Tag Archives: State Owned Enterprises

State-Owned Enterprise Reform Slogs On Slowly

TWO THINGS WILL emerge — eventually — from China’s reform of its state-owned enterprises (SOEs): the elimination of a lot of redundant capacity in heavy industry and some multinationals that are strategically important domestically and formidably competitive internationally.

China has 111 centrally owned SOEs (those under the State-owned Assets Supervision and Administration Commission), down from 196 in 2004. The goal is to more than halve the number to around 50.

The consolidation of heavy industry, which accounts for more than two-thirds of SOEs, will let that target be attacked forcefully. Capacity reduction, particularly in steel and coal, is a policy priority in the near term.

That will drive consolidations. So, too, with inefficient and unprofitable, or zombie, SOEs in all sectors. Making globally competitive SOEs, particularly those that can underpin and benefit from the ‘One Belt, One Road’ initiative, will also be undertaken by horizontal and vertical merger and acquisition.

Similarly, SOEs that operate in sectors identified as strategically important: vehicle making, ‘green’ industries, information technology, biosciences, advanced engineering (from defence to aerospace, robotics and advanced transport), energy (nuclear and renewables) and new materials. AVIC in aerospace and CRRC in high-speed-rail equipment are examples of merging existing SOEs into huge monopolists that can dominate the domestic market and provide a platform for international sales (just, it seems, the same way Western companies are going).

The intention is to reinforce government control over core industries while opening up some parts to private and, particularly in financial services and telecommunications, to foreign investors. The intention of what is delicately called ‘mixed ownership’ is to drive improvements in governance, competitiveness and efficiency. Wholesale privatisation is not on the cards, though some spin-offs, such as Sinopec’s sale of its retail division, are.

A contradiction in all this is that the current five-year plan, to 2020, calls for its ambitious growth target (average annual GDP growth of 6.5% to vault the ‘middle-income trap‘) to be achieved through innovation based on entrepreneurship and advanced technology, not oligopolistic state capitalism.

Yet economic decision making is being centralised as warp and woof of the Party’s reassertion of its political control.

At the same time, SOE reform is proceeding slowly (too slowly for the IMF) in the face of stiff resistance from long-standing interests that feel endangered and the anti-corruption investigations that are being used by President Xi Jinping to break it. The Maoist tradition of regarding SOEs as economic arms of political institutions (and the politicians that control them) has deep roots.

A similarly live memory is of the social unrest that followed Prime Minister Zhu Rongji’s round of SOE reform in the 1990s. Then, tens of millions of workers lost their jobs and the big state-owned banks carrying the SOEs bad loans had to be bailed out.

Even though SOEs have steadily withdrawn from labour-intensive industries over the past two decades and they no longer get favoured policy loans to the extent they once did, the risk of social unrest remains a significant reason that this latest round of SOE reform will proceed slowly.

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IMF Says China’s Slowdown On Track But Speed Up SOE Reform

THE INTERNATIONAL MONETARY FUND can usually be relied upon for a supportive word for China’s economic reforms. The heaviest punch aimed by Beijing in its report on the prospects and challenges for the global economy produced for the G-20 meetings in Shanghai at the end of this week is to criticize the slow pace of reform of state owned enterprises (SOEs).

The Fund’s staff would have likely known of the SOE reforms just announced. The State-owned Assets Supervision and Administration Commission said pilot projects for ten ownership, management and governance reforms would be introduced this year, along with further plans to merge and restructure large SOEs.

China Chengtong Holdings, an asset management company, and China Reform Holdings, an investment firm charged with revamping state-owned enterprises, have reportedly been nominated to kick off the pilots, a pair that makes it look as if state-driven industry consolidations to reduce industrial overcapacity are the priority.

With seeming knowledge aforethought, the Fund said:

The reform strategy for state-owned enterprises needs to be more ambitious and its implementation accelerated. While this reform aims at modernizing corporate governance, it continues to emphasize the strategic role of the state while providing no clear road map to a substantially greater role for the private sector and to imposing hard budget constraints.

Otherwise, the IMF report was typically tempered in its observations that China’s slowing growth is a main headwind for the global economy and will continue to be so, but the slowdown is part of a rebalancing of the domestic economy that will be good for global growth in the long term.

Growth in China is expected to slow as imbalances in real estate, credit, and investment continue to unwind and the economy rebalances towards consumption and services.

This process is on track, the Fund says, though there are risks and will be spillovers.

While the transition is proceeding broadly as expected, it is still fraught with uncertainty and likely to entail significant spillovers through trade and commodities, which could be amplified by financial channels. Economies most exposed to these spillovers are commodity exporters, those within the Asian supply chain, and machinery exporters.

The Fund continues to forecast 6.3% GDP growth for China this year and 6.0% in 2017, both down from last year’s 6.9%.

Wary of currency wars, the Fund also calls for clearer delineation of Beijing’s policy towards the value of the yuan.

