When the Aluminium
Corporation of China acquired a 9 per cent stake in Rio Tinto last
month, the Chinese state-owned company pulled off a number of firsts.
Not only was it the biggest ever overseas investment by a Chinese
group, it was also the largest ever dawn raid on the London stock
market.

Yet while most of the attention focused on what the share
purchase meant for BHP Billiton’s efforts to acquire Rio Tinto, the
acquisition heralded another important trend – the quiet revolution
under way in the Chinese state sector, which has produced a new
generation of confident companies with global ambitions.

A decade
ago, China’s state-owned sector looked like an economic disaster
waiting to happen. In the aftermath of the 1997 Asian financial crisis,
average profit margins in Chinese state companies fell to close to
zero, and many reported huge losses. The government felt it had no
option but to embark on a brutal programme of closures that left tens
of millions without jobs.

Fast-forward 10 years and the situation is almost unrecognisable. In
2007, the combined profit of the 150 or so companies controlled by the
central government is expected to have reached Rmb1,000bn (£70bn,
$140bn, €90bn). In the five years to 2008, this figure rose by 223 per
cent. At the end of last year, the list of the world’s 10 most valuable
companies contained four groups controlled by the Chinese state – even
if this partly reflected the relatively high valuation of the Shanghai
stock market.

What we are witnessing, in other words, is an
experiment in capitalism that could challenge much of the conventional
wisdom about state ownership. Plenty of countries have strong
state-owned companies in semi-monopolies such as telecommunications or
heavily regulated sectors such as energy and mining. Yet China is
trying to create a series leading public companies in industries
exposed to cut-throat competition, where technology, design and
marketing are crucial features – just the sort in which state-owned
companies have typically suffered at the hands of private rivals.

At
a time of growing discussion about whether there is a genuine “China
model” for economic development that involves a much bigger role for
the state, the fate of China’s public companies could help change the
terms of the debate.

One of the most interesting tests will be in
the car industry. Chinese companies have startled the auto industry
over the past three years by grabbing a 26 per cent share of one of the
most competitive markets in the world – which is also now the
second-largest. The company with the fifth-biggest brand in the local
market – ahead of Nissan, Ford and Hyundai – is the state-owned Chery
Automobile.

Based in Anhui, a poor province inland from Shanghai,
Chery has benefited greatly from local government assistance in terms
of access to financing and land purchases. Critics also claim that the
company cut a few corners in its earlier years – its highly successful
QQ micro-car was very similar to General Motors’ Chevrolet Spark.

But
Chery has also proved skilful at marketing, for example using the
internet to create buzz among young car-buyers, and has displayed a
ruthless control of costs – neither of which are traditional attributes
of state companies. Industry executives have also been impressed by the
heavy investment the company has made to boost its engineering
capabilities, which will be vital if it is to compete overseas. “Chery
looks, feels and has the DNA of a private company,” says Michael Dunne,
managing director of consultants JD Power in Shanghai.

State-owned
enterprises – often known by the initials SOE – are making their mark
in a string of other industries where there is plenty of competition
and companies need both capital and a technological edge.

China
is awash with private investment in steel, but the industry leader and
most technologically advanced steelmaker in the country is the
state-owned Baosteel. Chinalco, another SOE, has rapidly become one of
the world’s leading producers of aluminium and alumina and is
developing plans to become a diversified metals multinational.

Shanghai
Electric, meanwhile, is increasingly taking on Japan’s Mitsubishi and
Marubeni in bidding to build new coal-fired power plants around Asia.
China’s two state-owned shipbuilding giants, China Shipbuilding
Industry Corporation and China State Shipbuilding Corporation, are
expanding rapidly and beginning to catch up with their Korean and
Japanese competitors in terms of technology.

Some of the sector’s
improvements reflect reforms the government has pushed on the state
sector. Many SOEs have listed at least part of their shares, exposing
them to at least some shareholder influence. Executives’ compensation
is linked ever more to performance rather than bureaucratic formulas.

