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Petrochemical and Plastics Industry Outlook for China 1

Introduction 2

Executive summary 4

1 More petrochemicals and plastics 6

Thank you, WTO 6

Chemical brother 8

Petrochemicals dominate 9

Case study: China’s big three 10

Industry Parks 12

2 Key petrochemicals 14

Case study: The big players in petrochemicals 14

Ethylene 15

Propylene 16

Benzene 16

3 Polymers 17

Multinationals get into polymers 17

Polyethylene 18

Polyethylene terephthalate 19

Polyvinyl chloride 19

Polystyrene 19

4 Strategies and risks 20

Increasingly competitive environment 20

A leaner, tougher industry 20

Common due diligence issues in M&A 22transactions in China

Yangtze challenges Pearl River Delta’s leadership 24in polymers

Stay by the coast 25

Cooling measures will not hurt chemicals unduly 26

Improving chemical transportation in China 26

Chemical companies find intellectual property 27infringements a challenge

Power will be the biggest cost 28

Chemical registration 29

5 Conclusion 30

6 Appendix: Data 31

Chinese economy 31

Heavyweight trader 32

Consumer spending 33

Population 34

Contact us 35

Contents

2 Petrochemical and Plastics Industry Outlook for China

China and the chemicals industry is a phenomenal growth story. China has grown to

be the third-largest producer of chemicals and petrochemicals globally and has

reported growth rates of circa ten percent per annum for the last ten years. This

growth is driven by the demand for Chinese manufactured goods, as key customers of

the chemical industry have shifted their manufacturing and production to China. This

has allowed China to secure its position as the primary recipient of new chemical

investment in petrochemical and polymer facilities.

As some of the first petrochemical and polymer investments partly financed by foreign

companies are commissioned in Nanjing (BASF) and Caojing (SECCO), it is interesting

to note the revival in proposals for investment in the Middle East and, in the longer

term, in India. This in part reflects an expectation of continued high oil prices and a

desire to take advantage of natural gas feedstocks and encouraging economic growth

in India.

For China though, the increased focus on the Middle East and India is not a matter of

immediate concern. China does not possess significant oil and gas reserves; however,

the forecast growth rates are such that petrochemical and polymer capacity are

unlikely to keep pace with demand, and it is likely that the shortfall will be imported

from the Middle East. This will fundamentally alter the Asian chemical trade flows in

the coming years.

For the foreign companies that have invested, there is the promise of continued

growth. However, for those who have not, it may be difficult and expensive to catch

up with established players.

John Morris

Global Chair, ChemicalsKPMG LLP

Introduction


China’s surging economy and growing prominence on the world stage are increasingly

shaping the economies and manufacturing output of the Asia Pacific region.

As demand for manufactured goods continues to grow and the manufacturing base is

diversifying in their domestic market, China is fast becoming a chemicals and plastics

manufacturing hub, both in the region and around the world. It already has welcomed

many of the global players into the marketplace with a large number of them currently

building multi-billion-dollar integrated chemical plants.

Today, China is stepping up chemical and plastics production in the country in a bid to

meet surging demand both domestically and from around the globe with current

projections expecting China to be the world's biggest plastics market by around 2025.

China’s emergence as a leading economy and world power is no flash in the pan. The

past two years have seen Western companies launch an unprecedented wave of

investment in Asia with four-fifths of the world’s 500 largest organisations now having

a mainland presence. GDP growth reached 9.5 percent for the year ending 2004 and is

forecast to remain strong. Meanwhile, utilised foreign direct investment in China last

year reached US$60.6 billion as multinational investor interest gathered further

momentum.

Following the continued economic upsurge within the country, China is working hard

to improve its infrastructure and has proved that it is not just an export platform but

also a place where increasingly successful companies are doing research and

development.

KPMG’s experience in mainland China and the Asia Pacific region has already helped

organisations in the chemicals and plastics industry — both multinational and Chinese

— with their operations and strategies. Today, we have more than 4,200 professionals

on the ground in China with offices in Beijing, Shanghai, Guangzhou, Shenzhen,

Hong Kong and Macau.

Nelson Fung

Partner in chargeIndustrial MarketsKPMG in China and KPMG in Hong Kong SAR


Executive summary

China’s growing role as a producer and consumer of chemicals and petrochemicals is

having a profound impact on the global chemical industry. China is the world’s third-

largest producer of chemicals and petrochemicals, at US$120.8 billion in 2003 (around

five percent of world output). That value is forecast to climb 34.5 percent to US$162.4

billion by 2008 1.

China consumes more than nine percent of the world’s chemicals. From 1993-2003,

its chemical consumption increased by ten percent per year. By 2015, China is

expected to be the second largest chemical market after the United States (US) 2.

Today China accounts for roughly 15 percent of global demand, making it the world’s

second largest consumer of chemical goods — and the fastest-growing 3.

Furthermore, the mainland market is expected to account for some 40 percent of

global demand growth in 2003 – 2006 — reaching 20 percent of global demand by

2006, according to industry players based in China. At home, the country’s chemical

industry accounts for a staggering ten percent of Gross Domestic Product (GDP) 4.

The country’s booming economy is largely responsible for surging chemicals and

petrochemicals growth, with demand outstripping supply across the board. This is not

a flash in the pan. With China’s yearly growth rate forecast to remain around seven

percent until 20155, domestic chemical demand will continue to push beyond supply,

offering unprecedented opportunities for multinational companies. In Europe and

North America, margins for chemical companies will continue to tighten over the next

decade6, chemical margins in China are expected to remain well above levels of

industrialised , and could reach their peak in 2006-2007, according to one China-based

manager at a multinational chemical company.

Annual investment in China’s chemical industry is running at some US$30 billion, with

foreign investment accounting for 55–60 percent of this sum7. Major multinational

players are busy setting up or expanding mainland capacity in a bid to reduce under-

capacity in the country’s chemical industry. Mainland investors are drawn from the

world’s leading chemical giants: BASF, Bayer, BP, ChevronTexaco, Dow Chemical,

DuPont, ExxonMobil, Mitsubishi Chemicals, Shell and Total8. From 2001 to the end of

2005, BASF — the global market leader by sales — will have invested an impressive

US$2.4 billion in China, setting up major new sites in Nanjing and Shanghai. Bayer had

24 enterprises in China with a total sales value of US$1.43 billion in 2004, prior to the

spin-off of the Lanxess business. Smaller players are involved too: Air Liquide has

invested US$121 million in China, with plans to plough in a further US$35–55 million

per year if the strong growth in demand continues9.

________________________________

1 Datamonitor: Chemicals in China 2004 (base, consumer, pharmaceutical and speciality chemicals)2 European Chemical News, 4 April 20053 ibid4 AchemAsia 20045 Merrill Lynch, 14 September 20046 Financial Times, “Investment rockets as demand races ahead”, 8 September 20047 AchemAsia 20048 Asia Pulse:“China to Build Chemical Installations”, 25 May 20049 Datamonitor: Chemicals – Global Industry Guide, February 2005


Multinational players are focusing on a range of chemical facilities across China in a bid

to raise supply of basic chemical raw materials, organic chemicals, plastics and

polymers. Many investments are going towards building new production capacity in

industrial zones such as the Shanghai Chemical Industry Park (SCIP) in the Yangtze

River Delta. To date, foreign investors have already pumped in US$8 billion into large-

scale projects in SCIP10.

Foreign investment is vital for the development of China’s chemical and petrochemical

sectors. Local industry desperately needs the cash, technology, equipment and know-

how which foreign companies can provide. Yet this relationship is hopefully mutually

beneficial. The global chemical industry is increasingly dependent on the Chinese

economy, which saw 9.5 percent growth in 200411.

With so much riding on China, is its economic growth sustainable — or is the booming

chemical industry heading for a glut? Foreign investment is largely focused on bulk

chemicals and polymers, which are key raw materials for Chinese manufactured

goods. Those goods are primarily for export. Domestic demand is also forecast to

increase significantly, which will indirectly absorb a higher proportion of the country’s

chemical production. This is underlined by GDP growth rates, which are forecast to

remain strong at around nine percent in 2005 — falling marginally to seven to eight

percent over the next five years12.

