On July 8 Beijing sentenced one of its former ministers to death. The verdict was intended to send a message to senior politicians and state company heads: the graft party is over.
Liu Zhijun, the former head of the Ministry of Railways (MoR), was found guilty of bribery and abuse of power and handed a suspended death sentence. This came two years after he was arrested and kicked out of the Communist Party for accepting more than Rmb64.6 million (US$10.5 million) in bribes, using his power to allocate promotions and project contracts, and keeping 18 mistresses.
Liu amassed so much because he held immense influence over China’s railways industry. The MoR was both regulator and stat e-owned enterprise (SOE), responsible for building, managing and regulating the industry, all while running up approximately Rmb2.66 trillion in debt.
Liu’s corruption might be an extreme case, but similar dangers exist across China’s economy. SOEs enjoy high levels of influence in nearly every industry, from media to mining.
The government has for years used state companies to guide the country’s economic direction. It has come at the expense of private businesses, which have faced taxation injustice, been overlooked for contracts, shut out of fundraising opportunities and squeezed out of industries.
This discrimination has increased in the four years since the global financial crisis, as Beijing turned to the SOEs as lynchpins of economic stability.
Its decision to do so has become increasingly ironic. For all the size, capital and force that these state enterprises have over their peers, it is privately owned enterprises (POEs) that are increasingly shouldering China’s economic growth.
In 2012 the profits of industrial SOEs declined by 5.1% year on year, according to CLSA, while overall SOE profit growth was 2.7% for the first four months of this year. Over the same period the profits of larger industrial POEs rose 17.9%. More importantly, POEs are responsible for 80% of China’s new employment, a critical component to Beijing’s ambitious urbanisation goal.
The new administration led by president Xi Jinping and premier Li Keqiang is aware of this disconnect between SOE favouritism and POE productivity. Diversifying SOE power and cracking down on corruption have become their priority.
“The urgency to enact further SOE reforms, especially at the local government level, has increased recently. The SOE sector is not creating a lot of jobs and lagging in efficiency. It’s SMEs (small-to-medium-sized enterprises) that are contributing significantly in new jobs despite the many constraints that they face,” says Kim Eng Tan, senior director of sovereign debt ratings director at Standard & Poor’s (S&P).
Reforming the MoR was the administration’s first test case. On March 10 it divided the agency into two units, one to supervise the railways safety and quality, the other to manage the business aspects of the rail system. The latter will be opened to private participation.
More reform is set to come, and along with it further industry reform. If enacted correctly, it promises to offer opportunities for private businesses and investors alike. Asiamoney believes that three industries offer the most interesting privatisation and investment opportunities: healthcare, oil and gas, and – yes – railways.
Provided Beijing is willing to enact genuine industry reform, these sectors are the most likely to be open to more private-sector and foreign-investor participation, diminished barriers to entry and capital market access.
Signs of intent
SOE reform in China is not a new concept. Previous leaders have broached the idea of scaling back state companies that now number approximately 145,000. But these speeches are rarely backed up by concerted action.
Analysts believe that the current administration may be different. On March 17, prime minister Li delivered his first public press conference about minimising the government’s role in the economy. At the heart of this speech was the proposal to allow POEs to compete with SOEs.
“Reforming is about curbing government power,” Li said in his televised speech. “It is a self-imposed revolution that will require real sacrifice, and it will be painful…Talking the talk is not as good as walking the walk. We need to pursue market-oriented reforms.”
Li aired his thoughts again in a speech to his Party compatriots on May 24, echoing earlier statements from the very regulators heading up SOEs.
“More efforts will be made to reform the power, telecommunications, oil and petrochemical industries,” Wang Yong, the director of the State-Owned Assets Supervision and Administration Commission, wrote in a report to China’s legislature on October 24 last year. “Market entry into these sectors will be expanded based on the development of these industries.”
There’s a simple reason for this urgency: China’s economy is in danger of growing slower than the 7% minimum a year it needs to keep up with increasing urbanisation. Banks including Goldman Sachs, HSBC, J.P. Morgan, RBS, UBS and the World Bank have downgraded their growth forecasts for the country in 2013 to an average of 7.6% from 8.1% at the start of the year.
The SOEs bear a large portion of the blame for the nation’s economic inertia. They are enormous, capital-hungry, politically well-connected – and very inefficient.
