China's private-sector engine revs up, but will it keep firing?

By Elias Glenn and Shu Zhang TANGSHAN/GUIYANG, China (Reuters) - Toilet manufacturer Fenghua Ceramics Co is building a factory over farmland in north China's Tangshan city, its first major investment since 2000. While it plans to boost annual production by 20 percent, it won't be hiring more workers. It's a familiar dilemma vexing many small- and medium-sized enterprises across the country. Even as sales slowly improve, land and labour costs are rising and squeezing profit margins. The government has lauded this year's steady economic growth and the rebound in private sector investment, saying it shows stronger domestic demand, but economists warn the recent uptick may be short-lived as companies struggle to navigate a business landscape that heavily favours state-linked enterprises. And not all sectors will be able to create the thousands of jobs policymakers hope for even as investment picks up. "(The recovery) is still driven by previous monetary easing rather than sustainable changes in structural growth and reform," said Capital Economics economist Julian Evans-Pritchard. "The question is then what's going to happen to sales growth — it's probably not going to recover much further than it already has," he said. "If I was a Chinese firm, I'd have some concerns about the macroeconomic outlook over the next couple of years." China Beige Book, a research firm that surveys more than 3,000 companies quarterly, said firms saw revenues rise in the third quarter, but profit margins fell and cash flow deteriorated. "Profit margins are under threat because labour costs are rising every year. We have to upgrade the production process to remain competitive in the long term," said Daniel Dong, export manager at Fenghua, which has sales of 160 million yuan ($23.3 million) a year. Corporate underperformance is worrisome as the private sector is vital to China's economic health, accounting for 80 percent of employment in urban areas and more than 60 percent of investment. Private investment growth in January-October quickened to 2.9 percent, off a record low this year, but remains far below the boom years of above 20 percent a few years ago. Its performance also lags fixed-asset investment by state firms, which rose 20.5 percent in the first 10 months of the year. STATE SUPPORT Local governments have come to the aid of private enterprise with subsidies and other assistance, in part because they are rewarded for encouraging entrepreneurship and improving the business environment. Their support is in line with a major push by Premier Li Keqiang to put government to work for business. Guizhou Yangsheng Medical Equipment and Yangcheng Bakery operating in the southwestern province of Guizhou, among the fastest growing in China, received government help with capital raising and will use the funds for expansion. Yangsheng Medical sells to more than 1,000 hospitals across China and aims to be a bigger brand name, joining the tide of domestic companies the government is supporting to take market share from foreign names. Yangcheng Bakery, with a large factory in the provincial capital Guiyang, plans to open shops in every county in the province. Owner Zhou Zhaoming is adding new local snack products to ride the province's push into tourism, importing foreign technology and hiring more staff to develop new products. In Moganshan, a mountain area southwest of Shanghai, entrepreneur Shen Yang and a group of partners have received subsidies of several hundred yuan per square metre for the renovation of farm homes to be leased out as hotels. The state may be doing more than previously to help private firms, but they have far less insulation than their state-owned counterparts. Companies say the big challenge is a general slowdown in the economy combined with a highly competitive market where firms are sustaining production and employment levels despite pressure on margins. Indeed, there have been few signs of rising unemployment even in hard-hit sectors such as steel, with local governments offering subsidies and incentives to companies that avoid layoffs. Tian Weiguang, a manager at Sunshine Ceramics in Tangshan, says his industry is coming to a crossroads and must find ways to improve productivity. "There won't be rapid growth, but we can likely keep stable. The industry is at a point where it needs to adjust. If you don't upgrade, you'll have a hard time surviving," Tian said. (Editing by Jacqueline Wong)