With Chinese stocks soaring in the first half of this year, Mark Mobius has written a lengthy blog post covering developments in the reform of China’s State-Owned Enterprises (SOEs) and what that could mean for investors. To begin with, investors should keep in mind that China’s stock market is really multiple markets: The Shanghai (A Share) and Hong Kong (H Share) markets which are dominated by SOEs considered to be “blue chip” stocks while the Shenzhen (A Share) market is home to smaller domestic Chinese stocks. SOEs are also an important component of the Chinese economy as they represent perhaps two fifths of China’s economic output and a fifth of the country’s jobs plus they are a key mechanism for transmitting stimulus to the wider economy.
However, SOE reforms of some form or another have been going on for two decades now and as of last year, its unclear what direction the reforms will take with Mobius writing that:
Subsequent activity suggests that “privatization” as recognized in the West, with enterprises bought and sold in part or in full to the private sector, and the state withdrawing from involvement in management, does not appear to be on the agenda, at least for central government-controlled businesses.
Nevertheless, six enterprise pilot schemes of SOE reforms were announced in April 2014 with only two involving private capital where the companies sought to inject additional assets into existing quoted subsidiaries leaving a mixed ownership still dominated by state shareholders. Two other companies experimented with a Singapore style independent board focused on capital management where there is a barrier between the business and its state owners while another pilot program kept the SOE structure more or less in place but gave the SOE board rather than the state owner the power to appoint and incentivize the management team. Mobius observed:
The reforms appear to reflect a view in government circles that the key is to place circuit breakers between the CEO management and their government owners, with either the management themselves or an intervening level of asset management companies charged with enforcing a market-oriented business strategy.
In recent months, a merger occurred between two state railway engineering businesses in order to avoid the duplication of resources to create greater scale in overseas markets. This suggests that China’s government might be leaning toward this route to reform with Mobius writing:
In our view, judging by the reception of the railway merger, a wave of SOE corporate activity could potentially create significant opportunities for investors. However, a mere increase in scale without any other reform might have fewer long-term consequences on the SOE sector in terms of increased efficiency or market sensitivity, than was envisioned at the time of the original reform announcements. Of course, mergers, should they take place, would not preclude other measures, but the centrally owned SOEs may not in any case be the right place to look for early, ambitious reforms, in our view.
Mobius further went on to write that a number of factors could make more aggressive privatization of local government-owned SOEs more likely than for the centrally owned businesses with well over half of China’s provinces and municipalities having already announced some sort of SOE reform measures since the government’s aims were publicized.
To read the whole blog post, Developments in the Reform of China’s State-Owned Enterprises, go to the website of Franklin Templeton.
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