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Watershed era looms for state-owned companies
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THE central objective of China’s ambitious reform plan is to let the market play a decisive role in allocating resources and improving overall efficiency. Reforming state-owned enterprises (SOEs) is widely considered to be one of the most important pieces of this plan.
SOE reform is not only key to sustained macroeconomic growth and financial stability, but it is also important for improving corporate profitability, and, given that SOEs account for more than half of the market cap in the A-share market, the performance in the Chinese equity market.
While it is common to equate SOE reform simply with privatization, we think the transformation of SOEs includes changes in corporate governance, operational independence, incentive systems, budget constraints and the operating environment. The latter reforms can help improve SOE performance significantly without massive, outright privatization.
In the next couple of years, large-scale privatization is unlikely in China, given the continued focus of public ownership as a cornerstone of the current political system.
The probability of mass SOE restructuring and bankruptcies is also low, given the importance of maintaining economic growth and social stability. The Communist Party of China will likely retain the power to appoint the heads of large SOEs, and SOE budget constraints may not really be “hardened” because the government and banks remain the “supporters of the last resort.”
Meaningful progress
Nevertheless, we do expect meaningful progress in the following aspects of SOE reform: developing “mixed ownership” structures, divesting state assets, increasing dividend payments and transitioning to a more market-based operating environment.
• Developing “mixed ownership” structures among SOEs, in essence, means partial privatization. This can take different forms, including initial public offerings of unlisted state-owned assets, selling certain assets to specific private owners and increasing private ownership of listed companies.
For different firms, these measures could pave the way for one or all of the following: adjusting the incentive structure for management since “mixed ownership” companies are allowed to link compensation with company performance; focusing more on shareholder returns; improving profitability by getting rid of low-return assets; lowering debt leverage; and obtaining private capital.
• Divesting state assets could mean getting rid of non-core business operations to improve core profitability, retiring some excess capacities and lowering debt leverage through sector consolidation. At the local level, it could mean monetizing state assets to help local government finances. Such measures would also help reduce bad debts and benefit the banks as well.
• Moving to a more market-based operating environment could involve factors such as price reform and the introduction of market competition. The first factor could point to adjusting energy and utility prices, and to interest rate liberalization — measures already underway to reduce implicit subsidies to some SOEs and help reorient the economy. The second factor points to opening up certain sectors to private and foreign competition, and to leveling the playing field between SOEs and non-SOEs in terms of access to resources and markets. There will clearly be both winners and losers in these reforms.
• Increasing SOE dividend payments gradually in coming years should not only help increase local and central government revenues, but also should help improve SOE governance as retained “free” cash is reduced and spending is more scrutinized. The latter may lead to lower capital spending and less build-up of excess capacities as well.
How might these types of SOE reforms in China affect overall economic performance and the equity market?
For investors looking for large-scale privatization and mass SOE restructuring, gradual and piecemeal SOE reforms will unlikely be perceived as “game changers” for either the economy as a whole or the SOE sector in particular.
Nevertheless, these reforms can help improve corporate governance and incentive structures, cash flow and profitability, and competitiveness. Therefore, at the company and sector levels, there could be interesting and significant opportunities for investors. Of course, reforms could also expose problems in some SOEs and lead to consolidation in some areas.
Specific reforms
We think investors should focus on regions and sectors where SOE reforms may move faster, and on specific aspects and opportunities in these areas.
For example, the government is pushing forward with reforms in the petrochemical sector, which may be followed by reforms in the energy sector of oil, gas and power. Prices are being adjusted to better reflect market forces, and private and foreign companies will be allowed more investment opportunities in energy and petrochemicals.
In the railway and other transport sectors and in public utilities, the priority may be to adjust prices and introduce public-private partnerships. In competitive industries or those with excess capacities, the focus may be on divesting and restructuring assets. So far, regions such as Shanghai and Guangdong have already released specific plans for SOE reform and initiated the first steps, while other provinces are expected to finalize their plans in the coming months.
We expect SOE reform to be a recurring theme in the coming months and years.
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