Global Market Commentary

August 28, 2014

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China Deepens Reform and Privatization of State-Owned Enterprises

We wrote a few weeks ago that events in China show Xi Jinping decisively consolidating his power — specifically, the downfall of Zhu Yongkang, a former member of the Politburo Standing Committee and the most powerful politician to be investigated for corruption in the history of the People’s Republic. The fact that Xi’s anti-corruption campaign could sweep up such a figure meant to many observers that Xi felt confident against his opposition.

We noted that Xi might therefore be ready to move on to other reform plans, now that the reins of power are securely in his grasp. We got further evidence recently in the announcement of a new set of proposed reforms to the ownership and governance of state-owned enterprises (SOEs) in China.

China National Building Materials Group Is One of the State-Owned Giants Undergoing Pilot Reforms
China SOE










If these reforms go ahead, they could be instrumental in reinvigorating a large part of the Chinese economy — and could be a boon for Chinese stocks.

Past Efforts to Reform SOEs

In the late 1990s, China began the process of privatizing its SOEs by floating minority stakes. Another part of ongoing SOE reform in the late 1990s and early 2000s was described by the slogan, “Grasp the large, release China National Building Materials Group Is One of the State-Owned Giants Undergoing Pilot Reforms the small” — which meant that the state should retain control of the largest enterprises, while privatizing or liquidating small, poorly-performing state firms. This policy lasted until 2003.

Since then, however, the government has backed away from those plans — especially during the 2008 financial crisis and its aftermath. During that period, SOEs became a preferred means for the central government to stimulate the economy. Loose credit also encouraged many SOEs to become even more bloated and inefficient.

Currently, according to analysts, SOEs in China average a 4.6 percent return on assets (ROA), while private companies average 9.1 percent.

The numbers are even more dismal when one distinguishes between SOEs that are controlled by the central government, and those that are controlled by local governments. Non-financial local government SOEs have an average ROA of just 1.2 percent.

China is facing a secular slowdown in growth after the boom times that followed economic liberalization in the 1980s. The leadership knows that too sudden a deceleration in growth could lead to serious problems — including social unrest. To maintain its power, the Chinese Communist Party is reaching for all the pro-growth tools it can. The inefficiency of the SOEs noted above presents appetizing low-hanging fruit for a government eager to maintain growth.

The New Push

If SOEs can be reformed so that their return on assets closes even part of the gap with their private peers, that will be a significant accomplishment for the government.

How will they try to do it? The current reform effort has two components, focused on two distinct goals.

First is an effort to shift the governance of SOEs controlled by the central government. That governance is widely perceived — accurately, we think — as being more concerned with the central government’s economic objectives than with the maximization of shareholder value. The central government is aiming to shift this perception by making the governance of its SOEs more independent, and is experimenting with two means for doing so. One would transfer the government’s stake to dedicated capital management holding companies, which
would be politically insulated from policy pressures and able to concentrate on performance. The other would allow the companies’ boards of directors, rather than the central government, to appoint senior management.

Again, the overall goal is to make these companies less policy instruments, and more profit maximisers. If that goal can be accomplished, it may make the publically floated portion of these companies more appealing to the market. (In our opinion, this will take a long time to accomplish.)

In the case of SOEs that are majority-owned by local governments, though, there is another dimension to the new privatization push: dealing with the overhang of local debt.

Privatizing Local SOEs to Deal With Local Debt

Constant fears of a “hard landing” and an ensuing crash of the China’s financial system have been because people focused on the high debt levels taken on by localities over the years. As we have written before, we have not been worried about an eventual banking collapse in China, because we believe that the closed nature of the Chinese financial system, and the ample firepower of the People’s Bank of China, would be able to contain a financial crisis.

Nevertheless, we noted that much of the stress on China’s financial system has come from the over-leverage of local governments. Various methods have been employed by the central government to transfer that leverage from localities to the central government, particularly in the property sector. But finding new methods has become more pressing, especially as the central government’s policy goals are towards the liberalization of interest rates so that the Yuan can ultimately be more integrated into the global financial system.

The current move to float stakes of locally-owned SOEs falls into the same category. Local government debt currently stands at about $2.7 trillion, or 58 percent of China’s GDP. Selling stakes in their SOEs will help localities pay down some of that leverage.

This push for selling stakes in local SOEs is not entirely new — even before the recent announcements, Shanghai, Beijing, Guangdong, and Chongqing had announced that they would be privatizing portions of their SOEs. In the case of Shanghai, more than 60 percent of its SOEs would be opened to some level of private investment.

Local SOEs May Be Greeted With Skepticism

However, as we noted above, local SOEs have been weak and inefficient economic performers — even worse than the central government SOEs. Maybe the governance of local SOEs will eventually shift to mirror the changes being pushed for centrally-owned SOEs, but we doubt it. In our view the market will not look favorably on the shares of newly public local SOEs — because there is no guarantee that there will be any new governance to improve their performance. Will foreign investors be eager to own a stake in these companies through
opaque local government finance vehicle (LGFV) holding companies? The answer is no.

Still, we’re encouraged by the continuing incremental reform efforts. Central-government SOEs — the titans of the Chinese economic landscape — are cheap compared to their global peers, and for good historical reasons. If we see these reform efforts maturing, our interest in Chinese shares will increase.

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