GM is getting its 1% back, and it won't be cheap

Back in January, GM announced it wanted to buy back the 1% it had sold to its partner, Shanghai Auto (SAIC). In the post I wrote at that time, here was my prediction:

The only way I can see this happening is if GM were to agree to set up the sales organization that SAIC had first proposed, which may be possible now that the US government is no longer a majority owner in GM (though still technically the controlling owner).

As it turns out, this is exactly what is happening.  According to an article (free registration required) from Automotive News China:

Company CEO Dan Akerson told the Journal that the partners plan to split Shanghai GM into two units: sales and operations.

General Motors would have a 50 percent share of the operations unit, which would make product decisions. SAIC would retain a 51 percent share of the sales unit, which would allow the Chinese automaker to book the joint venture's revenue.

The remaining question, which the partners have not yet answered, is what consideration is changing hands. How much is GM paying to SAIC for the 1% of the manufacturing operation?

As for the ongoing implications, GM once again presumably has an equal say in SAIC-GM board meetings.  This is good for GM because they will have leverage in charting the direction of the firm, appointing executives, and planning production.

However, this new sales organization, of which SAIC will now own 51%, will funnel a bit more cash toward SAIC for the foreseeable future.  What's that worth?  According to my very rough, back-of-the-envelope math, possibly as much as $150 million a year in sales -- that's every year in perpetuity.*

If my math is even close to correct -- cut my figure in half and assume $75 million a year in sales -- that will very quickly add up to a lot more than the $85 million or so GM originally got for selling that 1% to SAIC in 2009.

Of course, SAIC and GM could just tell us what this will cost and people like me wouldn't have to do voodoo math. I'm sure GM's shareholders would like to know.

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* My back-of-the-envelope math.  According to the WSJ, GM gets about $30 billion in revenue a year from China.  Last year, SAIC-GM sold 1.2 million vehicles and SAIC-GM-Wuling sold 1.3 million (data here).  Again, very roughly, taking GM's 49% of SAIC-GM and GM's 44% of SAIC-GM-Wuling reveals that about 52% of GM's China revenue came from SAIC-GM.  Even more roughly, 52% of GM's $30 billion is $15.6 billion and 1% of that is $156 million.

Book Talk at USC

Several weeks ago I gave a talk related to my forthcoming book at the University of Southern California.  Watch as I attempt to summarize four years of research and a 300-page book in less than an hour.  :)

*UPDATED* - Who is Li Shufu's "Associate"?

UPDATE below...
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From the corporate governance files...

Geely is probably best known as the Chinese auto company that bought Volvo from Ford last year. It is also known as China's largest "private" automaker. I put the term "private" in quotation marks because, in China, the meaning of the word is not quite the same as in most developed countries.

As is generally well-known among China watchers, the government -- particularly local governments -- have influence on private businesses that goes beyond mere regulation. And the larger the "private" business, the greater the government's influence.

At a minimum, the local state is everyone's landlord. At the extreme, a local government can force private businesses to sell out to state owned businesses, as has been done with alarming frequency in the coal industry, or local officials can demand an ownership share.

On the positive side, not all governments necessarily seek to own or control private businesses, and many even provide help to private businesses in startup mode such as tax breaks, free or cheap land and utilities, access to bank loans, etc.

But the question that this kind of help often raises is, what does the government expect in return? Is it enough to be a successful business that employs people and pays its taxes on time, or do local officials expect more?

Because we always hear that Geely is a "private" business, I decided to try to find out exactly how "private" Geely is -- at least in terms of legal ownership. Geely is listed on the Hong Kong Stock Exchange, so its audited financial statements and accompanying notes are made available on the HKSE website. Geely's latest annual report (2009) is available here (pdf).

In an effort to determine who exactly owns Geely, I constructed the following partial org chart from information available in the annual report. The listed company is in the purple box. About 48 percent of the Geely Auto Holdings is held by public shareholders, and the remaining majority of shares are owned by a company named Proper Glory Holdings which is incorporated in the British Virgin Islands.

According to the annual report, Proper Glory is ultimately controlled by Geely's Chairman "Mr. Li Shufu and his associate," but for some reason it does not say who this "associate" is. (Here I am referring to the yellow box at the top of the diagram.)

