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 to 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 nonfinancial 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, 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

Seen through the lens of state share of revenue from listed firms, SOE reform made no real progress in 3Q2017. The share of revenue captured by listed SOEs in pillar industries declined, but it held constant in normal industries – and we consider the normal industries the best barometer of reform implementation. Other indicators show improved SOE return on assets and interest coverage on the back of price effects related to supply-side capacity cuts, which do not appear related to improvements in efficiency. SOE industrial asset, employment, and leverage ratios were largely stable.

Our outlook is for status quo outcomes in the state sector in the quarters ahead. The mixed-ownership trial for China Unicom was finalized in our review period, but this pilot program raises as many questions as answers. Government stressed SOE deleveraging and mandated that all SOEs implement a corporate structure by the end of the year. On paper, all central SOEs declared “mission accomplished” on this mandate two days before the year-end, but few material improvements in SOE governance are evident. Party efforts to strengthen political influence over SOEs may in fact push reform efforts in the other direction, given continuing leadership disquiet over unemployment and social stability.

Despite a political emphasis on SOE deleveraging, leverage ratios for SOEs held at around 60% even as private Chinese companies deleveraged.

This Quarter's Numbers

Our primary SOE reform indicator, which gauges the share of revenue captured by listed SOEs across a range of industries, was basically unchanged in the third quarter – with one notable exception. The SOE revenue share in pillar industries – those treated as core to future competitiveness, including autos, chemicals, construction, and electronics – fell to 46%, down from 51% in the previous quarter. This happened for two reasons. First, new private companies were listed on the stock market, increasing their share of total revenue in those sectors, and thereby reducing the share of SOEs. (This jump in quarter-on-quarter (qoq) growth in direct financing by Chinese companies is too new to show up on a four-quarter moving average (4qmq) basis in our Financial cluster, but it will be evident soon if it continues). Of 1,736 listed companies in pillar industries, all but one of 201 newly listed in 2017 were private. Within that 200, 81 were in the electronics industry, pushing the SOE revenue share down to 19% in 3Q2017 (from 22% at the end of 2016).

Second, SOE revenue is underperforming the private sector in steel and construction. Both are focal points of the campaign to cut production overcapacity as part of supply-side structural reform (SSSR). In steel, year-to-date revenue for private companies increased 50% yoy through the end of the third quarter, compared with only 35% for SOEs. In construction, private companies’ year-to-date revenue increased by 22% yoy, compared with only 10% for SOEs. These outcomes are somewhat surprising, because conventional wisdom is that state firms are better positioned than private companies with less political heft to benefit from the Xi Administration’s push to cut overcapacity.

Our primary indicator also shows that the share of SOE revenue in key industries – those slated for continued state control such as defense and telecom – held at 81% in 3Q2017, a mere 1% drop from 2Q2017. Although the indicator presents a notable decline since 2015, digging beneath the surface of the data suggests that the fall was mainly driven by one-off, acquisition-related effects and temporary revenue changes for a few private companies in the aviation and shipping industries. Starting from a low base, this outperformance accounted for around 30% of private companies’ total revenue increase in key industries from 3Q2016 to 3Q2017. That significantly skewed our indicator. Without these effects, the shift in the share of revenue held by SOEs would have been negligible.

Finally, in industries classified as normal – meaning those not assigned any priority status by Beijing – the SOE share of revenue held at around 16%, although private firms outperformed SOEs this quarter in all normal industry segments except for general manufacturing. Out of 1,353 listed companies in normal industries, only 142 were newly listed in 2017, even less than the 201 in pillar industries. This suggests stasis rather than a more decisive role for market forces and the private sector.

Our supplemental indicators compare SOEs’ performance with that of other market players beyond listed ones. Those indicators did not reveal any fundamental change. SOE share of industrial assets held constant with the second quarter at around 28% (see Industrial Assets by Ownership). Although their return on those assets improved to 3.8% from 2.8% a year ago, that did not happen because SOEs became more efficient. Rather, higher prices driven by SSSR pushed up profits across the board, and return on assets for other players improved even more than for SOEs (see SOE Return on Assets).

Despite a political emphasis on SOE deleveraging (see Policy Analysis discussion), leverage ratios for SOEs held at around 60% even as private Chinese companies deleveraged (see SOE Leverage). Our gauge of the ability of companies to service debt showed the SOE profit-to-interest ratio marginally improving to 4.0 from 3.8 in 2Q2017 (see SOE Interest Coverage Ratio). Finally, we note that as of the end of 2016, SOEs still employed 15% of China’s total workforce (see SOE Share of Employment).

This reflects the difficulties of bureaucratic inertia and entrenched interests that weaken and slow down the SOE reform agenda.

Policy Analysis: 3Q2017

Deleveraging SOEs was elevated as a policy priority in the third quarter. In July, President Xi chaired the National Financial Work Conference, which named SOE deleveraging as the nation’s most important policy task to reduce systemic risk. A month later, the State Council announced steps to achieve that goal, including adding an evaluation of leverage ratios into performance metrics for SOE managers, encouraging SOEs to repay debt out of retained earnings, implementing debt-to-equity swaps, investigating SOEs with rising debt, cutting overcapacity, and shifting SOE investments from traditional into new industries. Many of these strategies are so obvious that it is somewhat disheartening that they need to be restated.

The mixed-ownership restructuring plan for China Unicom, one of the three biggest telecom providers in China, was rolled out in the third quarter. Officials stressed the dilution of the state’s ownership in Unicom from 62.7% to 36.7%, pointing to that as the lowest level ever in a restructuring of a centrally owned SOE. But a deeper look raises questions about the seriousness of the approach. First, fourteen investors bought 35% of Unicom’s shares. These new investors were together given three seats on the nine-person board. Institutions controlled by the state, including Unicom’s holding company, will appoint the other six board members despite the fact that public shareholders own 25.4% of the company. The biggest new investor in Unicom as part of the mixed-ownership trial (taking 10.2% of the 35%) was China Life, also an SOE.

Second, Unicom’s additional share issuance also violated the China Securities Regulatory Commission’s (CSRC) reporting requirements effective February 2017. The CSRC granted special approval to the issuance after it was announced, an unfortunate signal that political priorities take precedence over financial regulations – and one that could have been avoided. Finally, it took more than a year for Unicom’s reform to be approved even though the company was identified as one of the first nine mixed-ownership pilots in September 2016. The National Development and Reform Commission (NDRC) announced 59 companies as mixed-ownership pilots as of the drafting of this report, but only Unicom and China Eastern Airlines have moved forward. This reflects the difficulties of bureaucratic inertia and entrenched interests that weaken and slow down the SOE reform agenda.

In July, the State Council published an action plan with policy designs to corporatize all central SOEs by the end of 2017. (And indeed, by the end of 2017, all central SOEs announced that they had successfully corporatized.) The intent is to utilize corporate structures to clarify the state’s role as a shareholder, and to allow other owners to exercise their ownership rights through the board of directors. A secondary aim is to grant more decision-making autonomy to professional managers, though recent efforts to strengthen Party committees within SOEs raise skepticism about Beijing’s commitments in this area. Taken together, piecemeal reforms and convoluted mixed-ownership trials remain the focus of policy. We continue to watch for signs of a turn toward a more market-oriented approach.

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