Reforming China’s State-Owned Enterprises

Recent Features

Features | Economy | East Asia

Reforming China’s State-Owned Enterprises

Although it faces strong resistance, reforms will be vital if the Chinese economy is to continue to evolve.

China’s huge apparatus of state-owned enterprises (SOEs) is a popular punching bag: economists decry its inefficiencies; foreign politicians complain about unfair competition; and many Chinese citizens criticize public displays of waste, like elaborate banquets. The Chinese government would counter that they provide a foundation for the economy as a whole.

As China’s economy evolves (and it does, albeit slowly at times), the clamor for SOE reform grows louder from all sides. What is the potential for reform? How damaging are SOEs to the Chinese economy? On the flip side, how have SOEs strengthened the system?

But first, a little background. According to Xinhua, at the end of 2011, there were 144,700 state-owned enterprises with total assets of 85.4 trillion yuan, revenues of 39.25 trillion yuan, and profits of 2.6 trillion yuan (43 percent of China’s total industrial and business profit).

Most SOEs are controlled by local governments, though it is those in the care of the central government that receive the most attention. Of those companies, there are three categories: those controlled by the State-Owned Assets Supervision and Administration Committee (SASAC), banking and finance organizations, and “media, publications, culture and entertainment companies,” administered by other agencies (for more details, see this China Economic Review piece.)

Recently, SOE profitability has taken a hit, reports this May Xinhua article: in the first quarter of 2013, SOEs reported 5.3 percent growth, compared to 2012’s first quarter growth figure of 7.7 percent. According to China Enterprise Research Institute researcher Li Jin, slower growth is attributable to “overcapacity, inefficient cost control, and slow industrial upgrading.” As for the types of SOEs that recorded slower growth, Li identifies them as “mainly in the traditional industries instead of high-tech or emerging industries” that “rely largely on expanding investment to boost growth.” Overall SOE profits are largely supported by just a few massive SOEs, such as PetroChina and China Mobile, according to China Economic Review, that are able to reap substantial profits by way of their “monopoly positions.”

This “monopoly position” of SOEs is one of their greatest advantages. State-owned enterprises are given government subsidies and have much easier access to credit than independent firms. The Wall Street Journal China Real Time blog notes that SOEs are the “beneficiaries of unfair subsidies and below-cost financing.”

Indeed, 85 percent of loans in 2009 were issued to SOEs, because banks themselves are state-owned, and are directed to let credit flow to other state-owned businesses. SOEs can get money more cheaply, paying lower rates for borrowing, and are more blasé about repaying these loans: SOE borrowing was a major source of non-performing loans in past crises.

In some industries, SOEs are granted a monopoly, with private enterprise not allowed to participate, especially in sectors related to national security. As the Wall Street Journal comments, “Beijing frequently justifies the state’s grip on key companies that form the “commanding heights” of the economy – like energy, power, steel, telecoms and shipbuilding.”

To be fair, this is true of many other countries, as well. However, as Andrew Batson, consultancy GK Dragonomics’ research director notes, “state firms do have a continuing and large presence in obviously non-strategic sectors — like restaurants — that is increasingly difficult to justify in a market-driven economy.” These structural advantages make it difficult for private enterprise to compete.

State-owned enterprises have a number of structural and organizational problems. In May, Xinhua reported the results of a National Audit Office audit of ten SOEs, which found a number of issues, including inaccurate accounting, incomplete financial statements, illegal practices and “poor management of investment decisions.”

The National Audit Office also reported (as noted in this Financial Times article) that a number of SOEs, including China Mobile and China Huaneng Group, violated taxation laws by giving employees “invisible benefits,” including gym memberships and life insurance, that allowed them to transfer “public resources” without paying taxes on them.

Chinese citizens often have a dim view of SOEs. Some would say this is because of jealousy of the “iron rice bowl” afforded to employees, but it is also in part because of flagrant spending: Beijing News (reported in this Financial Times piece) listed 10 SOEs that spent 2.9 trillion yuan on receptions in 2012, with China Railway Construction Corporation heading the list, spending 837 million, or 10 percent of its net profits.

The managers of SOEs are rewarded for prestige projects, not necessarily profit, and leaders of SOEs are appointed by the central government, largely on a political basis, rather than because of their business experience.