Looking back over the years, this "associate" did not begin to be mentioned as an owner until 2008, but he, she or it seems to be pretty important. If you do the math, this anonymous "associate" could potentially control up to 35 percent of the listed company. And if "associate" owns as little as 75 percent of Zhejiang Geely Holding Group Ltd, he, she or it would be the listed company's largest single shareholder with a 26 percent interest.

Furthermore, as you can see at the bottom of the org chart, Li Shufu and this mysterious "associate" also own 9% of the auto plants.



I contacted several friends who are even more knowledgeable than I about China's auto industry, and their assumption, like mine, is that Li Shufu controls the company. One suggested, however, that the "associate" may be Li's son or brother. Another speculated that it could even be a Communist Party member to whom Li is beholden for something.

I am not suggesting that there is anything illegal going on here, but it seems to me that Geely's auditor, the Hong Kong office of Grant Thornton (which has recently lost most of its employees to BDO) is not doing a thorough enough job of reporting by allowing a shareholder with the potential to control the company to remain completely anonymous.

If there is nothing to hide, why not reveal the name of the "associate"? At a minimum, why not reveal the respective ownership shares that Li Shufu and "associate" have in Zhejiang Geely Holding Group Ltd?

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UPDATE, January 28, 2011:

Thanks to one of my readers for bringing this to my attention.

Above I said that Li Shufu's unnamed "associate" could control the listed Geely company with 75% ownership of Zhejiang Geely Holding Group Ltd. (ZGHGL). That's not entirely accurate. I was thinking more like an accountant than a lawyer. (And I am neither, though my work previously involved a lot of accounting).

I should have more accurately said that the "associate" could control Geely with only a majority ownership of ZGHGL. If the associate held 50% plus one share of ZGHGL, then he would effectively control Proper Glory, which, because it owns 51.3%, also controls the listed Geely Company.

Again, while my assumption is that Li Shufu is the controlling owner of Geely, until someone reveals how much of ZGHGL the associate owns, we cannot be entirely sure of that.

Subsequent to the above post, I have also received information from someone who knows the identity of the associate. This "associate" is apparently an influential Party member who helped Geely to get central government approval for the Volvo purchase. Unfortunately, I cannot reveal the source, but it is someone whom I trust, and who is in a position to know.

If that is indeed true, then, if I were a Geely shareholder, I would be even more interested to know how much influence and/or control the "associate" actually has.

Anshan's proposed investment in US: are we OK with this?

A couple of days ago, news surfaced that Anshan Iron and Steel, one of the largest steel manufacturers in China intends to purchase a 20 percent stake in a near-bankrupt Mississippi steel mill. I say "surfaced" because the actual decision to pursue this investment apparently came in May, but for whatever reason never made the news in the US.

As would be expected, the Congressional Steel Caucus, a group of about 50 US lawmakers who are advocates of the US steel industry, raised objections to the proposed investment. These objections are similar to those raised by CNOOC's proposed takeover of Unocal back in 2005, so there is really nothing new here. The requisite "national security" implications are raised. And there is little doubt that the Steel Caucus's "investigation" will recommend against allowing this investment to happen.

Of course, the Steel Caucus can only make a recommendation; it does not have the final word, so it is not inconceivable that the investment could happen anyway. After all, a 20 percent stake is not a controlling stake, right? And even if it were, Anshan is just like any other profit-seeking business, right?

To address the first question, the answer is that we cannot always be certain whether 20 percent is a controlling stake. That really depends on who the other shareholders are and how large their stakes are. According to the Wall Street Journal, the Mississippi plant in question is owned by a private company, the Steel Development Co., which, according to its website is owned by "institutional investment firms headquartered in the United States, as well as [its] management group." So I think it is reasonable to assume that Anshan's proposed 20 percent stake would not be a controlling stake.

As for the question of whether Anshan is a profit-seeking business, the short answer is, yes, except for when it is not.

Beijing-based lawyer and blogger, Stan Abrams, posted a funny, and partially tongue-in-cheek, article today essentially making fun of the Congressional Steel Caucus's knee-jerk commie baiting (my term, not Stan's). While I largely agree with Stan's conclusion, I have to wonder whether the fact that Anshan is a state-owned enterprise is a significant factor that deserves further scrutiny.

