SOEs That Are SOL – China’s Forgotten and Unprivileged State-Owned Enterprises

Perhaps the most commonly-heard criticism these days of the Chinese government’s economic policy is that secret policies favoring State-Owned Enterprises (so-called “SOEs”) are becoming more numerous, heavy-handed and harmful to the prospects of private business in China. This criticism, like others of China,  gains strength and credence because it is basically unfalsifiable. Since the policies are secret and the impact hidden from direct view, the only evidence offered is the continued growth and profits of SOE giants like China Mobile, ICBC, Sinopec and others.

While it’s undeniable that SOEs do enjoy a lot of advantages private companies can only dream of, often including easier access to bank loans and markets rigged to prevent free competition, I’m dubious that a real shift really is taking place, and that the Chinese government is wholesale turning its back on private business in order to make life easier for SOEs.

Not all SOEs are living a life of wine and roses. For them, government support is limited, haphazard, often counterproductive. There are hundreds of such SOEs in China. They aren’t the giant companies many foreigners have heard of. These SOEs are surviving, but not really prospering, with clapped-out equipment, low profits, bloated workforces and balance sheets larded with debt. It’s by no means clear that having a government owner is more of a benefit than a liability.

These SOEs have no real pressure to optimize profits and increase efficiency.  Their government owners, to the extent they even notice these smaller industrial SOEs,  are mainly concerned that they should continue to provide jobs, hand over a bit of money each year in taxes and dividends, and continue to increase output. In many ways, for all the epochal changes over the last 30 years in China, many SOEs are still run much as they were during the days of complete central planning:  growing bigger is still more important than growing more profitable, innovative, dynamic.

Thirty years ago, all of Chinese industry was state-owned and most urban Chinese were employed by the state. Then came the private sector reforms and liberalization under Deng Xiaoping, the rise of private business (which officially now contribute more than 70% of China’s gdp) and the bankruptcy of thousands of large SOEs, when many of the largest loss-making SOEs were forced to close. This process of culling the loss-making SOEs is often called “淘汰” (“taotai”) in Chinese, a term I quite like. It literally means to “wash clean” or “wipe out”.

But, many thousands of smaller, barely-profitable SOEs survived “taotai”. They are the ones now often living in a state more akin to Dickensian squalor than the plush recipients of government favor. Visit, as I did recently,  one of the “un-taotai’ed”  SOEs, and you will soon be disabused of the idea that all SOEs are prospering and that the Chinese government is running an economy to benefit SOEs at the expense of private business.

The SOE I visited is in Shaanxi province, about an hour’s drive from the capital, Xi’an. The factory was established in 1966, at the start of the Cultural Revolution, by a team of thousands of workers forcibly relocated from Tianjin. It manufactures certain special types of fiberglass, including some used by China’s military and space program. The SOE still produces many of the same products, on 45 year-old equipment, in a sprawling and broken-down facility the likes of which I’d never seen before in China. Most of the buildings are dilapidated, the roads inside potholed. Polluted waste water belches from pipes into overflowing holding pens.

This company, in one sense, is lucky. It has no competitors inside China, and only two elsewhere, Soviet-era factories in Byelorussia and Latvia. Saddled with unnecesarily large payroll and other ancillary costs not related to producing fiberglass, profit margins are low. But, the company earns money most years, including about $1 million in profits in 2011.

The problem, though, is that the company can’t get the capital to modernize, expand or rationalize its workforce of almost 2,500. It’s still responsible for the running costs of a local hospital, school and kindergarten. When the company’s boss goes to the government for help, he’s mainly told to fend for himself. The company is too small to get any attention from its government owners. So, it floats along in a kind of sad limbo.

With money and profit-seeking owners, the company could probably grow into a quite successful industrial business. The market for its products is actually growing. If they could let go excess payroll and obligations, margins would likely rise above 15%, generating sufficient surplus to finance the large expansion plans and upgrade the company’s boss has been trying, unsuccessfully, to implement for six years. The government says it has no cash to inject. State-owned banks, for all their supposed leniency towards SOEs, won’t increase lending. Instead, the government is urging the factory boss to find a private investor, to put together some kind of privatization plan.

But, in this case and many like it, whenever the Chinese government won’t invest, few if any sane private investors will. Any new investor would have to fund the cost of layoffs of up to 1,800 people. Most are entitled to one month severance for every month of employment.  Average salary is around $500 a month.

