Sinology by Andy Rothman October 1, 214 a China has many unprofitable and highly indebted companies, but these are largely state-owned firms which dominate only a handful of industrial sectors. a The privately owned companies, which employ 83% of workers, are far more profitable and less indebted. a The overcapacity and debt problems faced by the state sector are significant and cleanup will be costly, but such issues do not represent a macroeconomic crisis. CHINA S CORPORATE LANDSCAPE China has many unprofitable and highly indebted companies, but are these firms representative of the country s corporate landscape? And how large is the scope of the problem? In this issue of Sinology, we explain that privately owned companies which employ 83% of China s urban workforce are far more profitable and far less indebted than the state-owned firms that dominate the listed universe and attract most of the media attention. Cleaning up the corporate debt problem will be expensive, but I expect most of the financial pain to be borne by the government s balance sheet, not by Party-controlled banks. This will likely lead to slower growth in China, but not to its collapse. Private More Profitable Official data for larger Chinese industrial firms (a group that includes listed and nonlisted companies) indicates that privately owned companies are far more profitable than state-owned enterprises (SOEs). In the first seven months of this year, profits for private firms rose 13% year-on-year (YoY), double the 6% pace of profit growth at SOEs. Figure 1. PRIVATE FIRM PROFIT GROWTH CONSISTENTLY FASTER YTD YoY % 5 - August Source: CEIC, as of 214 Profits by SOEs Profits by private firms Profits by all larger industrial firms 214 ANDY ROTHMAN lived and worked in China for more than 2 years, analyzing the country s economic and political environment, before joining Matthews Asia in 214. As Investment Strategist, he has a leading role in shaping and presenting the firm s thoughts on how China should be viewed at the country, regional and global level. Profit growth at private industrial firms (and please note here that private refers to ownership, regardless of whether the firm is publicly listed) has been cooling over recent years, with the current 13% rate down from 15% during the first seven months of last year, but this is still a healthy pace. A Larger Share of Profits Private firms now account for a larger share of total industrial firm profits than do SOEs. (And this data covers only larger industrial firms, excluding the profits of most private firms, which are too small to be included in the survey conducted by China s National Bureau of Statistics.) 1
Figure 2. SHARE OF TOTAL, LARGER FIRM INDUSTRIAL PROFITS BY OWNERSHIP Share % 6 5 4 3 2 1 April 214 SOEs Private firms Source: CEIC, as of 214 Private vs. State in the Listed Universe China s private firms also outperform SOEs in the listed universe, according to analysis by Desh Peramunetilleke, head of microstrategy research at CLSA, the Hong Kong-based brokerage. Desh examined the 188 of the largest non-financial Chinese companies listed globally in Hong Kong, the U.S. and Singapore, but excluding A-shares and found that the return on equity (ROE) of privately owned firms was significantly better (15% last year) than that of SOEs (11%). Figure 3. ROE SIGNIFICANTLY HIGHER AT PRIVATE FIRMS ROE (ex-finance %) 2 15% 1 5% 1999 China SOE 21 23 China private companies 215 (estimated) Sources: CLSA; FactSet, as of December 31, Similarly, margins for listed private companies (16% last year) trump those for SOEs (9%). Figure 4. PRIVATE FIRMS ENJOY HIGHER MARGINS Margin (ex-finance %) 2 15% 1 5% 1999 China SOE 21 23 China private companies 215 (estimated) Sources: CLSA; FactSet, as of December 31, 2
Private firms are also less indebted. Net debt-to-equity for listed private firms is 33% vs. 45% for listed SOEs. Figure 5. NET DEBT-TO-EQUITY 5 4 3 2 1 2 22 China SOE China private companies Sources: CLSA, FactSet, as of December 31, In case you are wondering, there are 112 private firms in the universe that Desh examined, compared to 76 SOEs. But given that private Chinese firms are almost always quite small, SOEs account for about 66% of the China market cap in that listed universe, vs. only about 34% for private companies. Figure 6. PRIVATE FIRMS: GREATER IN NUMBER, SMALLER IN MARKET CAP USD billion 1,8 1,5 1,2 9 6 3 1996 1998 2 22 Current China SOE China private companies Sources: CLSA, FactSet, as of December 31, Less Leveraged Analysis by the International Monetary Fund (IMF) of debt data for listed firms is consistent with Desh s findings: median leverage ratios for private firms are generally lower than for SOEs. (The IMF calculates leverage ratios based on total liabilities-to-total equity, which is likely to generate higher ratios than the debt-to-equity metric used by Desh, but this is another useful way to compare private and state firms.) In the manufacturing sector, the median leverage ratio for privately owned firms declined to 5 last year from 87% in, while the ratio for SOEs was 16% last year, down from 112% in. Figure 7. LEVERAGE RATIOS ACROSS INDUSTRIES: MANUFACTURING 15 1 1 5 23 Sources: WIND; IMF staff estimates, as of December 31, 3
