MP Econ Issue 2: SOE Reform
Why SOE Reform is so Hard (Part I)
It has been nearly a decade since Beijing launched its latest round of state sector reforms. Progress has been slow, and many have blamed the pace of reforms on a lack of political will. While political will is certainly necessary, that alone will not determine the extent and scope of state-owned enterprise (SOE) reforms going forward. That’s because SOE reform today is as much an intellectual problem as it is a political one.
To understand why, it’s important to first recognize the heterogeneity among SOEs. Here I present a simple taxonomy of SOEs: competitive, quasi-competitive, and natural monopolies. These categories are useful in examining the relative resilience of SOEs for different reasons, with competitive SOEs requiring the most elaboration. Indeed, SOEs’ market share in the overall economy has remained remarkably constant, and their stronger position is what makes reform such a confounding challenge.
1. Competitive SOEs: Those in sectors that compete directly with private firms
These SOEs have actually managed to stay in business despite having no meaningful advantage over private firms in terms of state support. This can be illustrated by the differences in average tax rates and government subsidies between publicly listed private and state firms in the steel sector, a quintessential example of a competitive sector (see Figures 1 & 2). Private steel firms now account for more than half of the market, and since steel is basically a commodity product, that means competition is fierce.
Figure 1. Tax Rates for Private vs. State Steel Firms (% of revenue)
Source: Company financial reports accessed through Wind.
Figure 2. Subsidies for Private vs. State Steel Firms (% revenue)
Source: Company financial reports accessed through Wind.
Perhaps surprisingly, it does not appear that the Chinese government systematically favors SOEs over private firms. If anything, steel SOEs on average bear more tax burden and receive less subsidies. And this pattern holds for other competitive sectors like property and automotive. Yet if SOEs are assumed to be less efficient and rely heavily on state support, then they would need significantly more, not less, help against private firms in these competitive sectors.
But this does not mean SOE performance has surpassed that of private firms. In fact, SOEs’ return on assets averaged just 3% over the last decade, much lower than the borrowing cost (see Figure 3). What may explain the resilience of these competitive SOEs is the “strongest survive” effect. That is, almost all the least efficient SOEs have either already exited or folded, leaving the relatively more efficient survivors that can still muddle through and compete with private firms.
Figure 3. SOE Returns Much Lower Than Borrowing Cost
Note: Borrowing cost is measured by average bank lending rate.
Source: Wind.
Even if these SOEs aren’t hugely profitable, at the very least they are no longer making large losses. This means most of these SOEs can keep their heads above water for a long time and fight a battle of attrition. As such, it will be up to the Chinese government to determine how much to use reform to push these SOEs to raise performance and profitability or to largely leave them alone.
2. Quasi-competitive SOEs: Those in sectors that enjoy considerable incumbency even as private firms are allowed to operate
Due to advantages such as size, many SOEs can capitalize on their incumbency advantage to maintain substantial market power. One such sector is infrastructure, which is open to private firm competition but in reality there is very little head-to-head competition. More often than not, private firms usually act as subcontractors for the SOEs that dominate the sector.
Another example is banking. Because Chinese state banks are some of the largest in the world, it is very difficult for private banks to challenge them. Disruptive technology firms such as Ant Financial may be the most formidable challenge to state banks yet. But so far, fin-tech firms have established more of a symbiotic, rather than directly competitive, relationship with state banks.
As a result, while a healthy mix of private and state firms exist in these quasi-competitive sectors, the mere presence of private firms does not translate into direct competition. This implies that the focus on ownership reform may be less effective than regulating incumbent SOEs so they don’t abuse their market position.
3. Natural monopoly SOEs: Those that exhibit strong economies of scale
Many SOEs are natural monopolies in their sectors, such as utilities and key network infrastructure. Although these SOEs tend to be mammoth like those in quasi-competitive sectors, the distinction is that natural monopolies have economies of scale. Scale then leads to significant cost advantages that make these SOEs essentially immune to competition, even if that sector is opened up to private firms.
In natural monopoly sectors, regulation again matters more than ownership. For example, private natural monopolies in Western market economies are usually subject to heavy regulation. Therefore, a focus on mixed ownership isn’t likely to fundamentally change the behavior of these natural monopolies.
The bottom line is that SOEs are now positioned very differently in the Chinese economy compared to the early 2000s, when they were highly vulnerable to market competition. Put differently, SOEs have by and large shed their training wheels after decades of state guidance and are now riding an adult bicycle on their own.
The variation of SOEs across sectors means that “reform” requires much more than a one-size-fits-all solution fixated on changing ownership structures. Differentiated solutions are required to shape the incentive structure of different types of SOEs that can both constrain and modify their behavior in the marketplace.
Part II will look more closely at areas of potential positive change in China’s state sector.
Houze Song is a research fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.
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