China in Transition

Can China Reform State-Owned Enterprises without Privatization?
—Creation of a Fair and Competitive Market Environment as the Second-Best Option

Chi Hung KWAN
Consulting Fellow, RIETI

For China, which aims for transition from a planned economy to a market economy, shifting from public ownership centered on state-owned enterprises (SOEs) to private ownership centered on private enterprises and other non-state-owned enterprises is a path that cannot be avoided. Generally speaking, this is achieved through the privatization of SOEs and the growth of private enterprises.

However, four decades after the launch of the reform and opening-up initiative in the late 1970s, SOEs still maintain a monopoly position in many sectors while continuing to receive governmental support. On the other hand, private enterprises are at a disadvantage in market competition, as they are still subject to all kinds of discriminatory treatments. In recent years, as the government's policy of fostering large and internationally competitive SOEs has added to this problem, the trend toward "the advance of the state and retreat of the private sector" (increasing the share of SOEs and decreasing the share of private enterprises) has emerged. Under the government of President Xi Jinping, instead of privatization, mixed-ownership reform, which injects private capital into SOEs, is being promoted. However, in most cases, state-owned capital continues to maintain control, with the ratio of private shareholding kept at a low level.

If SOEs are to be fundamentally reformed, privatization is desirable. If this is politically difficult, the second-best option is minimizing governmental market intervention and creating a fair and competitive market environment. When doing that, the principle of competitive neutrality advocated by the OECD will serve as a useful reference.

Conspicuous inequality remains between different types of ownership

The main cause of the inequality between enterprises operating under different types of ownership is that the government maintains control over the bulk of the country's resources, most of which it allocates to SOEs (Figure 1). Those resources include (1) resources liable to lead to monopoly because of a strong network effect, (2) land and other natural resources, (3) special permits for businesses requiring a market entry license, (4) investment-related resources, (5) resources related to industrial funds and investment funds, (6) price-setting rights, and (7) directly or indirectly controlled state-owned property.

Table 1. Resources Controlled by the Chinese Government
Table 1. Resources Controlled by the Chinese Government
Source: Prepared by the author based on a speech titled "Reform the method of resource allocation by the government and let the market play a decisive role" by Zhang Siping, a former Deputy Mayor of Shenzhen, at the Third China Economic Forum, September 15, 2018).

The allocation of resource by the government creates a market monopoly by SOEs and an unfair competitive environment. SOEs generate excess production capacity by expanding business with no regard for profitability on the back of their special status and the benefits of governmental policies, and their business activities also squeeze the business of private enterprises. This situation lowers the efficiency of resource usage, thereby bringing huge losses to the Chinese economy. Furthermore, the profits earned and assets acquired by SOEs as a result of the preferential resource allocation by the government have covered up problems, such as the enterprises' low level of efficiency (Note 1). This has caused delays in the reform of SOEs.

The government not only owns SOEs but also has the legal authority to supervise and manage all enterprises and the whole of society. The authority includes the power to supervise and manage private and foreign-invested enterprises that compete with SOEs, to approve their business licenses, and to levy various taxes on them. If SOEs can strengthen their own competitive advantage on the back of the state authority, fair competition cannot be realized.

Indeed, in China, SOEs are often given precedence over private enterprises in terms of law enforcement (Liu Yanan and Wang Wei Jian, "Why are CEOs Worried?" People's Daily, December 12, 2016). To be more specific, private enterprises' property rights and legitimate interests do not receive effective protection, so they face institutional and invisible obstacles to market entry and economic activity. In particular, at the time of a personnel change at a government agency, the reversal of the predecessor's commitments by the newcomer lowers private enterprises' motivation for investment. In addition, cases of abuse of judicial power by security and prosecution authorities to illegally seize private enterprises' assets are frequently observed.