In China, the challenge is to achieve a transition to a more balanced growth model while reducing vulnerabilities from excess leverage and strengthening the role of market forces, including in the foreign exchange market. The authorities should ensure clear communication of their exchange rate policies and be willing to accept the moderately lower growth consistent with rebalancing. In other words, the quality of growth matters, not just the quantity. If growth risks slipping significantly below a prudent range, the first line of defense should be on-budget fiscal stimulus that supports the rebalancing process. Although the transition process is likely to entail foreign significant spillovers through trade and commodities, possibly amplified by financial channels, a well-managed rebalancing of China’s growth model would benefit global growth down the road and reduce tail risks. The international community should support China’s efforts to reform and rebalance its economy.

The concern about the absence of market forces echoes the Fund’s criticism of the slow pace of state-owned enterprise reform, which it contrasts with the progress made on financial liberalization and in laying the foundations for stronger local government finances.

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Third-Quarter GDP Figures Underline China’s Hard Slog In Rebalancing

Dalian Market, Dashang Group's flagship store in Qingniwaqiao, Dalian, Liaoning, China, 2009

Third-quarter GDP growth came in at 6.9%, its slowest quarterly growth since the immediate aftermath of the 2008 global financial crisis.

The outcome was one tenth of a percentage point faster than forecast by private economists and in line with the government’s official target of “about 7%,” which Prime Minister Li Keqiang has fudged even more by saying slower growth is acceptable provided sufficient new jobs were being created — the subtext being that growth won’t be allowed to slow to the point where social stability is at risk.

To that end a series of old-school pump-priming measures have been taken — interest rate cuts (five in the past year), lowered bank reserve ratios (on three occasions), aid for exporters and speeded-up approvals for large infrastructure investment. However, as we have noted many times, these hold back the switch away from the economy being led by (debt-financed) infrastructure investment and exports to being led by domestic consumption.

Nonetheless that ‘rebalancing’ is happening, albeit more slowly than the leadership would like, and China needs for reasons that we shall return to below.

For all the attention paid around the world to the economic indicators of industrial output and merchandise trade, the tertiary sector of the economy — i.e. services — is growing faster than the secondary — i.e. manufacturing, mining and construction. In the third quarter, services expanded by 8.4% compared to secondary industry’s 6%.

In 2006, according to World Bank figures, industry accounted for 47.4% of the economy, services 41.9% and agriculture 10.7%. By 2012, services had nosed ahead of industry, 45.5% to 45.0% with agriculture at 9.5%. For last year, the numbers are estimated to have been 48.2% and 42.6. Meanwhile, exports have failed from the equivalent of 35.7% of GDP to 24.2%.

By comparison, services accounted for 78.1% of GDP in the U.S. in 2012 and industry for 20.6%. In Germany, the numbers were 68.7% and 30.5%, respectively, which gives a sense of how far China still has to go in rebalancing.

That all said, stronger fiscal spending and more measures to promote rapid credit growth is likely in coming months to keep the pump primed and the growth slowdown on a measured glide path. At the same time, the leadership needs to keep pushing through the deeper structural reforms that rebalancing demands and which China is running out of time to put in place if the country is to vault from the ranks of poor countries to rich.

The incongruity is that in the process of making its economy more market-oriented — albeit market-oriented with Chinese characteristics — it is building up its state-owned enterprises (SOE) to be more innovative and business-like in a way that distorts markets and entrenches vested interests that, in turn, increase the resistance to reform. It also crowds out the entrepreneurs and small and medium sized companies where growth-generating innovation flourishes.

Those need a business environment that is framed by good institutions and a regulatory and governance regime that may not be to the taste of big business in the form of the SOEs, who see their (patriotic) role as competing with other multinationals not fending off pesky upstarts at home. The third-quarter figures underline how much of a hard slog putting that in place that is proving to be.

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China’s State-Owned Enterprises In A Squeeze

The agency that oversees China’s big state-owned enterprises (SOEs)– the 117 that are centrally managed — provided a glimpse earlier this week of the profits squeeze they have been under this year. The State Assets Supervision and Administration Commission (SASAC), said that revenues in the first 11 months of this year, at 20.1 trillion yuan ($3.2 trillion), were up 9% on the same period of 2011, but net profits were flat at 1.1 trillion yuan. Given the favorable bank lending and policy advantages these SOEs get and the pricing power their market dominance lets them enjoy (collectively they account for 40% of non-farm GDP), a 5% margin isn’t overly impressive. But SOEs have been underperforming private sector enterprises for years.

This year could have been worse. Wang Yong, SASAC’s head, said that the SOEs profits were down in the first two quarters in the face of the sluggish global economy. Cost cutting in the third quarter reversed the decline. But SOEs got a helping hand, notably relief from some of their traditional social responsibilities such as providing housing, healthcare, child care, education and even groceries for staff.

Large companies everywhere are trying to shed health and pension costs to enhance competitiveness in tough times. China’s big SOE’s have also been pushed for some time by government into becoming leaner and more professional businesses that look less like government bureaucracies and more like the competitive multinationals that Beijing wants its national champions to become. In the hope they will forced into better governance, SOEs have been pressed to have listed subsidiaries and shed non-core businesses. They are now being pushed to become yet more efficient and to accept more private funding in the hope that will bring additional financial and managerial discipline, especially to those SOEs where it has been tardy in arriving. They are also being told to cut yet more costs, including the lavish salaries and perks of senior staff.

