Ambiguous Capital (Part II):

The Restructuring of China's State-owned Enterprise Sector

By Satya J. Gabriel

Reformers in the Chinese Communist Party (CCP) have recognized for years the need to improve the performance of state-owned enterprises (SOEs).  After two decades of experimenting with various restructurings,  the condition of these enteprises is worse than ever, despite steadily increasing labor productivity.  During that time, SOEs have suffered sharp drops in profit margins, cash flow, and, on average, a more than fifty percent reduction in the size 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).

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 by restructuring in the SOE sector has proven insufficient to maintain the previous level of employment. Unemployment rates and income inequality are both rising.

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 to shut 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. 

So what's wrong with these enterprises?  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.  Nevermind 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 conservative leadership in Beijing was, however, concerned about the growing drain on national budgetary resources and the pace of technological innovation and invention. 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 the 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 bureaucracy.

The first attempt at decentralizating authority took place in Sichuan Province.  It was another of the "touching the stones while crossing the river" 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 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 were sufficient to result in value maximizing behavior is open to debate.  However, the pragmatic conservatives 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. The falling surplus (realized in cash flow) is insufficient to meet the claims arising from SOE's debt load, 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

However, 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 expanding and also undergoing structural changes, and rapid growth in private enterprises, as well as new competition from foreign and joint venture firms. The overcapacity in the SOE sector can only be resolved (as opposed to reproduced) by exit. In other words, 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. It seems unlikely that the number of communal enterprises will expand. The Chinese government has shown little or no interest in communism and that 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.

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.