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Prevailing Winds

SOE Reform in China – Implications for Policymakers and Investors

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

Great Expectations

Many of America’s economic frustrations with China center around the role played by state-owned enterprises. For the past 25 years, America and China have been stuck in a cycle of hope and disappointment as it relates to SOEs. At present, there is a pervasive sense in the U.S. that China’s leaders have abandoned efforts to reform SOEs and are in fact committed to increasing their prominence within the economy.

American perceptions of Chinese SOEs were not always so pessimistic. In the 1990s and early 2000s, China engaged in a massive campaign of SOE reform. The Chinese government’s push to reform SOEs was largely motivated by necessity as corporate mismanagement had created a massive accumulation of non-performing loans. These bad debts grew so large that by the late 1990s, China’s largest banks were technically insolvent.1 Adding to the pressure to act was the Asian Financial Crisis. China’s leaders watched as many neighboring economies were racked by financial turmoil and political instability during that crisis, a fate they desperately wanted to avoid.

These factors motivated Chinese leaders to enact tough reforms on SOEs, most notably the “Grasp the Large, Let Go of the Small” policy in 1999. Failing enterprises were shuttered and millions of workers were terminated or forced into early retirement. The surviving SOEs underwent a restructuring process called corporatization, which involves adopting modern corporate structures, such as shareholders and a board of directors. In strategic sectors, such as steel, surviving SOEs were consolidated to create larger and more viable companies. Many SOEs would eventually list on China’s fledgling equity markets, bringing in new capital and the scrutiny of outside shareholders.

During this period, China also carried out significant financial reforms. Chinese banks discharged huge amounts of non-performing loans with government support. New rules were put into place to clean up the lending relationship between SOEs and banks to ensure the latter operated on more commercial terms. Additionally, the government solicited Western banks to invest in Chinese banks as strategic partners to help improve corporate governance and efficiency.2

As a result of all these reforms, there was a period in the mid-2000s when it looked like China might be on a path towards a less state-centric economy. This hope was centered around two trends that appeared to be taking hold. One was the expectation that the reforms seemed to be pushing SOEs towards a more market-based orientation. With better governance structures and a mandate from the top for improving profitability, it was reasonable to expect that SOEs would begin to act more like normal companies and less like the government bureaucracies many of them had been in the past.

The other major trend during this period was the tremendous growth of the private economy. Throughout the late 1990s and early 2000s, private companies grew rapidly in areas of the economy open to competition, such as in the export sector. Figure 1 shows the precipitous decline in the 2000s in the share of total exports from SOEs. Moreover, there appeared to be a willingness by the government to allow the private sector to displace SOEs in many key economic sectors and become a dominant source of output, investment and employment in the economy.

Figure 1. SOE Share of Total Chinese Exports
Sources: CEIC, National Bureau of Statistics of China.

Slowdown and Reversal

Hopes and expectations for SOE reform were slowly extinguished as the 2000s progressed. The initial burst of activity under the Jiang Zemin administration was not followed by further reforms under Hu Jintao’s government. The Hu administration seemed content to coast on the reforms done by their predecessors, which continued to pay economic dividends for many years. The convergence in productivity between SOEs and private companies, catalyzed by the reforms of the late 1990s, came to an end in 2007.3

There were even some indications during this period that the Chinese government was seeking to revive the role of SOEs as tools of government policy. In 2003, the government consolidated and strengthened its control over centrally-owned SOEs through the establishment of a new bureaucracy, the State-Owned Assets Supervision and Administration Commission (SASAC). China also began to vigorously pursue the “Going Out” strategy, which sought to bolster the overseas presence of SOEs and increase China’s outward foreign direct investment.

The impetus for SOE reform began to move into full reversal with the onset of the Global Financial Crisis. Faced with a collapse in export demand and huge job losses domestically, China launched an enormous stimulus package, larger in proportion to the size of its economy than what the U.S. undertook. Much of the stimulus was focused on infrastructure investment. State-owned banks lent huge sums of money to financing vehicles linked to local governments. These financing vehicles, in turn, financed a nationwide surge in infrastructure projects. SOEs, the recipients of much of these funds, dramatically increased their investment levels, helping to stabilize growth. Figure 2 shows the massive increase in fixed asset investment by SOEs during the stimulus. SOEs also maintained stable employment levels during this period at a time when Chinese workers, particularly migrant workers, were being laid off by the millions.

Figure 2. Growth Rate of Chinese SOE Fixed Asset Investment
Sources: CEIC, National Bureau of Statistics of China.

