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Nov 7, 2018 | 09:00 GMT

9 mins read

State-Owned Enterprises Are a Hard Habit China Doesn't Want to Break

People walk into a subway station in Beijing on Oct. 19, 2018.
(GREG BAKER/AFP/Getty Images)
Highlights
  • Beijing's apparent favoritism for the state sector has contributed to the strain on the country's private sector, which is already suffering from a slowing economy.
  • U.S. pressure on China to trim its support for state-owned enterprises (SOEs), along with Beijing's need to keep private businesses afloat, is pushing the government to deepen its SOE reforms.
  • Beijing may gradually open some selected industries – finance, high-tech and telecom – to private and foreign capital, but it won't bend to outside pressure over easing support for key industries.

China is again looking toward its state-owned enterprises (SOE) to help it navigate its economic course. In the decade since the 2008 global financial crisis, Beijing has increasingly relied on these businesses to drive its economy. As it faced sweeping unemployment and scrambled to prop up growth after that meltdown, it saw no better option than to pump up its state-owned giants with infrastructure, transportation and real estate projects. The stimulus ended in the early 2010s, but Beijing has continued to turn to SOEs to lead the country's economic transition, raising fears of favoritism among its privately owned businesses.

Beijing has sought to strengthen the SOEs with moves to consolidate industries, reduce output capacity and shrink the amount of debt in the economy. But in doing so, it has strengthened government control over many private businesses and created additional uncertainty and anxiety in both the private sector and in society at large. The increasing SOE dominance over several domestic industries and their rapid expansion overseas has put them in the crosshairs of the Western world, particularly the United States. Despite those issues, if China should be hit by another economic downturn, the government could once again turn to these giants to keep the economy rolling.

The Big Picture

Reforming China's state-owned enterprises (SOEs) has been on Beijing's to-do list for decades, but the government’s key objective has been to strengthen, not weaken, them. Today, the country’s SOEs, which account for more than a third of public investment, dominate heavy and strategic industries underpinning China’s development path. Still, increased pressure from the United States and the economic strain on the private Chinese companies may compel Beijing to further reform the SOEs and open access wider to markets.

A Bit Smaller, But Still Powerful

While China's SOEs remain strong, decades of market reform have dramatically reduced their role in China's economy. Their share of the gross domestic product fell from more than 50 percent to 25 percent in just 15 years; and they account for only 5 percent of industrial enterprises today, compared with 18 percent in 2003. Nonetheless, the significance of the state sector has strengthened.

Despite their receding role in almost every industry they once dominated — raw materials, transportation and construction — 80 to 90 percent of SOEs are now concentrated in vital or high-profit industries such as finance, power, energy, telecommunications and defense manufacturing. And these enterprises — particularly the roughly 100 centrally administered SOEs — have grown much bigger. By 2017, the assets of these enterprises alone had reached 72 trillion yuan ($10.4 trillion), up more than tenfold from 2003 and almost equivalent to China's total GDP for that year. Thanks to easy loans and unfettered access to government funding and assistance, these giants have been able to amass assets in areas where their private and foreign partners were either restricted or found it harder to compete. Since 2013, SOEs have received more than 60 percent of all new loans in China each year, peaking at 78 percent in 2016.

In many ways, the expansion and growing strength of the SOEs are what Beijing sought with its reform strategy. Despite its push to eliminate ineffective enterprises and to introduce market competition in most areas, its objective wasn't to weaken the state sector. Instead, it sought to consolidate the businesses through painful and risky restructuring in order to keep them focused and strong. That objective has been particularly obvious over the past five years as the central government repeatedly stressed "stronger, better and bigger" SOEs in pushing its reform agenda. In part, it called for further reductions of centrally administered SOEs, forced thousands of local "zombie" companies into bankruptcy, and aggressively sought mergers among large SOEs to reinforce their domination. Its sweeping capacity cuts in the industries that process raw materials, such as the coal and steel sectors, helped stabilize prices and led to double-digit profits for those debt-laden giants over the past decade.

Strains on the Private Sector

At the same time, the country's private sector has been showing signs of increasing strain. Private enterprises often lack the capacity to weather the storms of reform, and they are also hit hardest by the dual threats of a slowing economy and an extended trade war. In comparison with the state-owned giants, many private companies — particularly those low-end manufacturers and service providers that operate on thin margins — lack the resources to withstand a slowdown. They also have less access to financing and don't have the advantage of preferential policies that their state sector and foreign competitors enjoy. Therefore, a large number of private companies rely on investments in property and fixed assets to support their businesses, or they seek shadow loans that have higher financing costs. After property values flattened and investment returns peaked during 2014-15, these companies have struggled with loan costs, and Beijing's push to reduce debt in the economy worsened the problem. To make matters worse, more than 90 percent of the businesses hurt by Beijing's push to cut industrial capacity and add pollution controls are private coal, steel and chemical companies. They are being forced to close or to submit to acquisition by the state giants. Indeed, as state-owned industries overall reported record profit growth of 30 to 40 percent in the past two years, profit growth in private industries slowed to roughly 10 percent — among the lowest levels in a decade.

