SHANGHAI/HONG KONG -- In August 2017, the lumbering telecom operator China Unicom was selected as a test case for Beijing's latest attempt to reform some of its state-controlled companies.
It was a prime candidate for overhaul. China Unicom's former chairman, Chang Xiaobing, was found guilty of taking bribes and sentenced in May to six years in prison. And by some important financial measures, China Unicom's performance has been catatonic. Its return on equity -- a key indicator of overall efficiency as well as a yardstick of how much net profit a company returns to shareholders -- has been below 1% in recent years, compared to a global industry average of about 19.5%, according to an analysis of QUICK-FactSet data on 47 telecom operators.
"It is true that China Unicom's ROE is relatively low," Wang Xiaochu, who replaced Chang as chairman in 2015, admitted on May 11. Wang vowed that better performance was "just around the corner" for China Unicom once Beijing's pilot reform plan begins to take hold.
The government's plan to revive China Unicom is known as "mixed-ownership reform," which means inviting strategic investors to take stakes in the companies in the hopes that they will then push for greater efficiency. Under the reform plan, Shanghai-listed China Unicom received an injection of 75 billion yuan ($11.8 billion) in November from 14 investors, including heavy-hitters such as China Life Insurance, subsidiaries of Tencent Holdings, Baidu, Alibaba Group Holding, and Suning.Com.
Even after those investments, however, the state-owned parent remains the top shareholder and controls nearly 38% of the company -- a fact that may cloud the chances for significant improvements at China Unicom. "For so long as the state remains as a shareholder, however small it is, it is hard for private investors to make a difference," Hong Kong-based mainland brokerage CLSA said in a report published last September that was skeptical of China Unicom's reforms.
Exclusive data compiled by Nikkei Asian Review bear this out. China's state-owned companies have become far less efficient since 2007, despite a robust economy that has been expanding by at least 6%. At the nearly 300 state-controlled non-financial companies listed on mainland Chinese bourses, return on equity fell by more than half -- to 7.0% in 2017 from 15.6% a decade earlier -- according to an analysis of data on Shanghai- and Shenzhen-listed non-financial companies between 2007 and 2017.
Over the same period, major American and European non-financial companies recorded higher ROE. By last year their ROE was more than double the level of those of Chinese state-run enterprises, according to QUICK-FactSet data.
China's private companies also performed far better than their state-owned counterparts, with the ROE of non-state-owned companies reaching 8% in 2017.
The deterioration of efficiency in China's state-owned companies was due in large part to Beijing's response to the global financial crisis. The 4 trillion yuan stimulus package and other policy initiatives encouraged state-backed companies to make big investments at home and abroad using credit provided by state lenders. Those moves left the companies with swollen capital and asset levels.
Despite this legacy, President Xi Jinping appears determined to expand the role of the state in Chinese companies even further -- a reversal of the trend set in motion by Deng Xiaoping, who made SOE reform a priority in his "opening up" policy in December 1978 that gave more leeway to corporate managers. The communique of that landmark Communist Party meeting pointed to the "serious defect where power in economic management is overly concentrated" and suggested "most duties and responsibilities be delegated" to corporations.
For Xi, however, state-owned enterprises are the "basis for socialism with Chinese characteristics" and "supporting forces for the Party to govern and prop up the country."
He clearly spelled out the case for enhancing the Communist Party's influence over state-owned enterprises in an October 2016 speech, calling them "essential forces with strategic importance" to high-priority programs like the Belt and Road Initiative. He reminded leaders at state-owned enterprises to "bear in mind their number one role and responsibility is to work for the party."
Backing from Beijing can be useful when bidding for overseas assets. But it can also mean pressure to accept investments or strike deals that make political sense, but not business sense. Making tough cost-cutting decisions to divest, cut jobs and restructure are usually more difficult.
"The existence of SOEs, no matter how small the state's stake, is not conducive to corporate governance, market-based incentives or performance," CLSA said in its report. "The Party's goals are not always aligned with those of investors -- and no financial reform can be complete in such a setting."
One of the Chinese companies that saw its efficiency plummet over the last decade is PetroChina, Asia's largest oil company by market capitalization. While the recent rise in crude prices has helped its profits recover, its ROE remains a dismal 1.9%. The main culprit: an asset-buying binge during a period of high oil prices.
Along with its parent China National Petroleum Corp., or CNPC, PetroChina went on an aggressive hunt for oil and gas fields across the globe, especially between 2010 and 2014, when crude oil prices were above $100 per barrel -- mainly due to strong demand from China itself.
In November 2013, PetroChina and CNPC jointly bought a Peru-based subsidiary of Brazil's Petrobras for about $2.6 billion, giving it ownership of three oil and gas fields. Despite the huge outlay, these deals have so far failed to boost profit.
"We made relatively large investments when the oil prices were higher," then-President Wang Dongjin told the Nikkei Asian Review during a briefing in Hong Kong.
At the same time, major American and European oil companies operating under the same conditions as PetroChina managed to show better ROE readings, according to QUICK-FactSet data: 11% for Exxon Mobil, 8% for Total, 6.8% for Royal Dutch Shell, 6.3% for Chevron, and 3.5% for BP.
PetroChina's management is well aware of the circumstances. "We aim for ROE of over 10% in the long run," Wang said, although he did not specify when the company might achieve that target.
Earlier this year, after competing with existing stake owners, including Japanese oil developer Inpex, PetroChina won stakes in two offshore oil field concessions in Abu Dhabi for $1.17 billion.