Most notably, China is dependent on the continued import of oil, gas, metals and a

number of semi-manfactured goods to sustain previous growth rates. The quest to

secure supplies is evidenced by CNOOC’s abortive attempt to acquire UNOCAL and

recent purchase of PetroKazakhstan. Key challenges remain. Issues such as market

fragmentation, a lack of local technology and infrastructure constraints appear

insignificant in light of the above. It should also be noted that logistical costs are also

far higher than in other markets, with transport costs and tariffs accounting for up to

30 percent of total costs 13.

Despite these obstacles, it is clear that long-term economic growth and increasing

global integration are set to make China the world’s most important chemical market in

the 21st century.

________________________________

10 Economist Intelligence Unit, Business China, “Chemical Brothers”11 Economist Intelligence Unit, China Hand, “Investing” May 200512 China Economic Quartaly 2005 Q113 Economist Intelligence Unit, China Hand 2004, “Distribution”


Thank you, WTOChina’s sudden emergence as a global trading partner and favoured destination for

investment stems in part from its accession to the World Trade Organisation (WTO) in

December 2001. This long-awaited move rekindled interest among foreign investors in

the mainland market, sparking a third wave of (more cautious and thoughtful)

investment by multinational companies — notably global chemical giants.

Post-WTO China offers several key advantages for multinationals:

Greater transparency

China is working towards an increasingly rule-based business environment, thanks

primarly to efforts on the part of China’s Ministry of Commerce (MOFCOM). A central

part of this initiative involves cracking down on endemic local government corruption

— which manifests itself in the form of arbitrary decisions and ad-hoc fees imposed by

local government officials on foreign businesses. As a WTO member, China is obliged

to publish its trade and investment-related regulations and laws publicly and in English.

Foreign companies involved in disputes may now sue Chinese government

departments or lobby their governments to take China to the WTO over issues such as

intellectual property violations.

Improving infrastructure

Two decades of heavy state investments in China’s coastal infrastructure have seen

the emergence of modern highways, rail networks and ports. The talent pool is also

growing, with more young recruits trained at multinational companies and increasing

numbers of students returning from overseas to work in China.

Improving supply chain

Under the WTO, China has agreed to open up its warehousing sector by the end of

2005. Some foreign logistics providers are already in the market: APL Logistics has

opened the 14,000 square-metre first phase of a logistics centre in Shanghai’s

Waigaoqiao Free Trade Zone; and Australian chemical transportation specialist,

Tennant, has announced plans to triple its physical presence with a new distribution

centre in Shanghai and another in Tianjin, the closest seaport to Beijing 14.

Political unity

The smooth handover of power to the “fourth generation” leadership under President

Hu Jintao and Premier Wen Jiabao in 2002 – 2003 has sent a positive signal to

multinational investors that China’s market-orientated economic policies are set to

continue at a steady pace. The annual National People’s Congress session in March

2005 underscored the leadership’s growing concern with domestic social issues rather

than political infighting.

1 More petrochemicals and plastics

________________________________

14 Logistics Management:“China confronts logistics challenges”, 1 May 2004


________________________________

15 SinoCast, 1 April 2005

A new middle class

Continuing consumer confidence and renewed foreign investor interest in the wake of

China’s accession to the WTO coincides with the emergence of a generation of young,

high-spending consumers. These 20–30 year-olds have none of the political baggage of

their parents — and lack their tendency to save rather than spend. At the same time,

the easing of restrictions in retail and distribution in December 2004 promises to

create ever more pleasant shopping experiences for local consumers, accelerating an

evolution in the country’s retail landscape towards modern trade and chainstore

operations across the country.

Yet there are drawbacks for multinational companies in China’s maturing

market:

Less preferential treatment

WTO intends the removal of tax incentives and other concessions offered to foreign

companies setting up in China. Most designated investment zones — which

traditionally offered preferential treatment — are being phased out under the WTO

principle of equal treatment for all players.

Local protectionism

Despite Beijing’s pledge to implement WTO policy at all levels — notably in intellectual

property and greater business transparency — multinational companies may face local

protectionism at the provincial or city government level. Many local administrations will

seek to protect hometown industries from outside competition — whether foreign or

Chinese.

Multinational companies are looking forward to further liberalisation. China is due to

open its chemical fertiliser retail sector to foreign investors at the end of 2005. Wang

Wenshan, vice director of the China Nitrogen Fertiliser Industry Association (CNFIA),

confirmed in early 2005 that foreign investors would be allowed to set up chemical

fertiliser retail businesses in China from 11 December 2005, and wholesale businesses

from the same date in 200615.

Table 1Output of selected petrochemical products, 2001–2005

Product (in million tons) 2003 G1 (%) 2005* G2 (%)

Ethylene 6.12 0.81 7.30 55.32Methanol 2.99 13.58 3.80 91.25Synthetic rubber 1.27 6.44 1.70 103.42

________________________________

Note: *G1 — annual growth 1998-2003; G2 — annual growth 2000-2005Source: CNCIC Chemdata


Chemical brotherSo how has accession to the WTO impacted the Chinese chemical industry? China has

emerged as a key trader in the global chemical community, and its chemical sector is

now the most important component of its international trade. The country’s total trade

in oil, petrochemical and chemical products climbed 40 percent to a record high of

US$158.6 billion in 2004, accounting for 13.7 percent of China’s total foreign trade

value. Furthermore, with demand far outstripping supply, China’s trade deficit in

chemicals and petrochemicals climbed 54.8 percent to US$76.8 billion in 2004, with

imports of crude oil alone rising 34.8 percent to 123 million metric tons16.

________________________________

16 China News Digest, 23 March 2005

Table 2China’s top chemical trading partners, 2003

Total trade, US$ billion

________________________________

Source: China National Chemical Information Centre (China Chemical Industry Yearbook 2004 Statistics Report)

12.00

10.00

8.00

6.00

4.00

2.00

0

Japa

n

USA

Sout

h Ko

rea

Taiw

an

Germ

any

Hong

Kon

g

Sing

apor

e

Thai

land

Mal

aysi

a

Russ

ia

Aust

ralia

Saud

i Ara

bia

Cana

da

Indo

nesi

a

Indi

a

UK

12.49

11.16

9.02 8.82

3.31 3.272.64

1.91 1.81 1.80 1.72 1.49 1.43 1.37 1.17

Imports Exports

Japan 9.68 2.81USA 5.99 5.17South Korea 7.65 1.37Taiwan 8.05 0.77Germany 2.51 0.80Hong Kong 0.98 2.29Singapore 2.32 0.32Thailand 1.45 0.46Malaysia 1.40 0.41Russia 1.49 0.31Australia 1.26 0.46Saudi Arabia 1.27 0.22Canada 1.13 0.30Indonesia 0.89 0.48India 0.71 0.66UK 0.53 0.64

1.37


This trend is set to continue through 2005–06. Imports of oil, petrochemical and

chemical products climbed 19.4 percent to reach US$9.33 billion in January 2005,

according to the China Petroleum and Chemical Industry Association — while imports

of chemical products alone rose 26.4 percent to US$5.97 billion17. Exports for the

same month increased by an even more impressive 62.2 percent year-on-year to

US$3.98 billion, with exports of chemical products up 59.1 percent to US$3.41 billion.

Meanwhile, the average price of chemical exports grew about ten percent at the

Guangzhou Fair in April 2005, where the volume of business rose by 19 percent year-

on-year, according to the China Chamber of Commerce for the Import and Export of

Metals, Minerals & Chemicals18.

________________________________

17 China News Digest, 23 March 200518 Xinhua News Agency, 21 April 2005

Table 3Selected Chinese chemical products’ imports & exports, 2003

Imports volume Exports volume(million tons) % growth (million tons) % growth

Organic chemicals 10.4 17.7 12.6 42.9Inorganic chemicals 23.9 45.9 2.8 30.8Chemical fertilisers 12.1 -27.9 5.4 117.1Oil products 125.7 31.0 23.4 15.1Plastic products 1.3 -64.3 6.4 19.5

________________________________

Source: China National Chemical Information Centre (China Chemical Industry Yearbook 2004 Statistics Report)

Petrochemicals dominateBulk chemicals form the largest part of China’s chemical industry, with petrochemicals

the most important subsector. Petrochemicals are dominated by the country’s three

largest oil and gas companies: China National Petroleum Corporation (CNPC); China

Petroleum & Chemical Corporation (Sinopec); and China National Offshore Oil

Corporation (CNOOC). All are state-owned and all have been carefully controlled in

terms of strategy, operation and expansion.