Government's policies of "grasping the large and letting the small go" and "fostering large and internationally competitive SOEs" that have aggravated the trend toward "the advance of the state and retreat of the private sector"

To resolve the inequality between enterprises operating under different types of ownership, China has been promoting theoretical innovation so that it can overcome constraints imposed by existing ideologies. However, the pace of innovation has slowed down, making it difficult to keep up with changes in the circumstances. In particular, the reform initiatives implemented since the 1990s, such as "grasping the large and letting the small go" and "fostering large and internationally competitive SOEs," have afforded legitimacy to the trend toward "the advance of the state and retreat of the private sector" that later emerged (Yu Zhi, "Overview of the Reform of SOEs: History, Reality and Future," the Chinese-language website of The Financial Times, November 16, 2018).

In the 1990s, awareness of the need to implement privatization in order to improve the efficiency of SOEs spread. However, as the existing ideologies imposed constraints, the government failed to go ahead with full privatization of SOEs. In the name of structural adjustment, the government relaxed its control over small and medium-size SOEs (letting the small go) without privatizing large SOEs (grasping the large) in industries that form the core of the national economy. Most of the SOEs in industries which form the core of the national economy and which fall into the "grasping the large" category belong to raw materials industries in the upstream sector, such as mining and energy. SOEs which fall into the "letting the small go" category belong to competitive industries in the downstream sector that provide consumer goods and services.

At first, the structural reform that took the form of "grasping the large and letting the small go" had the effect of promoting the trend toward "the advance of the private sector and retreat of the state" (decreasing the share of SOEs and increasing the share of private enterprises), but it also sowed the seeds of the trend toward "the advance of the state and retreat of the private sector" (increasing the share of SOEs and decreasing the share of private enterprises). In recent years in particular, because the government has strengthened its stance of supporting SOEs in the name of "fostering large and internationally competitiveness SOEs," private enterprises are increasingly at a disadvantage in market competition. As SOEs can set the prices of raw materials they supply at a high level by exploiting their monopoly position in the upstream sector, they enjoy high profitability despite their low efficiency. In contrast, as private enterprises in the downstream sector have to purchase raw materials at high prices, their profitability is deteriorating. When SOEs seek to become stronger, they usually receive governmental support instead of exercising their own capabilities. Furthermore, many private enterprises are concerned over the risk that they may become subject to stronger regulation because they compete with SOEs or that they may be nationalized in a worst-case scenario.

Mixed-ownership reform is no substitute for privatization

In place of privatization, the Chinese government is carrying out mixed-ownership reform that injects private capital into SOEs.

Pilot tests are already being conducted in some selected SOEs. In particular, the reform of China Unicom has attracted attention, both in China and abroad, as a model case of mixed-ownership reform at a large SOE because it affects the company's main business and also because strategic investors that newly made capital participation include many well-known private enterprises, such as Alibaba and Tencent. However, following the mixed-ownership reform, China Unicom Group, the holding company, still retains its position as the controlling shareholder of China Unicom, and moreover, the share of state-owned capital, including equity holdings of other state-owned shareholders, is still higher than 50%. As a result, non-state-owned shareholders, including strategic investors, remain relegated to the status of minority shareholders with limited say in important decisions.

The most important goal of the mixed-ownership reform is improving the efficiency of SOEs by creating a fair and competitive market environment and strengthening their governance. However, it is doubtful whether the mixed-ownership reform is the most effective means of achieving that goal. If the goal of the mixed-ownership reform is resolving the state of monopoly by state-owned capital in some industries, the best way to do that is to enable enterprises operating under different types of ownership to compete with one another—particularly private enterprises to compete with SOEs—fairly and on an equal footing by lowering entry barriers. If the goal of the mixed-ownership reform is bringing change to the management structure, including corporate governance, by changing the shareholder structure, the government must change the approach of controlling SOEs in its capacity as their owner. If promoting privatization is politically difficult, the government should place the emphasis of the reform on creating a fair and competitive market environment as the second-best option.

Principle of competitive neutrality should be upheld

In a market economy, as fair competition is the prerequisite, even SOEs must participate in market competition as independent business agents, as other enterprises do, by enhancing their competitive advantage without relying on governmental support. As to how SOEs should operate in a market economy, the principle of competitive neutrality advocated by the OECD serves as a useful reference.

