The long march to the mixed economy in China

Author: He Fan, CASS and ANU

As in other areas, the reform of state-owned enterprises (SOEs) in China has been a gradual process. Now, almost 25 years after SOE reforms began, the government must tackle new problems: breaking down special interests, distancing the state from the daily operation of enterprises — and associated issues of corruption — and improving the overall efficiency of the economy.

After China adopted a planned economy in the 1950s — and private enterprises basically disappeared — SOEs played the dominant role in China’s industrialisation. They produced everything from satellites to matches. In the 1980s China launched market-oriented reform. A new type of enterprise, named Town and Villages Enterprises (TVEs), emerged. These were more like private enterprises but they operated under the name of collective ownership as political protection.

In the 1990s, under the leadership of then premier Zhu Rongji, China initiated a radical reform of SOEs. Under the mantra of ‘Grasp the large, release the small’, tens of thousands of weak SOEs were privatised or liquidated, millions of workers were laid off, and stronger SOEs were restructured and often listed on the stock market.

With these reforms, private enterprises in China were able to achieve real prosperity and foreign investment flowed in. The SOEs’ share of the economy declined dramatically because many could not compete with private and foreign companies. Poorly performing SOEs had to rely on subsidies — a heavy burden for the government. Although this reform seemed risky, the government had made shrewd calculations. Compared with ‘shock therapy’ in the Soviet Union, China took a gradual approach exercising patience and caution. Before throwing SOEs into cold water, the government encouraged the development of private and foreign companies, which helped to absorb many laid-off workers. That is how such a radical reform did not cause serious damage to economic growth and social stability.

Today China’s SOEs are very different from those in the 1990s. Now SOEs are fewer in number but much larger in size, especially those controlled by the central government. Rather than being scattered in competitive manufacturing sectors, many SOEs cluster in sectors of ‘strategic importance’, such as mining, energy, transportation, telecommunications, banking, and public utilities. There are also many SOEs controlled by local governments. They outnumber, but are often dwarfed by, their central counterparts. Those local SOEs are still involved in almost every industry — including information technology, machinery, automobiles, hotels, and hospitality — and their performance varies much more widely.

It is true that compared with private companies, SOEs are often inefficient, but unlike in the 1990s, now they reap handsome profits. So if SOEs do not financially burden the government and, even better, become cash cows, why bother to reform them at all?

The main reason why large SOEs are still profitable is that they enjoy monopoly privileges. In many sectors the existence of SOEs creates a barrier to entry for private investment. Even when private capital is allowed to enter, it often faces unfair competition. Ironically, even when these gigantic SOEs earned substantial profits, they did not contribute a commensurate amount to the government. They kept most of the revenue in their own pockets, meaning that there was no trickle-down to the general public. Now these SOEs are becoming special interest groups with a strong resistance to reform. Some are more like independent kingdoms in their own industries. Rent-seeking activities also breed corruption, as made clear by the current anti-corruption campaign led by Xi Jinping: many corrupt SOE executives are being removed or even put in jail.

China’s much-needed structural reform also relies on SOE reform. After the global financial crisis, it became clear that the traditional growth model of the last two decades was not sustainable, but the fiscal stimulus package announced in 2008, along with the extremely expansionary monetary policy adopted in 2009, caused many SOEs to become bloated and the return on assets to decline.

Economic growth is likely to slow in the future as China moves closer to the technological frontier and its demographic profile changes. But a large pool of surplus workers still needs to find jobs. They are unlikely to do so in SOEs that operate predominantly in capital-intensive sectors and thus cannot provide enough job opportunities. Instead it is private companies that are responsible for nearly all new job creation in China.

To rebalance the Chinese economy, the potential of the services sector needs to be unleashed. Breaking down the SOE monopolies is the only way forward. Without competition in the services sector, the supply of services by the SOEs is insufficient, quality is low, prices are high, and domestic demand is thus depressed. Encouraging more private investment will help to boost domestic consumption, reap the ‘reform dividend’ and sustain robust economic growth in the long run.

SOE reform is one of the priorities of the Third Plenum Report, a blueprint for reform released late in 2013 by the 18th Central Committee meeting of the Chinese Communist Party. The report includes the goal of raising the proportion of state capital earnings handed over to central finance to 30 per cent by 2020, up from 5–15 per cent for most SOEs. It promises to accelerate factor price reform in order to level the playing field. The government will also tighten control of SOEs by assigning discipline inspection teams as well as putting a ceiling for the salaries of senior SOE executives.

But the buzzword is ‘mixed ownership economy’. The basic idea is to encourage private capital to be involved in SOE reform. This will help to improve the governance structure of SOEs and provide more room for the role of private capital. Many private entrepreneurs have complained that ‘state capital is moving forward, while private capital is moving backward’. They are referring to the renewed concentration of power in the state-controlled segment of the economy after the global financial crisis. A ‘mixed ownership economy’ aims to promote the integration of state and private capital. In the end, state and private capital will stand shoulder-to-shoulder and hand-in-hand.

Yet many private entrepreneurs tend to be unenthusiastic about the invitation. There is widespread scepticism about the extent to which private investors will have management control over corporatised SOEs. Full privatisation is out of the question for the Chinese Communist Party. So what will be the difference between this new round of SOE reform and the last major push?

It is fair to say that privatisation is only one alternative for SOE reform. A related reform is the establishment of capital investment companies. Before the Third Plenum meeting, an influential policy report — co-authored by Development Research Center, a think tank affiliated to the State Council, together with the World Bank — had already discussed this idea. Temasek, the holding company used by Singapore to manage its SOEs, has been mentioned. The advantage of the Temasek model, compared with current Chinese SOEs, is that it focuses purely on maximising shareholder value while, at the same time, keeping the daily operation of the SOEs at arms-length.

China already has Temasek-style sovereign wealth funds like the China Investment Corporation (CIC) and Central Huijin Investment. CIC is mainly responsible for investing a small part of China’s US$4 trillion foreign exchange reserve, while Huijin has played an important role in reforming state-own banks. As China continues its reforms, more state equity is likely to be transferred to emerging state-owned capital investment companies, both at the central and local level. Institutional investors — like social security funds, insurance funds and private equity funds — are also being encouraged to participate in the restructuring and reorganisation of SOEs.

This will bring a sea change to the Chinese economy. The government can free itself from the awkward situation of meddling with the daily operation of SOEs and concentrate on the task of maintaining fair market competition and property rights protection. It will also try to stimulate competition among the SOEs. If the enterprises are not performing well, the state-owned capital investment companies can reduce their investments or sell their shares. This will force SOEs to behave more like other market entities and increase efficiency.

The clamour for SOE reform grows louder from all parts of China, and the government has taken the first step of a new long march toward the mixed economy. The process will be slow and controversial, but with changed rules, the game will be different. Large sell-offs of state capital are unlikely, but we should expect competition between SOEs and non-SOEs to become more transparent and fair. The main theme of the incoming Fourth Plenum is ‘rule by law’. This is the most important issue for the long-term stability of the Chinese economy.

He Fan is a Senior Research Fellow at the Institute of World Economics and Politics and Deputy Director of the Research Center for International Finance, Chinese Academy of Social Sciences. He is currently a visiting fellow at The Australian National University.

 This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘The state and economic enterprise.