After nearly 40 years of strong economic growth, many of the factors that led to China's economic rise are no longer working their magic. The once-abundant labor force is aging and increasingly expensive, the forces of globalization are in retreat, credit-fueled investment has resulted in a pile-up of corporate debt and overcapacity is everywhere. The once strong faith in China's long-term prosperity held by entrepreneurs and corporate founders is eroding. The ongoing economic transition poses many challenges for those national champions, many of which are debt-laden and failing to deliver reasonable returns.
Accompanying China's rapid economic growth has been growth of another kind: the surge of corporate China. As of 2016, China accounted for more than 20% of the Fortune Global 500 companies as ranked by revenues. Strikingly different from their Western counterparts, most of these Chinese companies are state-owned enterprises concentrated in the commodities, energy, and financial sectors. While these giants contribute significantly to China's gross domestic product, many do not generate much value.
For example, Aluminum Corp. of China, or Chalco, reported in March 2015 a net loss for the previous year of 16.2 billion yuan ($2.4 billion). Also in 2015, Sinosteel missed payment on its debt. Overall, China's listed companies have reported average returns on invested capital of 3-4% over the past 15 years, compared with over 10% ROIC for U.S. companies over the past 100 years.
Companies form the micro-foundation of an economy. Only when the micro-foundation exhibits a strong capability of creating value can the aggregate economy grow in a healthy and sustainable way. Recall the growth identity which says that the growth rate equals the investment rate multiplied by ROIC. This means both the investment rate and ROIC can drive growth.
To successfully transition China's economy without losing much growth, the country must shift its primary growth driver from investment to ROIC. To raise ROIC at the aggregate economy level, the micro-units of the economy -- Chinese companies -- must put value creation far ahead of the aggressive pursuit of operational scale.
Evolution under reform
Since the reform and opening of its economy, China has followed an investment-led growth strategy, accompanied by strong demand for capital and other production factors. Many, however, are still monopolized by the state. Furthermore, strong demand, together with the persistence of state monopolies yielded big state-owned companies in resources and other sectors.
Big does not equate to brilliant. These SOEs have been plagued by moral hazard issues and soft budget restraints, resulting in inefficiency. Empirical data indicates that SOEs on average report an ROIC 4 to 6 percentage points lower than non-state Chinese companies.
The lack of an open and integrated domestic market is also to blame. Because of reform and market liberalization, China has become a global business hub. Yet the domestic market is segmented. Fierce competition among local officials who are judged on their areas' economic performance has led to regional protectionism. This significantly increases the cost of cross-regional transactions. Without a level playing field, market competition creates winners who are better at rent-seeking than creating value.
Poor corporate governance practices and the diversification myth also explain the lack of great Chinese companies. Due to ineffective corporate governance mechanisms, many Chinese companies are unable to resolve what scholars call "agency problems" such as the strong incentive for senior executives to build corporate empires through debt financing. The obsession with building such empires may be very effective in creating colossal entities, but does nothing to improve ROIC.
How can Chinese companies transform themselves into value creators? Facilitating the emergence of great companies in China is more a marathon than a sprint. It calls for a more pro-market institutional foundation, involving a redefinition of the economic role of the government, enhancing the efficiency of financial intermediation, and seeding a culture of innovation and entrepreneurship.
The visible hand of the government in economic affairs has been a crucial factor in China's economic success. State planning and government spending have built the infrastructure indispensable for industrialization and economic takeoff. State involvement even set the stage for innovation. For example, the rise of Chinese e-commerce has benefited tremendously from the telecommunication network, highway system and high-speed railways built by the state.
The state has committed large amounts of resources to drive innovation in many crucial areas, a feat impossible for private companies alone. However, in the next stage of economic development, capital efficiency and innovation will be much more important. All levels of government should adjust their roles and strive to transform themselves from participants in economic activities to rule-setters and public service providers.
On the second point, deregulating interest rates and allowing private capital to enter the financial services sector will be key to rejuvenating China's financial system. Only when capital can be allocated more efficiently can company-level ROIC be improved. As such, China needs "Finance 2.0," a new-generation financial system that can channel funds from savers to end-users through simple, direct, and effective channels.
The Chinese economy has benefited tremendously from unleashing individual creativity, as attested to by the reform experiences of the 1980s and 1990s. The most feasible source of future economic growth is the improvement of total factor productivity. To make this possible, China must create a fair, equitable, and transparent business atmosphere, seed a culture of innovation and inspire entrepreneurship.
Great minds create great companies. China's new breed of companies will arise from those who are brave enough to disrupt incumbents through technology and business model innovation, hold deep respect for the market and customers, and aim at creating long-term value rather than short-term gains. On this point, Huawei Technologies, Alibaba Group Holding, Tencent Holdings, Xiaomi, and SF Express are front-runners that may herald the coming of a breakthrough. Only with more companies like them can the Chinese economy accomplish its long overdue metamorphosis from quantity growth to quality growth.
Qiao Liuis professor of finance and deanof the Guanghua School of Management at Peking University. He isthe author of "Corporate China 2.0: The Great Shakeup" (Palgrave Macmillan, 2016).