Economic Suicide In China

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Includes: FXP
by: Valens Research
Summary

The optimists’ argument is that problems can be avoided in the short term. What about after that?

Laurence Scofield and Joel Litman provide a research perspective on China from both top-down and bottom-up fundamental perspectives, utilizing Uniform Adjusted Financial Reporting Standards.

China's debt-to-GDP ratio today dwarfs that of Japan at the time it fell into crisis in 1989.

By Laurence Scofield and Joel Litman

On the tenth floor of one of the unfinished buildings strewn across a ghost town in southern China, a migrant worker calls the building contractor and tells him he'll jump off if he isn't paid his overdue wages.

Meanwhile, the contractor is also distressed. He climbs to the twentieth floor of the building and gets the developer on the phone. If he isn't paid, he'll jump off the building, too.

The developer, on the thirtieth floor of the building, calls the mayor and says if he isn't paid he'll join the other two in jumping off the building.

The mayor calmly replies that he'd like to jump off the top of the building as well, but he can't because he's under house arrest pending an investigation for "economic crimes."

The gallows humor of this story, recently making the rounds in Shenzhen, gets its edge from a series of real cases of workers who responded to the pressure of assembling mobile phones by hurtling themselves off the roofs of local factory buildings.

However, it also reflects the loss of opportunities that has crushed the dreams of so many who had hoped and expected that China's economy would go on bursting with the vitality it embodied until a few years ago.

Instead, large swathes of the economy seem hell-bent on economic suicide as company after company, from one part of the Chinese economy to another, persist in speeding toward self-destruction.

The origin of this self-destructive tendency lies in China's history of breakneck economic growth. For decades, the country's aim has been to grow the economy as fast as possible. However, a problem with this aim has emerged over the last several years: Much of this economic growth has become unprofitable or just marginally profitable, yet companies are continuing to grow even without sufficient profits to make the growth viable.

Our research comprised more than 800 non-financial companies in China listed on the Hong Kong, Shanghai, and Shenzhen stock exchanges. In order to maintain reliability and uniformity, this analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of firms. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. As such, our adjusted measures of corporate returns provide a more reliable, uniform economic view of Corporate China. To better understand UAFRS, please refer to our explanation here.

Unfortunately, this research shows that more than 70% of Chinese companies are generating a negative economic profit. In other words, the adjusted return on assets of nearly 600 of the largest companies in China is below the cost of capital of those companies.

In many developed nations such as the United States, when business returns fall below their cost of capital, management teams restrict asset growth. This is often met with cheers from shareholders and higher valuations that reflect that discipline.

This is not so in Corporate China, where more than 80% of firms have continued to expand their asset base through 2015.

This, self-inflicted or not, is a death sentence.

Growth of profitable businesses makes the economy healthy, expands the workforce, creates good jobs and increases national income. However, growth of unprofitable or low return businesses does just the reverse.

A lot has to happen before this problem is sorted out. A sign of how much has to happen is the gap between the market value of the Shanghai and Hong Kong stock exchanges.

The mostly neophyte, retail investors in Shanghai, who have held up the price to net assets of Shanghai listed stocks at 1.7 times, might not have cottoned on to this low profit problem yet.

The more sophisticated, institutional investors of Hong Kong, however, have dumped so many Hong Kong shares that the market there trades just slightly above net assets, the lowest since the Asian Financial Crisis of 1998.

The solution to the problem, breezily prescribed by mainstream banks and multilateral governmental organizations like the International Monetary Fund, is for China to "transition to a service-based economy."

The better solution is for China to develop profitable companies in both manufacturing and services.

Unfortunately, this isn't so quick and easy to accomplish as many people, such as those working in the IMF, hope it will be.

China's global economic claim to fame was its role as an export powerhouse, but with its foreign trade shrinking, export markets are tapped out.

So it urgently needs to come up with some very powerful new money spinners. Now it's betting on services.

One sign of the odds against this bet is that foreign companies in China, including those in the services industries, are finding business very tough. A business association survey in January found American companies would invest less in China in the coming year, echoing a similar survey done by European businesses in China.

Since so many American and European companies in China are engaged in the services sector, their cooling attitude to China business raises a troubling question: Can China develop good quality service businesses and consumption fast enough to make up for the decline in companies whose workers are jumping off the roofs of buildings?

This is the key question for the economy in China going forward. Unfortunately, the numbers aren't so encouraging yet.

While the government statistics show consumption represents more than half of the economy, government spending makes up a big chunk of its calculation of consumption.

Beijing hasn't released detailed statistics yet, but of the 51.4% of the economy it defines as consumption in 2014, only 37.9% was household spending.

A lot of people don't realize that a very large amount of the spending China counts as consumption is really government spending.

Even people who should know better are very confused about it. "[T]he truth is the nation's economic fundamentals remain strong and it's making progress in rebalancing its economy toward consumer spending," wrote South China Morning Post Editor Wang Xiangwei on January 25. "For the first time, consumption accounted for more than half of economic growth for the first year."

However, the truth is that China isn't making progress in rebalancing its economy toward consumer spending. China has a long way to go before its citizens' spending comprises half the economy on its own.