Stan says (again, tongue-in-cheek):

Everyone knows that the company is controlled by China’s Assets Supervision Commission of the State Council (SASAC), which means that the company is merely a tool of the Communist Party. With all of those subsidies, Anshan is definitely up to no good.

Well, let's take this apart. First of all, I think we can be sure that not "everyone knows" this. Whether they should remains to be seen. Second, yes, Anshan is indeed owned by SASAC, the arm of the State Council that holds the shares of China's largest state-owned enterprises.

Third, while Anshan isn't "merely" a tool of the Communist Party (it is also other things), it is nevertheless a tool of the Communist Party. Anshan is 67 percent owned by SASAC, which doesn't necessarily make it a tool of the Communist Party -- until you take a closer look. The senior management of SASAC-owned companies, including Anshan, are appointed, not by their Boards of Directors, not by SASAC, not by the State Council, but by the Politburo of the Chinese Communist Party. (Richard McGregor's new book documents much of this. It's also a great read. McGregor explains some of this in an interview here on the China Beat.)

I also found it interesting that Qi Xiangdong, Deputy Secretary General of the Chinese Iron and Steel Association seemed to bend over backward to try to redefine what "state-owned" means:

"A market-economy country like the U.S. shouldn't make administrative intervention to corporate behavior," Mr. Qi said. "Western countries still have a stereotype of [Chinese] state-owned enterprises. ...Anshan Iron is a listed company, and not a Chinese state-owned enterprise in the traditional sense." (WSJ, 5 July 2010)

Setting aside the irony that the king of state interventionist governments would lecture the US about what a market economy is, it is extremely disingenuous of Mr. Qi to suggest that a company that is 67 percent owned by the government is not state-owned. If I were a conspiracy theorist, which I'm not, I might begin to suspect that there is a Chinese plot to redefine English language words such as state-owned, democracy, rule-of-law, etc., so as to confuse their foreign detractors.

What about "all of those subsidies"? Well, since Anshan is indeed a state-owned enterprise, we can be certain that, at some point in the past, and probably at some point in the future, Anshan will benefit from government subsidies. Part of the reason for continued government control of major enterprises in China is fear of instability that would be caused by massive layoffs if these giant firms were to go bankrupt. As long as any company is in state hands, that's not a problem. Anshan is "blessed" with a soft budget constraint, and they know it.

Is Anshan "up to no good"? Probably not, though when it comes to the murky world of Chinese state-owned enterprises, nothing can be said with all certainty. Anshan's external shareholders, a diffuse group of individuals and institutions who collectively own only 33 percent of Anshan's shares, have no say in what the company does. Anshan is part of a large group company, and there is absolutely zero visibility into the operations or financial statements of the unlisted entities. It may also give us pause that a Chinese official stretches reason in order to declare Anshan not to be a state-owned enterprise when it clearly is.

So while Anshan is probably just looking for a good investment in a business that it already knows, without visibility into the rest of Anshan's dealings, its leadership, its true controlling owners (i.e. the Politburo), we cannot be absolutely certain.

So are we OK with this investment?

Yeah, why not? Let the folks in Mississippi take Anshan's money. When it comes to the power of the Chinese state, it pretty much stops at the borders of the United States. Once Chinese money and people enter the US, they are subject to rule-of-law. And while the Chinese may wish to redefine what that term means within their own borders, they will find US courts quite unsympathetic to any attempts to do so elsewhere.

国进民退: Is China Really Re-nationalizing? (II)

Following up on my post from March 27, I first wanted to look back in history a bit to the origin of the term guo tui min jin to determine how it entered the lexicon of policy a decade ago. I am not certain whether this particular exercise buys us any better understanding of whether the state is re-nationalizing businesses today, but perhaps it sheds a little light on why the idea is generating debate.

Referring once again to an official history of the reforms of China's state-owned enterprises, as I mentioned before, the credit for guo tui min jin is given to a Professor Wang Jue of the Central Party School.*

In 1999, Professor Wang was interviewed about this concept, and the following few lines are important for an understanding of what policymakers were apparently hearing from the originator of this concept. I will quote a line or two of the original Chinese and follow with my (possibly flawed) translations. Words in brackets "[ ]" are my own exegesis.

