Fixing up China's state-owned enterprises (SOEs) has been on Beijing's to-do list for decades. But as the companies have become increasingly buried under mountains of debt, addressing their deep structural flaws has once again moved to the top of the government's agenda. Chinese leaders are now working to speed the process of diversifying the firms' shareholders beyond the state, to expand corporate debt-for-equity swap programs and to phase out massive "zombie corporations" operating at a loss, all in hopes of keeping the nation's most important conglomerates afloat. Beijing's idea of successful reform, however, has less to do with instilling market principles that with preserving the power of the state.
The Downside of Beijing's Business Strategy
Over the past few decades, China's SOEs have racked up debt faster than they can pay it off. And for the most part, they have had little incentive to change their spending habits. In the Chinese public sector, profit margins have long taken a back seat to the companies' chief objective of serving the government's investment-driven growth strategy and keeping employment levels up. Though these goals have routinely led to inefficiency and corporate bloat, the companies' central role in Beijing's economic and political policies has guaranteed them unfettered access to funding and government aid.
This arrangement — and the risks it entails — have been on full display since the global financial crisis struck in 2008-09. As economies around the world struggled to pull themselves out of the ensuing slump, China propped up its own economy by lending money to SOEs to complete enormous infrastructure and real estate projects. After these undertakings were finished, however, numerous properties stood unsold and unoccupied, and the steel, coal and concrete sectors began to buckle under the weight of excess production capacity once construction tapered off. At the same time, household consumption stagnated, and cheap exports started to account for a slimmer share of the economy. Government-backed investment was soon one of the only drivers of economic growth and employment left in China — becoming a linchpin of national stability.
Meanwhile, the combination of heavy borrowing and shrinking profits left SOEs with massive debts that have continued to climb. According to official Chinese estimates, the companies' indebtedness rose sharply from 67.4 trillion yuan (about $10.1 trillion) in 2013 to 94.1 trillion yuan in 2017. This represents more than two-thirds of China's total corporate debt, which is already the highest among developed economies. Moreover, that debt is most heavily concentrated in the firms most closely controlled by the state. The 100 Chinese companies with the greatest central oversight alone are responsible for 49.8 trillion yuan in outstanding debt — more than half of the state-run companies' total — and have an average debt-to-asset ratio of 68.4 percent (compared with the SOE average of 65.5 percent). By contrast, China's private companies, which account for the bulk of the country's employment and economic growth, report a debt-to-asset ratio that is closer to 50 percent and steadily falling.
A House of Cards
These mounting SOE debts present a growing threat to China's sputtering economy, particularly as the country comes to grips with the prospect of an impending slowdown in the real estate sector. At present, real estate and construction together are thought to account for between 15 and 25 percent of China's gross domestic product, and they have driven much of the recent debt acquisition among the country's SOEs. Now, state-run companies in those sectors (and related industries such as steel, concrete and power utilities) hold about 40 percent of China's corporate debt and have an average debt-to-equity ratio of more than 90 percent — though some firms have seen that figure rise as high as 250 percent.
Faced with hefty debt-servicing costs and few profits with which to pay them, many of these companies have found themselves on the brink of bankruptcy. Though so far they have managed to survive, thanks in large part to the real estate boom of the past few years, they may not be able to hold out for much longer. Investment into the real estate sector has slowed to a trickle, housing prices in major cities like Beijing and Shanghai have leveled off or fallen in recent months, and the central government has continued to squeeze the real estate bubble. Barring an effort by Beijing to ease its grip on the industry, another housing slump appears to be looming, at least in certain areas, and that doesn't bode well for the sector's deeply indebted enterprises.
Finding Surer Footing
Amid these growing signs of trouble, China's leaders in 2015 turned to the thorny question of how best to reform the country's SOEs. Despite penning numerous guidance documents under seemingly innovative names, the solutions they proposed were the similar to those offered by their predecessors': Use debt-for-equity swap programs and public offerings to clear corporate balance sheets. Nevertheless, the proposals drew renewed attention at a high-level National Financial Work Conference in July, where Beijing identified tackling corporate debt as its highest priority.
The logic behind the programs is simple: By increasing equity among SOEs, their debt ratios would decrease, thus enabling struggling but fundamentally sound businesses to find surer financial footing. And since their inception, those programs have experienced some success. In the first quarter of 2017, for instance, Chinese businesses traded 238 billion yuan in outstanding loans for equity stakes. By July, moreover, 12 centrally administered SOEs in the steel and heavy industries sectors had entered into swap agreements, moving a step closer to turning trillions of yuan in debt into equity. Meanwhile, after encouraging more private ownership in state-run companies in non-strategic sectors, such as services and real estate, the government has begun doing the same in some of the country's most vital industries, including oil, telecommunications and military equipment manufacturing.
Despite recent growth in both programs, questions of their overall effect linger. After all, the debt-for-equity swap program covers only a fraction of China's outstanding corporate debt, which stands at roughly 130 trillion yuan. And because Beijing has not reformed the way in which localities finance their corporations — which often involves creative ways of simply issuing new loans — many inefficient SOEs may continue operating at the expense of the state-owned banks that provide the bulk of their financing. Furthermore, though many have lauded Beijing's effort to diversify ownership among SOEs, in general, the state has sold only minority stakes in the subsidiaries of larger groups, raising private capital while maintaining a majority share in the firms. Without new corporate governance rules and a restructuring of vital industries, neither program will do much to improve the productivity of China's state-run companies.
Taking on the Walking Dead
Aware of the limits to its two-pronged approach, Beijing has tried a third, more radical solution: killing off its zombie companies, the bulk of which exist at the local and provincial levels. According to a 2016 report by Renmin University, around 100,000 of these failing corporations are locally run SOEs; the industries with the biggest proportions of zombie firms are steel (51 percent), real estate (45 percent) and construction (32 percent). Since 2014, the Chinese government has started to allow some of these companies to default rather than bail them out. Baoding Tianwei Group, a power-generation equipment company, was the first to fall after it missed a 13 million-yuan interest payment in late 2015. Guangxi Non-Ferrous Metals Group and Dongbei Special Steel weren't far behind as they failed to make good on debts of 14.5 billion and 4.7 billion yuan, respectively. At the same time, Beijing has tried to loosen its laws on declaring bankruptcy, with the explicit purpose of eradicating zombie companies by 2020.
In some ways, the government's efforts may be paying off. In the first half of 2017, 4,700 corporations went bankrupt, a notable jump from the annual figures of 5,665 in 2016 and 3,684 in 2015. But despite Beijing's increasing willingness to absorb the risk of bankruptcies, local authorities and corporate officials have pursued them with caution — particularly in sectors with the highest employment levels, which often are also those with the greatest need for restructuring. For instance, only 10 percent of real estate companies and 2 percent of steel companies in China have declared bankruptcy this year. Likewise, inland provinces with economies that more heavily depend on SOEs for income and jobs have been slower to jump on the bankruptcy bandwagon than their more economically advanced peers on the coast.
Prioritizing the Political Dividends
This is not the first time the China has tried to reform its state-run companies, nor is it the first time those efforts have come up short — at least from a purely economic perspective. But Beijing's motives are not based solely in profit margins; they are also based in politics. As was true of previous corporate reform pushes, the central government is attempting to consolidate its control over the country's most critical sectors, amassing political power in the process.
Rather than root out and address the sources of SOE inefficiency once and for all, then, Beijing has taken a more measured approach that combines corporatization, consolidation and public sharing to slowly revitalize flagging industries. And all the while, it has taken care to keep a tight grip on the engines of the Chinese economy.