Owned by the State

Owned by the State – a look at state owned enterprises and how they compete with the private sector in China.

At the most basic level there are two distinct types of businesses in China, the State Owned Enterprise (SOE), and the more familiar, Private Enterprise (PE). A State Owned Enterprise is similar to a Crown Corporation in Canada in that they are owned and operated by the government. Examples in Canada include CBC, Canada Post, Via Rail, Lotteries, and in some provinces Liquor or Beer stores.

How are Chinese SOE’s different from Crown Corporations in Canada?

The key differences between our two nations with respect to government operated enterprises are (1) the number of companies owned by the state, (2) the impact such companies have on the economy in China, (3) at what level of government, ownership occurs, and perhaps most importantly (4) how policy can impact the role of the state owned enterprise in China. It is estimated there are over 100,000 SOE’s in China.

They generate over 50% of the goods and services and employ over 250MM people. Forty-three percent of the profits generated in China are from SOE’s. Ownership occurs at the central and local government level. They range in size from extremely large central government run businesses to fairly small local government factories.

The role of SOE’s

SOE ’s came into existence to employ people and to generate revenue for the government to spend on other initiatives. An additional trait is the ability to regulate industry and to implement policy changes far quicker than Private Enterprises. SOE’s exist to drive the goals of the state, whereas PE’s exist to drive shareholder/owner value.

As example, if the government wishes to cut emissions to improve the environment, their ability to set swift targets and roll them out in a state run company is far easier than a private enterprise. They could simply tradeoff profits by cutting back dirtier production processes or purchasingmore expensive but cleaner sub components. The state would be investing margin to clean up the environment.

Ultimately, SOE’s are given financial targets from the government much like PE’s are given by ownership. SOE’s are required to pay dividends back to state and in 2012 the request from government actually increased. Still it can’t be ignored that government policy plays a role in decision making.

Access to capital, an advantage.

An advantage SOE’s enjoy over their competitors is access to capital. SOE’s have an established trust level with their banking institutions (also state owned) and are granted loans quite easily. From the banks’ perspective, the risk of default is tolerable and most SOE’s are decently sized which is an added bonus for the bank. The SOE has access to the capital it requires to pay bills, or to fund growth initiatives.

PE’s on the other hand have usually not been around for very long and a large majority are defined as Small-Medium Enterprises (SME). Their risk profile is much higher with borrowing institutions than SOEs. According to the banks, SME’s receive only 20% of the bank loans while they generate a disproportionately large part of the GDP and workforce. Gaining access to capital is a challenge and many are forced to turn to private lenders or micro financers at borrowing rates much higher than their SOE counterparts.

The China Microfinance Institution Association boasted that the lending growth rate for 2012 was over 30% higher than corresponding bank lending. Clearly the PE’s have turned to this avenue to secure capital.

A recently highlighted trend was the importance of productivity growth in Chinese factories. In order to enable automation, capital outlays are required. SOE’s are in an advantageous position to address the challenge given their ability to borrow at preferred rates.

Consistent Labour, an advantage

Perhaps the greatest benefit SOE’s enjoy is low employee turnover rates. In a study by China’s largest human resource service provider, 51job.com, the turnover rate in 2010 for PE’s was over 18%, while SOE’s ran closer to 10%. For a number of reasons, many workers prefer working for state run companies. SOE’s pay well, workers enjoy better benefits, and there is a focus on both personal and family gains. There is a feeling of belonging to a bigger family when you work for a SOE. Factory workers also enjoy a more reliable source of income given they are usually paid hourly and not by piece count. If management doesn’t do their job to attract volume for the factory, the workers aren’t losing wages.

A stable workforce can result in greater pride of ownership and higher quality levels.

The Drawbacks

The advantages afforded SOE’s makes it quite easy to sit back and become complacent. The best run SOE’s are aware of this and take steps to address these risks.

When a PE has good cash reserves, they are able to make investment decisions whenever they choose. They are far more nimble than a SOE who must gain approvals up the chain when they wish to deviate from their annual plan. Part of the review is to carefully verify that this sudden investment aligns to the goals of the state. This requires management to have the foresight to anticipate resource requests far in advance and creates challenges as it is difficult to react.

Commitment to growth is another concern. The leaders of many SOE’s are paid a stable salary, often with small incentive plans or none at all. If they achieve explosive growth, their earnings don’t really change much. Contrast their PE equivalents and they are generally rewarded handsomely for explosive growth. Management of SOE’s typically prefer business deals which are more stable and reliable over the longer term.

Cost competitiveness can be a challenge. As SOE’s are usually quite socially responsible, their wage bill is usually much higher than PE’s. Also, the demands for higher dividends have added pressure to SOE’s recently. If they wish to maintain profit margins, unless they have superior sourcing to their PE competitors or big volume, there’s a good chance their pricing will be higher.

For those negotiating with SOE’s, it’s in your interest to take a few moments and understand if there are any additional goals they are working towards. If you’re able to align your objectives, it could open up new ways of achieving win-win.