Case study: China’s big threeSpun off from the Ministry of Petroleum in the 1980s, China’s three main state-

backed oil companies have grown to become true giants in the industry, each

having successfully listed overseas subsidiaries between 2000 and 2002.

China National Petroleum Corporation (CNPC), was established in 1988. Today

it is the country’s biggest producer and supplier of crude oil and natural gas, with

operations covering exploration and production, refining and marketing,

petrochemicals, natural gas and pipelines, field operations and technical services,

engineering and construction, and equipment manufacturing and supply19.

CNPC is China’s major producer and supplier of petrochemical products and

chemical feedstock, and has nine petrochemical companies. Products include

ethylene, synthetic resin, synthetic rubber, synthetic fiber, branded urea and

fertiliser.

CNPC’s domestic petroleum exploration and production operations are primarily

carried out by its largest listed subsidiary, PetroChina, which has most of its

operations in northern and southwestern China. CNPC’s ninety percent-owned

subsidiary, PetroChina, controls about 80 percent of domestic oil pipelines, 95

percent of domestic gas pipelines and 40 percent of the retail petrol market 20.

PetroChina runs 13 large oil and gas fields, 29 refineries, nine petrochemical

companies, 19 petroleum marketing companies and 12,102 gas stations. It supplies

79 percent of China’s local oil pipeline market and a full 95 percent of its domestic

gas pipeline market — not to mention some 40 percent of the domestic refined oil

products retail market.

With China’s energy needs surging, CNPC is also actively involved in petroleum

exploration and development projects in some two dozen countries worldwide,

including Azerbaijan, Canada, Indonesia, Myanmar, Oman, Peru, Sudan, Thailand

and Turkmenistan. In May 2004, CNPC and Kazakhstan’s state-owned KazMunaiGaz

signed a deal to build a 1,240-kilometre-long pipeline from Kazakhstan to China. The

next month, CNPC signed an agreement with Uzbekistan’s national oil and gas

company Uzbekneftegaz to boost cooperation in the oil and gas sector21.

CNPC is the Chinese government’s principal vehicle for signing contracts with

foreign energy companies. BP took two percent of the shares offered when CNPC

listed in Hong Kong and New York (the Initial Public Offerings raised US$3 billion)

and sold its stake in January 2004 for US$1 billion.

________________________________

19 Datamonitor:“China National Petroleum Corporation”, November 200420 Economist Intelligence Unit, China Hand 2005:“Politics, Economy and Basic Data”21 Datamonitor:“China National Petroleum Corporation”, November 2004


________________________________

22 Financial Times:“Investment rockets as demand races ahead”, 8 September 200423 Economist Intelligence Unit, China Hand 2005:“Politics, Economy and Basic Data”24 Financial Times:“Investment rockets as demand races ahead”, 8 September 2004

China Petroleum and Chemical Corporation (Sinopec) is the national leader in

downstream operations, with the country’s largest refining and petrochemical

capacity — particularly in southern and eastern China. Sinopec was listed in Hong

Kong, London and New York, raising an impressive US$3.5 billion and gaining

minority investments from foreign investors such as BP, ExxonMobil and Shell.

Today, Sinopec has joint ventures (JVs) with both BASF and BP, including a

EUR2.7 billion project with BASF through its Yangzi Petrochemical subsidiary to

produce 700,000 tons per annum of chemical products. Meanwhile, BP’s largest

single investment — US$2.7 billion — is with another Sinopec subsidiary, Shanghai

Petrochemical. The JV facility was commissioned in June 2005 and has a 900,000

tons per annum ethylene cracker with a forecast annual capacity of 2.3 million tons

per annum of derivative chemicals 22.

The country’s third state oil giant, China National Offshore Oil Corporation

(CNOOC), was incorporated in 1982 and (as the name suggests) is China’s largest

offshore oil and gas producer. Of the 26 offshore oil and gas fields in production in

China, CNOOC jointly or independently operates 15 of them 23. In February 2001,

CNOOC listed 27.5 percent of its shares overseas, with Shell taking a US$200

million stake. CNOOC has a JV with Shell subsidiary Shell Petrochemicals Company

Limited (CSPC) to build a US$4.3 billion petrochemical complex through its Nanhai

Petrochemical subsidiary at Daya Bay. This mammoth project — the largest single

Sino-foreign JV in China to date — involves the construction of a naphtha-fed

cracker with an estimated annual production capacity of 800,000 tons per annum of

ethylene and 430,000 tons per annum of propylene. Annual sales at the facility,

which is due to start commercial production in early 2006, will reach some

US$1.7 billion 24.


Central government strictly controls foreign investment in this key sector. Equity joint

ventures with local partners — state-owned enterprises (SOEs) — are the norm, and

even the new regulation, The Chinese Catalogue Guiding Foreign Investment in

Industry (effective from 1 January 2005), continues to classify the construction and

operation of petrochemical operations as “restricted” industries for foreign investors.

Such restrictions are nothing new in Chinese industry — particularly in one of such

value to the Chinese government. Beijing adopted a similar strategy when opening up

the automotive market to foreign competition: early joint ventures gave local partners

access to technology, production techniques and foreign know-how; these domestic

companies then expanded aggressively through merger and acquisition (M&A) to

become major players in their own right. A similar line of development can be

expected in the petrochemical sector, though the strategic significance of the chemical

industry will dictate a slower and more cautious pace.

In terms of examples of how investments are directed Shanghai Chemical Industry

Park (SCIP) provides an excellent example.

Industry ParksWhen the Shanghai government stated its intention to establish SCIP as Asia’s

largest petrochemical production base by 2005 — putting it on a par with the world’s

two leading chemical parks in Antwerp, Belgium and Houston in the US — the notion

was dismissed as ludicrous. Today SCIP is well on its way, with some US$8 billion in

foreign direct investment (FDI) and over US$12 billion expected by 2010.

Originally designated as a development area for chemical companies in the mid-

1990s, the 23 square kilometre petrochemical site was built in 1996 on reclaimed

land near the town of Caojing, some 60 kilometres south of Shanghai on the north

side of Hangzhou Bay. Initially based around a massive 50-50 joint-venture ethylene

cracker BP Corporation (Sinopec), the Park is now home to several multinational

players. Shanghai SECCO Petrochemical Co. Ltd., a joint venture between BP

Chemicals East China Investments Limited, Sinopec and Sinopec Shanghai

Petrochemical Company Limited. The SECCO complex, expected to begin operation

in 2005, will comprise a 900,000-metric-ton-per-year, naphtha-fed ethylene cracker,

plus downstream facilities with combined polyethylene, polypropylene and

polystyrene capacity of more than one million metric tons per year.


German polymer player Bayer Material Science AG is investing US$3.1 billion by the

end of 2005; BASF and US chemical firm Huntsman Inc have set up a US$1 billion

MDI- and TDI-manufacturing plant 25; Lucite has started producing 93,000 metric

tons methyl-methacrylate (MMA) plant in 2005 sourcing feedstock from Shanghai

SECCO Petrochemical Co. Ltd; and Mitsubishi Chemical is building a

100,000-metric-ton-per-year butanediol (BDO) facility, due to come onstream in

2007–2008. Costs for a planned second line will be 20–30 percent lower because of

use of existing utilities and infrastructure. Mitsubishi is seeking to supply strong

demand which pushed imports of butadiene to 70,000 metric tons in 200326.

