Shanghai Waigaoqiao shipyard
Still building: vessels under construction at Shanghai Waigaoqiao Shipbuilding © Gabriel Wildau

On a rainy afternoon at one of China’s largest shipyards, workers taking a break from welding cluster beneath the hulls of half-built vessels to keep dry.

Despite the collapse in freight rates that has ravaged the shipping industry, the yard at Shanghai Waigaoqiao Shipbuilding is not short of business. A worker could ride his bicycle across the 1.1km yard entirely under the line of partial hulls.

This and other state-owned shipyards are being kept busy by China Ocean Shipping Group, better known as Cosco, the country’s largest shipper by carrying capacity, which ordered 11 huge container ships last year. Caixin, the financial magazine, reported that the three ships ordered from Waigaoqiao would be able to carry 20,000 20ft containers, making them the world’s largest.

Cosco’s non-government shareholders may wonder why the majority state-owned company needs 11 new vessels. Its directors acknowledged in the company’s half-year earnings statement that “overall demand in the shipping market weakened” in 2015, while “oversupply in shipping capacity continued”.

Scheduled to be delivered in 2018, the timing of the ship order is made all the more surprising given the fall-off in global trade, down 12 per cent last year in value terms, according to the International Monetary Fund. Most forecasts say that situation is unlikely to improve soon.

The good news for Cosco is that it will not have to spend much of its own money to meet the $1.5bn cost of the ships. A 2013 regulation by the finance ministry provides a subsidy to shipowners that demolish old vessels and replace them with new ones from state-owned builders like Waigaoqiao.

Cosco is a vivid example of the problems facing China’s inefficient and debt-ridden state-owned enterprises. Excluding one-off items, the company lost Rmb3.8bn ($580m) in the first nine months of 2015. Its net debt-to-equity ratio, at 206 per cent at the end of September, was more than triple the average of 66 per cent for Shanghai-listed companies, according to Wind Information, a Chinese financial database.

With China’s economy growing at its slowest in 25 years, economists say dealing with unwieldy state owned enterprises is the single most important step to restructuring the economy.

“SOE reform, debt, overcapacity and ‘zombie companies’ are all deeply connected issues,” says Jianguang Shen, chief Asia economist at Mizuho Securities Asia. “For private companies in overcapacity industries, after several years of losses there’s no way to continue. The owner will shut them down or sell them off, but at SOEs they can keep getting bank loans or government support.”

Lumbering giants

Beijing has been seeking to steer its economy away from an overdependence on heavy industry and construction. State-owned enterprises are, however, clustered in smokestack industries like steel, coal, shipbuilding and heavy machinery, all tied to the old growth model. These lumbering giants are ill-suited to meet demand in the emerging services sectors such as healthcare, technology, education and entertainment — the fastest-growing areas of the Chinese economy.

The Cosco subsidy is one of hundreds that benefit state-owned groups. Subsidies for listed companies totalled Rmb30bn in 2014, according to data collated by Wind from company filings. The actual figure is even higher: many subsidies flow to unlisted enterprises, while SOEs also enjoy non-cash benefits like low-interest bank loans and discounts on land, water and electricity.

Senior leaders have pledged an overhaul of the state sector. “We must summon our determination and set to work,” Premier Li Keqiang told top economic advisers in December. “For those ‘zombie enterprises’ with absolute overcapacity, we must ruthlessly bring down the knife.”

Following through on that threat Yin Weimin, China’s labour minister, said yesterday that he expects 1.3m coal workers and 500,000 steelworkers to lose their jobs as part of efforts to deal with overcapacity, without specifying when the axe will fall.

Last September a Communist party-approved masterplan for reform outlined initiatives aimed at imposing market discipline on state companies. They included stake sales and depoliticising the appointment of senior executives, who are selected by the party’s personnel agency rather than ordinary shareholders. The approach pursued most aggressively, however, has been consolidation — where the government orchestrates mergers of big SOEs.

In the past year, the State-owned Assets Supervision and Administration Commission, which oversees non-financial SOEs, has approved the mergers of at least six very large enterprises. Among these is one to combine Cosco with China Shipping Group to create the world’s largest container line.

Communist party leaders believe larger SOEs will be more competitive globally. They have long viewed economies of scale as crucial for cultivating national champions. Size is considered more important now, with falling commodity prices hacking at profit margins on steel, coal, base metals and heavy machinery.

“[President] Xi Jinping probably believes that a large state-enterprise sector is good,” says Yukon Huang, former China country director at the World Bank and senior associate at the Carnegie Endowment for International Peace. “He looks towards the west and sees that major companies are big and getting bigger. When China’s leaders look overseas at so-called ‘market’ economies, they don’t get the sense that big companies and big mergers are bad.”

