State-owned enterprises are often blamed for China's economic problems. But amid President Xi Jinping's affirmation of the importance of SOEs, "supply-side" reforms over the past two years have resulted in an improvement in their performance on most metrics.
Unfortunately, these gains have come largely at the expense of private companies, many of which have suffered declining margins, smaller profits or rising losses.
Government stimulus, measures to restrain shadow banking and local politics are disadvantaging private companies, much to the detriment of China's growth potential. If Chinese policymakers hope to rebalance the economy and tap new growth drivers, reforms that improve the efficiency of state companies while at the same creating a level playing field for private companies will be needed.
Private companies in China are generally more efficient, more profitable and less indebted than their state-owned counterparts. As China looks to compete in advanced industries and allow the "new economy" to drive growth, innovative private enterprises should theoretically emerge as frontrunners.
However, since the middle of 2017, private-sector companies have weakened on most metrics despite a buoyant economy and a global environment that should have produced the opposite effect. Why then, as the economy posted surprisingly strong growth figures, are private enterprises struggling more than they have at any point since the 2008 global financial crisis?
This year, China has had at least 20 corporate defaults, 50% more than at this point last year. This is not surprising considering recent policies that have aimed to reduce financial leverage and shadow lending. As a result, overall credit growth has slowed markedly, bond yields and interest rates are higher, and informal flows of credit have all but collapsed.
The private sector has been disproportionately hit: all but one of this year's defaults have involved a private company. This can be traced to three factors that work against private companies.
First, the weakened business environment has driven down profit growth and increased losses. Second, reforms aimed at reducing shadow credit have sucked away an important source of growth finance for private companies. And last, private companies are not afforded the support that local governments tend to offer to SOEs that fall into trouble, such as bail outs or cheap credit squeezed out of local banks.
The stark difference between the performance of state-owned and private companies can be gleaned from recently released data. State-owned companies have continued to see rapid profit growth this year, with earnings rising 18% year-to-date, while profits at private companies contracted 22% over the same period. Profit growth at private companies have been deeply negative, in year-on-year terms, for the past seven months.
Diverging profit margins are one of the reasons behind the difference in performance. In January 2017, SOE profit margins surpassed those of private companies and they have continued to climb higher while margins at private companies have been falling since late last year, hitting an all-time low.
Other signals are also pointing to rising stress among private companies. The number of private companies classified by the government as "loss-making" rose sharply from mid-2017 to last March, to 32,000 from approximately 23,000. Meanwhile, the number of loss-making state-owned companies has continued to fall.
Asset-liability ratios, a measure of how much debt a company uses to fund its business, have also climbed sharply among private companies, showing their greater reliance on borrowing, while the ratio has fallen for SOEs.
Signs of improving profitability and efficiency at state-owned companies would normally be taken as positive, but should not be if the gains come at the expense of private companies.
The broader question is why private companies are doing so much worse than public companies, especially in an environment of strong export growth and healthy domestic demand? More broadly, what does this development mean for China's economy?
Government policies are largely to blame. Supply-side constraints, in addition to monetary and fiscal stimuli, have benefitted industries that generally feature a large concentration of SOEs.
Efforts to reduce production of coal and other commodities have raised prices for these raw materials, to the benefit of producers, which are mostly SOEs, and to the detriment of buyers, which are more often private companies. Mining and metal processing together accounted for more than 70% of Chinese industrial profit growth last year.
Financial-sector reforms, however well-meaning, have also been a factor. As new regulations continue to reduce the flow of shadow credit and reconcentrate lending on banks' balance sheets, they are having the unintended effect of squeezing credit for private companies.
The banking sector is still dominated by state-owned banks, many of which prefer to lend to state companies. Although cracking down on shadow banking may be the right policy to reduce financial-sector risk, an unintended consequence is that the banking industry is now increasingly reliant on state clients.
Government intervention aside, weak domestic demand is another factor contributing to the poor performance of private companies. The rise in the number of loss-making private companies and the reduction in private profits could signal that domestic demand is far weaker than official data lets on.
The existence of such private-sector stress exposes structural flaws in China's financial system, but also highlights risks to the country's growth prospects. Moreover, the weakness among private companies exposes the fallacy of "rebalancing." Growth in China is still very much driven by "old China" -- heavy industry, mining, investment and construction.
Highlighting this trend, the share of gross domestic product generated by industry rose in 2017 as did the investment share of GDP. The best measure of how China transforms to a more sustainable growth path is whether corporates compete on a level playing and how the market distributes resources.
Recent corporate performance highlights the difficult environment facing private companies, likely to the detriment of China's growth potential. As private-sector profits weaken, it is likely that investment will soon head the same way, thus weakening a key feature of China's recent rebound.
These trends are also impacting how foreign multinationals perform and invest in China. Although less affected by domestic credit conditions and supply-side constraints, foreign companies are committing less investment into China because they see a business climate preferential to state-owned companies.
Foreign enterprises contributed to China's rapid growth over the past two decades through direct investment and also through improvements to efficiency and productivity. Policies aimed at making SOEs bigger, stronger and better could push foreign companies to invest elsewhere.
Improving the efficiency of state-owned companies is a laudable goal, but not if it is done at the expense of private companies. To reverse this trend and create a level playing field, policymakers must follow through on market reforms: removing support for non-performing SOEs, allowing the market -- rather than "supply-side" production quotas -- to eliminate excess supply, and improving the allocation of credit to private companies by allowing for asset growth among private banks.
Since the reform era of Deng Xiaoping, private companies have been the primary drivers of employment, productivity and overall growth in China. If private companies are unable to compete against state champions, China's long-term growth potential will suffer.
Alexander Wolf is senior emerging markets economist at Aberdeen Standard Investments in Hong Kong.