The new investor would also, according to Chinese law, probably need to buy its shares from the provincial arm of SASAC at a price tied to the company’s net assets, not its rather dismal operating performance. The entire business may be worth only $10 million. But, using the net asset formula, which includes a big chunk of valuable land, the price almost triples. After all this money goes out the door, the new investor would need to pump another $12mn-$15 mn into the company to finance improvements and expansion.

For any investor seeking to buy control of the company, the likely rate of return after all these outlays, even under the most optimistic scenarios, would be under 10% a year.  That’s a deal that few investors would consider. Along with the need to shell out all the money, a new owner would also acquire lots of contingent liabilities of unpredictable size and severity, including the cost of an environmental clean-up, repairs to company-owned housing where most of the current 2,300 workers, as well as retirees, live.

After spending the day with him, I sympathize with the company boss’s plight. He wants to run an efficient operation, turn it into a leading producer of certain high-technology fiberglass materials, and maybe earn his way into owning a small piece of the company. But, the current mix of policies in China will make that hard, if not impossible, to achieve.

While big SOEs do enjoy a lot of political clout, with sparkling new headquarters, and a low cost of capital that other companies envy, these smaller SOEs inhabit an altogether different and inhospitable world. Government ownership is far more of a hindrance than a help. And yet, they have no real way to free themselves.  These SOEs are, as Americans would say, SOL.


Teaching the Elephant to Dance – China’s SOEs Transform

Over the last thirty years, China has gone from a country where just about all companies were state-owned enterprises (so-called “SOEs”) to one where now fewer than 30% are. Much of the dynamism in China’s domestic economy comes from these newer private companies. There are some very strong SOEs dominating key sectors of China’s economy, including China Mobile, Sinopec, ICBC and other large banks, as well as airlines and utilities. These companies have also been partially privatized by selling minority stakes on global stock markets. This has provided huge amounts of new capital and brought with it improved performance and corporate governance at these top SOEs.

But, many SOEs have failed, while others languish with inefficient production, overstaffing and outmoded products. For many of these, the prognosis is not good. But, at the same time, there is a entrepreneurial transformation getting underway at some of these SOEs. Managers are beginning to act more like owners and less like civil servants. We are seeing this now in our work. Some of the most interesting companies we’re talking to are SOEs eager to bring in outside capital as a first step towards privatization, and subsidiaries of larger SOEs looking for ways to split themselves off from their parent and go public independently.

I expect to see more and more private capital, particularly from private equity firms, going into SOEs. In some cases, the investors will find ways to take majority control. In others, they will link their minority investment to a corporate restructuring that gives the SOEs management equity, warrants, or other incentives to improve performance and profitability.

The likely result: some of China’s more tired SOEs are going to get a big dose of free market adrenalin. At the moment, there are lots of legal hurdles for private capital to enter into an SOE. The process is opaque. We’re spending a fair bit of time on behalf of several SOEs trying to figure out workable legal mechanisms. To succeed, any deal will take time and need champions in higher levels of government. But, practical economic policies tend to triumph in China. Private capital is, without question, the best option to improve the profitability and future prospects of many SOEs. This is good for employment, good for economic growth, good for worker incomes, good for accelerating development in inland China. These are all core policy goals in China.

I’m not able to discuss details or provide company names, but I can give an outline of several of the most interesting SOE transactions we are now working on. This should give a sense of the kind of changes that may be on the way for SOEs.

In one case, a subsidiary of one of China’s largest publicly-traded SOE construction holding companies is looking for ways, with the parent company’s encouragement, to spin itself off, raise private equity capital, and then try for an IPO. Though it contributes only about 5% of the parent company’s total revenues and operates in different markets than the parent, this subsidiary is one of the largest, most successful companies in its industry in China. Its profits this year should exceed Rmb 650mn (USD$100mn).

Because the parent company is already public, this subsidiary needs to fight for capital with other larger sister companies inside the conglomerate. It usually comes up short. With access to new capital, the subsidiary’s current managers are confident they could double the size of the business (both profits and revenues) within two to three years.  Outside of China, spinning off a subsidiary or selling a minority stake in an IPO is a fairly straight-forward process. Not so in China.