Consolidation has been taking place for more than a decade. Since its creation in 2003 the number of companies under Sasac control has fallen from 189 to 103, largely due to mergers.

Reform in reverse

Large-scale reforms began in the late 1990s after bad loans to state-owned companies pushed China’s banking system to the brink of collapse. An aggressive round of reform saw employment in state-owned companies almost halve from 70m in 1997 to 37m in 2005.

With the worst-performing SOEs shut or privatised, profitability improved. The return on assets at SOEs has always lagged behind that of private firms but the gap narrowed markedly in the early 2000s.

That changed with the 2008 global financial crisis. The huge stimulus that China rolled out to offset the slowdown relied on state-owned companies acting in the national interest. Banks were ordered to increase lending to SOEs, which dutifully splurged on new factories and equipment regardless of commercial need. The downsizing of the state sector came to a halt.

The stimulus fuelled a construction boom for factories, housing and infrastructure. Demand for output from state factories soared temporarily and SOE profits grew.

But the sector overindulged and the comedown was hard. Banks and regulators tightened lending amid worries about the rise in company borrowing and increasing local government debt; the housing market cooled and infrastructure spending slowed. Companies stopped investing because of rising debt burdens and slack demand for output from newly built factories.

At state-owned Aluminium Corp of China, where total assets surged from Rmb82bn in 2006 to Rmb175bn six years later, net losses hit Rmb17bn in 2014, the most of any listed SOE. It is not alone. Some 42 per cent of all SOEs lost money in 2013, according to official data. Total profits for such groups fell in absolute terms last year for the first time since 2001. The gap in return on assets between SOEs and private firms is now the largest in two decades.

Policymakers have made “supply-side reform” the major theme of economic policy for 2016 but many analysts doubt that merging big companies into even larger ones can address the cause of overcapacity and weak profitability. Sooner or later, companies are likely to have to swallow the pill of factory closures and employee lay-offs.

“Creating even larger SOEs is likely to exacerbate their already daunting financial and organisational ills,” wrote Wendy Leutert, a visiting researcher at the Brookings Institution’s China Centre. “Merging centrally owned firms will increase their market share at the risk of long-term competitiveness and efficiency gains.”

For many western economists, the answer is clear: raise efficiency through privatisation. Yet China’s top leaders have resisted this approach.

Sasac has cautiously experimented with “mixed ownership,” a euphemism for selling minority stakes. Far from shrinking its role in the economy, however, the leadership believes the answer lies in strengthening the ruling party’s grip on state assets, while making SOEs more competitive.

At a politburo meeting on November 23, party leaders decided that the focus of the reform effort should be to “strengthen, optimise, and enlarge” state firms, while rejecting “privatisation”, according to a detailed account of the meeting circulated on social media.

Mega mergers are also seen as a way to eliminate “malicious competition” between rival state groups. The country’s two biggest manufacturers of railway equipment agreed to combine at the end of 2014. The new group will be expected to bid for the rail projects that are central to Mr Xi’s ambitious New Silk Road initiative, aimed at helping Chinese companies sell infrastructure in Asia and the Middle East.

Millions of jobs at risk

The greatest obstacle to shutting lossmaking SOEs is the prospect of mass lay-offs, which Beijing fears could lead to social unrest. Merging weaker SOEs into stronger ones is seen as a less disruptive way to deal with excess capacity than forcing lossmaking state firms into bankruptcy, leaving millions jobless.

“If a stronger enterprise can restructure a weaker one, they can find ways to redeploy workers. They’re not just going to fire everyone immediately,” says Ju Jinwen, an economist who researches SOEs at the Chinese Academy of Social Sciences, a think-tank that advises the government. “Dealing with overcapacity creates unemployment pressure. This has to be considered.”

Longmay Group, the biggest SOE in the rust-belt north-eastern province of Heilongjiang, made headlines when it announced plans in September to lay off 100,000 workers. The company’s statement, however, shows that many of the workers will be diverted to associated companies, a sign of the political pressure on SOEs to maintain jobs.

At the Waigaoqiao shipyard, a solderer named Li is happy to work at a company where lay-offs are rare, even in tough times.

“After the financial crisis, a lot of guys left for smaller (privately owned) yards where pay was better,” he says. “Now they’re closing down. These days they regret it but it’s not easy to get back in.”

Additional reporting by Ma Nan

This article was amended after publication to correct the cost of the 11 Cosco ships from $15bn to $1.5bn.

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