The truth about China's SOEs

Lowy Interpreter

That China is a 'state capitalist' seems obvious both to foreigners, who fret about state owned enterprises (SOEs) investing overseas, as well as Chinese locals, for whom the state is omnipresent. Leviathan seems to straddle China's economy from the commanding heights to the kerbside.

But that perception would be misleading and outdated, says Nicholas Lardy in Markets Over Mao. China's SOEs mostly are fragmented, mediocre and rapidly losing ground to private business. The Economist summarises starkly:

...private companies accounted for one-fifth of industrial output in 2007. An expansive calculation triples their share to three-fifths. In cities almost all the 250m jobs created since 1978 have been in the private sector. More than 99 per cent of the urban labour force worked for the state in 1978; by 2011 only 18 per cent did. Looking at exports, the share of state-owned companies has fallen from two-thirds in 1995 to 11 per cent in 2012.

State firms now dominate output in only 6 out of 40 industries. What's remarkable, Lardy notes, is 'the significant erosion of SOEs' role even in some of the nine key "pillar" industries.'

Was this Beijing's grand plan all along? Are Chinese private companies unusually competitive? Or has the state ceded share through ineptitude? Lardy hints at all three factors:

Critics charge that China's government has aggressively deployed industrial policies favoring large SOEs at the expense of both foreign and private firms in order to create national champions...(but) these policies have not enjoyed the success that the critics claim.

SOEs have not exploited even monopolistic opportunities: 'there is no evidence that state firms have market power that boosts their relative profitability, or that they have become more powerful.' SOEs carry social burdens, but they benefit from handsome subsidies too. They also pay themselves lavishly, four times the average private salary.

No wonder private companies now earn almost three times what SOEs return on assets (13 per cent vs 5 per cent). 'The superior financial performance of private firms must explain a large share of their relatively rapid growth...they were able to rely much more on retained earnings to finance their expansion.' Private firms are better because they sweat their assets twice as hard.

Lardy disputes the widely-held view that SOEs 'crowd out' credit at the expense of small business. Fellow economist Huang Yiping complains: 'as state firms can easily get cheap loans to finance expansion, productivity has kept falling, eating into the economy's growth potential.' Yet according to Lardy, private firms account for half of new loans today, and even more investment. Although the state does continue to dominate the financial sector (another common gripe), even state bank managers know that 'private firms are on average a much better credit risk than SOEs.' Both Chinese private and state companies invest aggressively, but SOEs do so inefficiently, resulting in higher debt/equity leverage (85 per cent versus 60 per cent). Lardy's observation that 'state firms are contributing a declining share of output because of their low returns' squares with state capitalism's abysmal experience elsewhere.

Recent reforms therefore aim to introduce private sector discipline into SOEs through 'mixed ownership.' Yet these policies remain fundamentally conflicted and confused, neither convincing to private sector managers nor appealing for Party appointees. Salary cuts are planned for SOE managers, but society is rightly focused on their 'grey' income, which will remain invisible and stems from privilege. Privatisation remains a doctrinal taboo. Further opening to foreigners is reluctant, selective and transactional, a quid pro quo as China itself ventures abroad. It accepts FDI, as a European businessmen says, 'only where it is perceived to serve domestic industrial policies.' Lardy himself worries about 'a step back' in certain respects.

Private companies notably flourished in manufacturing, real estate, technology and now health care: there were 3000 private hospitals in 2005; now there are 7000. Lardy reckons that despite the difficulties, 'Chinese entrepreneurs created 25 million businesses in ten years.' Recent cutting of red tape spurred an impressive 20 per cent jump in new private firm formation.

But Beijing continues to dominate what it sees as 'strategic' sectors, and the private sector remains in a precarious position, depending on the support and protection of a party-state which is a potential competitor. Yet the success of Chinese private companies in technology is remarkable. It's unlikely Beijing voluntarily ceded this strategic sector; more likely it just couldn't keep up with developments. Now China has a private internet oligopoly, something Beijing can't be thrilled about.

Beijing couldn't now create competitive internet SOEs, but it has plenty of ways to compel internet operators. Lardy dismisses the suspicious view of the Party 'recruiting entrepeneurs and then either influencing or controlling their activities.' If it did so, 'burdening them with noncommercial objectives', they could hardly outperform SOEs so handsomely.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.