China: The complexities of the state-industrial complex

About one year has passed since the third plenum of the 18th Central Committee of the Communist Party, and we are only beginning to get a clearer picture on renewed reforms for stated-owned enterprises (SOEs). Some of these companies have pushed ahead with changes, but their impact on the long-term growth prospect of the economy remains unclear.

Compared with reforms to the fiscal system and the financial markets, SOE reform stands out as unique because every SOE has a different set of circumstances. That is why the central government has drawn out basic guidelines and detailed rules are fleshed out on an ad hoc basis by the local governments and enterprises.

This raises a big problem – those who are responsible for implementing the reform are in a position to benefit from it best. So it is not hard to imagine that they would seek out measures favoring themselves and reject policies which do not.

There are several points worth noting about the third plenum’s conclusion on SOE reform. First it says that SOEs should be divided into several groups: those providing services for public welfare, those charged with specific policy goals and those in competitive fields. It is unnecessary for state capital to hold a controlling stake in SOEs situated in competitive fields.

The meeting also concluded that the majority of SOEs can be reformed to have mixed share ownership and that SOEs should explore a proper incentive mechanism for management.

Judging by recently published SOE reform implementation policies and the discussion among officialdom and academia, most plans have been designed along the lines of reducing the share of state ownership in SOEs and attracting domestic and foreign strategic investors. But they all have a bottom line, which is to ensure that the state remains the controlling shareholder.

As for the incentive mechanism, the plans have proposed dividing SOE executives into two types: one that someday might enter public administration versus individuals that will remain as a corporate manager. Those who expected to go into the public sector will receive salaries similar to those of government officials at the same level.

However, neither SOEs controlled by the central government nor local governments are willing to lose the state’s controlling share ownership in SOEs in competitive fields. In conversations with government officials and some think tank researchers in a big coastal city, many are opposed to the idea of jettisoning state majority ownership in competitive SOEs. They have argued, for example, that state ownership in large food producers must be maintained to protect food safety. Strange, because in many countries, especially developed ones, food safety is guaranteed by a good monitoring and regulation system rather than the producers themselves.

The same flaw in logic can be found with the argument that a property developer controlled by state capital is the only way to ensure that urban infrastructure can meet regulatory standards. SOE reform can never achieve breakthrough development if we continue down on this path of relying on those being targeted to carry out the reform measures.

Measures like reducing the share of state capital, diversifying SOE share ownership and setting up a proper management incentive mechanism would certainly improve the effectiveness of SOEs, but systemic reforms will require more.

A large number of SOEs, which are in competitive industries, such as trade, consumption and real estate, must be converted into private enterprises, or at least companies with a genuine mixed-share ownership structure.

Another obstacle of SOE reform has to do with the government’s improper role and functions. Currently, governments at all levels are pressured to solve all problems in a short period of time, so they are tempted to rely on simply dictating measures to companies rather than the making of laws and regulations to solve problems.

Considering the two examples mentioned earlier, many governments in foreign countries uphold food safety by making laws and regulations and implementing them well. Many Chinese government authorities, however, prefer to have companies directly under their control so they can address issues by giving a call to the company’s executive. No doubt they would want to control more enterprises. But this is extremely inefficient.

In recent decades, China has had many reforms that helped lay the foundation for further economic development. Many more, however, have stagnated and faltered, including reforms for SOEs. That is why it may still be too early to celebrate this current round of SOE reforms.

*The author is the head of the China Research Department of Credit Suisse Securities