Low ROE could hurt China's funding of its huge pensions deficit

China has a problem. It has massive pension liabilities, estimated at $800 billion, and listed state owned enterprises which show dismal return on equity. The interim results of Chinese listed companies showed ROE of just 4.1% this year, down from 5% at the same point last year, according to research from emerging markets investment bank CLSA.

"To provide for our liabilities, we would typically look at an investment yield of around 10% per year," commented Ron Otsuki, CEO of insurance giant Manulife Funds Direct, Hong Kong.

ROE is not the same as investment yield as it is backward looking, whereas investment yield, based on the company's share price, is forward looking.

Still, ROE is a good indicator of company health, and China's listed companies, in most of which the government has an average 60% majority stake, show little sign of being able to generate the returns needed to fund China's pension system.

The background to the problem is that the government is hoping to attract the estimated $750 billion in national savings to the stock market in order to bail out loss-making state-owned enterprises. The government hopes such capital injections will enable companies to generate sufficient returns for the country to shift from the current pay-as-you-go system to a funded system, thereby removing the burden from the government.

But most traditional SOEs are in industries such as railways, steel, mining and property, and showed ROE of just 8.1% in 2000. The capital-intensive nature of some of these businesses can depress ROE, as can high inventory levels. The high inventory levels are the result of companies failing to respond to market forces and churning out goods which few people wish to buy.

Fred Hu, managing director for Asia economic research at Goldman Sachs, says inefficient capital allocation in China's domestic markets adds to the problem.

"The cost of capital is too low, and this leads to decreased ROE," he commented. There is a huge imbalance in China between the relatively small number of shares outstanding and investor demand, which is huge.

The easy availability of capital raised through equity issues diminished the drive of managers to utilize it to its full capacity, he added.

Analysts also blame un-incentivized management, neglect of shareholder rights, high levels of bank debt, rampant fraud and the lack of an institutional investor base to discipline Chinese companies.

In contrast to what most Chinese companies are now offering in the way of ROE is the rate of return foreign investors are looking for from China stocks. CLSA estimates that the required rate of return for foreign investors is 13%, calculated by adding a 4% market premium to China's foreign 'risk-free' rate of 9%, the current yield on China's 30-year US-dollar denominated Dragon bond.

But the returns of China's existing listed companies are still way below this. Indeed, "what's amazing about China is that the headline economic growth of over 8% for the past decade is not reflected in the ROE of listed companies," commented Elizabeth Tran, fund manager at American Express Fund Management International.

China's pensions system is entering a particularly dangerous phase since the country is moving from a pay as you go system, whereby new young workers into the system pay for retiring elder workers, to a fully funded system, where each generation pays for itself. This implies that the generation of working people during which the change takes place must pay contributions to safeguard its own future as well as paying for the previous generation, which has retired under the PAYGO system.

It's therefore likely the government will have to step in to pay for the shortfall from its own revenues, putting further strain on the government's 4% budget deficit.

But China's equity markets, in spite of their woeful returns do have some aces up their sleeves.

For example, although most mainland-listed companies are heavily in debt to the state-run banks, some Hong Kong-listed Chinese companies have very low, if any, gearing due o a conservative approach to debt. By increasing their gearing, and benefiting from the low interest rate environment, companies can improve their ROE. This is even more true of China's private sector, which already accounts for between 30-50% of China's GDP. Private companies have so far been starved of all forms of funding, so the ROE of these companies could rise dramatically were gearing to increase.

Some of these private enterprises have ROE dramatically higher than SOEs. In 2000, CLSA

Some experts believe the problem can be solved, as long as China's keeps up its recent growth rate.

"The mainland government is hoping, in addition to corporate restructuring, that by keeping GDP growth at 8% for the next several years the country will be able to out-grow the problem," commented Stuart Leckie, chairman of Woodrow Milliman Asia, a leading expert on China's pensions and welfare system.

"If China can keep growing at that rate, then there should be no problem," added Leckie.

On the other hand, other economists believe that China's growth rate could fall to as low as 6% after China joins the WTO, due to a sharp rise in bankruptcies and unemployment.