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Is China's Rail Freight Reform Heading for a Train Wreck?

BEIJING (TheStreet) -- It's not every day that a state-run newspaper in China lays bare ugly details of a dispute between an angry businessman and the government's railroad. But these are stressful times for the rail freight business and its customers in China -- so stressful that the newspaper in the city of Zhengzhou and government media censors, in an unusual move, last week let the businessman publicly vent grievances over rising freight charges.

Pressure in the rail freight sector has been building since China launched far-reaching market reforms for the national railroad system one year ago, just as the nation's economy was starting to lose steam.

Beijing eventually hopes to wean the government's China Railway (CRWOF) from public support by letting the market determine freight rates, passenger ticket prices, train schedules and employment levels. A new system for "fully reforming" the freight system is scheduled for roll-out June 15, China Rail announced last week.

What does this mean for investors?

It won't be easy. China Rail, which is listed on the Hong Kong and Shanghai stock exchanges, is a mammoth monopoly with deep government roots. It employs more than 2 million people, operates more than 60,000 miles of track and hauls most of the coal, iron ore and other bulk commodities vital to China's manufacturers. Its price controls have for years held down costs for freight customers.

Since the reforms were launched in May 2013, China Rail has been spun off from the government's Ministry of Railways and told to move toward marketization. Meanwhile, though, the railroad's central bureaucracy continues to oversee more than a dozen regional divisions, including Zhengzhou Railway and New York-listed Guangzhou Shenzhen Railway (GSH), each of which carries passengers and freight.

The reform's changes have strained relations with freight customers. The Henan Business Daily said the angry businessman, surnamed Qian, claimed that China Rail's Zhengzhou division had raised prices unfairly and dramatically by billing his company's flour shipments according to the weight of filled railcars. Before the change, shipping charges were based on cargo weight alone. Qian called the railway's bosses "unreasonable."

In fact, though, Zhengzhou's rate adjustment was in line with a central government decision in February aimed at lifting official controls on freight rates. China Rail gave each division the power to set new rates based on supply and demand.

The move effectively raised freight charges for all rail shipping nationwide, according to a recent report by Guotai Junan Securities. These hikes, coupled with the ongoing economic slowdown in China, are likely to reduce rail freight volumes and revenues, at least in the short-term, the report said.

Guotai Junan also cited overall risks for investors in the China rail sector, echoing a Morgan Stanley analysis of Guangzhou Shenzhen Railway in April.

Morgan Stanley's report cited a disappointing first quarter and a 64% year-on-year decline in 2013 earnings for the railway, which operates in the busy manufacturing zone near Hong Kong that includes the cities of Shenzhen and Guangzhou. The bank reacted by cutting its target price for Hong Kong-listed shares by 15%, and warned investors of "negative growth prospects" for the railway through 2016.

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