To see the dangers that lurk in China’s economic model, one need only look across the border to Vietnam. After aid from the former Soviet Union dried up in the late 1980s, Vietnam decided to try China’s proven recipe for success: mostly liberalize the economy, but retain control of the commanding heights through state-owned companies.
The results have been disappointing. Vietnam’s growth slid beneath 6% for the year 2011, well beneath its potential. Inflation is hovering at around 20%. Financial repression (when savers are forced to accept negative real interest rates) has encouraged Vietnam’s rich to eschew saving and plow cash into increasingly exotic assets – most recently, golf club memberships. Even the country’s leaders acknowledge that the situation will likely get worse in 2012.
Much of the blame has fallen on Vietnam’s many state-owned enterprises (SOEs), impressively unproductive companies that are kept afloat with ever-larger dollops of government aid. The result is both slowing growth and creeping inflation – known as the dreaded “stagflation.”
Corporate converts
Are China’s national champions destined to follow the same path? If they turn sour, the impact would be enormous: State-owned enterprises of one sort or another make up a staggering 50% of the Chinese economy, according to the US-China Economic and Security Review Commission.
Fortunately for Beijing, the fate of state-owned companies is far from clear-cut. SOEs are, by definition, simply firms created by the government, and their performance varies tremendously. Sure, Vietnam’s shipping giant Vinashin managed to go bankrupt even with government funding. But the sovereign wealth arms of Singapore and Norway regularly deliver better returns than many similar-sized private funds. The quality of China’s state-owned enterprises is similarly mixed. Some are caricatures of bureaucratic incompetence; others are stuffed with MBA-wielding executives spouting the gospel of shareholder value.
The presence of those leaner, meaner SOEs can be chocked up to painful but necessary reforms pushed through by Party Secretary Jiang Zemin and Premier Zhu Rongji in the 1990s. During their tenure, thousands of SOEs were closed, restructured or listed. an injection of market discipline that allowed them to avoid the malaise of their Vietnamese counterparts.
The numbers speak for themselves: China’s SOEs clocked up RMB1.99 trillion (US$315 billion) in profit during 2010, a whopping 39.7% year-on-year increase. During the first half of 2011, the growth was 22.3% – slower, but still better than most private Western firms.
Below the surface, however, a different picture emerges. Attempting to tease out the benefit SOEs receive from cheap government capital is devilishly hard, but a landmark 2009 study by economists Giovanni Ferri and Li-Gang Liu for the Hong Kong Monetary Authority found that “if SOEs were to pay a market interest rate, their existing profits would be entirely wiped out.”
Other studies suggest that SOEs may be losing a substantial amount of money, especially when the effects of high commodity prices in recent years are stripped out – just under one-third of total SOE profits in 2010 were generated by the country’s three oil giants.
No profit, no problem
The bottom line is that incentives matter, and China’s state-owned companies do not have the same incentives for efficiency as private firms. That means SOEs on average produce fewer goods and services with the same labor and capital than private firms, which drags on the economy. Some are also monopolistic, which leads to elevated prices.
The only permanent solution is further privatization, preferably while China’s economy is still strong enough to cleanly absorb the costs of reform. However, that seems unlikely for political reasons. Such a significant transfer of wealth would necessarily involve dislodging vested interests. For politicians to embark on needed reforms without an immediate cause and during a sensitive political transition seems almost foolhardy.
Moreover, few of today’s high-ranking officials appear to have Jiang and Zhu’s taste for liberalization. Serious market reforms are widely seen to have stalled around 2005, when the administration of Hu Jintao and Wen Jiabao consolidated its grip on power and began focusing on spreading the benefits of growth.
The 24-member Politburo is now dominated by provincial-level officials more keen on distributing patronage to their supporters than pushing agendas of any sort. And as Cheng Li of the Brookings Institution points out, party ranks are increasingly populated by corporate types with close links to SOEs. In short, the vested interests protecting state-owned companies are becoming stronger, not weaker.
Furthermore, would-be reformers are likely to find the going much tougher than Jiang and Zhu did just 15 years ago. With each successive political generation, power at the top of the Chinese state has become more diffuse; big changes now require larger and more unwieldy coalitions.
All this makes serious SOE reform unlikely, which is unfortunate. The system may seem sustainable now, but systemic issues usually bubble to the surface only during troubled economic times, when money-making becomes hard and inefficient companies go bust. This is precisely when reform will prove most painful and difficult to pull off.
Economic prognosticators continuing to whittle away at their China growth forecasts. The country’s leaders would do well to repair the roof while the sun is still shining.