CORN March 2015 Edition.
What’s holding back China’s heavy industrial state-owned enterprises?
Despite multiple reforms, most of China’s heavy industrial state-owned enterprises (SOEs) are still chronically inefficient, unprofitable, and graveyards for capital. The root of SOE inefficiency is the institutional setup: SOEs are showered with cheap credit and subsidies, while the government prevents the entry of non-state competitors. Within the firms themselves, SOE decision-making over personnel and capital is spread among so many different actors that none has responsibility for firm performance.
Makers of steel, automobiles, machines, as well as extractors of coal, petroleum and natural gas—these are just a few examples of how heavy industry in China is dominated by state-owned enterprises (SOEs). Part of this domination can be explained by history: China’s SOEs were once at the centre of the communist command economy. Another part can be explained by the key functions that these SOEs performed—and continue to perform—for the Chinese party-state: SOEs are major sources of tax revenue, industrial inputs and urban jobs. Yet, compared to the tens of thousands of relatively new non-state firms that sprung up and thrived “outside the plan”, China’s heavy industrial SOEs have for years been producing a smaller and smaller share of China’s total industrial output (Figure 1).
This article argues that the main pathologies of SOEs stem from an institutional setup that includes entry barriers to the heavy industrial sector, access to abundant credit for SOEs, and a myriad of actors pushing and pulling the state-owned enterprise in different directions yet no actors really taking responsibility for firm performance. Over three decades of “reform and opening” have not fundamentally altered these basic institutions, which prevents these SOEs from functioning as complex, profit-driven enterprises. Instead, most of these SOEs continue to survive from the largesse of the Chinese party-state, serving political purposes before economic ones.
SOEs with Chinese Characteristics
Established to stand at the “commanding heights” of China’s planned economy, many of these SOEs are today among the country’s biggest, most capital-intensive firms (Table 1). And just as they had nearly seven decades before, these firms possess a virtual monopoly over China’s heavy industrial sector, long since labeled a “pillar” industry (支柱产业).
Table 1: China’s 10 biggest heavy industrial SOEs (by gross revenue)
|Rank in China||
Fortune 500 Rank
|Name||2014 revenue ($US bln)||2014 net profit (US$ bln)||Industry|
|3||7||State Grid Corporation (国家电网公司)||333.4||8.0||Utilities|
|7||52||China State Construction Engineering (中国建筑工程总公司)||110.8||1.85||Construction|
|12||80||China Railway Construction (中国铁建 )||95.7||1.0||Construction|
|13||85||Shanghai Auto (上海汽车)||92.0||4.0||Automotive|
|14||86||China Railway Group (中国中铁)||91.2||1.5||Construction|
|16||107||Sinochem Group (中国中化集团公司)||75.4||0.8||Petroleum – Chemicals|
Today China’s SOEs are beasts peculiar to socialism with Chinese characteristics. Being state-owned in China means these firms are “owned by the people” (全民所有), which, just as it sounds, leaves ownership unclear. When it comes to the actual running of the companies, it gets far more confusing. In practice, ownership is dispersed among a number of stakeholders—government agencies, central line ministries, regional authorities, and local ministerial branches. This means that SOEs, regardless of the level of government to which they are bound—central, provincial, prefectural, or county—in practice day-to-day control of the SOE gets passed on to a host of managers and skilled workers. And here is the first source of SOE inefficiency: who actually is accountable for firm performance?
Another peculiarity of these holdovers from the socialist economy is the welfare services these SOEs must perform. SOEs under all levels of government are responsible for providing their employees with everything from housing to healthcare to pensions to insurance for disability and unemployment. And for China’s larger SOEs, these firms are also burdened with running hospitals, clinics and daycare centres. And being a magnanimous extension of a communist party-state also means that SOEs, even during lean economic times, cannot easily cut costs, manipulate worker benefits, or lay off workers—though as we will see, this last part has changed quite a bit. In reform-era China SOEs continue to perform critical social welfare functions, especially in urban centres where these firms are overwhelmingly concentrated.
But if Chinese SOEs could be seen as assuming a great deal of responsibility for its own workers—and their families, too—responsibility for its own decision-making is shockingly absent. Decision-making in the typical Chinese SOE is the result of a ceaseless tug-of-war between a multitude of self-interested actors, not all of whom see their fates as necessarily tied to the particular SOE’s performance. With this fragmented and unclear ownership, what results is responsibility being spread so thin—and spread among so many different actors—that responsibility is ultimately borne by none: bureaucrats choose managers for political above economic reasons; managers make decisions on capital which they do not own and for which they do not bear any direct financial risk; and workers, whose jobs and benefits are seen as inviolable rights in a socialist economy, have little or no material incentive to help the firm prosper. All are confident that, regardless of their actions, the SOE will be propped up by a party-state terrified of an SOE shuddering its doors, leaving thousands—perhaps more—workers unemployed and disgruntled.
