The Socially Responsible Profits That China Shouldn’t Ignore

It’s not his day to write, but our mate Greg Canavan sent us a note last night about the duelling China manufacturing surveys. You’ll recall that one showed expansion. One showed contraction. One was a government survey. One was a private sector survey. Greg elaborates:

The HSBC index [the private sector survey] surveys mostly small to medium sized firms ‘with less access to credit’. The ‘official’ index focuses on larger companies.

In line with my recent comments on this issue, the conflicting numbers may suggest that the privately owned, ‘capitalist’ companies are struggling and reacting to weaker economic conditions abroad.

The bigger, state owned ‘socialist’ companies (with a greater focus on maintaining employment and social cohesion – and much greater access to credit) continue to produce and ignore the price signals flowing through the economy.

It’s just a theory, but it matches up with a lot of the stuff I’ve been writing about China lately.

One of the price signals Greg reckons Chinese State Owned Enterprises (SOEs) ignore is profit and loss. An SOE subsidised by a State-owned bank isn’t under any particular pressure to make a profit. And when the goal of the organisation is to produce at all costs and ensure full employment (for all those millions who’ve moved from the farm to the city), profits really are secondary.

This must sound like Nirvana to the defenders of the Welfare State. Finally, a country where profits don’t matter! The trouble is, investing in loss-making ventures – or ignoring price signals – is an expressway to making many bad investment decisions, allocating resources poorly, and ensuring years (if not decades) of high unemployment and general human misery.

Greg pointed out in his last report that in China, the banking system bears the brunt of this “socially responsible lending”. Bad debts are never written off. They’re moved off one balance sheet and on to another. Loss-making businesses stay in business for political and social reasons.

Keeping the last sentence in mind, take a look at the price chart below. After taking part in Mario Draghi’s rally to start the year, the Shanghai Composite has resumed its pattern of making lower highs and lower lows. You can’t blame Chinese savers trying to beat inflation by buying stocks. Neither can you blame them for selling stocks when SOEs are under no particular pressure to make a profit. After all, it’s hard to return profits to shareholders if you aren’t making any.

Shanghai Stock Exchange Composite Index

Source: StockCharts

Of course we’re not suggesting that all Chinese companies are running at a loss. That would be absurd. But you can sense a fundamental paradox in this kind of State Capitalism. China wants just a little bit of free enterprise because that’s how you raise standards of living and create wealth. But it’s tried to balance free enterprise with the political objective of full employment and social stability.

Stability is probably over-rated, in our view. Static systems don’t allow movement. Without movement, no one can move up in life. And if you can’t move up, you might as well not get off your couch. Of course what people of free and open systems lament is that in order to have movement, it has to allow for people to make AND lose money. Some people get rich and are successful. Others are not. Is this unjust? Surely not.

But back to the point about China’s decision to “put people over profits”, as Greg puts it. When you remove profit from economic calculation – at the individual or national level – you compromise the ability of the system to do its job. Profits are feedback. They tell producers that the good or service they provide is something people want. It also rewards the most efficient users of resources or the firm with the best organisation, ideas, and execution.

Taking profit out of the calculation almost ensures you’ll waste resources or tie them up in inefficient businesses. But when you put it that way, it sounds like a textbook or management mistake. It’s so much worse than that. When you tie productive resources up in unproductive ventures, you don’t just waste time, energy, and capital. You waste lives.

Any economic model that allows (or even encourages) misallocated investment should offend you if you believe that people have the right to pursue happiness and improve their lives. In China’s case, the banking system is full of loans made to SOEs and local governments. This capital should be free to businesses and entrepreneurs who put it to better uses. But it’s not.

Greg also points out in his last report that China’s authorities know all this. His conclusion is that the Chinese realise the only way out of their huge banking problem (and their massive over-exposure to dollar denominated assets) is gold. They’re encouraging people to stock up on real money. That’s as much as we can say about his strategy without giving the goods away. But it’s certainly worth pondering.


Dan Denning
for Markets and Money

From the Archives…

Why BHP Should Be Bracing Itself For a China Slowdown
2012-03-30 – Greg Canavan

What Does “the Market” Mean to You?
2012-03-29 – Joel Bowman

Why Australian House Prices Are Set to Crash
2012-03-28 – Dan Denning

Why US Manufacturing Could Be Made in America…Again!
2012-03-27 – Chris Mayer

The Best Real Estate Bets
2012-03-26 – Eric Fry

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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