These companies have lost their premier status in China’s economy since the late 1990s, as economic liberalisation has helped expand the private sector. These efforts caused the SOEs’ share of industrial production to decline from 80% in 1999 to 44% in 2005 and 34% in 2011, and the private-sector share of urban employment to rise from 40% in 1994 to 82% last year. Almost all new job creation has come from private firms in recent years, according to CLSA. And private firms accounted for 66% of all fixed asset investment last year, up from 42% in 2004.
While SOEs no longer dominate China’s economy outright, they still tend to be the largest individual companies in their sectors, enjoying everything from political patronage to favoured tax statuses, guaranteed business streams from local governments or other SOEs, and favoured financing from banks. As a result, they have tended to focus on size rather than efficiency or profitability.
If Beijing is serious about developing more private-sector prowess it needs to eradicate these advantages, and that means a set of incremental rules changes to level the playing field between SOE and POE. Given what is likely to be heavy opposition among local government leaders, Li and Xi would be well-advised to begin by focusing on those sectors that are best-placed for reform.
Oil & gas
The energy sector makes for an ideal candidate for private-sector reform. SOEs in the sector have been among the more successful in China and it offers growing private opportunities.
The government has approached its oil and gas companies in a different way to the railway industry. Starting in 1982, the central government split its oil business into the three sections governed by three dominant SOEs: China National Offshore Oil Corp. (Cnooc), which is responsible for China’s offshore oil and gas presence; Sinopec, which oversees the retailing and refining of petrochemical oils in Southern China; and the China National Petroleum Corp. (CNPC), which manages exploration and production in the Northern China oilfields.
In dividing the oil and gas business amongst the three SOEs, the government also gave them the autonomy to become commercially sustainable to maximise the country’s oil and gas potential. They did this by learning from their overseas counterparts.
Cnooc went abroad to buy assets, including five blocks in Indonesia from Spanish oil company Repsol in 2002 and a stake in Australia’s North Western Shelf project. It developed quickly as a commercial entity. Sinopec engaged in foreign joint ventures with companies such as BP, Exxon and Shell to learn how to monetise downstream assets in oil. These relationships also taught Sinopec how to be commercial.
The industry has been more open to taking on non-SOE aid to advance business, and over the past year oil and gas companies have been willing to take on even more private partners, especially in the area of shale gas production.
“The major SOEs are trying to build up a collection of small private companies to complete projects, and there are some that will hold two rounds of auctions where companies will have to pitch for business and the successful ones will work with the SOE,” says Laban Yu, head of Asian oil and gas equity research at Jefferies. “There are just a handful of these companies doing this now and it’s unclear quite how private these smaller companies are, but this is a talking point.”
A key way of stimulating private interest will be to encourage shale gas production. China’s National Energy Administration targets 6.5 billion cubic metres of shale gas production in 2015 to make up 2% of the country’s total gas production, which will cost US$6 billion alone in 2015, Chen Weidong, chief researcher at Cnooc’s research institute estimated in state-owned newspaper China Daily. This is meant to minimise China’s dependence on oil and gas imports, and because the country claims the largest reserves of recoverable shale gas in the world, it’s a fair target.
Yet the process is more complex and the gas more costly to extract than most regular crude-oil processing. China was only able to produce 500 million cubic metres of shale gas in 2012, according to Peking University’s clean energy institute. Beijing is asking for private investment to help meet its targets. Such private company participation would also encourage innovation.
“The government understands that chaotic, small, independent oil and gas producers, which the US has, are the best for shale production,” says Yu. “The three large, risk-averse state-owned enterprises would never have figured out how to do shale. So China is trying to build up this collection of small private EMP [environmental management plan] companies to do it, but it’s still in the early days.”
China’s Ministry of Land and Resources’ first auction in July 2011 sold only two shale gas blocks: to Sinopec and Henan Provincial Coal Seam Gas Development and Utilization. The second round in September 2012 allowed both non-state owned Chinese entities and foreign joint ventures to participate in the bidding. Sixteen domestic companies won the rights to the 19 blocks on offer, including six SOEs, eight local government-run companies and two POEs. They join the JVs of Shell/PetroChina (the listed arm of CNPC), Chevron/CNPC and Conoco Phillips/ Sinopec teams who are already exploring blocks.