SOEs distort the Chinese economy in a number of important ways. First, as noted above, they guzzle much of the available credit, starving smaller enterprises, and their subsidies make it difficult for other companies to compete.

They also often don’t pay market price for resources, making them more likely to use those resources inefficiently, with implications for both the economy and environment. Additionally, a low level of accountability encourages a cavalier approach to efficiency in the use of resources (including employees) and end profits. Overcapacity can also be an issue, with industries producing product without considering the economy’s need for the item: this is particularly an issue in the steel and aluminum industries.

And from Economics 101: those in a monopoly position are able to charge more for their product. That puts pressure on Chinese consumers at a time when the government is trying to promote domestic consumption.

On a more general note, SOEs are happy with the status quo, and are powerful opponents of economic reforms, slowing the action needed to move China’s economy forward.

Foreign politicians claim that the privileges afforded to SOEs make their investments and acquisitions overseas unfair. And SOEs have been quite busy expanding their international portfolios: in 2011, China invested $60 billion abroad, 80% of that coming from SOEs, according to Xinhua. The state-run nature of these firms exacerbates foreign concerns about Chinese government involvement in companies on their own soil, particularly when these companies are potentially related to national security concerns, such as energy.

Recently, SASAC has been involved in a media campaign to promote the state sector as “transformed,” and “streamlined” via articles and reports carried by People’s Daily, Xinhua, and CCTV, as noted in this Wall Street Journal article. Anbound Consulting chief Jon Chen commented that the media blitz highlights that “State companies are an interest group and this is their pushback against reforms.”

An editorial in China’s state-run China.org.cn, “China’s SOE Monopoly Fallacy” argued that even within monopoly industries, such as oil and gas, there is competition: among state-run firms such as Sinopec, CNPC, and CNOOC.

SOEs have not been solely deleterious to the Chinese economy; positive ramifications have included shepherding key industries and giving China the building blocks for its rapid development.

Still, it is clear that reform is needed if the economy is to further evolve, and this is widely accepted by the Chinese leadership. In Li Keqiang’s first news conference as Premier this March, as reported by the Wall Street Journal, he said that the market would be given “greater room to operate, including allowing private businesses to compete on an equal footing with state-owned enterprises.”

Last October, SASAC director Wang Yong commented on reform plans, specifying the railway, postal, salt, power, telecommunications, oil, and petrochemical industries. He noted that enterprises would be encouraged to go public or to restructure, and that supervision would be tightened, particularly in regards to locally managed SOEs, about which he noted, “We have seen a tendency for some local governments to meddle in the everyday operations of state-owned enterprises.”

The question is what the nature of reform will be. China Economic Review cites experts as saying that “feasible reform wouldn’t significantly restructure SOEs but would rather change the way they are governed and regulated. Moves that could include changing the way SOEs appoint leadership or cutting subsidies that allow for high profits despite inefficiency.”

Keith Bradsher of The New York Times cites a political adviser as saying “public support for economic reform makes it impossible for the incoming team simply to do nothing” but that reforms may be limited to “the privatization of some state-owned manufacturers, like steel mills, which do not have monopolies and are plagued by problems like overcapacity, ferocious competition and heavy financial losses.” Industries such as “telecommunications, banking, health care and electricity distribution” will most likely not be targeted for reform.

One official at the Development Research Center, Chen Qingtai, suggested that the government “become essentially an investor in state-owned enterprises,” rather than “actively managing them.”

There have been some concrete steps toward reform: The Financial Times notes that there have been some openings for private investment in energy and finance, including “blocks for shale-gas exploration,” and that a pilot project in 2012 allowed for private groups to form lending institutions in Wenzhou.

Even these modest steps are facing significant resistance, including reluctance from SOEs themselves to change, and from local governments, which are often dependent on the profits of their local SOEs. Moreover, SOEs are a major source of employment, and the government is loath to create a cohort of angry, unemployed citizens.

The key will be to move reforms ahead quickly enough to mitigate economic distortions but slowly enough to avoid structural instability. Clearly, this will be a daunting but crucial task for new leaders Xi Jinping and Li Keqiang.