China’s leaders viewed their ability to command SOEs to spend and invest during this period as a key component of the country’s strong economic performance during the global financial crisis. Speaking in 2009, Li Rongrong, the head of SASAC, cited the important role played by central and local SOEs in implementing the Chinese government’s directives to stabilize the economy and preserve growth. In contrast, the more market-driven economies of the U.S. and Europe faced sharp recessions and years of low economic growth following the crisis. Subsequent analytical work has highlighted the critical role played by the private sector in responding to the crisis and propelling China’s growth in the years immediately afterwards.5 Nonetheless, the perceived instrumentality of SOEs during this period helped reinforce China’s commitment to preserving SOEs as a major component of the economy.

The Xi Jinping Era

The rise of Xi Jinping and his consolidation of power have coincided with an even stronger impetus to strengthen the role of SOEs. President Xi’s embrace of SOEs stems from a belief that they can advance his goals of strengthening the Communist Party of China (CPC) and reclaiming China’s former national greatness. In 2009, then Vice President Xi gave an early indication of his views, declaring that SOEs are “an important foundation of Communist Party rule.”6

In the Xi formulation, SOEs play a special role within the economy, providing public services, stabilizing the economy during periods of volatility, and supporting government industrial policy and other initiatives. While the private sector is not excluded from these activities, SOEs are viewed as more reliable, controllable, and less likely to become political threats. Whether viewed through share of lending or investment, the shift towards a more private-run economy has suffered a dramatic setback during Xi’s tenure. While no more profitable or efficient than before, Chinese SOEs have become more entrenched within certain sectors of the Chinese economy.

Instead of allowing failing state-owned firms to shut down or be displaced by private competition, the approach of the Xi Jinping administration has been an even greater emphasis on mergers between state-owned firms. As a result, some truly enormous state-owned conglomerates were established over the past several years. In 2015, the “Guiding Opinion on Deepening the Reform of SOEs” unleashed a rapid series of mergers across a range of economic sectors, including energy, infrastructure, food, and manufacturing.7 While the total assets of centrally owned SOEs continued to grow during this period, productivity of these firms stagnated.8

The Chinese government has also doubled down on using SOEs as a tool for the implementation of government policy. State-owned firms have been at the forefront of the Chinese government’s drive to develop domestic sources of key technologies, such as semiconductors. SOEs have participated in thousands of projects under the banner of the Belt and Road Initiative.11 When the spread of Covid-19 in early 2020 forced the Chinese economy into a severe lockdown, SOEs emerged as the economic engine of last resort, spending and investing while private firms pulled back.

SASAC’s reform agenda for SOEs under Xi has been disappointing. There had previously been hope that SASAC might embrace an approach similar to Singapore’s Temasek, allowing SOEs to be professionally run with minimal levels of government interference. Instead, SASAC is proceeding with a hybrid approach that adopts some elements of the Temasek model while retaining a large role for the government to guide state investment into key strategic sectors of the economy.

The Chinese government’s relationship with the private sector in the Xi Jinping era is marked by contradictions. China’s top leaders readily acknowledge the primacy of the private sector, stating that private companies contribute “more than 50 percent of tax revenue, 60 percent of gross domestic product (GDP), 70 percent of technological innovation, 80 percent of urban employment and 90 percent of new jobs and new firms.”14 When the private sector experienced an acute financing crunch in 2018, Xi Jinping declared his “unwavering support” for the private sector and there was a strong government response to help alleviate the problem.15 However, one aspect of that response led to SOEs taking an even more prominent role in the economy. SOEs and government guidance funds mobilized capital to bail out struggling private companies, in some instances taking a controlling stake.16 Throughout the tenure of Xi Jinping, there has been a clear shift towards reinforcing the position of SOEs within the economy.

Impact on American Businesses and Investors

SOEs in China are a major concern for American businesses and investors because of the protected role these companies play within certain sectors, their access to direct and indirect subsidies, and the extent to which they pursue non-market objectives.

Overall, SOEs are estimated to account for around a quarter of China’s economy, a far cry from many external popular perceptions of an entirely state-controlled economy.17 However, in absolute terms, the total output of SOEs is immense, larger than the GDP of the United Kingdom or India.18 Moreover, SOEs play a dominant role within certain sectors of the Chinese economy, including energy, aviation, finance, telecoms and transportation. The ability of American businesses to compete within these sectors is either limited formally by law or constrained through the monopolistic role of SOEs.

The dominance of SOEs in certain sectors is bolstered by direct and indirect subsidies. It is generally the indirect subsidies that are both more significant and harder to identify and track. The chief indirect subsidies to SOEs are below-market borrowing rates and government-financed restructurings that prevent bankruptcy. Both of these items allow SOEs to continue operating under circumstances where a private company would typically be forced to shut down or sold to a competitor. An example of this is the persistence of “zombie” companies in the steel and aluminum industries that continue to operate at a loss and have created a glut in supply of these commodities. SOEs also benefit from preferential access to land and government approvals.

