State-owned enterprises (SOEs) are a large and ingrained part of China’s economy. For decades, leaders have worked to improve SOE performance and to reform the sector, though 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 withdrawing 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), China’s central nonfinancial SOE owner and overseer, 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; 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 sector 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, pharmaceuticals, 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 vs. private firms, SOE vs. private return on assets, SOE vs. private ability to cover interest payments, and the SOE share of urban employment.

Quarterly Assessment and Outlook

Our quarterly assessment of SOE reform remains negative, the same as the last period. While the 2013 Third Plenum pledged that the state would remain a player primarily in public service and natural monopoly sectors, SOEs still dominate many sectors where the market was planned to play a larger role. The SOE share of revenue in normal industries showed almost no change this quarter, indicating that the state has no intention of withdrawing from industries with even minimal strategic importance. While reform stalls, SOEs continue to benefit from better credit access, which allows them to crowd out smaller private firms and improve financial sustainability at the expense of other private players.

Policy developments in the review period did not signal an expectation of increased pace of SOE reform in the coming quarters. Beijing reiterated the importance of deleveraging SOEs but provided no new guidance beyond accelerating the use of debt-to-equity swaps. A new State Council document on using capital management vehicles to improve SOE management offered no real breakthroughs, even after years of piloting with different approaches at both central and provincial levels. One promising development was the acceleration of mixed-ownership reform under the “Two Hundred Actions” plan, which promises to restructure more than 400 SOEs in key and pillar industries. However, the new campaign focuses more on incentivizing employees to acquire ownership stakes in SOEs via stock buying than it does on attracting private investors to SOEs, suggesting the state is still reluctant to relinquish control.

SOEs are benefiting from the policy environment: state-owned firms are the only enterprise category that showed an increased return on assets, lower leverage, and improved ability to service debt in the review period.

This Quarter's Numbers

Our primary indicator, which focuses on SOEs’ share of revenue among listed firms across key, pillar, and normal industries, remains almost unchanged from the last review period. Beijing’s 2013 Third Plenum decisions pledged to classify SOEs into commercial and noncommercial categories, and to allow commercial firms to compete fairly with other market players. However, even in normal industries, where Beijing has expressed little interest in playing a dominant role, SOEs’ share of revenue declined by merely 0.1 percentage point in 2Q2018, a much slower pace compared with a 1 percentage point drop each quarter in 2014–2015. This lack of movement suggests reform has stalled.

In key and pillar industries, SOEs maintain a substantial presence despite government attempts to entice private investment. Mixed-ownership reforms – which have been the government’s main mechanism for attracting private capital and the primary focus of SOE reform efforts in recent years – have not delivered hoped-for results. A new round of mixed-ownership pilots (see Policy Analysis) covering more than 400 central and local SOEs will only drive improvement in our indicators if the government meaningfully relinquishes control over these enterprises. So far it has proven unwilling to do so.

Amid a lack of reform progress, SOEs continued to enjoy easier access to credit, allowing them to expand faster than other firms – in some cases even by acquiring private firms that have been constrained by deleveraging efforts that limit their access to capital. This suggests that the 0.4 percentage point drop in SOEs’ share of industrial assets revealed in our data this quarter (see Industrial Assets by Ownership) will prove only temporary (in June, SOE assets growth accelerated to 2.8% year-on-year, compared with -0.3% growth for private firms). Other indicators confirm that SOEs are benefiting from the policy environment: state-owned firms are the only enterprise category that showed an increased return on assets (see SOE Return on Assets), lower leverage (see SOE Leverage), and improved ability to service debt (see SOE Interest Coverage Ratio) in the review period. Private firms by contrast saw significant deterioration in all these indicators. In other words, SOE viability is being maintained at the expense of other market players, which has worrying implications for China’s competition environment (see Competition).

[Recent] policies may stave off debt risks in the short term, but they do not present a long-term solution to SOEs’ debt problems, which are the result of poor efficiency, soft budget constraints, and implicit government support.

Policy Analysis

The review period saw a flurry of policy announcements; however, none suggests a serious breakthrough in SOE reform. On August 8, China’s SOE and financial regulators issued a joint document urging SOEs to accelerate deleveraging efforts. The document merely reiterated messaging from a State Council Executive Meeting a year ago, specifying leverage thresholds for different types of SOEs and requiring authorities to coordinate and expedite debt-to-equity swaps as the main mechanism to reduce SOE leverage. These policies may stave off debt risks in the short term, but they do not present a long-term solution to SOEs’ debt problems, which are the result of poor efficiency, soft budget constraints, and implicit government support.

The State Council also issued an opinion on July 30 that clarified the types of vehicles that can be used to “manage [state] capital.” Shifting from having the government directly manage SOEs to managing state capital investments was a key element of SOE reform in the 2013 Third Plenum Decisions, with the intention being to delegate more authority to SOEs, rationalize their commercial decisions, and improve their efficiency. The July State Council opinion described two types of capital management vehicles – “investment companies” and “operation companies” (as refined through previous pilot programs) – and specified how state investors should exercise control via these vehicles. Paradoxically, the State Council said that the main task of investment companies would not be to invest but instead to reallocate state capital toward key and pillar industries in order to serve national strategies, improve industrial competitiveness, and strengthen state control and influence. The state will act as a financial investor only through operation companies, apparently at a much smaller scale than observers initially hoped. Earlier pilots of operation companies at the national level have made only limited investments in recent years, and even though some local-level pilots drove more investments, they were not specifically mentioned in the July State Council opinion. Taken together, this watering down of the state capital management approach appears to be a major setback to 2013 Third Plenum SOE reform designs.

Finally, in August, the government announced another new campaign to accelerate SOE mixed-ownership reform. Titled the “Double-Hundred Actions” plan, the campaign aims to implement mixed-ownership and corporate governance reform in more than 400 central and local SOEs (including 61 listed companies) by 2020. The program concentrates mostly on key and pillar sectors, covering industries like oil, chemicals, and machinery. While the campaign is ambitious, there are reasons to believe it may disappoint, as have other mixed-ownership commitments. The two-year implementation time frame is relatively long, suggesting that SOE operational stability will continue to take priority over reform. Moreover, the campaign will focus on employee stock ownership as a means to dilute shares held by the state, rather than attracting outside private capital, as would be necessary for genuine mixed-ownership reform. We think this mostly reflects the state’s ongoing reluctance to relinquish control of its SOEs to private players. This does not bode well for the chances of further meaningful SOE reform breakthroughs in coming quarters.

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