Ambiguous Capital (Part II):

The Restructuring of China's State-owned Enterprise Sector

By Satya J. Gabriel

Reformers in the Communist Party of China (CPC) have recognized for years the need to improve the performance of state-owned enterprises (SOEs).[1]   After two decades of experimenting with various restructurings,  the condition of these enteprises is worse than ever, despite steadily increasing labor productivity (which has been more than offset by eroding market conditions and the strain of bank loans dating back to a time when the obligations generated by such loans were not taken seriously by senior SOE managers who had been accustomed to grants from the central authorities).  During that time, SOEs suffered sharp drops in cash flow, interest coverage ratios, accounting profit margins (reflecting a pervasive inability to generate sufficient surplus value to meet claims on enterprise cash flow), and, on average, a more than fifty percent reduction in the value of the surplus product (as measured by the residual over the wage fund plus depreciation of existing machinery and facilities). Although some SOEs have prospered under reform, most have suffered from the increase in competition over both output and input markets, as well as constraints on their ability to raise the rate of exploitation (mainly via a reduction in real wages and benefits). Thus, although the value of labor power and the cost of means of production have increased somewhat, the drop in the total value generated in SOEs has been much larger than might have been anticipated at the start of the reform process. It is, therefore, insufficient to rely on rising labor productivity to solve the problem. Some SOEs may be able to generate increased sales simply by producing cheaper goods, but not all. SOE senior management must improve their strategies for competing over output markets in order to generate the necessary surplus value/cash flow to meet all existing obligations and have sufficient retained value to finance a major technological and marketing overhaul. Anything less will only lengthen the period of pain in the SOE sector and present the possibility of a larger economic crisis.

Although the percentage of the labor force that is employed in SOEs has steadily fallen (to around 41% in 1997, according to the State Statistical Bureau), it remains clear that the success or failure of the SOEs is critical to the overall success or failure of the Chinese economy and the legitimacy of the CCP's continued monopoly control over government. The ability of the former commune enterprises, now called town-village enterprises (TVEs), and private enterprises to absorb the labor that is being made redundant (and subject to xia gang, formal layoffs) by restructuring in the SOE sector has proven insufficient to maintain the previous level of employment. The erosion in the financial position of small and medium sized SOEs, those controlled at local levels and operating outside of strategic sectors, such as mining and energy production, petrochemicals, steel and other basic materials, and defense related manufacturing, has been particularly rapid as the "Letting go of the small" policy has been implemented. Letting go of the small (and medium) sized SOEs, which tend to have a higher debt-equity ratio than larger, centrally controlled SOEs, is a priority for a central government that wants to wean SOEs from state subsidies so that more funds are available for value enhancing modernization projects. The cost is the displacement of larger numbers of workers, since the small and medium SOEs often have higher labor to total capitalization ratios than the larger more secure enterprises. Unemployment rates and income inequality are both rising (along with the crime rate, which remains relatively low by international comparisons, but has been positively correlated to unemployment rates).

The cost of keeping the SOEs alive continues to rise, however, and the government is becoming increasingly desperate to find a solution.  The losses suffered by the 46% of state-owned enterprises (SOEs) who are operating in deficit is particularly frustrating to the Chinese government, which has been forced to choose between providing heavy subsidies to these enterprises to keep them in business (adding to a rising national government deficit) or closing them down and increase the level of unemployment dramatically.  Given the weakness of China's social safety net, which will be a subject of a future essay, a drastic increase in the rate of unemployment carries the rather serious risk of generating social unrest and, as previously indicated, delegitimizes one-party-rule in China. 

Passage of the Corporation Law in 1994 (which received the official imprimatur of the Fifteenth National People's Congress in 1997), established the notion of "Keeping the large and letting go of the small," provided a legal framework for the corporatization of SOEs (as well as the sale of non-strategic SOEs to private domestic or foreign investors) and for discrimination against locally controlled/non-strategic enterprises in determining which firms would gain subsidies. This law was also designed to reduce the degree of ambiguity about control over enterprise capital, fiduciary responsibilities of managers, and rights of owners to sell assets.

