MP Econ Issue 3: SOE Reform II
Assessing Potential for Positive Changes in the State Sector (Part II)
Previously we assessed challenges to state sector reform and made the case for why it is less of a political problem than it is an intellectual one (see Part I here). In Part II, we examine the potential for positive changes that will likely take place in the state sector, despite the extant challenges.
Meaningful changes can be expected in competitive and natural monopoly sectors, but for the rest of the state sector, expectations for positive developments should be tempered. This is particularly so for central state-owned enterprises (SOEs), since they serve as both economic shock absorbers and as extensions of political power. Therefore, central SOEs will see few reforms and will continue to exert considerable influence on China’s political economy.
In competitive sectors, positive change will mostly take place among local SOEs. The same condition that drove the last round of major reforms in the 2000s is present today: local fiscal constraints. This will again be a main driver of reform in the competitive state sector, but the outcome will likely be different this time around.
Back in the early 2000s, fiscal woes led to massive privatization of SOEs, as local governments sold off money-losing state assets to reduce their fiscal burdens. But in 2020, that will be more difficult to do because of a lack of private investor interest in those state assets. That’s because during the previous privatization phase, state banks typically wrote off SOEs’ existing debt, which made even poor-performing state assets more attractive to private investors. But now, state banks are less willing to write off such debt, putting the burden back on the SOEs themselves. As a result, SOEs with lackluster performance will not be able to find buyers as easily.
Moreover, many of the local SOEs are in legacy sectors that have stagnated. That didn’t matter as much during the growth boom of 2000 to 2010, when China’s GDP and industrial output increased by 1.7 and 1.9 times, respectively. But today’s China is facing both slowing growth and a transition to a services-oriented economy. For discerning private investors chasing returns in the future economy, there is little upside to acquiring SOEs in legacy sectors because demand simply won’t be there.
Tianjin’s case is illustrative of this dynamic. The municipality faces both low growth and a severe fiscal problem, with a debt/GDP ratio of 102.5% (including off-budget debt), 40 percentage points higher than the national average. Selling state assets, then, is a decent solution to ease the municipality’s debt burden and to revitalize its economy.
But the Tianjin government has had mixed results in its privatization effort. On the one hand, it sold all its stake in one of the profitable SOEs that produces silicon wafers for semiconductors. The two main criteria for finding a buyer were the price offered and whether the investor plans to further invest locally. When selling good SOEs, the local government seems to care as much about the price as it does about stimulating local growth.
In contrast, Tianjin has had a hard time selling indebted SOEs in the steel and property sectors, despite repeated attempts. In the case of the property firm, one private investor even tried to run the firm for a few months but eventually gave up. The reason for the failure: the Tianjin government could not provide sufficient incentives to compensate the investor for taking over a distressed SOE.
This isn’t just exclusive to Tianjin. There are plenty of examples of profitable SOEs being privatized in financially struggling regions (see here and here), which combined hold around $1 trillion of SOE assets in competitive sectors. Even in wealthier cities such as Zhuhai in Guangdong, the government has raised capital by selling off its controlling stake in Gree Electric, a leading air conditioner maker.
Over the coming years, a substantial portion of these profitable SOEs will likely become privatized. Faced with hard budget constraints, local governments now have fewer choices but to part ways with “crown jewel” SOEs even if they don’t necessarily want to. Under new ownership, private investors should be expected to work hard to improve the performance of these high-potential yet underperforming SOEs, thereby contributing to local economic growth.
Beyond privatizing profitable SOEs, Beijing’s hawkishness on debt and its approach to fiscal prudence will lead to a general decline of local SOEs as a share of the overall economy. This is because local SOEs, particularly poor performing ones, will be less able to borrow and spend.
For instance, local SOE debt/assets ratio has declined since 2016 as debt growth has slowed (see Figure 1). Moreover, local government financing vehicle debt, another major source of financing for local SOE expansion, is also growing much slower. If these trends hold, then local governments’ influence in the economy will decline over time, which should be another positive development for China’s longer term growth prospects.
Figure 1. Local SOE Debt/Assets Ratio Has Declined
Source: Wind and author calculations.
Although central SOEs have appeared impervious to reforms, excessive dominance by natural monopolies has at times created more problems than benefits for Beijing. That’s because in the Chinese Communist Party’s (CCP) mind, it cares less about the “ownership” type of the firm but rather whether a firm gets so strong that it threatens to undermine the government’s control. In other words, there’s an unspoken “ceiling” to how big a firm can get, private or state, before it invariably comes under the CCP’s spotlight.
This is particularly true for natural monopolies because they are more capable of resisting Beijing’s orders, even if they’re “owned” by the state. The most recent revelation is how China’s national oil companies (NOCs) had deliberately lowered the diesel standard, contributing to severe air pollution.
Since these core state assets won’t be privatized, regulating them will be the next best option. To go toe-to-toe with natural monopolies, however, required centralizing political power as a precondition. Some of that was achieved through the anticorruption campaign, which had hit the energy sector particularly hard in the initial phase.
Once political power was centralized, Beijing went about weakening the key natural monopolies in energy and telecom that mainly took the form of breaking out existing assets and putting them under new entities. In telecom, for example, a new SOE was established to take over all the cell tower assets. Similarly, a new SOE was created to take over major pipeline assets that were previously entirely owned by the NOCs. In the power sector, Beijing weakened the State Grid’s price-setting power for electricity transmission.
These “reforms” will likely lead to some efficiency gains and a slightly more level playing field for private investors in these sectors. But it is no secret the ultimate purpose of these actions is about recalibrating the power balance between the central government and natural monopolies. Rearranging these monopolies’ assets so that they’re less vertically integrated will be the preferred method to force them to fall in line with Beijing’s mandates. Once Beijing decides an acceptable level of obedience has been reached, these reforms are unlikely to progress further.
Houze Song is a research fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.
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