The debt-financed investments of Chinese state-owned enterprises
By Michael Pettis
I want to start this newsletter with a story that may be fairly illustrative of one of the problems within the Chinese economy that I worry about. There was an article in last Sunday’s edition of the South China Morning Post about a real estate project in Guangdong. (WC Fields’ was supposed to have once called Mae West “a plumber’s idea of Cleopatra”, and for some reason that story popped into my mind when I read the article.)
It says that a real estate developer is attempting to build a replica of a beautiful Austrian village in Guangdong province not too far from Shenzhen:
It is a scenic jewel, a hamlet of hill-hugging chalets, elegant church spires and ancient inns all reflected in the deep still waters of an alpine lake. Hallstatt’s beauty has earned it a listing as a Unesco World Heritage site but some villagers are less happy about a more recent distinction: plans to copy their hamlet in China.
After taking photos and collecting other data on the village while mingling with the tourists, a Chinese firm has started to rebuild much of Hallstatt in Guangdong province, just 60 kilometres away from the Hong Kong border, hoping to attract wealthy mainlanders, “homesick” expatriates in Hong Kong and tourists. The project had drawn a mixed response from residents in the original village.
The article goes on to discuss the anger many of the residents of Hallstatt feel about having their town copied and replicated without permission.
That this sort of building project seems a tad over the top is not why I bring up the article. Those of us who live here are quite used to the many sometimes-bizarre projects aimed at attracting new wealth and signaling status. Of course if it makes the residents of Hallstatt feel any better, I am absolutely certain that the Guangdong replica will not be a perfect copy of Hallstatt. I have no doubt that there will be hundreds of architectural and cultural “improvements” that will ensure that no one confuses the shiny replica with its dowdy original. Excessive restraint typically isn’t one of the sins afflicting real estate developers that cater to the local rich.
What interested me about the article was something else altogether. According to the article, the project is being developed by “MinMetals Land, the real estate development arm of China MinMetals, China’s largest metals trader.”
I’m sure MinMetals is no slouch when it comes to trading metals, but it wouldn’t have occurred to me that a metals trading background would have made anyone particularly good at real estate development, and especially at developing such an undoubtedly classy project. This kind of thing, however, is actually not an anomaly in China. A surprisingly large number of SOEs and other large companies in China have real estate development subsidiaries.
In fact a lot of Chinese SOEs are involved in a very wide variety of business activities, and are especially fond of activities in which cheap capital is the comparative advantage, or in which there is political advantage to be gained. That makes real estate development and “high tech” two of the most popular ancillary businesses.
Does it matter? Perhaps. This type of business diversification is not new and it doesn’t have a very encouraging history. For example the 1960s in the US was a period which saw an explosion in the growth of what were then called “conglomerates”, and as is always the case, there seemed to be a plausible reason for their growth: good managers are good managers, and can generate growth from many types of companies, and their ability to generate growth is magnified by the lower cost of capital associated with substantial diversification.
But after the initial enthusiasm, conglomerates performed awfully, and in the 1970s in the US a consensus developed that large conglomerates involved in very different lines of business tended to be value destroying. The reason often given was that managers who might be successful in one line of business – say coal extraction – might not necessarily be especially good in another line of business – say children’s retailing, or movie production. By forcing senior management to disperse their expertise across a wide range of very different businesses, conglomerates were very good at mismanaging many if not all of the businesses they controlled.
Incentives affect behavior
I am not sure if I am totally satisfied with that explanation, although I am sure there is some truth to it. To me the main reason why conglomerates tend to be weak at creating value has to do with the distorted incentive structures involved in their creation.
In many cases – especially when skeptical investors aren’t monitoring their every move and threatening to punish them when they fail – senior managers had no great incentive to manage shareholder money very carefully. They do, however, have strong incentives to build their assets and to diversify – the former because the larger the company the more important and more highly remunerated the managers, and the latter because highly diversified businesses are more likely to be involved in whatever business is hot today and, because they are diversified and large, are less likely to fail.
In that case, as long as there were no constraints to managers’ ability to raise money and invest in other businesses, managers naturally did just that. The problem is that what is in the best interests of the shareholder – creating economic value to be captured by shareholders – is not necessarily in the interest of managers, who might find it totally rational to overpay for assets and to pile into “hot” markets.