“SOEs
are increasingly competitive in attracting top executive talent,” says
David Michael, head of Boston Consulting Group’s China office. “There
are a number of local Chinese managers of multinationals or private
sector companies who have gone to work in the state sector.”

Several
SOEs have taken on foreign strategic investors in recent years and some
have multinational executives on their boards. These relationships have
not been without tensions, but they have helped to sharpen performance.

The
government has attempted to ensure that those state-owned companies
competing globally are competitive at home. Chinalco’s acquisition of
shares in Rio was approved by a government agency only after it had
pitched its case against other SOEs, including Baosteel and Shenhua,
China’s biggest coal company and the world’s second-largest.

There
also have been increasing signs that China’s SOEs are learning the
skills of corporate finance. Chinalco’s snap purchase of Rio Tinto
stock was one example; another has been the ongoing tussle between
China’s two biggest airlines, Air China and China Eastern, which could
turn out to be the first public takeover battle between SOEs.

Last
year, Singapore Airlines agreed to buy a 15.7 per cent stake in China
Eastern, which is still controlled by the government but has listed
minority stakes in both Shanghai and Hong Kong. The Chinese government
gave its approval.

Yet Air China had other ideas, because it
wanted to join forces itself with China Eastern to create a national
champion. The company started to criticise the deal in public and lobby
China Eastern’s shareholders to vote against it. “Everywhere we went,
it seemed as if Air China had been there the day before,” says Li
Fenghua, chairman of China Eastern. Sure enough, investors rejected the
deal after Air China promised to make a higher bid. China Eastern has
so far rebuffed Air China’s offer.

Large SOEs in China have
always fought tough battles over strategy. But what has been different
about the China Eastern situation is that a lot of the debate has been
in public – and that Air China has gained an upper hand by offering
more money to investors rather than winning a backroom political deal.

Such reforms only explain
part of the success of some SOEs. According to Andrew Grant, head of
McKinsey’s China practice, many of the successful companies in China
have what he calls a “hybrid” structure, mixing features of private and
state companies. The best SOEs gain financial firepower from their
state parents but have sufficient independence to be managed like
private companies. Likewise, some of the most successful privately run
groups, such as telecommunications equipment maker Huawei and PC
manufacturer Lenovo, have been helped by their close ties to
government. “You are starting to see the development of a really
interesting dynamic in the state sector,” says Mr Grant. “It is not the
case that SOEs are going to dominate the entire economy, but I am very
optimistic about some of them.”

The idea of such “hybrid”
companies also helps explain the winners in other capital-intensive
sectors, including China’s auto industry. “To develop a car company in
China, you need to be able to play both sides, running the business
with private sector-type discipline but also getting close to local
governments for the land and bank contacts that this brings,” says Mr
Dunne.

However, the record of SOE reform has not been a uniform
success. While there are some outstanding state-owned companies, there
are also plenty that demonstrate the well documented pitfalls of
political interference and heavy-handed bureaucracy.

Top managers in SOEs are political appointees who can be forced to
move jobs regularly between different companies and government
departments. In a notorious case in the telecoms sector in late 2004,
the government shifted the heads of China Telecom, China Mobile and
China Unicom overnight, without giving them any notice.

Older
SOEs are often still grappling with outmoded equipment and might be
obliged to purchase components and other supplies from affiliated
companies, regardless of quality or cost. SOEs can also face more
restrictions than other companies when hiring and firing workers.

Although
corporate governance has improved, investors regularly complain about
lack of transparency in SOE finances, particularly over the transfer of
assets between listed companies and their state-owned parent groups.

Moreover,
there are several economic downsides to the increasing power of the
large SOEs for the Chinese authorities. Although China’s private sector
has grown sharply in recent years, the state sector still manages to
command the lion’s share of formal financing. The commercial banking
market is still dominated by the large state-owned banks and analysts
say that these banks still prefer to lend to other large SOEs. Indeed,
this close relationship is one reason that the Chinese economy is still
vulnerable to periods of over-investment.

