The Flaws and Potential of Asia's SOEs
Investors have been paying more attention lately to Asia’s government debt levels alongside other emerging markets. Meanwhile, there has been less focus on the other side of the balance sheet in Asia as many Asian governments own a large amount of productive assets in the form of state-owned enterprises (SOEs). SOEs, referred to as “government-linked companies” in places like Malaysia or “public sector firms” in India, are rare in most Western developed economies. These firms are typically national champions in strategic industries with strong government policy support. But among the broader investor community they are often viewed negatively, marked by an image of inefficiency, poor profitability and unprofessional, or even corrupt, management.
At Matthews Asia, we understand the challenge associated with Asia’s SOEs as they comprise a large part of our investable universe. Even in the region’s more developed economies, such as Japan, Korea and Taiwan, many listed companies still have significant government ownership. These SOEs certainly have their flaws, but we are open to the possibility that they may improve, given the right corporate governance and management incentives.
Asia’s state-owned companies are mostly concentrated in such capital-intensive industries as energy, utilities, transportation, telecommunications and banking. Governments typically initiated these investments because the private sector lacked investment capital. In the past, spending by Asian governments was more geared toward fixed asset investment than their Western counterparts, whose fiscal spending tends to focus on social welfare programs. As such, state-owned companies are essentially a reflection of a country’s accumulated assets or strategic sector focus. Thus, how well they are managed affects not only the companies themselves, but (depending on their size) also the economic health of the sponsoring government’s fiscal balance sheet. Let’s consider the example of Singapore. The island nation’s public debt-to-GDP ratio is among the highest in developed countries. However, if we take into consideration the net asset value of the Singaporean government’s investment company, Temasek Holdings, Singapore’s net public debt-to-GDP is much healthier than headlines may suggest. This is why Singapore still enjoys one of Asia’s highest sovereign credit ratings. This example highlights the importance of solid company management. Remember that mismanagement means the government will be accountable for additional funding should a bailout be necessary.
“Agency Problem” Magnified
All of the aforementioned underscores the “agency problem.” In modern corporate finance theory, the agency problem refers to a conflict of interest between a company's management and its shareholders. The manager, acting as an agent for shareholders and principals, is expected to make decisions that will maximize shareholder value. However, it is in the manager's best interest to maximize his own wealth. It is not possible to eliminate this agency problem completely, but managers can be motivated to act in the best interests of shareholders through incentives such as performance-based compensation; or through checks and balances such as shareholder voting rights, the threat of firing, or takeover.
Many SOEs in Asia are structurally ill-equipped to address the agency problem, which is understandably more prevalent among SOEs—particularly in Asia—than in the private sector. In addition to standard bureaucracy (officials are not incentivized toward change or innovation), government officials do not typically have the appropriate expertise to properly oversee the business. Finally, for publicly listed SOEs, minority shareholders often lack sufficient representation and become marginalized.
Many top SOE managers are politically appointed and their selection often has little to do with their business track record or competence. Ironically, such appointments tend to offer below market rate compensation for top managers at SOEs, as a large pay disparity between these SOE managers and government officials could cause public outcry and envy from other government officials. But the combination of low compensation combined with managerial responsibility for a major economic resource without proper oversight can lead to graft and corruption.
While many managers do resist the “temptation of the cookie jar,” mismanagement at these SOEs rarely cause for punishment or dismissal. Even after a serious transgression, an incompetent manager is typically just transferred back to his/her government job or another SOE management position.
Banking for Policy or Profit?
While a mismanaged SOE in a capital-intensive industry may present an isolated problem, the mismanagement of a state-owned financial institution could have knock-on effects throughout an economy. It is worth noting that many Asian governments retain significant ownership of the commercial banking sector. The rationale for this is often that governments aim to effectively implement industrial development policy by allocating credit to preferred industries. But this model can lead to a string of nonperforming loans and moral hazard.
