How reform has made China's state-owned enterprises stronger
Updated: Dec 17, 2020
State-owned Enterprises (SOEs) have played a key role in many developing economies with a dominant state influence, by fostering economic development and serving as a powerful tool for policy implementation.
In the past four decades, China has managed to transform from an agrarian state into the second largest economy in the world and a platform for the most cutting-edge innovations. This would not have been possible had its SOEs not survived through multiple stages of critical reforms in order to improve their governance.
Following the collapse of the Soviet Union, privatization has been viewed as the key “remedy” for the former members of the communist bloc. Eastern European transitional economies resorted to the so-called “shock therapy” in a rush to escape the past and converge with the prospering capitalist states. This shake-up was accompanied with severe crisis, social unrest and misappropriations, as the respective countries lacked inherent market institutions and a property rights framework for market processes.
China has chosen a more gradual approach of initially preparing the economy for the transition by building the necessary institutions and property rights infrastructure, as well as reforming SOEs into modern competitive corporations.
State-owned enterprises are an organic component of China’s political and economic governance, although their contribution to the national output has shrunk to 40%. They are still considered to be substantial building blocks of the economy and act as a buffer against internal shocks and external threats. The COVID-19 outbreak is precisely a case in point, as the pandemic has served as an internal shock and still threatens the economy due to cautious easing of lockdowns, as well as diminishing global demand. The Chinese Communist Party (CCP) recognizes that SOEs are not necessarily flexible and efficiently managed, and is therefore constantly pushing for institutional and firm-level reforms to manage stagnating growth and mounting debt, which was more than 300% of GDP in 2019.
The government is committed to maximizing the efficiency of state-owned assets by improving the governance of SOEs, redefining the state’s involvement in their management. The first step towards dealing with SOEs is to understand their different characteristics, depending on the hierarchy of ownership (central or local government) and degree of state ownership.
To consolidate the colossal number of state assets, the government decided to adopt a policy of “zhuada fangxiao” – grasp the big, release the small – which resulted in a wave of mergers into groups and privatization of small enterprises that were too costly to supervise. The ownership of companies previously owned by state agencies and operating in similar fields were transferred to holding companies wholly owned by the State-owned Assets Supervision and Administration Commission (SASAC). Currently there are 97 giant holdings directly owned by central government, which constitute the bulk of total assets owned by the state and are considered to be the most strategically significant enterprises.
The companies held by SASAC show evidence of superior governance in comparison to some of their privately-owned peers. Performance-based contractual relations were established with CEOs and directors of all centrally-owned enterprises with more detailed dividend targets. In order to improve accountability of the management and tame insiders, professional independent directors have been invited to join the boards.
Following improvement of operations, respective subsidiary companies would be listed, effectively introducing outside private supervision though partial privatization. Despite the common belief that SOEs tend to disrespect minority shareholders, SASAC empowers them and relies on private shareholders, so that it can reduce its own supervision efforts. The state then closely follows the reaction of private players through stock price dynamics, media publications and lawsuits, to keep itself informed of any misconduct.
Foreign institutional investors tend to be the most effective supervisors of partially-privatized SOEs. In contrast to local retail investors, they tend to have a more long-term agenda and are more interested in improving governance of their investments. Additionally, they usually have the capacity to uncover and raise concerns through different channels of communication to signal misconduct.
Foreign institutions that enter Chinese markets are usually equipped to operate in the environment of weak corporate governance and lack of legal minority shareholder protection. Their presence also improves transparency of the listed companies in addition to regulatory requirements, as listed SOEs are more prone to use external auditors.
What SOEs are typically associated with is actually representative of smaller enterprises owned by local governments. These enterprises lack supervision from the central government, leading to absent ownership and self-dealing activity. Generally, CEOs are deeply entrenched and engage in related party transactions for asset tunnelling, kickbacks and embezzlement. They tend to fully take advantage of the government’s lack of capacity to closely supervise remote enterprises. This activity makes private investors reluctant to invest in them, exacerbating the lack of supervision. There is virtually no division between the local governments and the enterprises, with local authorities treating SOEs as their own pocket, transferring assets back and forth as they deem appropriate.
The CCP has proven that SOEs can be improved and effectively managed within the state ownership framework, although it requires considerable effort and persistence. SASAC is currently working on advancing technological solutions in order to scale its capabilities and tighten supervision of the problematic locally-governed SOEs. Meanwhile, Xi Jinping’s fight against corruption and interest groups is still unfolding, focusing on higher level officials. This is another reason why centrally-controlled SOEs outperform their peers.
The state will continue to reform SOEs until they are equipped to compete in market conditions, with SASAC gradually easing its controlling mandate. China retains a grip on the big picture to mitigate major risks such as the current pandemic, as it is a developing economy at the stage of transformation and is still relatively fragile. The state is signalling that it is committed to making SOEs more efficient and intends to merely reserve the right for intervention in case of emergency. These measures have allowed China to swiftly impose lockdowns in high risk regions with less resistance from private sectors, allowing it to fight off the virus in the most effective way.
This same SOE lever has allowed the CCP to restart the economy with minimal lay-offs, as opposed to the situation in the liberal US, which is facing a dilemma amid record numbers of lay-offs not seen since the Great Depression.
The CCP has restated its pledge to empower private enterprises, particularly small and medium-sized enterprises (SMEs). Despite the fact that surging corporate debt is one of China’s major issues, state-owned banks have been instructed to support SMEs. The People’s Bank of China has further lowered the reserve ratio, earmarking RMB 800 billion (c. $115 billion) of “freed up” funds specifically for privately owned SMEs. Considering the need to give the economy a considerable push and central banks easing policy all over the world, the central bank has pledged to take a more decisive stance in boosting the economy.
Nonetheless, social implications and personal relations still prevail over property rights in China and therefore these should be the main areas for improvement, as well as promoting fair competition between public and private sectors. In order to sustain high growth, China will inevitably address these issues and aspire to provide a level playing field to improve productivity.
China has recently signed the first phase trade deal, where it has pledged to open the doors of its $21 trillion capital markets to foreign financial institutions. This means that financial giants like Goldman Sachs, Morgan Stanley, and JPMorgan Chase will be able to set up their wholly-owned subsidiaries and compete on an equal footing.
This move will certainly open the way for a drastic increase in the sophistication and discipline of the capital markets, as well as improvement of corporate governance. We are hoping to see further advances with regards to increasing market access, fostering competition and improving market institutions. Meanwhile, the West could also learn from China and consider adopting some of China’s policies in order to ensure better preparedness for “black swans” such as the prevailing pandemic combined with an unprecedented recession.