If the principle of competitive neutrality is to be followed, the government must maintain neutrality by giving equal treatment to enterprises operating under different types of ownership, including SOEs, private enterprises, and foreign-invested enterprises. In other words, the government must not provide, by means of policy, an unfair competitive advantage to existing and potential market participants, particularly SOEs. The principle of competitive neutrality was first proposed by Australia in 1996. Based on Australia's proposal, the OECD worked out and presented more detailed specifics through a series of reports starting in 2011 (OECD, "OECD Guidelines on Corporate Governance of SOEs, 2015 Edition").

  1. (1) There should be a clear separation between the state's ownership function and other state functions that may influence the conditions for SOEs, particularly with regard to market regulation.
  2. (2) Stakeholders and other interested parties, including creditors and competitors, should have access to efficient redress through unbiased legal or arbitration processes when they consider that their rights have been violated.
  3. (3) Where SOEs combine economic activities and public policy objectives, high standards of transparency and disclosure regarding their cost and revenue structures must be maintained, allowing for an attribution to main activity areas.
  4. (4) Costs related to public policy objectives should be funded by the state and disclosed.
  5. (5) As a guiding principle, SOEs undertaking economic activities should not be exempt from the application of general laws, tax codes and regulations. Laws and regulations should not unduly discriminate between SOEs and their market competitors. SOEs' legal form should allow creditors to press their claims and to initiate insolvency procedures.
  6. (6) SOEs' economic activities should face market consistent conditions regarding access to debt and equity finance. In particular:
    1. SOEs'relations with all financial institutions, as well as non-financial SOEs, should be based on purely commercial grounds.
    2. SOEs'economic activities should not benefit from any indirect financial support that confers an advantage over private competitors, such as preferential financing, tax arrears or preferential trade credits from other SOEs. SOEs' economic activities should not receive inputs (such as energy, water or land) at prices or conditions more favorable than those available to private competitors.
    3. SOEs'economic activities should be required to earn rates of return that are, taking into account their operational conditions, consistent with those obtained by competing private enterprises.
  7. (7) When SOEs engage in public procurement, whether as bidder or procurer, the procedures involved should be competitive, non-discriminatory and safeguarded by appropriate standards of transparency.

The Chinese government is also promoting the creation of a fair and competitive market environment as the objective of the market economy reform. To that end, the government issued "Opinions on Establishing a Fair Competition Review System in the Construction of Market System" (June 14, 2016), followed by the issuance of "Notice on Issuing the Fair Competition Review System Implementing Regulations (Interim)" (October 23, 2017). These documents prescribed that policy-making organizations, including administrative agencies, should conduct a fair competition review, evaluate the impact on market competition, and prevent the exclusion or limitation of market competition when they prepare regulations, normative documents and policy measures related to matters concerning market players' economic activities, such as market entry permission, industrial development, invitation for enterprises to locate business operations, injection of funds, invitation for bids, bidding, government procurement, code of management conduct, and qualification criteria.

Meanwhile, "Opinions of the Central Committee of the Communist Party of China and the State Council on Improving the Property Right Protection System and Providing Law-based Protection to Property Rights", which was issued on November 4, 2016, stated that the government should accelerate the establishment of a property rights protection system and effectively protect the property of economic organizations under different types of ownership and citizens, and that interference in judicial activities, judicial disputes and specified cases by senior officials of the Communist Party and the government should be prohibited.

Limitation of the government's intervention in the market as the prerequisite for a fair and competitive market environment

In order to thoroughly pursue the principle of competitive neutrality, the government's intervention in corporate activities and the market must be minimized.

First, the government's authority over resource allocation should be significantly reduced. The market should be allowed to play a decisive role in resource allocation, while the government's role should be limited to providing public goods, responding to market failures, redistributing income through social security, and achieving economic stability through macroeconomic policies.

Next, the government should sever its "parent-child" relationship with SOEs by maintaining the direction of the reform, which is moving toward the separation of government and business (see Box). SOEs must acquire the capability to compete in the market without governmental support.

