China economist, DBS Bank

After a decade of stagnation, state-owned enterprise reform in China is picking up. The last major overhaul was in the late-1990s, when then-Premier Zhu Rongji oversaw the dismantling of tens of thousands of SOEs. Around 30 million workers were laid-off. As weak SOEs exit the market in swathes, the average performance of those remaining rose sharply.

For the past 10 years, the government has been reluctant to allow SOEs to shut down or change ownership. Some officials have kept SOEs from going bankrupt in order to preserve government reputations. As a result, SOEs are increasingly inefficient and unprofitable. In the first half of 2014, one-third of central SOEs and half of local SOEs experienced declining profits or suffered losses.

What’s different from previous rounds?

While previous rounds of reform have resulted in a substantial decline in the number of SOEs, the current round is less about reducing the number than about improving efficiency.  Reform in the nineties centered on the principle of “grasping the large and releasing the small”, meaning that small and inefficient SOEs would be let go, leaving large ones in state hands. The current round of reforms would affect large enterprises as well; a pilot scheme announced by the top state-asset regulator in July has identified six large SOEs slated for reform.

A key feature of this round of reform is mixed-ownership, which can go both ways — private companies investing in SOEs, or SOEs investing in private companies. However, current reforms go beyond mixed ownership. Only two of the six large SOEs named in the pilot scheme will participate in the mixed-ownership program. The rest will also undergo reform but without privatization.

This round of reform will likely include more varied elements, such as giving SOE boards of directors more authority to appoint personnel, improvements in corporate governance and modernization of management systems. Ultimately the aim is for the state cede of control — not just ownership — of enterprises.

There is no one-size-fits-all strategy. More than 20 provinces have announced detailed plans for SOE reform, each with unique goals and initiatives.

Guangdong Province is aiming to increase the number of mixed-ownership enterprises to over 70 percent by 2017. Shanghai is aiming to concentrate 80 percent of state capital in four strategic new industries.

What to privatize?

There are currently 155,000 SOEs in China in virtually all industries. Given the complicated landscape, classification of SOEs helps identify those likely to be reformed first.

The most important classification is whether an SOE is in a strategic or non-strategic industry. A spokesperson from the State-owned Assets Supervision and Administration Commission (SASAC) has made it clear it does not want to privatize SOEs in strategic sectors, such as aviation, power and telecommunications. It would, however, invite investors to buy stakes in non-strategic SOEs. Government ministries are still deciding exactly which industries are and are not “strategic.”

In the event, privatization in non-strategic industries is gathering speed. An example is the Shanghai government’s 12 percent stake sale of Jin Jiang Hotel to a Chinese private-equity firm. The potential of privatizations in the non-strategic sectors should not be underestimated. As of 2011, 49 percent of China’s SOE assets were in non-strategic sectors, with some 80,000 SOEs so classified.

The second form of classification is central versus local SOEs and it is related to the first. Many of the 113 SOEs under the direct oversight of central SASAC are operating in strategic sectors. On the other hand, many local SOEs operate in non-strategic sectors.

A third type has to do with whether the SOE provides a public good. The state cannot feasibly stop subsidizing SOEs whose primary goal is to provide goods and services to the public. The Third Plenum’s sixty-point decision document stated that SOEs should focus on the provision of public services. Put another way, the state would retain control of companies in which it has comparative advantage over private owners. In line with this suggestion, Beijing’s SOE reform plan stated that more than 80 percent of state capital should be concentrated in public services by 2020. This means that privatizations of such SOEs are unlikely, although reforms to improve efficiency will be pursued.

In short, the current round of reforms is likely to proceed the quickest in local SOEs that operate in non-strategic sectors and are not involved in the provision of public goods.

Success is a cooperative outcome

One challenge to SOE reform is private enterprises’ willingness to participate. Company ownership and control are often separated. Investors may benefit from reform but have limited sway in management decisions.

The second concern relates to dividend payouts. It is unclear whether ownership would necessarily result in fair dividend payout or profit sharing. Existing profit sharing arrangements in SOEs are often opaque and accounts are unsystematically organized.

Private investors need to be comfortable with the fact that they can share the economic benefits of their investment, otherwise they will have little incentive to invest.

Third, some CEOs may worry that the sale of non-core subsidiaries could lead to accusations that they sold state assets cheaply, or even misappropriated them.

In the past, some parties who participated in SOE reforms found themselves in jail for misappropriating state assets.

Clarity in procedure and intent is needed for successful asset sales.

The state’s sales strategy is a key determinant of reform success. If the state is willing to put high quality assets up for sale, private enterprises would participate more actively, thereby smoothing out the reform process.

The potential for improvements in economic efficiency depends on the state’s willingness to relinquish control and private investors’ determination to introduce change. Reforms succeed best when public and private sectors see eye-to-eye on the ultimate objective. As economic growth slows and fiscal pressure on local governments mounts, pressure for accelerating reform will intensify.

As with most reform, resistance by vested interests may be strong. After a decade of stagnation, any amount of SOE reform will be an improvement.