Michael Pettis On The Disturbing Part Of That Austrian Town Being Reproduced In China

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[In an excerpt from his newsletter, Michael Pettis comments on the Austrian village being ripped off in Guangdong.]

That this sort of building project seems a tad over the top is not why I bring up the article. Those of us who live here are quite used to the many sometimes-bizarre projects aimed at attracting new wealth and signaling status.  If it makes the residents of Hallstatt feel any better, by the way, I am certain that the Guangdong replica will not be a perfect copy of Hallstatt.  I have no doubt that there will be hundreds of architectural and cultural “improvements” that will ensure that no one confuses the shiny replica with its dowdy original.  Excessive restraint typically isn’t one of the sins afflicting local real estate developers that cater to the rich.

What interested me about the article was something else altogether.  According to the article, the project is being developed by “Minmetals Land, the real estate development arm of China Minmetals, China’s largest metals trader.”

MinMetals might be very successful at trading metals, but it wouldn’t have occurred to me that a metals trading background would have made anyone particularly good at real estate development, and especially at developing “premium” projects like this one.  This might seem like a strange bit of business diversification. 

But this is actually not an anomaly in China.  In fact a lot of Chinese SOEs are involved in a very wide variety of business activities, and are especially fond of activities in which cheap capital is the comparative advantage, or in which there is political advantage to be gained.  That makes real estate development and “high tech” two of the most popular ancillary businesses.

Incentives affect behaviour

Does it matter?  Perhaps.  This type of business diversification is not new and it doesn’t have a very encouraging history.  For example in the 1960s the US saw an explosion in the growth of what were then called “conglomerates”.  There seemed at the time to be plausible reasons for their growth: good managers are good managers, and can generate growth from many types of companies, and their ability to generate growth is magnified by the lower cost of capital associated with substantial diversification.

But after the initial enthusiasm, conglomerates performed awfully, and in the 1970s a consensus developed that large conglomerates involved in very different lines of business tended to be value destroying.  The reason often given was that managers who might be successful in one line of business – say coal extraction – might not necessarily be especially good in another line of business – say children’s retailing, or movie production.  By forcing senior managers to disperse their expertise across a wide range of very different businesses, conglomerates were very good at mismanaging many if not all of the businesses they controlled.

I am not sure if I am totally satisfied with this explanation, although there is probably some truth to it.  To me the main reason why conglomerates tend to be weak at creating value has to do with the distorted incentive structures involved in their creation.

Unless sceptical investors are monitoring them and threatening to punish them when they fail, senior managers have no great incentive to manage shareholder money very carefully.  They do, however, have strong incentives to build their assets and to diversify – the former because the larger the company the more important and more highly remunerated the managers, and the latter because highly diversified businesses are less likely to fail and more likely to be involved in whatever business is hot today.

In that case, as long as there are no constraints to managers’ ability to raise money and invest in other businesses, managers naturally do just that.  The problem is that what is in the best interests of the shareholder – creating economic value to be captured by shareholders – is not necessarily in the best interest of managers, who might find it totally rational to overpay for assets and to pile into “hot” markets.

This distorted incentive structure ends up encouraging capital misallocation.  After a few exciting years in the late 1960s, we saw the consequence: the profitability of American conglomerates plummeted. Incentive structures, in other words, determine behaviour in the aggregate, and if the incentive is to ignore value creation in favour of some other objective, value creation tends not to occur.  In fact the opposite occurs.  Value tends to be destroyed if those other objectives can be met by deploying capital.

It is hard to imagine that in China today the incentive structure for top managers of SOEs is aligned with that of creating economic value.  Shareholders, where they exist, have few rights and almost no say in choosing or disciplining top managers.  Obviously enough the bigger the company, the more important the CEO tends to be, the more preciously his bankers and investment bankers will treat him, the more time he will spend with senior political leaders, and the more highly remunerated he, his family and his friends will be. What’s more, as Beijing tries to consolidate smaller companies into larger ones, the bigger the company are the more likely the CEO is to head of the surviving company. 

In that case companies of course will want to grow no matter the cost.  There is an additional and very important distortion that compounds the problem in China.  The most important comparative advantage that large Chinese companies have is access to cheap credit, and so from a P&L point of view the best policy is always to borrow as much as possible, and buy or build assets.  Even if the borrower overpays, or if the projects are value destroying, it doesn’t matter too much because artificially low interest rates are the equivalent of debt forgiveness, and after several years of hidden debt forgiveness, even the worst investments start to seem profitable.

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