China's Emerging State-Owned Enterprises (SOE) Reform Strategy1
- SOE reform is central to China's rebalancing. Successful implementation can instill confidence, facilitate other reforms, and unleash new sources of growth.
- SOEs are less efficient than private enterprises and their leverage is higher. They benefit from substantial implicit support (about 2–3 percent of GDP each year on average) in the form of land, protected markets, and preferential access to finance. The implicit support generates distortions in the use of resources, particularly on credit allocation.
- The announced SOE reform aims to broaden ownership and improve efficiency. Gaps, however, remain and it is not clear if the reform will substantially improve resource allocation.
- Hardening budget constraints, restructuring highly-indebted SOEs, introducing greater competition to state-dominated sectors, providing on-budget social support for layoffs and public services, and advancing on complementary reforms will be critical. Such a package of reforms could raise output significantly (3–9 percent) over the medium term.
1. State-owned enterprise (SOE) reform featured prominently in China's reform strategy, but important details are still being defined. Successful SOE reforms have the potential to improve resource allocation, strengthen confidence, facilitate other reforms, and unleash growth. It would leave China with a more dynamic set of SOEs that compete on a level-playing field with the private sector. They would feature modern forms of corporate governance with professional boards and management; nonviable ones would be restructured or allowed to exit.
A. SOEs—Less Efficient and Higher Leverage
2. Nonfinancial SOEs as a share of output and employment has declined, but they continue to take up a large share of resources. SOEs’ share of value added has fallen to 16 percent from 40 percent over the past decade and they account for about 10-15 percent of urban employment. Despite the decline, they account for about half of total bank credit and 40 percent of total industrial corporate assets.
3. SOEs tend to enjoy implicit support on factor inputs, such as land, credit, and natural resources. Given that many SOEs are endowed with land, they can use land as collateral and are able to borrow at favorable interest rates. Financing costs for listed SOEs, for example, tend to be about 40–50 basis points below the benchmark lending rate. Distortions arising from credit pricing are increasing and account for nearly half of the estimated implicit support (or 1½ percent of GDP). Adjusting for implicit support suggests that SOEs’ return on equity would have fallen from an average of 8 percent to about -1 percent during the period 2011–15. Widespread implicit guarantees are reflected in SOE's credit ratings that are about two to three notches above those of comparable private firms.
4. SOEs continue to build up leverage rapidly, while their financial performance has deteriorated further. Much of the rise in aggregate corporate leverage (the ratio of total liabilities to owners’ equity) since 2009 was channeled to SOEs. Their leverage ratios have risen rapidly to around 200 percent on average, mostly concentrated in overcapacity and heavy industries. At the same time, returns on SOE assets have deteriorated to about 2–3 percent, well below those of private enterprises. Their productivity is only about 30–40 percent that of private enterprises (Hsieh and Song, 2015). Moreover, the efficiency of Chinese SOEs appears to be lower than that in other developing economies, further underscoring the urgency of SOE reforms.
B. Current SOE Reform Plans
5. The government has made SOE reform a cornerstone of its reform efforts and announced a number of initiatives. The new Five-Year plan highlights the need to have "diverse forms of ownership and private participation in SOEs" as well as "restructuring zombie enterprises." At the same time, it also stresses "making SOEs bigger and stronger to strengthen the influence and to serve national strategies." Key principles include the following:
- Repositioning the state as a capital investor rather than operator. Mixed-ownership reforms envisage a spectrum of ownership structures (for example, cross-share holdings and public listings) and greater private sector participation in SOEs. The reforms envisage professional management and a better alignment of respective rights and responsibilities between owners and the board, with checks and balances.
- Classifying SOEs into broad categories, each with specific ownership structures, reform plans, and assessment criteria: (a) commercial strategic SOEs (such as defense, telecommunications, and major energy companies) will continue to have protected markets and will be entrusted to pursue national strategies such as "going global" and "creating global champions," possibly through mergers—the state will continue to hold majority ownership; (b) commercial nonstrategic SOEs will compete directly in the market; and (c) SOEs with social functions will be tasked to improve public services.
- Institutionalizing the leadership role of the communist party, such as through mobility between Party and corporate ranks. A Party member will serve as the chairman of the board.
- Resolving nonviable SOEs. The State Council committed to cutting aggregate SOE losses by 2017 and expediting the exit of nonviable "zombie" SOEs, including resolving near 350 subsidiaries of central SOEs and near 4,000 local SOEs.
