Posted on January 25, 2018
By Houze Song, Macro Polo
Dandong Port, located on the Yellow Sea just across the border from North Korea, is China’s only private port. And on October 30, 2017, it also became one of a handful of major companies in Liaoning province to default, having racked up more than 40 billion yuan ($6.2 billion) of debt. But unlike the province’s other high-profile corporate distress cases of the past few years, Dongbei Special Steel and Shenyang Machine Tool, Dandong Port is a privately owned and operated company. Still, the root causes of the private port company’s default lie not in the decisions its owners made but, ultimately, in the actions of an overbearing local government.
In this piece, the third in my series on how Liaoning offers a window on larger trends in the Chinese economy, I examine how government meddling in the province has, in fact, shaped and sometimes punished the private sector. I argue that even as Beijing has strived to cut red tape and make starting businesses easier over the past five years, the local government’s ad hoc intervention in areas that matter to private players has hampered the national priority of improving the business environment.
The Dandong Port case shows that one of the main factors in this is that, unlike in advanced industrial economies such as the G7, the line between private companies and state-owned enterprises (SOEs) can often blur in China.
The Liaoning economy is an example: state firms once dominated nearly all provincial industrial output but today, private companies are responsible for the remaining 60% of provincial output and are technically the main drivers of the local economy, according to official data. And yet, by some key measures, these private entities are functionally not so dissimilar from SOEs. In 2016, Liaoning’s non-state industrial firms proved to be only marginally more efficient compared to local SOEs, as measured by the asset turnover ratio (a measure of how much revenue one unit of asset can generate) and only half as efficient as the national average.
This flies in the face of conventional wisdom that argues that SOEs are largely responsible for dragging down efficiency in the Liaoning economy, a problem that could be “solved” by expanding the private sector. Why this is so has much to do with the fact that the Liaoning governments, at both the provincial and city levels, do not like to stay in their lanes and are prone to meddling in many spheres that affect private company operations and undermine their efficiency.
Of course, the degree of government intervention in the economy can be difficult, if not impossible, to measure. Most government intervention in China is undocumented, and to the extent that economic statistics—like fiscal subsidies and tax incentives—hint at the scope and scale of the problem, they reveal only more tangible aspects of state intervention. But it appears that less measurable aspects of local government behavior may be more prevalent and damaging in Liaoning than elsewhere, which is in part the result of the province’s legacy of industrial concentration.
Having served as China’s most important industrial hub during the planned economy era, Liaoning was essentially dotted with numerous one-industry cities. For example, Anshan, a city of 1.5 million and the province’s third largest, basically rests on a steel economy as measured by output. And the majority of the city’s steel-related activities, in turn, occur within a single SOE, Anshan Steel Group. In 2016, almost forty years after China began market reforms in 1978, steel still accounted for 60% of Anshan’s industrial value-added. And in industrial cities like Anshan, local officials can have a disproportionately large influence over a single firm. In more economically diverse regions, even if a local government’s key projects fail, many unaffected firms can still help to cushion the negative shock.
An Entire City Behind A Port
The case of Dandong, a port city on the border of China and North Korea, is illustrative of the negative consequences on private industry of a local government exerting its outsized influence in a homogenous economy.
Historically, the port was relatively small and predominantly geared toward serving the local Dandong economy. Unlike the nearby ports of Dalian and Yingkou, Dandong for a long time lacked major transportation linkages with other regions in China. Moreover, the waters around the port were too shallow to accommodate large ships. In 2007, the annual cargo volume of Dandong Port was less than 15% of the Dalian Port, the largest in Liaoning.
Dandong Port’s relative insignificance led the local government to part ways with this asset, selling it to a private businessman in February 2005, a period that saw the large-scale privatization of smaller SOEs. Today, Dandong is China’s only privately owned port.
Soon after the sale, the fortunes of Dandong Port actually did take a turn for the better. In June 2005, as part of an effort to revitalize China’s northeast, Beijing rolled out plans to upgrade transportation networks between Dandong and the rest of the northeast region. These improvements in connectivity made it worthwhile for the private owner to deepen the port itself. Based on its annual financial reports, Dandong Port borrowed more than 8 billion yuan ($1.2 billion) between 2007 and 2011 to upgrade its infrastructure, leading to a total investment during this period of more than 12 billion yuan ($1.8 billion). And these aggressive investments in improving transportation seemed to have paid off. The port grew healthily, tripling its annual cargo volume from 2007 to 2011, as container volume grew even faster.
But then, as is common in Liaoning, the Dandong municipal government couldn’t contain itself and sought to juice the success. In December 2011, the municipal Communist Party committee, the highest local authority, issued a directive that read, “the hope of the Dandong economy lies in the Dandong Port, thus the whole city will support the development of the port.”
In the wake of this directive, the Dandong government revised up the port’s 2015 cargo volume target from 150 million tons to 200 million tons (the lower target aligned with the private company’s own projections in 2009). Even though the port was a private business at the time, with the local government holding only a 20% stake, the company nevertheless followed local government orders diligently, sharply revising up its business targets and investment. To facilitate such an expansion of the port, the municipal government provided many incentives and subsidies, such as a tax rebate of 85% and cheap land. Soon after, the port began a period of reckless investments.
But the local government’s irrational exuberance was at odds with looming market dynamics. The bulk of the port’s business depended on demand for industrial goods and commodities. But by 2011, the commodity intensity of the Chinese economy began to decline and the so-called “commodity super cycle” was nearing the end of its run (see Figure 2). Already, in ports across the country, as well as in Liaoning’s two other major ports, the growth in through-put would soon slow to a crawl—something Dandong’s officials failed to forecast.