While SOEs only account for a quarter of China’s economic output, they still play a disproportionately large role in China’s equity and bond markets. Figure 3 shows the number of listed Chinese SOEs and their combined market capitalization, including both onshore and offshore exchanges. SOEs also account for a large portion of initial public offerings (IPOs) in Mainland China and Hong Kong. Looking at the 10 largest IPOs per year between 2015-2019, SOEs accounted for 70% of the IPOs and 63% of total funds raised.19 In the bond market, state-owned issuers account for the majority of total bond issuance.20 During periods of financial turmoil, the government has mobilized state funds – the so-called national team – to stabilize markets.

Figure 3. Publicly Listed Chinese Companies by Ownership Type
Number of Companies Market Capitalization (USD Billions)
State-owned 1,463 7,494
Private 3,799 10,829
Sources: Goldman Sachs21, Seafarer.

Both American investors and businesses can be negatively impacted by the tendency of SOEs to pursue non-market objectives at the behest of the government. A recent example of this is China’s drive to promote the development of domestic sources of critical technologies, most notably semiconductors. Thousands of companies, many of whom previously had no connection to the semiconductor industry, have rushed to support the government’s semiconductor initiative.22 SOEs, along with their listed subsidiaries, have some of the largest investments in developing China’s semiconductor capacity. Given that the impetus behind the semiconductor campaign is largely geopolitical rather than economic, it is possible that much of this investment will ultimately be wasted. In the meantime, American semiconductor companies will be challenged by competitors that do not operate along normal market-based considerations.

Getting Reform Back on Track

SOEs are here to stay as a major component of the Chinese economy, particularly in sectors the Chinese government views as strategically important. Given this reality, U.S. policymakers should push China to adopt a rules-based and transparent approach to managing SOEs with the goal of protecting the interests of American investors and businesses.

This approach should center around pressuring China to adhere to its own stated goals for SOE reform. Figure 4 outlines how China's Ministry of Finance classified SOEs in 2015.

Figure 4. China’s Three Categories of State-owned Enterprises
Public Service SOEs Provide public goods and services in areas fully controlled by the government, such as utilities. Example: State Grid Corporation of China.
Commercial SOEs in Strategic Sectors Operate in sectors of the economy that are strategically important or natural monopolies. Example: Aviation Industry Corporation of China.
Commercial SOEs in Fully Competitive Sectors Operate in sectors where there is significant competition from private and foreign firms. Example: China Foods Limited.
Source: Chinese Ministry of Finance.23

According to the Chinese government, SOEs in the first two categories, Public Service SOEs and Commercial SOEs in Strategic Sectors, should become more efficient through corporate governance reform and tighter government oversight. The latter category, Commercial SOEs in Fully Competitive Sectors, should be free to raise capital from the private sector, reduce the overall share of state-ownership, hire outside managers, and go bankrupt if they fail commercially. Chinese leaders at the highest levels, including Premier Li Keqiang, have also publicly committed to the competitive neutrality between SOEs and private firms in fully competitive sectors.24

The problem with this approach is that the government has not categorized SOEs in an open manner or provided the public with the results of that exercise. The categorization effort was delayed for years, presumably due to resistance from vested interests at SOEs that sought to avoid a commercial classification.8 As of the end of 2020, SASAC reported that it had completed the process for the central SOEs, but it has yet to share the result with the public.28

This lack of transparency has contributed to the growing levels of distrust, both within and outside of China, about the government’s intentions for SOEs. Despite declarations of competitive neutrality, private and foreign enterprises in China continue to cite a litany of disadvantages they face relative to SOEs. The SOEs that have undergone restructuring, including the case studies mentioned above, have yet to convince outside observers of the scope of their changes. The failure of the Chinese government to publicly live up to its own stated reform goals for SOEs has strengthened the argument of those that claim China has given up on broader economic reforms.

For SOEs, there is a fortunate convergence between the government’s stated goals, what would be economically beneficial for China, and what might help alleviate some American concerns. China should proceed with the core principles of its SOE reform goals: separating ownership and management, reducing interference in day-to-day operations, and allowing SOEs in competitive sectors to restructure and operate along market lines. As it proceeds with these goals, it should commit to much greater levels of transparency and communication with the rest of the world.

For SOEs listed on public equity markets, these changes should involve:

These reforms will not eliminate the tensions arising from the prominent role that SOEs play within the Chinese economy, but they will clarify the “rules of the road” for investors and provide some much-needed transparency to China’s capital markets.