Shale gas developers in China must pay US$4.76 million-US$12 million to complete a single well due to the country’s deposits being based in mountainous terrain near Chengdu. This compares to the US, where the relatively flat land over shale deposits means that the average cost-per-well is only US$2.7 million-US$3.7 million, according to Norton Rose. Due to the increased cost China is expected to invite even more private participation in the third round of bidding. The Shanghai Securities News reported on June 7 that the Ministry of Land and Resources may hold this auction at the end of the year and will encourage more participation from SMEs.
“These projects have immense financing needs, and this will create opportunities for private companies to raise cash, potentially both onshore and offshore,” says David Cogman, a partner at McKinsey & Company, adding that opportunities exist in the broader oil and gas sector. “There will be valid and growing opportunities for financing by investors outside China, private onshore investors or through partnerships.”
Shale oil is not the only opportunity for private companies. In May last year, CNPC signed an agreement with state and private investors to fund 48% of its Rmb116 billion West-to-East gas pipeline. The event marked the first time it allowed third-party investment into its business.
More such contracts are expected to follow, given China’s energy needs, offering potentially lucrative opportunities for domestic companies and even foreign corporates.
Healthcare
In theory healthcare services offer a great deal of opportunity for private-sector participation.
Approximately 22,000 hospitals exist in China, 8,440 of which are private, according to the Ministry of Health. However the private hospitals are mainly owned by local entrepreneurs and are much smaller – at 100 to 200 beds – compared to large public hospitals of 500 to 1,000-plus beds. Plus, most private hospitals are standalone.
The potential appeal of private hospitals is down to their business-like approach to patient care and medical services, with expertise a priority. Public hospitals are non-corporatised, fragmented and run by local municipalities that are intentionally not for profit to serve the broader community. There’s little competition to drive quality, services and innovation.
But as China’s middle class grows, more people will be willing and able to pay for better services.
Regulators are desperate to get expert private investors involved, inviting foreign investment into the space to jumpstart the process and improve quality. In January 2012, the National Development and Reform Commission (NDRC) even removed the 70% foreign-ownership cap on hospitals. It’s one of the few sectors that allows for outright foreign ownership.
Yet investment into the sector has been sluggish. The reasons are simple: foreign investors have little knowledge of China’s health market and lack incentives to invest there.
“Greater incentives are needed from a corporate investment perspective,” says Alexander Ng, an associate principal at McKinsey & Company in Hong Kong. “Private hospitals in China operate in a relatively difficult regulatory environment, and there are lots of areas for improvement – heavy regulation…multiple-practice licenses for physicians, restricted ability to set prices while accepting government insurance, and so on. There is already huge demand from the growing middle class for more and better hospital services, but many investors don’t have the confidence to capture the opportunities when they have a five-to-seven-year investment cycle.”
Given these difficulties, the most lucrative angle for an investor is to buy an existing asset – i.e. a public hospital that has real scale. But by doing this, the private owner would lose all direct government subsidies, which exist to keep costs lean and maintain hospitals’ non-profit status.
Under the current rules, private hospitals are also restricted by the government’s fixed pricing on everything from CT scans to X-rays and medical drips. All hospitals that accept state-backed insurance – which is the main provider for the Chinese public – are beholden to prices from the state’s medical catalogue.
The only way to bypass such restrictions would be to operate separately from China’s insurance and then either provide better services than public hospitals (to appeal to wealthier patients who are willing to pay a premium) or to charge a larger number of patients less for their services.
It is a difficult area in which to compete as government subsidies cover approximately 50% of patients’ medical costs, says Ng. Providing new services or building a new wing to support more patients takes time and investment before any hospital sees results.
Even the keenest private equity funds find it difficult to turn a profit in their five- to seven-year investment cycle. Both local and foreign investors need strong ties to the government to get licences and approvals for key parts of their business. If, for example, a hospital operator wants to purchase a linear accelerator to conduct cancer treatments the machine needs to be approved and licensed by regulators. Depending on the scope of the equipment and facilities, the State Council has been known to get involved.
However, analysts anticipate that Beijing will have to address these constraints, given how serious it is about attracting investment into the sector.
It must start by incentivising foreigners. Most importantly, the government should allow for-profit, private hospitals to operate without restrictions on pricing and be allowed to charge what they wish for services based on free-market principles. This is the only way that hospitals can charge enough to improve facilities and cater to a growing middle class. As Chinese citizens become wealthier and more urban, the country’s top 30%-40% can begin accessing better private care, predicts Ng.
