In this article, we investigate product demand patterns in China and explore the impact of structural changes associated with China’s economic reforms and integration into the world market. Our analysis focuses on the paper and paperboard segment of the pulp and paper industry, a traditional industry that has undergone significant transformation during the economic transition and globalization in China. Continuing economic reforms are dramatically changing the Chinese economy. These changes are having a great impact on traditional industries. Additionally, traditional industries are facing increasing competition from international producers as China gradually opens its markets. Given the combined effects of increasing international competition and market reforms, the demand dynamics for paper and paperboard products have important implications for other traditional industries.

China possesses a huge market potential for paper and paperboard products. Chinese total paper and paperboard consumption is currently ranked second in the world, only behind the U.S. The consumption of paper and paperboard products in 2001 reached 42.6 million metric tons, increasing at an average annual rate of 10.4% over the last 20 years. By comparison, the average growth rate of the U.S. paper and paperboard consumption over the same period is 1.85%. China’s imports of paper and paperboard products grew at an average annual rate of 12.7%, and the share of imports in consumption increased from 9% to 17% for the same period. In 2001, China imported 5.57 million tons of paper and paperboard products, almost double the amount in 1995. Recognizing that there are quality differences in products produced domestically versus those imported, we estimate two separate demand functions, i.e., the demand for domestic products and the demand for imports.

As implied by economic theory, Gross Domestic Product (GDP) has a significant impact on the demand for domestic products and for imports in China. Our results show that the demand for domestic paper and paperboard in China grows at almost the same rate as GDP. On the other hand, the elasticity of import with respect to GDP is 0.89 (and is significant at the 5% level). More specifically, when GDP increases by one percent, paper and paperboard imports increase by 0.89 percent (also statistically indifferent from one). Therefore, as the Chinese economy continues to grow, the demand for paper and paperboard products will grow rapidly.

Interestingly, we find that the demand response to both domestic price and international price changes is statistically insignificant before 1993, indicating that Chinese consumers of paper and paperboard products, mostly industrial consumers, were not responsive to price changes. In the early stage of China’s economic reforms, most firms were state owned, and thus had much weaker incentives to meet market criteria for continued operation. Moreover, in the early stages of economic reform, a dual pricing system existed for the same good, a market determined price and a price set by the planning system. State-owned enterprises (SOEs) usually enjoyed the privilege of paying for goods and services at planned prices, which were much lower than the corresponding market price. For these reasons, it is not surprising to find that, in the early stage of economic reform, the demand for paper and paperboard products was relatively insensitive to price changes.

This situation has changed after 1993 and the demand becomes more sensitive to price changes. According to our study, after 1993, the own-price elasticity of demand is -0.69 and statistically significant (i.e., when domestic price increases by one percent, the demand for domestically made paper and paperboard products drops by 0.69 percent). The economic reforms forced SOEs to adopt more market oriented approaches and increasingly employ market-related criteria to evaluate the success of the enterprise. Eliminating the dual pricing system and growth of non-state owned sectors has contributed to the increasing price responsiveness.

As China becomes more integrated into the world economy, the demand for domestic paper and paperboard products becomes subject to the vicissitudes of the international markets. Although insensitive to the international market in the early stages of economic reform, the demand of domestic paper and paperboard products does respond to international markets after 1993. The related price elasticity is 0.59 and statistically significant, suggesting that imports are a substitute for domestically made products.

The response of import demand to changes in the international price is -0.60. This relatively inelastic response to price suggests that relatively few substitutes are available for imported paper and paperboard products as a whole. This observation is also confirmed by the insignificant cross-price elasticity. More specifically, the import demand does not seem to be affected by the domestic price, although the demand for domestic products is responsive to international price. Therefore, these results are consistent with the notion that imports are a substitute for domestically produced paper and paperboard products but that domestically produced products are not a substitute for imports. This result can almost certainly be attributed to quality differences.

As the economic reforms deepened after 1993, the import demand response to international prices becomes even less price elastic (the difference of 0.10 percentage point is significant at the 10% level). One explanation is that as China’s ability to produce higher quality products has increased (for example, due to foreign direct investment; replacing small inefficient mills with state-of-the-art mills), its imports are increasingly targeted on some specific grades of products. Thus, demand becomes even less sensitive to price. If this is the case, we may expect that the income elasticity of imports for high quality imports will increase as the economic transition continues.

