The role of China's state-owned companies explained

Forty years have passed since Deng Xiaoping embarked on the liberal reforms which generated an average GDP growth of 10% and transformed China into a global manufacturing powerhouse with considerable political influence.

Ever since, the Communist Party of China (CPC) has been striving to gradually allow the markets to play a decisive role in resource allocation. The situation with China’s state-owned enterprises (SOE), however, is more complex than with the general economic picture.

In light of the changing global landscape and the Fourth Industrial Revolution, China is transitioning from an investment-driven export economy to an innovation-driven economy reliant on domestic consumption. The role of SOEs has become all the more important in these circumstances, as they have traditionally assisted the government in reforms - even though the new consumption-oriented economy requires a level of flexibility and responsiveness that publicly owned bodies generally lack.

China is home to 109 corporations listed on the Fortune Global 500 - but only 15% of those are privately owned. China’s SOEs are enormously bulky and therefore lack flexibility when responding to market demands.

It is evident from the charts above that SOEs are highly over-leveraged and structurally less efficient than their private peers. Stagnating growth throughout China’s public sector has led to a shrinkage in its overall asset holdings. SOEs are often criticised for abusing their preferential access to loans, and for lobbying for regulations which drive out competitive private companies. It is widely argued that the SOEs would not survive in an innovation-driven market environment without the perks they currently enjoy.

The inefficient management of government corporations has also worsened thanks to a high turnover rate among executives sparked by President Xi’s anti-corruption campaign. On one hand, the companies are relieved of corrupt executives - but on the other, SOEs are left with management who lack a coherent strategy.

While this has been happening, China’s private sector - which has been revving up since the global financial crisis - is now serving as the main driver of China’s economic growth. The combination of numbers 60/70/80/90 are frequently used to describe the private sector's contribution to the Chinese economy: they contribute 60% of China’s GDP, and are responsible for 70% of innovation, 80% of urban employment and provide 90% of new jobs. Private wealth is also responsible for 70% of investment and 90% of exports. The portion of exports from private enterprises might diminish as SOEs undertake more infrastructure projects in countries involved in the Belt and Road Initiative (BRI), increasing their public stakes in China’s exports.

The success of China’s private technology sector is also worth noting. Huawei is leading the global 5G revolution and the company is eager to spread its innovation globally.

Despite the above-mentioned factors, the Chinese government is still keen on supporting SOEs and is committed to making them bigger, stronger and more efficient. This is particularly relevant to certain strategic sectors where government oversight is essential - specifically in defense, energy, telecom, aviation and railway systems. Conversely the state is encouraged to divest from other industries by decreasing its ownership.

The State-owned Asset Supervision and Administration Commission (SASAC) is making great strides in implementing the government’s ‘zhuada fangxiao’ (grasp the big, release the small) policy, which has greatly reduced the number of SOEs through privatisation, asset sales, and mergers and acquisitions. The Commission, which was established in 2003, is currently concentrating on restructuring the remaining SOEs into modern profit-oriented corporations. Practically all of the entities overseen by SASAC are structured as corporations and are legally separate from the government with their own boards of directors, effectively delegating more authority to the executives.

There is also substantial work being done to improve SOEs through reorganisation, restructuring and enhancing their internal governance standards. The government went as far as introducing mixed ownership in telecoms company China Unicom, by selling shares worth around $11 billion to 14 private investors. This was done as a step towards making China Unicom more accountable and more focused on generating returns on equity, while retaining state control.

These efforts to make SOEs competitive while holding absolute control over their final decision-making reasserts the Chinese government’s commitment to consolidating state control while simultaneously allowing the market to be the ultimate resource allocator. In other words, the government wants to keep a close eye on market forces while reserving the ‘intervention option’ in critical situations.

China’s legal and regulatory systems are going through crucial transformations with regards to investment and intellectual property - but they are not yet prepared to regulate giant, strategically significant corporations, which is why the government has chosen to retain the option of direct control over its SOEs. Besides, once the property rights framework is brought to a certain level, the government could profit far more by privatising competitive enterprises rather than selling off distressed assets in the current legal environment.

Privatisation initiatives have been further delayed by the threat of an intensifying trade war. The CPC has been forced to prioritize security over efficiency, which means a conservative stance of increased centralisation - in order to facilitate an immediate response to any economic threat - is gaining more traction. The arrest in Canada of Huawei’s CFO, Meng Wanzhou, was followed by tough rhetoric from President Xi, who stated: “No one is in a position to dictate to the Chinese people.” These types of action are increasing levels of mistrust between the parties involved and are forcing China towards increased centralisation.

SOEs are frequently utilised as a mechanism for implementing policy, providing socioeconomic stability and building infrastructure. This coherent strategy has led to the emergence of megacities such as Hangzhou and Shenzhen, which have demonstrated the potential of entities operating collaboratively under state guidance. The CPC sees these types of cooperation as worthy of the costs of centralised governance.

Therefore, privatisation of SOEs at this stage seems to be more risky rather than rewarding, considering the potential social costs of layoffs, potential defaults and mismanagement of enterprises by new private owners, which could lead to major disruption and immediate destabilisation. The CPC is wise to continue taking action to improve the efficiency of SOEs and to gradually develop a privatisation framework for the future to ensure sustainable economic growth, as it realises that there is a limit to how much the government can improve SOE efficiency within a centralised governing system.

The government has proved its commitment to market-oriented reforms by boosting support for entrepreneurship through tax cuts worth around $300 billion. The state is also encouraging innovation in ‘deep tech’ through state-funded venture capital funds, establishing start-up accelerators and high-tech business parks.

The ultimate aim is certainly to ensure quality growth of the economy -and therefore, a prospective trade deal could further boost liberal market reforms through restoration of trust and a reduction of security concerns.