INvESTING IN CHINA: REFORM-MINDED CHINA SETS SIGHT ON STATE-OWNED ENTERPRISES DECEMBER 2014 MARKET INSIgHTS ONE YEAR ON, CHINA IS STILL SET ON SOE REFORM A little over a year into the unveiling of its expansive reform program, China seems to be plodding through the makeover of its state-owned enterprises (SOEs), despite market demands to quicken its pace. The Chinese government is playing it safe, opting for a gradual approach but taken together the proposed measures offer hope that policymakers are getting on with the reform program after years of vacillation. The reform plan that was announced November 2013 has gone well beyond what most market observers anticipated and is deemed crucial to helping achieve President Xi Jinping s goal of making China a moderately well-off society by 2020 and a fully developed nation by about 2049, the 100th anniversary of the People s Republic. 1 The transformation of China s massive SOEs is a key plank of the Communist Party s wide-ranging economic and social reform program. Other financial sector reforms that have grabbed attention is the flagship scheme to link the Hong Kong and Shanghai stock exchanges dubbed as the Shanghai Hong Kong Stock Connect and otherwise known as the Mutual Market Access (MMA) scheme. For the first time, foreign investors are allowed to buy and sell A shares listed in China directly. This stock trading link is closely correlated with SOE reform as many of the stocks eligible for the program are state-owned firms. While China is no stranger to reforms, the strength of the top leaders rhetoric and the level of detail for implementation suggest that this time around may be different and that the changes may yield desirable results. WHY THESE REFORMS ARE DEEMED CRUCIAL As the focus shifts to the quality of economic growth rather than the pace of expansion, the reform of China s SOEs, totaling about 155,000, is all the more crucial. SOEs make up about 65% of the A-share market cap and 80% of the H-share market cap, more than the share of SOEs in any other emerging market. They dominate China s strategic industries, giving them a hold over big commercial banks. About 120 of the SOEs are centrally administered through the State-owned Assets Supervision and Administration Commission (SASAC). The other SOEs are owned by provinces or municipalities and controlled by their governments. 2 The need to revitalise SOEs reflects the deteriorating returns and rising debt of these state firms. Local SOEs posted an average return on equity (ROE) of 11% in the 2009-2013 period as central SOEs averaged 11.6% lower than the 15% average made by private enterprises in China. 3 While their inefficiency is not Source: 1 South China Morning Post (Xi Jinping, a nationalist and a reformer), 6 June 2013. 2 UBS Securities SOE Reform: Unlocking value, 27 August 2014. 3 Goldman Sach s SOE reform series New plan and new beneficiaries, 9 June 2014.
Investing in China: Reform-minded China sets sight on state-owned enterprises Page 2 Fig.1. Average ROEs of SOEs versus Private Enterprises 25 20 15 10 5 0 Capital Goods Commercial and Professional Services Consumer Durables and Apparel Consumer Services Diversified Financials Energy Food and Staples Retailing Food Beverage and Tobacco Health Care Equipment and Services Household and Personal Products Materials Media Pharmaceuticals, Biotechnology Real Estate Retailing Semiconductors Software and Services Technology Hardware and Equipment Telecommunication Services Transportation Utilities OVERALL OVERALL Ex-Fin Central CEO Local SOE Private Enterprise Source: Goldman Sachs, 9 June 2014. substantially higher than private business, SOEs pay their employees 60% higher on average compared with unlisted Chinese companies. 4 SOEs tend to get preferential treatment from the state and are favoured by state banks over small and medium-sized enterprises. Over the years, SOEs have caused distortions in pricing and allocation of financial resources. As far as the impact on the economy is concerned, reforming the SOEs will slow leverage growth and accelerate productivity. Total assets of China s SOEs amounted to RMB 104 trillion as of end-2013, or about 83% more than the country s gross domestic product (GDP) in the same year. SOEs account for about 43% of industrial assets, 30% of revenue and 15% of jobs. That compares with most member countries of the Organisation for Economic Cooperation and Development (OECD) where SOEs account for less than 5% of the economy and typically less than 15% in most other developing economies. 5 The reforms will redirect the country s precious resources to more efficient state-owned sectors rather than the inefficient ones, ensuring continued productivity gain rather than loss. The proposed changes also lock down the SOEs contribution to the social safety net. The dividend payouts of SOEs should reach 30% by 2020 from the current 10-15% and that this amount will be used to improve people s livelihood. 6 Source: 4 China International Capital Corp Ltd (CICC) Eight Questions on SOE Reform, June 2014. 5 National Bureau of Statistics of China Website press release on 2013 GDP numbers, dated 20 January 2014; UBS Securities Asia Limited s China Investment Thesis Compendium, 12 September 2014. 6 Xinhua Website s China to claim more gains of state-owned capital, 15 November 2013.
