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
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
been relatively ineffective. SOE management culture, shaped in the
of monopoly, soft budget constraints, and political rewards, was well
management. It should not be surprising to find that many "old
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.