The World Bank’s China Delusions

A story has been going around that Chinese firms, state-owned or otherwise, are highly profitable and retain too much of their earnings. It is these profits, rather than bank loans -- the story goes -- that have financed China's surging capacity and rapid economic growth. Most recently, the World Bank sought to lend credence to this tale by running it in its China Economic Quarterly.

The Bank believes that return on equity capital by China's state-owned firms increased from 2% in 1998, to 12.7% in 2005, and from 7.4% to 16% by nonstate-owned firms. These translate into an average return on equity investment of more than 15% for all industrial firms -- respectable by almost any standard. Of course, these are the numbers that the National Bureau of Statistics (NBS) has been reporting all along.

Based on these numbers, the Bank concludes that China's rapid growth in capacity-expansion and fixed-asset investment poses no particular danger to the country's banking system. That's because, it says, the majority of China's investment is not financed by bank loans, but rather, by retained earnings.

Neither do World Bank economists foresee a danger of overheating or overcapacity in China. Mainland companies have earned so much that their retained earnings now represent 20% of GDP. If investments generate more than 15% return, on average, what better use is there for their money than to continue making investments? Why should China slow down at all? Accordingly, China's investment rate is not too high, but arguably too low, as some Chinese economists have recently suggested.

This finding is quite astonishing, as it contradicts some well-known truths about the Chinese economy. The fact is that bad loan problems have plagued Chinese banks for years, which is why the Chinese leadership has recently made a vigorous effort to reform the system. How can there be a significant nonperforming loan problem if banks finance only a small portion of growth behind so much equity? If firms are so profitable, where do the hundreds of billions of dollars of China's reported bad loans come from?

Of course, the reality is quite different from the World Bank story. In recent years, Chinese manufacturers have been caught in "biflation" -- soaring raw materials costs coupled with either flat or declining prices for finished products. Data show the prices of raw materials are up on average by about 37% since 2002. China's consumer-price index crept up only 6.2% during the same period, while prices of Chinese exports to the U.S. have actually fallen by 5.2%. With a deterioration of the terms of trade, profit margins must be severely eroded. So how can Chinese firms appear to be so profitable?

To get to the root of this question, I went back to the same data source that the World Bank used to derive its results. What I was able to find tells quite a different story.

The NBS database tracks industrial firms with annual revenues of 5 million yuan ($627,000) or more. The number of such firms rose from 155,000 in 2000 to more than 250,000 in 2005. For these firms, data are available, in aggregate, for such financial items as total assets, liabilities, sales revenue, costs of goods sold, major expenses and of course profits. But, notably, NBS officials confirm that the reported "profits" are not net of income taxes. The return on equity investment number reported by the World Bank is thus inflated by as much as one-third -- China's standard corporate tax rate.

Income taxes are not the only missing data. Instead of taking the reported profits number at its face value, one can derive profits by deducting major expense items from sales revenue. Such an exercise would produce, in the case of Chinese firms, a before-tax profit number smaller than the one reported on the "profits" line in the database. Officials of NBS tell me that this is because "profits" also include "investment income" and "income from subsidies," which are not reported separately in the published data. There is no telling the size of the government subsidies included in the final profit number, but they obviously should not be counted as part of a firm's true profit.

It is "investment income" that further exaggerates the profit number. When firms pay a dividend to their corporate shareholders, it creates an investment income. This means that the same profits are reported as profit once, and then maybe more times as investment income, as the same money is paid out in dividends to corporate investors or shareholders. To figure out the true profitability of an industrial firm, such income should be taken out to avoid double accounting. If government subsidies and investment income are excluded from reported profit figures, another couple of percentage points need to be shaved off the reported return on equity number.

Therefore, depending on the effective income tax rates, and how much subsidies and double accounting of investment income are included in the calculation, the true profitability number for Chinese industrial firms could be as much as 6 to 7 percentage points less than the 15.3% number from the World Bank results. The average profitability of Chinese industrial firms after such adjustments comes down to no more than 8% to 9%, a mere 3 to 4 percentage-point premium over China's average best lending rate of 5.7% in 2005, and far below the 6% to 9% premium for Hong Kong and U.S.-listed firms in the same year.

The performance of Chinese companies listed simultaneously on Shanghai and overseas stock exchanges also confirms that return on capital in China is generally lower than on overseas markets. On average, the stock price differentials of the same companies traded on domestic and overseas exchanges can be as much as 30%, indicating that return on capital within China is about 30% lower than without.

But that's still not the end of the story. Chinese industrial firms are suffering from falling profit margins caused by biflation. As seen in the above graph, gross profit margin has been declining steadily from 2000 to 2005. The margins have been squeezed because relentless capacity expansion has created, on the one hand, high demand for raw materials and increased prices in the global market and, on the other, overcapacity that has depressed prices of finished products.

As a result, many Chinese firms are struggling. Of the industrial firms captured in NBS's database, 23% incurred losses in 2005, while more than one-third of state-owned firms continued to lose money. The fact that China is a net importer of raw materials means its firms will continue to pay an increasingly high price, in terms of reduced profits, to commodity-producing countries.

Our true profitability numbers still do not account for potential write-offs in accounts receivables. Almost all firms write off a portion of aged receivables once deemed uncollectible. Since reported profits are not retroactively adjusted, the true net profit should be even smaller, unless the potential write-offs are previously and sufficiently provided for.

In China, a clear sign of overheating is the increase in receivables. The State Asset Supervision and Administration Commission has reported that in the first half of this year, receivables for 166 "centrally controlled" (read: largest) SOEs have increased 14% from a year ago, representing 16.2% of sales. For 36.1% of them, receivables account for more than 30% of total sales. These are signs of overheating, and they create particular risks for banks as receivables are likely to be financed by bank loans.

Any suggestion that Chinese firms are super savers ignores the facts. Large as corporate deposits may be in terms of China's GDP, they only represent one-third of total deposits in China's banking system, and have been declining in the past five years. Chinese firms borrow much more than they deposit. Much of their deposits are not for the purpose of saving, but rather to secure bank credit. For safety, Chinese banks require that corporations seeking a loan or guarantee put down a deposit of as much as 40% to 50% of the borrowed amount. It is beyond doubt that Chinese firms are net debtors, not net savers or creditors.

The profitability of Chinese industrial firms, or their retained earnings, cannot be the main drivers of China's capacity-expansion and fixed-asset investment. There is no question that China's growth continues to be financed by banks. In fact, total investment by industrial firms likely accounts for no more than 20% of the country's annual fixed-asset investment. Bank loans, on the other hand, are greater than China's GDP. Furthermore, off-balance-sheet credit can be as much as 80% of loans. Combined, bank's total credit likely equals two times GDP.

Chinese firms will continue to suffer from low profitability and low return on investment until China transitions away from this growth model of capacity expansion before domestic demand. This creates an increasing need to borrow as cash flows cannot meet the requirement for capacity expansion, increasing the risk for Chinese banks. The Chinese leadership knows this. It has taken measures to cool the economy and scale back investments.

Ultimately, to sustain growth, China needs to gradually transition itself from a growth model led by ever greater investments to one led by private consumption and productivity gains. It seems that China is already in the process of such a shift, whose success will improve the efficiency of its economy and free it from self-inflicted biflationary shocks.

Ultimately, to sustain growth, China needs to gradually transition itself from a growth model led by ever greater investments to one led by private consumption and productivity gains. It seems that China is already in the process of such a shift, whose success will improve the efficiency of its economy and free it from self-inflicted biflationary shocks.