Just as the notorious $6,000 shower curtain bought by former Tyco International chief executive Dennis Kozlowski in the 1980s on the company’s tab came to symbolize the imperial chief executive in the U.S., a 12 million yuan chandelier bought for the lobby of Sinochem’s headquarters in 2009 has come to stand for untamed extravagance among SOEs. However, cutting such excesses may prove easier than cutting remuneration though the austere expectations of the daily round of government officials that new leader Xi Jinping is imposing will apply to SOEs, too. The heads of the most important SOEs hold the equivalent of ministerial rank, with all the trappings that has implied. Many SOE bosses have been in the vanguard of the resistance to a more equal pay hierarchy within the companies, part of a broader reform to rein in income disparity across the country. Change will not take easily.

Though usually dominant in their industries, SOEs also tend to be in the older, heavier industries and less present in the strategic emerging ones higher up the industrial value chain. Changing that will require them not just to become more efficient but also more innovative. That has not been a natural instinct in organizations where there has been a revolving door between senior management and government departments and promotion has been a bigger incentive than profit.

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China’s State Capitalism: Leviathan Major and Minor

Three of ten largest corporations in the world are owned by the Chinese state–two energy companies, Sinopec and China National Petroleum, and a utility, State Grid. There are four state-owned enterprises in all on Fortune magazine’s list of the 500 largest companies in the world. As recently as 2005 there was none. The sluggish recovery of the developed economies from the 2008 global financial crisis has brought a bout of self-doubt to free-market capitalism. China’s model of state capitalism–dirigisme through state shareholding would be a shorthand description–is touted as the coming alternative.

Though much discussed and surprisingly widely practiced in countries rich and poor, relatively little is known about the functioning and economic implications of state capitalism in its new incarnation. The 20th century model of command economies–state-owned enterprises acting as the agents of government allocation of resources–has evolved into a 21st century one in which the state provides capital to corporations–either via equity or debt–and in the process becomes a controlling shareholder that seeks to optimize economic and political returns on its investment. The political returns manifest themselves as a wide range of public goods from industrial policy to social benefits.

Two academics, Aldo Musacchio and Sergio Lazzarini, take a look at this new state capitalism in a newly published Harvard Business School Working Paper*. First, some definitions. Musacchio an Lazarini identify two flavors of 21st century state capitalism.  One is through state majority control of publicly traded companies. China’s state-owned enterprises, such as the three mentioned above, are a prominent example. The other relies on minority investments in companies by official agencies such as development banks, state-controlled pension funds and sovereign wealth funds as well as national and local government. They summarize the two as,

the widespread influence of the government in the economy, either by owning majority or minority equity positions in companies or through the provision of subsidized credit and/or other privileges to private companies.

In short, Leviathan major and Leviathan minor.

The authors look at state capitalism around the world, not just in China. One point that leaps out of their study is how widespread the model already is, even in what are thought of as free-market economies. We pluck out of their paper this snapshot of it in China, using 2010 data, and by comparison in the other Brics.

Patterns of State Ownership in Brics
Country SOE output to non-financial GDP Listed SOEs SOEs as % of market cap. Number of SOEs with majority control No. of firms with federal govt. minority ownership
Federal State/
Brazil 30 14 34 247 n/a 397
China 30 942 70 17,000 150,000 n/a
India 13 29 4,014 217 837 404
Russia 20 12 40 7,964 250 1,418
S.Africa n/a n/a n/a 270 n/a n/a
Source: Musacchio and Lazzarini

Using Musacchio and Lazarini’s analogy of Leviathan as a majority investor and Leviathan as a minority investor, China falls under the rubric of the former. Government majority holdings in publicly traded companies outstrip minority holdings by a ratio of three to one. The average for the Brics is less than two to one. As a general rule, minority holdings are the result of state investment holding companies investing in a portfolio of firms. China Investment Corporation (CIC), the world’s third largest sovereign wealth fund by assets under management, fits that model. Though not particularly delved into by the authors, China’s state capitalism is also characterized by an upstream oligopoly of large state-owned enterprises in strategic industries, as, again, the three mentioned above illustrate.

Musacchio and Lazarini’s paper is descriptive, not prescriptive, but it does raise questions about some common consequences of 21st state capitalism that are readily applicable to China, where the 121 largest state-owned enterprises own $3 trillion in assets (2010 figures). Does China’s version, as entrenched and widespread as it is within the economy, promote or hinder the development of deeper financial markets and more professional and skilled corporate management and governance? Just as in the political realm, state, government and Party are often interchangeable, so are ownership, governance and management in the world of Chinese state capitalism.

