Can China reform inefficient SOEs?
Trust the Process?
China has been reforming its state-owned enterprises (SOEs) for the better part of the last four decades. And while they still may not be world-beaters as a group, SOEs are definitely more efficient today than they were in the past.
It is still in the middle of a very long journey — the latest milestone being “mixed-ownership” reforms and the announcement of Alibaba and Tencent leading a consortium to invest $12 billion in and join the board of China Unicom Group. “Trust the Process,” as a certain former NBA GM might say …
I did some research into the history of SOE reform in China because I thought understanding the last forty years would help put some perspective on where things stand today and inform how things may unfold over the next forty.
I also came across a very interesting company that provided a glimpse of what the future may look like for some state-owned enterprises.
Let’s start by jumping into a time machine.
A Short History of SOE Reform
In the beginning … or in this case the late 70s … everything in China was state-owned. There was no such thing as private enterprise.
The early Deng-inspired economic reforms were primarily focused on the agricultural sector and allowing private enterprises into the economy for the first time. But there was also a concerted effort to increase productivity at SOEs — especially in the industrial sector. For example, instead of handing over profits directly to the state, SOEs were allowed to retain some earnings and invest back into their businesses. They were given more autonomy in decision-making on production and resource allocation.
But profitability was a big issue — which makes sense as many of these SOEs were losing their monopoly status in their respective industries and private enterprises were allowed to come in and start competing. Meanwhile, SOEs still served a huge social function — they increased payrolls to take on the rising flood of rural-to-urban migrants and were still expected to provide job security and worker benefits (i.e. the “Iron Rice Bowl”). Financial performance suffered and SOEs relied on ever-increasing levels of bank debt to continue operating.
Major reforms proposed in November 1993 represented the next major milestone for SOEs. The “Grasping the large, letting go of the small (抓大放小)” strategy was put into full effect starting in the mid-90s. Under this strategy, small money-losing SOEs would be privatized or merged and were often converted into stock cooperative companies. Larger SOEs were retained by the state and underwent “corporatization” designed to delegate more authority to managers and align the interests of managers with stockholders.
From 1996 to 2003 the number of state-owned industrial enterprises had fallen from 127,600 to 34,280 [1]. Some firms sought listings on China’s nascent stock exchanges while some even listed in Hong Kong or New York and allowed foreign investors to invest for the first time. But privatization and reform also led to a huge wave of layoffs and the end of the “Iron Rice Bowl”: Two-fifths of employees at SOEs lost their jobs and suddenly there were tens of millions of unemployed workers on the streets with certain regions like the industrial Northeast hardest hit.
The survivors — less burdened by the bloated payrolls and massive pension liabilities — did well and some even thrived especially the ones in sectors where the State still largely retained monopoly power. In March 2003, SASAC (State-owned Assets Supervision and Administration Commission) was formed and tasked with overseeing the continued evolution of the two hundred or so largest SOEs with the objective of forming “national champions”.
Over the next decade, reforms appeared to be paying off. Profitability of central SASAC SOEs “more than quintupled between 2002 and 2012” [1]. After a period of consolidation, large Chinese “national champions” started showing up on Fortune lists of the largest global firms. Even Warren Buffett himself got in on the action, investing $488 million in Petrochina in 2002 and eventually making an 8x return on his investment as Petrochina briefly became the world’s first trillion-dollar market cap company.
But below the surface, some major problems were brewing.
First, it was not clear whether improvement in the financial performance of certain SOEs was the result of improved productivity or whether it was because these SOEs were were merely enjoying the benefits of cheap financing, subsidized land and monopoly status.
Second, as certain large SOEs got even bigger, they began to amass considerable financial and eventually, political power. “Absolute power corrupts absolutely” as a 19th-century British politician once remarked and China was no different — corruption seeped into the halls of numerous (if not most) SOEs in the first decade of the 21st century. A cadre of corrupt officials and executives, Macau casinos and luxury goods manufacturers benefited to the detriment of the masses.
