Reforming China’s SOEs

By JOHN ROSS

That China sees SOEs as the core of its economy is the key structural feature distinguishing China’s “socialist market economy” from the West’s “private market economy.”

Given that China’s economic system has outstripped capitalist market economies for over 30 years, what is the connection between China’s SOEs and its superior rate of economic development? Why has a “dominant position of public ownership” produced higher economic performance, and what are the specific problems leading to SOE reform? The answer to these questions indicates what the changes should be.

SOEs give China clear micro- and macro-economic advantages. The first micro-economic one is that as SOEs do not have private owners they do not pay dividends to private shareholders. Dividends are a significant proportion of Western economies – around five percent of U.S. GDP. In China profits which in the West would be dividend payments to private shareholders can instead be invested by SOEs. As Western private shareholders use part of their dividends for their consumption needs, therefore, SOEs raise the Chinese economy’s overall investment level. As investment is a chief driver of economic growth this enhances China’s economic performance.

SOEs second micro-economic advantage is that the state, and therefore state-backed companies, pay lower interest rates for borrowing than private companies – due to lower risk.

SOEs’ macro-economic advantages are even greater than the micro-economic ones. In a private economy no automatic mechanism ensures that company profits, which technically are a form of saving, are transformed into productive investment. Keynes put this in a famous comparison: “Saving means – so to speak – a decision not to have dinner today.  But it does not necessitate a decision to have dinner… a week hence.”

The theoretical possibility that private company savings will not be invested operates practically. A key mechanism leading to the 2008 international financial crisis was that U.S. companies did not invest all their profits. U.S. company operating surpluses rose substantially, from 20 percent of Gross Domestic Income (GDI) in 1980 to 26 percent in 2013, while simultaneously U.S. private fixed investment fell from 19 percent of GDI in 1979 to 15 percent in 2013. Falling investment, despite rising profits, led to economic slowdown and eventually financial crisis.

This situation has continued with the accumulation of U.S. companies’ “cash mountains.” By mid-2013 U.S. non-financial companies’ cash holdings reached US $1.5 trillion. 

U.S. companies, instead of investing, transferred money to shareholders not only in dividends but via share buy-backs. In 2014 U.S. S&P 500 companies spent 95 percent of their operating margins on buying their own shares or on dividends. Failure to invest meant that by 2013 the average age of U.S. fixed assets reached 22 years, the oldest since 1956.

As Larry Fink, head of BlackRock, the world’s largest asset manager, noted: “More and more corporate leaders have responded with actions that can deliver immediate returns to shareholders…while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.” The U.S. government can appeal for greater investment, but no mechanism exists to enforce this on private companies.

In contrast, in China state ownership of SOEs means they can, if necessary, be instructed to invest. This is a key reason why China’s investment level is far higher than the U.S.’s – in 2013, the latest internationally comparable figures, China devoted 45.9 percent of GDP to fixed investment compared to the U.S.’s 18.9 percent.

China’s ability to directly control investment through the state sector also creates stronger tools of macro-economic anti-crisis management than in Western economies. As the Wall Street Journal noted: “Most economies can pull two levers to bolster growth: fiscal and monetary. China has a third option. The National Development and Reform Commission can accelerate the flow of investment projects.”

This ability to set investment levels via its state sector is a key reason why China has strongly outperformed the U.S. since the beginning of the international financial crisis. From 2007 to 2014 China’s GDP grew by 79.9 percent versus 8.2 percent in the U.S. – China’s economy grew almost 10 times as fast as the U.S.’s.

But if SOEs overall give China huge advantages, what problems are the new changes designed to tackle? There are many individual issues but these are best understood in fundamental economic terms.

In China an error was made in the past of seeing SOEs as not just bringing economic benefits but performing a social function. SOEs not only provided employment but social security such as housing, health care, etc. This was an error for two reasons. First, providing such services increases SOEs costs – eroding or eliminating their advantage in terms of lower borrowing costs and not having to pay dividends to private shareholders.

Second, effective management requires specialization and focus. Company managers need to concentrate on their firms’ efficient functioning, while those delivering social protection need to concentrate on that. Trying to do both simultaneously inevitably leads to neither being done with utmost efficiency. SOEs should contribute to social protection by tax payments, not social security management. Remnants of this old system need to be eliminated.

Clearly demarcating SOEs purely economic functioning and enforcing financial discipline is aided by ensuring larger parts of their assets are in companies listed on share markets. This principle was followed in the recent reorganization of a major SOE, Shanghai Electric Group, which transferred assets from its unlisted parent company to a listed subsidiary.

Second, competition powerfully stimulates economic efficiency. But it must be understood within a globalized economy, not purely domestically. This is another feature of current SOE reform. To take a leading example, China previously had two state-owned railway construction companies – CNR and CSR. The theory was that their competition would stimulate efficiency.

But in reality, particularly in global competition in high speed trains, Chinese firms’ key rivals are international ones. Even the US $32.3 billion combined turnover of the two Chinese companies is far behind world leader Siemens’ US $96.5 billion – and China’s manufacturers also face competition from Japan’s bullet trains and Canada’s Bombardier. China’s merging of its two companies correctly flows from understanding competition in global, not domestic, terms.

This further relates to a more general question. Global data clearly show large companies have higher productivity than small ones. The greater role played by large companies in the U.S. is a key reason for its superior productivity compared to competitors – 45 percent of U.S. employment is in companies with more than 250 employees, compared to only 33 percent in the EU.

But China has over 100,000 SOEs – requiring consolidation. Taking the largest currently discussed proposals that the 112 centrally owned SOEs be merged into 30-50 goes in the right direction. This should be part of China’s general company consolidation – it is uncompetitive, for example, for China to have over 10 major automobile manufacturers compared to three in the U.S.

Finally, a key question is monopoly. Competition spurs efficiency but in some sectors it cannot operate normally because investment costs are too high to accommodate competing systems. No country has competing electricity grids or metro systems.

Faced with inherent monopolies, a “market solution” is the last thing required. The market operations of monopolies are well understood – they feature excessive prices and inferior quality. Inherent monopolies require an “anti-market solution” – keeping them in state ownership and imposing tough management to overcome their market tendencies. This is a key reason for the necessity to create a cadre of highly trained and tough state enterprise managers.

The fight against corruption is one aspect of that. In 2014, 70 SOE executives were placed under investigations for corruption which continued through to 2015. But an overall system of highly efficient state managers must be created.

In this regard, while the author is in general a strong supporter of China’s economic policy, he disagrees with one of China’s policies. Deng Xiaoping, famously noted that in China’s current “primary stage of socialism” payment must be “according to work.” He restated Marx. In strict social terms a manager is a very skilled worker. In every country, including the U.S., despite media myths, the overwhelming majority of large companies are run by managers not by “entrepreneurs” – the  owners of the companies. The reason these managers are so highly paid is that the work they do is ultra-skilled – decisions which can involve billions of dollars.

Singapore has the system most in accord with “payment according to work.” Managers are highly paid but subject to transparency and treated as workers – they can be easily sacked. It is because this is in accord with economic principles that Singapore has one of the most skilled, and non-corrupt, management systems in the world.

This approach of high SOE manager payment, however, is not China’s current system and would be extremely unpopular there.