Rebalancing China’s Railway Sector

This month China’s State Council announced the price of transporting freight by rail will no longer be directly set by the government. Removing government controls on freight rates will improve the profitability of China Railway Corporation – a new company recently created to take over the operation of China’s railways from the former Ministry of Rail. Higher, market determined freight rates, will also support the rebalancing of the economy by reducing implicit subsidies to the industrial sector.

On this blog we have often asserted that price distortions are at the root of China’s unbalanced, investment-led growth strategy, and removing these distortions of various types should be at the forefront of structural reforms. China’s railway sector is another area where price distortions have contributed to China’s investment-led growth strategy.

China Railway Corporation, like the Ministry of Rail before it, does not control the price of its products and services. Freight rates and passenger fares are set by the National Development and Reform Commission (NDRC). Freight rates have been adjusted annually while passenger fares are adjusted infrequently. Freight rates are expected to generate higher returns in order to subsidize passenger rates.

However, in recent years NDRC has kept freight rates too low for the Ministry of Rail to maintain profitability. The net income of the Ministry of Rail has fallen as a share of total assets from 4.18 percent in 2003 to 1.54 percent in 2012. At its current level the Ministry of Rail does not generate enough profits to cover the cost of debt servicing let alone generate an adequate return to finance additional investments.

Return   /></a></p><p>Low freight rates act as an implicit subsidy to industry. Most of the goods transported on China’s railway system are inputs for the industrial sector. Coal alone made up 38 percent of freight turnover in 2011. If the Ministry of Rail were to charge higher rates for freight that would increase the cost of inputs for the industrial sector and drive down profits in sectors like steel making. Lower returns in the industrial sector would encourage more resources to flow to higher returns in the service sector.</p><p>They also perpetuate a debt financing model that drains financial resources that could otherwise go to more profitable opportunities. In recent years the Ministry of Rail fell into a cycle of debt accumulation as profitability declined. The Ministry of Rail does not generate enough gross profits to cover debt servicing costs and depends on new borrowing to cover investment and debt servicing costs. As a result the leverage of the Ministry of Rail has soared. In 2012, the long term debt was 31 percent greater than the equity of the Ministry of Rail, making the firm vulnerable to any shocks to cash flow. If the railway system were capable of generating higher revenues, it could more rapidly amortize existing debt, freeing up capital to allocate to other sectors.</p><p><a href=Leverage Ratio MOR

Freight prices should be raised substantially from present levels.  At a minimum in order to slowdown the growing leverage of the China Railway Corporation (formerly the Ministry of Rail), rates should at least be able to generate enough revenue to cover debt servicing costs. In February, the NDRC increased average freight rates by 13 percent to an average rate of 13.01 cents per ton kilometer. The increase was only enough to cover debt servicing costs in 2012, it will still be too low to meet debt servicing costs this year. Considering the fact that freight volumes declined last year, China Railway Corporation will still need at least another 20 percent increase meet debt servicing costs this year. However, this would not be enough to reduce implicit subsidies to the industrial sector.

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