Whither China’s “State Capitalism”?
SOEs control large chunks of China's domestic markets. (Photo: Nikkei Asian Review)
By Yongnian Zheng and Yanjie Huang

Whither China’s “State Capitalism”?

Sep. 02, 2019  |     |  0 comments

“Structural reforms” has become a buzzword in recent decades whenever there is a crisis. Amid the Sino-American trade war, it is frequently mentioned as one of the key demands. While we need to wait until a new trade agreement is unveiled, for the precise definition of this vague term, a market-oriented reform of China’s state-owned enterprises or the SOEs, must be one of the key items in the list of “structural reforms” demanded by US President Donald Trump and his team of negotiators. But whether such structural reform included a section on the SOEs will come out in black and white is anyone’s guess. One thing that we know for sure is that Chinese negotiators will not easily make concessions on state-owned enterprises, especially the large business groups directly administered by Beijing, known as the centrally-managed SOEs.

Routinely listed on the top of Fortune 500, China’s centrally-managed SOEs control large chunks of China’s domestic markets and contribute a significant share of the central government revenue, while their CEOs sit on the People’s Congress and the Party’s Central Committee. Politically well-connected and financially well-endowed, they are easily imagined by outsiders as threat to a market-based economic order. China has thus been conceptualized as “state capitalism” in the West. Politicians and decision makers in the West often tend to exaggerate the role of China’s state sector and regard it as a threat to the functioning of the world market.

It is not difficult for one to find that such a conceptualization is too simple, and does not tell the reality of China’s economy. The non-state sector has grown very fast since the late Deng Xiaoping’s reform and open-door policy, and it now generates more than half of China’s total GDP, and about 70 percent of the total urban employment. China is now truly a mixed economy. Nevertheless, the state sector continues to be strategically important to the country’s political economy system. It is unimaginable that the state will give up its economic arms. There is bound to be an impasse if America insisted on a fundamental transformation of the SOEs. In the worst-case scenario, Beijing will interpret the threat as a signal of an “economic” war, as the structural difference in the two political economy systems would have become irreconcilable.

Such a difference has persisted for a long time ever since the Chinese economic reform started. Outsiders were probably neither the first nor the most dedicated critics of the SOEs. For decades, a fierce debate has been going on China’s SOEs among academic and policy circles. The question in debate is not whether China should have a SOE sector and whether the SOEs should be reformed or not, but how they may be reformed. Ever since the 1980s, Chinese government has articulated the importance of SOEs reforms. China’s top official think tank, the Development Research Center of the State Council, in conjunction with the World Bank, argued for the phase-out of the majority of SOEs in favor of market mechanisms in their blueprint for a fundamental reform of the SOEs in 2013.

This official position represents a midpoint between the market and the statist views, which both have empirical supports. The market school, whether it is radical or gradualist wing, always supports the eventual if not immediate elimination of the inefficient, market-distorting SOEs. In contrast, the statist school champions a slimmer but stronger state sector as the engine for economic growth and the bulwark against economic crisis. The mixed results of China’s SOEs reforms have followed elements of both positions. From the economic reforms of the mid-1990s, the share of the SOEs in GDP and employment have steadily declined. The global crisis of 2008 indeed helped the largest SOEs to accumulate assets from China’s credit-driven stimuli program and contributed to a structural imbalance. But even such a windfall of financial fortune did not change the trend. The share of the SOEs in employment declined from 2008 to 2018.

China’s state-sector is indeed in need of market-oriented reform, but the reform has to be well-proportioned. For one thing, they are part and parcel of Chinese state-dominated political economy, in accordance with a long political and intellectual tradition that stretched back to China’s first empires. As such, they followed a logic of institution evolution foreign to the wisdoms of Eurocentric theories of political economy. For another, they hardly constituted a fundamental challenge to global economic order. Their oft-quoted global prowess derives from a false analogy between the biggest multinational firms and China’s centrally-managed SOEs. Far from the fangs and claws of the Chinese leviathan, they were too much embedded in a state-dominated domestic order to be reckoned as effective multinational enterprises. In fact, they are often a source of nuisance rather than power for Beijing when they accumulated inordinate power. Instead of the flashpoint of an economic Cold War, China’s state sector can become a site of meaningful reforms if Washington and Beijing come to a better understanding of its past and future.

