By: Steve Dickinson

This post is part I of a two part series on why investing in Chinese companies can be so different than investing in Western companies.  In this first part, I address how the way Chinese companies typically view investment is so different from that in the West.  In Part two, I will talk about how this differing view so often impacts Chinese joint venture deals.

I often write and talk about how China’s lack of intellectual property protections stems in part for its contempt for the intangible. As an extension of this attitude, China also has what I would call a contempt for investment. For the Chinese, work is generally all that counts. Investment has no permanent value and it tends to be treated like a loan. Once the investment is repaid, the investor is expected to depart and allow the executives who run the company to receive all future rewards. Investors that insist on sticking around to earn a return on their investment are considered to be fundamentally dishonest. Since the investor is operating in bad faith, it is perfectly acceptable for the Chinese company owner to use extra-legal methods to get rid of the investor that overstays its welcome.

This attitude explains one reason why investment in Chinese companies is so difficult. Take the typical venture capital portfolio. The typical venture capital investor is not expecting that every investment will result in a substantial return. Instead, it hopes that one investment of many will score big, resulting in a pay-off that compensates for the relative failure of other investments in the portfolio.

It is difficult to make this approach work in China. The Chinese side is quite happy to accept venture investment in a project that fails. When the project fails, the investment is lost, but the effort of the founders is also lost. As far as the Chinese side is concerned, both sides lost the same amount and they feel no need to compensate the investor for its losses. In fact, the entrepreneur usually believes the loss of its time and effort is a much greater loss than the loss of the investor. After all, the investor only lost money, which can be replaced. The time and effort of a young entrepreneur cannot be replaced. This loss is therefore much more tragic that the mere loss of money.

On rare occasions, however, the project will work and the venture will succeed. In that setting, the entrepreneur founders will expect that the investor will be happy with receiving a return equal to its investment plus a small amount of profit roughly equivalent to the interest it would have earned on its money. When the founders learn that the investors intend to ride the project to the very end, reaping the majority of the financial benefit, the founders believe that they have been tricked. Their work is the entire value of the company. How can it be justified for the investor to stick around and reap the rewards when the investor has done no work? No one expects their banker to continue to demand payments after the loan has been repaid.  In fact, such a demand from a lender would be seen as fundamentally wrong. The same is often seen to apply to an investor. Since the investor’s continuing demand for payment seems fundamentally wrong, the founders will work to eject the investor in some way, even if this is actually damaging to the company. The fact that this attitude is completely contrary to current Chinese law is irrelevant. The attitude is deep-seated and seems to pre-empt any consideration of what is provided for in China’s legal system.

This attitude makes private equity difficult to do in China. I am often challenged when I say there really is no domestic private equity in China. Critics point out the large number of funds that are called “private equity funds” that operate all over China. However, when examined, these funds seldom resemble what we call private equity in the United States. The Chinese funds are more like what we would call “short money lenders.” They lend to a project at high rates of interest. They take their capital and interest and then leave. They usually do not attempt to enter into any kind of a long-term arrangement with their investment targets. This is because they fully understand the basic principal: loans are acceptable, even at high rates of interest. Equity investment is not. Work counts, but investment does not. Think communism.

What are you seeing out there?

I know I have been writing too much lately regarding China’s economy and I know that much of what I have written has been negative. But I have to tell you that I am starting to see all sorts of fissures breaking out in China’s economy and they are scaring the hell out of me. I am not writing to jump on any bandwagon (as one e-mailer accused me) but because I am really worried.

I am worried not just from what I am seeing, but because the real economists out there (not the people who claim to be economists just because they live in China) are also saying some pretty scary things. One of those real economists, Michael Pettis, just came out with what I see as a brilliant piece on how China has overinvested in capital and how its capital investments have been misallocated. It is entitled, “How do we know that China is overinvesting” [link no longer exists] and I strongly urge you to read the whole thing.

I love Pettis’s piece for three reasons. One, I have never bought into the idea that a bunch of geniuses sitting in Beijing are betting at allocating funds than the invisible hand. And I certainly have never bought into the idea that the local governments spending funds are either.  Two, I have been seeing with my own eyes what I thought to be misallocations, but at least half the time when I raise them to people, I get a response like, “well surely the people in Beijing are better equipped to know whether 3 million vacant condos, bridges to nowhere, and train stations in nowhere make economic sense than you are.” I have never thought that is the right question and I have always felt that many of those who refuse to admit China can do no wrong economically are so tied to the system as to have lost any real perspective. Three, the analysis is absolutely first rate and it has been a long long time since i have seen an analysis of Chinese economy of which I could say that.

The article focuses on China’s investment in electric car technology as an example of misallocated capital and it does a great job of explaining why even an investment so initially appealling as that can be a big mistake.

Pettis explains why he sees China having missollacted its capital:

Of course the question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect.  I would argue that there are several reasons why we should believe that capital has been wasted on a large scale for many years.  The first reason is simply historical precedents, something which unfortunately rarely enters into most economic analysis.  No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.

The fact that China is so poor is often proposed as an argument as to why this cannot also be the case for China, but of course this is a nonsensical argument.  Poorer countries with lower levels of worker productivity are less able, not more able, to absorb very high levels of investment.  This may seem counterintuitive at first, but only if you believe that there is a single optimal level of investment for every country regardless of its specific conditions.  If the purpose of investment is to save labor and labor cost, then it should be clear that the lower the level of worker productivity and the cheaper and more abundant the amount of labor, the less investment in capital stock is justified.

This is why when so many analysts compare the per capita capital stock of China with that of the US or Japan, and then announce that this proves China has a long ways to go before it runs out of investment opportunities, I am always surprised, and even a little skeptical about their economic backgrounds.  This comparison simply does not make sense.

If it did, overinvestment crises would be largely limited to rich countries, not poor countries – something that is certainly not confirmed by history.  Anyway I find bizarre the idea that the best comparison for China, one of the poorest countries in the world even if you accept the validity of GDP numbers and ignore the very low GDP share of household income, is the US or Japan, two of the richest and most technologically advanced countries in the world.

But I think there are more formal reasons to believe that China is misallocating capital.  Common sense suggests that when there is massive investment with

  • very little accountability,
  • severely distorted prices,
  • an incentive structure that concentrates the benefits of investment in specific jurisdictions and over a short time period while spreading the costs throughout the national banking system and over the debt repayment period (which can be decades),
  • no or very limited budget constraints,
  • factional and regional conflicts, and
  • shifts in responsibility as the instigators of the investment are promoted (often because of the positive impact of their own investment initiatives),

it would be a rare system in history that did not tend towards substantial capital misallocation.

Certainly the evidence on SOE investment suggests that this is indeed what happened.  A number of studies have suggested that if over the past decade you add up direct subsidies, the impact of monopoly pricing (which is of course simply a tax on households) and the interest rate subsidy, they total anywhere from six to ten times the aggregate profitability of the SOE sector.  This means that unless the externalities associated with the SOEs are also at least six to ten times their aggregate profitability, they are actually value destroyers.

If you have any interest at all in China’s economy, you really should read the whole article. I buy it. Do you?