A difficult exercise

When John Phelan visited Beijing in 1986, the New York Stock Exchange boss was presented with a gift by Deng Xiaoping. It was a stock certificate issued by Feilo Acoustics, the first company in socialist China to sell shares to the public. Excited to become the first foreign stockholder of a Chinese firm, Phelan flew to Shanghai to register ownership of the souvenir. The overcrowded office that he visited – a small room lacking even a toilet – would later develop into Shanghai’s stock exchange.

Feilo’s path from state ownership to shareholder-based company was a rocky one. When it was founded in 1984, the audio equipment factory even found it difficult to fill out a registration form. There were only three types of legitimate company at the time: large state firms, collective enterprises (township cooperatives which had evolved from communes) and one-man shops run by self-employed individuals.

Feilo wasn’t even sure which type of company it was (it opted for collective enterprise). Meanwhile the idea of stock-issuing enterprises was running into heavy political resistance. After giving out its first dividends to shareholders in 1986, Feilo was fined Rmb40,000 ($6,406 at today’s exchange rate, but a considerably bigger sum back then) for “illegal distribution of state assets”.

The man credited with changing this mindset was influential economist Li Yining. From the early 1980s, Li had published papers that called for the reform of the Chinese economy via a joint-stock system. He urged that large SOEs be transformed into share-issuing companies. Others also wanted a stock market but few had the courage to speak out so strongly. Li was even dubbed as “Mr Shareholding” for his persistent advocacy. His ideas gradually prevailed and he helped to draft the earliest company law legalising joint-stock firms. His pupils, including Li Keqiang (now the nation’s prime minister) and Vice President Li Yuanchao, would form the core of Beijing’s reformist sect.

Now 84 and the honorary dean of Peking University’s business school, Li has just earned himself a new nickname: Mr Mixed Ownership. Why so? The veteran economist’s analytical work is getting mention as reformers talk about allowing private and even foreign capital to dilute some of the influence of state capitalism in the domestic economy (we discussed the term mixed ownership first in WiC230).

But equally significant is that staff ownership in state firms, a concept that Li has been advocating for three decades, has also become part of the new debate.

Are SOE officials driven by the right incentives?

Aided by the global financial crisis of 2008, China’s banking regulators have often argued that the current arrangements are working fine – for financial institutions, at least. After all, ICBC’s net profits climbed 10% to top Rmb263 billion ($42 billion) last year. But its chairman Jiang Jianqing made just Rmb1.1 million and his remuneration stayed largely unchanged as he steered ICBC to become the world’s most profitable bank for three years in a row.

None of ICBC’s senior management owns a single share or stock option in the bank. Back in 2006 the financial institution approved a performance-based programme. But the scheme will expire soon (in 2016), having yet to be exercised.

Why? Staff ownership in state firms, especially in the financial sector, is an unusually sensitive topic. Central government has long been concerned that state firms are prone to reckless growth. Throw in a range of these new personal incentives to take a punt, and the fear is that that the risks worsen. Plus there is a fear of a public backlash if top SOE (state-owned enterprises) exectives are shown to be banking huge personal gains.

As a result only 95 SOEs, or less than 4% of the country’s listed firms, have proposed equity-based incentive schemes for employees since 2005. Even then most of these plans were shelved or vetoed by regulators.

“Many proposals were structured in a way of equal shareholding for all staff,” the China Securities Journal says. “It became a welfare system, which was deemed ineffective.”

At the top, most senior SOE executives are appointed by the Party’s Organisation Department. Even after some of their firms undertook IPOs, it seems that climbing the political ladder was a greater priority than financial remuneration (for a case in point, see our profile of former Chinalco boss Xiao Yaqing in WiC233).

Similarly, even in cases where executives at state firms have been in line for option plans (most notably when major SOEs began listing in Hong Kong 15 years ago), many chose not to cash them in.

“These stock options are all fake,” one oil boss complained to Caijing magazine six years ago. “Besides the option contracts, we sign another contract which commits to ‘not exercise these rights with liberty’.”

That may start to change, now that the policy mood seems to favour more incentivisation for value-creating business leaders. “The Third Plenum’s communiqué has stipulated clearly that shareholding by employees should be encouraged as part of the mixed ownership reform,” 21CN Business Herald notes.

Which SOEs will pioneer the changes?