国退民进—就是国家退出来，让老百姓进去。有人说国退民进是搞私有化，其实不是，民有经济和私有经济是两个概念，

Guo tui min jin means the state withdraws to let the common people go in. Someone said that guo jin min tui means privatization [um, like me a few posts back], but that is not the case. People’s economy (民有经济) and private economy (私有经济) are two different concepts. [Note that he’s distinguishing between “the people” collectively and private individuals.]

私有经济是民有经济的一个部分。集体经济、股份制经济都是民有民营的。

The private economy is part of the people’s economy. The collective economy [encompassing some of the few remaining township and village enterprises or TVEs] and the shareholder ownership economy [encompassing firms that have undergone conversion to a shareholding, though not necessarily publicly listed, corporation] are also part of the people’s economy.

民有民营是相对国有国营说的。不是国有国营的都是民有民营的，它既有公有性质的也有四有性质的，也有公私混合所有制的。

“People owned and managed” (民有民营) should be contrasted with “state owned and managed” (国有国营). If a company is not state owned and managed then it is people owned and managed. [He’s saying these two types are mutually exclusive.] The people owned and managed (economy) contains the natures of both public and private ownership. [If I’m not mistaken, here he is saying that people owned and managed enterprises can have both the state and individuals as owners – which, again, if I’m not mistaken, violates the mutual exclusivity implied by his previous sentence.]

So what, in a nutshell, does all of this mean? Assuming the policy truly was influenced by Professor Wang, as this official state-owned enterprise history says it was, then this is what I have learned:

• Everyone outside China (or inside, for that matter) who interpreted guo tui min jin as privatization was simply wrong.

• The many shareholder reforms among state-owned enterprises that took place over the past couple of decades all qualify as guo tui min jin reforms. That despite the fact that few of these shareholding enterprises were listed on China’s stock markets (only about 1,800 firms are traded), and among those, all but about 200 continue to have either the state, or a state-owned entity, as the controlling shareholder.

• One may also say that this has all been a wasted effort anyway: how unusual is it, really, for politicians and officials to interpret rules and policies for their own benefit?

As promised last time, I will later post a summary in English of a good article in Chinese describing the current debate around guo jin min tui. But I’ve taken enough of your time for today.

Thanks for reading.

And, by the way, I welcome clarifications anyone has to offer in translating the Chinese material above.

The next post in this series can be found here.

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* 章迪诚，著，中国国有企业改革编年史，（北京：中国工人出版社，2006） pp.556-7.

China Stakes on SOE Corporate Governance

ChinaStakes, a fantastic Shanghai-based political economy site that I follow daily, has posted a commentary on a recent People's Daily article that asserts the importance of Communist Party leadership in state-owned enterprises.

I somehow managed to miss this People's Daily commentary, so I am happy that ChinaStakes has highlighted it for us. If there has been any doubt as to the role of the Party in China's SOE, People's Daily makes it crystal clear: SOEs exist to serve the political aims of the party. Any economic goals are only secondary.

You can read the entire ChinaStakes post here.

How do Australia's Foreign Investment Rules Apply to China?

Australia's government announced yesterday an easing of foreign investment rules. The rules have apparently come under criticism recently for causing delays that may be overly burdensome to foreign investors.

One recent deal, the proposed purchase of a controlling interest in Aussie miner Rio Tinto by Chinese metals company Chinalco, was canceled during Australia's review process. According to Reuters, some critics have complained that the delay caused by Australia's review process injected doubt and uncertainty, possibly causing Rio to cancel the deal before a decision was rendered. There is, of course, no evidence to support this speculation.

The Reuters story also points out that the changes to Australia's rules only affect private investment. Sovereign investment, that is, investment by foreign governments, is still subject to the same rigorous review process. So in fact, this change in rules would have had no effect at all on the Rio Tinto purchase. Chinalco is owned by China's central government, and its proposed controlling purchase of Rio was only a small part of the $12 billion in Chinese state investment into Australia proposed during the first five months of 2009.

One question not addressed is how exactly Australia will distinguish between "public" and "private". Among most countries with market economies, the question is not so difficult to answer.

For example, if Ford Motor Co. from the US wanted to buy an Australian parts company, this would be considered "private" investment. But if General Motors wanted to buy the same parts company (and assuming it were able, which I know is a bit of a stretch) this would be considered "public" since GM's majority shareholder is the US government.

