SOE reform in China
The role of China in today’s global economy cannot be understated. While the rest of the world was hit hard by the global financial crisis, China continued its break-neck growth rate. We take a look at the role of state-owned enterprises (SOE) in China and the risk it poses to China and the global economy.
State of SOEs in China
SOEs in China contributes about 30% to the country’s total industrial output and investment. In recent months, overcapacity, overleverage and concerns that SOEs are muscling out more efficient private entities have become a lightning rod for criticism from investors and businesses.
SOEs serve many purposes and are an important policy tool for the central government. As part of this ‘implicit’ arrangement, SOEs often receive preferential treatment from government entities and institutions such as cheaper access to financing from banks. Despite reforms in the SOE sector during the late 20th and early 21st centuries, market distortions still make the field an uneven one between SOEs and private enterprises.
History of SOE reform
Despite being the backbone of the Chinese economy in the early 2000s, stiff competition coupled with change in financing laws (SOEs used to receive funding from the Ministry of Finance but this was scrapped in favour of a bank financing model) and over investment led to significant financial deterioration.
Overcapacity issues and high leverage ratios among SOEs caused a high percentage of non-performing loans (NPL). The central government launched a reform plan in the late 1990s in an attempt to return SOEs’ balance sheets into the black. Large scale corporate restructuring took place and smaller SOEs were merged into larger entities and a comprehensive debt-equity swap programme was instituted, supported mainly by banks and asset management firms. Human capital redundancy, a huge issue back then, led to overall headcount at SOEs to be streamlined. This exercise led to vastly improved financial performance of SOEs and less risky balance sheets for Chinese banks.
Issues in the SOE sector
Despite years of reform, the issues that plagued SOEs in the past are still prevalent.
1. Overleverage and overcapacity
During the global financial crisis, credit flowed freely to SOEs to prop up investments and spur growth. Data compiled by Citibank showed net debt-to-asset ratio in SOEs approaching 60% in 2015, similar to levels before the previous reform exercise. Corporate debt-to-GDP ratio in this period also increased to over 140%, leading to debt-servicing capacity issues. Due to the level of debt extended to SOEs, reduction in debt-servicing capacity might lead to excessive pressure on Chinese banks holding these debts. Official data by the Chinese government showed average capacity utilization to be around 67% in 2015, down from 70% a year ago, contributing to downward pressure on China’s PPI which may increase debt burden and discourage investment.
2. Inefficient allocation of resources
Previous reforms (mentioned earlier) led to trimming employment at SOEs. Despite providing lower unemployment, SOEs still consume a large chunk of resources (financial or otherwise). This misallocation of labour and capital inevitably leads to market distortions as resources are not efficiently utilized.
3. Distortions in financial markets
SOEs have benefited (and indeed are benefiting) from concessionary financing from banks who are incentivized to maintain good relations with authorities. State-backed guarantees to prices and preferential regulatory treatment are also underlying issues in the SOE sector.
Policy Announcements on SOE Reform
In August, the government announced some initiatives for SOE reform.
The National Development and Reform Commission announced that private capital will be welcomed in ‘strategic’ sectors such as oil and gas drilling. A level playing field for private companies will be instituted by removing political barriers to encourage non-state companies to participate in the 160+ projects outlined in last November’s 13th Five Year Plan.
The Ministry of Commerce said China will start to encourage opening up of its education, finance, culture and manufacturing sectors, especially in the western regions, to foreign investors.
Overcapacity will be reduced by 10% within 2 years in central government controlled companies, said the State-Owned Assets Supervision and Administration Commission.
Fiscal relationships between central and local governments will be improved and a system that demarcates expenditure and fiscal responsibility at different levels government will be established.
SOE reform: What to expect?
SOE reform in China weighs heavily on political considerations. Because SOEs are the bedrock of China’s economy and policy agenda, SOEs will always exist not just for economic purposes but also due to ideological and political necessity. Complete privatisation of SOEs in the mould of Thatcher’s Britain would not be realistic. Improving operating efficiency, while a goal of the government, would go hand-in-hand with enhancing the impact of SOEs on the Chinese economy.
SOEs are likely to continue to dominate key sectors and governmental support (explicit or not) will still be prevalent. As the reform process involves many stakeholders from the central and local governments to banks and regulators, how to reform and how fast to do so would depend on a combination of internal incentives or external pressure on stakeholders. As the speed of reform is likely to be gradual, the world watches with bated breath on China’s next move, which could potentially have an impact on the global economy. As the saying goes: when the Chinese economy sneezes, the world catches a cold.
WRITTEN BY FELIX LIM FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT
