China has made progress implementing the reform agenda of last November's Third Plenum. Private and foreign investors, especially those in Hong Kong, find themselves at the crux of Beijing's plans for markets to play a 'decisive' role in its statist economy. Two recent reforms are potentially momentous. First is the 'mixed ownership' model for state-owned enterprises (SOEs). Second is the Rmb550 billion 'through-train' cross-trading facility between the Hong Kong and Shanghai stock exchanges. While seemingly unrelated, these two developments are interwoven into a broader quest to make the economy more flexible, competitive and responsive to market signals.
State capitalism badly underperforms the private sector in China (see graph below). The result is a misallocation of capital on a grand scale, which worsened after the legendary 'command stimulus' of 2009 — headlined at Rmb4 trillion, but in reality perhaps an order of magnitude bigger if you count local government and associated credit spending. Beijing wants to purge these excesses by introducing private sector expertise and discipline.
That's where mixed ownership and the through-train come in. By allowing SOEs to share ownership of certain assets, and by permitting greater capital account exchange with the outside world, China's SOEs can be whipped into shape by sheer force of financial discipline. Actually, there is nothing much novel here. Socialist European nations championed mixed economies decades ago. But China's reforms are significant for their sheer scale, thus the potential upside if they succeed.
The poster-child of SOE reform is Sinopec, one of China's three oil giants. Sinopec is spinning off its retail marketing division, with some 30,000 petrol stations. There is undoubtedly upside to this business and the IPO could value the unit at US$50 billion. Sinopec will raise much-needed cash by bringing in outside stakeholders. But as any businessperson will tell you, majority control (and seats on the board of directors) ultimately counts for everything. Sinopec chairman Fu Chengyu proposes that only 30% be sold, broadly and preferably to domestic investors, who'll figure out among themselves their board representation. Sinopec will duly take note of their advice, no doubt.
Is this 'divide and conquer' governance? What restraints could minorities exert if Sinopec were ever called into 'national service' again like in 2009? To be sure, aligning management incentives with public share prices can work. But the carpet-bagging of wealth by management has always been a pernicious problem, as when relatives of executives mysteriously end up owning under-priced assets of SOEs. Past forays by private capital into infrastructure PPPs ended badly for these minorities, who found little redress in China's SOE-friendly courts. Today, they will demand extra inducements.
There is a strong sense of a system that remains captive both to the regulators and to state-appointed managers (some of whose positions actually overlap). The yield gap between private and SOE borrowers has actually been widening recently, reflecting market belief in Beijing's guarantees of SOEs. But if big SOEs are never permitted to fail, how can investors gauge the risks?
This leads to the second topic: the through-train. If there is a governance dispute or scandal in an onshore company, will Hong Kong investors be treated the same as mainlanders? Will Hong Kong's regulators, who today run a tight ship, make special forbearances for powerful PRC interests? Shirley Yam sees the scheme as a Frankenstein, 'a marriage between beauty and beast.' A WSJ editorial asks, 'will Hong Kong pull Chinese standards up, or will China drag Hong Kong down?' And will the train be shut down at Beijing's whim if markets misbehave? No wonder global investors fret over Shanghai's inclusion in global benchmarks as 'crazy, terrible and unfair.' Other technical questions must be resolved in the next six months before the pilot is fully operational, but the real unknown is how two radically different systems can mesh.
The China that Xi Jinping dreams of is 'a giant Singapore' where SOEs are run professionally for profit, with real outsiders and a stern rule of law – yet with the government calling the big shots. But China's overweening party-justice-military-state won't achieve best-in-class governance. Sinopec looks nothing like Singapore.
The contradictions in China's dexterous hybrid model aren't ideological; the Party's pragmatists reconciled those differences long ago. Instead, the problems are thoroughly practical. A party editorial unwittingly reveals the conundrum, exhorting SOEs 'to turn their political advantage to a competitive advantage.' Inviting private capital into politically advantaged companies could simply worsen corruption. If the leadership is serious about reform, those advantages must be curtailed; but then private investors may feel short-changed. Either way, the risk is what Minxin Pei would describe as a 'trapped transition' – capitalism stuck in no-man's land.