But how would these rules apply to Chinese companies?

For example, Lenovo, maker of the Thinkpad on which I write this post, is a publicly traded company. If it wanted to buy an Australian software firm, surely it would be considered private, right? Not exactly. When you follow the trail, you find that Lenovo's controlling (though not majority) shareholder is the Chinese Academy of Sciences, a government-controlled thinktank.

What about Geely Motors? Geely is traded in Hong Kong, and its controlling shareholder is the company's Chairman, Li Shufu, a private Chinese citizen. I think this case would be more clear cut, and indeed, apparently Australia thought so when they allowed Geely to buy DSI, an Australian maker of drivetrains.

However, as I pointed out in a recent post about Geely, the line between "public" and "private" in China can be blurry. Despite the private ownership of Geely, China's State Council apparently maintains the right to sign off on Geely's strategy for expansion.

Human Flesh Search Engines in the World of Finance

Today I encountered a new term: "listed company human flesh search engine" (上市公司人肉搜索).

Those who follow China are familiar with the term "human flesh search engine" as a metaphor for a spontaneous online uprising of people whose main purpose is to exact revenge for a perceived wrong -- an online equivalent of the mob who showed up outside Dr. Frankenstein's house with torches and pitchforks.

This term has now been prefixed with "listed company" to describe people who obtain inside information on listed companies and spread that information online for the purposes of manipulating the share price.

The Shenzhen Stock Exchange announced today that it would be taking steps to counter this kind of behavior, first of all by simply warning investors of the risks of following the advice of such unauthorized communication. They even used a term that I have not often encountered in the Chinese press: 投资者关系 or investor relations -- a concept that has been slow to catch on in China so far since the only investor most listed companies have to worry about is the government.

Secondly, and most importantly, the Exchange vows to strengthen supervision over the manner in which listed companies release information to the public, ensuring that information is released in a more timely manner. In a lesson that many governments could stand to learn, the Exchange gets the fact that rumors can be countered with more timely release of official information.

An "industry insider" was quoted as saying that, from this point forward, people without credentials would have to "shut their mouths", and only those with approved credentials would be able to conduct equity analysis for public consumption. Organizations providing analysis will be supervised by both the authorities and the investing public. If someone has a problem with a particular analyst's work, they may file a complaint.

This is a good start, and many of the provisions make sense; however, as with all good starts, there are shortcomings. First, the internet is a big place, and while the authorities have developed the capability to filter out political content, it will be much harder to filter out information regarding companies. Any filter that blocks certain keywords could end up blocking legitimate information channels as well.

Second, while it is good that there are legitimate equity analysts with valid credentials in China, I have yet to find anyone in China who accords fundamental analysis any importance in their investment decisions.

It is early days yet, and Chinese shares still do not reflect the underlying value of the firms they represent. And even if they did, the state's controlling share in most of the listed companies makes inside information as to the state's intentions one of the most important pieces of information for determining the future direction of a stock price. Will credentialed analysts be privy to such information?

Remind me again...What does "IPO" mean?

It has been so long since we've seen any IPO action that the average observer may be forgiven for not remembering what the term means.

Sohu, a Chinese portal site has filed with the SEC its intention to list the shares of its online game subsidiary on NASDAQ. Sohu, itself also listed on NASDAQ, controls 70.7 percent of the shares of Changyou, the subsidiary that it intends to list.

This latest IPO is all the more interesting because it is a Chinese company preparing to list shares in the United States. In the 1990s, Chinese IPOs in New York, particularly those of internet-related companies, were not uncommon. A number of large Chinese SOEs also listed their shares in the U.S. in order to take advantage of the vast sums of wealth available outside of China.

Over the past decade or so, there has been a noticeable decrease in overseas (not including HK) Chinese IPO activity for a couple of reasons. First, the Central Government has begun to speak out against overseas listings and encourage more domestic listings. Second, there's so much more money floating around China now, and domestic investors are always eager to snap up new offerings.

According to this story at Economic Observer Online, online games have been a bright spot in an otherwise dismal economy this year. Sohu's online game revenues are already 2.4 times the same period last year.

