China’s much-anticipated reform of social security and state-owned enterprises marks an important step in the shift to more sustainable growth, further improving the long-term outlook for Chinese consumption and domestically exposed industries despite the current market volatility.
As we have previously noted (1), China’s state-owned enterprises (SOEs) and social security system have been in the sights of the authorities for some time, who understand that reforming them will help smooth the trajectory of the Chinese economy. However, progress has proved to be painfully slow, as bureaucracy and political infighting have caused friction.
In the second half of 2015, the Chinese government finally began taking meaningful steps. In September, it announced the division of SOEs into two pools: those seeking profit and those focused on public welfare. Two months later, it advocated handing the governance and supervision of commercial SOEs to a “Temasek-style” investment company, or an assortment of such companies, which will have responsibility for restructuring and increasing the value of these SOEs. (1)
There are 150,000 SOEs in China, with over 100tn RMB ($15.7tn) in assets. Since the global financial crisis they have exhibited worrying levels of operational inefficiency, recording a 4.6% return on assets in 2014 versus a private-sector average of 9.1% (2). Improving these inefficiencies should contribute to the ongoing transformation of the Chinese economy, even amid the current volatility.
Capital to the people
The government’s holding company would manage the equity of profit-seeking SOEs, monitor their management teams and improve operations, as they attempt to produce better returns on state capital. They would do this by better incentivising management, overseeing capital allocations and providing industrial support. In its guidelines, the State Council indicated that these companies would also be expected to dispose of inefficient assets, with a focus on breaking up “zombie” SOEs and those with excess capacity.
Capital released by the disposal of the most unproductive SOEs, alongside savings from reduced investment in others, would be reinvested in major infrastructure projects, newer industries, the industrial supply chain and firms with “strong competitiveness,” according to the State Council (3). However, some of the capital released by the restructuring will be distributed into social security funds, which currently have a significant shortfall in assets – particularly pension funds for people without access to retirement savings vehicles, or those who cannot afford to contribute to one.
Greater social security means more consumption
Chinese social security reserves have been under strain for some time. China’s state pension programme was launched in 1997, but was only expanded to a broad proportion of its citizens through reforms in 2009, 2011 and 2014. These reforms put the programme’s capital shortfall in the spotlight, with a reported unfunded liability of $5bn (¥31.9bn) in 2014 (4), which has grown as the ratio of active to retired workers continues to shrink. The transfer of state assets should help to plug this gap.
Part of our investment case for China is the growth of domestic consumption, which in the short term is partially offsetting declining Western demand for exported Chinese goods, and should be a force for sustainable growth in the long term. While consumption is growing, it has been limited by the lack of social security available in certain parts of the country. In urban areas, where social security is more widely available, consumption growth has been steady; in rural areas with looser social security nets, it has been lower. The additional funding for social security provided by the SOE reforms should help redress this balance, improving the outlook for companies exposed to domestic consumers.
Easing the pension burden for companies
A broader benefit of this transfer of capital is a reduction in corporate pension burdens. At present, China’s 20% basic pension contribution rate, funded through a combination of payments from employees and employers, ranks in the top 10 among all nations. When this is combined with other benefits, companies pay out 44% of wages in the form of social security contributions. With the proposed capital transfer, the basic pension contribution rate could be reduced by as much as a quarter to 15%.
The reforms should also have a ripple effect on corporate culture and competitiveness. As a controlling owner of state assets, the proposed investment company would likely encourage better corporate governance as it works to improve SOEs. Meanwhile, as the new holder of substantial SOE equity, the National Social Security Fund would also support stronger governance standards by focusing on return on capital and taking a hands-off approach to management, which would be a clear departure from the current situation.
13m hukou for the migrant workforce
These reforms are only one aspect of ongoing social change in China. A month after announcing the boost to pensions for those without contributions, the Chinese state announced that it would allow residency permits, known as hukou, for about 13m unregistered workers in cities (5). This will allow these predominantly rural migrants to access state benefits, such as education and healthcare, in the areas in which they reside and work, rather than those in which they were born. As such, this change will help improve productivity, as workers are more likely to settle in urban areas and establish fuller lives with their families, further increasing consumption and demand for services.
China’s economic and political reforms are increasingly important as it seeks new ways to compete beyond cheap manufacturing. With a broader distribution of wealth through stronger social security, and more efficient and competitive industrial companies resulting from corporate reform, the prospects for the long-term sustainable growth of the Chinese economy continue to improve.
This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
1. “Opinions on the Reform and Improvement of State-owned Assets Management System,” published by the State Council on 4 November 2015.
2. “China’s state-owned enterprise reform plans face compromise,” published by The Financial Times on 14 September 2015.
3. “Opinions on the Reform and Improvement of State-owned Assets Management System,” published by the State Council in November 2015.
4. “Expert urges pension reform over earlier-than-expected deficit,” published by China News Service (ECNS.cn) on 19 November 2015.
5. “China wants hukous for its 13m unregistered citizens,” by Shannon Tiezzi. Published by The Diplomat on December 10, 2015.
The views and opinions contained herein are those of Hermes Emerging Markets, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. The information herein is believed to be reliable but Hermes Fund Managers does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion.
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