When governments define certain industries as preferred, state-owned banks are usually pressured to allocate credit to companies in these sectors. It is crucial that banks conduct thorough credit analysis and due diligence, regardless of government pressure, as it is the banks that have to face the reality of bad loans and an impaired loan book. The consequences of restricted lending capability can be felt across an economy and in an extreme case, lead to a credit crunch. Clearly, China’s banking sector is feeling the effects of a reversal in its former strategic industries, including solar and shipbuilding. Across the Strait, Taiwan’s banks also need to set aside a special allowance to cover loans for certain industries previously favored by Taiwan’s government just a few years ago, including those for technology-related areas like dynamic random-access memory (DRAM) and LCD panels.
In the chart below, you can see a comparison of long term return on assets (ROA) between private sector and state-owned banks in India, Indonesia and Taiwan, in which both types of banks have significant market share. Over a 10-year cycle, private banks have shown stronger return on assets to public sector banks.
If governments in Asia are seeking to retain their investment holdings in SOEs in both financial sector and non-financial sector, is there a proper way to do this? How sound is Singapore’s model? Temasek has a global investment portfolio of approximately US$171 billion(S$215 billion), and is considered one of the world’s preeminent institutional investors. However, few people know that its start was relatively humble. Incorporated in 1974, the investment firm first set out to commercially manage a portfolio initially valued at roughly US$281 million (S$354 million), which it acquired from Singapore’s Ministry of Finance. This move enabled the government to focus on its core role of policymaking and regulations. Today, Temasek remains under the sole ownership of the Singaporean government. Although its investment scope has already reached beyond Singapore’s borders to many global markets, its core investments remain within the many Singaporean firms it acquired from the government 40 years ago.
Because Temasek is a majority shareholder of many major listed Singaporean corporations, there are several companies in Singapore that are defacto SOEs. However, equity market investors seem to show much more confidence in these companies in Singapore compared with their peers in other parts of Asia. This is reflected in many corporate governance polls; corporate governance for Singapore’s stock market has been consistently rated one of the highest in the region.
While many other countries in Asia have expressed a desire to adopt the Temasek model, very few have actually successfully done so. Why has this model been so successful? First, its Chairman of the Board and its CEO roles have been split into two separate positions, a key indicator that senior management takes corporate governance seriously. Second, at least half of its board members are independent, and are comprised of a mix of former government officials and private entrepreneurs. Third, to reduce the agency problem, Temasek managers are paid competitively and measured against performance targets. Only by doing so can companies can attract and retain top talent. Many Temasek-controlled companies have either promoted experienced managers internally or hired external managers with good track records for top executive posts.
In addition, let us consider returns through dividends. Not surprisingly, investors expect returns on the capital they risk. Dividends may arguably be the most important form of those returns. Most Temasek-controlled companies have adopted stable dividend policies. In this case, what is good for investors is also good for the Singaporean government. Temasek’s dividend collection provides a healthy contribution to the fiscal budget.
Finally, successful investors must also know when to dispose of assets. This is one thing often forgotten by many imitators of the Temasek model. Among the 35 companies in Temasek’s initial investment portfolio, only 12 remain today. The rest have all been divested or liquidated. By exiting certain businesses, Temasek has been able to focus on companies that are relatively more competitive to generate healthier returns.
Some critics argue that the Temasek model is just a refined form of state capitalism, and that government ownership of businesses reduces market competition. Temasek’s close links to government and its senior personnel appointments have drawn questions of a potential conflict of interest. (The firm’s Executive Director and CEO is the wife of Singaporean Prime Minister Lee Hsien Loong.) These present some valid concerns. However, if state ownership of some strategic sectors is inevitable in certain countries, then the Temasek model seems to provide better structure and greater transparency.
At Matthews Asia, our bottom-up approach to investing has us more excited about entrepreneurial spirit than state wealth. We are encouraged to see that many Asian countries continue down the path toward privatization. China, for example, has begun opening some sectors, once monopolized by SOEs, to its private sectors. Other countries are following suit. Vietnam has plans to let private business play a more vital role in its economy. We believe introducing an entrepreneurial spirit to industries that have long been dominated by the state should be positive both for the public and the private sector.
Sherwood Zhang, CFA
The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein.
The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information.
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