The market, however, is not impressed. Sohu was downgraded to "sell" this morning.

Suppliers and Transparency in China's Auto Industry

Note: This particular post is more theoretical in nature than usual. It is based on research and discussions with knowledgeable people, but I do not yet offer empirical evidence to support my claims. I welcome constructive criticism from anyone with the time and inclination to read this to the end.

Q: What factors influence a Chinese auto assembler's selection of suppliers?

• low price?
• dependable quality?
• flexibility?
• degree integration with supply chain?
• all of the above?

A: All of the above should be important, and indeed many of these factors probably enter into many sourcing decisions; however, there is another important factor that, if not unique to China, is certainly important in the world's more controlled economies. That factor is transparency.

The transparency I refer to here is not transparency of a supplier's operations; it is transparency of an auto group's financial condition -- or more precisely, the lack thereof. Before I explain what this means, a little background is in order.

The typical Western model of assembler-supplier relationship has evolved over time from one of in-house suppliers to many outside suppliers. At some point, GM decided to focus on its core competency, assembling automobiles, and it spun off its Delphi parts maker. Ford did much the same with Visteon. Delphi and Visteon are now publicly traded companies that not only manufacture parts for their former owners, but are also free to do so for any other firm that wishes to engage their services.

The value for Ford and GM is that they now have more options for sourcing parts, and their suppliers now have to compete against each other for business.

What sort of assembler-supplier models do we see in China? So far I have identified two ideal types: the group parts supplier network and the external parts supplier network. In reality, these types are not mutually exclusive, and we see varying mixes of the two among China's domestic auto assemblers. However, by considering these two types we can gain an understanding of the motivations of Chinese auto assemblers.

The first type, the group supplier network, is one in which all or most suppliers, while not a part of the auto assembly enterprise, are part of the same group or "jituan" (集团) as the assembler. The second type is similar to the Western model in which all or most suppliers are external to, and not organizationally linked with, the assembly firm.

It is easy to assume that Chinese automakers, like their Western counterparts are moving toward the second model for the same reasons that GM and Ford did: increased competition among suppliers allows for lower prices. However, among China's major, listed automakers, the first model continues to dominate, and for reasons unrelated to efficiency. Furthermore, while the landscape continues to evolve, there are varying degrees of internal vs external suppliers for listed Chinese firms.

We might then assume that, ceteris paribus, those companies with the higher degree of internal supply have lower profitability since their suppliers endure less competition for business. In theory, however, we should expect to see exactly the opposite.

In China, most of the major automakers, despite being partially listed on the stock markets, are part of much larger group companies or "jituan". These jituan, while holding controlling ownership in the auto assembly firms, also own many other subsidiaries including hospitals, kindergartens, retail stores, real estate, and yes, auto supply firms. While the jituan's listed auto firm is required to publish audited annual financial statements, the jituan, and all of its non-listed subsidiaries, are not bound by such requirements.

This lack of transparency works in the jituan's favor. By requiring its internal parts suppliers to sell parts to the listed auto assembler at or below cost, the jituan is able to pump up the earnings of its listed subsidiary while hiding the losses of its non-listed subsidiaries. And, all things being equal, higher earnings by the listed subsidiary, lead to a higher stock price which increases the value of the jituan's controlling stake.

The auto firm with many external suppliers, on the other hand, buys a larger portion of its parts at a market-determined price, a price that will allow the parts supplier (itself also possibly a listed company) to earn a reasonable profit. Consequently, the assembler that benefits from competition among its suppliers is punished in the market for doing the right thing. Being unable to force its suppliers to absorb losses, the firm with external suppliers should, all things being equal, earn a comparatively lower profit than the firm with many internal suppliers.

This problem has not escaped the notice of China's State Council or its market regulators. In recent years, there has been increasing discussion of the concept of a "complete listing" (整体上市). The idea here is for a gradual move toward a listing of an entire jituan rather than selected subsidiaries.

As with many new concepts in China, rhetoric often outstrips implementation. For reasons that should be obvious, the jituan are in no hurry to increase transparency, and the government is in no hurry to witness the negative effects on China's stock market that would surely obtain if subsidiary losses are brought to light.

Central SOEs: Score One for Transparency!

