China needs to turn its capital ideas into SOE reform

Authors: Zhengjun Zhang and Sarah Du, King Parallel

State-owned enterprise (SOE) reform in China has come a long way.

SOEs contribute to 23.4 per cent of industrial revenue and 21.6 per cent of profits — a significant drop from more than 80 per cent of both industrial revenue and profits at the start of the reform and opening up in the late 1970s. In 2014, 88 Chinese SOEs were included in Fortune Global 500, Fortune magazine’s annual list of the top 500 corporations worldwide by revenue.

SOEs now make up just 4.9 per cent of firms in China’s mining, manufacturing and utilities sectors. But there are still a few long-term problems that must be resolved.

State capital is deployed across too many sectors, including some purely commercialised ones. SOEs show general features of weak competitiveness: they are small, poorly structured and inefficient. For example, 76.6 per cent of all SOEs in China are classified as small or micro firms. There is excessive concentration of shareholding and administrative meddling, which makes it hard for SOEs to set up governance mechanisms that suit a market economy. Even for listed firms, the state ownership share is over 70 per cent in many cases.

These problems spring from some of the policy defects of SOE reform. First, the goals of state ownership are unclear. It is hard for SOEs to formulate and communicate clear objectives at all relevant levels. This makes it difficult to build effective accountability systems, and inhibits the rational re-allocation of state capital. Second, the government has been used to intervene, and there has been lack of supervision of how ownership rights are exercised. As a result, ownership entities have been executing a kind of enterprise management rather than capital management. Third, warped corporate governance has spawned ineffectual boards of directors, one-size-fits-all remuneration policies and a tendency for internal bureaucratisation.

China has several quite unique characteristics. It has a large population (close to 1.4 billion); it is a middle income country with US$3200 per capita disposable income in 2014; and it is a transition economy that is still developing its market mechanisms and institutional systems. With these characteristics, China needs to keep a large toolbox to deal with potential challenges on its development path.

One tool inside the box is the control of ownership of SOEs. SOEs can be assigned objectives that are different from those of developed Western economies. But the weaknesses of SOE corporate governance in all jurisdictions across the globe are very similar. This brings a real challenge for SOE reform in China: how can China use its SOEs as a unique and important developmental tool while addressing the problems of SOE governance that can be concluded in many countries?

China should use state ownership to remedy market failures, stabilise the foundations of the economy and implement the government’s industrial policies. State capital should be deployed to more sectors than in developed countries. It should be used to ensure the provision of public goods, to offset additional regulatory cost for natural monopolies and to carry out specifically designated functions. State capital should also be deployed in sectors with particular strategic significance.

If the state is to exercise ownership over an SOE then it should meets three conditions. First, the rights, responsibilities and benefits of each department or entity of the state that is exercising ownership over the enterprise must be aligned. Second, there must be a system of checks and balances overseeing policymaking, implementation and supervision of ownership. Third, there should also be well-defined channels to reach the objectives of ownership.

Boards of directors should be independent, expert and accountable. They should possess almost complete authority for strategic decision-making in accordance with market principles and the rights and responsibilities of their type of SOE.

In the medium to long term, China needs to improve its state ownership policies and management systems. The state should define the goals of ownership and delineate the boundaries of the state economy. It must streamline the channels through which the state exercises its ownership rights and the relationship between different bodies. The government should distribute more state capital to sectors that need SOEs, such as public services, natural monopolies, imperfect contracts and industries that pursue national strategies. SOEs should be restructured in order to strengthen competitiveness and eliminate inefficiencies.

By establishing state-owned capital investment companies, the government can find opportunities to implement these much-needed reforms.

China should unveil its plans for state capital and the structure of future SOEs. Mixed public and private capital should still be promoted for commercially-oriented SOEs operating in competitive sectors. China needs to reform SOE governance, strengthen the market principles of governance, introduce a new system of governance that would classify SOEs by category, and clearly define the principles by which the state participates in corporate governance. By implementing these reforms, China can realise the goal of ‘capital management’ over ‘enterprise management’.

State capital and SOE reform needs coordinated and coherent policy. The reform designs made at the top should flow down to concrete policy plans. China needs to further clarify the broad goals and specific objectives, as well as the rights and responsibilities of SOEs.

Zhengjun Zhang is the managing partner and CEO of King Parallel, Beijing. Sarah Du is director of State Ownership and SOE Consultancy, King Parallel.