China's state-owned enterprises -- including quoted giants like China Mobile (CHL), Sinopec (SNP), PetroChina (PTR) -- are a lucky breed, or so conventional wisdom would have it. They have lower cost of capital and less competitive pressures of private sector competitors. China's big banks (also state-owned) are always happy to lend, and if things do turn sour, China's government will bail everyone out.
The reality, however, is substantially different and substantially more challenging. SOEs live in a different world than they did ten, or even three years ago. They are more and more often under intensifying pressure to achieve two incompatible goals: to continue to expand revenues by 15%-25% a year, but to do so without corresponding large increases in net bank borrowing. The result, over time, will be that SOEs will need to rely increasingly on private sector capital and stock market investors to finance their future growth.
This message came through especially loud and clear in the policy document published by the Chinese leadership after the recent Third Party Plenum in November. SOEs are told they need to become more attuned to the market and less dependent on government favors and protection. This new policy pronouncement is reverberating like a cannon blast inside the state-owned economy, based on conversations lately with the top people at our large Chinese SOE clients.
No one at these SOEs is entirely sure how to fulfill the orders from above. But, they are all certain, from long years of experience, that the environment SOEs operate in is going to undergo some significant change, likely the most significant since the "Great Cull" of the mid-1990s when thousands of SOEs were pushed into bankruptcy. Too many of the surviving SOEs have done little more than survive over the last twenty years. They managed to stay in the black, sometimes by resorting to rather idiosyncratic accounting that ignored depreciation.
Investors have long viewed China's SOEs as reliable, if rather dull, quasi-monopolies, handed a ticket by their government owners to make easy money in China's enormous domestic market. But, the steady-state world of SOEs is going to become more turbulent, with bigger gainers and bigger losers.
The Chinese leadership is embarking on a tricky, somewhat contradictory, mission: to simultaneously shake up the SOE sector, make it more efficient and responsive to market forces, while keeping SOEs embedded in the foundation of China's economy. Much has changed about the way Chinese leaders view and manage SOEs. But, a key principle remains intact. The architect of the policy, Deng Xiaoping, put it this way, " As long as we keep ourselves sober-minded, there is nothing to be feared. We still hold superiority, because we have large and medium state-owned enterprises."
In other words, SOE privatization is not on the menu, at least not in any large-scale way. SOEs, particularly the 126 so-called "centrally-administered SOEs" (央企) will remain majority-owned by the government. The government is suggesting, however, it wants these SOEs, as well as the other 100,000 or so smaller ones active in most parts of the Chinese economy, to be run better and more profitably. But how? That's the a topic of discussions I've been having over the last month with the bosses at our SOE clients.
The rate of return (as measured by return on assets) at SOEs has, in almost all cases, drifted down over the last ten years, and is now probably under 3% a year. If bank borrowing and depreciation were more properly amortized, the rate of return would likely turn negative at quite a lot of SOEs.
In some cases, this reflects the cruel reality that many SOEs operate in low-margin highly-commoditized industries. But, another key factor is that the government body that acts as the owner of most SOEs, SASAC (国资委), is not your typical profit-maximizing shareholder.
SASAC manages the portfolio of SOE assets like the most risk-averse executor. It demands three things above all from SOEs: don't lose money; don't pilfer state assets and keep revenues growing.
When your owner sets the bar a few inches off the ground, you don't try to break the Olympic high jump record. No SOE manager ever got a bonus, as far as I've heard, from doubling profits, or improving cash flow. Pay-for-performance is basically taboo at SOEs. The whole SOE system, as it's now configured, is designed to produce middling giants with tapering profits.
Rather than shake-up SASAC, the country's leaders have given SOEs a green light to seek capital from outside sources, including private equity and strategic investors. They should provide, for the first time, a voice in the SOE boardroom calling for higher profits, higher margins, bigger dividends.
It's a wise move. SOEs need to carry more of the load for China's future gdp growth. You can't do that when you are achieving such low return on assets. Among the SOEs we work with, there's a genuine excitement about bringing in outside investment, and operating under a new, more strenuous regime. Surprised? The SOEs I know are run by professional managers who've spent much of their careers building the business and take pride in its scale and professionalism. They, too, see room for improvement and see the downsides of SASAC's approach.
Outside capital can help these SOEs finance their future expansion. It could also open new doors, especially in international markets. The big question: can - will - private equity seek out investments in Chinese SOEs? It's unfamiliar terrain.
Earlier this year, I arranged a series of meetings for twelve of the world's-largest institutional investment firms to meet a large SOE client of ours. These firms collectively have over $700 billion in capital, and each one has at least ten years' experience in China. They are all keen on this particular deal. Yet, none of these firms have invested in any SOE deals over the last five years. For many of the visiting private equity firms, it was their first time ever meeting with the boss of a profitable and successful SOE to discuss investing.
In this case, it looks like a deal will get done, and so provide a blueprint for future institutional investing in Chinese SOE. The Chinese leadership ordered a shakeup to the state owned sector. It's getting one.