The real picture on China’s state-owned enterprises

It’s time to really debunk the myths on China. Its state-owned enterprises are inefficient, but they still dominate the key sectors.

Last week, Business Spectator carried an article by Nicholas Lardy from the Petersen Institute for International Economics entitled Debunking four myths about the Chinese economy.

Lardy is a leading expert on the Chinese economy and someone whose work this author has found enormously useful. In this column, the intention is not to disagree with Lardy’s arguments when it comes to the facts presented but to place a different interpretation on them and come up with some different conclusions.

The first myth that Lardy seeks to debunk is the idea that China’s economy is dominated by state-owned enterprises. To make the point, he correctly points out that state firms account for only one-fifth of manufacturing output, compared to four-fifths when reform began. They account for only 10 per cent of investment in manufacturing and only one-tenth of China’s exports.

All these points are accurate. But why focus on manufacturing to make the point that China is not a state-driven economy? Manufacturing in China is dominated by export-manufacturing, and export-manufacturing is dominated by foreign-owned and foreign-invested firms. This is why SOEs only account for 20 per cent of manufacturing in the country and only 10 per cent of investment in manufacturing. Given the rise of China as an export-manufacturer for foreign firms, it is also no surprise that the share of manufacturing by SOEs has dropped from 80 per cent in 1979 to 20 per cent currently.

But look at the sectors where SOEs do dominate in terms of both market share and investment: automobiles, information technology, petrochemicals, aviation, insurance, energy, banking, railways, media, shipping, construction, metals, telecommunications, and industrial chemicals. To these have been added a number of key ‘emerging industries’ in alternative and new energy technologies, new generation IT (e.g., cloud technology and high-end software), biotechnology, new generation automobile technology, high-end equipment manufacturing (especially in aviation, satellite, marine and intelligent manufacturing technologies such as robotics and 3D printing), new energy sectors (such as wind and solar), and new and advanced material sectors.

Sure, private firms are behind the majority of output in terms of final economic activity (measured as GDP). For example, many of the services sectors are dominated by private firms. But in the sectors listed above, foreign and private domestic firms are minority players in all of them as a matter of policy and practice. These sectors are the ones that define a modern and rapidly industrialising economy. Where it really matters, the Chinese economy is state-dominated and becoming increasingly so.

Second, Lardy argues that the perception that China is one of the world’s most powerful bureaucracies in terms of employment is incorrect, and cites figures from France, the US, Germany, Mexico, Turkey and South Africa showing that government employment per 1,000 residents in China is less than in these other countries.

Once again, the prima facie facts are not disputed. But there are a number of things to consider here. For one, the Chinese system does not offer anywhere the same level of public social services as countries such as France, Germany or the US, or even in important respects Mexico, Turkey and South Africa. Therefore, one would expect there to be less government employees.

The fact is that after Malaysia, China has the most number of bureaucrats per 1,000 residents in all of Asia. As an indication of the growth of power and influence of the Chinese bureaucracy in a more modern context, the number of officials before and after the Tiananmen protests in 1989 has doubled from 20 million before to over 40 million today -- proportionate with the increase in the economic relevance of the Chinese Communist Party since the 1990s onwards (compared to the 1980s.)

The third point put forward by Lardy is the perception that SOEs are more powerful than ever is misleading. To make the argument, he points out that while leading SOEs earn astronomical profits and that profits of central SOEs had quadrupled from 2003-2013, the reality is that most of these profits were made by just a handful of SOEs, with the majority of SOEs suffering declining profits. Lardy also cites figures showing that the return on assets of central SOEs have been persistently less than their cost of capital, meaning that SOEs are actually a huge drag on the Chinese economy given the resources they are offered.

The problem is that I am not so sure the facts presented make the point intended. It is true that around 80 per cent of all central SOE profits come from around a dozen firms, with the other 100 firms underperforming. (There are over 140,000 provincial and local SOEs. These figures deal only with centrally managed SOEs, which are the giants in the Chinese commercial system.)

To get an extent of their dominance, the top three SOEs in the country generate more revenues and make more profits than the combined revenue and profits of the largest 500 private firms in China -- a statistic demonstrating SOE dominance if there ever is one. The fact that the majority of SOEs are underperformers is not an argument for a political-economy that is NOT state-dominated – only an argument that the SOE system is a drag on national wealth, which is a point that Lardy correctly makes. Indeed, the fact that the return on assets of central SOEs is less than their cost of capital is indication that these SOEs receive enormous amounts of capital even when they are not deserving of it in commercial terms. That is, in a nutshell, the problem of China’s state-dominated political-economy. In other words, Lardy is making the point that China’s SOE-dominated system is highly inefficient, which is indisputable. This is not the same point as the one arguing that the Chinese political-economy is NOT state-dominated, which was the broader intention.

This leads to the final point made by Lardy that private firms are not credit starved, as is often suggested (including by this author). To substantiate, Lardy cites data released by the People’s Bank of China that private firms received 52 per cent of all credit from 2010-12, with SOEs receiving 32 per cent over the same period.

Yet, these statistics are misleading. SOEs receive over three-quarters of all formal finance (mainly bank loans), which are the cheapest available credit in the Chinese financial system. Private firms are generally forced to rely on the secondary lending market, which includes the so-called shadow banking sector: off-record loans offered by SOEs and other cash rich firms, pawn operations, and other ad hoc entities set up to provide secondary finance. Non-formal finance is significantly more expensive and it is a credit to the efficiency and hustle of China’s private firms that they outperform SOEs, even though they are forced to pay more for credit (perhaps this is why they outperform SOEs, which have less incentive to be efficient and innovative.)

In any event, the point is that the formal part of the Chinese financial system heavily favours SOEs. The shadow banking sector emerged largely because private firms are starved of credit. This is evidence of a financial system, and a political-economy more generally, that privileges SOEs.

Finally, as an on-the-ground test of how things work, ask any business person working in China how the political-economy works. Tell them that the role of the Chinese Communist Party in the economy and the dominance of SOEs in all key sectors are overstated and they will likely look at you aghast.

Dr John Lee is an Adjunct Associate Professor at the University of Sydney, a senior fellow at the Hudson Institute in Washington DC, and a Director of the Kokoda Foundation defence and security think-tank in Canberra.