Sunday, March 23, 2008
State-owned Enterprises of China: Commanding the commanding heights
Brilliant insights on State-owned Enterprises and their march forward in China:
China’s champions: Why state ownership is no longer proving a dead hand
By Geoff Dyer and Richard McGregor
When the Aluminium Corporation of China acquired a 9 per cent stake in Rio Tinto last month, the Chinese state-owned company pulled off a number of firsts. Not only was it the biggest ever overseas investment by a Chinese group, it was also the largest ever dawn raid on the London stock market.
Yet while most of the attention focused on what the share purchase meant for BHP Billiton’s efforts to acquire Rio Tinto, the acquisition heralded another important trend – the quiet revolution under way in the Chinese state sector, which has produced a new generation of confident companies with global ambitions.
A decade ago, China’s state-owned sector looked like an economic disaster waiting to happen. In the aftermath of the 1997 Asian financial crisis, average profit margins in Chinese state companies fell to close to zero, and many reported huge losses. The government felt it had no option but to embark on a brutal programme of closures that left tens of millions without jobs.
Fast-forward 10 years and the situation is almost unrecognisable. In 2007, the combined profit of the 150 or so companies controlled by the central government is expected to have reached Rmb1,000bn (£70bn, $140bn, €90bn). In the five years to 2008, this figure rose by 223 per cent. At the end of last year, the list of the world’s 10 most valuable companies contained four groups controlled by the Chinese state – even if this partly reflected the relatively high valuation of the Shanghai stock market.
What we are witnessing, in other words, is an experiment in capitalism that could challenge much of the conventional wisdom about state ownership. Plenty of countries have strong state-owned companies in semi-monopolies such as telecommunications or heavily regulated sectors such as energy and mining. Yet China is trying to create a series of leading public companies in industries exposed to cut-throat competition, where technology, design and marketing are crucial features – just the sort in which state-owned companies have typically suffered at the hands of private rivals.
At a time of growing discussion about whether there is a genuine “China model” for economic development that involves a much bigger role for the state, the fate of China’s public companies could help change the terms of the debate.
One of the most interesting tests will be in the car industry. Chinese companies have startled the auto industry over the past three years by grabbing a 26 per cent share of one of the most competitive markets in the world – which is also now the second-largest. The company with the fifth-biggest brand in the local market – ahead of Nissan, Ford and Hyundai – is the state-owned Chery Automobile.
Based in Anhui, a poor province inland from Shanghai, Chery has benefited greatly from local government assistance in terms of access to financing and land purchases. Critics also claim that the company cut a few corners in its earlier years – its highly successful QQ micro-car was very similar to General Motors’ Chevrolet Spark.
But Chery has also proved skilful at marketing, for example using the internet to create buzz among young car-buyers, and has displayed a ruthless control of costs – neither of which are traditional attributes of state companies. Industry executives have also been impressed by the heavy investment the company has made to boost its engineering capabilities, which will be vital if it is to compete overseas. “Chery looks, feels and has the DNA of a private company,” says Michael Dunne, managing director of consultants JD Power in Shanghai.
State-owned enterprises – often known by the initials SOE – are making their mark in a string of other industries where there is plenty of competition and companies need both capital and a technological edge.
China is awash with private investment in steel, but the industry leader and most technologically advanced steelmaker in the country is the state-owned Baosteel. Chinalco, another SOE, has rapidly become one of the world’s leading producers of aluminium and alumina and is developing plans to become a diversified metals multinational.
Shanghai Electric, meanwhile, is increasingly taking on Japan’s Mitsubishi and Marubeni in bidding to build new coal-fired power plants around Asia. China’s two state-owned shipbuilding giants, China Shipbuilding Industry Corporation and China State Shipbuilding Corporation, are expanding rapidly and beginning to catch up with their Korean and Japanese competitors in terms of technology.
Some of the sector’s improvements reflect reforms the government has pushed on the state sector. Many SOEs have listed at least part of their shares, exposing them to at least some shareholder influence. Executives’ compensation is linked ever more to performance rather than bureaucratic formulas.
“SOEs are increasingly competitive in attracting top executive talent,” says David Michael, head of Boston Consulting Group’s China office. “There are a number of local Chinese managers of multinationals or private sector companies who have gone to work in the state sector.”
Several SOEs have taken on foreign strategic investors in recent years and some have multinational executives on their boards. These relationships have not been without tensions, but they have helped to sharpen performance.
The government has attempted to ensure that those state-owned companies competing globally are competitive at home. Chinalco’s acquisition of shares in Rio was approved by a government agency only after it had pitched its case against other SOEs, including Baosteel and Shenhua, China’s biggest coal company and the world’s second-largest.
There also have been increasing signs that China’s SOEs are learning the skills of corporate finance. Chinalco’s snap purchase of Rio Tinto stock was one example; another has been the ongoing tussle between China’s two biggest airlines, Air China and China Eastern, which could turn out to be the first public takeover battle between SOEs.
Last year, Singapore Airlines agreed to buy a 15.7 per cent stake in China Eastern, which is still controlled by the government but has listed minority stakes in both Shanghai and Hong Kong. The Chinese government gave its approval.
Yet Air China had other ideas, because it wanted to join forces itself with China Eastern to create a national champion. The company started to criticise the deal in public and lobby China Eastern’s shareholders to vote against it. “Everywhere we went, it seemed as if Air China had been there the day before,” says Li Fenghua, chairman of China Eastern. Sure enough, investors rejected the deal after Air China promised to make a higher bid. China Eastern has so far rebuffed Air China’s offer.
Large SOEs in China have always fought tough battles over strategy. But what has been different about the China Eastern situation is that a lot of the debate has been in public – and that Air China has gained an upper hand by offering more money to investors rather than winning a backroom political deal.