Under current rules, the CSRC, China’s stock market regulator, will not allow the parent simply to spin off the subsidiary through an IPO. There are related party transactions and deconsolidation issues.  So, we are looking at ways for a large strategic investor to buy a controlling stake in the subsidiary, then pour in as much as $250mn in new capital. The subsidiary will then build up its business to where it could either qualify for an IPO three to five years later, or the PE firm would exit by selling its stake back to the parent.

The management of this subsidiary are quite keen to put in their own money and become shareholders if their business can be separated and put on a path to IPO. They have done a very solid job building the business to its current scale, and would likely do markedly better if they had a real stake in the performance of the company.

In another deal we are working on, a chemical company now majority owned by Sinopec is bringing in new capital to buy the Sinopec shares and recapitalize the business. The company was started seven years ago by a private entrepreneur, who raised the original capital from Sinopec. The entrepreneur now controls about 40% of the company’s equity. Through the deal we’re working on, he will become the majority owner and the private equity investor will own the rest.

We’re also in discussions with the international division of one of China’s giant SOE electricity companies. This group already has sizable projects and revenues in Southeast Asia and Russia, where it built and operates large hydro and gas-fueled power plants. The international division, however, is being held back by high debt levels at the SOE parent. This means the international division has trouble borrowing enough to finance its continued growth. Since the international division is already structured legally as a Hong Kong company, it should be possible for it to raise private equity then IPO in Hong Kong. We think this division can raise as much as USD$500mn in the next three years, both in private equity and IPO.

These three (the construction subsidiary, the chemical company and international power plant business) are all very solid businesses that outside investors will likely flock to. We’re also trying to find a way to help a more troubled smaller SOE based in central China. They make certain types of special fiberglass. The core business is fundamentally sound, but is stuck also doing some other things that lose money.  It is too small now to qualify for an IPO, and is having a hard time in the current environment increasing its bank borrowing. The existing managers are eager to have an outside private equity investor come in and not only provide the capital, but also help improve manufacturing efficiency and marketing, and chop away the loss-making parts. They think an investment of Rmb 50mn could increase profits by a similar amount within two years.

As anyone with experience will tell you, working with SOEs can be a complicated and time-consuming process, particularly compared to dealing with a company founded and run by a private entrepreneur. While we’re fortunate to have strong entrepreneur-led companies as clients, I also quite enjoy working on these SOE transactions. It affords an up-close view of the way SOEs operate and problem-solve. I’m also getting to participate, in a small way, in perhaps the most significant transformation now taking place in China’s economy. With new capital and perhaps new ownership structures, SOEs are going to thrive as never before. Their greater efficiency and greater profits will be a challenge for the private sector, but overall will be a plus for China.



China’s Tax Revenues: An Embarrassment of Riches

You’ve got to love the timing. With U.S. mired in a debt and spending crisis, with tax revenues stagnant and its government about to run out of borrowed money to spend, the Chinese government just announced that its fiscal revenues during the first half of 2011 rose by 29.6% compared to a year earlier. One country is a fiscal train-wreck, the other a fiscal gusher.

China’s tax revenues are surging for a host of reasons that set it apart from the US – the economy is booming, and in particular, businesses are thriving. According to the Chinese Ministry of Finance, profit taxes are growing especially quickly. Income and corporate tax rates are stable, at rates far lower than the US. China levies a nationwide VAT, while most of the US charges sales tax. Consumer spending is growing by over 20% in China, while it’s basically flat in the US.

To all these must be added another crucial difference: China is modernizing so quickly, that every year money pours in from new sources. China doesn’t need to raise tax rates to increase tax revenue. It just allows its citizens to get on with their lives.

Take auto sales. A decade ago, China produced and sold about two million cars. This year, it will sell about 20 million. China passed the US two years ago to become the world’s largest auto market. Since then, sales have grown by a further 40%.

Along with creating some of the world’s worst traffic congestion, all these new car sales do wonders for the country’s fiscal situation.  Start with the fact that every car sold in China has not just a 17% VAT built into its price, but a host of other taxes and levies. A consumption tax adds as much as 40% more to the sticker price depending on the size of the engine. Customs duties are also levied on imports.