These marked the first major acquisitions by Chinese players in a major Middle Eastern country, where returns are usually more stable. According to Wang, the internal rate of returns for the stakes stands at 8.2%, and will improve to over 10% in the coming years.
Chief Financial Officer Chai Shouping told Nikkei that the latest acquisition "meets our criteria of over 10% ROE," indicating that ROE and other gauges of return are essential when the company considers acquiring foreign businesses.
Emphasis on harmony over efficiency
Xi has overseen a push to make SOEs even larger. Contrary to his intention, however, the combined net profit of mainland-listed state-owned enterprises has not grown much, averaging between 300 billion and 400 billion yuan a year. There have been cases in which management efficiency has worsened because merged companies gained dominant market shares and lost the incentive to restructure.
A case in point is CRRC, the world's largest train maker, which was created in 2015 through the merger of two state-run companies, CNR and CSR. The combined company's ROE in 2017 was around 7%, down from more than 10% in 2015. Because state subsidies usually inflate the company's net profit -- by around 10% last year -- critics say its real ROE may have been almost 1 percentage point lower.
The former CNR and CSR were both export-oriented. At the time of the merger, the cabinet-level State-owned Assets Supervision and Administration Commission of the State Council, or SASAC, explained that the merger was intended to avoid "vicious competitions" among domestic companies that would prove "detrimental to national interests."
The merger pushed the new company's revenue up to 200 billion yuan, overtaking global rivals such as Siemens of Germany and Alstom of France, but that did not mean improved management efficiency at the Chinese state conglomerate.
CRRC had more than 186,000 employees at the end of 2015. It has since cut about 10,000 jobs, but the number of recipients of corporate pensions increased by 8,000, meaning that the impact of the restructuring has been limited. With worried employees pressuring the government before the merger was completed, the management had to offer repeated assurances that their jobs would be secure.
Zhu Rongji, who served as vice premier, central bank governor and premier between the 1990s and the 2000s, slashed jobs at state-owned companies as part of reforms aimed at restructuring the overall economy and preparing the country for accession to the World Trade Organization in 2001. Zhu was widely seen as destroying the "iron bowl," the guarantee of lifelong income and benefits that employment at state-owned enterprises had once entailed.
The current leadership, however, has focused on stabilizing the economy to preserve social and political harmony -- and therefore seems unwilling to carry out drastic restructuring.
While CRRC struggles to streamline its business, its European rivals are teaming up to take on the industry leader. Under a deal agreed on March 23 and expected to close by year-end, Alstom will merge with Siemens's railway operations, creating a new company in which Siemens will hold just over a 50% stake.
The projected revenue of the European alliance is 15.3 billion euros ($18.0 billion), around 60% of CRRC's. Its employee headcount, however, is 62,000 -- about a third of CRRC's. The two partners expect synergies worth 470 million euros over four years after the merger. They also have a blueprint for giving the new company a competitive edge, including making use of Siemens' advanced digital technologies. "A dominant player in Asia has changed global market dynamics," Siemens President and CEO Joe Kaeser said in a statement, in an apparent reference to CRRC.
On the other end, CRRC Vice President Lou Qiliang, who is in charge of overseas operations, attributed the sluggish results in 2017 to its "lost price advantage" due to rising material costs and unfavorable exchange rates, according to local media reports.
When the management team met in Beijing in April to discuss international operations for 2018, they slashed their target for overseas contracts to $7 billion from last year's target of $9 billion. The company's actual overseas contracts in 2017 totaled $5.7 billion, around 60% of the target.
"CRRC's competitive edge has centered on price, and the company has to rely on imported technologies," Beijing Jiaotong University professor Zhao Jian told local media. It remains unclear whether the company can improve its earnings power on its own.
Chinese stock markets were created mainly to help state-owned companies raise funds for restructuring. The Shanghai Stock Exchange was reopened in 1990 after being shut for about 40 years, and the bourse in Shenzhen was founded around the same time. The government initially prioritized core business operations to be spun off from state-run enterprises, which were in relatively better condition. But as more companies went public, the quality of state-owned enterprises being listed began to deteriorate.
Wendy Liu, head of China equity research and chief equity strategist for greater China at Nomura International Hong Kong, says that the SOEs offer the country protection during downturns.
They are an "economic buffer" for the government, especially during "the extreme chilliness of night," like the global financial crisis. And when overcapacity issues surface at the state-owned companies, the private sector often benefits.
China Unicom and its state-backed peers, China Mobile and China Telecom, demonstrated how the government can use the SOEs to achieve greater economic goals. The parents of all three of these big telecoms are "central companies" -- strategic large-scale state-owned enterprises under the direct jurisdiction of SASAC.
Liu, a former telecom sector analyst, noted that the state-backed push by the three main telecom operators to cut tariffs may have hurt their bottom lines, but had the effect of boosting China's new-economy companies.
More affordable mobile phone and broadband services provided by the telecom carriers helped make the mobile internet services of emerging companies like Alibaba, Tencent and Baidu available to more consumers.
Indeed, these three companies -- collectively known as BAT and all listed abroad -- enjoy double-digit ROEs: around 19%, 33% and 17%, respectively. Among all Chinese listed companies, Alibaba and Tencent boast the largest market capitalization.
Meanwhile, the state-backed companies, however inefficient, have another important role to play, Liu said -- especially when it comes to helping prop up the economy during difficult periods.
"Chinese state-owned enterprises, to a certain degree, are counter-cyclical instruments," she said.