• What is the outlook for China's state-owned enterprises (SOEs)?


Reform of China's SOEs, atop the commanding heights of the economy, is in the air.  
02 Jul 2012 

  • As instruments of China's massive stimulus in 2009-10, state-owned enterprises (SOEs) have greatly increased their influence at the expense of the private sector.
  • Even after decades of market reforms, China's leaders believe that a strong state sector is required to compete globally and steer domestic economic development.
  • SOEs are conduits of wealth and sources of leverage for the Communist Party, and all of the incoming senior leaders have close links with state companies.
  • Private-sector firms complain they are disadvantaged because SOEs overcharge for essential services and receive preferential treatment from state banks.
  • However, recent policy signals suggest that private-sector dynamism and innovation, rather than SOE capacity expansion, may soon be encouraged.
  • This implies that some leaders understand that further misallocations of capital by a resurgent state sector risk suppressing China's future growth prospects.

China appears to be returning to greater state control of the economy. Although the ultimate outcome is uncertain, state-owned enterprises (SOEs) are both increasing their political clout and tightening their lock on critical economic sectors.  Comprising 129 major conglomerates under the purview of the central government, as well as thousands of enterprises owned by the provinces and municipalities, China’s state sector is the wellspring of wealth and privileges for the Communist Party’s ruling elite along with their associates and relatives.

As Beijing in recent weeks turned to a more robust effort to halt the economy’s sharpest slowdown in three years, leaders have been looking for ways to reinvigorate growth while encouraging more private investment to fund the restructuring of state-controlled entities. The State-owned Assets Supervision and Administration Commission (SASAC) has, though, been vague about how private investors will be allowed to become involved in restructuring or what sorts of equity stakes they may receive in return.

Beijing’s decision in early June to allow market forces a greater role in setting interest rates could set the stage for a move away from low government-set rates that fueled decades of investment-intensive growth in China. Measures to open up state-dominated sectors such as railways, banking, insurance, and securities to private capital for the first time were announced in May.

Why has China’s state sector surged as its economy cooled? 

ebb jul 02 2012 china highspeedrail
Infrastructure, a key stimulus beneficiary
During three decades of reform and opening to outside market forces, China allowed once-suppressed private entrepreneurs to prosper, often at the expense of inefficient SOEs that had been the mainstay of the command economy. More recently, however, state-owned interests have been resurgent in the face of private-sector competition, at least temporarily halting the decline in the proportion of industrial production by companies controlled by the state.

Beijing’s forceful effort to reverse the economic downturn brought on by the global financial crisis, entailing massive government stimulus spending and state bank lending, gave a huge boost to the state sector:
  • It is very likely that most of the $588 billion stimulus program that funded infrastructure construction and other major projects in 2009-10 went to state-owned companies, although no breakdown of that total has been made public. 
  • Some of the largest and most politically well-connected SOEs appear to have used the influx of government funding to strengthen their market position in key sectors or to enter new ones.
  • In recent months, reports in the Chinese media have detailed how both central and local SOEs have become major players in the real estate industry, lining up billions of dollars in construction projects and land deals.
Nevertheless, distortions and waste contribute to declining profitability in China’s state sector. According to government figures, profits earned by central SOEs in the first quarter of 2012 fell 8.6% year-over-year to $106 billion.

What is driving greater state involvement in business?

In recent years, SOEs have widened their control over key Chinese industries including autos, aviation, chemicals, energy, machinery, metals, telecommunications, and information technology.  Currently, all but one of the 100 largest publicly listed Chinese companies are majority state-owned. 

Notwithstanding decades of market-oriented reforms, consensus exists within China’s leadership that the country needs government-run enterprises to compete globally and steer domestic economic development.  This top-down, statist strategy -- in part patterned on the earlier experience of Japan and South Korea in building modern economies with heavy government involvement -- was reinforced by leaders’ perceptions that western laissez-faire economic models had been discredited in the wake of the global financial crisis:
  • In a speech in March, Premier Wen Jiabao pointedly extolled what he termed the superior advantages of China’s socialist approach to economic management.
  • Propaganda Ministry directives this year have reinforced the statist approach, proscribing use of terms such as 'monopoly' to describe state enterprises.
ebb jul 02 2012 china cnooc
SOEs, like oil giant CNOOC, are instruments of power
China’s ruling Communist Party, facing the inexorable rise of an increasingly affluent entrepreneurial class, relies on SOEs with near-monopoly positions in key sectors such as telecommunications or heavily regulated sectors such as mining and energy as conduits of wealth as well as sources of political-economic leverage.  In return, the largest SOEs are able to secure preferential funding from state banks and coordinate investment activities with government planning and regulatory agencies.

