How SOE Reform in China can Lead to Greater ODI

The rapid rise of China’s outbound direct investment (ODI) in the past decade is a significant economic phenomenon — one met with a lot of resistance in some destination countries, particularly due to the abundance of state-owned enterprises (SOEs). However, despite concerns over SOEs’ motivations and political connections, the recent round of SOE reform brings good prospects for further Chinese ODI.

The rapid rise of China’s outbound direct investment (ODI) in the past decade is a significant economic phenomenon — one met with a lot of resistance in some destination countries, particularly due to the abundance of state-owned enterprises (SOEs). However, despite concerns over SOEs’ motivations and political connections, the recent round of SOE reform brings good prospects for further Chinese ODI.

According to China’s Ministry of Commerce, in 2014, Chinese companies invested US$116 billion in 156 countries — about 45 times more than in 2002. The country ranks first among developing countries in both ODI stock and flow. In addition, there is vast potential for additional ODI growth.

In 2014, China’s GDP per capita reached US$7485. At this time, China became a net exporter of direct investment. Estimates are that China’s ODI will increase at the annual compound growth rate of 19–22 percent in the decade from 2013. This would make the total increased volume of China’s ODI during 2013–20 between US$2.5 trillion and US$3.6 trillion.

However, the rapid growth of China’s ODI has led to concern in some host destinations. These concerns come from not only the media and the public, but also governments, scholars and other analysts.

A leading concern is the high share of China’s ODI by Chinese SOEs. SOEs dominate Chinese ODI, especially before 2009. According to our calculations, between 2005 and 2013, 89.4 percent of the US$807.5 billion of Chinese ODI and contracts linked to SOEs.

Among the concerns of ODI recipient countries is that the Chinese government drives SOE ODI, with political and state-based strategic considerations rather than commercial ones. That generates fear that SOE investment is potentially harmful to the national interest of destination countries.

In response to such concerns, the overseas regulatory environment confronting China’s ODI is getting tougher, especially towards SOEs. The United States passed the Foreign Investment and National Security Act in 2007. Australia and Canada also issued new foreign investment guidelines in 2008 and 2009 respectively. All have made SOEs’ investments in their domestic markets more difficult.

However, the concern from developed countries fails to reflect a key feature of Chinese SOEs. In the past 30 years, SOEs have undergone a series of reforms. In the early-1980s, government bodies directly attached to and operated Chinese SOEs. Subsequent reforms carried out, stretching into the 1990s, to separate the government’s ownership from management’s operating role. Moreover, the 2000s saw nine government bodies engaged in managing SOEs abolished.

In 2003, the Chinese government established the State-Owned Assets Supervision and Administration Commission (SASAC). Unlike former regulators, SASAC enjoys consolidated powers over SOE regulation — there has been a massive shift from fragmented to concentrated regulatory power.

In 2006, SASAC issued some guiding opinions on SOE capital investments, mergers and acquisitions. The opinions made it clear that if central SOEs did not rank among the top three of their industry, they would merge and face acquisition. The goal then was to reduce the number of central SOEs from 155 to between 80 and 100. In 2014, there were 112 central SOE groups.

The government and politics clearly, closely connect SOEs. However, this does not necessarily mean that SOEs’ behaviour reflects their owners’ policy purposes. Since the market-oriented reforms began in 1978, the regulatory regime has been changing dramatically. The main trend is towards consolidating what were decentralised regulatory powers. There has been incremental transition from a separated regime to an integrated regime.

With this transition, SOE regulators have had stronger incentives to promote ODI. SOE investments have increased dramatically since the establishment of SASAC in 2003. But this may also have coincided with an increase in collusive behaviour, which can lead to an increase in the volume of low-quality ODI. While this would contribute to SOE ODI growth, it would lower the efficiency of Chinese ODI as a whole.

The political environment also negatively influences China’s SOE ODI. China’s corruption problem is severe. In 2014, China ranked 100th among 175 countries on the Transparency International’s Corruption Perceptions Index. Corruption can lead to low-quality investment — domestically and internationally — and so imposes a cost on the SOE owner and the Chinese economy.

Since 2013, Chinese President Xi Jinping has overseen a high-profile anticorruption campaign. This has targeted hundreds of thousands of officials at all levels of government and in the state-owned sector. As of 2015, it had executed over 270,000 cases involving officials from all levels of government. The scale of the campaign has had several consequences for China’s SOE ODI. While slowing SOE ODI growth, it ultimately enhances its efficiency by discouraging collusion.

In 2013, the Chinese Communist Party announced a new set of reforms, including SOE reforms. These include developing a mixed-ownership economy, improving the state-owned asset management system, improving SOE governance and management systems, and strengthening the budget system for state-owned capital operation.

This new round of SOE reform and previous ones identify several differences. Mixed ownership is now the basic form of the socialist economic system. As a result, the majority of SOEs can now become mixed-ownership entities. Private capital is also encouraged to take controlling shares, and employees can hold stocks.

The SOE reforms, as difficult and complicated as they are, will bring profound changes to the Chinese economy, as well as to Chinese enterprises and their overseas investments. As the SOE reforms evolve, so should the world’s views on them.

Time for a new look at China’s SOEs is republished with permission from East Asia Forum