CKGSB website

CKGSB Knowledge

SOE Reforms: Why it is Better to go Slow

by Major

September 30, 2015

Risk

Reforming SOEs in China is a gradual process requiring thinking through before actual implementation. Any attempt to speed up implementation can have devastating consequences.

On September 14, China’s State Council released a guideline document on deepening reforms of state-owned enterprises (SOEs). The plan called for, among other things, diversification of ownership and improvement of corporate systems—principles already laid out during the Communist party’s Third Plenum back in 2013.

There are few quantifiable reform targets or timetables; instead, the document stresses upon the importance of not rushing through or forcing any immature reforms.

While the plan underwhelmed many observers who expected a more radical privatization agenda, it is a reflection of the ideology of Chinese President Xi Jinping, anonymous government advisers and officials told The Wall Street Journal.

As Party Secretary of Shanghai, Xi witnessed the successful transformation of SAIC Motor, a state-run carmaker in the city, and came to the view that SOEs should remain the cornerstone to the Chinese economy, officials told the newspaper.

The conservative approach to reforms also derives from concerns that a rapid and thorough privatization could result in economic and social woes for China, according to experts.

Tighter Control

When well-known TV journalist Chai Jing released her documentary Under the Dome in March, she received as much criticism as praise from the public. The documentary, which highlighted the devastating impact of air pollution in China, called for an end to state monopolies in the energy sector as a solution to combat the problem. The logic is that if private developers were allowed to conduct exploration, China’s oil and gas production would surge, replacing coal as China’s cleaner source of energy.

But naysayers are quick to point out: “Look at what happened when the coal industry was privatized in the 1980s.” What they are referring to is tens of thousands of substandard coal pits that brought astronomical wealth to their irresponsible private owners at the cost of the environment and human lives.

In 2013, Beijing ordered a full-scale shutdown of such mines and SOEs were asked to take over—a classic example of how privatization could go awry.

“[Privatization] would improve corporate governance only if private shareholders were better able to hold management to account than China’s current system,” says Leslie Young, Professor of Economics at Cheung Kong Graduate School of Business, adding that China’s weak legal framework does not have sufficient strength to support better corporate regulation.

He adds that China’s immature business institutions would allow the wealthy and well-connected to also loot state assets in a “Big Bang privatization” scenario, as we have witnessed in Russia and other eastern European countries in the 1990s.

“The rapid privatizations simply made enormous profits for the Western companies and private equity investors that bought up and stripped eastern Europe’s SOEs,” says Salvatore Babones, Associate Professor of Sociology at University of Sydney. “China’s current leaders must be aware of the long-term economic dependency that this generated.”

Therefore, instead of risking losing control, Beijing has opted to fix the management of SOEs through the Party.

Diversification Dilemma

According to government mouthpiece China Central Television, between 2013 and 2015, more than 80 SOE executives have been disciplined for wrongdoings. Beijing’s anti-graft campaign has been relentlessly going after SOEs this year—since March, the Party’s discipline inspection commission started examining 26 SOEs controlled by the central government, and dozens of senior executives have been reportedly taken down, including some in the most powerful monopolies like Petro China. The fallout can be big: at Petro China half of the Party committee members have been taken down.

“The political functions of Party organizations should be given full play in SOEs, and their role in the corporate governance structure should be clarified lawfully,” the guideline says.

While tightening the grip can curb delinquency in the short term, the arrangement might discourage private businesses to participate in the ownership diversification campaign that Beijing is trying to promote, as more Party influence will run the risk of further weakening the voice of minority shareholders.

“Most private business leaders feel that they would be powerless on the boards of mixed-ownership companies,” wrote Yukon Huang, a Senior Associate at the Carnegie Endowment for International Peace, in Financial Times last year. “Interest in becoming a partner in such undertakings is tepid except when valuable assets are up for grabs and participation is more likely to be a wealth transfer to the well-connected.”

