Do China's firms make healthy profits?

The Economist's latest economics focus, Profits and prophecies, argues that Chinese companies earn higher returns than is commonly claimed:

It may be the world's fastest-growing economy, but do China's firms make healthy profits? This is the subject of a lively debate* among economists, investors and businessmen.

According to the conventional wisdom, Chinese companies use capital inefficiently and have enormous overcapacity. As a result, profit margins are thin and falling, and heavy borrowing to finance unprofitable investment puts the banking system at risk.

However, Bert Hofman and Louis Kuijs, two economists in the World Bank's Beijing office, disagree. According to their analysis, based on figures reported to China's National Bureau of Statistics (NBS) by more than 200,000 state-owned and private companies, the profits of industrial companies have soared by an average of 36% a year since 1999. The average pre-tax return on equity by state-owned firms increased from 2% in 1998 to 13% in 2005; private companies' return went up from 7% to 16%. Furthermore, most corporate investment is now financed out of companies' own cashflows and only one-third from outside sources, such as banks.

This view was attacked in an article in the Far Eastern Economic Review by Weijian Shan of TPG Newbridge, one of the most successful private-equity firms in Asia. Mr Shan, an old hand at evaluating Chinese firms, says the World Bank is “deluded”: most Chinese firms make little profit, their margins are being eroded, and their investment boom is being financed largely by lending from state-controlled banks.

Who is right? The answer is important for policymakers as well as for investors. If the return on capital is indeed low and falling then today's pace of growth will prove unsustainable.

Mr Shan says that it is nonsense to argue that high profits are driving investment when business as a whole is such a big borrower. Total bank credit is bigger than the country's GDP, which is exceedingly high by international standards: in America the ratio is only 44%. Yet borrowing says nothing about the strength of profits. Firms can have high retained earnings (ie, saving) yet still need to borrow if they invest more than they hoard.

Hong Liang, an economist at Goldman Sachs, argues that the high ratio of credit to GDP in China partly reflects the immature state of the country's securities markets. Corporate bonds amount to only 4% of GDP compared with over 100% in America. Ms Liang's analysis supports that of the World Bank: she calculates that the debt-to-equity ratio of Chinese industrial firms has fallen from 1.8 to 1.4 over the past decade as firms have financed more investment from profits rather than borrowing.

It is true that gross lending to firms is much bigger than lending net of deposits, which the World Bank focuses on. Profitable firms deposit their saving in banks, which then lend it to less profitable ones. The stock of bank debt and hence the risks of bad loans may therefore still be large.

Mr Shan insists that excess capacity, soaring commodity prices and flat or falling prices for finished goods are eroding profit margins. Using the same data as the World Bank, he calculates that gross margins fell from 18% of sales revenue in 1999 to 15% last year. But gross margins take account only of the direct costs of production; they exclude selling, distribution, administrative and financial costs, which have all risen more slowly. After deducting all costs Messrs Hofman and Kuijs reckon that profit margins have risen from less than 3% in 1999 to almost 6% in 2005.

But surely Mr Shan has a point: how can profit margins increase when wages and raw material prices have been rising so rapidly? Since 1998 wages have gone up by no less than 14% a year, while export prices have fallen. The explanation is that productivity has grown even faster than wages, expanding by 20% a year in industry, cutting unit labour costs. As a result, the share of national income going to workers has declined, while that to firms has increased. Profit margins were squeezed slightly in 2005, as commodity prices shot higher, but this year they have widened again.

Efficiency gains

The improvement in average profits should not be a surprise, as it partly reflects productivity gains in the wider economy. The growth rate in China's total factor productivity (the efficiency with which both capital and labour are used) has been one of the fastest in the world over the past decade, thanks to the expansion of the private sector, as well as a substantial restructuring of state-owned firms.

...Since profits and capital spending have boomed hand in hand, what has happened to the return on capital? Ms Liang estimates that it has risen steadily since the late 1990s, unlike in the early 1990s investment boom, when it plunged. For those sceptical about the NBS data she also analyses the profits of Chinese companies listed overseas, whose finances are audited according to international accounting standards. The average return on equity in China is similar to that in America and Europe (see chart, above). An independent study published by the OECD last year also found big gains in the return on capital of Chinese firms. In 2003 the average rate of return for private-sector industrial firms was higher than the average in developed countries.

Even if total profits are booming, China still has many corporate duds. A fifth of all industrial firms (and a third of state-owned enterprises) continue to lose money. Experienced investors also know that even if they find a profitable firm, all too often they fail to provide foreign investors with a decent return. This is good reason for investors to tread carefully. However, for the economy as a whole, China's rising profits should promise more years of strong growth ahead.

