Date
24 October 2017
Local SOEs are smaller. It’s easier to dramatically improve their outlook by injecting good regional projects such as those set to gain from the economic focus of a local economy. Photo: Bloomberg
Local SOEs are smaller. It’s easier to dramatically improve their outlook by injecting good regional projects such as those set to gain from the economic focus of a local economy. Photo: Bloomberg

Why local SOE reform could be an important trading theme

China’s state media has openly applauded efforts to reform state-owned enterprises in Shanghai.

Investors who have been closely following the process were reminded that SOE reform is on pace.

China kicked off the latest round of reform in 2013 given the pressing need to resolve major problems in SOEs including operating losses, debt and weak creditworthiness.

SOEs booked a combined profit of 1.13 trillion yuan (US$169.5 billion) in the first half, down 8.5 percent from the year before. Steel and non-ferrous industries reported industry-wide losses, while petroleum, chemical, petrochemical sectors witnessed big profit declines.

In the meantime, non-financial SOEs had a combined outstanding debt of 83.55 trillion yuan as of the end of June.

The sum may soon outstrip that of their US counterparts.

As of the end of July, there were 38 debt defaults by 18 issuers, involving 24.8 billion yuan, double the level last year.

Nearly 70 percent of the defaulters were SOEs. The real picture could be worse given that some SOEs have window-dressed their financials one way or another.

What’s more worrying is loss-making SOEs continue to ramp up investment, partly because they have access to low-cost funds and also because of their mandate to carry out national strategy.

As such, they don’t pay much attention to whether capital is generating enough return.

Their huge debt pile is the biggest headache for SOEs, many of which keep piling up debt to keep things going.

The government has proposed a debt-to-equity swap but the program has failed to gain much support.

Debt by non-financial SOEs is expected to reach 88 trillion yuan by the end of the year.

Even if the debt-equity swap program can take care of 18 trillion yuan of the total (my estimate is it will take 10 years for China’s A-share market to absorb this amount of new equities), the outstanding debt still represents nearly 100 percent of GDP.

It’s easy to see why reform is such a pressing issue.

Under the reform theme, would central SOEs or local SOEs offer better investment opportunities?

Most central SOEs are in traditional cyclical industries. Their enormous scale and huge debt are big negatives.

Reform, like mergers and acquisitions, could help eliminate some excess capacity but substantially raising their profitability will be hard.

By contrast, local SOEs are smaller. It’s easier to dramatically improve their outlook and valuation by injecting good regional projects such as those set to gain from the economic edge and focus of a local economy.

Shanghai has been leading the way for SOE reform.

Soon, other regional powerhouses such as Shenzhen, Guangzhou and Tianjin are likely to accelerate their own reform process if they don’t want to be left behind.

The trend will eventually spread to less developed regions. Some great investment targets are hence likely to emerge.

This article appeared in the Hong Kong Economic Journal on Aug. 8

Translation by Julie Zhu

[Chinese version 中文版]

– Contact us at [email protected]

RA

Senior investment banker

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