In the non-financial services sector, the median leverage ratio for privately owned firms fell to 44% last year from 72% in, while the ratio for SOEs was 96%, down from 16% in. Figure 8. LEVERAGE RATIOS ACROSS INDUSTRIES: NON-FINANCIAL SERVICES 15 1 1 5 23 Sources: WIND; IMF staff estimates, as of December 31, In the transportation sector, the median leverage ratio for privately owned firms was 64% last year, down from 85% in, while the ratio for SOEs was 86%, up from 66% in. Figure 9. LEVERAGE RATIOS ACROSS INDUSTRIES: TRANSPORTATION 15 1 1 5 23 Sources: WIND; IMF staff estimates, as of December 31, Leverage is high and rising among private firms in the property sector, although the median ratio was lower than among SOEs. For private real estate firms, median leverage was 214% last year, up from 161% in, while the ratio for SOEs was 263% last year, up from 221% in. Some of the rise in leverage was due to an increase over recent years in pre-payments for new homes, but with significantly slower sales growth this year, these high leverage ratios are likely to result in some consolidation in this sector. Figure 1. LEVERAGE RATIOS ACROSS INDUSTRIES: REAL ESTATE 3 25 2 15 1 5 23 Sources: WIND; IMF staff estimates, as of December 31, 4
Median Debt in Line with the Region Our main point is that China s private firms are more profitable and less indebted than their state-owned counterparts. But we also want to note that median debt-to-equity levels at all listed Chinese firms (33%) are not dramatically higher than those for Asia ex- Japan and ex-china (24%), and are close to ratios in South Korea (37%), while lower than the median in Thailand (5). Figure 11. NET DEBT TO EQUITY PROFILE OF MARKETS IN ASIA EX-JAPAN Net gearing* 16 12 8 4-4 -8 Taiwan Indonesia Hong Kong Asia ex Japan, ex China Sources: CLSA, FactSet, MSCI, as of December 31, Expensive, But Not a Crisis The overcapacity and debt problems faced by the state sector are significant and will likely be very expensive to clean up, but do not represent a macroeconomic crisis. Consider, for example, that the sectors facing the most dire problems steel, aluminum and cement are dominated by SOEs but together account for only about 5% of China s industrial sales. I do not expect a serious cleanup of the most inefficient and debt-ridden SOEs to happen soon, but it will likely begin before the end of the decade. And I expect most of the financial pain associated with this cleanup to be borne by the government s balance sheet, not by the Party-controlled banks, which were, after all, lending to Partycontrolled SOE factories at the Party s direction. Thus, the eventual SOE cleanup will result in a gradual rise in China s fiscal deficit/gdp ratio (which last year was about 2%), not in a dramatic increase in the banking system s non-performing loan ratio. Private Firms Drive China Malaysia It is, of course, not surprising that private firms are more profitable and less indebted than their state-owned counterparts, where employment and other social issues may be more important than commercial considerations, and where there has been a long history of capital misallocation. But this difference between China s private and state firms is often overlooked, as is the key fact that private firms are the backbone of China s economy and increasingly drive growth. For example, private companies account for 83% of China s urban employment. Figure 12. MOST URBAN EMPLOYMENT IS PRIVATE India Asia ex Japan 1 th 9 th percentile range 25 th percentile Median 75 th percentile *Gearing is a measure of financial leverage, expressed as a ratio that compares a form of owner s equity (or capital) to borrowed funds. India ratios are based on FY14 data Millions 4 Singapore China Korea Thailand Philippines 3 2 1 199 1995 2 State-controlled urban employment Private employment Source: CEIC, for private firms as of December and for state controlled firms as of December 5
We estimate that private firms also account for about 9 of net new job creation in China. And private firms account for two-thirds of total fixed-asset investment, up from 55% in and 42% in. Figure 13. MOST FIXED-ASSET INVESTMENT IS PRIVATE RMB billion 5, 4, 3, 2, 1, SOEs Private firms Source: CEIC, as of December 31, The rise of the entrepreneur is a key factor behind our view that although we believe the economy will continue to grow more slowly in coming years, this will be a gradual deceleration, to 5% to 6% GDP growth by 22, rather than a hard landing. Figure 14. GRADUAL DECELERATION OF GDP GROWTH IS INEVITABLE AND HEALTHY The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect the writer s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. 214 Matthews International Capital Management, LLC SI8 Percentage points YoY % 16 16 14 12 1 8 6 4 2 (2) (4) -4 1996 1998 2 22 214 216 218 22 Final conumption Gross capital formation Net exports of goods and services GDP growth rate (RHS) Sources: CEIC; MICM estimates The rise of the entrepreneur is also important because of the pressure it places on the Communist Party to accelerate changes to China s economic, social and legal structures. The growing role of private firms, for example, requires a financial system that supports the entrepreneurs who create the country s new jobs, which should lead to better capital allocation. An economy and society increasingly based on property rights puts pressure on the establishment of the rule of law and more transparent governance. And a growing middle class arising from the private sector puts pressure on the government to increase environmental protection and raise the quality and availability of health care and education. Andy Rothman Investment Strategist Matthews Asia 14 12 1 8 6 4 2-2 6