China hopes to create its own military-industrial complex, but it won’t be easy.
The Chinese defense
industry has once again become the focus of world media after a string of attention-grabbing
headlines this year. On April 25, the Thai government approved a $393
million submarine contract with
China. The day after, China’s first domestically built aircraft carrier was
launched at Dalian port. The following week, China’s first civilian airliner,
the Comac C919 took its
maiden flight, another feat for the defense corporations involved.
Now the world’s second-largest
spender on national defense, China is advancing reforms in its defense
state-owned enterprises (SOEs). Xi Jinping, as commander-in-chief, has long
been vocal about deepening defense industry reform,
a sentiment shared by his colleagues on the Central Military Commission (CMC).
In 2015, General Xu Qiliang, vice
chairman of the CMC, “called for China to develop a military-industrial complex
like the one in the U.S.”—where the private sector and the invisible hand
assume the leading role.
Hungai (混改), or mixed-ownership
reform (MOR), is the vehicle for reaching this goal. Why is MOR needed? How
does the state intend to implement MOR? What are the obstacles facing MOR? Will
MOR succeed in helping China catch-up with the U.S. defense industry? I propose
that MOR will have limited success because of the structural restrictions of
the Chinese defense industry.
Why MOR
In 2016, China had a defense budget of $146.6 billion, and
the output of its
defense industry was estimated to be around $362 billion. Yet despite the
astronomical figures, the Chinese state-owned defense industry has many
underlying challenges common to corporations of its type. (Wholly or partially
state-owned European defense companies share
strikingly similar problems.) With soft budget constraints and shielded from
competition, it is not a surprise that inefficiency, lack of innovation in
certain areas, and mounting debt are prevalent among defense SOEs.
MOR hopes to remedy these
problems by drawing in funds, expertise, and methods of operation from the
non-public sector. One of MOR’s twin goals is to relieve the state’s financial
burden by broadening access to capital market financing — from 2010 to June
2016, the defense industry raised $62.87 billion from issuing bonds and
equity. The other, perhaps more important long-term objective is to introduce
market forces into the industry and pressure company executives toward reform
along market lines — hence the emphasis on mixed-ownership.
How to MOR
There are three main
methods for implementing MOR. Securitization, a critical mean of
fundraising by transforming assets into securities, is one leg of the tripod.
The current Chinese defense industry securitization rate is comparatively low,
at 25 percent, when U.S.
counterparts stand at 70 percent. Although the state would like to have more
defense assets go public, national security remains a concern because the most
productive assets (i.e. research institutes) generally hold classified state
secrets. For years there have been talks of injecting research institute assets
into publicly traded companies. Reports surfaced in January 2017 about
plans to reorganize secret and non-secret research institute assets, and a
March article confirmed that research institute reform plans have been internally ratified.
An employee stock
ownership plan is another method. Designed to raise employees’ enthusiasm for
their work, the plan caps employee
company ownership at 30 percent, “with each individual employee owning no more
than one percent of the total.” The state stakeholder, however, will still hold
at least 34 percent of a company’s total equity. The plan is currently being
tested in pilot programs.
Public-private
partnerships manifested through civil-military integration constitute the third
pillar of MOR. Encompassing both defense conversion (junzhuanmin; 军转民) and civilian contracting
(mincanjun; 民参军),
civil-military integration seeks to reduce technological redundancy and
accelerate the exchange of dual-use technology. Currently, civilian goods
constitute 80 percent of China’s two largest
shipbuilding conglomerates’ gross industrial output.
In March 2017, the
People’s Liberation Army (PLA), for the first time in its history, declassified more
than 3,000 dual-use technology patents and released 2,346
to the public in an effort to increase transparency, incentivize innovation,
and facilitate defense conversion. The patents included a synthetic
aperture imaging system, a high power pulse modulator for a medical linear
accelerator, a lateral drift control method for unmanned helicopters, and a
blast energy absorbing honeycomb structure, to name a few. In addition, the
military opened more of its current projects to civilian contractors. However,
the contradiction between
the state-owned and non-public sectors remains, as the former still mistrusts
the latter, and the latter wishes for more leverage in dealing with the former.
