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Emerging Markets

The road to Chinese SOE reform is paved with dividends

November 2017

Gita Ramakrishnan, Senior Investment Manager

China's authorities are prodding their state-owned enterprises to increase dividends. That's good, because bigger payouts should translate to better returns on equity.

Investors should be hoping that Chinese authorities succeed in pressing the country’s state owned enterprises (SOEs) to boost dividends. That’s because bigger payouts would lift SOEs’ return on equity (ROE) – a particularly important consideration now that Chinese companies are poised to play an ever bigger role in the world’s equity market.

According to our estimates, increasing the A-share dividend payout rate by five percentage points from current levels to the emerging market average of 39 per cent1 would boost ROE levels by as much a tenth. By 2024, ROE would be around 13.7 per cent under the higher dividend payout ratio compared with around 12.7 per cent were the ratio to stay unchanged.2

Bigger dividends, better returns

Forecast additional return on equity for Chinese A-shares given 39% payout ratio compared to 34% payout ratio, basis points

Additional return on equity
Source: Bloomberg MSCI CN; Pictet Asset Management. Data as of 01.11.2017

Encouraging SOEs to become disciplined dividend payers would boost ROE in two ways. First, it would reduce the amount of cash sitting unproductively on corporate balance sheets. And second, it would reduce management’s inclination to pursue capital investments with poor prospects. Examples of capital misallocation are legion. Industrial overcapacity, much of which is concentrated in SOEs, is a chronic problem in China – ranging from 15 per cent to 35 per cent, depending on sector.3 In 2000, China made 15 per cent of the world’s 850 million tonnes of steel supply. 

By 2016, China alone was producing 810 million tonnes, very nearly as much as the rest of the world combined.4 Meanwhile, in recent years China has variously accounted for 60 per cent of global cement output and smelted 37 per cent of the world’s copper.5

Given SOEs generate a third of China’s national output, such a misallocation of resources represents a significant drag on the economy. In effect, the build-up of this excess capacity comes at a cost to other sectors of the economy, estimated to be worth some 4 per cent of GDP a year, according to the International Monetary Fund.6 

Plenty of cash to be paid out

But can Chinese companies justify bigger dividends at a time when they appear to have piled on vast amounts debt? The fact is that the SOEs tend to have considerable cash balances. What’s more, their ultimate backstop, the Chinese government, has cash holdings estimated at 30 per cent of GDP.7 

And now a special body that reports directly to the most senior echelons of government, the State-Owned Asset Supervision and Administration Commission, is banging the drum for bigger dividends, recently arguing that SOEs should “improve their dividend payout mechanism to improve investor returns”.

This could be a boon for minority investors. SOEs may be state run but some 50 per cent of their equity is owned by private investors and these firms make up more than 80 per cent of the total capitalisation of China’s Shanghai listed A-share market.

Any reform that improves ROEs could set the stage for significant outperformance of Chinese stocks

These companies are already an attractive proposition for investors – average returns of the largest A-shares SOEs are either in line or above those of their counterparts in the developed world and other emerging markets. Any reform that improves ROEs could set the stage for significant outperformance of Chinese stocks.

What’s more, this comes at a time when Chinese equities are growing in importance in investors’ portfolios. For instance, the weighting of A-shares in the MSCI emerging market index, a leading benchmark, is likely to rise to 5 per cent by 2019 and 20 per cent by 2022 from 2.5 per cent today.

China’s corporate landscape has evolved dramatically over the decades. Encouraging SOEs to relinquish more of their cash could generate another major step change.