The Logics of State-owned Enterprises

To understand the nature of the state sector in China, we need to begin with the historical roles of market and the state in China. Ever since China’s first imperial dynasties of Qin (220-209 BC) and Han (206-220 AD), vibrant market networks have existed alongside the imperial state, whether under unified dynasties or during periods of disunity. During two millennia of imperial rule, the relative roles of state and markets were defined by two broadly-defined schools of economic thoughts, the Legalists and the Confucians. Similar to the Enlightenment debate between the Mercantilists and the Physiocrats, the Legalist-Confucian debate centered on the structure of the national economy. Should the state subject market forces to its political and fiscal purposes? Or should it follow the reasons and rhythms of the markets?

For centuries, the Legalists and Confucians contended for power and influence, with the former gaining power in crisis and the latter reigning as orthodoxy during relative peace. The economic roles of the imperial state waxed and waned, but the ideology of state control over market endured. The market networks gradually grew from local village fairs to nationwide merchant networks, but they never amounted to a bedrock of the national economy or constituted a theoretic revolution in economics. The Chinese concept of the economy or Jingji remained a Confucian statecraft in which markets only existed as instruments. Except for several periods of radical statism, including the most recent socialist experiments of Mao Zedong and his colleagues, Chinese economy has evolved around a balance of top-down state power and bottom-up market forces. The state could never eliminate market, nor market actors take full control over the economy. We conceptualize this form of political economy as “market in state”, in which the market remains instrumental in a state-centered system, rather than constituting an overarching institutional framework of the political economy.

This balance between state and market is key to understanding the Chinese economy as a three-layered structure. At the very bottom were grassroots market economies, operating on the levels of households, neighborhoods, and local communities. Except for a minimum level of infrastructure and tax levy, the traditional state usually adopted a laissez faire attitude without penetrating into this layer of the economic life in ordinary times. At the middle level, the local state agents, the bureaucrats and businessmen formed a nexus of power between the markets and states at various geographical and administrative levels. Traditionally, these included the local gentry and Confucianized merchants, who shared with bureaucrats local power and responsibilities. China’s vast army of private entrepreneurs nowadays, whose businesses grew above a certain designated size, enters into such a system of co-optation, if not personal networks of local leaders.

On the top of the pyramid were the strategic actors of the national economy, which were affiliated with or managed by the state, such as the centrally-managed state-owned enterprises. Traditionally, their preambles were the imperial factories and the various economic agencies administered by the Imperial Household Agency of the Qing Court. A tiny fraction of the late imperial China, these agencies nevertheless controlled the creams of the technical expertise of the empire and supplied the daily needs of the imperial elites. The imperial merchants of the Canton System, who traded directly with British East Indies Company, also fell into this category. Despite their similar roles as agents of the monarch in China and Europe, China’s imperial enterprises and the European colonial companies had little in common.

From imperial textiles factories to giant state-owned enterprises, the explosive developments of China’s state sector in the 20th century followed the heels of China’s geopolitical developments. When the late Qing dynasty launched the first arsenals, railways, and other modern factories in the late 19th century, they initially followed the bureaucrat-merchant partnership of the traditional model. In early 20th century, the Republican state, both under ideology and the imperative of war with Japan, resorted to state-ownership as a means for national salvation. Meanwhile, the war destroyed much of China’s nascent modern private enterprises. When the Pacific War was over, most modern industrial and financial enterprises fell into state control. They were in turn taken over by the Communists who reunited mainland China in 1949.

The Maoist economy initially exploited an enhanced model of concentrated power to its extreme by following a Soviet model. But Mao’s conflict with the Soviet leaders soon derailed the model. On the one hand, the larger state-owned enterprises collaborated closely with the military and made numerous breakthroughs in the heavy industry, often relying on Western and Japanese technology in the 1970s and 1980s. On the one hand, anticipating a total war with Soviet Union, Mao created smaller units of state-run enterprises with a focus on local self-sufficiency. During much of its history, the state sector were products of these extraordinary circumstances. As instruments of the states, they were developed to support ever-expanding military preparations against China’s powerful rivalries, such as the British Empire, the Japanese Empire, and the Soviet Union, from the mid 19th to the late 20th century. With the collapse of the Soviet empire, the state sector entered a period of prolonged relative decline and never recovered its status of unquestioned dominance in the late 1970s.

