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China kicks the can on SOE reform

The media often focus on events of pomp and pageantry at the expense of other important news. Such is the case with the just concluded state visit by Chinese President Xi Jinping to Washington. The blanket coverage of the U.S.-China summit had the unfortunate effect of overshadowing another significant development: the rollout of a blueprint by the Chinese Communist Party to reform state-owned enterprises.  

     Of all the reform goals announced by Xi's government, the most critical is the overhaul of SOEs. Employing 63 million people, the 180,000 SOEs account for roughly 40% of China's gross domestic product, based on an estimate by investment bank Goldman Sachs. According to China's Ministry of Finance, the net asset value (assets minus liabilities) of SOEs at the end of 2014 amounted to a staggering 35.5 trillion yuan ($5.57 trillion), equivalent to nearly 60% of GDP. 

     However, the SOE sector is notoriously inefficient. Macquarie Group, an Australian investment bank, estimated that Chinese state-run enterprises (excluding banks) recorded no profit growth in the last five years while private companies gained double-digit increases in profitability. A detailed study by Nicholas Lardy, a leading China economist at the Peterson Institute for International Economics in Washington, reached a similar conclusion.

Looking to the future

Obviously, the future of the Chinese economy is inseparably connected with the combined performance of the SOEs. If they remain inefficient and dependent on preferential government treatment, including through the provision of cheap capital, protection and monopoly rights, they will drag down China's overall economic growth.

     Beijing understands the critical importance of reforming SOEs. But such restructuring directly threatens the Communist Party's hold on power. In defending its political monopoly, the party needs to directly wield significant economic power to fulfill two objectives. One is to allocate resources to politically important priorities, such as prestige projects and industrial policy. The other is to reward its supporters with plum jobs. That is why Chinese official media unabashedly claims that state-run companies constitute the economic foundations for the rule of the party, and accuse those calling for privatization of attempting to destroy it.

     Navigating between national economic priorities and the ruling party's survival is an impossible task. This dilemma can be seen in the latest document by the party's Central Committee and the Chinese State Council on plans to reform state-run enterprises.

     The fairest overall characterization of this document is that it lays out the party's bottom-line positions and identifies key objectives in broad terms. But lacking specifics, no meaningful reforms are likely to occur in the short term mainly because the document is no more than a work in progress.

     The document's most important value lies in the principles and guidelines it spells out. A close reading of them, however, indicates the results are unlikely to differ from past and largely unsuccessful attempts to improve performance at state-run companies.

Flawed reform plans

The blueprint falls short in three key areas: governance, ownership and exit strategy.

     As expected, the document promises largely cosmetic changes in the governance structure of state-run companies. While declaring that the role of directors will be strengthened and that the majority of any SOE board must be independent directors, the document does not provide any guidance on how these independent directors will be selected.

     In the Chinese context, appointing an executive at a state-run company to serve as an independent director on the board of another SOE is probably not going to make much difference. Another question is, who will appoint these independent directors? As long as the state retains majority ownership or a controlling share of a company, the state, not outside shareholders, will determine these appointments, which of course will be made to suit management interests.

     The emphasis in the document on enhancing the role of the party in state-owned enterprises, especially in personnel appointments, raises further doubts about the efficacy of governance reforms. Since SOE executives are, without exception, appointed by the Communist Party, they will confront constant conflicts of interests in exercising their fiduciary duty. When faced with decisions that may hurt party interests, such as its economic priorities and control of personnel, a chief executive who owes his job to the party is unlikely to bite the hand that feeds him.

Deepening the confusion

Even more disappointing is the document's provisions on ownership reform. Confusing to the extent of being incomprehensible, these provisions ostensibly aim to introduce private capital into state-owned enterprises as a means of revitalizing their efficiency. But the injection of private capital will be restricted to preserve the state's majority ownership. This proposed reform probably offers a cure even worse than the disease. It is hard to imagine that any sane private investor would be willing to be a minority shareholder in a stodgy SOE when there are better returns elsewhere.

     Another potential pitfall is that mixed ownership is likely to create another legalized avenue for the elites to accumulate -- or essentially steal -- SOE assets. Well-connected businesspeople or family members of officials can invest a small amount of money for a disproportionately large share of the ownership of a state-owned enterprise, a frequent and well-reported practice in the past. In all likelihood, should the mixed ownership reform go forward, genuine private entrepreneurs will either be deterred or excluded, while cronies will be able to cheaply acquire valuable assets. This is hardly a recipe for making state-owned companies more efficient.

     Finally, Beijing seems determined to maintain nearly all SOEs in business. It divides them into three categories: commercial, national security and public utility. It will be tricky to apply this imprecise categorization in practice (for example, where does the state-owned mobile communications giant China Mobile belong? Arguably, in all three categories).

     More importantly, the Chinese government is reluctant to allow them to go out of business. In only one context does the document indicate that, for "commercial" enterprises, "the strong should win and the weak should be allowed to die in orderly entry and exit." Unfortunately, there is no further elaboration on this point. This is understandable because, in reality, putting SOEs out of business is like trying to slay zombies -- they simply refuse to die.

     One can only hope that this cautious document is a fig leaf for more radical reform. We do not need to wait long to find out. In the afterglow of his U.S. visit, Xi will have to show that he actually means more than what he says.

Minxin Pei, a professor of government at Claremont McKenna College, is the author of "China's Trapped Transition" (HUP 2006).

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