The lack of interest in working with the state is being reflected in another area of reform that Beijing is pushing forward—the Public Private Partnership initiative, or PPP. Since central regulators have heavily cracked down on the shadow banking sector, local governments face the challenge of raising enough capital to finance large infrastructure projects, and introducing private investors will effectively lower their financial risks.

However, the implementation of PPP initiatives is not always smooth.

“Many private enterprises are not very [excited] about PPP” because the returns are not attractive enough or they have concerns about engaging with local governments, said Wei Jianing, a research fellow at the Development Research Center of the State Council, during a recent CKGSB economic forum. According to Wei, to make the model work, more reforms are needed to strengthen the rule of law and ensure equal partnerships between the government and private businesses.

Fiscal Uncertainty

Even if private investors are enthusiastic about owning a part of an SOE, there are strict limits on how much they can buy, given the worries described above. The state is only going to give up its controlling stake in companies operating in those “sufficiently competitive” industries, the document says, and it should remain the controlling shareholder in companies that have to do with public service, national security and “lifelines of the national economy”.

There are no details on the classification of industries so far; officials at the National Development and Reform Commission (NDRC) told the press recently that a more specific plan would be released as early as the end of the year. However, analysts believe that Beijing is unlikely to give up control in sectors such as finance, education and telecommunications, where financial returns can be appealing.

Logically, maintaining control in lucrative SOEs is important to keep Beijing’s fiscal revenue stable. The only quantifiable target in the reform plan is to raise the share of profits that SOEs have to turn in to 30% by 2020 from the current average level of 20%.

However, the central leadership still hopes that market-driven adjustments will keep SOEs profitable and competitive. Chinese Premier Li Keqiang recently said during a State Council meeting that SOEs are “in urgent need of reforms as languid mechanism and poor management have resulted in declining profits”.

In 2014, SOEs’ return on assets (ROA) stood at about 4.6% on average, only half of private companies’ 9.1%. In the first half of 2015, revenues of SOEs dropped 5.8% annually, while profits declined slightly by 0.1%, according to China’s Finance Ministry.

So the conundrum is to promote just enough privatization that can motivate managers and encourage market-driven decision-making—but not enough to threaten the dominant role of the Party.

Stability Concerns

The other worry that comes with large-scale privatization is mass unemployment—a not so distant memory that still haunts millions of working class families.

During the 1990s, the reformist former Premier Zhu Rongji embarked on a broad privatization movement of SOEs; numerous factories and their affiliated institutions, such as schools and hospitals, were shut down or sold to private owners, causing the loss of tens of millions of jobs nationwide.

While the process is believed to have laid the foundation for a more robust private sector to emerge later, the social and political risks it brought along with it continue to spook policy makers today.

According to Xinhua News Agency, China still has roughly 150,000 SOEs, which employs more than 30 million people across the country. The reform guideline does mention that “a batch” of SOEs could be merged, and “a batch” could be eliminated, especially in areas with severe over-capacities; but analysts believe that the scale of such elimination will be very limited, as the slowing Chinese economy is already exerting pressure on the labor market and worker unrest is on the rise.

“It’s unlikely for SASAC (State-owned Assets Supervision and Administration Commission) to eliminate an SOE; it’s more likely to happen to lower-level subsidiary companies,” analysts from Sinolink Securities wrote in a report.

Given the reasons above, China’s SOE reform is meant to be a gradual process; and before Beijing has enough faith that further privatization will serve its national goals, “it’s better to play it safe,” says Babones.

You may also like

Leap of Wealth

Becoming a billionaire in China is eminently possible, but maintaining a top spot is becoming increasingly difficult.

by Faye Bradley | Sep. 23 2021

Special Delivery

Chinese logistics companies are beefing up efforts to apply unmanned technology to logistics and delivery activities.

by Mark Andrews | Sep. 23 2021

Bolstering the Base

Making state-owned enterprises more efficient while allowing them to retain their crucial policy role is one of the biggest challenges that.

by Major Tian | Sep. 23 2021

Green Shoots?

Can China kick its decades’ long coal addiction in order to meet its ambitious climate targets.

by Crystal Wilde | Sep. 23 2021