Ironically, when the trade talk spotlighted China’s state sector as emblematic of unfair subsidy and trade practices, China’s economy is undergoing a structural reform in favor of the non-state, market actors.

China’s economic reforms in the last four decades unfolded under unprecedented geopolitical stability under Pax Americana. Survival was no longer in question and efficiency became a paramount concern for the Chinese political economy. For the first 15 years, China’s SOEs reforms followed gradualist approaches, when the Party continued to hope that they could compete with nascent private and collective firms with managerial reforms. In a mere one decade between 1994 and 2004, the state sector underwent breathtaking reforms under China’s former premier Zhu Rongji, when the overwhelming majority of China’s small and medium SOEs were sold to non-state owners under the strategy of “let go the small, keep the big”. Those that still remained were concentrated in the monopolistic and oligopolistic positions in strategic industrial sectors like power, petrol, telecommunication, banking and finance. The outcome was a distinctive segmentation of the markets between the upstream industries controlled by state capital and the downstream industries controlled by non-state entities. By the late 2000s, China’s largest state enterprises were consolidated into around 150 large business groups and put under the aegis of the State Assets Supervision and Administration Commission or the SASAC.

Throughout Chinese history, China’s state sector has been a cornerstone of domestic economic order and a counterweight to changing geopolitics. It was reactive rather than active, defensive rather than offensive, inward than outward looking. The watchword for state-owned enterprises, especially the centrally-managed SOEs, is stability and proportion. Their excess expansion or contraction are both signs of weakness and crisis. Solidly embedded in China’s domestic economy and political system, they were far from the Chinese version of Western multinational companies. Despite their immense size and domestic political weight, their clout outside China was limited at best. When they participated in construction projects and made investments overseas, it was usually under a development strategy, such as the “Belt and Road”. In general, they were not enthusiastic actors on the global markets, since these projects and investments tended not to be as profitable as domestic ones. Once outside China, they tended to comply with global standards and practices.

The Power and Limits of the State Sector

In the 1990s, though the Zhu Rongji reform cost the jobs of 30 million former SOEs workers, it nevertheless saved the state sector. The “let go of the small” part of the reform unloaded the livelihood of urban Chinese workers and transferred the responsibilities to the private sector. The SOEs used to support the urban working population and their families in the 1980s, but now the private sectors employed 70 percent of all urban Chinese labors. The “keep the big” part of the reform transformed the largest state-owned enterprises into the representatives of the newly minted Chinese-style state capitalism. After laying off more than 30 million workers, the post-reform SOEs only employed a fraction of the urban labor force, but their average assets were 10-12 times of the non-state sector.

By 2003, these enterprises were consolidated into centrally-managed SOEs and locally-managed SOEs. The centrally-managed SOEs were usually corporatized former ministries and bureaus of the planned economy and inherited their control over nationwide infrastructure and sometimes even seats on powerful central political bodies like the Party’s Central Committee and National People’s Congress. These Janus-faced political and economic actors could throw their weight around China, even vis-à-vis provincial and local leaders. Every year during the National Congress, provincial leaders had to hold meetings with the CEOs of the large SOEs to discuss investment opportunities for local economic development. The large SOEs had become economic barons and lords, wielding immense power and acting on their vision for “a strong state”.

The power of the centrally-large SOEs derived from their status as hegemonic economic actors and well-connected political actors. This combination worked optimally when it represented national interests in a domestic setting. This unique combination of strength was most effective when it came to national development strategy. In the capacity as leading actors in the domestic markets, these SOEs enjoyed undisputed advantage in dealing with buyers and sellers. For example, before the Global Financial Crisis, Liu Zhijun, China’s Minister of Railway, negotiated aggressively with Japanese, French, Canadian, and German high-speed railway companies by playing one potential partner against another. He eventually secured highly lucrative deals to introduce the appropriate technology for China’s high-speed railway networks. The expansion plans for the railway received massive injection of central government finance following a 4 trillion stimulus package. Today, China’s high-speed railways are by far the longest in the world.

