China Soes Final

8/3/2019 China Soes Final

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Chinas state-owned enterprises remain a drag on the economy during the reform era

even though their efficiency might be improving, (World Bank 1996). Discuss.

Introduction

It is no doubt that Chinas state-owned industrial enterprises (SOEs) have fared poorly in

comparison to non-SOEs during the reform era, with statistics available detailing the

declining profitability endured by these firms. However, to proclaim they have been a drag on

the economy without giving much thought into the changing nature of Chinas restructuring

economy would be unreasonable. SOEs have performed far better than is conventionally

held (Laurenceson and Chai, 2000; 24), despite having to pay higher taxes, wages, and

increasing social welfare burdens compared to non-SOEs. Advocates of shock therapy or the

big bang approach will disagree (Lo, 1999; 693), linking the weaker performance to

institutions that conform less to market regulation and claim SOEs are not reformable. This

paper will argue that SOEs have not been a drag on the economy as the World Bank has

alleged in its 1996 report (World Bank, 1996; 23), but have performed remarkably well given

their circumstances during Chinas reform era.

SOEs by nature are enterprises owned and governed by the state. A significant discussion has

centred around SOEs being inefficient and loss making, one when considering 44% of

Chinese SOEs were loss-making enterprises in 1996 is difficult to contest (Bramall, 2000;

394). Given that collectively owned enterprises (COEs) are mainly township and village

enterprises (TVEs) run and influenced by local governments, the comparison between them

and SOEs cannot justify private ownership is better (Lo, 1999; 695). These smaller firms are

usually characterised by labour-intensive modes of production, due to the abundance of rural

labour and with capital being expensive to deploy in such areas.


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If one looks into the performance of large and medium size enterprises (LMEs), which have

been at the heart of Chinas transformed Soviet-type economy you will see their performance

has been comparable, if not better than COEs throughout the entire reform era accounting for

46 percent of industrial output in 1993 (Lo,1999; 695). LMEs are overwhelmingly state-

owned enterprises, but a question arises to why LMEs have been considered to be more

successful than both SOEs and non-SOEs given their operations are less marketised and their

institutions far less akin to private ownership (Lo, 1999; 694). To assess whether SOEs have

been a drag on the economy we must venture into three important areas affecting their

performance: profitability, productive efficiency and the restructuring of firms since 1978.

Profitability

Basic economy theory will tell us falling profitability is a serious issue for the competitive

firm, even if these losses are subsidised by the state. During the reform era, both SOEs and

non-SOEs have faced declining performance though greater focus has been given to SOEs.

Financially SOEs outperformed COEs in the boom years of the 1980s, but were outperformed

by COEs during the recession and subsequent rebound period in the 1990s (Lo, 1999; 696).

During the downturn SOEs had incentives not to cut production, as a build up of inventory

stock in the then accounting system would have proportionally cut the share of the wage bill

and depreciation charges thereby boosting profits (Holz, 2003; 66).


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Source: (Lo, 1999; 699)

To be fair, the rapid rise of rural firms did not begin to erupt until after 1984 and the growth

of their numbers bore into the monopoly profits enjoyed by SOEs and subsequently reduced

profit margins (Bramall, 2000; 393). Naughton proposes it was this rise in competition from

rural TVEs and COEs which contributed to the declining profitability of state-owned

enterprises (Naughton, 2007; 275), and given in a perfectly competitive economy exit for

non- profitable firms is easy, in Chinas context the exit ofSOEs was incredibly difficult

(Holz, 2003; 164). New rural enterprises could enter product niches in which SOEs did not

operate in, such as producing miscellaneous household goods including buttons, ribbons and

plastic ID card holders as displayed by households in the Wenzhou region (Naughton, 2007;

283).


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Whilst credible, Naughtons argument has been opposed by Fan Gang , Wing-Thye Woo and

Jeffrey Sachs who propose excessive labour remuneration is to blame (Holz, 2003; 96).

They show in aggregate that total income rose faster than total net output (ibid), however

with the emergence of new firms and the introduction of competitive policies, SOE managers

would have had to keep wages competitive or else suffer a haemorrhage of skilled labour

(Bramall, 2000; 391). Furthermore, the wages of workers would eventually be tied to

enterprise performance.

To simply ignore other costs such as tax and welfare a fair and accurate diagnosis cannot be

made. COEs have enjoyed lower taxes and tax concessions throughout the reform era, as

have firms in special economic zones, both paying 35 percent and 15 percent income tax

prior to 1994 (Laurenceson and Chai, 2000; 33). Although 30 percent of TVE profits were

channelled to local governments to support agriculture, this money was reinvested in rural

enterprises as local governments knew they would make a return on their investments. SOEs

on the other hand faced much higher tax obligations; 55 percent prior to 1994 (ibid). It should

be noted before the tax reforms were implemented in the early 1990s, SOEs were obligated to

hand over all profits to the state, and profit incentives did not come into force until the early

1980s (Naughton, 2007; 304). Contribution to state revenue by SOEs and COEs was 71

percent and 17 percent respectively in 1995, highlighting the tax inequality between the

enterprises (Lo, 1999; 706). As a legacy of the planning system SOEs face high welfare

burdens including providing housing, health insurance, disability insurance and pensions; an

obligation not necessitated by rural enterprises (Qian and Weingast, 1997; 259). Pension

payments in particular have been on the rise, increasing from 9bn Yuan in 1985 to a

staggering 60bn in 1995, equivalent to 12 percent and 90 percent of their after-tax profits

respectively (Lo, 1999; 706).


