Andrew Sheng & Xiao Geng: China's SOEs at a crossroads

China has lately been facing harsh criticism for the direction of its reforms of state-owned enterprises, particularly its strengthening of the role of Communist Party committees in SOE management. But while this might seem like a step backward, there are good reasons to boost oversight, at least for now. With China undergoing a fundamental transformation into an innovation-driven, knowledge-based, and services-led economy, its leaders must think carefully about how to reform SOEs.

In the past, the role of SOEs was clear. Over the last three decades, they underpinned China’s emergence as a global manufacturing powerhouse. In the process, they became dominant, especially in sectors prone to natural monopolies (such as telecommunications and power) and key strategic sectors (such as steel, coal, and banking).

But the traditional single-sided markets where SOEs lead are now being disrupted by new technology firms like Alibaba and Tencent, which straddle multi-sided markets of production, logistics, and distribution by using unified platforms that benefit from economies of scale. By creating platforms for consumers and small-scale producers these firms have directly challenged the SOE business model.

New digital platforms respond quickly and efficiently to public needs. These businesses are more collaborative or sharing than the traditional business of manufacturing. Given China’s population of 1.3 billion, these platforms can disrupt the incumbent producers by offering superior scale, speed, and convenience, including access to global markets.

Meanwhile, the SOEs’ obsolete business model makes it difficult to identify and respond to new opportunities in a changing economy. China’s state-owned telecom companies and banks, for example, have failed to respond to new technological challenges. Even traditional private companies like Huawei and Midea have done better, adjusting to shifting consumer demand and changing factor costs by retooling as quickly as possible.

Such responsiveness is critical today, when the inexorable logic of technological progress is demanding a transformation of China’s growth model. With demand for consumer hardware and durables falling, China must begin to develop its own higher-tech products, while building a strong services sector. And with world exports of goods declining China must activate its domestic consumer base.

But the inability to update the roles and business models of SOEs is holding China back. SOEs may enjoy privileged access to bank credit, natural resources, and land, but they also suffer from rigid governance and high staff turnover. When it comes to key personnel, the Communist Party establishment calls the shots. So, for SOEs to make changes, there must be consensus among officials in charge of business, industrial policy, and politics.

In the late 1990s, public listings of SOEs had the twin benefits of securing new resources for tackling legacy losses and propelling governance and productivity gains. Today, however, privately owned technology platforms have captured much of the valuation gains of the new economy. As a result, policymakers are struggling to find a way to finance the creative destruction of outdated SOEs burdened by debt, excess capacity, and obsolete equipment.

It is this uncertainty that seems to have spurred the authorities to rethink their original reform plan. They recognise that, when economic and financial systems comprise intricate networks of a variety of interlocking and interdependent elements, changes to one component can have far-reaching consequences. With the recent adjustments to the reform strategy, China’s leaders have bought themselves time to figure out where SOEs can fit into the new economy.

The answer probably lies in new public infrastructure challenges. If SOEs shift their business models to provide platform and regulatory services at low cost they can help, for example, to manage the use of information by large private platforms. Or they might help to guide the entry of foreign tech giants like Facebook and Google into the Chinese market, to ensure that those companies do not become too dominant.

State-owned banks, for their part, might be able to provide multi-tiered financing for the small and medium-size enterprises that are eager to shape and enrich the new economy. Finally, SOEs can enter into public-private partnerships with local businesses to handle the construction and management of transport and traffic systems, urban drainage, and bodies responsible for food safety, pollution control, and public security.

The good news is that the Chinese government has plenty of assets with real value, amounting to more than 140 per cent of gross domestic product. Those assets can help to smooth the transition to this new SOE business model, such as by plugging the holes in the social security system and addressing legacy liabilities.

China’s SOEs are at a crossroads. Given the high stakes of reform, the country’s leaders are right to take some time to assess their options. Whichever route they take is sure to be challenging. But those challenges pale in comparison to the problems that would arise from sticking to the old SOE model.

©Project Syndicate, 2016.
Andrew Sheng is Distinguished Fellow of the Asia Global Institute at the University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng, Director of the IFF Institute, is a professor at the University of Hong Kong and a fellow at its Asia Global Institute