Securities Daily reports (from Econ. Observer Online) that, beginning with 2009, China's Central State-Owned Enterprises (SOEs) will publicize their annual reports. This is big news!

Until now, central SOE results have been reported in aggregate, but the only enterprise level numbers we could see were those we could glean from the annual reports of the listed entities owned by SOEs. Now we will apparently be able to see the annual reports of all 141 group companies owned by central SASAC.

One unanswered question: who will audit these rat's nests of confusing cross-shareholdings, and how reliable will the numbers be?

Improving Central SOE Corporate Governance?

The State Council and SASAC have announced a "breakthrough" in drawing boundaries between the Party and Central SOE Boards of Directors that will reportedly result in greater "scope of authority and independence" for enterprise boards.

According to this article in the Economic Observer, for the past four years, SASAC has been conducting a "trial" of sorts with boards of directors -- which seems surprising since China's Company Law (公司法) already prescribes the purpose and functions of the Board of Directors, Supervisory Board and the Shareholders Meeting.

Perhaps the need for the "trial" has been that things weren't working out as planned. According to an anonymous outside board member interviewed for the article, "the gap between the trial board of directors and a 'real board of directors' is huge." Boards simply do not have the authority to "hire and fire, conduct performance evaluations, and set compensation" as is prescribed under the company law.

However, according to a document released late last year, 《关于董事会试点中央企业董事会选聘高级管理人员工作的指导意见》, the power to appoint each firm's general manager, deputy general manager, chief accountant and board secretary will now fall to the board of directors.

Until now, this duty was handled in combination by SASAC and the Party's Organization Department (i.e. Personnel Department). From this point, the only apparent involvement of the Party will be when the Board of Directors "reports" such appointments to the Party Committee of SASAC.

The document does acknowledge that, while the company law has required that these powers be vested with the Board of Directors in the past, this has not been the case, and it will change. In other words, "we've been breaking the law, but we're gonna stop now".

What Motivates SOE Chief Executives?

We all know the standard neo-classical economic theory of how state-owned businesses cannot outperform privately-owned businesses. (Or if we don't know it explicitly, we in the West have all heard it in some form for most of our lives.)

There are several key reasons for the theoretical lack of competitiveness of state-owned enterprises (SOEs), one of which is that the state's objectives are conflicted between the economic and the political. This makes it difficult for the state to provide the proper incentives to the chief executives of these SOEs.

The recent story on the attempt by Chinalco, a central SOE, to increase its controlling stake in Rio Tinto, a publicly traded Australian iron-ore producer, has received a lot of press as of late. (See stories here, here and here for a little background.)

Of related interest is yesterday's news that Xiao Yaqing, Chairman and CEO of Chinalco (as well as its listed subsidiary Chalco) is resigning right in the middle of negotiations over the Rio Tinto stake. While the timing of this resignation seems a little strange, I think it illustrates very well what drives these guys.

According to this SCMP story, Xiao, who until now has been an alternate member of the Communist Party's Central Committee, will apparently take up an important position in China's cabinet, also known as the State Council. I spoke with someone in Beijing today, and the rumor going around -- and I stress that this is just a rumor -- is that Xiao will become Deputy Secretary General of the State Council under Ma Kai.

While probably not as high profile a position as CEO of Chinalco, this position is considered to be a reward for Xiao's work, and is not surprising. These kinds of political appointments are not at all unusual for those who run SOEs in China.

Another recent example is Li Xiaopeng (son of former Premier, Li Peng, not to be confused with gymnast Li Xiaopeng) who last year vacated the position of Chairman of Huaneng Power to become Vice-Governor of Shanxi Province.

An interesting related question I cannot answer is whether the performance of an SOE under a given Chief Executive affects his chances of political promotion.

And if it does matter, I wonder whether those analyzing performance are able to distinguish between brilliant leadership and a merely coincidental intersection between a CEO's turn at the helm and a bull market.

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UPDATE: Confirmation of the rumor. Looks like Xiao Yaqing will take up the post of Deputy Secretary General of the State Council.

An Ownership Conundrum for the State

Following the previous few days' posts here and here, today I just happened to be scouring the annual reports of Dongfeng Auto, trying to figure out who owns what.