Old Habits Die Hard
Year after year in the “reform and opening” era, the SOE share of China’s industrial output had gotten smaller and smaller with no rebound in sight. So, it was by the mid-1990s, over fifteen years into the reform era, that Chinese policymakers finally recognized that the condition of most of China’s SOEs was economically untenable. It was Zhu Rongji, the no-nonsense premier with a feel for economic matters, who led the painful restructuring process. Thousands of loss-making SOEs—especially those labour-intensive ones with relatively small output and tax remissions, and thus relatively unconnected to the party-state’s vital operations—were shut down. The policy of transforming the state sector, essentially based on the size of the firm, came under the slogan “retain the large, release the small” (抓大放小). Given the go-ahead from the central government, local governments sold or shut down unprofitable local state-owned enterprises en masse in a wave of bankruptcies and privatization.
Labour was hit hard. Some 30 to 40 million state workers were laid off. But the slide in cutting public sector employment didn’t stop there. Whereas nearly 110 million Chinese were public employees in 1995, by the end of 2002, that number had plummeted to just under 70 million. Employment in industrial SOEs fell at an even sharper rate, from 44 million in 1995 to 15.5 million in late 2002. Today, only about 10% of Chinese workers are employed by the state—well below the proportion of workforces in Germany (15%), the US (nearly 17%) and France (almost 27%). And despite various commentaries on the return of government intervention in the Hu Jintao-Wen Jiabao administration, the number of state employees fell over one-fourth by the end of their ten-year tenure. All in all, in just a three year-period, the number of industrial SOEs fell from 110,000 in late 1997 to just over 53,000 by the end of 2000—a staggering decline of 55%.
The Making of “Modern Corporations”
Besides massive layoffs, another aspect of SOE restructuring, as well as preparing for China’s imminent entry into the World Trade Organization around the turn of the century, was the “corporatization” of some 10,000 SOEs—that is, the transformation of command-economy era enterprises into joint stock companies with shares traded publicly on exchanges in Shanghai, Hong Kong, New York, among others. SOEs deemed to be at the “commanding heights” of the industrial economy, such as steel, defence, and energy, stayed state-owned and overwhelmingly under central government control. These surviving SOEs only marginally reduced their payroll compared to those firms that underwent more radical ownership restructuring.
Despite all the excitement surrounding SOE corporatization, the boards of directors of the largest, most capital-intensive SOEs remained firmly under the control of the Chinese party-state. Unsurprisingly then, key positions on the boards are filled with Chinese Communist Party (CCP) officials, who have connections with managers in state-owned banks, as we will also see.
Well over a decade since this “corporate” transformation, the restructuring has actually not turned the surviving thousands of SOEs into the profit-driven firms that are described in economics textbooks. Simply turning these SOEs into “corporations”—still state-owned but now infused with market capital and some degree of shareholder oversight—continues to skirt the real issue: China’s institutional setup, rooted in the communist past and defended to-the-death by vested interests who profit from these coddled cash cows. China’s institutions surrounding its heavy industrial sector continue to be the real barriers to better SOE performance. Using the “visible hand” of the state to guide investment, upgrade firm techniques or sending managers to Western universities for MBAs is not going to make these SOEs behave like profited-driven actors.
So, despite wave after wave of reform, the classic symptoms of SOE inefficiency are still here: chronically low productivity, too many employees, unclear or creative accounting, profitability as desirable but optional, nepotism and patronage in appointments, as well as the requisite amount of waste and corruption for which SOEs are notorious.
Why all of these inefficiencies persist is, first and foremost, because SOEs have been able to avoid the hard choices of doing business: pressures for profits from shareholders; hard budgets that keep a firm’s losses within reason; as well as bankruptcy and “market exit”—the threat of hell for any firm. Put in another way, it seems that no matter how much money many of China’s heavy industrial SOEs lose they are nevertheless kept afloat by credit or government subsidies. And it is to this point that we now turn.
Where Credit Goes to Die
No discussion of chronic SOE under-performance would be complete without assigning equal blame to China’s state-owned banks. Doing what banks do in times of economic prosperity—of which China has experienced over three decades—China’s state-owned banks rarely lend to SOEs on market terms, and do so at favourable rates. As an integral part of China’s iron triangle, with the party-state and SOEs occupying two corners, China’s banks munificently shower SOEs with generous amounts of capital with little or no strings attached—and without corresponding return-on-investment either. That this capital is in fact the savings of hundreds of millions of thrifty Chinese citizens is no secret.
But borrowing per se is not the problem; rather, it’s a question of how SOEs are using the money. For those perennial loss-makers bringing in no cash and sinking under their own weight, these funds are commonly directed toward the quasi-social welfare duties—wages, housing, pensions, and so on. For others, an untold amount just falls through the cracks of opaque accounting and unaccountable management. In theory, borrowing can be good: when a firm borrows capital that goes toward long-term productive investments—potentially profitable projects or efforts to modernize that increase productivity that pump up profits in the future—they can use those future profits to pay back the loans and grow the business. But apart from SOESs in oil and gas, which turn over profits largely because of their commodity of focus, other SOEs, like those dealing with steel and coal, suffering from global price volatility and low growth, this borrowed capital is spent covering the firms’ productions costs or servicing old debts.
