China Markets

As Tewoo Default Fires Up Doomsday Crowd, China To Roll Out SOE Reform

"World-class companies".

China is all set to embark on a three-year plan to reform state-owned enterprises, state media says.

The initiative will kick off in 2020, apparently, with a focus on operating margins and R&D expenditures, which will be considered alongside profits and debt ratios when evaluating performance.

This is billed as a “two benefits and three rates indicator system” in a China Securities Journal article that cites Hao Peng, Secretary of the Party Committee and Director of the State-owned Assets Supervision and Administration Commission of the State Council (hopefully, he never has to wear a name tag with his entire title on it).

The article also cites Zhou Lisha, a researcher, who offered the following justification for the new system:

Revenue and profit margins are indicators of the efficiency of a company’s operations and reflect the ability of business managers to obtain profits through operations while considering operating costs. The intensity of R & D investment Under the guidance of high-quality development, in the process of scientific and technological innovation and industrial development, enterprises need to increase the R & D layout of the scientific and technological industry and the “two benefits and three rates” indicator system to guide enterprises to focus on improving operating efficiency and increasing scientific and technological innovation. 

These types of initiatives are always introduced and promoted using high-minded word salads replete with references to “high quality development” or some other nebulous phraseology.

China Daily published additional details on what it describes as a plan to turbocharge mixed-ownership and reorganization. Next year, the broadsheet declared, China will create a group of “world-class companies”. Li Jin, chief researcher at the China Enterprise Research Institute in Beijing, said the reform initiative will inject “fresh momentum” into the economy and domestic capital markets.

Li previewed this more than a month ago in another China Daily article. “The plan will put forward a clear mission and specific evaluation measures to better define the ongoing mixed-ownership reform, strengthen supervision of SOE assets, improve their innovation and enhance incentive mechanisms to boost productivity”, he said, on November 14.

The bottom line is that this is yet another promise from Beijing related to SOE reform, a point of contention not just in the US-China trade spat, but also more generally. State guarantees, subsidies and a hodgepodge of other support mechanisms have drawn criticism from abroad and are generally blamed for promoting overcapacity, inefficiency and unfairly disadvantaging foreign competition.

Private defaults have hit records for two consecutive years in China, but SOE defaults remain subdued. “We estimate that 13.2% of the domestic corporate bonds outstanding at the end of 2018 were issued by POEs, with the remainder 86.8% issued by SOEs (including local government financing vehicles)”, Goldman notes, adding that “of the 31 new defaults by POEs so far this year, we estimate they had RMB 113.1bn of bonds outstanding at the time of default, equating to 4.3% of all outstanding POE bonds at the end of last year”. The same figure for SOEs is just 0.04%.

Earlier this month, Tianjin government-owned commodities trader Tewoo Group (a Fortune Global 500 company last year) said the majority of its dollar bond investors had agreed to a restructuring that would give debtors between 37 cents and 67 cents on the dollar. It was the largest dollar-bond default from an SOE since 1998.

Essentially, the episode laid the groundwork for future SOE defaults, and while the outcome was tautologically described by Lucror’s head of Asia as “poor for investors that bought the bonds at par”, at least there’s some precedent now – that is, the market knows Beijing will tolerate SOE defaults, especially amid ongoing stress in the economy and that, in turn, should promote discipline among market participants.

Of course, Tewoo’s plight brought out the fearmongering, with some portals copy/pasting Bloomberg’s coverage and cherry-picking the scariest-sounding passages on the way to suggesting that a Chinese bond apocalypse might come calling before Christmas.

Not surprisingly, that “call” didn’t pan out.

But the experience quite clearly suggests that Beijing will acquiesce (and perhaps even promote) a more “market-oriented approach to clean[ing] up mess[es]”, as Bloomberg put it.

In other words, you can expect more Tewoos, in part because there has now been a Tewoo.

Whether or not that’s a good or a bad thing depends on who you are. As the “keen” observer mentioned above pointed out, investors who buy bonds at par don’t love restructurings, and the market isn’t going to love the prospect of a destabilizing wave of SOE defaults.

But to suggest that Beijing would allow that to happen is to traffic in patent nonsense. “A sharp pick up in defaults can be destabilizing and any sudden removal of implicit government support can potentially raise systemic risk concerns”, Goldman recently said, in the course of describing the pace of onshore defaults as proceeding at “the right speed”.

Admittedly, it’s not clear if there is a “right” speed for dollar bond defaults, but it is out of the question that Beijing would allow things to spiral so far out of control that SOEs start to tip like dominoes. Nobody wants that, even staunch international critics of China’s policies towards state-owned entities.

For what it’s worth, profits at SOEs rose 5.3% in the 11 months through November, a pace Bloomberg describes as “the slowest since 2017” and Xinhua calls “steady” (those juxtapositions are always amusing).

Not helping matters is entrenched PPI deflation. Industrial profits fell 9.9% in October, the worst showing on record.

Read more:

PPI Deflation Bites In China, As Industrial Profits Sink Most On Record

Mind-Boggling Local Government Debt Dynamics Should Probably Worry China Watchers In 2020

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