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Private firms will generally avoid venturing into industries where profitability is low, such as

the energy sector in Chinese industry. In sectors such as coal mining, petroleum extraction

and electricity output prices were kept administratively low by the state, as these outputs

would act as inputs for other sectors. The lions share (Cheng and Lo, 2002; 421) of losses

endured by SOEs was concentrated in this sector, accounting for 83 percent of total losses in

1986, 80 percent in 1990 and 72 percent in 1995. Although productivity may have been high,

profits could not be increased due to the state-set prices. One cannot simply overlook this fact

and ascertain that SOEs are inherently unprofitable, because if output prices in this sector

were set at market prices, then inputs in other sectors would have been much higher,

producing uncompetitive firms.

Neoclassical economists will argue fixed prices distort the optimal allocation of resources and

do not reflect the level of scarcity in an economy (Laurenceson, 2000; 23), though fixed

prices in China have allowed inflation to remain relatively low. A surge in inflation did occur

in 1988, at the cause of market-price implementation which would have caused demand to

fall and real income to decline; this led to a policy of macroeconomic contraction which then

adversely affected profits and productivity (Bramall, 2000; 390).

Profitability by itself cannot explain the worsening performance of state-owned enterprises

during the reform era, nor can it dig into the changing productivity of firms throughout this

period which we now look into.

Productive efficiency

SOEs are said to be less efficient than COEs and TVEs, with their share of industrial output

falling to 33 percent in 1996 from 77 percent in 1978, whilst the TVE share of output rose


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from 9 percent to 28 percent in the same period (Naughton, 2007; 300). By having the state

subsidise losses and finance investment, SOEs could afford to be lacklustre in their

productivity habits, unlike rural enterprises that had to compete to survive in an ever growing

atmosphere. However, enterprise loss subsidies have been falling throughout the reform era

accounting for only 0.5 percent of GDP in 1996 (Lo, 1999; 702) indicating performance has

been improving.

Source: (Lo, 1999; 702)

To analyse changes in productivity growth we look into changes in total factor productivity

(TFP), a residual we can obtain from the Cobb Douglas function:

a = q - l (1-)k,

where a represents TFP and and (1-) the elasticity of labour and capital respectively. Lo

estimates TFP growth for SOEs to have been 1.49 percent between 1980-1886, and 3.6

percent for COEs in the same period when =0.4 (ibid; 699).


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Source: (Lo, 1999; 700)

Laurenceson and Chai have graphed the changing patterns of TFP of SOEs over the course of

reform along with total price performance (TFP), with the results showing a rising trend in

TFP but a decline in TPP, indicating a worsening of the terms of trade for SOEs due to input

prices from agriculture being high and many output prices being low (Laurenceson and Chai,

2000; 31).

Source: (Laurenceson and Chai, 2000; 32)


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One explanation for the slower rise in TFP can be attributed to the fact that many SOEs

corporatized following the introduction of Company Law in 1994, thus changing their

enterprise category and leaving inefficient firms behind in the SOE category. However the

shareholding sector experienced declining TFP, at an average rate of 7.96% per annum

between 1993-1996 (Jefferson, et.al, 200; 13), quite surprising due to their nature as profit-

seeking enterprises. Furthermore, some TFP growth can be credited to accelerated technical

progress in the 1980s, and through technology transfers through FDI which expanded after

1992 (Bramall, 2000; 237) causing a rise in capital productivity in SOEs of 7.72 percent

between 1992-1996 (Jefferson et.al, 2000; 8). As firms were restructuring their enterprises,

many formed joint-ventures with foreign firms who then invested and transferred new capital

into China. Foreign firms were encouraged to invest in China with intellectual property rights

incentives if production and technology were transferred (Naughton, 2007; 360). Although

rural enterprises enjoy greater property rights over collective land, TVE property rights have

been viewed as fuzzy (ibid; 121) given the complexity of land-use negotiations.

Rural enterprises were able to absorb surplus labour, and were free to relieve workers if their

contributions were not providing much value. In contrast, as many SOEs predate back to the

planned era in where employment was preferred over profitability; state-industrial workers

were offered permanent contracts and could not be laid off during downturns or periods of

falling demand (Laurenceson, 2000; 29). Thus in the economic downturn of 1988-92 labour

productivity fell, but began to rise across all sectors during the decade as corporatisation

allowed firms to lay off redundant workers, growing at 8.5 percent for SOEs between 1992-

1996 and 18.81 percent for COEs (Jefferson et.al, 2000; 9). SOE capital productivity too

suffered similar declines in the downturn, averaging 3.42 percent per annum in the downturn,


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but rose to 7.72 percent between 1992-96; with their profit-to-capital ratio being close to that

of COEs (Lo, 1999; 694).

