Should Government Controls Keep You from Investing in China?

In 1992, China shifted its economy from being fully centrally planned to what the government calls a social market economy--an economy in which the government cedes some of its control over the allocation of economic resources to market forces. Since then, more and more state-owned enterprises (SOEs) have sold shares to the public in China, Hong Kong, and New York.

As the Chinese economy continues to grow 7%-10% per year, investors are eager to buy a piece of China to benefit from this economic growth. However, the fact that the Chinese government still controls more than 50%-90% of the shares of these companies, and appoints their executive managers, makes many investors nervous. How can the little guy be sure that the government will act in the best interests of all investors? In this article, we explore the pros and cons of investing in China's SOEs in order to determine whether the potential rewards outweigh the risks.

The Details on State-Owned Enterprises
Many Chinese government-controlled companies are multibillion dollar firms that play very important roles in the Chinese economy. These SOEs operate in a variety of industries, including  China Telecom  and  China Mobile  in telecommunications;  China Life Insurance  and Bank of China in finance;  PetroChina ,  Sinopec , and  CNOOC  in energy;  Huaneng Power International  in utilities; and  Aluminum Corp of China , or Chalco, in basic materials. Their future performances are largely dependent on China's overall economic performance.

The government has retained stakes in these companies mainly as a way to maintain control over a complex and fast-growing economy. The SOEs generally compete in the largest, most vital sectors in the economy. Large holdings in these companies improve the government's ability to pursue its overall goals for economic growth and development. The government is keenly aware of the problems caused by the rapid privatization of the former Eastern Bloc and wants to avoid a similar catastrophe. The government is also keen to nurture the SOEs to the point that they will be able to compete with big global competitors before the economy is fully opened to outsiders.

In some cases, government controls are very helpful for the Chinese-listed companies because they limit competition, protect profitability, and support growth. In other words, the controls can help companies create sustainable competitive advantages--what we refer to as economic moats--which can be difficult, if not impossible, for competitors to overcome. In other cases, government controls can hurt minority investors because they command these companies to do unprofitable things, such as forcing oil and utility firms to sell below cost through price controls or banks to make loans that are unlikely to be repaid. These situations can erode shareholder value in a hurry.

Benefits of Government Controls
First, government controls can limit competition. Chalco, the second-largest alumina producer in the world, enjoys a dominant position in the world's largest aluminum-consuming nation. The Chinese government shut down small aluminum firms to prevent overinvestment in domestic aluminum capacity in recent years, further enhancing the firm's regional dominance. In addition, with government help, the company has successfully established international footholds in its quest to find alternative and long-term sources of raw materials.

Another good example of limits to competition comes in the financial sector. As part of its World Trade Organization commitments, the Chinese government recently allowed foreign banks such as  Citigroup (C) and  HSBC (HBC) to open retail branches in China and operate business in the Chinese currency, the renminbi. However, these foreign banks can only accept renminbi deposits of more one million renminbi, which will preclude most Chinese customers. Given these restrictions, Chinese banks such as Bank of China and Industrial and Commercial Bank of China will still enjoy limited competition from foreign banks in the coming years.

Secondly, government controls can protect profits. PetroChina is owned 89% by the Chinese government. Its parent company, CNPC, has basically taken on the task of investing in and developing high-risk or capital-intensive projects, and then selling them to PetroChina at favorable prices--a boon to investors who find the value of their company rising with few of the downside risks associated with exploring for and developing oil and gas deposits. The Chinese government also charges PetroChina a lower income-tax rate than that of international oil companies--around 25% compared with 40%.

In telecommunications, China Mobile dominates China's fast-growing wireless market. The Chinese government continues to delay issuing 3G licenses, allowing China Mobile to expand its lead in signing up wireless customers. In 2005, both the firm's total subscribers and revenue grew about 20%. The Chinese government also set China Mobile's international long distance call prices 5-10 times higher than those of foreign telecommunication firms.

Thirdly, government controls can support companies' growth. For example, as the largest independent power producer in China, Huaneng Power International has a strong relationship with the central and local governments to get approvals to build and acquire new power plants. This advantage helped the firm's revenue grow 25%-30% mainly though acquisitions in the past several years.

Drawbacks of Government Controls
While government involvement can help the SOEs, the state can force companies to take actions that aren't beneficial to minority shareholders for the sake of social stability. A good example of this type of policy is a cap on prices. Due to the combination of high coal prices and government-controlled electric prices, Huaneng's profit margin decreased 1,300 basis points in 2005, which led to operating income growth of just 1.3%. In the face of soaring international crude oil prices, the government kept fuel prices artificially low, forcing refiners like PetroChina and Sinopec to suffer losses on their refining operations.

Another example comes in telecommunications. The establishment of wireless 3G standards, expected in the near future, could make or break several of the country's telecom companies. An unfavorable set of standards could cut into these companies' growth rates, particularly that of the largest player, China Mobile.

The state can also change the rules of the game midstream. Reacting to domestic aluminum shortages, the Chinese government reversed its rebate policy on aluminum exports and instituted a 5% export tax, which will present Chalco with increased competition.

So what does it all mean for investors? One rule of thumb is to consider whether a company has a natural monopoly or not, because government-imposed monopolies or oligopolies rarely benefit economies or investors in the long run. Using this rule, Huaneng Power and China Telecom operate in industries that typically work best in regulated monopoly situations. On the other hand, banking, energy, and mobile phone service tend to work better in competitive situations. We expect China to continue to open to foreign competition, so unless the domestic incumbents become the national champions that the government hopes to produce, then companies like Bank of China, PetroChina, and China Mobile could struggle.