Railroaded? The Logic Behind Merging Two Chinese Train Manufacturers

Examining the possible reasons behind the merger of two Chinese train manufacturers, China CNR Corp. and CSR Corp.

On September 4 China’s State-Owned Assets Supervision and Administration Commissions (SASAC) announced that it may merge China’s two largest train makers, China CNR Corp. and CSR Corp. There is a certain irony here because the two were originally one. Assets from the China National Railway Locomotive & Rolling Stock Industry Corp. were spun off to form CNR in 2000 and CSR in 2002 with the goal of introducing competition into the market. SASAC now may undo this.

Economic theory provides two main reasons why firms in the same industry would merge: market power and efficiency. Under the market power motive firms combine so that they can control a larger market share and raise prices. This could derive directly from more bargaining power over their customers or from implicit collusion on prices made easier due to fewer firms that must coordinate. The alternative is that firms merge to achieve greater efficiency and lower costs. Firms may merge to consolidate overlapping operations that reduce equipment or labor costs. The overlap could be in manufacturing facilities, research and development, or back-office functions such as accounting.

Both the market power and efficiency reasons lead to the same outcome for the combined firm—higher margins. So why should we care? Because they have different implications for those who buy trains and ride them. If the combined firm increases market power, this raises train prices. This means fewer trains are bought and those that are will be more expensive. Because these costs must ultimately be paid it means passengers will pay higher ticket prices or the government greater subsidies. This is bad for society. If the combined firm succeeds in lowering costs, this has the opposite implication—lowering train prices and passenger fares. This is good for society.

Both of these possible motivations have appeared in the reporting about the proposed CNR-CSR merger. One article cites both analysts who think the merger would “end cutthroat competition between the two companies” and others who think eliminating overlapping products and redundant expenditures on research and development will lower costs.

I decided to see if stock market evidence will help illuminate the motive behind the merger. Both reasons benefit the firms themselves so looking at CNR and CSR’s stock performance is of no help (trading in both were halted on the day of SASAC’s announcement but both went up considerably the following day).[1] However, looking at the stock performance of CSR and CNR’s competitors may help. If market power motivates the merger then competitors will also benefit. It is always better to compete against a firm that charges higher prices. If efficiency motivates the merger, then competitors will be hurt. It is always worse to compete against a more efficient rival.[2]

The Wall Street Journal lists CNR and CSR’s main competitors as Canada’s Bombardier Inc., France’s Alstom SA, and Germany’s Siemens AG. I looked to see how these firms’ stocks fared relative to the market on the day of SASAC’s announcement. If they went up a lot relative to the market, then this is evidence for market power as the motivation while if they dropped a lot this is evidence for efficiency.

On September 4 Alstom went up 0.81% compared to 1.65% for France’s CAC index, Siemens went up 1.48% relative to 1.02% for Germany’s DAX index, and Bombardier went up 0.27% versus a fall of 0.52% in Canada’s TSX index. If we use a simple average, the three firms’ returns increased by 0.86% while the three exchanges increased 0.72%. That these are not terribly different from each other implies that the three competitors’ fortunes were not greatly affected by the announcement and that any impact is minor.[3]

However, we need to be careful about this conclusion. There may be other reasons why the competitors’ stocks were unaffected. Railcar manufacturing may not be a significant enough part of these competitors’ businesses that their stock price would move significantly. All three of these firms are diversified manufacturers. Another possibility is that there were informed traders who knew about this announcement well before September 4 and the information was already reflected in the stock prices.

Given the inconclusiveness of this test, we can try one other thing. The two possible motivations for the merger have different implications for China Railway Corp. (CRC), the state operator of China’s rail network, which buys most of its railcars from these two firms. Increased market power in train manufacturing would lower CRC’s margins and stock price while higher efficiency would increase both. CRC’s stock price went up 1.20% on September 4 while Hong Kong’s HIS index (where CRC is traded) went down by 0.08%.[4] This is some evidence that the proposed merger may increase efficiency of the merged firm.

Again we need to be careful.[5] Other events may have moved CRC’s stock price on September 4. Also, as a government-controlled enterprise CRC may not be profit maximizing. Perhaps the increased stock price reflects market expectations that CRC will receive more generous subsidies in the future as the government changes its overall rail strategy in response to the merger.

This evidence is far from conclusive and does not imply that the merger go forward summarily. It suggests that the merger may not significantly harm competition but more rigorous analysis should be applied to determine the impact of the merger. Too hasty a decision may result in railcar customers and passengers being “railroaded”. Work on the US transcontinental railroad in the 1860s proceeded so quickly that it is thought to have led to this expression: having something forced on you so quickly that you do not have the chance to consider or object.

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Update: China’s National Development and Reform Commission (NDRC) recently announced that the salt monopoly held by China National Salt Industry Corporation and which I recently discussed will be abolished in 2016. For reasons I discussed there, this is welcome news.

[1] CNR and CSR’s management reportedly oppose the merger despite these increases. However, as executives of state-owned enterprises (SOEs), control may motivate them more than profits.

[2] This idea is due to Eckbo, B. E. (1983). ‘Horizontal Mergers, Collusion, and Stockholder Wealth’, Journal of Financial Economics, 11, 241-273.

[3] Eckbo recommends a more sophisticated technique than I present here—called a stock-price event study. This relies on modern finance theory to estimate whether a stock price increased or decreased abnormally during a certain period. I implemented this more sophisticated approach in three- and five-day windows around September 4 using stock data from March 3 through November 20 and found the same insignificant results.

[4] CRC’s management reportedly opposes the merger but again as an SOE its executives may have motivations other than profit.

[5] In addition, Eckbo’s more rigorous test does not reveal a significant stock price reaction for CRC on September 4. That is, the increase is not out of bounds with what modern finance models would predict.