China’s government has long come under criticism for the strength of its state-owned enterprises (SOEs). Analysts and economists say the dominance of these companies is actively inefficient and promotes the poor allocation of capital.
For years such criticisms fell on largely deaf ears, particularly when the 17,000 SOEs were used as engines of economic growth and stabilisation following the 2008 global financial crisis.
But under Xi Jinping, SOEs have lost their hallowed status. In November 2013’s Third Plenum the government discussed introducing a “diversified ownership model” to SOEs, a euphemism for limited privatisation.
These plans have led to Sinopec’s decision to sell a third of its petrol station operating subsidiary. It had drawn interest from 37 potential buyers according to chairman Fu Chengyu in late August. Plus the country’s telecom companies are seeking to combine their tower assets to create a new company for privatisation before year’s end, as part of broader efforts to deregulate the sector.
Then on August 30 China’s Politburo passed reforms cutting the salaries and perks of top executives at SOEs by 50% or more, according to the South China Morning Post, with government executives slated to become more members of the board of directors and professional managers employed to handle day to day operations. SOE reform is truly getting underway.
The change of heart over SOEs is down to the desire of Xi and his advisers to make progress in two areas: corruption, and economic growth.
The Chinese Communist Party’s ultimate legitimacy relies upon its ability to keep making its people more prosperous. But its very monopoly on power has led to endemic abuse of power and corruption. China’s SOEs are deeply enmeshed within this. Many are effective monopolies or oligopolies over important state sectors. The officials running these companies are often as powerful – if not more so – than government ministers.
Added to this, over the past six years the SOEs have rapidly grown on the back of enormous amounts of cheap money from the state banks. They were given this to keep China’s economy on track, but while investments and acquisitions have abounded, it has come at the cost of balance sheet health. Many SOEs are now deeply indebted, and relatively few highly profitable.
This could be overlooked while China’s economy was still soaring, but it isn’t any longer. Gross domestic product (GDP) growth has slipped to around 7.5% - good by most country standards, yet barely above the rate needed to keep supplying enough new jobs to support the country’s increasing urbanisation.
Xi is well aware of these issues. He has made an anti-corruption drive core to his government, which has announced plans to reform the country’s SOEs, increasing private ownership and spinning off non-essential assets.
These sound like good moves that could add a fillip to China’s economy if applied with enough zeal. But there lies the sticking point. Beijing’s reluctance to diminish its oversight of its companies could limit the effect of its reformist efforts.
Changes coming
Beijing’s SOE reforms efforts to date have revolved around improving management incentives and spinning off non-essential divisions of core players.
The State Assets Supervisory and Administrative Commission (Sasac), the national agency tasked with overseeing China’s state companies, is broadly pursuing three types of SOE reform. The first involves placing state companies into national investment management companies, much like Temasek of Singapore. So far the State Development and Investment Corp. and the China National Cereals, Oils and Foodstuffs Corp. have been prepared as the first two organisations to become asset holding companies. Others will likely emerge.
The second will encompass SOE companies selling large stakes of themselves or subsidiaries to private companies, asset managers and private equity funds. The third involves changing select SOEs’ management structure, and introducing performance reviews and compensation changes such as options.
The plans sound progressive, but the sheer scale of SOE involvement in China’s economy will limit its impact, even if rolled out across all SOEs.
“If you include all banks and telecom companies, SOEs contribute close to 50% of China’s market cap and GDP,” says the head of China research at an international bank. “These companies fundamentally support the Communist Party’s rule. And you cannot really change them; they are just too big.”
Companies like China Mobile, the world’s largest mobile company or ICBC, the world’s biggest bank are too strategically for the Communist Party to turn over to private sector control. They are expensive too; China Mobile has a market capitalisation of HK$2.01tr ($259.34bn).
So Sasac is pushing large SOEs to sell large stakes in particular divisions, sometimes after a restructuring. One example of this is Beijing’s Sinopec’s budding sale of one third of its retail division; another the creation of a telecom tower company. The hope is that such SOE units will have substantial stakes of 30%-50% sold to private hands. Analysts hope Beijing will sell even more.
“It makes sense for the government to gradually decrease its stake down to 30% and give minority shareholders the power to choose a chairman and make it more responsible to shareholders than under government management,” says the head of research. “They are likely to become more profitable afterwards. That’s one big reason why Guangdong is the most profitable province in China.”
These plans make sense, given historical precedence. In the 1990s the government reduced its ownership in a number of Guangdong-based companies after it announced plans to liberalise the province’s economic controls. One example is Gree Electrical Appliances, a home appliance company in China that is now 64% owned by the Zhuhai government in Guangdong. Gree has been subject to the recent reform efforts too; in February the government of Zhuhai’s Sasac transferred Gree’s 51.94% stake in Gree Real Estate to a new company that it operates.
A heavy hand
But private companies rubbing their hands at the thought of buying SOE assets had best be careful.
It will take time to select and sell stakes. And there is no guarantee at the end of it that private owners will get as free a hand as they would want to bolster profit and efficiency in these companies.
China’s SOEs are notoriously overstaffed, partly as a means to minimise unemployment in China and therefore social unrest. Even as Beijing slowly divests its majority position in some SOEs or SOE units, it will likely insist that any attrition in the staff rate is limited, perhaps at only 1% or 2% a year.
“Private enterprises are generally more efficient than SOEs, so it raises the question why they would want to buy into them unless the SOEs are monopolies. But if they are, it’s unlikely the government will want to reduce its stake in them,” says the research head.
The likely outcome is that the state keeps a sizeable minority stake in these companies and ensures they get SOE-equivalent financing levels, giving them an advantage over purely private peers.
“In three years’ time we may see some good progress, but if the government only reduces its stake to 75% or 65% it won’t mean that much,” says the research head.
Indeed, the government should sell its stakes entirely if it wants these companies to truly be exposed to the need for efficiency. Fail to do so and the companies will in all likelihood enjoy better funding rates than their private sector rivals. They could use this to their advantage, particularly if they are already dominant in the industry.
“Managers of a former SOE could take advantage of reforms that benefit them while using their SOEs’ privileged access to bank credit to squeeze out private competitors,” says the strategist. “If this isn’t handled well it could end up creating the opposite of what is intended.”
Deregulated SOEs could also look to form cross shareholdings with other state companies, building conglomerates much like South Korea’s chaebol. This is a particular risk for the businesses being pulled into the new state management companies.
“There’s a risk that a lot of SOEs turn themselves into big chaebol type companies with the government’s blessing,” says the strategist. “We’ve already seen a few deals done in that direction.”
He points to China Mobile’s acquisition of 20% of Shanghai Pudong Development Bank in 2010 as an example of cross sector consolidation.
Embracing privatisation
China’s SOE reform instincts make sense. They are likely to throw up both acquisition and potentially listing opportunities, as well as making the management of some smaller SOEs more investor-orientated.
But in conducting these reforms Beijing should embrace privatisation whole-heartedly, retaining at most passive minority stakes in the companies it sells, and allowing the buyers free rein to cut costs after a suitable transition period. Above all it should resist the temptation to let its larger SOEs become opaque multi-sector conglomerates.
Doing so would help ensure Beijing’s SOE sector facelift adds real value to the economy. Failing could cause its reform attempts to do more harm than good.