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Zhao Hu is an analyst with Morningstar China.

Lacklustre profits and heightened risk associated with investing in US and European equities have forced more investors to invest in Chinese equities, particularly the state-owned enterprises (SOE). Government enterprises have seen a 37.9 per cent jump in profits in 2010.

As a result, SOEs now represent more than 30 per cent of China's GDP. Although SOEs have a lower return-on-equity, investments in these state-controlled behemoths have been safe.

We believe, however, the incoming reform of SOEs after the leadership transition in 2012 poses a serious risk to their profitability and return-on-capital.

Reform critical to achieving sustainable growth

It is now a grave concern that the continuing inefficient allocation of profit and capital gain expenditure by the Chinese SOEs would derail the rebalancing of the Chinese economy.

The state government's drive to build its "national champions" for the past five years has effectively created a powerful special interest group whose advancement is built upon the retreat of private and foreign businesses from China.

Additionally, we believe poor allocation of capital largely contributed to the creation of the large imbalance in the Chinese economy we see today.

Firstly, due to the under-development of the equity and bond market, more than 80 per cent of the capital flows are through state-owned banks.

And because of the difficulty for banks to gather trustworthy information on the credit history of the SMEs [small-to-medium enterprises] and risks associated with their business practices, banks with enormous amounts of low-cost savings prefer lending to the SOEs.

A report by the Unirule Institute of Economics showed real interest rates for SOEs were 1.6 per cent, while the average market interest rate was 4.68 per cent from 2001 to 2008.

Secondly, lower taxes and land costs for the state-owned companies are much lower compared to private enterprises and foreign companies.

Finally, little oversight on their capital expenditure also contributed to the problem. After 2007, government mandated SOEs to pay dividends.

Although the majority of the listed SOEs pay dividends to their parent shareholders (usually the holding company), these dividends do not go to the State-owned Assets Supervision and Administration Commission of China (SASAC), and therefore can't count as part of the revenue for the government.

With ample amounts of cash, lower cost of doing business and little oversight on capital expenditure, SOEs continue to expand their production.

This led to the over-capacity and China's over-reliance on investment. Between 1981 to 1999, the average return on equity of SOEs was only 8.6 per cent compared to 12.9 per cent from non-state-owned enterprises.