Modern China Research Project-Ned Bless

Introduction to Chinese SOEs

On August 24, 2015, in one day of trading, 8.5 percent of the value of the Shanghai stock market was wiped out. This crash was largely prompted by fears of slowing economic growth in China. For years, the Chinese Communist Party has had a so-called “Grand Bargain” with the peasants and middle class; they tolerated a repressive, authoritarian regime and, in turn, received economic growth and prosperity. However, the prospect of slowing economic growth could cause a collapse of this agreement, with potential repercussions across all of Chinese society. China’s economy, which has long been the focal point of the CCP’s attention, is unique amongst world economies in that it is somewhere in between capitalist and socialist. While China has been encouraging additional private investment for the past two decades, large parts of the economy are still controlled by the CCP through state-owned enterprises, or SOEs. These SOEs are a sort of middle ground between state and private ownership: many of them act like private companies, with some even publically traded, but the one thing that they all have in common is that their strategic decisions are made by the Party. The CCP’s unwillingness to divest some of its control over the economy through SOEs will undermine China’s economic growth, as well as social stability within China.

Historical Context

The roots of the present crisis can be traced back through history all the way to Mao Zedong and some of his first major reforms after winning the Chinese Civil War. As a Communist, one of Mao’s core ideals was collective ownership and working of the land. His most major reform towards this goal was the Great Leap Forward in 1956, in which “99 percent of the rural population” had their lands reorganized into “26,000 centralized People’s Communes” (Green 244). This enormous reorganization of China’s farmland marked the beginning of state ownership on a massive scale, but it was not without its consequences. Mao grossly overestimated the production of these communes and, as a result, historians estimated that the famines caused by the Great Leap Forward caused “20 million to as many as 45 million deaths” (Green 245). While state ownership is not necessarily a bad concept as a whole, these tragic events showed that the bureaucratic ineffectiveness of the CCP would prove to be a major obstacle to state ownership in the future.

Furthermore, after the death of Mao, the economic liberalizations made by Deng Xiaoping greatly increased China’s economic growth. One of the largest changes as part of Deng’s “Four Modernizations” was the opening of the economy and slight relaxing of state controls. In doing this, Deng “lured foreign investors to China…setting the stage for China’s three-decade-long economic boom” (Barboza). Encouraging foreign investment was one of the ways that the CCP set up China’s economic boom, and they saw that by loosening their grip on China’s economy slightly, they were able to greatly increase China’s economic productivity. This loosening of economic controls was one of the reasons why the CCP was able to meet Deng’s ambitious target of “quadrupling Gross National Product…from $250 billion to $1 trillion” (Whitten 292) by 2000.

Through these reforms, the CCP saw that loosening their grip on the economy could have a greatly positive impact on China’s economy as a whole. However, the CCP is an authoritarian regime which has its own interests foremost in its decision making. They were in a position where they wanted to remove economic controls to let the economy grow, but at the same time wanted to maintain their iron-fisted control over the economy.

Analysis

As China has transitioned into the 21st century, the SOE system has shrunk some since the days of total party control over the economy, but it still plays a major role in the way that China’s economy operates. While the overall size of SOEs compared to the economy as a whole has been shrinking, there have still been new SOEs being started by Party members. Many of these are in industries which are not important to the CCP, such as hotels, restaurants, and shopping malls. The reason why these exist is because “the temptations to branch out have been too great” as SOEs have received “cheaper financing from state-owned banks”, “favoritism from local governments” and “a lighter touch from regulators” (The Economist). Thus, starting an SOE in a non-strategic industry is a decent way for a Party member to make some extra money on the side. However, in recent years, the CCP has shown a willingness to divest some of its interests in non-critical industries. For example, many of these smaller SOEs are “more accessible to private investors since they are concentrated in non-strategic sectors” (The Economist).

As the graph above shows, SOEs in China have always performed worse than privately run companies. Opening up some SOEs to more private investment is an important first step if the CCP does want to truly reform China’s economy.

On the other hand, there are some SOEs which the CCP will likely never give up. These are the SOEs concentrated in strategic sectors: banking, mining, petroleum, etc. The CCP wants to remain in control of the economy, and the best way for them to do this is to retain control over some of the most important sectors of the economy. Although these SOEs are generally better-performing than their counterparts in non-strategic sectors, they still “gobble up a huge share of bank loans” (Guilford), which makes it more difficult for small start-ups in China to get the capital that they need. Even though these SOEs are not necessarily in danger of failing, they still have a non-negligible impact on the Chinese economy. Another reason why the CCP will likely not give up these SOEs is because of who benefits from continued ownership of these SOEs. While private companies in China would certainly benefit from the CCP selling off some of the SOEs, the CCP will always do what benefits the Party the most. Ultimately, the largest problem with China’s state-owned sector is that the SOEs “always defer to the desires of the Communist Party before market considerations” (Cendrowski). Because of this, Chinese SOEs will never follow the markets in their decisions, but rather will always reflect the will of the CCP.

So, to see whether these strategic sector SOEs will have an adverse effect on the Chinese economy, one can compare the performance of Chinese SOEs versus non state-owned companies around the world.