Nicholas Borst,
As of December 31, 2020, China Foods, Ltd. comprised 1.6% of the Seafarer Overseas Growth and Income Fund. View the Fund’s Top 10 Holdings. As of December 31, 2020, China Foods, Ltd. comprised 3.6% of the Seafarer Overseas Value Fund. View the Fund’s Top 10 Holdings. As of December 31, 2020, the Seafarer Funds did not own shares in the other securities referenced in this commentary. Holdings are subject to change.
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
  1. Michael F. Martin, “China’s Banking System: Issues for Congress,” Congressional Research Service, 20 February 2012.
  2. Guonan Ma, “Sharing China’s Bank Restructuring Bill,” Institute of World Economics and Politics, Chinese Academy of Social Sciences, 2006.
  3. Chang-Tai Hsieh and Zheng (Michael) Song, “Grasp the Large, Let Go of the Small: The Transformation of the State Sector in China,” Brookings Papers on Economic Activity, The Brookings Institution, February 2015.
  4. Li Rongrong, “Speech at the National Conference on Supervision and Administration of State-owned Assets (李荣融在全国国有资产监督管理工作会议上的讲话),” State-owned Assets Supervision and Administration Commission of the State Council, 24 December 2009.
  5. Nicholas Lardy, Markets Over Mao: The Rise of Private Business in China (Washington, D.C.: The Peterson Institute for International Economics, 2014).
  6. Barry Naughton, "State Enterprise Reform Today," in China’s 40 Years of Reform and Development: 1978–2018, edited by Ross Garnaut, Ligang Song, and Cai Fang (Australia: ANU Press, 2018.
  7. Guiding Opinion on Deepening the Reform of SOEs (国务院关于深化国有企业改革的指导意见),” Central Committee of the Communist Party of China and the State Council of the People’s Republic of China, 24 August 2015.
  8. Nicholas Lardy, The State Strikes Back: The End of Economic Reform in China? (Washington, D.C.: The Peterson Institute for International Economics, 2019).
  9. Factbox: Shenhua and Guodian - China's latest state marriage,” Reuters, 29 August 2017.
  10. About Us Profile,” China Energy Investment Corporation, Accessed 2 February 2021.
  11. Wendy Leutert, “State-Owned Enterprises in Contemporary China,” The Routledge Handbook of SOEs, 28 May 2020.
  12. A New Group of 11 Central Enterprises for the State-owned Capital Investment Companies for Pilot Program Launched (新一批11家中央企业国有资本投资公司试点启动),” People’s Daily, 8 January 2019.
  13. Implementing Opinion on Promoting State-owned Capital Investment and Operation Companies (国务院推进国有资本投资, 运营公司改革试点的实施意见),” State Council of the People’s Republic of China, 14 July 2018.
  14. Vice-Premier Vows Unwavering Support for Private Sector,” State Council of the People’s Republic of China, 19 October 2018.
  15. Xi Vows ‘Unwavering’ Support for Private Sector After China Rout,” Bloomberg News, 21 October 2018.
  16. Hao Chen and Meg Rithmire, “The Rise of the Investor State: State Capital in the Chinese Economy,” Studies in Comparative International Development, 29 July 2020.
  17. Chunlin Zhang, “How Much Do State-Owned Enterprises Contribute to China’s GDP and Employment?,” World Bank, 15 July 2019.
  18. Andrew Batson, “Is China experiencing an advance of the state sector?,” Andrew Batson's Blog, 16 February 2021.
  19. China IPO Watch 2019,” PWC, 2020. State and private ownership classification according to the author’s research.
  20. Kate Jaquet, “The Evolution of China’s Bond Market,” Seafarer Capital Partners, March 2019.
  21. Kinger Lau, Timothy Moe and Si Fu, “China Weekly Kickstart,” Goldman Sachs, 27 February 2021.
  22. Kathrin Hille and Sun Yu, “Chinese Groups Go from Fish to Chips in New ‘Great Leap Forward’,” Financial Times, 12 October 2020.
  23. Guiding Opinion on the Classification on the Definition and Classification of SOEs (关于国有企业功能界定与分类的指导意见),” Chinese State-owned Assets Supervision and Administration Commission, Ministry of Finance, and National Development and Reform Commission, 30 December 2015.
  24. Competitive neutrality “implies that no business entity is advantaged (or disadvantaged) solely because of its ownership.” See Antonio Capobianco and Hans Christiansen, "Competitive Neutrality and SOEs: Challenges and Policy Options," OECD, 1 May 2011.
  25. Clare Jim and Julie Zhu, “State-owned China Unicom to raise $12 billion from Alibaba, Tencent, others,” Reuters, 16 August 2017.
  26. 2017 Annual Report,” China Unicom, 2018.
  27. Bloomberg. Data as of 17 February 2021.
  28. SOE Reform: ‘Four Beams and Eight Pillars’ Implemented –Three Year Action Plan Launched (国企改革: “四梁八柱” 落地 三年行动开启),” Guangming Daily, 13 October 2020.