Investing in China: Reform-minded China sets sight on state-owned enterprises Page 3 SOE reform scorecard Ownership diversification, removal of favoured access to markets and resources, and creation of state-owned capital management companies are key features of SOE reform. If all goes according to plans, in a decade s time, these SOEs, except for a strategic few, will resemble private companies in terms of efficiency and profit orientation. Furthermore, private companies will be allowed stakes in sectors that are the exclusive preserve of SOEs to develop a mixed ownership economy. The private sector will be able to own stakes in state investment projects and employees of these multiownership enterprises will be allowed to hold shares in their companies. There has been considerable progress on the reform front. China Petroleum and Chemical Corp, an SOE and otherwise known as Sinopec, sold a combined 29.99% stake in its fuel-retailing business for 107 billion yuan (USD 1.75 billion) to 25 investors, one of them to listed conglomerate Fosun International Ltd. 7 CITIC Group, one of China s largest state-owned conglomerates, injected USD 37 billion of unlisted assets into its Hong Kong-listed subsidiary Citic Pacific, a move that will subject Citic Group s full portfolio to the increased transparency and discipline that comes with being a publicly-traded company. 8 Bank of Communications, China s fifth-largest bank, is studying plans to deepen its mixed ownership structure. China Everbright, part of the government-owned Everbright Group, plans to become a joint-stock company rather than a wholly-owned SOE, a move seen by analysts as a prelude to the flotation of the group s unlisted assets. 9 In the first half of 2014, earnings of SOEs reflected the positive impact of the government s anti-corruption campaign as well as SOE reforms. While SOE revenues fell 6.1% in the first half of the year, earnings before interest (EBIT) margins improved. Many SOEs, under pressure to reform and curb corruption, started to trim expenses which led to better earnings. The net gearing of SOEs dropped for the first time since 2010 and were especially seen in the solar, coal, utilities and transport sectors. 10 China also liberalised pricing of telecommunications services, pushed for the creation of a new national telecom tower company and opened up 80 new investment projects in sectors previously dominated by SOEs to private competition. Shanghai Hong Kong: Making the Connection The Shanghai-Hong Kong Stock Connect programme cranks open mainland China s capital markets and promotes the internalisation of the Renmimbi. Until such a scheme, only licensed international institutions can invest in foreign stocks and bonds through a Qualified Stocks Foreign Institutional Investor (QFII) programme and the Renminbi Qualified Foreign Institutional Investor (RQFII) programme. Under the MMA, investors in Hong Kong and Shanghai are able to trade eligible shares listed on the other s market through local securities firms or brokers. Trading is subjected to a quota and the northbound aggregate quota is set at RMB 300 billion while the southbound is placed at RMB 250 billion. Hong Kong and overseas investors, without QFII or RQFII icenses are able to purchase eligible stocks listed on the yuan-denominated A-share market in Shanghai through the Hong Kong Exchange. Mainland Chinese investors are permitted to purchase the eligible Hong Kong-listed stocks. Each day, up to RMB 13 billion (USD 2.1 billion) in daily quota can head north into China from Hong Kong while a maximum of RMB 10.5 billion can go south. The daily quota limits the maximum net buy value of the cross-boundary trades each day. 11 Source: 7-9 Bloomberg News Sinopec story, 14 September 2014; Citic story, 27 March 2014; Everbright Group Revamp; 01 August 2014; Morgan Stanley s China deleveraging: SOE reforms are progressing, 4 June 2014. 10 UBS Securities. China H-Share Strategy. MSCI China H114 interim results review giving more credit to SOEs, 10 September 2014. 11 Website on the Shanghai-Hong Kong Stock Connect http://www.hkex.com.hk/eng/csm/chinaconnect.asp?langcode=en
