It's been four years since China announced a key initiative to inject private capital and management expertise into state-owned enterprises (SOEs). Yet most SOEs continue to be controlled or dominated by government bodies, and this year we've seen more of the reverse trend, with SOEs investing in or rescuing private companies. This show that progress of "mixed-ownership reform" has been slow. Nonetheless, S&P Global Ratings believes the initiative's success shouldn't be measured on ownership patterns alone.

In our view, the end goal is efficiency. Mixed-ownership is one of several reforms aimed at transitioning China from its rapid, catch-up growth phase to a more balanced and productive output model. Wider and more independent shareholding structures can reduce wasteful spending at the corporate level, enhance governance, and boost returns on investment. However, there is no one-size-fits-all approach. In some cases, cutting bureaucracy and idle capacity will reap productivity gains. In others, investors may feel more comfortable knowing government stakes and relationships remain strong. Sometimes the "mixed ownership" involves well-run SOEs investing in less successful state-owned counterparts.

As the saying goes: "It doesn't matter whether the cat is black or white, so long as it catches mice." There is no clearly defined path to mixed-ownership reform. The credit implications are also diverse. More private-sector participation could reduce the debt burdens of local and central governments. From a bottom-up ratings perspective, however, lower expectations of support could weaken credit profiles.

No Simple Path To Reforming SOEs

We believe a direct, clearly defined path to mixed-ownership reform is not practical. This is because Chinese state influence in business is large, diverse, and complex. While China's private sector is a generator of jobs and tax revenues, SOEs remain a dominant force. State firms, for example, account for 89% of all outstanding corporate bond issuance by value; with the total outstanding equal to Chinese renminbi (RMB) 21.9 trillion (US$3.1 trillion) and about 79% of issuers by number. Some Chinese SOE count among the world's biggest corporations; others are small, local businesses that might do anything from farming to light manufacturing to property development, or a mix of all three.

Mixed-ownership is a fairly open process based on guidelines published by state planners (see table 1); that said, there are some requirements and deadlines. For example, SOEs need to appoint nonexecutive directors on its management boards by 2020. Last year, the so-called "Double-100" campaign was introduced. The government is in the process of identifying 100 central SOE's subsidiaries and 100 local SOEs subsidiaries to be fast-tracked for mixed-ownership reform.

Table 1

Not only are the profiles of Chinese SOEs diverse. So are the reasons for ownership reform. Broadly speaking, we see two motivations: (1) SOEs seeking strategic benefits; and (2) SOEs that need the money.

Those in the first category seek minority shareholders to improve efficiency and profitability, share expertise in an industry, build strategic alliances, or even for help in carrying out government policy. Others are zeroing in on private capital as a funding source at a time when local governments have a mandate to deleverage. They are willing to widen the share base if private investors can provide additional funding or capital to the SOE, or help them realize a higher valuation on their assets.

The government is unlikely to relinquish control if SOEs operate in strategic sectors (e.g., telecommunications, military, energy). Mixed-ownership in strategic sectors has also tended to occur at subsidiary or listed company level. As such, the influence of new shareholders are generally limited and the impact to the group is generally modest (see table 2).

Table 2

Moderate Gains From Past Cases So Far

In our view, mixed-ownership reform has led to modest gains, as measured by profitability. A premier example is a consortium's 2017 investment into state-owned telecom operator China United Network Communications Group Co. Ltd. (China Unicom), whose performance traditionally lagged industry leaders. Private owned enterprises (POEs) Tencent Inc., Alibaba Group Holding Co. Ltd., Baidu Inc., JD.com Inc., and Sunning.com Co. Ltd., together took up 18.9% of the China Unicom in the deal, and SOEs China Life insurance and China Structural Reform Fund took 10.2% and 6.1% stakes respectively (see organizational chart below).

The deal was seen as offering potential benefits to all parties: Unicom could leverage the tech giants' user base and product offerings, while the POEs gained strategic interests in a major telecom operator.

Unicom's new subscribers have grown at a faster clip since the deal, and the company has improved its product offering by leveraging on its relationship with Tencent. At this juncture, profitability has not closed the gaps with industry leaders (see chart 1). In terms of governance, representatives of the new investors have an equal presence on the board, but the overall decision-making process of the company appears to have changed little. This could partly be because the consortium is large, so individually each participants' influence is too small to effect fundamental change. Including the stakes held by China Life and the China Structural Reform Fund, the Chinese government's direct and indirect interest in Unicom remains above 50%.

Chart 1

China Petroleum & Chemical Corp.'s (Sinopec) partial sale of its retail assets to a consortium of 25 SOE and POE strategic investors was another high-profile deal, dating back to 2014. The 29.58% sale brought in RMB105.4 billion (US$15 billion) proceeds and helped the company to deleverage during industry down cycle. Nonetheless, the anticipated operating efficiency improvement for its retail business has been slow to materialize. In our view, the minority investors also do not have significant influence on the segment's governance or operations. In this case, the benefit of obtaining strategic investors could be a one-off financial gain.

No Easy Fix For Indebted SOEs

More recently, overly indebted SOEs have attempted mixed-ownership to relieve financial burdens. However, this is not an easy sell. We believe private investors are wary of taking over debt-strapped SOEs, particularly if the government is seen to be cutting ties to the business. Investors want to know that government backing will remain in place, such as to negotiate debt extensions if needed, or provide incentives or other types of support to improve profitability and help put the SOE on the road to recovery.

For example, the Tianjin government has had no success so far in finding strategic investors for Tianjin Real Estate Group Co. Ltd. Several companies including central SOE developer Poly Real Estate Group Co. Ltd., and the large POE developer Sunac China Holdings Ltd., have both taken turns to help manage the debt-strapped developer; but, so far, no deal has been reached for either company to take ownership or control of the company.