These issues exploded into public view as the internal party power struggle between Bo Xilai and Xi Jinping factions burst onto front page news in early 2012. One of Bo’s biggest allies was Zhou Yongkang (周永康) who rose to power through the state-controlled oil & gas sector eventually leading one of the largest SOEs in China National Petroleum. He was the largest “tiger” to be brought down by Xi Jinping’s anti-corruption campaign and when he was convicted in 2014, authorities said that they had been able to seize over $14 billion of assets from his family and associates. This gives you a sense of scale of what was going on.
SOE reform figured prominently during the Third Plenum sessions in November 2013. A plan centered around “mixed-ownership” emerged in 2015 and a few large enterprises — including China Unicom — were picked to kick things off earlier this year.
Which brings us to the present.
Trust the Process
Economic reform in China has always been a gradual process and SOE reform has very much followed this style as well. Chinese government officials saw how “big bang liberalization” in post-Soviet Russia led to wholesale looting of the public sector. As I described in another answer about the Chinese vs. Soviet experience:
At the same time, the collapse of the Soviet economy and bitter experience of the Russian people in the 1990s following its poorly implemented "big bang" style series of market-oriented liberalizations also served as a warning to Chinese policymakers that reforms had to occur gradually and at a measured pace. This is one reason why economic (and other) reforms in China often appear to follow a "two steps forward, one step back" type cadence.
It was simply unrealistic to think that you can take what was once a former department of the Ministry of Posts and Communications and turn it into a world-class corporation overnight.
But “gradual” does not imply that reform will happen in a nice, straight line. Instead, reform in China seems to follow a certain cadence:
Strategize — a lot of brainstorming and discussion about the problems that need to exist and various approaches to address those issues
Plan — drawing up specific policy and laws
Experiment — picking several case studies and implementing there first
Mass roll-out — learning from the initial case studies, improving the plan and rolling out en masse
As it relates to the latest set of SOE reforms — policymakers strategized about what to do with SOEs during the Third Plenum meetings in November 2013. A high-level set of goals was announced and SOE reform figured prominently on the list. Then in 2015, a more detailed plan was announced centered around the idea of “mixed ownership”. Then earlier this year, the first test cases were selected, with China Unicom being the most prominent one.
This suggests that we are in the “Experiment” phase as of late 2017. Presumably, policymakers will look closely at the China Unicom experiment and see how they need to amend or tweak the rules … or even ditch the plan completely.
Hikvision
In my building we were thinking about upgrading some of our various systems and our vendor presented different options for all the various components — but for security there was only one company he would recommend.
“Half the cost and higher quality and reliability,” he said. “Hikvision.”
“Hik who?” I thought to myself.
I had never heard of this company before but that was a pretty strong endorsement so I looked into it.
It turns out that Hikvision is the leader in video surveillance systems in China — incidentally one of the most surveilled countries on the planet — with around 35% market share. As my security consultant alluded to, it is starting to dominate overseas markets as well and now generates a third of its sales overseas. It is one of the innovation leaders in an industry that is in the middle of a transformation from a hardware-centric to software-oriented solution. Hikvision’s R&D team is 9,000 strong and the company has a proven track record of innovation, incentivizing employees with stock-based compensation and fostering an “internal startups” culture that sounds straight out of the official Silicon Valley playbook.
It also turns out that Hikvision — officially “Hangzhou Hikvision Digital Technology Co. Ltd.” — is a Chinese state-owned enterprise.
I bring up Hikvision because it is a real-world example that SOEs aren’t pre-destined to be inefficient lumbering beasts whose existence rests solely on having a state monopoly or benefiting from some protectionist policy. It is indication that SOEs can change and evolve and maybe even one day become world leaders on their own merits.
Seeing how much Chinese SOEs have changed over the past four decades and seeing examples such as Hikvision that show the art of the possible in the future, my overall conclusion is that yes, I believe Chinese SOEs as a group can definitely get better and more efficient in the years to come.
Note
[1] Source: Markets over Mao: The Rise of Private Business in China by Nicholas Lardy
This was originally published on Quora in December 2017.