One of the key factors shaping the downbeat outlook many investors have on China is the concern that misallocated investment has led to chronic overcapacity and very low profitability in many sectors in China’s industry.
This is also a factor in assessments of financial risks. With interest rates likely to trend higher in the coming years, financial risks would rise all the more if many investments do not yield enough economic return to service the debt with which they are financed.
We know that misallocation of investment has also taken place in the commercial sphere and that chronic overcapacity is haunting sectors such as steel. But how representative is this misallocation of industry as a whole?
We present an overview of the profitability trends in China’s industry, showing how profitability in different sectors has responded to the different forces that China’s industry has been subject to.
We find chronic overcapacity and low profitability in some parts of heavy industry, but we also find that other industrial sectors have faced a rather different setting and have seen profitability holding up significantly better in recent years.
Profitability in China’s industry has fallen in recent years because of the economic slowdown. The rate of return on assets (ROA) is probably the best indicator of profitability. We use the industrial survey to calculate it.
The average ROA for industry as a whole peaked in 2011 at 9.1%. It then fell in 2012 and 2013 as profits were affected by the weakness of the economic cycle, alongside downward pressure on output prices (see chart below).
A fall after a long rise
Average ROA and profit margin, industry
Sources: CEIC, RBS
This followed a long-term upward trend in profitability since the late 1990s that was driven by the restructuring of state-owned enterprises restructuring and rapid private-sector growth, fast productivity growth and economies of scale. Thus, at 7.4%, the average ROA in industry in 2013 was still higher than before 2010.
The chart above also shows how the profit margin – profits as a share of sales – correlates reasonably closely with the ROA. As it is easier to get consistent time series data for the profit margin in individual sectors, we base the discussion on sectoral trends on profit margins.
In looking at industries, we do not follow the classification of the National Bureau of Statistics, but group the sectors according to our own criteria. The sectors are:
- mining and extractive industries (coal, petroleum and natural gas acquisition, ferrous metal, non-ferrous metal, auxiliary and other mining)
- heavy industry (petroleum, coking and nuclear fuel, chemical material and product, chemical fiber, rubber and plastic products, non-metallic mineral products, ferrous and nonferrous metal smelting and pressing, and fabricated metal products)
- light industry (agriculture and sideline food, food, wine and liquor, tobacco, textile, garment and apparel, leather et al, wood processing et al, furniture, paper making, printing et al, cultural products et al, pharmaceutical products)
- machinery and equipment (general and special equipment, automobile, other transport equipment, electrical machinery and equipment, computer, communication, etc, and instrument and meter equipment)
Profitability in three sectors
Sources: CEIC, RBS
Mining and extractive industries
Profit margins for mining tend to be higher than for most other sectors of industry. In 2013, the (unweighted) average profit margin for mining and extractive industries was 11.1%, or 5 percentage points higher than the total industry average.
That is partly because the production process is relatively capital-intensive, which means that the income accruing to capital, and thus profit, makes up a relatively large share of the total.
It is also because many extractive sectors are shielded by various policy-induced barriers. At 31.3% in 2013, profit margins are particularly high in oil and gas extraction.
Heavy industry exhibits many of the problems that investors worry about. Overall, profitability fell to very low levels in recent years amidst weak demand, often chronic overcapacity and weak output prices.
Looking at the individual heavy industry sub-sectors, steel is the most extreme example of the worsening profitability. Profit margins have fallen to around 2% in 2012-13, in the context of substantial declines in factory gate prices. Other metals are not doing much better.
The chemical industry, though, has not been doing as badly during this period, as it supplies to a broader range of sectors and has been better able to upgrade the value chain.
Steel, chemicals, other metals
Sources: CEIC, RBS
In our view, the overcapacity and chronically weak profitability in sectors such as steel clearly illustrate the problems resulting from heavy government involvement, especially of local governments.
Local governments have traditionally hindered administrative attempts to reduce overcapacity. It remains to be seen whether the central government’s current attempts will be more successful.
Profitability trends look quite different here. Overall, light industry has also seen a fall in profit margins in 2012-13, reflecting the slowdown, weak export demand and price pressure.
However, the fall in margins has been substantially more modest ompared with heavy industry.
Textile, food and pharma products
Sources: CEIC, RBS
The better performance in light industry comes in spite of the fact that the production process is typically more labor-intensive than in heavy industry, making light industry more vulnerable to substantial pressure on profitability from rapid wage growth in China.
Evidently, productivity growth and movement up the value chain has helped offset much of the impact of these wage-cost pressures on margins. Also, light industry tends to be more dependent on domestic consumer demand and has seen relatively good pricing power.
This has especially been the case for industries such as food processing. They have benefited from a very rapid increase in the number of households able to buy groceries such as processed, packaged food. As a result, margins have held up better.
Machinery and equipment
The evolution of profitability in this industry has been in between that of the heavy and light industries, with (unweighted) average profit margin falling to 5.7% in 2013.
We think that China’s machinery and equipment industry has done relatively well in offsetting cost pressures by means of productivity increases, automation and moving up the value chain, and that it is well-positioned to do well as global demand recovers.
However, it has been particularly affected by the weakness of global demand growth in recent years, especially in export-oriented sectors such as communication and computer equipment.
Chronic overcapacity and low profitability haunt parts of China’s industry, especially in several heavy industry sectors. In other industrial sectors, profitability has held up significantly better, especially in those sectors exposed to rapidly rising domestic consumption.
As a result, despite major problems in parts of heavy industry, average profitability in overall industry has held up reasonably well in the face of the slowdown of demand and cost pressures in recent years.
In turn, that is why, despite headline-making anecdotes, we have not really seen financial stress among corporates building up in a systemic way.
We expect the trends observed here to broadly continue in the coming years. Where does that leave the more problematic heavy industry sectors?
While we are optimistic about the fortunes of much of China’s industry, we do not expect the problems of chronic overcapacity and low profitability in sectors such as steel to be resolved any time soon, taking into account the considerations affecting local governments.
The discussion here has been about industry. There is, of course, a broader process of rebalancing of the pattern of economic growth taking place, with the services sector having done better than industry in recent years.
About the Author
This article is excerpted from “Top View: China,” a report by Royal Bank of Scotland and affiliated companies that was published on 27 March 2014. It has been re-edited for conciseness and clarity. ©Copyright 2014 The Royal Bank of Scotland plc and affiliated companies (RBS). All rights reserved.
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