A further step in weening the vast majority of SOEs from government support was the establishment in 1998 of a recapitalization program modelled after the US government's rescue of the savings and loan sector in the 1980s.  The Chinese government established four asset management companies to take over assets of SOEs who were unable to pay existing debt.  The state-owned banks holding these non-performing loans were allowed to write-off debt related to these asset transfers, providing the banks with improved balance sheets and more liquidity for making future loans.  The hope was that the SOEs, with reduced existing debt, would take this opportunity to get their financial houses in order and focus on improving profitability to avoid future problems.  The banks had an incentive to improve their lending practices, providing future loans only to those firms who could demonstrate the capability to generate sufficient cash flow to pay such loans, providing an additional incentive for SOE managers to improve their strategic planning and implementation. 

What is the likelihood that SOE managers will succeed at improving their firms?  What was wrong with these enterprises in the first place?  Are the problems faced by the SOEs unique to state-owned enterprises?  In order to answer these questions we need to examine the operating conditions of state-owned enterprises, to uncover the problems that generate poor operating results, and compare these conditions and problems to the environment in other firms, including the highly successful  town-village enterprises (TVEs) discussed in the previous essay.

In Western corporate finance it is usually assumed that the primary mission of corporate management is value creation:  managers are assumed to select those assets and activities that will generate the higher net present value for the enterprise.  Never mind that this may not always be the case.  If agency problems were not so serious in the United States, the subject of agency costs would not be so prominent in the b-schools.  In any event, if managers are to be value maximizers, they must be able to identify and then implement investment projects and restructurings of present assets that result in higher overall net present value for the portfolio of enterprise projects/investments.  Are managers in the SOEs both motivated and empowered to do this?

For most of the history of the SOEs the answer was an unambiguous no.  SOE managers were neither rewarded for nor empowered to engage in value creation.  SOE managers were governed by the dictates of a central plan created by bureaucrats and political leaders in Beijing and provincial capitals.  Managers were simply informed of output quotas and other outcomes expected to be generated by their firm.  The managers had very little influence over either the choice of inputs and outputs, output targets, prices set forth in the plan, or the parameters used in the design of the plan.  Managers also had very little influence over investment decisions that would determine their relative success at meeting plan targets.  Nevertheless, because managers operated within a noncompetitive market under soft budget constraints, these institutional rigidities and inefficiencies did not pose a serious threat to enterprise survival. Perhaps even more to the point, managers' performance evaluation was based largely on political factors, so the existing environment also did not impede their attainment of personal success.

The pragmatic modernist leadership in Beijing was, however, concerned about the growing drain on national budgetary resources and the pace of technological innovation and invention (which is rising, but not quickly enough to guarantee the future success of Chinese firms in global competition with "Western" capitalist transnationals). They had the example of the USSR to demonstrate the risks of not solving the problems created by centralized planning and market monopolies. And they had the example of the rural reforms to demonstrate that changing incentives could result in positive changes in output and reduced dependency on national budgetary funding. It was, therefore, clear that something had to be done to change the incentives for SOE management. It is not surprising, then, that much of the early tinkering with the way SOEs operate involved shifting more decision-making authority to managers and away from the external bureaucracy.

The first attempt at decentralizating authority took place in Sichuan Province.  It was another of the "crossing the river by feeling for stones" experiments that has come to epitomize the reform era. In 1979, managers in 84 industrial enterprises were given decision-making powers --- in both investment and operating areas --- that had previously been vested in the external bureaucracy.  In particular, the managers were given partial authority over equipment and materials purchases, labor hiring and assignment, and pricing.  As an incentive for the managers to make good decisions, they were also allowed to retain, for use in the enterprise, a larger share of the surplus generated.  Whether the authority or the incentive was sufficient to result in value maximizing behavior is open to debate.  However, the pragmatic modernists who were then in power in Beijing decided the results were sufficient to generalize the reforms.  Gradually other managers were granted the same powers that had allowed the Sichuan managers to gain greater control over their enterprises. 

