China’s state-owned enterprises at a crossroads

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This article first appeared in Forum, The Edge Malaysia Weekly, on July 25 - 31, 2016.


China has lately been facing harsh criticism for the direction of its reforms of state-owned enterprises, particularly its strengthening of the role of Communist Party committees in SOE management. But while this may seem like a step backward for China’s market-oriented reforms, there are good reasons to boost oversight, at least for now.

With China undergoing a fundamental transformation into an innovation-driven, knowledge-based and services-led economy, its leaders must think carefully about how to reform the SOEs so that they can contribute to the new economy.

In the past, the role of the SOEs was clear. Over the last three decades, they underpinned China’s emergence as a global manufacturing powerhouse, by spearheading the country’s infrastructure-construction boom. In the process, they became dominant, especially in sectors prone to natural monopolies (such as telecommunications and power) and key strategic sectors (such as steel, coal and banking).

But the traditional single-sided markets where SOEs lead are now being disrupted by new technology firms such as Alibaba and Tencent, which straddle multisided markets of production, logistics and distribution by using unified platforms that benefit from economies of scale. By creating platforms for consumers and small-scale producers — what is essentially public infrastructure — these firms have directly challenged the SOE business model.

New digital platforms respond quickly and efficiently to public needs. These businesses are more collaborative or sharing than the traditional business of manufacturing, allowing consumers and smaller start-ups to shape products and services, from design to distribution. Given China’s population of 1.3 billion — a major competitive advantage in terms of innovation and purchasing power — these platforms can disrupt the incumbent one-sided market producers by offering superior scale, speed and convenience, including access to global markets.

Meanwhile, the SOEs’ obsolete business model — not to mention strong inertia — makes it difficult to identify and respond to new opportunities in providing public goods in a changing economy. China’s state-owned telecommunications companies and banks, for example, have failed to respond to new technological challenges.

Even traditional private companies such as Huawei and Midea have done much better, adjusting to shifting consumer demand and changing factor costs by retooling as quickly as possible, acquiring, for example, robot technology and product designs from the West.

Such responsiveness is particularly critical today, when the inexorable logic of technological progress is demanding a transformation of China’s growth model. With demand for consumer hardware and durables falling, China must begin to develop its own higher-tech products, while building a strong services sector. And with world exports of goods declining — both cyclically and as a result of the growth slowdown in the advanced economies — China must activate its domestic consumer base.

But the inability to update the roles and business models of SOEs is holding China back in this regard. SOEs may enjoy privileged access to bank credit, natural resources and land, but they also suffer from rigid governance and high staff turnover, spurred by President Xi Jinping’s anti-corruption campaign. When it comes to key personnel, the Communist Party establishment calls the shots. So, for SOEs to make changes, there must be consensus among internal and external officials in charge of business, industrial policy and politics.

In the late 1990s, public listings of SOEs had the twin benefits of securing new resources for tackling legacy losses and propelling governance and productivity gains. Today, however, privately owned technology platforms, many of which are listed abroad, have captured much of the valuation gains of the new economy. As a result, policymakers are struggling to find a way to finance the creative destruction of outdated SOEs burdened by debt, excess capacity and obsolete equipment.

It is this uncertainty that seems to have spurred the authorities to rethink their original, more aggressive reform plan. They recognise that when economic and financial systems comprise intricate networks of a variety of interlocking and interdependent elements, changes to one component — especially one as dominant as China’s state sector — can have far-reaching consequences. With the recent adjustments to the reform strategy, China’s leaders have bought themselves some time to figure out where the SOEs can fit into the new economy.

The answer probably lies in new public infrastructure challenges — the kind that the advanced economies are already facing — including issues related to information security and competition. If SOEs shift their business models to provide platform and regulatory services at low cost, taking advantage of economies of scale, they can help, for example, to manage the use of information by the large private platforms. Or they might help to guide the entry of foreign tech giants such as Facebook and Google into the Chinese market, to ensure that those companies do not become too dominant.

State-owned banks, for their part, might be able to provide multi-tiered financing for the millions of small and medium enterprises that are eager to shape and enrich the new economy. Finally, SOEs can enter into public-private partnerships with local businesses to handle the construction and management of transport and traffic systems, urban drainage, and bodies responsible for food safety, pollution control and public security.

The good news is that the Chinese government, at both the national and local levels, has plenty of assets with real value, amounting to more than 140% of gross domestic product. Those assets can help to smooth the transition to this new SOE business model, such as by plugging the holes in the social security system and addressing legacy liabilities, including those arising from past corruption, non-performing loans and inadequate provision of public goods and services.

China’s SOEs are at a crossroads. Given the high stakes of reform, the country’s leaders are right to take some time to assess their options. Whichever route they take is sure to be challenging. But those challenges pale in comparison to the problems that would arise from sticking to the old SOE model.  — Project Syndicate

Andrew Sheng is Distinguished Fellow of the Asia Global Institute at The University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng, director of the IFF Institute, is a professor at The University of Hong Kong and a fellow at its Asia Global Institute.