Imperial growth fallacy of China just won’t die
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.