Lacklustre profits and the heightened risk associated with investing in U.S. and European equities have forced more investors to delve into Chinese equities, particularly the state-owned enterprises (SOEs). Government enterprises saw a 37.9% jump in profits in 2010. Profits from SOEs in the financial services, resources, and transport sectors more than doubled. As a result, state-owned enterprises now represent more than 30% of China’s gross domestic product. Although there is a lower return on equity, investments in these state-controlled behemoths has been safe. But we believe that incoming reform after the leadership transition in 2012 poses a serious risk to the profitability and return on capital for state-owned enterprises.
Reforming SOEs Is Critical To Achieving Sustainable Growth
It is now a grave concern that the state-owned enterprises will derail the rebalancing of the Chinese economy. Behind the state government’s drive to build up its “national champions” for the last five years, it has effectively created a powerful special interest group whose advancement is predicated upon the retreat of private and foreign businesses from China. Additionally, we believe the SOEs’ poor allocation of capital is mainly responsible for the large imbalance in the Chinese economy today.
First, due to the underdeveloped equity and bond markets, more than 80% of capital flows through state-owned banks. And because it is difficult to gather trustworthy information on the credit history of small and midsize enterprises, banks with an enormous amount of low-cost savings prefer lending to the SOEs. A report by the Unirule Institute of Economics showed that from 2001-08 the real interest rate for SOEs was 1.6% while the average market interest rate was 4.68%. Second, taxes and land costs are much lower for state-owned companies compared to private enterprises and foreign companies.
Finally, little oversight on the capital expenditures of state-owned enterprises also contributed to the problem. The government didn’t mandate that SOEs pay dividends until 2007. Although the majority of listed SOEs pay dividends to their parent shareholders (usually the holding company), these dividends do not go to the state-owned Assets Supervision and Administration Commission of China (SASAC), and therefore can’t count as part of the revenue for the government.
With an ample amount of cash, a lower cost of doing business, and little oversight on capital expenditures, SOEs continue to expand their production, which led to the overcapacity and Chinese economy’s over-reliance on investment. Between 1981 and 1999, it required CNY 0.5 of investment to produce CNY 1.00 of GDP growth; for the last 10 years, China needed CNY 1.70 of new investment near to produce the same amount of GDP growth. At the same time, the SOEs’ average return on equity was only 8.6% compared to 12.9% from non-state-owned enterprises.
Progress Has Been Slow, but Sure to Happen
Between Sinopec’s lavish spending on luxury liquor and CRCC’s low returns despite receiving substantial subsidies, cheap credit and preferential treatment, we have never seen such resentment toward the SOEs in the mainstream media. But pressure from domestic and foreign businesses and the government’s push for reform have not translated into meaningful change so far. The government’s efforts have largely been lip service.
However, the community has recognised that new leadership and policy are needed to address the misallocation of capital by the SOEs, a critical step in the wealth transfer process that will help boost private consumption and reduce reliance on investment. Already, there has been progress made this year. First, tax codes have been updated to reflect the fair price of these state-owned assets and to compensate for environmental damages and health-care costs. Second, SOEs are to pay 45% of their earnings to the government, a sharp increase from the current 5%-10%. We believe the move to scale up the dividend payout ratio will not only improve capital allocation efficiency but also help lower payroll taxes to finance spending in the inadequate social security system, which contributed to a high savings rate in China.
As Chinese communist party leadership is set to change hands in 2012, we anticipate quicker and more meaningful reform, which will have profound implications on state-owned enterprises’ allocation of capital. With a larger share of funding going to more productive private companies as well as reducing subsidies and phasing out preferential treatment for the large SOEs, we will see productivity gains that power China’s economic growth.
Industries Poised To Prosper From This Reform
In the medium to long term, we see three major industries that stand to benefit from more efficient allocation of capital. First, urbanisation will remain a driving force for economic growth, but less investment on infrastructure and capacity expansion spells trouble for materials, particularly basic metals (aluminium and zinc) and building materials (steel, glass, and cement). Shenghua Coal and Baosteel will benefit from the consolidation of SOEs in these industries.
Second, small and medium-size banks (Merchant and Mingshen Bank) that have more exposure to SME lending and can provide better private banking services also should profit from the liberation of the interest rate.
Lastly, as Chinese households receive higher returns on their savings, we believe consumption for the younger generations of the lower middle class will grow substantially and upper middle class spending on luxury, leisure, and personal services is likely to grow faster than GDP in the medium to long term.
