"How profitable is China" was the title of a very interesting article written by Jonathan Anderson of UBS. It attempts to answer the above question using basic macro economic data, and simple intuitive logic.
There exists a great deal of anecdotal evidence that China is a very difficult place to make money, especially for foreign multinationals.
Most people have the feeling that many large Western multinationals have sunk billions in the country seeking to capitalise on the booming local economy and billion plus local population and came to grief.
Anderson argues in his short article that quite contrary to current investor perception, China has been profitable for multinationals, and surprisingly seems to have been more profitable than most other large emerging markets.
Anderson quotes figures from the US Bureau of Economic Analysis and the China Economic Quarterly, both of which have been data-tracking the earnings of US-affiliated firms in China.
What do the BEA numbers show? At first cut, nothing very exciting. For while the latest numbers (year ending 2003) show record profits being made by these companies (US-affiliated) in China, the aggregate amount at $4.4 billion is still lower than profits these companies make from Mexico or Japan.
Thus, US companies seem to make more money from a market of 95 million people than the teeming masses of China. Aren't China and the huge profit potential of its vast domestic market thus all a mirage? Why is so much FDI being attracted to this country when returns are mediocre at best?
Anderson goes on to use the above data to make a compelling case as to why China is actually quite profitable for MNCs, and prove the notion that while everyone is not making money in China, most companies clearly are.
First of all, the report looks at firm-level data on returns on equity and return on invested capital. Looked at from this perspective, China's profit record looks quite good.
Equity returns for both the Hong Kong-listed H shares and domestic A shares at 13-14 per cent were above Asian averages and even the RoIC at 10-12 per cent was in line with other Asian markets.
These data at least do not seem to indicate that companies in China have a profitability problem.
Critics can of course challenge these numbers and conclusions pointing to the small sample size of listed companies in China (compared to the broad economy), and their above-average quality.
Most of the listed companies in China are still majority-owned by the state in one form or another and thus may still be reaping some element of monopoly profits.
Critics also point to the huge NPA problem in the financial system, such a build-up in NPAs seems to point to a fundamental profitability problem in the economy, quite contrary to RoE data.
While these caveats are partly valid, I do not think it takes away from the basic notion that China can be a profitable market for companies, and money can be made, maybe not by all but certainly by the better-run corporates.
Additionally, those who make profits have returns in line with or better than their peers in other emerging markets.
The above profitability numbers are for listed companies and mostly domestic. Is it possible that foreign firms do particularly poorly in China? Could that account for the poor perception? They are mostly unlisted and thus will not be reflected in the above RoE/RoIC analysis.
As Anderson points out in his note, the truth is actually the opposite. For, according to Chinese manufacturing statistics, foreign-invested companies have consistently made higher profits than their domestic competitors.
Foreign-funded firms have had on average a 100-basis-point higher profit margin than the average Chinese company over the past decade.
As another route to checking this finding, the report looks at the balance of payments as another source of profit data. Like many countries, China provides BoP figures for FDI inflows as well as outflows of direct investment income.
Anderson and his team then aggregate this FDI inflow over time, and by using an assumed depreciation rate, arrive at some sort of a working proxy for the cumulative stock of FDI.
Once you know the stock of investments and the annual FDI profits, you can arrive at a number for rate of return on invested capital.
Using this methodology, the rate of return on foreign investment in China over the last decade was approximately 10.4 per cent. Any number over 10 per cent is clearly good, especially when compared to other large emerging markets, which provide a similar level of detail in their BoP accounts.
Even markets like Korea and Mexico have rates of return numbers averaging only 4-6 per cent.
Thus, it seems quite clear that foreign companies do make profits in China. A related question could be, however, whether any of the western multinationals make money.
Even the staunchest critics of China will concede that savvy Taiwanese and HK-based entrepreneurs have been able to leverage the low cost of labour in China to relocate basic assembly and light manufacturing operations.
These entrepreneurs understand China well, but what of the developed country multinationals with their bevy of expatriate staff who entered China primarily to tap into the huge domestic markets.
The common perception is that they have got butchered.
To get a grip on this issue (at least for US companies) the report goes back to adjusted BEA data used by the China Economic Quarterly. In 2003 US companies earned $4.4 billion in China, compared to $5.7 billion in Mexico, a huge differential, until you realise that the stock of FDI in Mexico is almost twice that in China.
Which means that US firms recorded a higher rate of return from investments in China than Mexico. Mexico is important as a point of comparison because it has been a huge recipient of US FDI, and is widely seen as a very profitable investment destination for US companies.
Adjusted BEA data also indicate that not only have US companies consistently made money in China, more so than in most other emerging markets, but that their returns have also been rising over time.
Despite all the anecdotal stories of China being an investment black hole for most western MNCs, the numbers seem to indicate otherwise. Not only do international companies make money, but their rates of return in China are higher than in most other comparable emerging market countries.
One can arrive at this conclusion even after keeping all the caveats about data quality and comparability in mind.