The authors note that Leviathan major state capitalism tends to establish itself in response to market failure, notably where capital markets and corporate governance are weak. In an ideal world, it leads by example to improvements in both. Yet in China’s case, the big state owned banks are so dominant in the financial system and are such an important arm through which the government exercises monetary policy, that that may not happen, regardless of how hard the reformers are now pushing for financial reform. Which leads directly to a bigger question, whether vested interests and cronyism are so entrenched that the system is captive to its agency problem–that those running China’s state capitalism use its as a way to create and distribute public goods in order to legitimize the Party’s monopoly grip on power and to allow the ruling elite rather than the state as a whole to capture the economic rents it generates. John Hempton of Bronte Capital has provocatively described this as  China as a kleptocracy. That may be over-egging the pudding, but to what extent will determine how China continues to ascend the ladder of economic development.

*Leviathan in Business: Varieties of State Capitalism and Their Implications for Economic Performance by Aldo Musacchio, associate professor in the Business, Government and the International Economy unit and a Marvin Bower Fellow at Harvard Business School, and Sérgio G. Lazzarini, Insper Institute of Education and Research, HBS Working Paper Number: 12-101, May 30, 2012

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A Key Question For China’s Financial Reform: How Small Is A Large Role For SOEs?

Prime Minister Wen Jiabao’s comment about breaking up what he called the monopoly of the four big state-owned banks is the tip of the iceberg in the fierce internal debate about the role of state-owned enterprises (SOEs) in China’s economy. That debate falls under the general but misleading rubric, financial reform. Yet it is not about privatizing the banks and the SOEs. Nor is it about replacing China’s model of state-driven capitalism with a free-market version. It is, instead, about two critical but related political questions. First, can the Party can still achieve its policy goals–of which the overriding one is maintaining its monopoly on political power–while controlling, through the state, a smaller share of economic output? Second, how far dare it go in risking loosening its political control by shrinking the state sector in order to let the private sector create more of the economic growth it needs to legitimize its monopoly on power?

This debate is going on against the backdrop of a leadership transition, always an unsettling time, and compounded by now being in conjunction with a critical transition in China’s economy. It is widely if not universally accepted among the top leadership, that China’s three decades of rapid fixed-investment and export-fueled growth are coming to their close. The country needs to rebalance its economy to get the sustainable growth that will let it slow the economy without coming to a full-stop, to defuse the debt bombs and deflate the asset bubbles caused by its investment-fueled growth, and to make the great leap forward to clear the middle-income trap and land as a developed economy.

How much structural change does that require, not just economically, but politically? More pointedly, how much further can economic reform go without political reform? It is a debate that has been off-limits, in public and much of the Party, since 1989, not least because it questions the trade-off of continuing rising living standards for living under of one-party rule (with the acceptance of the corruption and cronyism that involves rather than concern for the absence of Western-style civil rights and liberties.)

Hard-line statists and Mao revivalists, the so-called neo-Comms, maintain that the SOEs–and a firm stabilizing social hand–are a tried and trusted means to steer the economy through its present challenges, validated by the 2008 global economic crisis that laid low Western free-market economies. They provide the Party through the state with a mechanism for the administrative guidance of the economy. In the absence of market-based monetary policy tools, the big four banks sit at the center of this web of control dialing up or down the available supply of funds to their SOE customers as required to regulate investment levels.

Economic reformers fear This model are no longer fit for the new task at hand. The banks are inefficient allocators of capital, as the mounting piles of bad bank debt attest, while the SOEs crowd out the private sector, notably small and medium-sized enterprises that will be needed to create the productivity growth, jobs and innovation that China will need for the next stage of its economic development. With the inopportune political demise of Bao Xilai, the ex-boss of Chongqing and poster boy for the post-Maoist revivalists, putting the old guard on the back foot for now, the reformers are taking the opportunity to press their case. They are not calling for the abolition of SOEs, but saying that they need shaking up and scaling back, a case also argued by the Development Research Council/World Bank report on China in 2030, which we described as a “political manifesto disguised as an economic blueprint”.

China has more than 110,000 SOEs, but the 121 “national champions” in the strategically important “pillar industries” that report to the State Assets Supervision and Administration Commission (SASAC) and their big state-owed lenders (separately regulated) are the nexus of the country’s state-directed capitalism. They have a sway over the economy disproportionate to their number–5% of corporations but 40% of GDP at best guesses (nearer 50%, if thousands of small rural local-authority-controlled enterprises are included). In the pillar industries, which include both strategically important sectors and emerging technologies, SOEs control more than 90% of the assets. Their political and economic power have become so entwined at all levels that they have become deep redoubts of vested interest.

Consolidation, driven by merger and acquisition (the number of national champions, for example, has been reduced from 193 in 2003), now means that 40 or the 46 Chinese companies that rank among the world’s 500 largest corporations are SOEs. That only gives the biggest even more economic and political clout with which to defend the privileges they enjoy. The most topical of these is their ready and cheap access to loans from the big state-owned banks. Private companies are mostly forced to turn to unofficial sources and pay usurious interest rates–the issue Wen highlighted and the experiment in Wenzhou is seeking to address. SOEs get favorable tax treatment, and land and raw material subsidies. They are first choice when it comes to government procurement. As with bank loans, it keeps it all within the club. SOE staff have a powerful incentive to defend their turf, too: salaries are five times the average in the non-state sector. The benefits are better, too, and the political access unrivaled.