 

* “The World Bank’s China Delusions” by Weijian Shan, Far Eastern Economic Review, September 2006.

“China’s Investment Strength is Sustainable” by Hong Liang, Goldman Sachs Global Economics Paper No. 146, October 2006.

“Profits Drive China’s Boom” by Bert Hofman and Louis Kuijs, Far Eastern Economic Review, October 2006.

“China Quarterly Update”, World Bank Office, Beijing, May 2006.

Comments

[Arthur Eckart]

There are often contradictions in China's macro data. The article states China's productivity increased 20% a year in industry. However, over that time, prices of energy and raw materials soared. So, it seems, there were massive inefficiencies to begin with, e.g. high labor to capital ratios, or the economy was really much smaller several years ago. Also, it seems, there continues to be massive inefficiencies, e.g. falling export prices, excess capacity, negative externalities, etc. Nonetheless, both wages and profits are growing at double-digit rates each year. China's GDP growth is high. Yet, saving is high, which seem to imply a larger proportion of China's GDP is being exported, or either GDP growth or the saving rate aren't really that high. Nonetheless, it's possible, China is financing growth through excessive domestic credit, which adds to inefficiencies, if the output data have been accurate. Perhaps, there are incentives to skew data, similar to the Soviet Union system, or it's really a miraculous economy.

[Arthur Eckart]

Perhaps, a little humor supports my statement above.

Subject: Capitalism 101

Traditional Capitalism:
You have two cows. You sell one and buy a bull. Your heard and the economy grows. You sell them and retire on the income.

American Capitalism:
You have two cows. You sell one and force the other to produce the milk of four cows. You are surprised when the cow drops dead.

Hindu Capitalism:
You have two cows. You worship them.

French Capitalism:
You have two cows. You go on strike because you want three cows.

Italian Capitalism:
You have two cows, but don't know where they are. You break for lunch.

British Capitalism:
You have two cows. Both are mad.

Spanish Capitalism:
You have two cows. You ask the EU for an agricultural subsidy. With the money you get, you open a bar. In the meantime you get your unemployment subsidy. The cows were dead three years ago.

Japanese Capitalism:
You have two cows. You redesign them so they are 1/10th the size of an ordinary cow and produce 20 times the milk. You then create clever cartoon images called Cowkimon and market them globally.

Chinese Capitalism:
You have two cows. You have 300 people milking them. You claim full employment, high bovine productivity, and arrest the newsman who reported the numbers.

Russian Capitalism:
You have two cows. You count them and learn you now have 5 cows. You count them again and learn you have 42 cows. You count them again and learn you now have 12 cows. You stop counting cows and open another bottle of vodka.

Timothy M. Doyle

[Ray Lopez]

China's GDP data are corrupt. See the thread here: http://tinyurl.com/ykvjtc

[Arthur Eckart]

I read an article recently that China's GDP surpassed Japan's GDP to become the second largest economy. It may be possible, because China has roughly 1 billion more people than Japan. Another article stated that there were roughly 1 billion people in China earning less than $3 a day. So, 1 billion times $1,000 a year is $1 trillion. It also stated there's a "middle class" of 200 million in China, although it's relatively poor compared to developed countries. So, 200 million times $10,000 a year is $2 trillion. China could have a GDP of over $3 trillion, or perhaps $4 trillion or $5 trillion, which would surpass Japan's GDP. India should also be able to surpass Japan. However, China will need to collect taxes to pay for health, education, welfare, etc. With its large population, it'll need to invest a great deal in human capital. I doubt China, at this point, could adopt a negative income tax for low income workers or provide any significant economic stabilizers, e.g. universal unemployment insurance. It seems, China's policy is to expand as fast as possible, no matter what the cost, because there's no choice, e.g. to prevent social unrest.

[Arthur Eckart]

Also, I may add, China's economic policy reminds me of Amazon.com's corporate policy of increasing revenue at any cost, which initially resulted in large negative earnings, to build economies of scale and gain market share. Amazon.com became the market leader. However, it's still in a competitive industry and earns little profit.

[Lafayette]

The Japanese and Chinese economies are roughly similar, if one compares them historically.

The Japanese did exactly the same thing, without a Central Committee guiding it but a democratically elected one-party system nonetheless, to establish itself as a world exporter in the after-war years (post 1950). They also employed a devaluation of currency, in relation to the dollar, to promote exports for decades.

The strategy worked. Why should the Chinese NOT use the same device?

China is like a pressure cooker building steam ... if it can be controlled, so much the better. But, it remains to be seen if the Communist leadership can do just that.

The countryside is fomenting below the cover. The schooling is practically non-existent, as are health services. That cannot go on forever.

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