The new leaders of the Chinese Communist party recently announced that the market would play an expanded and “decisive” role in allocating China’s resources. Yet the same announcement reaffirmed the continued “vitality” of the state-owned enterprises that dominate the country’s economy.
While these two goals appear to be in conflict, they could both be advanced by allocating substantial blocks of shares of such enterprises to the National Social Security Fund, a Chinese manager of pension assets. This approach would have the added virtue of strengthening the pension system by increasing pre-funding of retirement benefits.
In China, a small group of state-owned enterprises hold a near monopoly of power in key sectors – such as banking, energy and transportation – and pay little or no dividends. If China’s economy is to become more productive, they must become more responsive to market forces, with lower customer prices and lower operational costs than competitors. As a result, China has begun negotiations with Europe and the US on investment treaties, which would allow foreign companies to compete in some of the sectors dominated by state-owned businesses.
Chinese leaders should also adopt another strategy to make them more responsive to market forces: establishing a large institutional shareholder that could put pressure on the state-owned enterprises to run more efficiently and pay more dividends. Although most of the large examples have sold shares to public investors, these investors are widely dispersed throughout the world, and have little influence on the corporate strategies of state-owned businesses or their dividend policies.
In other countries, institutional investors with concentrated equity holdings have been effective at imposing market discipline on publicly traded companies, even those controlled by one family or group.
Hedge funds and pension funds holding large blocks of shares in European or US companies have led the fight to make substantial changes when these companies underperform. For example, these institutional activists have persuaded companies to improve the design of executive compensation, sell or spin off unprofitable business units and increase dividends to shareholders.
The best Chinese candidate to become an influential institutional investor is the National Social Security Fund. It manages assets for some pension plans, and it has received a modest portion of the proceeds from initial public offerings of state-owned enterprises.
The national fund already provides some subsidies to local governments to help them pay their legacy pension benefits, but these subsidies must be increased dramatically to sustain China’s current pension system.
Under the current pension system, state-owned businesses and large urban enterprises have generally been required to contribute 20 per cent of the wages of their employees to collective pension pools run by local governments. These employees must also contribute 8 per cent of their wages to individual pension accounts run by local governments. If these pension contributions were invested in diversified securities portfolios, those investments would go a long way towards pre-funding future pension obligations of current workers.
Unfortunately, most of these pension contributions are not being invested by local governments because they must pay legacy benefits to pre-1997 workers who never made any pension contributions during the “iron rice bowl” era.
As a result, most local governments are financing legacy benefits on a pay-as-you-go basis, meaning that the contributions of current workers go primarily to pay the pension benefits of already retired workers.
This pay-as-you-go strategy is very dangerous for China because of its looming demographic challenge. Workers as a percentage of the total Chinese population peaked in 2012 and this percentage is declining rapidly. Despite expanding exceptions to the one-child policy, the number of workers supporting each retiree is projected to decline from six in 2010 to two by 2040.
In other words, the pension contributions from the current generation of workers will be grossly insufficient to pay the retirement benefits of prior generations of retired workers.
In short, by allocating blocks of state-owned enterprise shares to the national fund, the leaders of the Chinese Communist party can achieve three objectives at the same time.
First, with these blocks of shares, the national fund can bring market forces to bear on such businesses to improve their productivity and increase their shareholder returns. Second, as these state-owned enterprises became more productive and profitable, they could continue to be important economic participants in China. Third, the higher shareholder returns at these businesses would allow the national fund to help local governments pay the legacy benefits that are undermining the current pension system.
Robert Pozen is a senior lecturer at Harvard Business School. This article was co-authored by Theresa Hamacher, president of Nicsa