The threat of bankruptcy could scare SOEs straight. As we’ve seen, it already sent thousands of mostly labour-intensive SOEs at the local government level into extinction or privatization. The credible threat of bankruptcy could also help cure the various types of unproductive pathologies listed above—or at least that threat could help tighten their spending habits. But, in what has become an unwritten rule of government-business relations in China, China’s biggest industrial SOEs are not allowed to die. And they’re definitely not allowed to privatize.
Giving managers greater degrees of autonomy in increasing efficiency has helped, but SOEs at all levels are still pulled in every which way by a myriad of interests. What results is a situation in which no actor—within the government or within the firm—can muster the authority to gain control of decision-making in the firm.
The Institutional Revolution that Never Came
As impressive and successful as Chinese policymakers have been in daring to set up a basic market economy, Chinese policymakers have nevertheless adamantly refused to relinquish micro-managing the heavy industrial sector. In some respects, this is understandable: SOEs employ millions of workers, almost all located in cities and any number of whom have the potential to mobilize against the party-state; SOEs generate billions in tax revenue, absolutely vital as the government makes material promises of an “affluent society” (小康社会) and a middle-income “Chinese dream”; and SOEs provide key industrial inputs to other sectors of the economy, the health and growth of which party-state legitimacy and social stability now seem to depend.
The institutional revolution has simply not happened. The economic rules of the game have not been transformed, but merely altered. For SOEs, the institution of ownership continues to hamstring its performance while stifling entrepreneurship and innovation—all of which help drive long-term economic growth. Ownership in this case means decision-making on personnel and cash flow. In the typical SOE, far too many people make decisions on firm behaviour and firm capital, but ultimately nobody is responsible for firm performance.
To make matters worse, it’s often the wrong people who are making these decisions—those appointed to support the political interests—everything from hoarding capital to swelling the ranks with excess workers to exploiting the ubiquitous guanxi or “relationship” phenomenon in Chinese society. Even in the best managed SOEs, the sheer myriad of “agent-owners” nevertheless bring their own ideas on how the firm should operate, which inevitably results in contradictory and incoherent decisions. With so many cooks in the kitchen, ultimately no one is responsible when the meal comes out undercooked or burnt—or if the meal gets made at all.
To conclude, the institutions that divide and dilute firm ownership while protecting loss-making firms ultimately provide neither incentive nor punishment for SOEs that fail to push for efficiency or returns-on-investment. What results then is unsurprising: assets decaying, debts inescapable, opportunities squandered and potential unfulfilled.
Having lived, worked and studied in China for six years, Scott is currently a Ph.D. student at the University of Toronto. He is especially interested in China’s elite politics, state-owned enterprises (especially oil companies), foreign policy-making and foreign relations, especially with resource-rich states. He has conducted multiple research visits in Africa where he examined China’s investments there. Scott also previously worked for the Office of the Governor General of Canada.
He can be reached at scottchrismcknight [at] gmail.com
 Edward S. Steinfeld. (1998) Forging Reform in China: The Fate of State-Owned Industry, Cambridge University Press, 11.
 Yingyi Qian and Xu Chenggang (1993). “Why China’s Economic Reforms Differ,” Economics of Transition 1(2): 135-70. The authors summarize these categories on pp. 138-40.
 C. A. McNally and P. N. Lee. (1998). “Is big beautiful? Restructuring China’s state sector under the zhuada policy.” Issues Studies 34: 22-48.
 Y.-S. Cai. (2002). “Relaxing the constraints from above: politics of privatizing public enterprises in China.” Asian Journal of Political Science 10: 94-121.
 Although state enterprises cut 40.3 million jobs between 1995 and 2002, employment by firms in the “other” and private sector categories by 16.8 million. SSB and MOLSS. (2001). 《中国劳动统计年鉴》(China Labour Statistical Yearbook, 2001). 北京: 中国统计出版社, p. 23.
 China’s ground-breaking Company Law of 1994 codified a handful of alternatives to state ownership. Indeed, many state firms converted themselves to limited liability firms and joint stock corporations with boards of directors and shareholder governance institutions. For more on this, see D. Z. Ding and M. Warner. (2002). “‘Reinventing’ China’s industrial relations at enterprise level: an empirical field-study in four major cities.” Industrial Relations Journal 30: 243-260; also R. P. Weller and J.-S. Li (2000). “From state-owned enterprise to joint-venture: a case study of the crisis in urban social services.” China Journal 43: 83-99.
 Because board members of “corporatized” SOEs are occupied by party officials, who in turn are connected to peers in the state-owned banking sector through guanxi networks, lending from banks to SOEs can take place not because of the soundness of the business but because of political connections. It is impossible to tell just how common this phenomenon is.
 A firm’s budget constraint is said to be “soft” when the long-term viability of the firm becomes unrelated to the firm’s profitability or liquidity. Janos Kornai. (1992). The Socialist System: The Political Economy of Communism. Princeton University Press, pp. 140-5.
 Because SOEs enjoy an abundance of cheap—meaning low-interest rate—credit from state-owned banks, SOEs have lobbied hard against interest rate liberalization and capital market reform, both of which the People’s Bank of China is keen to undertake.by