The result has been less than uplifting. The percentage of total industrial output attributable to SOEs continues to decline.  In 1978, at the beginning of the reform process, SOEs generated about 78% of industrial output.  By 1997 the SOE share had fallen to about 27%. Overcapacity in the SOE sector has gone from problem to crisis proportions. Attempts to sell off SOE assets to reduce this level of overcapacity has also been met with less than stellar success.

To put it in blunt terms, SOEs continue to bleed red ink.  Gross margins have fallen steadily over the past two decades.  I would estimate that the surplus generated by SOEs (using data from the State Statistical Bureau) has fallen by more than half since 1980.  In 1997, 46% of SOEs were operating in deficit. Based on the failure of some SOEs to even meet wage obligations to their current work force or to satisfy tax demands from state officials (who managers would rather not antagonize), a subset of SOEs are not generating a surplus at all (or just enough to pay those managers). In any event, the falling surplus (realized in cash flow) is insufficient to meet the claims arising from SOE's debt meaning that the SOE crisis is also a banking crisis. 

It is not surprising that the reengineering of SOE management processes has been relatively ineffective.  SOE management culture, shaped in the context of monopoly, soft budget constraints, and political rewards, was well ingrained in management.  It should not be surprising to find that many "old school" managers would be resistant to changing their ways.  And even those managers willing to change may have very little training in new ways of doing things.  In the absence of an active market for corporate control, change in management behavior is likely to remain sluggish, leading to more negative net present value decisions, destroyed surplus value, and lost time in the race to transform China's SOE sector into one comprised of world class firms capable of competing with Western transnationals.

The experience of the SOEs has many parallels in the United States and other more technologically advanced capitalist nations.  For example, the experience of utility companies post-regulation is, to a significant extent, analogous to that of these SOEs, where utility managers faced with competition and changes in the regulatory environment have had to learn new management practices.  The transition is neither easy nor pleasant and some utility companies are likely to run into trouble.  The relatively high amounts of debt carried by traditional utilities has, to a significant extent, shielded them from the market for corporate control, creating a resemblance to the conditions faced by SOE managers. As with the SOEs, it will take time to weed out those utility company managers who are unable to effectively adapt to the changing economic and political environment.  The utilities do, on the other hand, face the very real prospect of bankruptcy, which provides an important disciplinary mechanism for utility company managers. They can only destroy so much value before they are forced out.

Most SOEs, on the other hand, continue to be protected from the sharp edge of hard budget constraints.  It will take time to create the proper political conditions for some SOEs to exit industries where there is sizable overcapacity and for surviving firms to undergo the necessary technological and cultural transformation.  In the real-world Darwinian struggle for survival those firms that adapt best to the changing economic, political, and cultural circumstances are more likely to survive, if not prosper.  Adaptation is not simply a question of shifting economic practices from less to more efficient, however.  It never is in any capitalist social formation.  SOE managers who can decode the new rules of the game and figure out how to manipulate not only economic variables but political parameters will have an advantage over those managers who continue to act as if the present mirrors the past.  Nevertheless, some economic institutions have been born or reborn into this new environment (the government is restructuring many of the larger SOEs into keiretsu-like multi-enterprise groups) and do not have the burden of adjustment.  In this context, the crisis for SOEs (the dinosaurs in this Jurassic landscape) provides opportunities for newly evolved firms, whose managers are unburdened by the old rules or the old obligations. [2]  To be more specific, the crisis in the SOE sector has created enormous opportunities for the TVE and private sectors in a process analogous to, although on a much grander scale than, the opportunities created in telecommunications by the breakup of AT&T.

