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POLICY: Tanking SOE Profits Highlight Need for Privatization

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Bottom line: Beijing should launch an aggressive campaign to privatize state-owned enterprises, which could cause some short-term pain but will ultimately put the economy on a more stable long-term footing.

Profits tumble at SOEs

The latest profit reports for big state-owned enterprises (SOEs) are coming in for the first 2 months of the year, and the picture isn’t pretty and even looks quite worrisome for China’s thousands of state-owned enterprises (SOEs). New data published late last week showed profits for SOEs tumbled 14.2 percent in January and February combined, as they continued to be plagued by problems like overcapacity and weak demand due to China’s slowing economy.

But one of the biggest problems facing these companies, and one that threatens their long-term survival, is their failure to act commercially, a legacy of China’s planned economy that saw big SOEs historically function as tools for executing government policy. Such a tendency is what, for example, drives steel makers to continue producing at full throttle even when every ton of product they sell adds to losses due to the sector’s huge overcapacity.
This kind of behavior is driven partly by the implicit understanding that such losses are acceptable, and that the local or central government will step in to rescue these SOEs if they become insolvent. Such a pattern could lead to a financial nightmare if allowed to continue, since the government would be ill-equipped to handle mass insolvencies that could soon occur if profits continue to erode as China’s economy enters a “new normal” of slower growth.

To prevent that from happening and set the economy on a more stable long-term footing, the government should consider the bold step of launching a major privatization campaign that would ultimately affect all SOEs, from the biggest giants like PetroChina down to the smallest local manufacturers.

According to the new data released by the Ministry of Finance, SOEs posted profits of 222.6 billion yuan ($34.2 billion) in the first 2 months of the year. (English article) That figure was down 14.2 percent, or more than double the 6.7 percent decline a year earlier. The picture was even grimmer for SOEs administered by local governments, which saw their profits tumble 41 percent in January and February.

At the same time, SOEs saw their total revenue fall at a much smaller rate of 5.8 percent to 6.2 trillion yuan in the first 2 months of the year. That indicates that companies continued to maintain production at close to year-ago levels despite weak demand, resulting in the much larger rate of profit erosion. As a result, total debt of SOEs swelled by 18 percent in the first 2 months of the year.

Individual Laggards

The worrisome situation is reflected on an individual basis in the many recently released annual earnings reports from most major SOEs over the last few weeks. Leading oil company PetroChina (HKEx: 857; Shanghai: 601857; NYSE: PTR) was typical, reporting its net income fell 82 percent in last year’s fourth quarter to a record low for the company. Similarly, Baoshan Iron and Steel (Shanghai: 600019), China’s second largest steel maker, warned in January that its 2015 net income plunged 84 percent as rapidly slowing demand and overcapacity caused prices to tumble.

While many of the largest SOEs are publicly listed, government entities remain their largest shareholders in nearly all cases. That means that while these companies may try to boost profits to satisfy investors who buy their publicly traded shares, the government is still their ultimate boss that they need to please. Such a reality leads to situations where, for example, a company like Baosteel may maintain output even if that means selling at a loss, since trimming production might cause its hometown of Shanghai to miss its economic growth targets.

Privatization of these companies would rectify that situation, since the companies would no longer feel compelled to give top priority to satisfying local government officials, freeing them to focus on maximizing profits. Such a shift would also remove the implicit promise of government rescues if SOEs ran into financial difficulties, further boosting companies’ incentives to behave commercially.

Resistance to such a move could be large, especially from government stakeholders who would be reluctant to surrender their direct control over these companies. But experience in more mature western markets shows that Beijing and local governments can still continue to exert influence, albeit more indirectly, though policies like tax incentives and regulation.

Such a privatization campaign would by no means be easy, and might cause some short-term pain in the form of layoffs, slowing investment and even some closures. But that would be far better than the prolonged downturn and huge long-term risk that maintaining the old SOE system would pose.

(NOT FOR REPUBLICATION)

The post POLICY: Tanking SOE Profits Highlight Need for Privatization appeared first on Business China : news for investors in China.


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