This part of the sharp divergence between the state and private sectors has more to do with the unintended consequences of policy goals and the ongoing economic slowdown and transition than any intentional aims. Forcing the Chinese economy higher up the value chain of production — a key objective for Beijing — has led to suffering among smaller or weaker businesses, including some local SOEs. With the private sector contributing 60 percent of GDP, 70 percent of technological innovation and 80 percent of employment, the central authorities in Beijing can no longer afford to be perceived as favoring the state sector over the private. This apparent favoritism is reinforced by its policy priorities toward state-led initiatives such as the Made in China 2025 program and its overseas infrastructure development. In addition, the government has combined a financial crackdown with a push for political conformity to ensure that large private businesses toe the state and Communist Party line.

Stumbling Reform and a Backlash

This state-private conflict has led to intense debates within China, prompting the central authorities to try to clarify the country's economic course. In recent weeks, several top leaders have delivered messages trying to appease private business. This push culminated in President Xi Jinping's speech on Nov. 1; he reiterated the Party's continued support and called for better policy execution to help finance and protect private businesses as well as ease their burdens. Many of these speeches simply reflected Beijing's long-standing policy positions. The actual improvements for private business continue to hinge on substantial reform of the financial system, the tax structure and more. And work on those policies has either slowed or stalled since last year. More importantly, the call to revitalize private business is pushing the central authorities to further loosen the regulations controlling SOEs, but that reform process has been stumbling.

A chart shows how debt is spread throughout the Chinese economy.

To make SOEs more competitive, the government has been pushing for public-private ownership in the power, energy and railway sectors. But that proposal met resistance from state interests that wanted to maintain controlling shares and reluctance from private and foreign investors. Reform has also been hindered by the government’s strong preference for SOEs as leaders of key development initiatives. It has repeatedly turned to the politically loyal and capital-rich state-owned giants over other choices for a host of massive industrial, technological and infrastructure initiatives at home and abroad. According to official estimates, centrally administered SOEs alone accounted for over 70 percent of the total value of infrastructure projects in the Belt and Road Initiative.

In the meantime, SOEs have continued to aggressively campaign for railway, road and port projects overseas, as well as to acquire high-tech and strategic assets. This drive has fed suspicions and led to accusations about their unfair competitive advantage from foreign businesses and governments, and it has reinforced criticism of the country's restrictive market access. This advantage included subsidies and support for industries in the Made in China 2025 program and has taken center stage in the ongoing China-U.S. trade war and economic competition. Washington also sought to strengthen trade rules — from its initial draft of the Trans-Pacific Partnership (TPP) treaty (before it withdrew from the pact) to its current push for World Trade Organization reforms — in part to isolate China's state-led system.

Chinese-Style Competitive Neutrality

The combined internal and external pressure on China's SOEs will likely push Beijing to extend reforms that offer greater market access and boost competitiveness. Indeed, policy debates in recent months have intensified, and officials are increasingly speaking of "competitive neutrality" when hinting at the next stage of reforms. The term is used by the Organization for Economic Cooperation and Development and was included in the TPP deal to broadly refer to a level playing field. Of course, it may be unrealistic to expect Western-style competitive neutrality within a Chinese social-capitalist system. The country lacks even basic neutrality in finance, subsidies, debt responsibility and supervision. But altering one of those areas comes at the expense of the others and of Beijing's objective to keep the state sector strong.

While Beijing aims to assure both domestic and foreign private businesses of its commitment to reform, any changes will likely be used to defend the practices of its overseas SOEs from foreign governments. Still, Beijing may be compelled to gradually create more access for foreign and private capital in selected industries, such as finance, high-tech, telecom and energy, and to widen SOE ownership to lessen the influence of state capital. But it is unlikely to reduce state support in key sectors, such as semiconductors and aviation, where China is racing to gain greater independence. Furthermore, as the economy slows and the trade war continues, Beijing may again find its resolve tested, and it may once again be forced to turn to the SOEs to help salvage the economy — as it did during the financial crisis a decade ago.

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