Also in 2004, Air Liquide of France announced plans to build an industrial gas plant

at SCIP which will supply existing or soon-to-be-completed chemical plants run by

BASF, BP, and Sinopec27. The SCIP investment is a key component of Air Liquide’s

planned investment in China, which will reach US$500 million over the next five

years, according to company chairman Benoit Potier28. Air Liquide invested about

US$12 million each year between 1999 and 2002, followed by US$58 million in

2003 — and an estimated US$103 million in 2004. The China investment represents

half of Air Liquide’s planned investment in Asia by 2008.

As SCIP fills up, interest is growing in neighbouring Nanjing Chemical Industry Park

(NCIP). A number of international chemical firms have set up in the park. And in July

2005, US-based speciality chemicals manufacturer Albemarle announced plans to

build a repackaging facility for its polyolefin co-catalysts and future production

centres for polymer additives. NCIP is also home to a major BASF/Sinopec ethylene

cracker29.

______________________________

Source: Economist Intelligence Unit, Xinhua, Sinopec website

______________________________

25 Rubber World, 1 May 2004, p726 Asian Chemical News, 18 October 2004, p3327 Chemical Week, 18 February 200428 Chemical Week, 15 September 200429 Asia Pulse:“Chemicals Co Albermarble to set up China facility”, 27 July 2005


Case study: The big players in petrochemicalsNowhere is multinational investment in China’s chemical industry more substantial

than in petrochemicals. Dozens of major players have invested heavily in mainland

operations, originally via joint ventures and now — regulatory restrictions permitting

— in M&A.

BASF of Germany, one of the earliest and largest investors in China’s chemical

industry, will have invested some US$3.1 billion in China by the end of 2005. BASF

sees the Chinese chemical market growing at an annual rate of 5.7 percent up to

2015 — and intends to earn 20 percent of its turnover and profits in Asia by 2010.

Investments include a US$3 billion power plant and ethylene cracker complex in

Nanjing.

Bayer AG’s Bayer Material Science division is building a 230,000-metric-ton-per-

year plant in Caojing to produce diphenyl methane diisocyanate, a key raw material

in the production of polyurethane. The plant is due to be online by 2008.

Dow Chemical (Dow) of the US, which has a number of production sites in China,

has been keen to gain a ‘petchem footprint’ on the mainland. In August 2004, the

company announced plans to build a US$3 billion petrochemical plant with a yearly

production capacity of more than one million metric tons of ethylene.

DuPont of the US now has 25 projects in China but continues to increase its

mainland investments. These include the March 2004 acquisition of a solid

surfacing business and announcement of a hydrofluorocarbon (HFC) joint venture,

as well as plans to open a US$15 million corporate research and development

(R&D) facility near Shanghai in 2005.

ExxonMobil is building a long-delayed US$3.5 billion refining and petrochemicals

joint venture with Saudi Aramco and a local partner, Sinopec Fujian Petrochemical 30.

The project involves construction of an 800,000-metric-ton-per-year ethylene plant

with downstream units producing 400,000 metric tons per year of polyethylene and

300,000 metric tons per year of polypropylene.

Shell Chemical has set up a petrochemical joint venture with CNOOC in southern

China: an 800,000-metric-ton-per-year ethylene cracker is due to come onstream in

2005. Shell has also agreed to license its coal-gasification technology to four

ammonia producers in China.

______________________________

Source: Dialog, Reuters, company websites, AFX

2 Key petrochemicals

Petrochemicals have seen and will continue to see continued growth driven by foreign

investment. Increasingly, as oil prices remain high, some investment will be redirected

to the Middle East with its readily available and cheap feedstocks.

________________________________

30 Chemical Week, 1 September 2004


________________________________

31 Xinhua Economic News:“Profile of China’s oil industry”, 27 January 200532 Xinhua News Agency:“China’s 2004 Ethylene Output Hits 6.26 Million Tons”, 3 February 200533 Asia Pulse Businesswire:“Pure Benzene Production, Demand grow steadily In China”, 3 March 200534 Xinhua Economic News:“Profile of China’s oil industry”, 27 January 200535 Chemical Week Vol 167 Issue 15:“Chemical Industry Parks Flourish”, 4 May 200536 ibid

EthyleneDespite existing industry restrictions, the reality is that China needs foreign

technology, capital and know-how. Demand for ethylene typifies the across-the-board

growth in China’s chemical and petrochemical sectors over the past decade, climbing

as high as 17 percent during some years 31, while domestic supply grew by just 12

percent a year. The result — a sharp increase in the import of both petrochemical raw

materials and downstream finished products — has given multinational companies an

opportunity to import foreign raw materials and products to meet much of China’s

demand for polyethylene resin and ethylene-derived petrochemicals.

Like other sectors, domestic production of ethylene has surged over the past three years:

China produced a total of 6.26 million tons of ethylene in 2004, while production capacity

climbed to six million tons 32. Sinopec and CNPC dominate production of feedstock

ethylene and many petrochemical intermediates and downstream products, with their

combined capacity making up over 90 percent of the country’s total output 33. In a bid to

raise production and quality, both Sinopec and CNPC have started to form partnerships

with global chemical players to build world-class ethylene crackers. Yet despite these

investments, China is expected to remain short of ethylene for at least another decade 34.

Not surprisingly, multinational companies are looking to capitalise on this shortfall.

Massive new capacity is due to come onstream over the next two years. BP and

Sinopec have jointly built and commissioned a 900,000-ton project, Shanghai SECCO

Petrochemical; BP and CNOOC are constructing an 800,000-ton plant; and

ExxonMobil, Sinopec (and Fujian Petrochemical) and Arabian American Oil Co. of Saudi

Arabia are busy building a 600,000-ton facility in China’s southeastern Fujian province.

BASF-YPC, the 50 - 50 joint venture between BASF and Sinopec subsidiary Yangzi

Petrochemical (YPC), completed construction of a 600,000-m.t./year ethylene plant at

NCIP in the first quarter of 2005 35. The cracker, along with downstream units that will

produce ethylene glycol, acrylic acid, acrylates, oxo alcohols, formic acid, propionic

acid, methylamines, and dimethyl formamide, are scheduled to start operations in mid-

200536.


PropyleneIncreased spending on consumer goods — promoting a corresponding surge in

demand for packaging — is driving consumption and the production of propylene,

which is used in the auto and construction industries as well as for wires and cables.

Over the past three years, local manufacturers have increased capacity, reducing

China’s reliance on imported product (most of it from Japan, Italy and the Netherlands).

BenzeneWith downstream production of styrene, phenol, cyclohexanone and caprolactam (CPL)

increasing in line with economic growth, production of benzene is set to remain strong

through 2005. Over 30 percent of all benzene production in China in 2003 went towards

styrene monomer production — which reached 2.4 million tons in 2003 and 2.55 million tons

in 2004. Domestic benzene demand is forecast to rise to 2.8 million tons by the end

of 2005 37.

“China’s pure benzene output grew steadily to top 2.5563 million tons in 2004, up 5.3

percent year on year and a record high38. There are more than 50 pure benzene

producers in China at present, mainly under Sinopec and PetroChina. Sinopec

produced 1.4291 million tons of pure benzene in 2004, up 5.1 percent year on year and

accounting for 55.9 percent of the country’s total; while PetroChina produced 712,700

tons, up 4.2 percent and accounting for 27.9 percent of the total39.

China’s pure benzene consumption grew at an average annual growth of 11.4 percent in

the “Ninth Five-Year Plan” period (1995-2000) 40. Average annual growth of pure

benzene consumption was nine percent in the “10 Five-Year Plan” period (2001-2005).41

________________________________

37 Asia Pulse Businesswire: “Pure Benzene Production, Demand grows steadily in China.”, 3 March 200538 Xinhua Economic News: “Pure Benzene Production, Demand grow steadily in China”, 3 March 200539 ibid40 ibid41 ibid


More than any other sector, polymers have seen industry growth spurred by China’s

export markets and increasingly by emerging domestic consumers. Polymers are

among the most important chemical products currently being made in China: demand

continues to outstrip the supply of synthetic resins, artificial fibres, and higher-value

polymers such as ABS, polyurethanes, unsaturated polyesters and polyamide — all

fuelled by frenetic growth in sectors such as electronics, construction and

automotives 42.

The polymers covered below represent only a small selection; others would include

ABS, polyurethane and polycarbonate. These polymers have also experienced dramatic

growth rates.

