Any investors expecting to buy the most valuable assets sold by Beijing’s in its state-owned enterprise (SOE) privatisation process will likely be disappointed because the government will not sell its crown jewels for strategic reasons. This, in turn, puts a limit on how far SOE reform can go in the medium-term.
The rapid build-up of China’s corporate debt in recent years has raised systemic risk, as the combination of slowing GDP growth and financial liberalisation increases funding costs and credit risk. Corporate deleveraging has become an integral part of SOE reform. Privatisation is a crucial solution if China’s deleveraging process is to succeed. Beijing is promoting mixed ownership reform before implementing full privatisation. Local SOEs have performed worse than their central counterparts, but they are easier to sell. And therein lies the conundrum. Beijing will not sell its crown jewels due to their strategic importance to the Communist Party. Selling the other SOEs may not realise their book value due to structural and cyclical weakness in the short- to medium-term. Expect privatisation to focus on the non-strategic and consumer sectors.
Corporate debt raises systemic risk…
Corporate leverage (most of which comes from the SOEs) has grown rapidly since 2008, when it went from an estimated 97% of GDP to 167% in 2014. Beijing is committed to structural reforms even at the expense of economic growth. Deleveraging has, thus, become the centre piece of its reform strategy, which will include at least partial privatisation of state assets. The question is within China’s controlled system, how will privatisation proceed?
SOEs have generated most of China’s corporate liabilities. The country went through a period of deleveraging in the late 1990s and early 2000s (Chart 1) when former premier Zhu Rongji implemented a major SOE restructuring, using the entry to the World Trade Organisation as an external discipline to force a significant downsizing of the state sector and of corporate debt.
However, corporate leverage has risen again since 2008 at an annual compound rate of 28%, while nominal GDP growth has fallen from double to signal digit rates. Corporate debt (again, mostly generated by the SOEs) was the biggest driver for boosting the total credit-to-GDP ratio from 153% of GDP in 2008 to an estimated 250% of GDP in 2014 (Chart 2).
The second major driver was local government borrowing via the local government financing vehicles (LGFV), which is often classified as corporate debt because the LGFVs are companies created by the local governments to circumvent borrowing restrictions. As a result, the average SOE debt-to-equity ratio grew by 60 percentage points to 200% between 2003 and 2013. In contrast, the leverage ratios of private and foreign industrial companies have fallen in recent years (Chart 3), suggesting a crowding out of private sector borrowing by the state companies.
The rapid build-up of corporate debt is becoming a serious risk to the financial system because slower economic growth is crimping corporate profits, raising the insolvency risk of the highly leveraged SOEs. Indeed, the return on assets (ROA) of state firms has been much lower than that of foreign and private firms (Chart 4), implying a higher risk for SOEs’ repayment ability than for the private sector.
… And the need for deleveraging
Crucially, this risk will be aggravated by the gradual and eventual removal of deposit interest rate controls, which will put upward pressure on lending rates. This will hurt the less profitable state firms more by pushing up funding costs when their pricing power is constrained by competition under structural reforms. The ROA of state firms was already only half of the weighted average bank lending rate of 7.5% in Q3 2104. Unless their ROA rises along with financial liberalisation, further increases in lending rates will raise the default risk of the SOE sector.
So deleveraging of the state sector is needed not only to diffuse systemic risk, but also to make room for reallocating capital to the private sector, which is a driving force for building China’s “new economy” under the structural reform initiative.
SOE reform with mixed ownership
Beijing appears to be addressing the country’s corporate debt risk by partially privatising some SOEs. This process takes the form of mixed ownership and is seen as the lynchpin of SOE reform by President Xi Jinping. Mixed ownership involves selling more shares of SOEs to private investors, but with the bulk of the ownership remaining in state hands. Full privatisation is politically implausible in the medium-term.
The central government launched several “experiments” involving six centrally-owned SOEs in 2014 as part of this reform initiative, including selling some of its stakes in two SOEs, the China National Building Materials Group and China National Pharmaceutical Group Corporation (Sinopharm).
Two other SOEs, the State Development and Investment Corporation (which builds mega infrastructure projects) and China National Cereals, Oils and Foodstuffs Corporation (COFCO), were chosen for a pilot scheme designed to raise efficiency by transferring control of state equity to state-owned holding companies that will focus on capital management and maximisation of shareholder value, rather than advancing policy goals.
The other two SOEs participating in one or more of the pilot reform schemes are China Energy Conservation and Environmental Protection Group and Xinxing Cathy International Group (a heavy equipment manufacturer previously owned by the military).
Local governments are also starting to sell infrastructure assets to pare debt. To facilitate this effort, Beijing has launched a “public-private partnership” (PPP) scheme to allow private investors to operate and jointly own local SOEs and infrastructure assets.
The privatisation conundrum
However, even partial privatisation is a big challenge for the reformers. The crown jewels are all concentrated in strategic sectors, such as oil, aviation, rail, gas, electricity, post and telecommunications. The Communist Party will not let go of these in the medium-term. Other valuable but non-strategic sectors, such as property, metals, construction and retail, can be sold more easily, but they may not fetch their book value due to structural and cyclical weaknesses. Further, the expected returns on the PPP projects may not be attractive enough to entice significant private investment. This is because the sale prices of the PPP projects are often set too high, or local governments’ control on the projects’ tariffs severely restricts their earnings potential.
Local SOEs have also performed worse than their central counterparts, as seen in their inferior return on equity (Chart 5). However, this may be a blessing in disguise for investors because it means there could be plenty of scope for improvement under private ownership. They are also more accessible to private investors as most are not in the strategic sectors.
Under these circumstances, Beijing will likely focus on mixed ownership reform in non-strategic and consumer-oriented sectors. The Jin Jiang group is a notable example. It is a local SOE controlled by the Shanghai government, and is one of the world’s largest hotel groups, managing properties and travel agencies across China. There are tens of thousands of other state firms like Jin Jiang that are in the economic lowlands, with no strategic importance to Beijing. They are running hotels, developing property projects, managing restaurant chains, operating shopping malls, and providing social, business consulting, leasing and entertainment services.
Privatising the state assets in these sectors would generate about RMB18 trillion in revenue, according to estimates by the State-owned Assets Supervision and Administration Commission (SASAC). This would be enough to reduce LGFV debt (which is seen as a “time bomb” by some analysts) by more than 90%, equivalent to almost 20% of all outstanding SOE corporate debt.
Senior Economist, BNPP Asset Management (Asia) Ltd., and author of “Demystifying China’s Megatrends: The Driving Forces That Will Shake Up China and the World”, Emerald Publishing 2017, and ten other books on the renminbi, China and Asian economic development. Lo was listed on the International Who's Who Professionals in 2000 and 2011, and has many years of international research experience in economics, financial markets and public policy and standards development, covering North American and Asian economies.