China's Party Congress last week further indicated that the authorities will seek to maintain the dominance of state-owned enterprises (SOEs) in key strategic sectors and will promote the role of SOEs in driving sectoral shifts and advances up the value chain to support economic development, says Fitch Ratings.
The reform agenda will continue to focus on consolidation, with the aim of creating national champions that can lead development. An increase in hybrid ownership structures is also likely, as the government looks to increase its presence in emerging sectors.
The authorities are unlikely to consider a reduction in SOEs' market position to tackle corporate sector inefficiencies, at least in the medium term. Instead, the government will use consolidation and capacity cuts in sectors experiencing severe oversupply to increase SOE productivity.
There are currently 98 SOEs under the supervision of the central State-Owned Assets Supervision and Administration Commission. This is likely to fall to less than 90 over the next 12-18 months, with mergers most likely in the power, defense, construction and machinery sectors.
Consolidation will include horizontal mergers to create entities with larger market share and greater economies of scale, as well as vertical mergers to enhance cost efficiencies along the supply chain and smooth profit volatility.
The August 2017 announcement of a consolidation of Shenhua and Guodian, for example, contained elements of both, creating China's largest power producer and coal mining company.
The authorities are likely to expect newly combined entities to play a strategic role in executing reform priorities. These companies will also have a mandate to lead sector development by focussing on high-value-added activities and products and to drive investment in strategic emerging sectors that can be integrated within their core businesses.
Non-core subsidiaries, particularly loss making entities, are likely to be divested during integration to lower the financial burden on the combined entity. So far, this has not resulted in large layoffs, as SOEs have found solutions for labour settlement and redeployment.
However, scope for redeployment is shrinking, with heavy industry creating fewer jobs as the economy shifts to higher-value-added and service industries. This could constrain efforts to curtail overcapacity, as mass lay-offs, like those following the mid-1990s SOE reforms, would be politically unpalatable and therefore unlikely.
Hybrid ownership structures are another important component of the government's corporate reform agenda. This includes private investment in SOEs as part of a long-standing strategy to improve the entities' management and performance, as well as SOE cross-holdings that aim to lower risks to the value of state-owned assets and form strategic alliances, although the benefits of the latter are yet to be seen.
SOE investment in private companies is also becoming increasingly common. The government could be using this approach to obtain stakes in private companies that are highly influential in 'new' strategic sectors, allowing it to monitor and manage financial risks and steer decisions that could affect the broader economy. This could mean companies might not always act solely for financial reasons.
The government is also likely to see investment in private companies as a way to pivot away from declining traditional SOE sectors towards those with higher return and growth potential. This is in keeping with SOE investment in joint funds that target new-economy sectors, such as renewables, IT, logistics, finance and AI.
These investments could integrate well with SOEs' core businesses and facilitate economic re-balancing, but there is also a risk that misguided decisions will be taken by SOEs that lack investment experience and are stepping into unfamiliar areas.
Policy driven over-investment is also a risk, with low-end new-energy vehicles already looking like a cautionary example.