Multinationals get into polymersBASF, Huntsman, Shanghai Hua Yi (Group) Co, Sinopec Shanghai Gaoqiao

Petrochemical Corp and Shanghai Chlor-Alkali Chemcial Co have formed a joint

venture to build a US$1 billion integrated isocyanates facility in SCIP that will

become fully operational by 1 July 2006. The facility is forecast to produce 240,000

tonne/year of crude MDI and 160,000 tonne/year of TDI.

Bayer Material Science AG is building a US$450 million polycarbonate plant in

SCIP in Caojing. Due to come onstream in mid-2006, the plant will have an eventual

capacity of 200,000 metric tons per year.

BP has agreed to license gas-phase polypropylene (PP) technology to Sinopec

subsidiary, Beijing Yanhua Petrochemical’s polypropylene plant, at Yanshan to allow

for the production of homopolymers and copolymers by end of 2005.

Dow’s main derivatives production sites in China are at Zhangjiagang, where it

produces polystyrene, styrene-butadiene latex, and epoxy resins; and Ningbo,

where it produces propylene oxide (PO) and polyols. Dow also operates with Asahi

Kasei in a joint venture, SAL Petrochemical Co, which runs a 120,000-metric-tons-

per-year polystyrene plant, also in Zhangjiagang.

DuPont is building a PET film train with a capacity of 17,000 metric tons per year at

Foshan via DuPont Hongji Films Foshan Co., a joint venture between DuPont Teijin

Films and Foshan Plastics Group. The expansion will increase DuPont Teijin’s

capacity in China to 57,000 metric tons per year.

GE Plastics of the US has spent US$60 million on doubling its plastics-

compounding and film-extrusion capacity at Nansha, which it first set up in 1996.

The plant supplies acrylonitrile butadiene styrene, polycarbonate, and polyphenylene

oxide compounds and blends.

______________________________

Source: Interview with an industry expert

3 Polymers

________________________________

42 AchemAsia (2004):“The Economics of China’s Petrochemical and Chemical Industry”


PolyethyleneFuelled by China, the Asia-Pacific region has overtaken the US for the first time to

becoming the world’s largest polyethylene (PE) consumer 43. Consumption of PE

throughout the region exceeded 16 million metric tons per year in 2002, representing a

60 percent leap since 1998.

PE demand in the Asia-Pacific region is projected to grow by another 7.5 percent per

year for the next three years, reaching 23 million metric tons by 2007. China’s PE

consumption will make up more than half of this, with 7.7 percent growth taking its

consumption to 12 million metric tons by 2007. Compare this with North American

demand for PE of seven percent since 1998, reaching 15 million metric tons in 2002 —

and the 4.8 percent forecast to reach 19 million metric tons by 2007. Furthermore,

Chinese PE demand will keep on growing, doubling to 17.6 million tons after 2012 44.

The growth in Chinese demand for PE is closely linked to the growth in China’s GDP,

however, there are signs in the last six months that demand is slowing. This in part

reflects an inventory build up in the first quarter and a squeeze on trade credit and the

Chinese government took steps to prevent the economy overheating. Whilst demand

remains strong the slowdown is of relevance as additional capacity comes online.

What is certain though is that China will remain a net importer for the foreseeable future.

LG Chemical of South Korea has started up a 100,000-metric-tons-per-year PVC

expansion at its LG Dagu Chemical joint venture plant at Tianjin, bringing total PVC

capacity at the site to 340,000 metric tons per year. LG is also planning a joint

venture with Fujian Petrochemical (Quanzhou) for a chlor-alkali and PVC plant at

Quanzhou.

Kaneka of Japan has built a US$4.6 million plant at Suzhou to produce 1,200 metric

tons per year of expandable polyolefin beads.

Noveon of the US has built a thermoplastic polyurethane (TPU) plant near

Shanghai.

Run Da Group (Hong Kong) is building an 850,000 metric tons per year styrene

plant in Zhuhai in southern China. The unit is scheduled to start up before 2008.

________________________________

43 Philip Townsend Associates, (www.ptai.com)44 China Chemical Reporter:“Supply shortage in ethylene market”, 26 June 2005


________________________________

45 China Plastics & Rubber Journal: “Demand for PET on the rise” by Zhang Feng, March 200546 China National Chemical Information Centre, 8 April 200547 http://news.pack.net.cn/newscenter/xzyc/2004-02/2004226135226.shtml48 Chinese Polystyrene Consumption49 China National Chemical Information Centre, 8 April 200550 http://www.asahi-kasei.co.jp/asahi/en/news/2001/e010926sm.html

Polyethylene terephthalateIn 2002 alone, China’s consumption of purified terephthalic acid (PTA) — the primary

raw material used to make polyester fibres for textiles and PET for bottles, packaging

and film products — exceeded 6.6 million tons. Yet just 30 percent of that was met by

local production.

Jiang Chengshi of the Chinese Academy of Engineering forecasts that mainland PET

consumption will reach 20 million tons in 2010. The average annual increase rate in

Chinese PET consumption will be 8.5 percent, reaching 14.3 million tons in 2005,

18.3 million tons in 2008 and 20 million tons in 2010 45.

Polyvinyl chloridePolyvinyl chloride (PVC) has boomed since the mid-1990s, thanks in large part to

China’s ongoing construction boom. Production climbed from 1.37 million tons in 1995

to 3.39 million tons in 2002, while demand climbed 22.2 percent — the fastest rate

worldwide — from 1.87 million tons to 5.60 million tons. China is now expected to

become the world’s largest PVC market, overtaking the US some time in 2005–06.

Demand is forecast to rise 8.2 percent to 7.7 million metric tons in 2005 46, rising to 10

million metric tons by 2010 47.

PolystyrenePolystyrene resins or polystyrene blends (e.g. ABS) are widely used in consumer

electronics, appliances, information technology equipment, packaging and toy

applications 48. Domestic demand is forecast to reach 3.3 million tons in 2005 and up to

4.2 million tons by 2010 49. Yet local production is expected to reach only 2.2 million tons

in 2005 and 3 million tons in 2010, according to an industry expert interview. Expanded

polystyrene (EPS), which saw demand climb 18.8 percent to 1.4 million metric tons in

2004 — is forecast to reach 1.6 million metric tons by end of 2005.

Multinational companies have already set up mainland operations. Asahi Kasei supplies

styrene from its plants in Japan to SAL Petrochemical (Zhangjiagang) Co. Ltd., a 50 - 50

joint venture with Dow Chemical for the production of polystyrene in China50. The

120,000-metric-ton-facility gives easy access to fast-growing consumer markets in the

Yangtze River Delta and further upriver.


Increasingly competitive environmentGiven the comparative advantages offered by China, it is not surprising that

multinational chemical companies remain committed to stepping up their mainland

investments. While concern was initially expressed by central government efforts to

reduce capital spending, and so, cool overheating, this was carried out in a selective

way — in contrast to the austerity drive of the mid-1990s — and targeted the

offending sectors such as construction materials 51. Rather than a “hard” or a “soft”

landing, the most likely secenario now appears to be a continuation of strong growth

with further close attention paid by the Chinese leadership to potential overheating.

These positive investment conditions are encouraging more multinational players to

enter the mainland market — a move which will no doubt increase competition. At the

same time, local partners are benefiting from the local technology and equipment

brought to them by their local joint venture partners. These companies may well

eventually constitute stiff domestic competition for the global chemical giants now

entering the market.

A leaner, tougher industryFor the time being, however, China’s domestic chemical sector remains largely

fragmented, obsolete and under-invested. With the exception of state-run industry

leaders such as the big three oil and gas players, China lacks large-scale homegrown

companies capable of taking on the multinationals.

This will change. As in other industries, it is the government’s intention to nurture the

development of a handful of indigenous companies with the scale and standards to

survive both at home and on the international stage. While the consolidation of the

chemical industry will be painful, the ultimate emergence of larger, more efficient

chemical companies will benefit the industry as a whole.