For local authorities, the port was the one business that they counted on to drive the city’s fortunes. That was because the port’s expansion could stimulate the local economy by not only increasing infrastructure investments, but also supporting growth in industries that depend on the port, such as logistics and trade. Investment at Dandong Port alone was expected to reach 46 billion yuan ($7.1 billion) over the 2011-2015 period. To put this staggering figure into perspective, the size of the entire Dandong economy is only around 70 billion yuan ($11 billion).
The local officials were apparently so bullish on the port’s business that in their five-year plan for 2011-2015, they estimated local GDP to grow by 20% annually. Yet a bearish market for commodities left the port, and by extension the city, in the lurch because of its homogenous economy. Unlike other Liaoning cities, Dandong has a relatively small manufacturing sector, or less than 30% of the local economy. It is proportionally far smaller than both Liaoning as a whole and compared to the national average.
While it is impossible to know whether Dandong city actually grew by 20%, it seems highly improbable that it reached anywhere near that level of growth. One key indication of this likely failure came in early 2017, when Liaoning’s governor confessed that all cities had been over-reporting their GDP figures, and forced them to revise their data. After this revision, Dandong authorities said that the city’s 2016 GDP was only 74.8 billion yuan ($11.5 billion), 60% below its target for 2015. Ironically, after adjusting for inflation, Dandong’s 2016 GDP is actually lower than its 2010 GDP, which remain unrevised.
The Road to Default
In 2012, Dandong Port enjoyed healthy positive cash flows from its port business, but it was insufficient to meet the city’s ambitious investment plans. To bridge the funding gap, the port borrowed heavily. In addition, Dandong Port also carried out many quasi-public investments under the direction of the local government. In other words, Dandong Port also served as something of a “local government financing vehicle” to borrow and invest off-budget. By 2016, the local government owed Dandong Port close to 1.2 billion yuan ($180 million).
The rosy picture local government painted for Dandong Port failed to materialize. In 2015, the annual cargo volume for Dandong Port was only 150.2 million tons, 25% below the official target but actually met the original 2015 target that the private company itself projected. Since Dandong’s debt repayments depended on increasing cargo volumes, the dramatic slowdown in cargo volume growth meant that it had to continue borrowing more and more. Soon, the company’s debt-to-equity ratio more than tripled from less than 100% in 2008 to more than 300% in 2015.
Moreover, in late 2016, the owner of Dandong Port was reportedly involved in a series of political and business scandals, and the company was repeatedly forced to assure investors that its owner was not under investigation. Concerned by Dandong Port’s increasing riskiness, creditors balked at providing the company with long-term credit.
Between January 2016 and its eventual default in October 2017, the company was able to issue only 550 million yuan ($84 million) of bonds with maturities longer than one year. The rest of the funding gap had to be met through short-term debt. This proved to be nearly impossible as the company had more than 15 billion yuan ($2.3 billion) of debt due each year in 2016 and 2017. Such a situation forced the port to constantly borrow new money in order to service its existing liabilities.
While it managed to roll over its debt in 2016, the company continued to face serious liquidity problems into 2017 as its financial performance did not improve. At the end of September 2017, Dandong Port only had 42 million yuan ($6.4 million) of cash on hand and did not have the resources to pay the bond or to raise new debt.
Investors had already lost confidence and wanted their money back. So even as Dandong Port in October 2017 raised sufficient funds to repay the interest on a bond that was due to mature in 2019, the bondholders unanimously decided to exercise the put option that allowed them to sell the bond early and demanded repayment of the bond’s 1 billion yuan ($150 million) in principal. Although Dandong made a last-ditch effort to persuade investors to hold the bond by raising the interest rate on the remaining two years from 5.86% to 7.5%, investors were not impressed.
So with more than 17 billion yuan ($2.6 billion) of debt due by mid-2018, the company could no longer roll over its debt. The port ultimately decided to default on its more than 46 billion yuan ($7 billion) worth of debt, of which more than 30 billion yuan ($4.5 billion) is in the form of bank loans and bonds. At the time of this writing, Dandong Port has not entered bankruptcy and is still privately held, but it is far from clear how this situation will be resolved.
Currently, all major bank creditors have agreed to not withdraw loans and let the port be managed by its existing owner. But it seems inevitable that this port will be sold again. And with the potential sale, Dandong Port’s distinction as the only private port may end. There is already news that the China Merchants Group, a central SOE, has an interest in acquiring this port, which would effectively return it to state ownership.
Denouement
What are the lessons of this example of the collision of public and private interests and actions? In the Dandong Port case, the excessive influence of the local government led, ultimately, to wasteful investment and considerable losses. Still, to a large degree, the private interests behind Dandong Port initially benefitted from the government’s largess—until, of course, the company eventually defaulted.
One lesson for China more broadly is that local governments can quickly change from being a firm’s powerful ally to its worst enemy. Under such an operating environment, local government connections often matter more than business acumen or market dynamics, leading to cases where the most connected, rather than the most competitive, businesses flourish.
Another lesson is that irrational exuberance is a deeply ingrained characteristic of local governments in China, and this can affect the fate of private business interests, who simply cannot resist the political pull of the government’s influence and inducements.
A final lesson is that China’s private companies, however “private” they may be technically, still operate in a political and regulatory environment that can undermine their well-intentioned efforts to operate unfettered as private entities.
The next and final installment in this Liaoning series will shift from ports to manufacturing to explore how the provincial government confiscated and ruined a local automaker once seen as the most promising in China. It aims to wrap up the series by offering some broader conclusions on how local developments reflect and inform national challenges in China.
Source: Macro Polo
