Explaining Debt Complexities: efficiency growth versus paying down debts.

In my previous post I described how discussing PPI only tangentially relates to China’s debt and debt servicing, the real crux of the re-balancing debate. I addressed capital expenditure declines as evidence of companies trying to find profits in an over invested market but was quick to point that this was just part of “overall Chinese debt dynamics.” This post will expand on, what I called, debt complexities by examining how China previously handled it’s non-performing loans.

A Unique Growth Model Facing a Unique Set Of Problems

I recently finished reading China 2030, published by the World Bank and the Development Research Center of the State Council. The reading left me with two strong thoughts, one much more relevant and important than the other. First, and completely unrelated to my blog post today, I wonder how changes in government function effect Zipf’s law in relation to language frequency.  Is there an Oxford English Corpus or Brown Corpus equivalent in China? Is there an equivalent corpus before the Chinese revolution, so I can measure the change in frequency of “harmonious?” I say this in half jest, but I would be interested in seeing how language changes with central planning. Secondly, and much more conducive to today’s writing, is the emphasis in the document about how unique Chinese growth is and the problems China is now facing.

The document first deserves praise in how much it covers. It is staggering in what it sets out and lists many opportunities for increasing economic efficiency. Although it is staggeringly thorough, it completely misses the difficulties facing the Chinese economy. What is immediately hindering Chinese growth is not economic efficiency but debt that is growing twice as fast as the Chinese economy, debt growing faster than debt servicing.  We can observe the same phenomenon, the exact same conditions, in China roughly twenty five years ago. Throughout the 1980’s China had an incredibly high investment rate, was faced with daunting urbanization, and set the foundation for soaring debt, debt that led to massive privatization in the 90’s.

 

Evidence is in the FDI

Early in the years of establishing a ‘market economy’ the Chinese state still vastly favored SOEs. SOEs were given greater access to bank loans, legal protection, access to land, and were able to corner key industries.  Many of these SOEs accumulated large assets and even larger debts.  As the debt levels rose, the companies, despite their large ‘superior’ assets, were unable to out grow their debt. They ended up forming joint ventures with foreign firms, which had greater legal acquisitions rights than their Chinese equivalent. The Chinese economy had many state entities unable to grow out of their debt, so they were privatized by selling their assets to foreigners. This is worth repeating; the Chinese government already privatized large swaths of the Chinese economy,but state asset acquisition was not available to ethnic Chinese.

A large portion of this post is influenced and takes data from Yasheng Huang’s riveting, must read- Selling China. I would be amiss to not mention this book. It is a must read to even a causal China watcher.

Seeing FDI as a sign of weakness and privatization is a new idea. Indeed, the World Bank and many institutions laud Chinese FDI as a signal of Chinese power. The amount of FDI entering China in the 90’s is colossal. Huang writes, “Between 1992 and 2000, the cumulative FDI inflow amounted to $286.6 billion… the FDI flows to the United States in 1996 was roughly twice as large as FDI flows to China, but the US economy was seven times as large.” This amount of money is monumental if you also consider that China has a huge state sector which pumps money into fixed assets.  China’s FDI to capital formation ratio net of investments by the state is large- really large, and it’s sudden rise in the 90’s is telling, rising from 8.6% in 1986-1991 to 27.9% in 1992-1998.

At the same time, contractual alliances with foreign firms declined relatively- compared to FDI- and absolutely. Read that again.  Huang writes, “In 1988,contractual alliances amounted to $550 million, but by 1994 had declined to $180 million.” FDI poured into China at insane levels at the expense of contract alliances.  Chinese firms, even those that had the support of the state, hit a growth ceiling because of their debt.  In my previous post I said that PPI was important, but one could not simply look at a rising cost to produce goods as  a sign of Chinese growth constraints. One could extrapolate that economic efficiency is the problem. This is not the case. Debt, non productive assets, weigh the Chinese balance sheet. Growth stopped. The Chinese economy found its answer in the form of privatization via foreign capital.

Consider the financing structure of the Beijing-XYZ Gear. Beijing Gear factory entered into a joint venture with XYZ Automotive. Beijing Gear offered RMB 55.8 million in equity contribution- 38.3 million in equipment and 17.5 million in inventory. XYZ Automotive offered RMB 35.6 million in equity contribution. 27.6 million in cash.  This is a state asset swap to a private joint venture.  Beijing Gear had debt that it could not service, it could not outgrow this through efficiency improvements. It had to service its debt. It had to sell its assets.

Consider the financing structure of PPG-NCIC. NCIC (Nanchang Chemical Industry Corporation) had a debt of RMB 90 million that it could not outgrow. It formed a joint venture with PPG (Pittsburgh Plate and Glass) with an equity base of $5 million. PPG committed a %60 stake with $3 million in cash. NCIC contributed its machinery and equipment. This is a state asset swap to a private joint venture.

Math!

I would first like to discuss some basic math that I will expand in a future post. Local governments receive two types of income from SOEs: taxes and dividends. An SOE then has a value to the government equivalent to its profit and tax, plus any idiosyncratic value a local government may assign to having an SOE- this can range from corrupt fund misappropriation to having a company to keep employment stable. We can thus write it as follows, where V is value, D is dividends- thought of as profit times equity, T is taxes- defined by pre-tax profit times tax rate, and I is idiosyncratic preference (if I was an economist at a large institution this was be some Greek letter you have never seen. I hope you can forgive my lack of Greek letters).

V = D + T + I = (P x E) + (PTP x TR) + I

Tax can also be written as:

ATP = PTP – (PTP x TR) = (1- TR) x PTP

After adding formula two into formula one, one can solve for PTP. Note, for this step I am omitting I. It is addressed later.

PTP =  (V) / ([TR + E] – [TR x E])

This simply shows that, intuitively, a local government receives all of the pre-tax profit. So if a SOE, taxed at 55%, provides V (again, minus I) 100 RMB, we can see:

PTP = (100) / ([.55 + 1] – [.55 x 1]) = 100

Now consider that if the government wanted a greater return, here just 101 in V- again not accounting for I, but expected this return from the joint venture where it has a minority stake (49%).

PTP = (101) / [(.55 + .49) – (.55 x .49)] = 131.09

 

*So to consider a joint venture profitable, the local government must think the joint venture will be roughly 30 percent more efficient (this also assumes they will be taxed the same! Foreign invested entity tax rates are usually lower. If the Joint venture, privatizing state assets, has a 33 % tax rate it will need pre tax profits of 153.4, a 50% efficiency increase, to provide the state with more value (101)). Furthermore, that doesn’t take into account I (I didn’t forget).

So a joint venture is only viable if the SOE is not making money or is saddled in debt.

( [PTP + I] – [ Principle Debt x Debt Interest Rate]) < PTP / [(TR + E) – (TR x E)]

This is just back-of-an-envelope type math, but it serves a purpose in highlighting that the joint venture, privatization, was not seen as a way to make money. It was a way to eliminate debt burdens.

Conclusions

This blog post, like all of the Chinese publications to include China 2030, does not explicitly define accounting identities. Instead, it shows how companies cannot outgrow debt burdens through efficiency and how China previously privatized to solve rising debts.

I am serious in my pursuit to expand the basic math. More to follow shortly.