Many SOE executives simultaneously hold senior positions in the government and, having gained a political clout commensurate with their growing wealth, are in a position to extend the economic reach of the companies they direct.  Two current members of the leadership inner circle, the Politburo Standing Committee, are former heads of oil and machinery SOEs, and all of the prospective new generation of senior leaders have ties to the heads of state enterprises or were themselves former SOE executives.

Are state companies crowding out the nascent private sector?  

Some Chinese and western economists warn that policies favoring SOEs at the expense of private companies could undermine China’s long-term growth prospects by stifling entrepreneurial dynamism and innovation.  Several indications of a public-private disparity are frequently cited:
  • Private firms complain that they are squeezed by SOEs overcharging for essential services including power, telecommunications and transportation.
  • Because lending decisions by state banks discriminate in favor of large, politically well-connected state companies, private business owners also say they face a higher cost of capital than do SOEs.
  • Partly in response to such complaints, Wen recently promised a series of targeted measures to lower financing costs and channel more credit to small and medium-sized private companies.
Nevertheless, despite central-government initiatives to sustain entrepreneurial activity, private firms face competition from more than 8,000 state-owned investment companies established by local governments during the past three years to dispense the flood of official stimulus spending. Much of this was channeled into lucrative business and industrial ventures that otherwise would be handled by private enterprises.

How do state firms strengthen China's expansion overseas?

ebb jul 02 2012 china angola
China’s role in Angola is part of a wider African venture
China’s increasingly powerful state enterprises have an outsized effect on global businesses and transnational investment flows.  Driven largely by major state energy companies’ acquisition of resource-related assets in South America and Africa, China’s overseas investment surged to $21.4 billion in the first quarter of 2012.  Although analysis of China’s cross-border investment flows is obscured by gaps in official statistics, reports published in June by private investment firms estimated that SOEs accounted for 98% of total deal value in the first quarter.

Several factors underlie the upward trend in foreign activity by Chinese state enterprises:
  • SOEs’ preferential access to financing from state-controlled banks means that they are able to adopt longer-term planning horizons, putting them in a better position to make deals in volatile market conditions abroad.
  • According to some Chinese academic analysts, the political connections of state energy companies enable them to shape Beijing’s conduct of energy-security and foreign policies in ways that advance their commercial activities abroad.
Could the state reduce support for SOEs' global thrust?

Recent policy signals from Beijing may mark the beginning of a step back from advantageous financing and regulatory treatment that benefits state enterprises in their competition with foreign rivals.  Part of the shift may be due to changing perceptions of China’s leaders: seeking to rebalance the economy to rely more on domestic consumption rather than exports, they have shown interest in finding ways to benefit more from innovation by private companies than from capacity expansion by SOEs. 

Another possible impetus to change is pressure from China’s trading partners:
  • For the first time, according to US officials, Chinese policymakers at high-level strategic and economic consultations in May said they would commit to begin scaling back SOEs' access to preferential export financing and other special treatment that gives them a competitive advantage over domestic and foreign rivals. Washington will be anxious to see how stated intent translates into action.
  • Unofficial remarks by US participants in the talks suggested that Chinese officials are also considering whether to require SOEs to pay out more of their earnings as dividends. This, if implemented, would represent a stepping up of Beijing’s campaign over the past year to pressure state companies to turn over more of their profits to fund social spending.

China's new generation of leaders, who are poised to assume office later this year and next, will contend with an increasingly muscular state sector. That prospect will shape, and possibly inhibit, any new initiatives to rebalance the economy or to reinvigorate policies of openness and reform of the sort that pulled China out of the command-economy era a generation ago.

The heavy emphasis on infrastructure investment in Beijing’s current stimulus campaign means that state enterprises will play a central role in revitalizing the economy, at least for the near term. However, recent initial steps toward liberalization of interest rates and opening of the capital account may point to a policy shift entailing changes that reformers within the Chinese leadership have long advocated in order to make the economy more efficient and increasingly driven by domestic demand. 

If so, it probably means that some among current and incoming leaders understand the potential downside of a resurgent state sector -- manifested in distortions stemming from widespread misallocation of capital -- that could suppress China’s growth prospects going forward.  Such leaders are likely exploring ways to foster private enterprise and reverse the slide toward greater state dominance of the economy.