State-owned enterprises (SOEs) are a large and ingrained part of China’s economy. For that reason, leaders have worked to improve SOE performance and reform the sector for decades. Much change has in fact occurred, but the meaning of “reform” has varied through the years. For former Premier Zhu Rongji in the 1990s, SOE reform meant consolidating state control over large SOEs and withdrawal from small ones, which contributed to private sector prosperity and a decade of economic growth. In 2006 the State-owned Assets Supervision and Administration Commission (SASAC), the central non-financial SOE owner and overseer formed in 2003, redefined SOE reform as an effort concentrated on seven key industries where the state would retain a dominant role, and nine pillar sectors where the state would “direct” development. President Xi Jinping’s 2015 SOE reform vision stresses managing SOEs based on their “core” industries: those in normal commercial industries should decrease state ownership and maximize profits, those in key industries and pillar sectors should separate commercial and strategic business lines, while those providing public services should focus on cost control and service quality.

We use China’s own classification scheme to assess SOE reform progress. For listed companies where information is available, we gauge SOE revenue relative to all revenue in three clusters: (1) key industries (defense, electricity, oil & gas, telecom, coal, shipping, aviation, and rail – a new one vaguely referred to as a key industry in recent years); (2) pillar industries (autos, chemicals, construction, electronics, equipment manufacturing, nonferrous metals, prospecting, steel, and technology); and (3) normal industries (tourism, real estate, general manufacturing, agriculture, pharmaceutical, investment, professional services, and general trade). As SOE reforms are implemented, the state firms’ share of revenue should at a minimum decline in normal industries – those that Beijing has identified as suitable to market competition as the decisive factor. To supplement this primary indicator, we look at the share of all industrial assets held by SOEs, leverage ratios at state versus private firms, SOE versus private return on assets, SOE versus private ability to cover interest payments, and the SOE share of urban employment.

Quarterly Assessment and Outlook

Though our quantitative outcome indicators do not show SOE reform progress in 2Q2017, the volume and quantity of policy movement was impressive and may foreshadow future progress. Reformists looking for market competition to break down SOE monopolies are contending with conservatives pledged to “direct” the market. New rules on corporate governance help tip the balance to shareholders, allowing more transparency and potentially better corporate strategy. The reality of financing constraints showed up in President Xi’s declaration that SOE debt levels were the top priority at mid-summer, making the prospect of meaningful reform implementation in the sector more likely. If financial realities, 2Q2017 policy moves and mid-summer political commitments all line up, the question is whether “mixed ownership” plans – the so-far disappointing strategy for implementation – will continue to be the main reform, or if a more market-oriented approach will be adopted.

Though our quantitative outcome indicators do not show SOE reform progress in 2Q2017, the volume and quantity of policy movement was impressive and may foreshadow future progress.

This Quarter's Numbers

Our primary SOE reform indicator offers a mixed picture. The SOE revenue share in “key industries” bounced back slightly from a 78% low in 4Q2016, reaching 81% in 2Q2017. Both “pillar” and “non-strategic’ SOE revenue shares were stable, at 49% and 17% respectively. Overall, this implies no real SOE reform progress on the ground.

The increase of SOE key industries’ share is no surprise. Since mid-2016 the biggest force affecting market financials has been supply-side structural reform and capacity cuts in steel and coal, which have driven up commodity prices in upstream industries and pressured margins downstream. Coal prices were particularly strong, nearly doubling SOE revenues in this sector. In addition, SOEs have been more active in rail and shipping this year. In all of these industries, private firms are struggling with tighter investment rules and rising financial costs more than their SOE cousins, although these factors have flattened out as the year progressed.

The flat revenue shares in both pillar and normal industries suggest that higher prices upstream are affecting SOEs and non-SOEs similarly, in the aggregate. At the individual industry level, non-state firms are outgrowing SOEs in higher tech and consumer-facing pillar industries (e.g. electronics, equipment manufacturing) and non-strategic industries (pharma, real estate, tourism, professional services). However, unlike in early 2014 when we clearly observed declining shares for SOEs in normal industries, recent SOE mergers and mixed ownership initiatives have not impacted the market structure yet, as seen through revenue shares.

Our supplemental indicators provide more perspectives on SOEs and private firms. Industrial Assets by Ownership adds to our revenue story shown in the primary indicator. The SOE share of assets has barely changed over the past few years. The only period of decline was in late 2014, which likely resulted from a reclassification into the hybrid shareholding corporation category. Meanwhile, SOEs are taking on significantly more debt than private and shareholding corporations, with debt to assets ratio steady around 60% while private firms are de-leveraging (see SOE Leverage).