To attract clientele, private hospitals should also be allowed to install professional management committees to implement changes, instead of the current system where hospitals are overseen by local community leaders. While they do need the support of the local community, to become commercialised also requires a business-focused management team. In addition to keeping the community’s best interests in mind, such a team should also have the ability to introduce new products and services into a hospital’s portfolio to drive innovation.
As the healthcare industry liberalises, it will be possible to create hospital chains that serve a wider client base without restrictions on price and services.
Railways
China’s railway sector may have been under the spotlight due to Liu’s arrest and conviction, but it’s among the country’s more appealing growth sectors as China seeks to accommodate one billion increasingly urbanised travellers.
Real opportunities exist for private companies to get involved now that the central government has split the MoR.
In terms of capital-raising, the MoR historically was the only state agency outside the Ministry of Finance able to sell its own bonds. The privatised China Railway Corporation (CRC) segment will be responsible for that issuance as part of a broader array of structural changes announced on March 10.
The new arrangement raises questions over the MoR’s reported Rmb635 billion long- and short-term outstanding bonds. As the central government will no longer be compelled to guarantee that debt, the likelihood is that Beijing will have to continue guaranteeing the initial bond batches to ensure their success.
To attract investors, analysts expect the CRC to pay a hefty premium when it issues its next bonds.
“It’s a top priority for the government to push for the development of the railway network because railways have better energy efficiency than other modes of transport, and that means more investment will be going into this sector in the future,” Patrick Xu, a research analyst at Barclays, told Asiamoney at the time of the MoR’s breakup.
Among the MoR’s most recent debt sales were Rmb20 billion of seven-year bonds and 20-year bonds sold in October 2012, paying respective coupons of 4.57% and 5.11%. The CRC is likely to have to pay 20 basis points (bp) to 30bp more than this for future issues.
The CRC’s first domestic bond sale – a Rmb20 billion five-year bond sold on May 23, which offered a coupon of 4.5%, according to Dealogic – has yet to reflect this premium. This is because the agency has essentially shifted from being a government agency to an SOE organisation. But as investors begin to see more private participation in the railway sector, the prices will begin to shift, while still getting a fair amount of support.
“Ultimately the new issuer will have to strike the balance of paying more for financing on their own without the MoF guarantee,” said a China credit analyst assessing the MoR’s break-up. “But there will be a lot of support for the railway industry by the government early on, and investors can be confident they will repay their debts.”
The new company is also likely to reach out to the private sector for contract work in areas ranging from equipment, advertising, infrastructure, technology and engineering. The MoR reportedly relied on SOE support for these services in the past, and these relationships ultimately tarnished the MoR’s reputation. The State Council is not looking forward to letting it happen again, and private companies with the requisite expertise could be the beneficiaries.
Experts believe that there are two possible directions the railway industry will take. The first emulates Japan’s system, which has seven railway companies that each own their own infrastructure and assets. These companies independently operate in different regions of the country, and two are listed in Tokyo.
The second is the UK’s model, which has private railway companies bid to use state-owned infrastructure and railroad tracks.
Both options mean private companies will have an opportunity to develop railway businesses, and may give railway SOEs an opportunity to list, extending the opportunities for private participation.
The Japanese model seems easiest for China to emulate. The CRC now has 17 regional bureaus managing the country’s railway system. These could feasibly be divided into 17 companies with the autonomy to contract private companies to provide operational materials. They can also become listed eventually, which would help the railway industry to diversify its debts and create new avenues for long-term financing.
Private practice
The three industries highlighted here offer just a taste of the opportunities available to privately owned enterprises in China, provided the country’s new leadership lives up to its words.
The break-up of the MoR earlier this year is an encouraging sign that Beijing is willing to restructure select industries. Cracking down on corruption also offers POEs more opportunities. Most economists Asiamoney spoke with predict that the dominance of provincial SOEs will wane in the coming three years, with only central government SOEs enjoying the clout they currently have in five to seven years’ time. Many predict the Xi and Li administration will achieve SOE reform during its 10-year rule.
It’s vital that such predictions are accurate, as cronyism among Party officials and state companies is reducing the effectiveness of the country’s economic heft.
“If China is not successful at this and SOEs continue to have too much power then it’s possible for everything to start falling apart. It’s a step that needs to be taken, and at least there’s a real feeling that the administration is willing to do what is needed,” says Jefferies’ Yu.
Xi and Li are saying the right things, but cutting the country’s SOEs down to size will take years of effort against entrenched opposition. It’s to be hoped both men have the determination to keep to their tough talk. China’s future economic well-being depends on it.