This spreadsheet compares the performance of the 10 largest non state-owned petroleum companies to the two major petroleum SOEs in China, PetroChina and Sinopec. The three metrics being used compare slightly different parts of a company’s profitability: return on assets, or ROA, shows effectively how much money a company is making as a percentage of its total assets. This is lower for the Chinese companies because they are so large that their capacity for production has outpaced demand, and so, while they may have the same net income as a non state-owned corporation, they may have extra assets which are just sitting idle, and so this lower ROA shows that the SOEs are less efficient than non state-owned companies. ROE, or return on equity, is another metric that compares the performance of different companies, and it is how much money a company makes as a percentage of its equity, which is defined as assets minus liabilities. While the liabilities of SOEs are typically lower than non state-owned companies due to their ability to borrow money more cheaply, their ROEs are still lower because of how high their assets are compared to other companies. This metric again shows the inefficiency of SOEs compared to non state-owned companies. The final statistic is profit margin, which is net income divided by revenue, and so it effectively measures how much money a company makes as a ratio of how much money it brought in. The SOEs actually perform better in this category, largely due again to their ability to borrow cheaply from state-run banks. Since they are having to pay less in interest, their net income is higher, which gives the SOEs better profit margins.

Predictions

Based upon the need for the CCP to hang on to SOEs to exert its control over the economy and the problems associated with SOEs, even in strategic sectors, the CCP will most likely not respond effectively to the economic crisis which they are facing. The CCP elites are effectively caught between a rock and a hard place: they want to retain a great degree of control over China’s economy, which requires them maintaining control over the SOEs, but at the same time want to increase China’s economic growth, which is much more difficult with the SOEs weighing down many sectors of the economy. Additionally, they may need to make a decision about how to solve this crisis sooner rather than later: while China still reports GDP growth rates of around 7%, analysts have found that “underlying metrics suggest the real growth rate could be nearer 3%-4%” (Reklaitis). If economic growth is really slowing to such a low level, the fragile balance upon which public support for the CCP is built could be threatened.

Furthermore, as CCP tries to transition China from a resource-heavy industrial economy to one more service-based, SOEs may not have as large of a role to play anymore. As China moves towards this service-based economy, the CCP will want to protect its strategic-sector SOEs, but some of these operate in industries that may become obsolete in this new economy. Two of the industries which the CCP has designated as strategic, which the CCP “would maintain sole ownership or absolute control over” are “petroleum and petrochemicals” and “coal” (Szamosszegi and Kyle). If the CCP truly wants to move towards a service-based economy, these two industries, coal especially, will have to play a smaller role in the economy. This means that the CCP will either have to give up some of its interests in these industries, or these industries will slow and potentially stall China’s economic transition.

Antithesis

On the other hand, some may say that the CCP will be able to overcome this crisis, because they have faced crises like this in the past and have always found a solution. However, this assertion is incorrect behind this crisis is of a different order of magnitude from anything the CCP has faced in the past. For example, the Great Leap Forward caused what could be described as a “breakdown of the Chinese economy” (Encyclopedia Britannica). However, while the Great Leap Forward was obviously unsuccessful, it was not a radical overhaul of the Chinese economic system. It was only a change within an already established Communist system. The crisis that the CCP is facing now pits their supposedly Communist ideals against the reality that the more capitalist their economy gets, the better it performs. Going forward, the CCP really only has two options for what to do: they can relax some of their controls on the economy in the name of economic growth, or they can tighten their controls and only delay the inevitable.

Works Cited

Barboza, David. "The Man Who Brought Modernity to China." 21 October 2011. New York Times. 13 December 2015 <http://www.nytimes.com/2011/10/22/books/the-impact-of-deng-xiaoping-beyond-tiananmen-square.html>

Bland, Ben. "China's banks face tightening bad loans squeeze." 30 August 2015. Financial Times. 15 December 2015 <http://www.ft.com/intl/cms/s/0/3eace0ec-4d6d-11e5-9b5d-89a026fda5c9.html#axzz3uPuJiE9x>.

Cendrowski, Scott. "Why China's SOE reform would always disappoint." 15 September 2015. Fortune. 15 December 2015 <http://fortune.com/2015/09/15/why-chinas-soe-reform-would-always-disappoint/>.

Encyclopedia Britannica. "Great Leap Forward." 3 March 2014. Encyclopedia Britannica. 16 December 2015 <http://www.britannica.com/event/Great-Leap-Forward>.

Green, David. "The Early Years of the People's Republic of China." China Since 1644: A History Through Primary Sources. Boston: Cheng & Tsui, 2014. 241-246.

Guilford, Gwynn. "China’s latest refusal to fix its state-owned companies is bad news for the global economy." 16 September 2015. Quartz. 15 December 2015 <http://qz.com/503160/chinas-latest-refusal-to-fix-its-state-owned-companies-is-bad-news-for-the-global-economy/>.

Reklaitis, Victor. "China's GDP at 6.9%? Try 3%." 19 October 2015. MarketWatch. 15 December 2015 <http://www.marketwatch.com/story/chinas-gdp-at-69-try-3-analysts-react-to-latest-growth-figures-2015-10-19>.

Szamosszegi, Andrew and Cole Kyle. An Analysis of State-owned Enterprises and State Capitalism in China. Washington, DC: Capital Trade, Inc, 2011.

The Economist. "Fixing China Inc." 30 August 2014. The Economist. 14 December 2015 <http://www.economist.com/news/china/21614240-reform-state-companies-back-agenda-fixing-china-inc>.

Whitten, Todd. "Socialism with Chinese Characteristics." China Since 1644: A History Through Primary Sources. Boston: Cheng & Tsui, 2014. 292-295.