23 October 2018
Jinjiang International, a Shanghai SOE that operates the city's famous Peace Hotel, is a good candidate for mixed public-private ownership. Photo: Bloomberg
Jinjiang International, a Shanghai SOE that operates the city's famous Peace Hotel, is a good candidate for mixed public-private ownership. Photo: Bloomberg

Privatization in China – where are the opportunities?

As Beijing pursues privatization as part of the reform of state-owned enterprises, many investors are looking to buy into China’s major industries, such as oil and gas, aviation and telecommunications.

They will likely be disappointed, because Beijing is unlikely to sell firms in these strategic industries on any meaningful scale any time soon.

China’s state companies have been borrowing heavily. They have generated most of the country’s corporate liabilities, with total credit (which includes shadow banking) soaring to an estimated 250 percent of gross domestic product last year from less than 150 percent in 2008.

The rapid build-up of corporate debt is becoming a serious risk to the financial system, because slower economic growth is crimping corporate profits, raising the insolvency risk facing highly leveraged companies.

This risk will be aggravated by the gradual and eventual removal of deposit interest rate controls, which will put upward pressure on lending rates.

This will hurt the less profitable state firms more by pushing up funding costs when their pricing power is constrained by competition.

The return on assets (ROA) of state firms is only half the weighted average bank lending rate of 7.5 percent in last year’s third quarter.

Unless their ROA rises along with financial liberalisation, further increases in lending rates will raise the default risk of the state-owned sector.

Deleveraging has, thus, become the centerpiece of Beijing’s reform strategy, which will include privatization of state assets.

The question is, within China’s controlled system, how will privatization proceed?

Beijing appears to be addressing the country’s corporate debt risk by partially privatizing some SOEs.

This process takes the form of mixed ownership and is seen as the linchpin of SOE reform by President Xi Jinping.

Mixed ownership involves selling more shares of SOEs to private investors.

But with the bulk of the ownership remaining in state hands, full privatization is politically implausible in the medium term.

The central government launched several “experiments” involving six centrally owned SOEs last year as part of this reform initiative, including selling some of its stake in two SOEs, the China National Building Materials Group and China National Pharmaceutical Group Corp. (Sinopharm).

Two other SOEs, the State Development and Investment Corp. (which builds mega infrastructure projects) and China National Cereals, Oils and Foodstuffs Corp. (COFCO), were chosen for a pilot scheme designed to raise efficiency by transferring control of state equity to state-owned holding companies that will focus on capital management and maximisation of shareholder value rather than advancing policy goals.

The other two SOEs participating in one or more of the pilot reform schemes are China Energy Conservation and Environmental Protection Group and Xinxing Cathay International Group (a heavy equipment manufacturer previously owned by the military).

Local governments are also starting to sell infrastructure assets to pare debt.

To facilitate this effort, Beijing has launched a “public-private partnership” (PPP) scheme to allow private investors to operate and jointly own local SOEs and infrastructure assets.

However, even partial privatization is a big challenge for the reformers in China.

The crown jewels are all concentrated in strategic sectors, such as oil, aviation, rail, gas, electricity, post and telecommunications. The Communist Party will not let go of these in the medium term

Firms in other valuable but non-strategic sectors, such as property, metals, construction and retail, can be sold more easily, but they may not fetch their book value, because of structural and cyclical weaknesses.

Further, the expected returns on the PPP projects may not be attractive enough to entice significant private investment.

This is because the sale prices of the PPP projects are often set too high, or local governments’ control of the projects’ tariffs severely restricts their earnings potential.

Local SOEs have also performed worse than their central counterparts, as seen in their inferior return on equity.

However, this may be a blessing in disguise for investors, because it means there could be plenty of scope for improvement under private ownership.

They are also more accessible to private investors, as most are not in the strategic sectors.

Under these circumstances, Beijing will likely focus on mixed ownership reform in non-strategic and consumer-oriented sectors.

Jinjiang International (Group) Co. Ltd. is a notable example. A local SOE controlled by the Shanghai government, it is one of the world’s largest hotel groups, managing properties and travel agencies across China.

There are tens of thousands of other state firms like Jinjiang that are in the economic lowlands, with no strategic importance to Beijing.

They are running hotels, developing property projects, managing restaurant chains, operating shopping malls and providing social, business consulting, leasing and entertainment services.

These non-strategic sectors present the most viable investment opportunities for investors looking to benefit from China’s privatization.

Opinions in this article are the author’s and do not necessarily reflect those of BNPP IP.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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