This distorted incentive structure ended up encouraging capital misallocation, and after a few exciting years, the profitability of conglomerates plummeted. Incentive structures, in other words, determine behavior in the aggregate, and if the incentive is to ignore value creation in favor of some other objective, value creation tends not to occur. In fact the opposite occurs. Value tends to be destroyed if those other objectives can be met by deploying capital.
It is hard to imagine that in China today the incentive structure for top managers of SOEs is aligned with that of creating economic value. Like anywhere else, the bigger your company, the more important you tend to be as CEO, the more preciously your bankers and investment bankers will treat you, the more time you will spend with senior political leaders, and the more highly remunerated you, your family and friends tend to be. What’s more, as Beijing tries to consolidate smaller companies into larger ones, the bigger you are the most likely you are to be the head of the surviving company. In that case companies will want to grow.
There is an additional and very important distortion. The most important comparative advantage that large Chinese companies have is access to cheap credit, and so from a P&L point of view the best policy is always to borrow as much as you can and buy or build assets. Even if you overpay or if your projects are actually value destroying, it doesn’t matter too much because artificially low interest rates are the equivalent of debt forgiveness, and after several years of hidden debt forgiveness, even the worst investments start to seem profitable.
Under those circumstances, I would not be confident that every large SOE investment or every move to diversify is likely to create economic value. The fact that nearly every important SOE, and many not-so-important ones too, have real estate development subsidiaries probably has a lot more to do with access to cheap capital and the opportunity to share in the real estate bonanza than with any real ability to add to the underlying wealth of China.
Everything is debt financed
And of course if it is true that SOEs are investing unnecessarily for reasons that have nothing to do with value creation, one consequence is likely to be an increase in debt, as SOEs borrow and invest. I have written a lot about unsustainable increases in debt in China, and on that note let me append below something that I wrote this week for the New York Times.
I was asked by the newspaper to identify some of the difficulties facing China with an especial emphasis on the worries that have surged in the past year over the large debt levels run up by local government financing vehicles. My response was that the focus on this kind of debt might be at least partially misplaced.
For the past decade China-focused analysts have been able to describe static economic conditions with some accuracy but have failed generally to understand the underlying growth dynamics. We’ve done a great job, in other words, of describing the landscape through which the train is passing, but because we don’t understand where the train is headed we are constantly shocked when the landscape changes.
It should have been clear for many years that China’s investment-driven growth model was leading to unsustainable increases in debt. As recently as two years ago most analysts were ecstatically – and mistakenly – praising the country’s incredibly strong balance sheet, but when Victor Shih shocked the market last year with his analysis of local government borrowing, the mood began to change. Now the market has become obsessed with municipal debt levels.
But dangerously high levels of municipal debt are only a manifestation of the underlying problem, not the problem itself. Even if the financial authorities intervene, unless they change the economy’s underlying dependence on accelerating investment, it won’t matter. They will simply force the debt problem elsewhere. In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point – which China may have reached a decade ago – debt begins to rise unsustainably.
China’s problem now is that the authorities can continue to get rapid growth only at the expense of ever-riskier increases in debt. Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts. But not yet. High, investment-driven growth is likely to continue for at least another two years.
I want to stress this point. Right now everyone is worried about municipal debt levels and wondering if Beijing’s plans to resolve the problem will work or not to clean up the municipalities. But this is the wrong focus. The problem is not whether or not the municipalities will be able to repay. Repayment simply means shifting the debt servicing to another entity, and we should be worrying not about the debt-servicing ability of specific borrowers but rather about the whole system. The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.
When is an increase in debt unsustainable?
As I see it there are three things that make increases in debt unsustainable. The first, obviously, is borrowing for consumption. This is what happened in the US and in the peripheral countries of Europe until the 2007-08 crisis, and it is pretty clear that this kind of borrowing cannot go on forever. Why not? Simply because with consumer financing the value of liabilities rises more quickly than the value of assets, and this cannot go on forever unless the borrower has an infinite amount of excess assets.
But it is a testament to how US-centric the whole world is that we cannot seem to separate underlying problems from the US manifestation of that problem. Since the US spent much of the past decade experiencing an unsustainable increase in debt to finance consumption, most of the market assumes that this is the only way it can happen. Since we aren’t seeing consumer financing in China, then there cannot be an unsustainable debt rise in China.
But consumer financing isn’t the only way it can happen. The second way we can experience an unsustainable increase in debt is when borrowing is used to fund investment that is misallocated or wasted. Whenever the value of liabilities rises more quickly than the value of assets, the increase in debt is by definition unsustainable unless, of course, the borrower has an unlimited amount of excess assets. This is a little more complicated to explain, but the process is just as definitive.