SOEs continue to be much less efficient than other players (see SOE Return on Assets). Even recent capacity cuts in sectors such as steel have only improved SOE return on assets by 0.5%, compared with a much more dynamic private sector, suggesting that the SOEs are still not reacting to market forces the way leaders hoped. As a result, SOEs still face higher risks in servicing debt, with average net income just 3.7 times debt interest payments, compared with 11 times for private firms (see SOE Interest Coverage). As the annual data in SOE Share of Employment reminds us, SOEs have for years been declining as a share of employment, even while their share of assets and burden on debt levels holds steady or worsens.

Policy Analysis: 2Q2017

Important SOE policy reform developments occurred in the second quarter, even if these have not yet translated into outcomes. In 2015-16, SOE reform largely stalled despite frequent SASAC announcements on paper. Weak market conditions, priority attached to target GDP growth numbers, and emphasis on stability left limited space for SOE reform other than a handful of government-directed mergers. Starting late last year, supply-side structural reform policies (not limited to SOEs) pushed up commodity prices, improving profitability for some SOEs. This year reform has centered on the concept of “mixed ownership,” the implementation of which became clearer this quarter.

In March, Premier Li’s 2017 work report committed “actual steps” of reform in electricity, oil, natural gas, rail, aviation, telecom, and defense (all key industries, except for coal). Specifically, the report urged reform of electricity and oil & gas, including opening up the commercial business niches of these industries. Multiple steps have since been taken in this direction:

  • On March 31, National Development and Reform Commission (NDRC) Vice Chairman and key Party economic advisor Liu He chaired the Commission’s annual meeting, pledging to publish all reform plans by June and implement them before the October Party Congress;
  • On April 21, China National Cereals, Oils and Foodstuffs Corporation (COFCO) announced a sale of 50% of its financial subsidiary – a demonstration of rationalization and restructuring;
  • On April 22, the NDRC approved the Aviation Industry Corporation of China’s restructuring plan for its logistic business, a third example of restructuring in the aviation industry (after Eastern China Airline’s deal to sell 55% of its logistic business to private investors initiated in October 2016 and China Southern’s strategic alliance with American Airlines signed in March);
  • On May 23, the State Council issued an oil & gas reform plan, including steps to open prospecting and distribution to competition and adjust the pricing mechanism;
  • In telecom, China Unicom unveiled a mixed ownership plan in August, garnering considerable market attention as an important demonstration for the so-far vague mixed ownership initiative.

The State Council separately focused on the question of SOE corporate governance in a May 3 document. The guidance addresses the delegation of power to SOE boards of directors, adds checks by external directors, and requires Communist Party involvement in company affairs to be defined in corporate articles of association. Related to that, the document committed to restructure all central SOEs as standard corporations by the end of 2017. With only 30 out of 99 SOEs “corporatized” in this way as of 2Q2017, this goal looks ambitious. If successful, these steps will improve corporate decision making and better define incentives to guide SOE behavior. This development was then strengthened by another State Council document a week later, which clarified SASAC’s role as focused on managing state capital instead of specific firm assets. This follow-up document delegated 43 specific responsibilities to the corporate or provincial level, covering areas from restructuring to management recruiting. This opens the door to many possibilities for firms to make their own decision, although SASAC retains the power to direct capital resources where it thinks fit (and not necessarily to maximize returns).

Finally, under SASAC’s new assignment in managing state capital, on June 3 SASAC put out new classifications for the SOEs under its management. The new classification includes “about 50 industrial conglomerates, at least 20 investment companies, and 2~3 operation companies.” Specifically, “industrial conglomerates” should be concentrating on key and pillar industries and pursuing vertical integration (oil, electricity); “investment companies” should invest in multiple industries and explore strategic emerging industries (CDIC Group, China Merchants, COFCO, Poly Group); and “operation companies” are the ones seeking to maximize returns on assets through capital allocation (Chengtong, China Reform Holding). SASAC insisted that these classifications were consistent with the “commercial and public welfare” classifications previously announced, but it is unclear how the two classification systems interact, how SOEs leaders in different industries will be evaluated, and how to reconcile the various schemes that are on the table. Importantly, counting the number of firms implied by SASAC’s new classification system suggests that there will be about 80 SOEs in the future system, compared with 99 SOEs in 2Q2017. More SOE consolidation therefore appears to be coming.

Explore the Reforms

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