
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.

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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

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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.

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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.