Overall, as economic transformation progresses, the Chinese economy is becoming an increasingly market-oriented system. This is particularly evident from the increasing demand response to both domestic and international prices. However, there is a need for more research in order to discern the effects of other structural changes and of joining the WTO.

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Center Director, Penny Prime, talked with Phil Groves, President of DAC Management, LLC., a distressed asset management company. Mr. Groves has been involved in evaluating and participating in the market for these companies and NPLs in China for the last several years.

PP: You have experience in distressed assets around the world. What changes in China motivated you to participate in this new market?

PG: The single biggest factor is, of course, the decision by China to focus great attention and resources on reforming its banking system. In 1999, four new entities were created to address the large amount of non performing loans held by the Big 4 state owned banks. The new entities, the four Asset Management Corporations (AMC’s), received nearly $200 billion in NPL’s from the state owned banks. In 2004, they received another batch of NPL’s. The AMC’s have been the primary source for Chinese NPL’s over the past four years.

A second factor has been China’s entry into the WTO at the end of 2001. As part of the negotiations, China agreed to improve its banking system and also open it up to foreign banks by 2006. This has created an impetus to address the large amounts of NPL’s and distressed assets in the banking system.

A third factor has been the conscious effort to privatize state owned entities (SOE’s) during the past few years. This has created great opportunities for investors as the amount of potential acquisitions has grown substantially over the past several years.

A fourth factor has been the steps taken by the Chinese central bank to address the economy’s growth. Credit tightening, interest rate hikes and other regulatory mandates have had a significant impact upon the distressed market in China.

PP: Could you tell us about your companies and what business you are doing in China?

PG: We have a group of companies that focus exclusively on investing in China. The main entity is DAC Management but we have a variety of entities inside and outside of China. The group was formed in 2002 to source, invest in and manage Chinese distressed assets, with a primary focus on China’s banking system and state owned enterprises. With offices in Beijing, Harbin, Hong Kong and Chicago, the DAC companies are pioneers and leaders in acquiring and managing non-performing loan portfolios (and other state owned assets and entities) from China’s four state owned Asset Management Companies (AMCs), banks and various governmental entities.

The firms employ twelve professionals in China and the United States, with broad experience in alternative investments and China’s distressed debt and asset market. Prior to creating DAC, I represented and co-invested with the first foreign investors to acquire a portfolio of China’s NPLs in 2001 and the first foreign investors to repatriate dollars from China through the successful management of a NPL portfolio in 2002.

PP: Where do you see the greatest opportunities in distressed assets and non-performing loans in the next two years?

PG: The greatest opportunities will be the privatization of the thousands of SOE’s and the NPL’s currently still held by the banks (as opposed to the AMC’s).

PP: What is the expected pace of the SOE privatization process?

PGl: China is working hard at privatizing SOE’s now. In my opinion the next 2-3 years will be the “golden age” for investors. Since no new SOE’s are being created (unlike NPL’s) they are a scarce resource.

PP: I understand that right now the banks are not allowed to sell their NPL’s. Is that correct, and if so, when do you expect this to change?

PGl: You are correct that there has never been a direct bank sale of NPL’s due to regulatory and approval issues. Many distressed investors have been waiting for the first bank NPL for some time. I expect it to happen in 2005, but the timing is uncertain.

PP: What are the greatest risks and challenges in working in this sector?

PG: The greatest challenge is establishing an on the ground team that can successfully acquire and profit from distressed assets and debt. It is a long and arduous process that requires infinite patience. The greatest risk, in my opinion, is the uncertainty of the laws that impact distressed investing in China. The laws and regulations in this area are not clear and not well established. Thus, there is uncertainty that makes long term planning difficult.

PP: Mr. Groves, thank you very much for talking with us.

Phil Groves’ contact information:

President, DAC Management, LLC

200 South Wacker Drive, 31st Floor

Chicago, IL 60606

pgroves@dacmllc.com

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