Such reforms only explain part of the success of some SOEs. According to Andrew Grant, head of McKinsey’s China practice, many of the successful companies in China have what he calls a “hybrid” structure, mixing features of private and state companies. The best SOEs gain financial firepower from their state parents but have sufficient independence to be managed like private companies. Likewise, some of the most successful privately run groups, such as telecommunications equipment maker Huawei and PC manufacturer Lenovo, have been helped by their close ties to government. “You are starting to see the development of a really interesting dynamic in the state sector,” says Mr Grant. “It is not the case that SOEs are going to dominate the entire economy, but I am very optimistic about some of them.”
The idea of such “hybrid” companies also helps explain the winners in other capital-intensive sectors, including China’s auto industry. “To develop a car company in China, you need to be able to play both sides, running the business with private sector-type discipline but also getting close to local governments for the land and bank contacts that this brings,” says Mr Dunne.
However, the record of SOE reform has not been a uniform success. While there are some outstanding state-owned companies, there are also plenty that demonstrate the well documented pitfalls of political interference and heavy-handed bureaucracy.
Top managers in SOEs are political appointees who can be forced to move jobs regularly between different companies and government departments. In a notorious case in the telecoms sector in late 2004, the government shifted the heads of China Telecom, China Mobile and China Unicom overnight, without giving them any notice.
Older SOEs are often still grappling with outmoded equipment and might be obliged to purchase components and other supplies from affiliated companies, regardless of quality or cost. SOEs can also face more restrictions than other companies when hiring and firing workers.
Although corporate governance has improved, investors regularly complain about lack of transparency in SOE finances, particularly over the transfer of assets between listed companies and their state-owned parent groups.
Moreover, there are several economic downsides to the increasing power of the large SOEs for the Chinese authorities. Although China’s private sector has grown sharply in recent years, the state sector still manages to command the lion’s share of formal financing. The commercial banking market is still dominated by the large state-owned banks and analysts say that these banks still prefer to lend to other large SOEs. Indeed, this close relationship is one reason that the Chinese economy is still vulnerable to periods of over-investment.
The massive boom in the local stock market, which saw companies raise more money in mainland China last year than in any other market, has also largely benefited SOEs. The 12 biggest initial public offerings last year in Shanghai were all by SOEs and accounted for 85 per cent of the capital raised.
Shen Minggao, an economist at Citigroup in Beijing, argues that the recent boom has affected the economy in other ways, by delivering most of the benefits of economic growth to state-owned companies in the form of higher profits, with relatively little going into the pockets of ordinary wage-earners. The massive reorganisation of the state sector in the late 1990s pushed responsibility for a lot of health and education spending on to families.
Meanwhile, the state has been the main beneficiary of the recent surge in SOE share prices, given that in most of these companies only a small proportion of the shares are actually traded – 4 per cent in the case of Industrial and Commercial Bank of China. “It is the state and not households that became wealthier during the blossoming of the SOEs,” says Mr Shen. “Households actually enjoyed only a small portion of the expanding wealth cake.”
Greater independence is good for corporate performance, but there are also signs that China’s more powerful SOEs are outstretching the ability of the country’s regulators to control them. The most remarkable incident occurred last summer, when the large state-owned oil companies forced the authorities to raise fuel prices by helping to create an artificial shortage.
The Chinese government sets prices for oil sold domestically, which puts pressure on the large oil companies – PetroChina, Sinopec and CNOOC – when international prices rise. The response from the large oil companies was a high-stakes game of bluff with the authorities: the amount of oil sold in China was reduced and several large refineries were put on “scheduled maintenance”. When many smaller, private refineries also refused to sell oil at the government-set price, creating an even bigger shortage, the authorities had no option but to increase prices.
The SOEs are also facing a backlash in some Beijing policy circles over their overseas investments. PetroChina has been operating in Sudan for over a decade, during which time Beijing has forged a close relationship with Khartoum. While these ties have prompted criticism that China has weakened international efforts to halt the violence in Darfur, PetroChina has at times sold more of the oil from Sudan to Japan than it has at home – prompting some experts to ask if the controversial Sudan policy actually brings real benefits.
Zhu Feng, of Peking University, says that the oil companies have “hijacked” the country’s foreign policy on Sudan. “Chinese oil companies and a lot of other oil companies in Sudan have made the money. It is not the people or the country [that have made money],” he says.
According to Zhang Yunling, at the Chinese Academy of Social Sciences: “It is not the government deciding to go to Sudan. It is the oil company. They have gradually developed their business and asked the government for support.”
Erica Downs, of the Brookings Institution in Washington, says Sudan is the “crown jewel” of PetroChina’s international business, but that “the company’s domination of the Sudanese oil industry arguably has done more damage to China’s reputation abroad than the activities of any other Chinese SOE”.
“The case demonstrates how the overseas activities of a Chinese SOE can simultaneously harm one Chinese foreign policy objective – to be and be perceived as a responsible rising power – and help another – to enhance energy security,” she says.
The Chinese government has attempted to improve its public relations in recent years, ordering ministries, with varying success, to explain decisions to the foreign and local media. Petro-China, however, one of the country’s most powerful companies, has shown no inclination to fashion a public message.
Elsewhere, in countries as diverse as the Philippines, Zambia and Peru, Chinese investments have provoked a political backlash. “In the future, this issue will become more and more serious,” says Mr Zhang.
For the ruling communist party the political benefits of the SOEs’ new wealth far outweighs any financial costs incurred in keeping them at the “commanding heights” of the economy. To maintain its grip, the party needs a strong state sector with the power to balance a rising entrepreneurial class. The risk for the authorities, however, is that over-mighty companies end up dictating policy themselves.