Source: (Lo, 1999; 698)

One advantage state-owned enterprises enjoyed over their rural competitors was the fact that

they were able to benefit from soft budget constraints, with 62 percent of fixed investment

being funded by the government in 1978 (Naughton, 2007; 305) though this figure dropped to

a mere 3 percent in 1997. The state soon stopped lending to banks but carried on asking for

remittances, and the only source of finance for enterprises were now banks which had been

broken up into central and four large smaller banks (Holz, 2003; 62). Borrowing from banks

was an incentive to increase efficiency, though in practise many banks lent on the request of

local politicians and planners rather than commercial viability (ibid). In contrast, TVEs and

COEs faced a hard budget constraint. They did not have access to state finance, but relied on

finance from rural credit cooperatives (RCCs), who were funded from household savings

(Qian and Weingast, 1997; 259). Household savings began to grow along with the rapid rise


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of rural enterprises, and with it loans increased because deposits increased (Naughton, 2007;

279). Harder budget constraints simply contributed to greater incentives for non-SOEs to

increase their profitability; else they would of course go out of business.

Restructuring

The pre-reform era was characterised by central planning and fixed prices, neither of which

would deem practical to neoclassical economists. However, the 1980s would see many

reforms be implemented to provide greater incentives for SOEs to improve their productivity

and profitability, in order to become more competitive with the rising trend of rural

enterprises.

Pilot reforms in the 1980s and the Company Law act in the early 1990s sought to turn

enterprises into profit-seeking firms, and paved way for the restructuring of

organisations.(Lin and Zhu, 2001; 310). Under the modern enterprise system SOEs

transformed into limited liability and limited liability stock companies, employee-

shareholding co-operative and private enterprises, the latter being the least favourite with

only 7 percent of restructured SOEs choosing this option according to an industrial survey

carried out in 1998 (ibid; 321).


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Source: (Lin and Zhu, 2001; 323)

For the limited companies, assets would be divided into shares and sold internally and

externally, with limited liability stock companies being allowed to enlist on the stock

exchanges. The number of industrial SOEs shrank from 120,000 in the mid 1990s to 31,750

in 2004 (Naughton, 2007; 313), and with it the proportion of loss-making SOEs have fallen

but non-SOEs have gone up (Cheng and Lo, 2002; 421). Better performance has come about

through greater pressures slapped onto managers who now report to the board of directors,

albeit they are still chosen or appointed by members of the state. But then why have profits

been falling despite this drive for profit-seeking? Many firms were heavily indebted and had

surplus personnel which they simply could not lay off easily, giving rise to Nicholas Lardys

argument that it is this high liability-to-asset ratio which is the cause of loss making (Cheng

and Lo, 2002; 421). Though the debt problem was alleviated somewhat by banks lowering

interests rates seven times between 1996-1999 reducing SOE obligation in interest payments

by 250bnYuan (Lin and Zhu, 2001; 337).


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Profit incentives introduced in the early 1980s were accompanied with the dual-track price

system. Managers could retain a portion of the profits earned by the enterprise should quota

targets be met (Naughton, 2007, 311) and these profits would be paid out in bonuses to

managers and employees, causing a concern for the state council who levied a progressive

bonus tax in 1984 (Holz, 2003; 78). Greater autonomy in price setting was given to

enterprises and managers were given greater latitude in setting wages for workers, which

were later linked to profits (Yusuf, 2006; 56); giving rise to criticism that excessive wages

have caused falling profitability. No longer would workers be offered permanent employment

but rather 5 year contracts would be the new method (Bramall, 2000; 391). TVEs have also

privatised during the reform era mainly in 1995-6, with many closing down due to

inefficiency or increased competition both domestically and abroad (Naughton, 2007; 271).

Conclusion

This paper has attempted to counter the argument that SOEs have remained a drag on the

Chinese economy throughout the reform era, despite improvements in efficiency. The

performance of SOEs to non-SOEs has been close, despite having to pay higher taxes, wages

and welfare contributions, whilst having to remit all profits back to the state until later

reforms were implemented.

SOEs located in the energy industries were subject to keeping output prices low, so that other

sectors in the economy could benefit from cheaper inputs; this of course contributed to lower

profitability but labour productivity in these sectors has remained high. Labour productivity

has risen in the state sector, albeit through the policy reforms carried out in the 1980s causing

firms to be more profit-seeking (Cheng and Lo, 2002; 418). A shift towards market prices has


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taken place, and although earlier efforts resulted in a rise in inflation, later efforts have been

much smoother.

The comparison of SOEs to non-SOEs is biased against SOEs. The average performance of

SOEs is poor because the worst performing SOEs are not allowed to exit in large numbers

whereas some of the best performing SOEs prior to 1998 restructured into companies or joint

ventures (Holz, 2003; 164). This paper has confined the analysis to three areas: profitability,

productive efficiency and restructuring, but one must go beyond competition and ownership

analysis to determine how best to solve the paradox of declining profitability and increasing

efficiency (Jefferson, et.al 2000; 16) if China is to set a concrete example of successful

economic development for other developing countries to follow.


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