These all add up fast. The government’s tax take from the sale of a single Mercedes-Benz can easily top Rmb325,000 (US$50,000). Last year alone, sales of Mercedes-Benz in China doubled. This year, Mercedes will sell about 180,000 cars in China. Total tax take: about USD$1 billion. Keep in mind that Mercedes-Benz has less than 1% of the Chinese market. BWM, Porsche and Lexus are also doing great in China. While they are all doing well, the Chinese government does even better. The government earns far more on the sale of every luxury car than the manufacturers do.

The sales and consumption taxes are just the start. Most news cars in China are sold to new drivers. That means, every year, there’s a significant net increase in the consumption of gasoline. Each liter of gasoline also carries a variety of different taxes – VAT, consumption tax, resource tax. Plus, almost every gas station and refiner in China is owned by companies majority-owned by the Chinese government. So, profits at the pump flow back to the government.

At the moment, the gasoline price in China is about Rmb7.5 per liter,  or Rmb30 ($4.60) per gallon. Figure the Chinese government is making about Rmb10 ($1.50) per gallon sold in tax. Each new car sold this year will likely contribute an additional $500-$600 in fuel taxes, or about Rmb100 billion in total. Again, a big chunk of that will be a net increase in fiscal revenues, since there are so many new drivers each year.

Think the same for sales of new apartments, air-conditioners, iPads and iPhones, plane and high-speed train tickets. Each one has all sorts of taxes built into its sales price, and then an annuity of future tax revenues from energy taxes, fees and assessments.

In the US, taxes and spending are so high, people grow more and more reluctant to spend. Huge budget deficits today, as Milton Friedman long ago established,  creates the expectation of tax increases tomorrow. Americans adjust their spending accordingly. Not so in China. Chinese keep spending and the government reaps the bounty.

As flush as the Chinese fisc now is, tax revenues represent only one part of the government’s huge cash hoard. To begin with, there is the over $3 trillion in official foreign exchange reserves. This money contributes little to no benefit to the economy as a whole, except bottling up pressure on the Renminbi to appreciate against the dollar. It’s basically money buried in the backyard.

The government also owns significant – often controlling — shares the country’s biggest and most profitable companies, including SinoPec, China Mobile, China Telecom.

Net profits at the 120 biggest centrally-controlled Chinese SOEs rose by 14.6% year-on-year during the first half of 2011, reaching Rmb457.17 billion yuan ($71 billion) . These 120 SOEs are meant to pay taxes and levies of almost twice that, Rmb850 billion, up 26.4% from 2010. No one quite knows how much of that money actually reaches the Chinese Treasury. But, of course,  the money is there, should it be needed – in a way the US Social Security “Trust Fund” most assuredly is not.

China Needs Shale Gas as Much, If Not More, Than US

Shale gas is the most important major new source of energy on the planet, as well as the most important development in the petroleum economy since deep water drilling. Shale gas is reshaping the world’s energy market in a way that even a decade ago seemed unthinkable. This is especially true in the US, where most of the shale gas development is now taking place. Ten years ago, shale gas was just 1% of American natural-gas supplies. Today, it is about 25% and could rise to 50% within two decades. Estimates are that US has more than a 100-year supply of natural gas, thanks to the development of shale gas. Natural gas is used for everything from home heating and cooking to electric generation, industrial processes and petrochemical feedstocks.

Shale gas was first discovered over a century ago. But, it’s only become a commercially-viable source of natural gas with the invention, over the last twenty years, of new drilling technology to break layers of rock and release the gas trapped within. The technology is known as hydraulic fracturing (now widely known as “fracking” or “fracing”). The companies that have played the leading role in developing this technology are mainly all American. They are already making billions of dollars using their techniques to drill deep under the surface across the continental US and harvest the gas trapped there.  The US, which just a few years ago looked to be running out of natural gas, now may someday begin exporting, thanks to its large deposits of shale gas.

The US has long been the world’s largest user and importer of energy. Last year, it was announced that China has overtaken the US in overall energy consumption. Its energy imports are on track to overtake America’s. Although natural gas use is increasing in China, it only comprised 4 percent of the country’s total energy consumption in 2008.

Beneath China’s surface also lies shale gas, most likely quite a lot of it. According to information released by the US Energy Information Administration (EIA) in April, China has 1,275 tcf of technically recoverable shale gas resources, nearly 50% more than the US.  Those estimated recoverable reserves are more than one thousand times the amount of natural gas used in China in 2010.

