ChinaTech #7 China's State-Owned Enterprises
... and the concept of social enterprise theory
This new segment by Shobhankita Reddy is your go-to newsletter for updates and perspectives on China’s tech ecosystem. This edition explores the role of State-Owned Enterprises in China’s economy
A lot has been said about the inefficiency in Chinese state-owned enterprises (SOE) - that political priorities dictate capital flows into less productive sectors with SOEs at the forefront is well-known.
The price-to-book (P/B) ratio of the CSI Central SOE Composite Index, a publicly listed SOE stock benchmark, also lags behind that of the POE (privately owned enterprises) Index. This is indicative of the lower premium offered to them by the market.
The reasons behind the inefficiency are easy to guess. Mismanagement, corruption, and lack of market incentives given that they benefit from heavy government support and subsidies, are all true.
But this may not provide a full picture.
Karen Jingring Lin and others, in their 2020 study of 40 years of Chinese SOEs, posit that there are reasons the SOEs are advantageous to the government.
First, government interventions in the market can benefit the economy by maximizing resource mobility to create capital-intensive industries. These industries are essential for the economy, but investing in them requires long gestation, imported equipment, and large lump-sum investments that cannot be achieved by the market alone.
Second, the government sees SOEs as the second-best way to maintain social stability, without which the economy cannot function properly.
They explain that the incentives of the economic agents running these corporations are not aligned with the state that owns these corporations. The outcomes the state aims to achieve here are multi-fold - reducing the unemployment rate and income polarization in the economy, maintaining social and political harmony, and not just value maximization.
They highlight a case study from the early 1980s when the economy was just beginning to open up. Prior to the reforms, labour mobility in terms of rural-urban migration was almost non-existent, and SOEs dominated the factors of production. This quickly changed.
As entry restrictions imposed on non-SOEs were also gradually relaxed, China’s SOEs started facing more competitive challenges due to the coexistence of different ownership types. While less regulated and less protected non-SOEs attracted young workers, China’s SOEs were forced to create job opportunities by producing surplus products that society did not want. Lin et al. (1998) show that SOEs were not only prohibited from dismissing excess workers but were also forced to employ more workers. As a result, 20% to 30% of the total labor supply in China’s SOEs was redundant (Bai et al., 2006). While private firms could hire temporary workers, SOEs did not enjoy the same flexibility, as they relied mainly on permanent workers assigned as part of the central planning system of the government. This led to alternating cycles of labor shortages and surpluses in firms (Nee, 1992).
While several rounds of reforms over the decades have attempted to improve operational efficiency of the SOEs, they argue that this isn’t a story of a turnaround.
.. statistics show that in 2017, the employment rate of SOEs accounted for about 34.37% of total employment in urban units, even with China’s total industrial output in the public sector reduced to 19.75%. According to statistical data, the average annual salary of SOEs and non-SOEs has increased substantially since 2000, but the dynamics of salary growth of SOEs are more vigorous. The average annual salary of employees of SOEs is 8.38% higher than that of non-SOEs.
Bearing people’s retirement benefits, absorbing excess labour, sponsoring public projects and helping jump-start local economies are all expectations of the local and central governments that affect the balance sheets of the SOEs. To this, throw in the mix of mismanagement or corruption.
The authors explain -
SOE managers often attribute their losses to the policy burdens imposed by the state, and the state cannot distinguish between the lack of effort or competence of SOE managers and the effect of policy burdens on firm performance. In turn, the state will bail out financially distressed SOEs through fiscal subsidies and tax cuts.
Thirdly, they state that this is ideological.
The government uses SOEs to maintain control over key elements of society, the “commanding heights” of state control advocated by Vladimir Lenin. Controlling a set of firms and outputs are consistent with the government’s interests.
Starting with the ‘China Puzzle’, they ask a fundamental question - what explains China’s high economic growth despite the lack of market-supporting institutions and the rule of law. They theorise that the role of SOEs in the Chinese economy is not to be underestimated.
Social enterprises refer to a prime example of hybrid organizations in Western countries; they were created to achieve social goals, yet through business methods (Brakman Reise, 2013). Therefore, they are different from for-profit and not-for-profit organizations, and can be defined as organizations that integrate both social logic and financial logic (Battilana and Dorado, 2010).
Chinese SOEs are companies fitting the social enterprise concept in that they are set to balance the demand of multiple stakeholders effectively (Bruton et al., 2015). More important, China’s institution provides a better supporting ecosystem for SOEs to reinforce the creation of social value when pursuing value maximization. SOEs could sacrifice profits and efficiency to fulfil social roles when necessary. Such a characteristic enables the Chinese government to focus on developing social welfare with supporting economic infrastructure, and thus makes the “China puzzle” feasible.
But how would one define a SOE?
Franklin Allen and others have a nuanced take.
They explain that most measures of Chinese SOE and POE numbers are wrong and that the numbers officially reported by the Annual Industry Survey (AIS) (published by China’s National Bureau of Statistics) do not necessarily reflect the realities of the company structures on the ground.
Firstly, while the number of firms that are 100% state-owned has declined, the number of companies with some level of state ownership has increased sharply.
… while central and local governments are investing in a larger number of firms, the average holding in firms is declining.
... the evidence suggests that while keeping its stake in firms, governments are moving more toward indirect control of firms with state equity.
Secondly,
The researchers find that state ownership tends to boost firm growth and productivity and has mixed effects on profitability.
Firms closer to central and provincial governments in the ownership hierarchy tend to have higher growth rates in assets, while firms more remotely owned by governments tend to have higher profitability and efficiency. Compared to private firms, firms with state ownership tend to have lower borrowing costs on average. Firms with mixed ownership also enjoy similar favorable borrowing terms from state-owned banks as 100% state-owned enterprises.
Most importantly, by studying different ownership stakes of local, provincial and central governments in companies, they argue that the increased and high number of mixed ownership firms indicates that the state plays a much more significant role in the economy, much larger than through its role via the SOEs that it owns 100%.
This paints a more complex picture for the role of state control in the Chinese economy, one that is different from neat divisions between private and government-owned enterprises. It points instead to the government tentacles spreading farther and wider, even if more loosely, and reaching out to more market units.