By Christopher Balding
A LITTLE-NOTICED statement last week could portend the next big battle in China’s effort to control its debt. On Aug. 2, the finance ministry issued directives that state-owned companies improve returns, control risks and make sure that “projects are financially viable before decisions are made.”
That the government feels the need to spell out such obvious goals tells you the depth of the problem. China’s sprawling array of state-owned enterprises—with millions of employees across all sectors of the economy—may be the biggest obstacle to its broader effort at financial reform. Previous attempts to rein them in have largely failed. But if the government has any hope of real deleveraging, this time will have to be different.
SOEs are huge, and so are their liabilities. They’re responsible for non-financial corporate debt equal to 90 percent of gross domestic product. Facing limited competitive pressure, they’ve driven the worst of China’s debt-led excess: Return on assets for these firms in 2016 was a paltry 2.9 percent, compared to 10.2 percent in the private sector.
One reason is that China’s banking industry, which is itself almost exclusively state-owned, channels loans to SOEs in the expectation that they’ll have an implicit government guarantee. SOEs provide only 16 percent of China’s jobs and less than a third of its output, but they receive an astonishing 30 percent of all loans. With credit so easily available, they have little incentive to economize.
They’re also burdened with conflicts of interest. Despite the new directive to focus on profitability, SOEs are still subject to orders from Party committees that sit above their corporate boards. Some firms have chafed at this arrangement, but in general political objectives—such as maximizing local employment—take priority over profits. Party leaders even refer to privatization as “wrongheaded thinking.”
China’s “Belt and Road” initiative offers a case in point. Even amid a broad crackdown on overseas investment, firms are being prodded to plow hundreds of billions of dollars into the initiative—mostly for unprofitable infrastructure projects—while simultaneously being told to prioritize return on investment. They can be forgiven for being a little confused.
Given all these challenges, complying with the new directives will be difficult. Regulators have tried numerous reform strategies in the past. One has been to merge multiple inefficient SOEs, in the unlikely hope that combined they will create one efficient SOE. Another has been to draw distinctions between “commercial” and “public service” SOEs, hoping to give the former some private sector-like flexibility. But as long as these companies can fall back on favorable bank loans, the impetus to improve efficiency will be limited.
Public-private partnerships are the latest trend. Chinese listings on Hong Kong’s stock exchanges are now dominated by companies with government shareholders. But a public listing by itself doesn’t necessarily impose market discipline; SOEs tend to sell only small stakes to private investors, often as a way to inject badly needed capital or even to disguise debt.
Will this latest effort prove any more effective? In 2015, at the height of the stock market boom, a report from China’s National Audit Office criticized SOEs in similar terms. Yet two years later, government control has only tightened and SOE revenue has been driven up primarily through higher defense spending. Reform this time around will likely prove just as challenging.
A better approach starts with recognizing that using state-linked firms as a social-welfare system only hampers development. A vast amount of capital is being misallocated to dying industries, while China’s energetic small businesses receive less than a third of corporate loans. The “iron rice bowl” is great for the lucky workers who secure lifetime jobs at SOEs, but it limits opportunities for everyone else.
A related goal should be to have more faith in private enterprise. China is producing world-class companies, from tech firms such as Tencent Holdings Ltd. to leading smartphone manufacturers such as Huawei Technologies Co. Even its restaurants are minting billionaires by focusing on customer service and eschewing IPOs. Investment should be flowing to these enterprises rather than to state-run behemoths that will never be productive or profitable. Make that happen and China’s challenges start to look a lot less daunting.