Im­pe­rial growth fal­lacy of China just won’t die

Financial Chronicle - - EDIT, OPED, THE WORKS - AN­JANI TRIVEDI

THE big state-owned Chi­nese en­ter­prise is back. But this time, it isn’t 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 firms to spur ac­tiv­ity. That’s squeez­ing out pri­vate and small firms. The econ­omy cer­tainly mer­its con­cern. Trade fric­tions and Chi­nese 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-firm prof­its are hum­ming along, ris­ing 16% in July from a year ear­lier. Earn­ings at state-owned en­ter­prises rose 24%, al­most dou­ble the 13.4% rate for pri­vate firms. A closer ex­am­i­na­tion presents wor­ry­ing signs. While up­stream in­dus­tries like min­ing and en­ergy posted gains of over 100%, man­u­fac­tur­ing sec­tors like ma­chin­ery and equip­ment slowed.

Drill down through other en­cour­ag­ing data and there’s a sim­i­larly mixed pic­ture. A mea­sure of Chi­nese firms’ abil­ity to ser­vice 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 firms, 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 firms are get­ting worse, they’re hold­ing in­ven­tory for longer, and the time it takes them to con­vert work­ing cap­i­tal into cash is in­creas­ing, Goldman Sachs Group found in an anal­y­sis of more than 4,000 Chi­nese firms.

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 firms 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. The wide-rang­ing cam­paign to re­duce debt has hurt de­mand and left pri­vate, smaller firms in the lurch. The num­ber of money-los­ing pri­vate firms jumped about 40% as of June from a year ear­lier, while the num­ber of un­prof­itable state­backed firms stayed flat.

China has a long his­tory of us­ing state-owned be­he­moths to drive eco­nomic ac­tiv­ity – dat­ing back to im­pe­rial times. Such in­dus­trial gi­ants first ap­peared dur­ing the Qing dy­nasty in 1864, as the gov­ern­ment at­tempted to re­vive a weak­ened econ­omy af­ter the end of the Taip­ing Re­bel­lion. What lit­tle in­dus­tri­al­i­sa­tion re­sulted from the so-called self-strength­en­ing move­ment “was char­ac­terised by a fo­cus on heavy in­dus­tries’ serv­ing the gov­ern­ment’s mil­i­tary and de­fence pur­poses,” as his­to­ri­ans Wil­liam Goet­z­mann and Elis­a­beth Koll wrote in their book.

One dif­fer­ence this time: Bei­jing has talked about bol­ster­ing SMEs through le­gal pro­tec­tions and pro­vid­ing more credit. Un­der ex-PM Zhu Rongji in 1990s, the plan was ex­plic­itly to “grasp the large, let go of the small.”

His­tory shows pri­vate firms have far higher pro­duc­tiv­ity. Their av­er­age RoAs have been 4-6 per­cent­age points higher than state-owned en­ter­prises over the past 2 decades. The more the state sec­tor con­trib­utes to GDP, the worse it’s for econ­omy’s longterm ef­fi­ciency and pro­duc­tiv­ity. 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 de­merg­ers of sev­eral firms (some of which are now be­ing re­com­bined) haven’t pro­duced any real vic­tors. Ef­fi­ciency, earn­ings and re­turns on equity have de­clined. China com­bined two rail equip­ment mak­ers in 2015 into CRRC Corp, a firm with a mar­ket value of $130 bil­lion: RoE has fallen since then to about 11% from 13.5% pre­merger, and mar­gins have been flat at about 5%. Listed state-owned en­ter­prises have traded at dis­counts to their pri­vate peers.

Run­ning the pri­vate sec­tor dry has never helped Chi­nese em­per­ors. This time won’t be any dif­fer­ent.

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