Despite the huge size of the China’s chemical industry and an average output of more

than 15 percent over the past two years, it is not a specific target for government

support — largely because the country imports some 50 percent of its chemicals

consumption, and so has a significant trade deficit in this sector52.

________________________________

51 Chemical Week, 22 September 200452 Chemical Week, 18 August 2005

4 Strategies and risks


However, the Chinese government is nurturing new chemical players modelled on its

three main state-owned oil and gas giants: CNPC, Sinopec and CNOOC. Indeed, in

May 2004 it added a fourth major player to the petrochemical sector with the creation

of the US$688 million China National Chemical Corporation (CNCC). CNCC is a merger

of five existing firms, including China National Blue Star (Group) Corporation, China

Haohua Chemical Industrial (Group) Corporation (CHC), and three other companies

controlled by CHC.

The inclusion of Blue Star, founded by a local entrepreneur in 1984 and managed along

the lines of a private company, is an interesting pointer for future possible

consolidation within the state chemical sector by the State-owned Assets Supervision

and Administration Commission (SASAC), an increasingly powerful ministry-level body

within the government.

At the same time, the government continues to restructure its big three players in a

bid to raise efficiencies. In the first quarter of 2004, Sinopec launched a huge job-

cutting programme intended to reduce yearly costs in its chemical business by some

RMB700 million in 2004 53.

Yet, wholesale rationalisation of the chemical industry remains some years away. What

SASAC will aim to do over the next five years is to improve internal management and

operating efficiencies within a handful of major chemical companies with a view to

listing them on international stock markets 54.

Meanwhile, emerging giants such as CNCC will be encouraged to continue their

expansion through acquisition. In April 2005, CNCC signed a deal with the China

Development Bank (CDB) to acquire an unspecified number of agricultural chemical

companies and local R&D facilities with loans from the CDB. SASAC wants to develop

CNCC as a major agchems player capable of taking on multinational players at home —

and hopefully abroad 55.

________________________________

53 Chemical Week, 7 April 200454 AFX, 28 April 200555 Chemical Week, 30 April 2005


Common due diligence issues in M&A transactionsin China

Quality of financial information

• Companies often follow cash-based accounting or inconsistently-applied

accounting principles. Financial statements audited by firms other than reputable

international firms may be unreliable.

• Accounting systems can be often be paper-based. The quality of financial.

management and internal controls are commonly weak by Western standards.

• Two sets of accounts are often maintained — one for tax reporting and the other

for internal purposes. Neither may be accurate.

• Common issues include:

– Inaccurate sales figures

– Inaccurate margins due to poor product costing

– Related-party transactions

– Inadequate provisions

– Undisclosed liabilities

Regulatory requirements

• Foreign investment restrictions and other regulatory hurdles impact investments

in China. One of the biggest obstacles is often the statutory valuation process.

• A statutory valuation performed in accordance with China Valuation Guidelines is

generally required under PRC regulations whenever a foreign investor enters

into a transaction with a state-owned enterprise.

• China’s statutory valuation process differs from those observed internationally.

Independence is not observed in some cases. Qualifications and competency

vary. Valuation methodologies are not uniform or well-codified.

• Foreign investors frequently raise doubts about the fairness of the process and

reasonableness of the valuation results. It is critical that they understand and are

involved in the process early on, as once the valuation is endorsed by the State,

there is little room for negotiation as the transaction price cannot deviate

significantly from the prescribed value.

The Eight Golden Rules for foreigninvestors looking at M&Aopportunities in China

• Know what you are doing

• Do your homework

• Cultivate your importantrelationships

• Send your best people (early)

• Be prepared to walk away

• Be patient

• Handle developing countryproblems efficiently

• Seek out good advice

________________________________

Source: KPMG Financial Advisory Services practice in China


Tax environment

• Chinese enterprises (especially private ones) often follow certain tax

minimisation or tax avoidance strategies that may not be acceptable to foreign

investors or sustainable due to increased enforcement.

• China is in the process of harmonising its foreign and domestic company tax

regulations under WTO. Tax incentives currently provided to encourage foreign

investment are at risk.

• Foreign investors’ exposure to historical tax liabilities and future tax status are

dependent on the transaction structure — an asset or equity deal.

Unique market

• China’s markets are very diverse and unique.

• Data collection difficulties are abound and the quality of information is often

poor. Official statistics can be misleading or inaccurate, and are frequently

based on non-standard classification methods. The level of corporate disclosure

in China is low even among listed companies. Publicly available information

typically yields little use in analysis.

State-owned enterprise issues

• State-owned enterprises (SOEs) historically shouldered many of China’s social

burdens.

• Many SOEs are currently undergoing reforms, but still have legacy issues that

impact foreign investments:

– Non-productive or non-core assets

– Redundant employees

– Massive employee welfare and retirement obligations

– Excessive debt burdens

– Cross-guarantees to other SOEs


Yangtze challenges Pearl River Delta’s leadershipin polymersThe Pearl River Delta (PRD) has been playing a leading role in the development of the

plastics industry in China since the nation’s economic reform and opening-up started

two decades ago. The dominant position of the province, which is facing problems of

limited resources, insufficient room for further development as well as lack of support

for sustainability, is, however, being challenged by the fast-growing Yangtze River

Delta (YRD) — Shanghai and its neighbouring provinces, Zhejiang and Jiangsu.

The PRD remains China’s largest plastic processing region. Guangdong, the largest

single producer of plastics in the country saw processing volumes of 4.2 million

tons in 2003, or 25.5 percent of the country’s total production of 16.5 million tons.

Some 350,000 people work in the plastics products industry, which in 2003

registered output of RMB77.5 billion (US$9.4 billion) — of which RMB38.4 billion

(US$4.6 billion) was exported.

But the YRD is catching up. In 2003, plastic products production in Zhejiang ranked

second behind Guangdong with 3.2 million tons, while Jiangsu was third with 2.1

million tons and Shanghai ninth with 580,000 tons. Together, the YRD accounted for

nearly 36 percent of total national output.

How can the PRD maintain its edge? In December 2004, Mr Fu An, Chairman of

Guangdong Plastics Industry Association, called on the provincial industry to exploit

the new opportunities presented by the creation of the Pan-PRD economic area, a

loose affiliation of neighbouring provinces such as coastal Fujian and also (more

significantly) under-developed inland provinces such as Jiangxi, Hunan, Guangxi,

Hainan, Sichuan, Guizhou and Yunnan.

With these eight provinces together accounting for just one-third of plastic

production in the Pan-PRD, Mr Fu is hoping to develop capacity through increased

foreign investment in the region. But despite the opportunities offered by these

untapped markets, the YRD’s superior marketing skills will continue to lure

investors northwards in the hope of accessing a wealthier consumer market.

_____________________________

Source: China Plastics & Rubber Journal (December 2004), Hong Kong Trade Development Council


Stay by the coastChina continues to invest heavily in infrastructure as its economy races ahead. The

country’s distribution and logistics sectors are highly fragmented — although the

country’s accession to the WTO has prompted Beijing to address its traditionally

bureaucratic system for retail, distribution and transportation and to facilitate foreign

investment in these once restricted sectors.

The government has embarked on a major infrastructure programme to improve

intermodal transport; it is seeking to remove some of the bureaucratic layers —

remnants of China’s centrally planned economy — which currently hamper the

distribution of goods; and as a WTO member, it is opening up its distribution and

logistics markets to foreign competition before the market is fully liberalised in 2006.

These measures are essential if China is to make the most of the added benefit that

WTO membership can bring to its economy and if foreign companies are to succeed in

an operating environment where a poor distribution model can spell disaster.

Yet China’s supply chain-related costs remain markedly higher than anywhere else in

the industrialised world, while services fall below international standards. The

transportation of hazardous chemicals can be especially problematic in such an

environment, where the required transportation technology is lacking.

Much of the country’s rail freight capacity is tied up in coal transport, as ever-larger

amounts of raw materials are moved from mines in the north and north-west to power

stations in the east and south. The government is investing in new railways, but the

completion of new lines remains several years away. Part of the problem lies with the

Ministry of Railways’ unwillingness to permit greater foreign investment in the

construction and operation of railway lines — a move which would doubtless improve

chemical and general freight transport across the country.