Dongfeng Auto is one of only two Central SOEs in the auto business. It began life as "Second Auto Works" back in 1969, but at some point probably figured that if they were ever to become the largest, they would have to dump the name. (They claim to be the third largest behind First Auto Works and Shanghai Auto Works.)

The hard part about figuring out ownership of Chinese companies is that it is only possible when one or more of the entities is listed on a stock market. Otherwise, there really is no requirement for state-owned (or any non-listed company, for that matter) to divulge anything about the company.

Fortunately for us, Dongfeng has at least two listed entities. One, Dongfeng Motors Group Company (东风汽车集团股份有限公司) is listed in Hong Kong, and is represented by the green box below. The other, Dongfeng Auto Corp. (东风汽车股份有限公司) is listed in Shanghai, and is represented by the purple box at the bottom of the chain.

While I'm at it, I apologize for the rough nature of this sketch. I wasn't intending it for public consumption, but I later decided that it may be of interest to some readers. Also, this sketch is not intended to be a comprehensive picture of all entities in the Dongfeng group. My goal here was merely to lay out the chain of Central Government ownership which is represented by the colored boxes.



The interesting thing about this picture is that the central government, in this case, SASAC (the pink box at the top) is several layers away from the entity that actually manufactures cars: the purple box at the bottom.

If you do the math, the central government only controls roughly 20 percent of the real business (100% of 70% of 50% of 60.1%). Renalt/Nissan, on the other hand, controls about 30 percent of the real business (50% of 60.1%).

It seems to me that this is exactly the kind of situation that the central government is wanting to rectify. Auto firms have already been identified as among China's "pillar" industries, and the central government has already expressed its intention to consolidate its controlling ownership in these enterprises.

While I don't think the Central Government intends to order Dongfeng to abrogate its partnership with Renalt/Nissan, the minority shareholders in the two listed enterprises (小股东) may want to reconsider long-term ownership.

Central SOEs to be Held to a Higher Standard in 2010

(And they really mean it this time.)

SASAC's Assistant Director in charge of performance assessment announced that SASAC is preparing to look harder at SOE performance beginning in 2010. They had been planning to implement tougher measures in 2009, but apparently the financial crisis, any number of natural disasters, the Olympics (feel free to throw in any other excuse you can think of) have necessitated a relaxation of the rules.

But they really are planning to judge SOEs based on "economic value added" (EVA) starting next year. Honest, they really are serious this time.

All cynicism aside, EVA is a pretty rigorous financial calculation based on the idea that a business must cover both its operating costs and its capital costs. It is calculated by subtracting the opportunity cost of capital from a firm's net operating profit after tax.

Part of the reason for choosing this calculation is a concern that SOEs have traditionally engaged in unproductive investment without regard to the cost of capital. According to aggregate statistics from China's Statistical Yearbook, there is a pretty significant gap between private and state-owned industrial firms in terms of asset productivity. (These stats compare only state-owned enterprises with private enterprises. These stats for state-controlled enterprises were not available.)




Part of the reason for this is that a lot of these SOEs are probably still saddled with old, unproductive assets. Another reason is that the leaders of these SOEs have often been motivated, not by profitability, but by size. Traditionally, anything they could do to make their respective enterprises larger before moving on to their next political appointment was considered to be a good thing.

SASAC has been expressing its concern about this over-investment for years, and according to the article, they plan to establish a threshold above which investment must get approval from SASAC. Furthermore, the EVA measure, which some enterprises have reportedly adopted voluntarily, will become a part of the annual evaluation.

However, I can imagine a few difficulties as SASAC attempts to implement these measures. I cannot imagine how they will begin to calculate the cost of capital for these firms given that SASAC's 142 SOEs collectively control about 22,000 subsidiaries (see SASAC 2007 Annual Yearbook in your local university East Asian Library)． SASAC lacks the small army necessary to oversee this process.

Also, they will need to decide on some sort of benchmarks against which to measure performance. But against what kind of firm would you benchmark a sprawling state-owned industrial firm? Other state-owned firms?

Finally, SASAC will need to put some teeth in its rules and mete out punishment if it expects these standards to be followed. However, I'm not certain whether SASAC even has the power to enforce such standards. The leaders of these SOEs, while some may be recommended by SASAC, are generally appointed by the Party with approvals from other relevant organizations.

It sounds like a nice idea though.