With the caveat that SOEs as a group are no more monolithic than any other large group of companies across multiple industries, privilege has not turned into performance. Qiao Liu of the University of Hong Kong has calculated that the average return on equity for SOEs to be 4%, compared to 14% for unlisted private firms. But there is a great range among the profitability of SOEs: those in industries dominated by the state are highly profitable; those in sectors with high levels of competition, not so. (Gao Xu, while working as an economist at the World Bank’s Beijing office, made a detailed analysis of SOE performance by industrial sector.)

China’s WTO membership committed Beijing not to interfere in the commercial decisions of SOEs, but as top executives are appointed by the Party, SOEs tend to be politically self-regulating. They take it as a patriotic duty to fall in behind the goals of five-year plans. That is not to say they are docile handmaidens. As players in the patchwork of power and patronage that rules China, they have their own agendas to promote and turf to defend, as well as those of factional interests allied to them. One reason that the pace of financial reform has been so glacial in recent years is that it is seen by SOEs as a threat to their position.

That has not prevented reformers’ long-standing efforts to at least improve the governance of SOEs, by structuring them less like ministry departments and more like shareholder corporations, even if government at some level is the sole or controlling shareholder. The creation of SASAC in 2003 was an attempt to provide external institutional oversight that would promote more professional management of SOEs. More recently, foreign investors have been brought in via offshore listings of SOE subsidiaries in the hope that international management best practice will arrive along with new equity. The biggest SOEs have been pushed overseas in part to experience business in competitive, rule-bound markets that China will, eventually, have to create at home if it is to have balanced growth. This experience has also provided them with a stark lesson in how the rest of the world assumes that even the most commercially-oriented SOEs are an arm of government, as companies like Chinalco and Huawei have recently found out.

Loosening the ties that bind SOEs to state and Party is necessary if China is to give the private sector more scope to drive the growth the county needs to move to the next phase of its development. This goes far beyond just making more credit available to small and medium-sized enterprises, a welcome start though that would be for China’s entrepreneurs. However, socialism with Chinese characteristics, or even capitalism with Chinese characteristics, means that state-owned companies will continue to play a large role in the economy. Privatization, as happened in the former Soviet Union and Eastern Europe, is not on the cards. It is a matter of how small is large.

For foreign companies and investors, some sectors will become more open to them as they will to private Chinese companies. Others, strategically important, will remain off-limits not just to foreigners but domestic private firms as well. SOEs will strongly resist being reined in, as they have successfully done before. They may find the fight tougher this time. The political stakes are certainly higher as the Party confronts its defining dilemma: how to loosen the ties that bind without endangering either economic or, worse, political stability.

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China’s Reform, The World Bank And Vested Interests

The World Bank’s report on China in 2030 is a political manifesto disguised as an economic blueprint. Even the title, Building a Modern, Harmonious, and Creative High-Income Society, hits political not economic buttons. Not that the Bank casts it in that light, but it does provides China’s reformers with both strong arguments and influential backing to press ahead with reviving the economic reform. That has slowed to a glacial place now it has hit the hardest rocks of vested interest.

The World Bank gives the document intellectual and international heft. The participation of the State Council’s Development Research Centre, a prestigious government think tank, and with that the involvement of some of the most prominent technocrats who drafted the current five-year plan, lets the report avoid criticism leveled at recent International Monetary Fund recommendations for stepping up economic reform. That was castigated for being being an outside view that didn’t understand the realities of China. That can’t be said of the Bank’s report. It also gives it the implicit imprimatur of Li Keqiang, the man expected to take over from Wen Jiabao as prime minister in the current leadership transition and thus the Politburo member in charge of the economy. He signed off on the current five-year plan. He also told World Bank president Robert Zoellick, in Beijing to present the report, that China has “a long way to go before realizing modernization”.

Li is being realistic about the challenge ahead for China’s reformers. The World Bank report offers them a strategic description of the way forward rather than policy prescription. Its six strategic directions for China’s future are:

  • Completing the transition to a market economy;
  • Accelerating the pace of open innovation;
  • Going “green” to transform environmental stresses into green growth as a driver for development;
  • Expanding opportunities and services such as health, education and access to jobs for all people;
  • Modernizing and strengthening its domestic fiscal system;
  • Seeking mutually beneficial relations with the world by connecting China’s structural reforms to the changing international economy.

They are goals familiar to anyone who has read China’s current-five year plan, even if that couches them in terms that give more prominence to reductions in income inequality, universal social services, greater environmental protection and more energy efficiency. The Bank’s overarching message, though, lays out the unstated sub-text behind the five-year plan: structural reform is needed to promote a market-based economy, redefine the role of government, lessen the power of state enterprises and develop the private sector.

There is no doubt that China’s economy has reached the point in its development at which the dirigiste methods that have delivered 30 years of double digit growth need to change. Growth will inevitably slow in the coming years. All industrializing nations run into the law of large numbers. The exports and fixed asset investment that have driven growth cannot be sustained at that pace. Growing a $6 trillion economy by 10% in a year is a far greater task than growing a $350 billion one that much. That latter number is, best guess, roughly the size China’s economy was in 1981 in nominal terms. That is was 30 years of 10% growth does to $350 billion economy: turn it into $6 trillion one.

