of small robot makers have sprung up, competing on price but unable to either reach the production scale to drive their costs down, or produce the quality necessary to charge higher prices.

"These guys don't have any price advantage at all," said Gong.

This problem is not limited to robots.

"Concentration in a lot of Chinese sectors is very low," said Andrew Batson, economist at Gavekal Dragonomics in Beijing.

"There's a phenomenon where some sectors are designated as favoured, like solar power and now robotics, and local governments sponsor their local champions and you get overcapacity."

Economists note the one area where reform has gained least traction is in the long-mooted shake-up of the state-owned sector and the role local governments play in driving growth, together the largest contributors to fragmentation and overcapacity.

Without more aggressive rationalisation of China's industrial policy, changes to interest rates aren't likely to do much good.

"In theory, Beijing's recent moves will support the economy," said Wu Yinghua, executive at Guangdong Aolin Magnetic Electric Industrial in southern China. "In reality, it doesn't help us."