21CN suggests that Sasac, the major shareholder of more than 100 of the major SOEs, will decide which firms go first in developing share-based incentives for their management teams. One of the Sasac-controlled firms, China Metallurgical Group Corp (MCC), said late last month it would unveil its own plans this year, reportedly allowing key management to own up to 20% of MCC’s subsidiaries. According to Economic Information Daily, other leading SOEs including oil giant CNOOC have also set up internal task forces to blueprint shareholding changes. The introduction of a stock option scheme has been recognised as a priority at Wuhan Iron & Steel as it seeks to turn around its core steelmaking business. More drastic reforms have been tabled at municipal SOEs like Greenland Holding, the largest real estate firm controlled by the Shanghai government, which is already pursuing a backdoor listing on the city’s bourse. China Securities Journal notes that 43 Greenland executives have set up an investment vehicle with registered capital of Rmb100,000. After a slew of “complex partnership agreements”, it is set to control about 29% of Greenland, which is valued at about Rmb65.5 billion.

The Hunan provincial government also announced this month that it will offer more flexible pay programmes as part of its plan to securitise 80% of the province’s state assets by 2020, while the Guangdong government has said that all new managerial staff for the province’s SOEs will be picked via a market-oriented process (implying, presumably, paying for performance).

Steven Sun, HSBC’s head of China equity strategy, also said this month that investors will see more changes at the top, particularly for SOEs in competitive sectors. “We expect more external directors to sit on boards, more professional hires rather than political appointees, and more equity-based incentives such as options and warrants,” Sun writes.

Will staff ownership invigorate SOE shares?

Looking at data on 48 companies on the Shanghai exchange which have already announced equity-based incentive schemes, HSBC’s Sun found that most stocks rose sharply after the plans were introduced.

As a whole, they climbed 33% on a one-year basis and 39% over two years. That’s a significant finding given that the key Chinese index is down over 30% in the past three years.

For SOEs in particular, a classic case is Kunlun Energy, the gas unit under CNPC’s Hong Kong-listed arm PetroChina. Before stock options were made available for Kunlun’s senior executives in 2007, the company carried a market value of HK$28 billion ($3.6 billion). Then came an incentive scheme, and subsequently Kunlun bosses secured the injection of some of CNPC’s prized natural gas assets. The result? The share price has nearly quadrupled over five years.

Unfortunately Kunlun’s chairman Li Hualin, who owns company shares worth HK$570 million (and more in unexercised stock options) sullied his reputation last year when he was removed as part of the anti-graft purge against CNPC officials linked to former public security chief Zhou Yongkang (see WiC207). Of course, hundreds of SOE executives without stock options have been arrested for corruption too.

Central authorities have been particularly cautious about giving out stock options to key officials in the all-important banking sector – in spite of increasing evidence that allowing employee ownership could lift the stock market, where these state lenders carry a heavy weighting.

In 2012 the China Securities Regulatory Commission ran a consultation about allowing state banks to pay 30% of their staff’s salaries in stock options. The Securities Daily revisited the idea this month, noting that employee remuneration at the 16 biggest banks totalled Rmb500 billion in 2013. By paying 30% of staff salaries in options, banks could use the spare capital to repurchase their shares, giving their stock prices a short-term boost. As many bank stocks are currently trading below net book value, such an incentive scheme would be a more effective way to boost share prices than expecting Central Huijin (the controlling shareholder) to raise its own stakes in the state lenders, the newspaper suggested.

How to weigh the pros and cons?

HSBC’s Sun says the quality of managerial staff is the key issue. “It remains to be seen to what extent the SOE reform will change the system and make professional hires a common practice rather than the exception,” he comments.

But for the veteran Li Yining, allowing employees to become stakeholder in SOEs is an efficient way to pursue mixed ownership reforms. It might also reduce some of the temptation for state bosses to help themselves to company cash or assets illegally. But to achieve this China needs to take another leap of faith over the divide between state and private ownership. “Wealth and profit are created by both capital resources and labour resources,” Li told a Party conference on mixed ownership last month. “It is important to allow the innovators, managers and everyone who have contributed to obtain a stake during the wealth creation process.”

When it comes to blurring the line between what is state-owned and privately-held, another notable example is telecoms equipment giant Huawei. The firm is controversially accused of having secret links to the Chinese state, although it vehemently denies that it is an SOE.

But regardless of its ownership status, another of the interesting things about Huawei is the extensive stock purchase scheme available for staff (see WiC155). Although Huawei isn’t listed, a restricted share scheme allows the workforce to earn bonuses when the company increases profits. The incentive has worked: Huawei staff have created (arguably) China’s most globally competitive firm.

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