It is a remarkable achievement. Yet the arc of China’s development is not that different from the rapid industrialization phase of countries such as South Korea, Japan or even, much earlier, western Europe and the U.S., even if the magnitude of China’s arc is on an unprecedented scale. The country’s well of cheap labor, transferred from farm to factory, is starting to run low. Demographics, too, are working against growth. The value of foreign-developed technologies diminish as they age. Most of all, the economy needs to move up the value chain if it is to clear the barrier at which so many developing economies fall, that point where per capita income reaches at $10,000-12,000 a year. Vault it, and a nation becomes a middle income country on the road to being a rich one. Fail, and the country ends up stuck on a plateau of disappointed expectation.

China needs to do all that is recommended in the World Bank report if it is to clear that so-called middle-income trap, or economic Great Wall. The report doesn’t put it in these exact terms, but its message is that without reforms, growth will slow to the point where there isn’t the momentum to make the leap. This in not about whether there will be a hard or soft landing in the near term, though the Bank warns that responses to short term problems could undermine long-term strategy.

It is the politics that is the quagmire. There are clear implications for the Party in adopting market reforms. No country has done so successfully and remained a one party state. Even Japan’s Liberal Democratic Party, the closest approximation any democracy outside a city-state has had to one-party government, was eventually put into opposition at the ballot box. There is a difference between political rights and civil liberties, and the Party may find a seam in that distinction in which to work. But it would be a brave Bystander that bets on it.

The Bank does not push an overtly political agenda of what elsewhere in the world would be seen as neoliberal reforms. It hopes instead to push on an open door, offering practical steps to further an agenda China’s economic policymakers, if not all its leaders, have frequently endorsed. It does, though, call for the government “to redefine its role to focus more on systems, rules and laws” and for “redefining the roles of state-owned enterprises (SOEs) and breaking up monopolies in certain industries, diversifying ownership, lowering entry barriers to private firms, and easing access to finance for small and medium enterprises.” Those are all overtly political acts. The Bank recognizes the extent of the political opposition from vested interests to its proposed reforms. Even getting to this point with its report has been a political to and fro. The text is still a “conference edition”, i.e. subject to further revision, for which read political to and fro. State media’s reports on the report are low key (you’ll have to read to the final paragraph to find mention on it).

Reining in the power of the SOEs provides a particular challenge to the reformers. SOEs, like the military, are a source of power, money and influence for the princelings, the descendants of Mao’s original revolutionary leaders, an elite collective dynasty of some 400 families who hold extensive sway over the Party, army and the economy. Xi Jinping, the assumed successor to Hu Jintao as president, is one of their number. The princelings are neither a monolithic block nor are all opposed to reform. But modernizing the governance of the PLA to make China’s military internationally competitive is an easier sell for the reformers, and a creates more winners among the incumbents, than modernizing the state-owned enterprises and banks to the same end.

Yet without removing the structural distortions that the increasing sway of the of SOEs and banks hold over the economy, the sustainability of China’s growth remains in doubt. The double challenge is that the side effects of the twin forces of untrammeled infrastructure investment driven by SEOs and local governments that are little more than property developers–high energy consumption, inefficient capital allocation, unfettered real estate development and environmental degradation–also put economic growth at risk and threaten greater social unrest and thus the Party’s political legitimacy. Breaking the vested interests will be extremely hard for the reformers. Where they are not corrupt, they are systemic. Or both. That is one reason that reform has slowed to the extent it has.

Development of the private sector, giving more freedom to businesses to be innovative, changing the deeply rooted attitude of officials at the lower levels of the Party and government that quantity of economic growth matters more than quality of growth, more transparency to local government finances and governance, are all big changes from the way officials have done things for 30 years, 30 years that from inside China look immensely successful. China’s resilience to the post-2008 global financial crisis, and the authorities response to it, has, if anything, only further set back the case for structural reform.

That changes that China needs to rebalance its economy and go to the next phase of development go the nub of the nexus of government, Party and state, don’t make them any less necessary. How the new leadership handles it will be the measure of its success as custodian of the Party, state and government for the next ten years. The Bank is being politically adroit in casting its timetable for reform to well into the leadership term of those now about to assume the reins of power. Yet how, and whether, President Xi resolves the inevitable factional infighting between the inevitable winners and losers from reform, will determine the cast of his successors long before then.

If there is one thing a state-planned economy should be good at it is producing plans. Beijing has so many accomplished technocrats, and especially among its economic policymakers, that producing really good blueprints for change isn’t a problem for it. Implementing them is the challenge. For all the World Bank’s backing, an institution that may well be led by a Chinese before 2030, these are going to need strong domestic political leadership to be brought to fruition. That means the emergence of a modern-day Deng Xiaoping figure, singly or collectively, or, what no one wants, wrenching crisis. Otherwise China’s economy will stall, and wrenching crisis of another kind ensue. China will then look very different in 2030 from what anyone now is planning for.