It is also essential to accelerate the reform of monopoly industries. It is important to ease entry regulation in industries monopolized by SOEs, permit entry by enterprises operating under different types of ownership, including private and foreign-invested enterprises, and strengthen price control and the supervision of service quality by the government in sectors prone to natural monopoly.

However, while the government continues to own SOEs, it will be difficult to implement those policy measures. Although further innovation in ownership theory is required in order to prompt a policy shift to the promotion of privatization, there are not yet signs of such innovation occurring (Note 2).

(Box) The trend toward separation of government and business has been reversed

What has been occurring at SOEs in recent years is an increase in intervention by the Chinese Communist Party and the government, rather than the separation of government and business (Zhang Siping, "How will SOEs survive and develop in a fair competitive environment?" Shenzhen Innovation and Development Institute, November 14, 2018).

First, managers at SOEs are increasingly becoming civil servants, as the civil servant status is being applied to them again. "The Decision of The Central Committee of the Communist Party of China on Major Issues Concerning the Reform and Development of SOEs" adopted at the Fourth Plenum of the 15th CPC Central Committee in 1999, prescribed that the civil servant status of managers at SOEs should be abolished. However, in recent years, the central and local organization departments of the Communist Party have been applying the civil servant status to managers at SOEs again and regained the personnel appointment authority concerning senior officials from the government agencies responsible for management of state-owned assets and the board of directors of SOEs. This has opened a channel whereby senior officials of the Party and the government move to top management posts at SOEs, making it possible for senior Party and government officials with no experience in business management to assume the post of chairman or CEO at SOEs. As a result, public recruitment for senior executives at SOEs has been discontinued, and SOEs have become similar to the Party and the government in terms of not only the selection of leaders, performance management, and the appointment system but also the remuneration system. In particular, because the remuneration level for senior Party and government officials is lower than the level for executives at non-state-owned enterprises, competent personnel are unlikely to be attracted by SOEs even if open recruitment is used.

Moreover, Party committees have acquired control over decision-making at SOEs. The role of Party committees in SOEs has extended beyond the traditional scope, which was limited to the supervision of enterprises, to decision-making. As a result, the authority of the board of directors has weakened, while shareholders have lost some legal rights prescribed by the company law, including the rights to make important decisions and to elect managers, which they previously exercised in accordance with the size of their shareholdings. In particular, however much a private enterprise is investing in an SOE, it has to follow decision-making by the Party committee there. Unless these problems are resolved, it will be difficult to establish corporate governance at SOEs.

The original text in Japanese was posted on April 11, 2019.

  1. ^ Between 2001 and 2013, the average return on equity (ROE) for state-owned and state- holding industrial enterprises was 9.1%, lower than the average ROE of 15.7% for non-state-owned industrial enterprises (China Statistical Yearbook for the relevant years). In addition, SOEs not only receive subsidies from the government but also enjoy other benefits, such as the reduction or exemption of fund-raising cost, land usage fees and the resource tax, so their ROE does not reflect their actual business performance. According to an estimate by the Unirule Institute of Economics, if it is assumed that the profits obtained by SOEs through the government's preferential policy measures have to be earned by them at their own cost, their average ROE would be minus 3.7% (Unirule Institute of Economics, "Characteristics, Performance and Reform of SOEs," the website of Unirule Institute of Economics, January 5, 2016).
  2. ^ 2. The "Guideline to Deepen Reforms of SOEs," which was announced on September 13, 2015, classifies SOEs into for-profit entities and public welfare enterprises. For-profit entities are subdivided into competitive enterprises (for-profit Class I) and specific-purpose enterprises (for-profit Class II), and different reform policies have been indicated for the two categories. Enterprises in the for-profit Class I), which operate mainly in sectors where there is sufficient market competition, such as the consumer goods sector, are allowed to diversify their stock ownership structure by introducing other state-owned capital and non-state-owned capital (mainly private capital) through a stock exchange listing on a group basis (including the main business operations). In addition, in the case of this class, the government does not necessarily seek to control enterprises through state-owned capital. Fully pursuing this policy will pave the way for the privatization of SOEs in competitive industries.

March 13, 2020