Two things clearly show this: 1) household spending will have to grow by a huge amount to replace government spending counted as consumption, and 2) household consumption currently isn't increasing at all. It's actually been falling.

According to the latest data available from the World Bank, China household spending in 2014 slightly declined compared with 2011.

In fact, of the 206 countries and territories whose household spending to GDP is tracked by the World Bank, China has the lowest percentage of household spending to GDP except for ten of them: Algeria, Brunei, Equatorial Guinea, Gabon, Kuwait, Luxembourg, Saudi Arabia, Oman, Qatar, and Macau.

Considering the special circumstances of most of these, such as the oil states of the Gulf with their tiny populations and the single industry economy of Macau, this group doesn't make up the kind of company China officials want to be in.

For several years, one has repeatedly heard from insiders and foreigners that China is undertaking "structural reforms." But even Mr. Wang, one of Beijing's most unabashed cheerleaders, concedes that the much trumpeted reform plans of the third plenum in 2013 have made "little progress to show for it all."

Nonetheless, the notion that reforms are being zealously pursued by Beijing keeps re-circulating.

In mid-January, ex-Goldman Sachs analyst Jim O'Neill wrote in a British newspaper that the "C" in his famous BRICs coinage was "going through a necessary and complex structure reform and recent volatility should not obscure the progress that has been made."

Mr. O'Neill's evidence of this progress was a rather vaguely observed "economy driven more by its own consumers." Exactly how this is happening or what consumers are doing to bring it about, he didn't say.

However, with January's consumer confidence figures at a record low, we're unlikely to see a consumer boom soon unless a lot of government spending is added in. (And since the statistics bureau counts part of government spending as consumption, consumption appears a lot bigger than it would be in other countries.)

We are, however, very likely to see big non-performing loan write-offs at major banks, but this shouldn't be confused with reform. It's the opposite of reform as it merely perpetuates the cycle of banks shifting dud loans to "asset management companies" that receive fresh capital injections from the government and then crank up lending to uneconomic businesses all over again.

Carried on long enough, this causes the whole country to go broke.

The government in Beijing has lately announced a full frontal attack on so-called "zombie companies," but so far markets have seen very few credit defaults or bankruptcies among major firms. Indeed, very few would appear to be coming soon. As the slowing economy cuts earnings, companies increasingly need fresh note offerings to pay off old obligations, according to one top arranger of bond offerings from state-owned and listed firms. Issuance of corporate notes is forecast to jump at least 30 percent in 2016 to top 10 trillion yuan ($1.54 trillion), more than the annual economic output of Spain.

"It's urgent to solve some companies' liquidity problems, as profitability has worsened given the slowing economy," says Ji Weijie, a bond analyst at Beijing-based China Securities. "If they can't roll over their debt, there may be bigger default risks or even systemic risks."

In other words, more and more debt is needed just to manage the current decline in growth. We are left to wonder how quickly growth would decline without it.

Yet without creative destruction, the economy cannot recover its former vitality.

Of course, China isn't the only country that needs to restructure. Low interest rates globally have pushed capital into trillions of dollars of investments -- in both the services and industrial sectors -- that wouldn't have been attractive or even realistic at higher interest rates. These low interest rates keep projects and businesses alive that wouldn't survive otherwise.

The distortions have become so great that Reserve Bank of India governor Raghuram Rajan recently claimed he didn't know what assets were worth any more. It was to prevent these kinds of further distortions that the U. S. Fed took the unusual step of raising interest rates despite many signs of economic weakness in America.

However, no country has a more serious problem of sick companies on life support than China. Its zombie companies have gorged on cheap funding and have often expanded operations without regard to their cost of capital. Moreover, many have enjoyed political favoritism on top of it.

State-owned companies account for 30% of the country's total corporate assets but receive 80% of total bank loans, equivalent to $16 trillion or roughly 150% of China's gross domestic product.

A quarter century ago, another country tried to merge, coddle and rehabilitate zombie companies after an asset bubble burst.

Japan has been paying the high price of low growth and deflation ever since.

"One wonders if China is the new Japan," Maurice Obstfeld, the International Monetary Fund's chief economist, recently remarked, a sign that the IMF knows how tough the transition for China is going to be.

Everyone hopes that China can avoid Japan's lost decades. Regrettably, the optimists' case has so far been weak because its main argument is that problems can be avoided in the near term. Questions about the risks of the medium and longer term are unanswered.

"The desire to turn China into a global economic bogeyman is unduly alarmist," wrote John Plender recently in the Financial Times. "It still has enough fiscal and monetary latitude to avoid a hard landing and a financial crisis."

Did not Japan, the global economic darling of the 1980s, also appear to have enormous fiscal and monetary latitude before it fell into crisis in 1989? The unpleasant reality is that Japan's debt to GDP at the time was dwarfed by China's debt to GDP of today.

China must do its utmost to avoid that fate.

Laurence Scofield, a Hong Kong-based fund manager, has lived in Hong Kong for 40 years. Joel Litman is Chief Investment Strategist of Valens Securities and Valens Research, headquartered in New York City.

They can be contacted at laurence.scofield@macrovalue.com and joel.litman@valens-securities.com, respectively.

Disclosure: I am/we are short CHINA EQUITIES AND RENMINBI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.