China’s imperial growth delusion just will not die

This article first appeared in The Edge Financial Daily, on September 13, 2018.
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THE big state-owned Chinese enterprise is back. But this time, it is not looking sturdy enough to prop up the economy.

As growth stumbles, Beijing is falling back on a tried and trusted solution: using large, government-backed companies to spur activity. That is squeezing out private and small firms. 

The economy certainly merits concern. Trade frictions and Beijing’s crackdown on the underbelly of the financial system have combined to sap confidence. Higher borrowing costs, weak household spending and rising prices point to the beginnings of what could be a wider consumption downgrade. Meanwhile, fixed asset investment growth is near record lows, and the fiscal situation is looking increasingly constrained.

A superficial reading suggests the renewed pulling of state levers is working: Chinese industrial company profits are humming along, climbing 16% in July from a year earlier. Earnings at state-owned enterprises (SOEs) rose 24%, almost double the 13.4% rate for private companies.

A closer examination presents worrying signs. While upstream industries such as mining and energy posted gains of more than 100%, manufacturing sectors like machinery and equipment slowed sharply.

A measure of Chinese companies’ ability to service their debt has improved, leverage levels have stopped rising, and their liquidity in the form of cash to short-term debt is at its highest level in a decade.

But for private companies, measures of debt are still broadly climbing. They also lack the preferential access to cheap credit of their state-owned counterparts. Operating conditions for small companies are getting worse; they are holding inventory for longer, and the time it takes them to convert working capital into cash is increasing, Goldman Sachs Group Inc found in an analysis of more than 4,000 Chinese companies.

Key to the resurgence of gargantuan national champions such as China State Construction Engineering Corp have been supply side reforms, including strict curbs on environmentally-unfriendly companies and factory closures in industries with overcapacity. President Xi Jinping’s Belt and Road Initiative has also driven business their way.

These policies have pushed out marginal players. Meanwhile, the wide-ranging campaign to reduce debt has hurt demand and left private, smaller companies in the lurch. The number of money-losing private industrial companies jumped about 40% as of June from a year earlier, while the number of unprofitable state-backed firms stayed flat. 

History shows that private companies have far higher productivity. Their average return on assets have been four to six percentage points higher than SOEs over the past two decades. 

Given that state enterprises now account for almost a third of all Chinese profits, up from 15% in early 2016, that should be a concern.

Even over the past decade, repeated mergers and de-mergers of several national champions (some of which are now being recombined) have not produced any real victors. Efficiency, earnings and returns on equity have declined. China combined two rail equipment makers in 2015 into CRRC Corp, a company with a market value of about US$130 billion: Return on equity has fallen since then to about 11% from 13.5% pre-merger, and margins have been flat at about 5%. Listed SOEs have traded at discounts to their private peers.

Effectively suppressing private companies — especially now, when the state’s purse is looking smaller and its ability to prop up state-backed giants is constrained — is not sustainable. State-owned companies depend on government spending rather than solely demand like their private sector peers, but fiscal revenues are falling sharply. Even though industrial SOEs look to have improved, they still carry the bulk of stressed debt in the system. 

In the latest example of the squeeze, Beijing is planning to extract more in tax from companies to replenish state coffers for an ageing population. China’s social security tax rate is the highest in the world at around 43%, versus 13.3% in the US and 30% in Japan, according to Nomura Holdings Inc. Private enterprises, or employers, are the biggest contributors to social security tax in urban areas, paying almost twice as much as SOEs.

Running the private sector dry has never helped Chinese emperors. This time will not be any different. — Bloomberg