Investing in China: Reform-minded China sets sight on state-owned enterprises Page 4 Fig.2. SOE Share of MSCI Market Cap 80% 70% 60% 50% 40% 30% 20% 10% 0% China Poland Russia Malaysia Czech Indonesia Greece Thailand Brazil GEMs Colombia Chile Turkey Taiwan Egypt India Korea South Africa Mexico Philppines Peru Hungary Source: UBS, Datastream, September 2014. The new trading link is closely associated with SOE reform as 402 or 71% of the 568 stocks eligible for north-bound trading are state-owned companies while 124, or 46% of the 268 south-bound trading stocks are owned by the state. 12 The Shanghai-Hong Kong MMA program kicked off on 17 November 2014. 13 After the heightened interest prior to the launch, the Northbound trading cap of RMB 13 billion was hit within five hours of the market s opening while southbound initial trading was slower than expected as mainland investors left more than 80% of the buying quota for Hong Kong equities unfilled on the first day. 14 Still, hopes are high that the pilot program is the beginning of a major new wave of financial reform. Going forward, some see Hong Kong s stock market being connected to that of Shenzhen and perhaps other links involving bonds, commodities and foreign exchange. Moreover, some expect the investment quota for the Shanghai Hong Kong link to be raised in the future and that the programme will eventually include more stocks. The link is also seen to pave the way for A-shares to be included in international indices, possibly by major index providers such as MSCI Inc. Given the lower correlations of the A shares to global equities, they may also be seen as a means for diversification to international investors. Ultimately, the trading link could pave the way for more compelling changes in opening up China s capital account. Source: 12 Website on the Shanghai-Hong Kong Stock Connect http://www.hkex.com.hk/eng/csm/chinaconnect asp?langcode=en 13 Yuanta Investment Strategy s Shanghai-Hong Kong Stock Connect to Kick off on November 17, dated 11 November 2014. 14 Press release on the Market Highlights of the Shanghai-Hong Kong Stock Connect debut, 21 November 2014 http://www.hkex.com. hk/eng/newsconsul/hkexnews/2014/documents/141121news.pdf
Investing in China: Reform-minded China sets sight on state-owned enterprises Page 5 Fig.3. Trading rules and trading flows for Shanghai Hong Kong Stock Connect North-bound Trading Shanghai Stock Exchange (SSE) HKSE Subsidiary Hong Kong brokers Hong Kong and overseas Investors (institutional and individuals Total quota: 300 billion RMB Daily quota: 13 billion RMB/day Tradable stocks: 568 (SSE180, SSE380, SSE A+H shares) Quoted in RMB / settled in RMB T+1 Limit Order only Margin trading and covered short selling permitted Rights issue subscription allowed China institutional investors and individuals with >500K RMB balance China brokers Hong Kong Stock Exchange (HKSE) south-bound Trading Total quota: 250 billion RMB Daily quota: 10.5 billion RMB/day Tradable stocks: 268 (Hang Seng Index, SSE A+H shares) Quoted in HKD / settled in RMB T+0 Margin trading and SBL permitted Source: Yuanta Investment Consulting. Successful reforms will be China s biggest dividend While the push for SOE reform in China has started, we hope to see consistent progress on this front, specifically in the areas of privatisation and governance. A steady accumulation of reforms will likely allay market worries about the depth of the government s commitment. We are hopeful that mixed ownership will enable the SOEs to face market disciplines and better allocate their assets as well as improve corporate governance practices. We believe in the government s determination to effect reforms proven lately by its ability to allow slower growth despite calls for major stimulus measures. Nonetheless, breaking the back of the SOE beast is fraught with challenges given the various interests involved as well as the other reforms that the government is undertaking involving land, financial sector and labour. For sure, the government s political resolve will be put to test given that it will have to balance reform with its growth goal. We are expecting, however, that China s leaders will cautiously traverse the path of reform, mindful of the mistakes that past changes have wrought. One key challenge for the government is preventing its measured implementation of reforms from slowing to such an extent that the crucial and painfully achieved changes are stalled. As Premier Li once said reform is like rowing upstream. Failing to advance means falling back. 15 Source: 15 Xinhua, 13 March 2013.
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