The Chinese economy continues to transform rapidly with SOE restructuring speeding up (providing lucrative opportunities for consultants), TVEs (which are also government-owned) expanding and also undergoing structural changes, and rapid growth in private enterprises, as well as new competition from foreign and joint venture firms.  Joint venture firms, in particular, have been gaining market share in the domestic market since the central government changed its 1980s-era policy of requiring these partnerships of foreign and domestic firms to orient their production to the export market.  The overcapacity in the SOE sector can be resolved (as opposed to reproduced) by a combination of exit and Keynesian macroeconomic management (increased aggregate demand can help some SOEs to become profitable, although this is not a panacea --- firm management must develop an effective strategy for taking advantage of the market opportunities produced by higher demand). In other words, even in an environment of increasing aggregate demand, a lot of firms need to disappear altogether, some need to be merged or taken over. The resulting unemployment problem can be partially solved by creative government policies that encourage more entrepreneurship, particularly self-employment (the ancient class process), including partnerships of ancient producers.[3]

China's entry into WTO will provide an additional institutional setting for continued movement along the current path of reform --- away from the old state monopoly capitalism towards decentralized and competitive capitalism. As firms become subject to the discipline of hard budget constraints and exit, management incentives to focus on generating value (through positive net present value investments and management practices) are likely to increase. This will mean that Chinese firms are likely to become leaner and meaner, posing an even greater challenge to their competitors in other nations.  Perhaps firms in the "West" and "East" should look at the problems in the SOE sector in China and count their blessings. 
 
 
 

NOTES

[1] State-owned enterprises are herein defined as enterprises owned and under the bureaucratic control of either central or provincial government authorities. These enterprises are component parts of the overall governmental bureaucracy. The managers of SOEs received instructions/commands related to investment, the acquisition and use of technology and inputs, and the composition of output from higher level authorities within the context of the overall national plan. State owned and controlled banks were closely linked to these SOEs and providing necessary financing for investment. (Additional comments added on December 7, 2003): In later essays a distinction is made between state-owned and state-run (directly controlled) enterprises. This amendment was made after reading Stephen A. Resnick and Richard D. Wolff's 2003 text, Class Theory and History. There is no reason to assume that the simple fact of state ownership of all or a majority of shares in an enterprise should necessarily imply that the state controls the appropriation and distribution of the surplus value generated within that enterprise. However, when the state does directly control the appropriation and distribution, as in the case of enterprises that are integrated within the state bureaucracy (state-run enterprises), then this has important implications that warrant categorizing such enterprises in a different way than enterprises that are simply state-owned (or privately owned, for that matter). State-run enterprises (SREs) employ workers to create value in circulation of products or intermediate goods or machines, but they are also often commanded to create use values that are not realized in the market or in other forms of circulation, such as in the provision of health care, education, housing, food, and clothing to employees and their families. This social welfare function of SREs creates a very different type of balance sheet, income, and cash flow statement than might be the case under an arrangement where the firm is not required to serve such a social function. Thus, the flow of surplus value back into the firm in the form of these social welfare use values may be an important reason that the firms operate in deficit (when viewed in income statement terms). You can read more on this in later essays.

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[2] (note added 4 February 2004) Yi-min Lin makes the argument that the growth in relatively autonomous capitalist firms in China has led to a transformation in political processes within the state and Party such that the agents of the state (and Party) have become more independent of central authority and free to trade public authority and assets for personal gain. Thus, agents of the state become de facto agents of capitalist firms, receiving shares of distributed capitalist surplus value in exchange for providing the managers in these firms with access to public assets and/or guarantees that public authority will be exercised in ways beneficial to these managers. See Between Politics and Markets: Firms, Competition, and Instituional Change in Post-Mao China; Cambridge: Cambridge University Press, 2001.

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[3] It seems unlikely that the number of communal enterprises will expand. The Chinese government has shown little or no interest in communism and this is unlikely to change. Indeed, reliance on the rhetoric of communism has already largely given way to nationalism and modernism as justifications for the existing political arrangement.

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