The situation is similar for SOE reform via mergers and acquisitions. According to media reports, the Qinghai provincial government has been looking to sell Qinghai Provincial Investment Group Co. Ltd. (QPIG) to two central SOEs--Aluminum Corp. of China Ltd. (Chalco) and State Power Investment Corp. Ltd.--to relieve its debt burdens. However, so far, no deal has been reached. The potential sale of QPIG by the Qinghai government may also indicate weakened willingness to support the company over time, which could deter investors.

Potential Fall In Government Support Outweighs Better Fundamentals

The credit impact of mixed-ownership reform varies, in our view. This is all the more so amid slowing economic growth-- reform benefits may not be easily realized while government support for SOEs could sharply fall if ownership declines.

Typically, we would expect mixed-ownership reform to improve the stand-alone credit profiles of SOEs because new funding from equity sales reduces financial leverage and boosts liquidity. However, in most cases thus far, the benefits have tended to be modest. For example, the Sinochem Hong Kong (Group) Co Ltd. received Hong Kong dollar 7.8 billion (US$1 billion) by selling a stake in its subsidiary China Jinmao Holdings in July 2019. While the deal size was large in absolute terms, the proceeds amount to only about 6% of Sinochem's total debt as of 2018. Capital injections can provide one-off financial benefits to the company, but long-term operational improvement is less visible, as seen in Sinopec's case above.

On the other hand, extraordinary government support may weaken over time if there's a significant reduction in government ownership, less government monitoring, and the SOE becomes more commercially arm's-length. This is particularly so if SOE subsidiaries are disposed of because they are not strategic to the government or SOE parent.

Greenland Holding Group Co. Ltd. sold stakes to strategic investors in 2013 as part of a reorganization that led to public listing in 2015. The Shanghai-based developer is solid company on a stand-alone basis and operates largely on a commercial basis, rather than to purely fulfill Shanghai development policies. As such, we don't view the company as having potential extraordinary government support in times of need, even though the Shanghai government retains 45.37% interest in the company, and it remains under supervision from the Shanghai State-owned Asset Administration and Supervision Commission. When one of Greenland's affiliates defaulted in 2016, neither Greenland nor the Shanghai government provided direct financial support to the affiliate

In our view, SOE parents may not extend extraordinary support to distressed subsidiaries or affiliates once their shareholdings are diluted substantially. This year CITIC Guoan Group defaulted; the company had privatized in 2013 under controversial circumstances (with little transparency on the buyers or valuation process) but CITIC Group Corp., a central SOE, held on to 20.94% of shares. Despite bearing the same name and retaining an interest, CITIC Group did not provide extraordinary support to the company.

Increasing Reverse Ownership Trend

A slowing economy makes mixed-ownership reform even more complicated because POEs may have less capacity to seek deals, given private business generally has inferior access to credit. In fact, shareholder control has been more likely to change from POE to SOE than vice versa in the past 18 months (see chart 2). This trend has picked up, particularly as POE defaults started to rise in 2018 and the government stepped in to stabilize the situation. A case in point is Beijing Orient Landscape & Environment Co. Ltd., which defaulted earlier this year, was rescued with government funding, and is now government-controlled.

Direct government equity can improve the recipient POE's liquidity and funding access. However, it's unclear if the company's operations and governance will meaningfully change. Over time, the short-term benefits of economic and employment stability of "bailing out" troubled POEs could be outweighed by continued misallocation of capital and resources.

Chart 2

Chart 3

Reform Is The Challenge

Achieving mixed ownership is the easy part. The reform path is trickier, including what and how to improve the company. For well-run SOEs, there's not a lot of impetus to give up control. For underperforming SOEs, it's hard to find strategic investors to rejuvenate the companies. Private capital is usually very selective, and unwilling to invest in companies without good business and financial prospects. And unlike privatization trends elsewhere, in China investors often prefer, at this stage, that governments remain stakeholders in troubled businesses, or show willingness to provide support to alleviate investor burdens.

In some cases, local governments have attempted to use SOE reforms, including mixed-ownership, to bail out highly indebted or uncompetitive SOEs. These deals will have limited chance to succeed, in our view, because investors will be unwilling to participate, and the reforms are not meant to rescue companies that don't have viable business recovery plans (see "China's Updated Workout Regime Takes Aim At The Chronically Insolvent," published on Ratings Direct on July 22, 2019).

Through trial and error, some successful models will likely emerge. While Unicom still lags competitors, its performance has begun to improve, and in time could pave the way for more meaningful reform. In July 2019, China Southern Airlines Co. Ltd. raised RMB30 billion from various local government investment platforms of Guangzhou, Shenzhen, and Guangdong. The airline said new capital and shareholders will improve its financial position and modernize its decision-making process. In our view, this type of deal may lead to future strategic cooperation between SOEs to achieve synergy and efficiency.

Ultimately, the flexibility on mixed-ownership comes down to dual challenges facing China: external pressure to "open up" its economy and secondly, finding a new growth model to solve its debt problems. Reforming SOEs in a slowing growth backdrop makes the task more challenging but also more pressing.

Related Research

• China's Updated Workout Regime Takes Aim At The Chronically Insolvent, July 22, 2019
• Is China's Great Debt-For-Equity Swap Working? A Reality Check At Year Three, May 30, 2019
• Tianjin Troubles Underline Vulnerabilities In China's SOEs, April 30, 2019
• China's SOEs Can't Guarantee Timely Government Support, March 1, 2019