Beijing is on a mission to revamp its state-owned enterprises, and show the world that investing in President Xi Jinping’s China can reward everyone from domestic savers to skeptical money managers.

Officials have kicked off a drive in recent months to boost the valuations of SOEs, a massive cohort that has contributed little to gains in the nation’s stock indexes over the years. These firms are in every corner of the economy — ranging from banking to ports and the steel industry — and the major entities account for almost half of the overall market capitalization, said Goldman Sachs Group Inc.

The campaign, which has fueled a jump of over 50% in some SOE stocks, is accompanied by a slogan of buying into a “valuation system with Chinese characteristics.” While it’s unclear what exactly that means, the SOEs do sit at the heart of a crucial debate: the role of markets and investors in listed state companies in an era when Xi has extended his grip over the economy.

All this is happening as global money managers have become increasingly cautious about Chinese assets after years of regulatory crackdowns and geopolitical tensions. With China’s stocks ranking among the world’s worst performers this year, a drive that can realign the targets of the nation’s biggest state companies with the interests of investors may well bring about a market revival.

“The valuation system with Chinese characteristics has apparently helped sentiment somewhat, but we are more focused on long-term reforms, of which VSCC is a part of a bigger theme,” said Stella Li, Investment Director at abrdn Plc. “A long term and continued reform that increases ROE, efficiency and transparency does improve the attractiveness of A shares to global investors,” she said referring to stocks traded in Shanghai and Shenzhen.

Scores of SOEs have rallied hard since China Securities Regulatory Commission Chairman Yi Huiman referred to the SOE valuation system during a speech in November. The official narrative is that these companies’ valuations are unduly low given that the firms play a dominant role in the world’s second-biggest economy.

A gauge of shares of central government-owned companies has climbed about 5% following Yi’s remarks, outperforming the CSI 300 Index which is little changed. SOE stocks such as PetroChina Co., China Telecom Corp. and China Satellite Communications Co. each gained more than 50% from late November through early May, when the rally reached its peak.

There’s been growing optimism about state-owned firms after the regulator introduced a new set of targets this year to assess them. Focusing on metrics like return on equity and operational cash ratio increases the pressure for SOEs to step up buy-backs and dividends as well as boost income from core operations.

Industry Laggards

Traditionally, SOEs’ metrics have tended to lag those of their private-sector peers. For example, liquor maker Wuliangye Yibin Co. has a five-year average ROE of 25%, compared with 40% for Sichuan Swellfun Co.

Industrial & Commercial Bank of China Ltd, the nation’s biggest lender by market cap, is trading at a price-to-book ratio of 0.51 times and 0.38 times in Hong Kong. This compares with 0.75 times for Japan’s Mitsubishi UFJ Financial Group Inc. and 2.45 times for Commonwealth Bank of Australia.

Over the past decade, industries dominated by SOEs such as telecoms, banks and utilities have traded at a long-term discount of around 11% relative to their peers in emerging markets, and at a 28% discount to global counterparts, according to Morgan Stanley.

For Sharukh Malik, portfolio manager at Guinness Global Investors, getting SOEs to reduce their cash holdings is key since many hold as much as half of their balance sheet in cash. “That’s definitely positive for the China story,” he said. “The reform may also be in the form of better earnings growth and leading to higher return on capital profile, another positive from an institutional point of view.”

But the sheer size of the SOE universe suggests that the campaign will be neither quick nor easy.

China has a sprawling network of state firms, with the central government directly controlling 98 entities in key industries, according to the national regulator. While profits of central SOEs climbed 115% between 2016 and 2022, their market capitalization rose only 12.7%, lagging a 16% increase for the broader market, said Chen Jiao, an executive at China Reform Holdings Corp.

Additionally, policymakers who execute the reforms will have to juggle competing interests as unlike most investors, state-owned firms tend to prioritize social goals over profits.

“It’s good to see such improvements via visible KPIs such as financial metrics, i.e. profit growth, ROEs, dividend payout etc.,” said Xiadong Bao, fund manager at Edmond de Rothschild Asset Management in Paris. “But the sustainability of this alignment is unknown, as the priority items on the agenda of SOEs may reshuffle according to their different mandates in different periods, as SOEs are supposed to shoulder more social burdens.”

There’s a lot at stake: If Beijing fails to revitalize its SOEs, this may fuel more debate about the viability of President Xi’s reforms.

“SOE reform is a long-term process and it’s not new in China’s overall reform history,” said Edmond de Rothschild’s Bao. “But it can ignite the hope that a more market-driven approach may prevail and a structural improvement in SOEs’ fundamentals and shareholder return policy shall help the market sentiment.”