Assume, for example, that a local mayor borrows $100 dollars to build a subway system. The subway creates economic value, directly because businesses can grow more quickly thanks to lower transportation costs, and indirectly because consumers can spend more of the time and they have money left over,
If the economic value of the subway exceeds $100 dollars, the mayor can service the loan by taxing (directly or indirectly) the increased economic value. In that case net assets rise because there is more than enough to repay the cost of the investment.
If the economic value created is less than $100, however, the loan cannot be fully serviced without forcing someone – usually the taxpayer – to step in a make up the difference. This is what we mean by an unsustainable increase in debt – it will result either in a default or in a rescue.
We need to be careful about how we define the loan servicing cost. What matters is not the interest rate actually paid, but rather the theoretically “correct” interest rate. Why? Because that is the true servicing cost to the economy as a whole. Imagine if the US government passed a law saying that the interest rate on all of its debt is now set at 0%. Would it have any trouble servicing its debt? Of course not. So why not do it if it solves the debt servicing problem? Because artificially lowering the interest rate is simply a way of transferring the borrowing cost to the lenders. It does not reduce the true cost, it simply turns it into something else.
So if we want to know what the debt-servicing cost in China really is, it doesn’t help to look at the financial statements of the borrowers to determine whether revenues exceed the interest expense, even if you trust the financial statements. You would have conceptually to raise the interest rate for local and municipal governments, SOEs, real estate developers, etc. substantially – probably by at least 5 or 6 full percentage points or more – to eliminate the impact of artificially suppressing the rates. It is only then that you can calculate the true debt-servicing cost
Forget about consumer financing
The third kind of unsustainable debt increase is caused by a sudden explosion in contingent liabilities. When balance sheets are structured in risky or mismatched ways, an unexpected change in circumstances can cause a sharp change in the relationship between the values of assets and liabilities, and so result in a net surge in indebtedness.
There are many examples of this kind of mismatch. Financing companies that lend against assets, including copper or land, run the risk of a surge in net indebtedness when asset prices fall. Banks that borrow short and lend long are mismatched, and can see assets fall relative to liabilities when interest rates surge. The PBoC has a huge currency mismatch on its balance sheet. Because it borrows in RMB and lends in foreign currency, mostly dollars, as the value of the RMB rises against the dollar, its net indebtedness automatically rises too.
Mismatched balance sheets are not always a problem. When the surge in contingent liabilities occurs under “good” conditions, it can actually be stabilizing for the economy because there will usually be a corresponding reduction in net liabilities when things are going badly. For example central banks usually like their currency mismatches because they only lose money when their economies are doing very well and there is pressure for their currency to appreciate. When their economies are doing badly, of course, the pressure is for depreciation and they actually make a profit on their mismatch just when they need it.
They are hedged in that case. To be hedged means to make money when things are otherwise going badly for you and to lose money when things are otherwise going well. It is only when the balance sheet is what I called “inverted” in my book that you have a problem.
Take copper financing by lenders in China. This is an example of an inverted balance sheet. As the biggest consumer of copper, China largely sets global copper prices. If China is growing quickly, this tends to push up the price of copper, and lenders who are secured by copper see the value of their loans increase – they become more secure. The lenders of course are delighted. They are probably making good money because China is growing, and on top of it their loans are becoming more secure than ever.
Of course this changes if the Chinese economy were suddenly to slow, especially if it slows sharply. In that case the lenders would probably see their revenues decline at the same time as the value of the collateral supporting their loans declines. If their borrowers are then forced to liquidate the collateral in order to repay the loans (which is likely to happen if the economy slows sharply), the liquidation value could easily be less than the value of the loans. In that case China would see an unsustainable rise in its debt – and notice this always happens at exactly the wrong time.
It is important to remember this when thinking about financing risks in China. We often hear analysts argue that because China has little consumer financing and because mortgage margins are high, they don’t have a debt problem. This argument is about as useless as the claim that because China has large reserves it is unlikely to have a financial problem. The limited consumer and mortgage financing in China means that china will not have a US-style financing problem, and the large amount of reserves means that China won’t have a Korean-style financing problem, but no one has ever seriously argued that those are the kinds of risks China faces. What matters is the level of debt, whether or not its growth is sustainable, and the kinds of contingent structures that are embedded. I would argue that all three measures are worrying.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at email@example.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.