The massive boom in
the local stock market, which saw companies raise more money in
mainland China last year than in any other market, has also largely
benefited SOEs. The 12 biggest initial public offerings last year in
Shanghai were all by SOEs and accounted for 85 per cent of the capital
raised.

Shen Minggao, an economist at Citigroup in Beijing,
argues that the recent boom has affected the economy in other ways, by
delivering most of the benefits of economic growth to state-owned
companies in the form of higher profits, with relatively little going
into the pockets of ordinary wage-earners. The massive reorganisation
of the state sector in the late 1990s pushed responsibility for a lot
of health and education spending on to families.

Meanwhile, the
state has been the main beneficiary of the recent surge in SOE share
prices, given that in most of these companies only a small proportion
of the shares are actually traded – 4 per cent in the case of
Industrial and Commercial Bank of China. “It is the state and not
households that became wealthier during the blossoming of the SOEs,”
says Mr Shen. “Households actually enjoyed only a small portion of the
expanding wealth cake.”

Greater independence is good for
corporate performance, but there are also signs that China’s more
powerful SOEs are outstretching the ability of the country’s regulators
to control them. The most remarkable incident occurred last summer,
when the large state-owned oil companies forced the authorities to
raise fuel prices by helping to create an artificial shortage.

The
Chinese government sets prices for oil sold domestically, which puts
pressure on the large oil companies – PetroChina, Sinopec and CNOOC –
when international prices rise. The response from the large oil
companies was a high-stakes game of bluff with the authorities: the
amount of oil sold in China was reduced and several large refineries
were put on “scheduled maintenance”. When many smaller, private
refineries also refused to sell oil at the government-set price,
creating an even bigger shortage, the authorities had no option but to
increase prices.

T he SOEs are also facing a backlash in some
Beijing policy circles over their overseas investments. PetroChina has
been operating in Sudan for over a decade, during which time Beijing
has forged a close relationship with Khartoum. While these ties have
prompted criticism that China has weakened international efforts to
halt the violence in Darfur, PetroChina has at times sold more of the
oil from Sudan to Japan than it has at home – prompting some experts to
ask if the controversial Sudan policy actually brings real benefits.

Zhu
Feng, of Peking University, says that the oil companies have “hijacked”
the country’s foreign policy on Sudan. “Chinese oil companies and a lot
of other oil companies in Sudan have made the money. It is not the
people or the country [that have made money],” he says.

According
to Zhang Yunling, at the Chinese Academy of Social Sciences: “It is not
the government deciding to go to Sudan. It is the oil company. They
have gradually developed their business and asked the government for
support.”

Erica Downs, of the Brookings Institution in
Washington, says Sudan is the “crown jewel” of PetroChina’s
international business, but that “the company’s domination of the
Sudanese oil industry arguably has done more damage to China’s
reputation abroad than the activities of any other Chinese SOE”.

“The
case demonstrates how the overseas activities of a Chinese SOE can
simultaneously harm one Chinese foreign policy objective – to be and be
perceived as a responsible rising power – and help another – to enhance
energy security,” she says.

The Chinese government has attempted
to improve its public relations in recent years, ordering ministries,
with varying success, to explain decisions to the foreign and local
media. Petro- China, however, one of the country’s most powerful
companies, has shown no inclination to fashion a public message.

Elsewhere,
in countries as diverse as the Philippines, Zambia and Peru, Chinese
investments have provoked a political backlash. “In the future, this
issue will become more and more serious,” says Mr Zhang.

For the
ruling communist party the political benefits of the SOEs’ new wealth
far outweighs any financial costs incurred in keeping them at the
“commanding heights” of the economy. To maintain its grip, the party
needs a strong state sector with the power to balance a rising
entrepreneurial class. The risk for the authorities, however, is that
over-mighty companies end up dictating policy themselves.