For the foreseeable future the coastal regions will remain the key regions for chemical

investment, as these remain the most advantageous areas to operate.


Cooling measures will not hurt chemicals undulyAlthough China’s largest chemical manufacturers are state-run, privately-owned

chemical companies account for some 55 percent of the industry. These companies

cannot rely on government relationships to guarantee lines of credit during periods of

economic tightening — as in the first half of 2004 56.

If Beijing chooses to exert further selective cooling measures in 2005–06 in a bid to

rein in economic growth, the likely result would be the end of credit for private

companies running independent chemical projects.

Neverthless, since the chemical industry’s exposure to fixed-asset growth is limited,

the government’s sensitive curbing in 2004 of fixed-asset investment rather than

consumption bodes well for future tweaks to the economy, since it means that the

chemical industry is generally less exposed to the economic changes than other

sectors, such as metals 57.

Improving chemical transportation in ChinaSince early 2004, Chinese ship owners and port management authorities have

started to implement schemes run by the Chemical Distribution Institute (CDI) to

help move chemical cargoes more efficiently and safely.

CDI’s primary objective is to improve the safety and quality performance of marine

transportation for the chemical industry by running three schemes CDI Marine, CDI

Marine Packed Chemicals (CDI-MPC) and CDI Terminals. The schemes all use

accredited and continuously trained inspectors who provide reports and data on

ships which is then stored on a database that can be easily accessed by chemical

companies looking for ships to move goods.

CDI has growing value in Asia, where total shipping volumes increased by some

300 percent between 2000 and 2003 and are expected to increase another 150

percent by 2006. In other words, while 200,000 tons were shipped in 2001, by 2006

that figure will have risen to 1.1 million tons.

Frank Forster, Senior Transport and Distribution Logistics Manager for BASF Asia

Pacific, believes there are benefits to joining the CDI scheme. These include the

one-industry approach: many global chemical giants — such as BASF, Chevron, and

Dow — have already signed up.

Yet according to one participant, culture rather than cost is the key barrier. Ship

owners participating in CDI have no charges to pay; instead, chemical companies

participating in the scheme must pay an annual fee of US$2,500-US$3,000 based

on the number of ships they charter.

________________________________

Source: CDI Marine Packed Cargo website, interviews conducted with a journalist and a lawyer by KPMG

________________________________

56 Chemical Week, 18 August 200457 ibid


Chemical companies find intellectual propertyinfringements a challengeA key obstacle to production and R&D investment in mainland China remains

intellectual property protection. While bulk chemicals producers have less to fear from

intellectual property infringements, those multinationals introducing new technology

and equipment into state-of-the-art production facilities need assurances that their

intellectual property will be safeguarded. Since local partners tend to be reputable

state chemical and petrochemical companies, this may to be less of a problem.

However, as regulatory restrictions ease and foreign partnerships with local players

increase, the need to protect intellectual property will become more acute. Although

the Chinese government has revised its Trademark, Copyright and Patent laws in line

with the WTO requirements, the ability — not to mention the willpower — of the

authorities to implement this legislation remains in question. Many government

departments lack the capacity to enforce rulings beyond provincial level, while those

multinationals that do seek legal action may find themselves facing new hurdles —

such as poorly-trained judges.

Although China’s ability to protect intellectual property will remain a key challenge, this

should not deter multinational chemical firms from entering China. As in other

industries, in the long term, multinational companies will only be able to maintain and

build market share by technological innovation and the introduction of new products.

Many global players have recognised this and are already setting up R&D centres in

mainland China — taking advantage of lower personnel costs. Furthermore, heavy

state investment in emerging industries such as biotechnology and semiconductors

means that China is well-placed to start developing its own technology over the next

decade. The country’s universities and research institutes provide a large pool of

academic and scientific talent.


________________________________

58 SinoCast China Business Daily News: “China’s power storage expected to fall to 10mnkw”, 2 August 2005; Comtex:“Southern China to beFaced with Power Shortage this Summer”, 16 June 2005

59 Chemical Week, 18 August 2004

* For detailed discussion on power supply in China, please refer to“Energy Outlook for China” issued by KPMG in Hong Kong in 2005

Power will be the biggest cost*A potential risk stems from rising world oil prices and power shortages caused by

China’s acute infrastructure constraints. Surging demand for electricity has severely

strained the national power grid, resulting in widespread shortages in major cities in

summer 2004 — as well as during the winter months of 2004–2005 in some cities.

Outages were fewer than feared in summer 2005, though southern China experienced

some power cuts58.

The Chinese government initially diverted electricity from less developed regions in

western China in a bid to meet demand in key industrial hubs such as Beijing,

Guangzhou, Shanghai and Shenzhen. But as air-conditioner use surged in the hot

summer months, city authorities were forced to order thousands of factories to

introduce temporary shutdowns and to stagger outages to reduce peak power

consumption. While power cuts caused serious operating problems for some

chemicals manufacturers — particularly in power-intensive production such as chlor-

alkali production59 — China’s large refining and petrochemical complexes (with their

strong links to local and central government) were mainly unaffected.

Since China is a net importer of oil and so hostage to rising barrel costs, power prices

could rise after 2005 — leading to more possible electricity shortages and eventually

raising production costs for multinational chemical companies in China. Particularly at

risk would be large-scale petrochemical facilities. Global oil prices continue to rise.

Since China has to import an increasing proportion of its oil, it follows that operating

costs on the mainland will rise.

Multinational companies already profess to being concerned about the power supply

for their operations. The manager of one specialty chemical manufacturer which relies

on large amounts of electric power says that without a guaranteed power supply, the

development of his plant and the specialty chemical business in general will suffer

significant costs and be unable to develop at its full pace.

Higher operating costs may also result from the Chinese government’s decision to

implement more stringent environmental protection laws over the next decade.


60 Chemical Week, 18 August 200461 ibid

Chemical registrationThe regulation of greatest concern to chemical manufacturers is China’s Chemical

Notification Programme, which took effect in October 2003. The Programme

applies to chemicals that are not yet listed in China’s official chemical registration

list, or “inventory.”

While most commodity chemicals are already on the inventory, numerous specialty

chemicals are not. In the case of many colorants, catalysts, and chemical

intermediates, a certificate of notification must be sought from the State

Environment Protection Agency (SEPA) in Beijing. To do this, applicants must

provide detailed information on a substance’s molecular structure, uses, scheduled

annual amount to be manufactured or imported, toxicological and ecotoxicological

characteristics, accident prevention and emergency response measures and

pollution prevention and waste disposal methods.

While penalties are small — fines ranging from RMB10,000 – RMB30,000

(US$1,200–US$3,600) — violation could result in a moratorium of up to three years

on import or manufacture of the substance in question 60. Furthermore, the cost to

chemical companies of non-compliance could be even greater in terms of applying

for new projects or other operations where official approval is necessary. Chemical

companies are therefore taking the inventory seriously. (Exemptions from

notification include: substances used for R&D and that do not exceed one metric

ton per year, and any polymers that contain less than two percent of the monomer

and chemical substances used to conduct toxicological tests.) 61


5 Conclusion

Those foreign companies who have already invested in China understand what a

tremendous opportunity this market offers, both in terms of current and projected

levels of domestic demand, as well as potential export opportunities in the future. At

the same time, margins in China are expected to remain well above ‘normal’ levels for

the foreseeable future, presenting a stark contrast with the more mature European

and North American markets, where the current and medium-term picture is looking

somewhat tighter.

Taking this into account, it is not surprising that multinational chemicals players remain

committed to pursuing their mainland investments, and that their Chinese partners

remain hungry for a transfer of skills, technology and ‘know-how’ to their domestic

operations. Witness the roughly US$30 billion of annual investment that is now being

made annually across the various chemicals segments in China.

However, despite the opportunities, significant challenges and risks are inherent in

doing business in the Chinese chemicals market. There are also many questions that

can be raised in terms of the long-term sustainability of current growth levels.

KPMG believes that a leaner, tougher chemicals industry, driven by consolidation, will

most likely emerge in the future. New competition will also appear, particularly as

domestic companies strengthen. Additionally, infrastructure development, intellectual

property concerns, energy availability issues and supply chain costs will all have a

bearing on how the industry performs.