For China in decades to come, as much as for America, shale gas could be the energy “game-changer”, increasing energy self-reliance and helping to shift the country away from its heavy reliance on coal for electricity generation. Domestic shale gas, if fully exploited, would have enormous impacts not only in China, but worldwide. It could moderate China’s skyrocketing demand for petroleum, one of the primary drivers of higher oil prices. It would mean less coal gets mined and burned, which would have widespread environmental benefits and also ease the strain on the nation’s transportation infrastructure, a large part of which is now devoted to moving coal from where its mined to where its burned for electricity.

China already has more cars and busses running on natural gas than the US. Quite a few cities, including some large ones like Chongqing and Urumqi in Xinjiang, have many of their taxis running on natural gas. There is already a large infrastructure of “natural gas stations” across China. In other words, China stands to benefit, proportionately, even more from the US from a large supply of cheap, domestic natural gas.

The key question is: will China be able to tap its shale gas efficiently? In fact, it may be one of the most important questions in world energy markets over the next five to ten years. The technology is new, complex and almost entirely American. The owners may not be interested to share it with Chinese companies. For one thing, most of the companies with core technology and experience in tapping shale gas are themselves producers, not just suppliers of drilling equipment. Under current rules, they might not find China a very attractive market, especially when the US has so much untapped natural gas, as does neighboring Canada.

China’s leaders clearly understand the importance of shale gas to its economy and the importance of US shale gas technology. China’s goal is to produce 30 billion cubic meters a year from shale, equivalent to almost half the country’s gas consumption in 2008.  In November 2009, US President Barack Obama agreed to share US gas-shale technology with China, and to promote US investment in Chinese shale-gas development.

That sounds more significant than it probably is. President Obama cannot do much to help China, since the US government has little shale gas technology of its own, nor can he provide any real economic incentive for US companies to share technology with China. If there is a good market reason for US companies to drill for shale gas in China, they will surely do it. That is not the case now, as far as I can tell. Energy production and pricing are both heavily controlled by the Chinese government. A US shale gas producer would probably not be able to fully-own a shale gas field in China, nor sell its output at world market prices.  So, my guess is the owners of the best shale gas technology will not likely share it with China.

PetroChina and China National Offshore Oil Corporation (CNOOC) bought stakes in North American shale drillers like Chesapeake Energy and EnCana with the intent of acquiring technology and ramping up production at home. But, it is not certain, to say the least, that this strategy will pay off — becoming a small shareholder is not the same as buying a right to that company’s technology and expertise.

That leaves China with two choices, neither of which is appetizing: first, rely on domestic technology; second, try to obtain US technology by other than legal means. It could take domestic producers a long time to master the technology, and even then, it may not be equal to the best of what the US now has. With the second route, the problem is that it’s not enough just to get hold of drilling equipment. Exploiting shale gas reserves requires a mix of special equipment and know-how, which is far harder to obtain. A lot of the most successful shale gas fields in the US, for example, use horizontal drilling, a method pioneered in US, that allows operators to “ drill down to a certain depth and then to drill at an angle or even sideways. This exposes more of the reservoir, permitting the recovery of a much greater amount of gas,” according to the noted energy researcher Daniel Yergin.

China needs its shale gas, now. It is of vital importance to China, as well as the rest of the developed world. Everyone is hurt if Chinese demand for petroleum continues to push prices higher and higher, especially when there is an attractive alternative, that China shifts more of its energy consumption to natural gas, produced at home.

It’s a troubling sign that China’s Ministry of Land and Resources continues to delay distribution of the country’s first official shale gas blocks. Its first announcements indicated that only Chinese state-owned energy companies could bid on rights to these shale gas deposits.

My preference would be for China’s government to make it as financially rewarding to exploit shale gas there as it is in the US. It can do this with a mix of tax incentives and various rebates available, for example, to US companies that develop shale gas fields in China. The US oil industry doesn’t bother much with politics. They go where there is money to be made.

China will likely spend over $180 billion this year on oil imports, enriching foreigners in places like Iran, Russia and Venezuela. Based on that uncomfortable fact, and that using more natural gas will cut the environmental damage caused by burning so much coal, the rational policy choice is to do about whatever it takes to get US shale gas producers to come to China and start drilling, fraccing and pumping.

My advice: let it be done, and let it be done soon.