SOEs in search of strategy for change amid reform drive

State-owned enterprises are losing competitiveness and the support from investors, but the way forward is still far from clear

Even as the central government called for further reform of China's massive State-owned enterprises, a policy that could undermine their dominant market positions, investors were pulling funds from their shares.

A survey by Bloomberg News in late February found that oil producer PetroChina Co Ltd ranked only 14 on a list of the top 20 emerging-market stocks in terms of market capitalization, down from fourth place a year earlier. It was the only Chinese company to make the top 20.

SOEs are also losing their market competitiveness. According to research by the world's largest brand consulting firm, Interbrand, released in November, China Mobile Ltd's brand value slumped even though it managed to retain its top position in the list of Best China Brands. However, private-sector Internet giant Tencent Holdings Ltd saw its brand value increase by 84 percent.

"China Mobile, of course, realized how tough the competition is and modified its market strategy," said Tang Yaqian, deputy strategy director of Interbrand China.

In many industries, nimble private companies are forcing SOEs to change. Examples can be found in recent moves: Shanghai-based Dazhong Insurance Co Ltd obtained approval from the China Insurance Regulatory Commission for a change in its equity ownership. China Petroleum and Chemical Corp, known as Sinopec, announced on Feb 19 that it will open its highly profitable oil retail business to private capital participation.

Zhuhai Gree Group Corp, wholly owned by the Zhuhai State-owned Assets Supervision and Administration Commission in Guangdong province, announced a day later it would transfer its asset stake in Gree Real Estate Co Ltd to a newly established company, and sell an equity stake of less than 49 percent via public tender to introduce strategic investors.

"In our view, the current wave of SOE reform started with quality companies and quality assets. We think this is the right approach and expect it to be expanded. We think local governments, facing rising financing costs, increased regulation of the shadow banking business, pressures to roll over debt and the need to cut overcapacity, will be active in seeking opportunities to restructure local State-owned enterprises," said Jian Chang, chief China economist at Barclays Plc.

However, this is far from enough. According to its Ministry of Finance, China has more than 100,000 SOEs at all levels, with combined assets of about $13 trillion. Reforming that many enterprises in a manner that satisfies everyone "will be difficult and will take some time, notably because that part of the Chinese economy increased quite significantly during the financial crisis," according to Pascal Lamy, former director-general of the World Trade Organization.

China started its reform of the SOEs in 1997 in preparation for joining the WTO. Based on Ministry of Finance figures, the total number of SOEs fell from 262,000 in 1997 to 146,000 in 2003, when the State-owned Assets Supervision and Administration Commission was founded. The number of SOE employees dropped from 70 million to 42 million over the same period.

However, Andrew Batson, director of China research at GaveKal Dragonomics, an independent economic and financial research firm, said China's policy for SOEs has increasingly diverged from its path since 2003, and the environment has been further complicated since 2008 by a dramatic loosening of monetary policy and lowering of lending standards, as well as the government's mobilization of many SOEs to engage in public-sector stimulus projects.

"SOE assets are not, in fact, being concentrated in the sectors the government wants. The returns on SOE assets have sharply deteriorated. As a result, a significant part of the Chinese economy is underperforming," Batson said.

Consequently, the problems are increasingly evident in China's State sector: falling returns, rising debt and a loss of strategic focus, he added.

As noted by Batson, since 2003, the central government has become extremely reluctant to allow any SOE - large or small, central or local - to shut down or change ownership. In combination with loose monetary policy and political pressure on SOEs to support short-term growth, this shift has worsened the incentives for the managers and supervisors of State-owned firms.

"China's government does have the ability to improve the financial performance of its SOEs. And it can help them to fulfill their original mandate while also boosting the potential for future growth across the entire Chinese economy. The best solution is to return to the policy orientation of the 1997-2003 period, when the government encouraged the exit of underperforming SOEs," he said.

Batson also added that a solution can be achieved by requiring a set of interrelated changes, which include a more flexible approach to managing the government's SOE assets and a clearer strategic focus for the SOE sector overall, with performance targets that are calibrated to various goals that different SOEs must meet.

Other aspects of reform could include the creation of a clear process for underperforming SOEs to close down or be transferred to private ownership or in other words, an "exit" mechanism, and reduced political interference in SOE investment decisions, Batson said.