Capitalizing on the Global Financial Crisis, China’s leading electricity distributor, the State Grid launched an ambitious expansion project to build the most advanced ultra-high voltage transmission system. As part and parcel of the project, the State Grid expanded aggressively by taking over major manufacturers of electrical generators and vertically integrating the power system, in spite of repeated protests from China Machinery Industrial Federation. When a prominent Fujian-based leading business magazine, Business Weekly, reported on the industry-wide concerns over these expansions and the risk of an ultra-high voltage system, the magazine was suspended for publishing such an article. Meanwhile, the ultra-high voltage transmission networks had been named as a national level strategic project. China’s ultra-high voltage, now installed across thousand of miles, has become a wonder in the history of electrical engineering and a source of pride for China’s power sector. To get things done is among the chief virtue of China’s state firms but this virtue entails the uncanny ability to sweep aside any critical voice. This is also an integral part of their strength.

Financial and political positions were not the only ways that large SOEs flexed their muscles. In 2013, when Beijing’s infamous toxic smog problem evolved into a public health crisis, observers found that one of the causes had been the low environmental standard of China’s oil refineries. Upon close inspection, it was found that the code was drafted by a committee staffed by none other than representatives of Sinopec and China National Petroleum Company. For years, these actors had been reluctant to revise an outdated pollution standard, jeopardizing the air quality of the capital. Americans will have no problem finding an eerie parallel between China’s SOEs control over industrial standards and the big internet companies’ domination over the internet via the Federal Communication Commission.

The centrally-managed SOEs might show a semblance of a global business group, but their nature was also the limit of their strength. For one thing, the investment-driven growth model worked less well abroad. Overseas ventures of Chinese state-owned enterprises could easily fail due to hot-headed decision-making. In 2006, CITIC Pacific invested USD 415 million to acquire two large mining companies and their mines from Australian corporation, Minerology Co. Anticipating a steady stream of iron ore to supply China’s expanding needs, CITIC Pacific had hoped to get the iron ore shipment by 2009. But the first shipment only came about in 2013 after it had spent nearly 10 billion. The strategy to control cost and increase efficiency by undercutting environment, labor and other costs failed miserably. Meanwhile, the unit price of iron had fallen more than half from its pre-crisis height. The capital outlay had far exceeded the expected returns in the near term. In recent years, the CITIC and its Australian partner have been mired in an extended legal battle over the future cost of mining rights. While the project is too costly and strategic to be abandoned, it is widely recognized in China as a classic case of failure and misjudgment.

For many Chinese state-owned enterprises, opportunism was as harmful to overseas investment decisions as hot-headed decisions. Take the example of China Overseas Engineering Group Co. (COVEC)’s experience in Poland. In 2009, the corporation won a bidding to build a highway for the Polish government ahead of the 2011 European Cup. Competing with a host of well-established European firms, COVEC’s offer was too hard to resist, since its bidding price of EUR 472 million amounted to less than half of the Polish government budget. Confident in its ability to squeeze cost and even bear some short-term loss, the COVEC was also sure that it could play the trick it played well with regards to publicly-funded projects in China: underbid first and raise the price later when the politically-determined deadline drew near. The events soon spin out of control. The company had to confront with unmanageable increase of building cost, but also the non-negotiable demand of the Polish government. Devoid of any political clout, COVEC found itself in a legal battle that it could not possibly win. Eventually, the COVEC had to swallow the loss and pay a large indemnity in accordance with the contract.

While some Chinese SOEs failed in their overseas investment due to their lack of political levers, others failed in their joint mission on account of unexpected political risks. In 2009, China’s Power Investment Corporation signed a contract with the Burmese Power Ministry and a local company in Myanmar to build a hydropower plant on the Irrawaddy River. If built, the Myitsone Dam would generate up to 6,000 MV electricity per year and projected revenue of 17 billion to the Myanmar government in 50 years. Meanwhile, the project would require the relocation of 1,000 people across 47 villages and make the region vulnerable to cost of geological risks like earthquake. The construction of the dam barely started when the main ethnic minority in the region, the Kachin people backed by the Kachin National Organizations, launched concerted protests at Burmese embassies across the world. In June 2011, the political situation became even more delicate as war broke out between Kachin separatists and Burmese government forces, making it impossible to proceed with the plan. In September 2011, the President of Myanmar announced the official suspension of the project. The Chinese side withdrew all its construction personnel in 2013.

