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China’s State-Owned Enterprise Reforms: Credit Implications
China’s state-owned enterprises (SOE) account for the lion’s share of corporate bond activity in China, representing about 55% of Chinese corporate debt outstanding, according to the IMF. Given the size and importance of this market, we believe it is key to stay on top of trends in China SOE reform. There is a common perception that reform to SOEs equates to market reform; that when SOE reforms diverge from free-market principles, or are slower than what the market expects, the government is therefore backtracking on SOE changes. We believe, however, that free markets are only part of the point; the bigger picture is whether the government pursues SOE reforms in an orderly and stable manner, at a pace which is suitable for a massive economic system like China’s.
Flexible Implementation of SOE Reforms
The Chinese government has articulated 10 major principles in driving SOE reforms (see Appendix). In our view, their ultimate objective is a more efficient economic and governance structure for SOEs. Although market principles are included in reforms, the government is not dogmatic about any single guiding principle. The pace of action and emphasis on each principle varies over time. If one principle is de-emphasized, it may be revived again at a later date. We should also note that there tends to be more action after reform guidelines on a specific principle are published, which gives direction to corporate and regulatory actors.
Moreover, different themes have been emphasized in different years according to the broader macro backdrop at the time. For example, in 2014 the focus was on hybrid ownership, management remuneration and employee ownership, while in 2015 the government emphasized anti-corruption measures, state capital management and the categorization of SOEs to reflect their degree of strategic interest, and thus the need to maintain government control. In 2016, mergers and acquisitions, and supply-side reforms have been the focus. Meanwhile, the pursuit of reforms has created investment opportunities, particularly in the areas of hybrid ownership (where SOEs are able to monetize certain businesses) and M&A, which we expand upon below.
Movement in M&A
This year, we have seen many large M&A deals being struck among the SOEs, particularly in the “old economy” sectors with overcapacity, such as shipping, steel production and mining. M&A activity in some areas is part of an effort to restructure large but inefficient operations. In such cases, reforms have often proceeded with larger-than-usual government ownership and involvement, given unattractive fundamentals (sunset businesses, zero or low profits, large legacy burdens like excessive employment) that would discourage private players from participating. By merging companies in such sectors, the government can actually lead the restructuring, forcing smaller, inefficient players out. Note that even in such mergers, we have not seen a high number of de-listings of operating units or nationalizations. In addition, there has been a pick-up in SOE defaults, which implies a willingness to let market forces work, although continued attempts to contain any social impact or market contagion are likely.
Credit Implications of SOE Reforms
We believe that the reforms have generally (but not uniformly) had a positive impact on corporate fundamentals, resulting in more credit rating upgrades than downgrades. The effects include the following:
- Better valuations . As SOEs adopt better governance and become more efficient in both operations and capital allocations, that should improve equity valuations (better earnings multiples), which will also benefit bond valuations.
- Improving earnings . Especially for industries with overcapacity that are undergoing consolidation, the removal of unnecessary competition should help improve margins going forward. Supply-side reforms have clearly supported earnings for steel and coal companies this year.
- Rating agencies’ approval . SOE reform is seen as credit-positive by rating agencies, as efficiency levels, corporate governance and capital allocations across industries improve. However, there is more caution concerning SOEs in competitive industries, as their perceived strategic importance may be reduced if ownership falls below 50% or the government cedes control.
- Strategic importance is less certain . SOE reforms have actually created a greater divergence in the strategic importance of SOEs, with some gaining ground and others declining. The uncertainty is also an outcome of the government allowing “zombie companies” to fail. (“Zombies” are highly leveraged, inefficient and high-cost companies which would collapse in the absence of government support.) There have been 15 SOE defaults since April 2014, with the pace accelerating in 2016. Defaulted SOEs are mostly in sectors with overcapacity issues, such as steel, coal, solar, non-ferrous metals and industrial machinery.
- Leverage impact . M&A deals have in some cases had a positive impact on leverage, with the surviving entity emerging as a stronger credit.
Conclusion: No Backtracking, but Caution Is Essential
Overall, we do not see any backtracking on SOE reforms. The overarching principle behind the changes is to make SOEs more efficient, although this is not solely driven by profit or free-market objectives. We believe that SOE reforms will continue to shape the corporate landscape. Looking at M&A since 2013, the impact of SOE reforms on credits has generally been positive for offshore bondholders. At the same time, we believe that the government will continue to allow zombie companies to fail, requiring investors to maintain a focus on bottom-up fundamentals and avoiding weaker standalone credits with unclear public mandates.
Appendix: The 10 Principles for China’s SOE Reforms
The 10 principles articulated by the Chinese government are as follows 1 :
- Independent Boards of Directors : Delegate more power to boards in “pilot enterprises” for mid- to long-term strategic planning, senior management selection, performance review, remuneration management, management of gross salaries, and management of significant financial decisions.
- Market-Oriented Management Selection : Authorize boards in management selection, performance review, remuneration, distribution, etc. Define different responsibilities of SASAC (which oversees the SOEs), corporate boards and the Communist Party committee in management selection and regulation.
- Professional Managers : Advance a professional manager system on the basis of market-oriented management selection.
- Dual-Track Remuneration : Improve the differentiated remuneration system of SOE management; establish and complete remuneration system for professional managers.
- State Capital Investment and Operating Companies : Explore the proper relationship between SASAC and SOEs, ways to supervise state assets, how state capital can be professionally managed; establish market-oriented business operation in state capital investment and operating companies.
- Mergers and Restructuring of Central SOEs : Explore routes to and models of central SOE restructuring and integration, ways to integrate business; eliminate competition in homogenous markets; improve quality and efficiency.
- Hybrid Ownership Reform in Key Areas : Pick pilot enterprises in power, oil and gas, railway, civil aviation, telecom and military industries; introduce non-state capital to diversify ownership structure.
- Employee Stock Ownership in Hybrid-Owned Enterprises : Explore which enterprises are suitable for employee stock ownership, methods of implementation including stock exchanges and buybacks; ensure transparency and prevent “tunneling” (or siphoning of funds to senior management or shareholders).
- Information Transparency : Improve corporate and supervision system. Prevent state asset erosion.
- Separation of Unnecessary Social Burdens, Solve Legacy Issues .
1 Source: The State Council, Credit Suisse, July 2016.
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