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The One Question That Matters About China’s Model Of State Capitalism

Monday’s publication will push the World Bank’s report, China in 2030, to center stage in the emerging, if ultimately pointless debate about whether China’s state-directed capitalism is better than the U.S.’s free-market capitalism. The later has undeniably damaged its case with the self-inflicted injuries that caused the 2008 global financial crisis. The revival of the 1930’s blend of banker and gangster, bankster, is timely and apt, in that regard, just as are the Occupy protests that have sprung up around the free-market world. But, in their rush to throw out some fetid bathwater, capitalism’s critics risk tossing out the baby, too. Nor is the Chinese model a proven substitute. For all that it has seen China though the post-2008 crisis period with higher growth rates than the Western Economies, the long-term costs have yet to fall due.

The World Bank report reportedly argues that the dirigiste model that has seen China through a remarkable three decades of economic development has run its course. We don’t yet know the details of the Bank’s arguments, but this Bystander has long argued the necessity of structural change if China is to move up the development ladder. The heart of the real test for China’s state capitalism is not whether it is better than banksterism. It is, can it vault the country from the ranks of poor countries to rich. To do so, it will need to clear the middle-income trap or the economic Great Wall–choose your metaphor–something no developing country has done without institutional change. This Bystander thought it timely to republish China’s $10,000-12,000 Question, first published in January last year, examining whether China can defy history:

Whether political reform is an inevitable consequence of China’s economic reform has been a longstanding question. Ilian Mihov, an economics professor at INSEAD,  the Paris-based business school, flips the question on its head. He asks whether the country’s ability to develop its economy rapidly can continue without institutional reforms regarding the rule of law, governance and accountability.

In a recently published report of a session on China at an INSEAD symposium in Singapore last November, Mihov said China needs “deep structural reforms”. Command economies can only sustain fast growth with weak institutions for so long. The tipping point comes when per capita income reaches $10,000-12,000 a year, the point at which developing economies tend to stop developing without institutional change (see chart below)*.

“There is not a single country that has good quality institutions and is poor,” Mihov said in Singapore. “The gap between rich and poor is driven by poor productivity that is linked to poor quality institutions and poor business environment.”  As evidence he offers the contrasting experiences of Singapore and Venezuela. Even more dramatically, consider the economies of the old Soviet bloc, which collapsed as per capita incomes hit and then got stuck at the $12,000 a year level (adjusted for current prices).

China’s annual per capital income is $4,000. At current growth rates that gives it less than a decade before it starts bearing down in earnest on that tipping point or The Great Wall as Mihov inevitably dubs it.

What makes for the aforesaid poor quality institutions and a poor business environment includes political instability, government inefficiency and the prevalence of corruption. Those are factors within government’s control. There has been progress, albeit piecemeal, as with, for example, the current anti-corruption campaign and the improving quality of China’s civil, if not criminal courts. There are other reasons than planning for long-term economic development for those changes, but the $10,000-12,000 question is whether that progress continues at a sufficient pace to carry the country through the transformation to a new peak of development. Or will it be left stuck on the plateau of stagnation?

The growing economic and political clout of state-owned enterprises is another possible impediment to progress. Like Japan before it, China has grown fast by replicating and improving on what advanced economies have already done and producing and selling the results much more cheaply. Yet, as Japan found out, there comes a point where innovation has to replace imitation if growth is to be sustained.

China’s state-owned national champions and aspiring multinationals are ambitious, adaptive and fast learners (as were Japan’s). They are developing R&D and product development capabilities but they remain reliant on access to low-cost capital from the state, have rudimentary organizational and financial management skills by the standards of multinationals and have yet to acquire two of the most essential traits of a globalized multinational, managing diversity and allowing the intrapreneurship in which innovation can flourish (traits that few Japanese multinationals were able to acquire).

Beijing is throwing a wall of money and of engineers and scientists at making its national champions more innovative (dealing with diversity isn’t even on the radar). Yet in the process of building up the SOEs it is distorting markets and entrenching vested interests that increase the resistance to reform. It also crowds out small and medium sized companies where growth-generating innovation truly flourishes. Those need a particular business environment which is possible only with good institutions and a regulatory and governance regime that may not be to the taste of big business in the form of the SOEs, who see their (patriotic) role to be competing with other multinationals not fending off pesky upstarts at home.

That sets up a dilemma for the leadership. If the Party’s legitimacy to monopolistic rule depends on continuing to deliver the economic growth that keeps its citizens getting richer and Mihov is right that the country’s rapid economic growth cannot continue beyond a certain point without institutional reform, then managing the role of government in the economy and overcoming state-owned vested interests — in other words reforming itself — becomes China’s policy planners most important concern.

*There is a 2009 research paper on the $10,000-12,000 barrier by Mihov and his colleague Antonio Fatas, The 4Is of Economic Growth, from which the chart above was abstracted. A summary focusing on China, Another Challenge To China’s Growth, was published in the Harvard Business Review of March 2009.

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China’s $10,000-12,000 Question

Whether political reform is an inevitable consequence of China’s economic reform has been a longstanding question. Ilian Mihov, an economics professor at INSEAD,  the Paris-based business school, flips the question on its head. He asks whether the country’s ability to develop its economy rapidly can continue without institutional reforms regarding the rule of law, governance and accountability.

