China’s Low-Profit Growth Model

From the Far Eastern Economic Review:

... At issue is not whether the profits of Chinese firms have grown, as the World Bank researchers suggest. No one disputes that. But a growing dwarf is still no giant. At issue is whether China allocates and uses capital efficiently enough so that it produces a return on capital at par or better than international markets. The question is: By international standards, how efficient is China in using its capital?

My own analysis of the same data used by the World Bank concludes that the return-on-equity numbers reported by it are significantly overstated because they do not net out such items as corporate income taxes. The World Bank does not dispute this. But it insists that Chinese firms are now making so much profit that undistributed profits or retained earnings finance more than half of their investments, whereas bank loans finance only one-third or as little as one-sixth. If this is true, it suggests that Chinese firms finance their investments with much less debt in proportion to equity on average than probably all their international peers, and therefore by implication they must have been more profitable. For evidence, the World Bank points to the increase in the proportion of corporate savings in China’s national savings, now accounting for more than 20% of GDP.

... As a macroeconomic concept, corporate savings consist of more than just undistributed profits. In addition, corporate savings include depreciation, amortization (both of which are treated as costs in any corporate income statement) and other things (including government subsidies). Depreciation alone is a big number. China’s growth is driven by fixed-asset investments which now represent more than 50% of GDP and still grow at 25% to 30% per year. As such, China’s fixed-asset base expands each year and so the amount of depreciation from such an asset base also increases. Nobody knows for sure how big the depreciation number is because China’s statistical authorities do not have complete data in this regard, but one can make some safe estimates. ... By this calculation, depreciation alone (11% of net asset value) is more than 1.2 times as large as undistributed profits (9% of net asset value) or at least 55% of corporate savings. Undistributed profits at most represent about 45% of corporate savings.

Therefore, if corporate savings represent 60% of corporate investments, undistributed profits account for no more than 27%, from a macroeconomic point of view. How remarkable a percentage is that? Not very.

... By now, we know that average ROE for Chinese industrial firms is not high by international standards. We have also established that undistributed profits do not finance more than half of corporate investments. Neither do corporate savings. The increase in net margin for Chinese industrial firms in the past seven years comes entirely from interest rate cuts. Banks have played the rich uncle, rescuing and subsidizing Chinese firms with huge amounts.

So are Chinese banks profitable on average in comparison with their international peers? Not at all. The past three years were the best ever for Chinese banks. Yet, their average net return on assets, at 0.4%, is the lowest in Asia. Even without taking into account the need for provisions for bad loans, they are still the least profitable among their Asian peers with their pre-tax, pre-provision profit return on asset of merely 1.1%.

... China has embarked on major banking reforms and meaningful progress has been made. But the economy’s growth continues to be driven by excessive liquidity, and so is costly and inefficient. Improving profitability, returns and efficiency remains the highest priority. While China is on the right track in her search for a cure, the last thing she needs is someone in a doctor’s white gown to come along to tell her she is in excellent health. Fortunately, the leadership knows better. The policy of the central bank to raise interest rates, mop up excess liquidity, curtail lending to overheated industries and generally increase the cost of capital is correct and necessary for sustained growth in the long term.