MOR Outlook
There are a few challenges
facing MOR in China. Although eroding under the anti-corruption campaign,
entrenched interests in the defense industry can always make an argument
against market-oriented reforms in the name of national security. The chasm
between the state-owned and non-public sectors is deep, and it will take time
before defense executives are willing to share power with new owners based on
fairness and mutual respect.
Chronic underperformance
makes some defense assets a tough sell. Companies related to military
informatization are performing well. Five out of eight subsidiaries of
the China Electronics Technology
Corporation, specializing in informatization, witnessed year-on-year
net income growth in 2016. Seven out of eight have debt to asset ratio above 33
percent, while five out of eight enjoyed over ten percent ROE in 2016.
However, high
debt-to-asset ratios and unsatisfactory return on equity (ROE) are common among
other firms. China Shipbuilding Industry Corporation (CSIC) and Aviation
Industry Corporation of China (AVIC), two of the most securitized defense companies behind
China’s first aircraft carrier and civilian airliner, respectively, are not
performing well. CSIC’s two listed arms are experiencing net income growth, but
their ROEs are below satisfactory. The ROE for China Shipbuilding Industry Co.
Ltd. (SHA: 601989) in 2016 was 1.23
percent and 1.73 percent in 2017. China Shipbuilding Industry Group Power Co.
Ltd. (SHA: 600482) had a ROE of
4.22 percent in 2016 and 6.05 percent for 2017. Only one out of AVIC’s 14
defense subsidiaries has a satisfactory ROE of above ten percent. Nine are more
than 50 percent in debt.
China State Shipbuilding
Corporation’s three listed arms have the worst balance sheets. In 2016, CSSC
Science and Technology Co. Ltd. (SHA: 600072) suffered a net loss of $6.23 million,
-143.49 percent year-on-year. The debt-to-asset ratio was 63.92 percent, with
an ROE of -1.18 percent in 2016 and 5.12 percent in 2017. COMEC (SHA: 600685) had a net income of $10.33 million,
-27.56 percent year-on-year. The debt to asset ratio was 77.5 percent, with its
ROE at 0.69 percent in 2016 and 1.47 percent in 2017. China CSSC Holdings Ltd.
(SHA: 600150) lost $377.37 million in 2016 net
income, an astonishing 4314.78 percent drop year-on-year. The debt to asset
ratio was 67.88 percent, and ROE in 2016 was -17.43 percent with a 2017
projection at 0.2 percent. These figures look awful to retail investors and
even to state-controlled institutional investors (banks, insurance companies,
and investment firms) that put profit second to strategic aims, which in part
explains why the stocks of companies involved in building the first aircraft carrier and civilian airliner plummeted
on their launch date.
There are three additional challenges for
investors, particularly private equity firms. First and foremost, China’s
defense industry only accepts RMB funds, further complicating matters for
funds using USD. Second, the lack of information and transparency continues to
be an issue. The Chinese defense industry is extremely secretive. If not for
the CMC’s push, the defense companies will not have opened itself voluntarily.
Publicly available information on the inner workings of the defense industry is
scant, and knowledgeable individuals prefer to deal only with people well
versed in the defense business. Insider trading is not only the norm, but
also a necessity. Finding the right investment targets and knowing the PLA’s
demands as well as future trends within the armed forces require special
connections that most investors simply do not have.
Lastly, the defense
industry is still commanded by the
“plan” and the state will not surrender its leadership position since defense
is considered a “strategic sector.” The enormous power the state has in shaping
corporate governance means non-state shareholders will always be at a
disadvantage. Despite renewed promises to delimit the power of Party
organs, shareholders, the board of directors, the supervisory board, and
management, it is wise to remain skeptical regarding this question. According
to Curtis J. Milhaupt and Wentong
Zheng, MOR will not fundamentally change China’s SOEs because the
state can exert influence over companies regardless of direct or indirect
ownership stakes.
In conclusion, although
the defense industry is heating up to be a popular investment target due to
growth potential, it is a complex and risky cluster that will keep investors
cautious. While MOR will probably have some success in fundraising, a complete
industry overhaul along the lines of the U.S. military-industrial complex is
impossible due to the state-owned structure of China’s defense corporations.
Zi Yang is a researcher
and consultant on China affairs. He covers Chinese politics, security, and
emerging markets. Zi holds a M.A. from Georgetown University and a B.A. from
George Mason University. Follow him on Twitter @MrZiYang.