All these cases of investment failures share a uniform pattern. They all had their roots in the SOEs’s unique logic of operation in the domestic markets. In the domestic market, the state-owned enterprise could rely on the coordination of central authorities and the cooperation of local government. But once they were in a global setting, the performance of the “national team” was lackluster. Like any western enterprises, they played by the rule and often lost the game due to lack of experience and a measure of foolhardiness, encouraged by their experiences at home.  In fact, the most successful Chinese enterprises in the global market are never state-owned enterprises. They are usually large private firms, like Lenovo and Xiaomi, that adopted an international standard of product development and marketing and worked closely with business partners abroad. Even the telecommunication equipment giant Huawei, a vanguard of 5G networks technology caught in the media whirlwind nowadays, is also not part of the “national team”.

Future of China’s State Sector

Historically, the state sector has always been an integral part of the Chinese political economy. Their function is neither purely economic nor political. Unlike the public sector in the West and Japan, China’s largest state sector are cash cows for the government, though they reserve much of the profits for their own expansion. Unlike national champions of South Korea and government-linked companies in Singapore, they are not strong at global competitions, though they often make rash investments abroad. But so far, they have been performing on a stable basis and delivering reliable service in the sectors under state control. The question is, how to provide goods and services efficiently and equitably?

The efficiency question has been subjected to debates for decades. The emerging consensus seems to categorize state-owned business into strategic and commercial enterprises. For commercial enterprises, such as the telecommunication giant China Mobile, further reform aims to introduce private capitals and create a more diversified ownership structure, and eventually, a market-based, even playground for different enterprises. For years, China has tried to learn from the Singapore Temasek Model, where the Ministry of Finance indirectly control via shareholding platform but let the enterprises hire professional and compete on the market. To be sure, China is not a city-state. The history of Chinese state sector is much longer and follows a different development logic. But the Singapore model can serve as a reference, if not roadmap, if future reform is to follow a market-oriented direction and vertical separation of politics and economy. While the state can control the shares and receive profits, the management should follow strict professional standards. There must be a fair playground for state and non-state sectors, taking into consideration their respective contribution to the public interest.

Furthermore, future state sector reforms should match the state-owned enterprises’ power with their responsibility. To that end, the state sector should behave more like a public sector, a source of affordable and equitable goods and services to the people. While the SOEs are economic and fiscal entities, their primary area of responsibility is to provide security and support people’s livelihood. Size and profits must take a backseat. Should they generate profits, the profits should primarily help to shore up public finance and contribute to the National Pension Fund, before endorsing any expansion and especially overseas investment projects. Those should be the domain of private enterprises. Any efforts to strengthen the state sector without highlighting their primary responsibility risk further erosion of public trust.

Ironically, when the trade talk spotlighted China’s state sector as emblematic of unfair subsidy and trade practices, China’s economy is undergoing a structural reform in favor of the non-state, market actors. The expansion of the state sector has been stalled and their attraction dwindled. Today, the representative Chinese enterprises were no longer Sinopec or State Grid, but the Alibaba Group, BYD, Xiaomi, and Huawei. They offer high-pay jobs, better career paths, and more global business culture. They attract the best and brightest regardless of family backgrounds. They compete globally, especially in Asia, Africa, and Latin America, although their main market is still domestic. In this regard, they are not really different from other East Asian multinational companies. If there is structural reform, the commercial SOEs need to cooperate and join forces with its domestic counterparts, while the political voices of the private enterprises should be institutionalized. The Janus-faced amphibious model of state capitalism could not last. A product of Chinese history, the state sector must reinvent itself through constant reforms to keep abreast of the pace of our times.

Leave a Reply

Your email address will not be published. Required fields are marked *