You may not know it. But, the Central SASAC, State-owned Assets Supervision and Administration Commission of the State Council, the People's Republic of China, just initiated a 3-year Performance Assessment Policy that will transform Chinese business practices. This dramatic change may have an equal or greater impact on China than Deng Xiaoping's 1978 reforms.

THE POLICY

The Central SASAC governs a portfolio of 130 companies with $3 trillion in assets, $3 trillion in sales, and 12 million employees. Companies include CNPC (PetroChina), Sinosteel, China Mobile, State Grid, Air China, and almost all large industrial and service companies with state ownership. Other SASACs represent major states and cities and include hundreds of major organisations with tens of billions of assets and millions more employees.

All follow the guidelines promoted by Central SASAC. As major policy decisions are taken by consensus, SASAC guidelines have explicit or implicit support from Premier Hu and the Politbureau. No tectonic change occurs without years of study and debate, and transformation happens gradually, building buy-in among the key constituents affected.

In this case, the guiding principle is simple and straightforward: from 01.01.2010, enterprises must earn returns above the cost of capital; executives are now expected to be responsible stewards of investor capital. Performance appraisal, variable-pay compensation (bonuses), and promotion/dismissal are based partially on a simplified version of EVA®, economic value added, which equals the net operating profit after tax – (capital employed x cost of capital for debt and equity). The great change will not seem brave to many C-suite executives, especially as sales will initially remain 60% of the goal, with EVA at 40%. But, for these enterprises, it is a great leap forward into the unknown.

Although SASAC has started the companies with a low capital cost (5.5%), half produce negative EVA. Many have grown by consuming artificially low-cost debt or government subsidy. Most do not provide dividends but have become conglomerations of businesses. Transparency highlights the resulting value destruction. This was okay until 31.12.2009. Now, it is unacceptable. For thousands of managers who have ascended by being excellent administrators and delivering growth, this is culture shock.

BENCHMARKING

SASAC's decision places their firms in the forefront of performance management. Many of the world's premier firms remain obsessed with market share and size, at any cost. Their goals are sales, EBITDA, EBIT, or net profit (EPS). None of them are accountable for the cost of capital. Using it for capital investments matters not when management pay packages are driven by sales, assets, or people managed. Financial institutions' fixation on market share caused the collapse of Western financial markets, under the weight of zero-down mortgages. Even firms that underline their commitment to returns (ROCE, RONA, ROE, or ROA) are less value focused than their annual reports suggest. Therefore, SASAC's explicit demand that enterprises earn rates of return above a cost of capital differentiates them from most sovereign wealth funds, even with the artificially low cost of capital.

Why does SASAC not go further and demand that the companies beat a more accurate and higher cost of capital? This would likely show that most portfolio firms have destroyed value, and that positive EVA is possibly many years away. Although improvement in EVA matters more than whether it is positive, the psychological effect could diminish any enthusiasm for adoption. In China, change happens step-by-step, even if to an outsider, it appears to happen at lightning speed. Therefore, SASAC starts the companies with a lower capital cost and asks them to make only a few basic adjustments to their financial accounting statements, which should encourage greater investment in research and development and a move from low-cost, lower quality products and services to higher value offerings. Only Singapore's Temasek Holdings requires such a high standard of performance.