6. In some areas, the current reform proposals are more closely aligned with international good practices, however, important details still need to be defined. According to the Organization for Economic Co-operation and Development (OECD), the proposed governance reforms would be broadly consistent with their Guidelines, provided that there is sufficient transparency on the role of state. The announced plan, however, leaves much room for interpretation given that it envisions both greater market discipline and state leadership in major decisions.
7. So far implementation has been uneven. Ten pilot programs with a few selected SOEs have started in 2016, focusing on mixed-ownership reforms and professional management through recruitment, compensation, and board of directors. The State Council recently announced the removal of certain social functions of SOEs (the provision of utilities and property management services for SOE employees). Coastal provinces have advanced faster, and in some cases, resolved near half of the identified zombies, while progress is slow in regions where SOEs play an outsized role in the local economy. Reform of central SOEs has advanced slowly, in part because of their complex multi-layer subsidiary structure.
C. SOE Reforms to Unleash Growth
8. Building on current reforms, measures should focus on improving efficiency and resource allocation. Critical elements include:
- Restructuring or resolving SOEs. Triage the universe of SOEs to (i) identify those that are fundamentally sound; (ii) liquidate nonviable SOEs (which does not necessarily mean closure); (iii) establish a restructuring plan for viable but insolvent SOEs. Expedited out-of-court restructuring for priority distressed companies that would use independent experts may complement the existing insolvency framework. Given the size and complexity, progress should be kick-started with a few high-profile pilot cases for indebted SOEs. Noncore objectives such as social functions (e.g., hospitals, schools, and provision of utilities) should be transferred to the fiscal budget with the related assets and expenses accounted for.
- Hardening budget constraints. Gradually removing implicit guarantees through greater tolerance of defaults and carefully allocating losses to firm owners and creditors will improve the markets’ assessment of credit risks in a financial system unaccustomed to defaults. Removing implicit SOE support through credit, land endowment, and natural resources would not only help address the existing debt overhang, but also improve the efficiency of new credit allocation. At the same time, increasing as soon as possible the transfer of SOE profit (a target of 30 percent by 2020), which is now mostly reinvested (including providing capital injections, subsidies and addressing their legacy costs) and well below the target, to the fiscal budget and allocating SOE capital to social security funds would contribute to hardening budget constraints.
- Introducing greater competition. Reducing entry barriers and phasing out restrictions that give SOEs a privileged role will send a clear signal. Allowing entry of private firms in the state-dominated services sector such as logistics and telecommunications (currently more stringent than in OECD markets), breaking up administrative monopolies, and promoting the growth of dynamic small and medium-sized enterprises would foster competition and promote growth.
- Providing social support. To facilitate the restructuring process, on-budget fiscal support will be important. This would minimize the social costs of layoffs, retraining, and relocation of workers. The recently-established RMB 100bn restructuring fund for coal and steel industries is an important step into this direction.
- Advancing complementary reforms. To foster an enabling environment for SOE reforms, complementary reforms are needed. These include reforms on the household registration system, rural land property rights, and a framework for insolvency and resolution. Fiscal reforms to improve social security portability and align intergovernmental finances by matching expenditure responsibilities with revenue sources will help address SOE legacy issues.
- Improving coordination. SOE reforms are complex with vested interests and straddle many agencies. There is merit in establishing a well-staffed high level group with a clear mandate to promote and implement practical restructuring of SOEs. Strong coordination between the central and local governments, as well as financial regulators, will facilitate the process.
9. SOE reforms could generate significant growth potential. Using a two-sector model with reasonable parameters—including SOEs’ share of the economy, productivity, and cost of capital differentials—suggests that such SOE reforms can improve growth prospects significantly over the medium term. A better allocation of capital and labor to the private sector and narrowing the productivity gap between SOEs and private enterprises could lift the level of output by 3–9 percent compared to baseline projections, or about 0.3–0.9 percentage points of growth a year if the effect is spread across a decade.
Figure 1.SOE Reforms
Sources: OECD Service Trade Restrictions Index (2015).
KowalskiP.M.BugeM.Sztajerowska and M.Egeland2013 “State-Owned Enterprises: Trade Effects and Policy Implications” OECD Trade Policy Papers No. 147 (Paris: OECD Publishing).
Organisation for Economic Cooperation and Development2016Policies for Sound and Effective Investment in ChinaBetter Policies Series (Paris: OECD Publishing).
State Council2015 “Comments on State-owned Enterprise Mixed-ownership Reforms” (September 24). Available on the internet:http://www.sasac.gov.cn/n85881/n85921/c2111460/content.html