This report highlights what exciting, but challenging times lie ahead for both

multinational and domestic chemicals companies. There is no doubt that China is set

to be the world’s most important chemicals market in the 21st century. Do you have

the vision and dynamism to take advantage of the opportunities, but also the realism

and patience required to succeed in China?

Norbert Meyring

Head of Industrial Markets

KPMG in Shanghai


Chinese economyChina’s economic growth over the past three decades has been nothing short of

staggering. GDP grew from RMB450 billion (US$54.4 billion) in 1980 to more than

RMB11 trillion (US$1.33 trillion) by 2003, making China the world’s sixth largest

economy62. GDP growth reached 9.5 percent in 200463, despite selective cooling

measures — and current forecasts for 2005 stand at around nine percent64.

Economic growth has primarily benefited coastal provinces, which have dominated

GDP provincial rankings over the past seven years65 (The exceptions — Tibet, Qinghai

and Chongqing — are all recipients of special central government investment which

has pushed up GDP growth rates.). These fast-growing coastal economies are

historical centres for trade, agriculture and industry. Guangdong province — the key

centre for foreign investments since the 1980s — saw GDP growth rise by a relatively

modest 85.9 percent between 1997 and 2004, compared with other less-developed

provinces and municipalities.

________________________________

62 National Bureau of Statistics, China State Statistical Yearbook 200463 ibid64 China Economic Quarterly (Q1 2005)65 National Bureau of Statistics, China State Statistical Yearbook 2004

While GDP growth in primary industry (raw materials production and heavy industry)

averages just three percent per annum, secondary industry (light industry and

manufacturing) growth is as high as nine percent per annum. Furthermore, high-tech

industries are growing at more than 20 percent a year. Tertiary industry (supply and

service industries) growth is also strong, at nine percent — contributing up to

60 percent of GDP in major cities such as Beijing.

Table 4

China’s top ten provinces by GDP growth, 1997-2004*

%

________________________________

Source: Access Asia, China Economic Quarterly, National Bureau of StatisticsNote*: 2004 interim data based on historical growth rates and Chinese government estimates

Tibe

t

Shan

ghai

Zhej

iang

Beiji

ng

Tian

jin

Qing

hai

Shan

dong

Chon

gqin

g

Jian

gsu

Fujia

n

120

110

100

90

80

118.5 117.1112.2 111.1 109.9

106.3

99.9 98.4 97.1 95.2

6 Appendix: Data


Heavyweight traderOver the past two decades China has become one of the world’s largest trading

nations, driven by demand for cheap manufacturing and raw materials. Today it is

emerging as the world’s workshop — a position it is likely to keep for at least another

two decades. China’s integration with the global trading community has been

strengthened by its accession to the WTO in December 2001, obliging it to commit to

the gradual liberalisation of most of its industries.

Over the past four years, China has introduced a wide range of regulatory, tariff-related

and liberalising measures in a bid to create a more transparent and internationally-

recognised business environment. This has helped accelerate its climb up the list of

top trading nations (see Tables 5 and 6).

Table 5World’s top traders by exports, 1993-2003

US$ billion 1993 Exports 2003 Exports

________________________________

Source: World Trade Organisation

US

Germ

any

Japa

n

Fran

ce UK Italy

Cana

da

Net

herla

nds

Hong

Kon

g

Chin

a

Belg

ium

465

724

380 362472

222

385

748

181304

169290

145

272

140

293

135 92

438

255

800

600

400

200

0

Table 6World’s top traders by imports, 1993-2003

US$ billion 1993 Imports 2003 Imports

_______________________________

Source: World Trade Organisation

US

Germ

any

Japa

n

Fran

ce UK Italy

Hong

Kon

g

Cana

da

Net

herla

nds

Belg

ium

Chin

a

1400

1200

1000

800

600

400

200

0

603

1306

343242

383217

388

602

209

388

148289

141233

139246

126 118234

413

261104

China became thethird largest traderby imports in 2003.

China became thefourth largest traderby exports in 2003.


Table 8Per capita consumer expenditure by broad sector, 1997-2003

Current Prices (RMB per capita) 1997 1998 1999 2000 2001 2002 2003

Food 1,782.64 1,820.98 1,863.68 1,962.81 2,123.76 2,208.52 2,371.43Medicines and healthcare 139.49 166.41 194.51 224.68 249.32 279.73 306.66Clothing and footwear 517.43 494.79 475.19 509.76 548.86 557.23 595.23Household durable goods 284.80 330.19 381.97 395.07 431.61 470.48 506.50Transport and communication 189.94 219.32 248.98 276.97 309.00 340.15 371.51Education and entertainment 358.09 416.04 474.24 528.66 586.13 647.68 707.83Housing 278.12 331.79 388.02 424.72 474.07 525.02 573.28Services 162.44 178.26 195.11 213.30 234.29 253.47 275.47TOTAL 3,712.94 3,957.78 4,221.71 4,535.98 4,957.03 5,282.28 5,707.91

________________________________

Source: National Bureau of Statistics, China Economic Quarterly

Table 9Retail sales as a proportion of consumer expenditure, 1997-2003


Consumer expenditure 3,712.94 3,957.78 4,221.71 4,535.98 4,957.03 5,282.28 5,707.91Percent change 20.23 7.76 7.82 8.64 10.43 7.68 9.19Retail sales 2,858.26 3,022.17 3,211.42 3,521.57 3,800.78 4,321.53 4,759.02Percent change 9.46 5.73 6.26 9.66 7.93 13.70 10.12Retail sales percentof expenditure 76.98 76.36 76.07 77.64 76.67 81.81 83.38

________________________________


Table 10Urban average annual income/expenditure, 1997–2003


Average household income 12,391.58 13,543.25 14,001.00 14,843.53 16,269.66 16,289.73 16,859.15Average householdexpenditure 12,024.29 12,599.04 12,266.16 12,346.25 12,580.35 12,485.56 13,247.79Expenditure as percentageof income (%) 97.04 93.03 87.61 83.18 77.32 76.65 78.58

________________________________


Table 7China’s trade with APEC, EU and ASEAN, 2003

US$ million Total % change* Exports % change* Imports % change

APEC 621.788 33.7 310.609 30.1 311.179 37.5EU 125.217 44.4 72.155 49.7 53.062 37.7ASEAN 78.252 42.8 30.925 31.1 47.327 51.7

________________________________

Source: General Administration of CustomsNote*: Year-on-year change over 2002

Consumer spending


Population

Table 11China’s total population, 1997–2003

Population (billion) % annual growth

1.300 1.30

1.250 1.20

1.200 1.10

1.150 1.00

1.100 0.901997 1998 1999 2000 2001 2002 2003

________________________________

Source: National Bureau of Statistics

1.2081.221

1.2341.248

1.2611.275

1.288

Table 12Population by urban-rural divide, 1997–2003

Million persons Urban Rural

900

800

700

600

500

400

300

200

100

01997 1998 1999 2000 2001 2002 2003

________________________________

Source: National Bureau of Statistics

407.24

800.66

417.56

803.57

428.36

806.00

440.18

807.93

452.54

809.57

461.93

813.03

472.85

815.50


KPMG in China and

KPMG in Hong Kong SAR

Nelson Fung

Partner in chargeIndustrial MarketsChina and Hong Kong SARTel: +852 2826 7215e-Mail: [email protected]

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Head of Industrial Markets, ShanghaiTel: +86 (21) 6288 2298e-Mail: [email protected]

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Ronald Sze

Head of Industrial Markets, Guangzhou,Shenzhen and MacauTel: +86 (20) 3758 8530e-Mail: [email protected]

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Head of Financial Advisory ServicesChina and Hong Kong SARTel: +852 3121 9800e-Mail: [email protected]

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Head of Risk Advisory ServicesChina and Hong Kong SARTel: +852 2826 7267e-Mail: [email protected]

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Head of Strategic & CommercialIntelligence UnitChina and Hong Kong SARTel: +86 (21) 6288 3051e-Mail: [email protected]

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