In a recently published report of a session on China at an INSEAD symposium in Singapore last November, Mihov said China needs “deep structural reforms”. Command economies can only sustain fast growth with weak institutions for so long. The tipping point comes when per capita income reaches $10,000-12,000 a year, the point at which developing economies tend to stop developing without institutional change (see chart below)*.

“There is not a single country that has good quality institutions and is poor,” Mihov said in Singapore. “The gap between rich and poor is driven by poor productivity that is linked to poor quality institutions and poor business environment.”  As evidence he offers the contrasting experiences of Singapore and Venezuela. Even more dramatically, consider the economies of the old Soviet bloc, which collapsed as per capita incomes hit and then got stuck at the $12,000 a year level (adjusted for current prices).

China’s annual per capital income is $4,000. At current growth rates that gives it less than a decade before it starts bearing down in earnest on that tipping point or The Great Wall as Mihov inevitably dubs it.

What makes for the aforesaid poor quality institutions and a poor business environment includes political instability, government inefficiency and the prevalence of corruption. Those are factors within government’s control. There has been progress, albeit piecemeal, as with, for example, the current anti-corruption campaign and, as Dan Harris from China Law Blog points out, the improving quality of China’s civil, if not criminal courts. There are other reasons than planning for long-term economic development for those changes, but the $10,000-12,000 question is whether that progress continues at a sufficient pace to carry the country through the transformation to a new peak of development. Or will it be left stuck on the plateau of stagnation?

The growing economic and political clout of state-owned enterprises is another possible impediment to progress. Like Japan before it, China has grown fast by replicating and improving on what advanced economies have already done and producing and selling the results much more cheaply. Yet, as Japan found out, there comes a point where innovation has to replace imitation if growth is to be sustained.

China’s state-owned national champions and aspiring multinationals are ambitious, adaptive and fast learners (as were Japan’s). They are developing R&D and product development capabilities but they remain reliant on access to low-cost capital from the state, have rudimentary organizational and financial management skills by the standards of multinationals and have yet to acquire two of the most essential traits of a globalized multinational, managing diversity and allowing the intrapreneurship in which innovation can flourish (traits that few Japanese multinationals were able to acquire).

Beijing is throwing a wall of money and of engineers and scientists at making its national champions more innovative (dealing with diversity isn’t even on the radar). Yet in the process of building up the SOEs it is distorting markets and entrenching vested interests that increase the resistance to reform. It also crowds out small and medium sized companies where growth-generating innovation truly flourishes. Those need a particular business environment which is possible only with good institutions and a regulatory and governance regime that may not be to the taste of big business in the form of the SOEs, who see their (patriotic) role to be competing with other multinationals not fending off pesky upstarts at home.

That sets up a dilemma for the leadership. If the Party’s legitimacy to monopolistic rule depends on continuing to deliver the economic growth that keeps its citizens getting richer and Mihov is right that the country’s rapid economic growth cannot continue beyond a certain point without institutional reform, then managing the role of government in the economy and overcoming state-owned vested interests — in other words reforming itself — becomes China’s policy planners most important concern.

*There is a 2009 research paper on the $10,000-12,000 barrier by Mihov and his colleague Antonio Fatas, The 4Is of Economic Growth, from which the chart above was abstracted. A summary focusing on China, Another Challenge To China’s Growth, was published in the Harvard Business Review of March 2009.

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As SOEs Give With One Hand, What Will They Take With The Other?

This has been a good global financial crisis for China’s large state-owned enterprises. Their economic and policymaking clout has expanded. The days of loss-making SOEs are a distant memory. Front of mind now is a cadre of wealthy and powerful national champions and state-controlled multinationals dominating the commanding heights of the economy. There are more heads of SOEs on the Party’s central committee than ever before and often they outrank the regulators and supervisors for their industries.

Along with that has come a surge in profitability. Collectively, the centrally administered SOEs will make 1 trillion yuan of profits for the first time this year. The energy and natural resources, finance and telecommunications SOEs have done particularly well. Most have done well from the real-estate boom, too, thanks to their political connections, so well that central government has ordered them to get out of property development where it isn’t a core business as part of the measures to let down that particular bubble. The response has been lukewarm to say the least.

The Finance Ministry has also now told more SOEs to start paying a dividend to central government and those that already do to increase the cut of the their profits they hand over. These are both measures that the SOEs and their supervising ministries have fiercely resisted. Even at the proposed maximum 15% of post-tax profits, that is still half the effective rate imposed on state-owned companies in most other parts of the world.

With the emphasis on social welfare priorities in the new five-year plan, it may have come to the point where even the SOEs, whose profits increased by 50% year-on-year in the first eleven months of this year, couldn’t keep their hands stuffed in their pockets anymore. But as they give with one hand, we wonder what they will take with the other. More regulatory actions like giving the state-owned telecoms carriers a duopoly over VoiP telephony, and squashing pesky private-sector competitors eating away their profits?

 

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