We’ll make it up on volume
That state-owned enterprises should prove less profitable than private sector enterprises is conventional wisdom in capitalist circles. Another empirical example has been mentioned in the latest issue of The Economist in the article “Of emperors and kings.” In the case of China, the $3.7 trillion of assets held by these enterprises created a cumulative turnover of around $2.5 trillion and profits of $129 billion last year. But most of those profits are made by a just handful of companies with peculiar advantages, like those in natural resources. Predictably, business people at these state-owned enterprises cite official meddling as a key factor in this asset inefficiency.
This is because technocrats, to which these companies are ultimately accountable, aren’t solely judged on the financial performance of the enterprises; they are judged along a whole host of Key Performance Indicators (KPIs) that cover different facets of policy. But as long as those KPIs are being met and GDP grows at a decent 7%–9% clip, why care about the asset efficiency?
Because GDP growth does not a priori lead to wealth creation. How can this be? Hugh Hendry at the LSE Alternative Investment Conference last year used a real estate project example to illustrate how GDP and wealth can be disconnected. If you build a building, then the construction activity increases GDP for that time period. However, if we think of asset values as determined by the discounted value of the asset’s future cash flows and you build these assets without sufficient demand, then you’re going to end up with cash flows decretive to asset values. To illustrate this principle more dramatically, if the lack of demand is so bad that the cash flows can’t cover the debt taken out in the course of building the project, then the defaults will impair the wealth of the bondholders. And if the scale of the building’s default is large enough or is coincident with the defaults of neighboring buildings experiencing similar asset impairments, then this will unleash a systemic cascade that will lead to a recessionary deflation for the entire country. Doesn’t that scenario sound a little too familiar to Western ears?
Other challenges ahead
The other night, Jing Ulrich appeared on Charlie Rose. Extensive discussion on the internal stability issues facing China like wealth disparity, urbanization, fossil fuel dependency, and natural resource deficiency.