China’s state enterprise reform: Bigger, yes, but better?

As the Chinese economy posts its slowest growth in six years, major reforms to China’s state-owned enterprises are now in the final planning stages. The Xi Jinping administration has pledged to overhaul and consolidate the state-owned economy to tackle widespread inefficiency and corruption.

A wave of mega-mergers among state-owned firms has already been announced in railways, nuclear power and other industries. Consolidation may be easier politically than market reforms, but it’s not the right way forward. China’s crown jewel firms don’t need to be bigger; they need to be better.

State-owned enterprises are a relic of China’s communist past, but they remain critically important to the Chinese economy today. They still contribute nearly a third of China’s GDP and continue to enjoy preferential access to domestic credit. The central government itself owns more than a hundred firms, concentrated in strategic sectors like defense, petroleum and power.

These companies have become major international players, controlling an astronomical $690bn in assets abroad and with 47 centrally-owned firms ranked in last year’s Fortune Global 500.

After more than three decades of market reforms one might think that Beijing’s portfolio of state-owned companies has been shrinking together with the state-owned economy as a whole. In 2003, the central government owned 196 firms; today it owns 112. But all but three of the companies that “disappeared” were actually merged into other centrally-owned companies.

Unsurprisingly, central-owned firms’ average number of subsidiaries has ballooned from 82 in 2003 to 191 in 2010, according to a new report by the Brookings Institution. However, conspicuously absent from the government’s state industry housecleaning is the trash can—a standardised process for the worst performers to be privatized or go bankrupt.

Advocates of the consolidation approach to reform argue that it combines complementary capacities, thereby boosting state-owned companies’ efficiency and competitiveness. They point to the coming fusion of two state-owned nuclear firms, State Nuclear Power Technology (SNPT) and China Power Investment Corporation (CPI), into a $96bn corporate giant.

Here, the melding of SNPT’s advanced third-generation nuclear power technology purchased from Westinghouse Electric and CPI’s vast capital resources is a clear win-win. Even more ideal, SNPT Chairman Wang Binhua was the former general manager at CPI, smoothing negotiations and future executive integration. But such auspicious conditions are unlikely to be replicated, especially for rumored mega-mergers in the petroleum, shipbuilding, and telecommunications sectors.

Combining state-owned companies won’t produce the global industrial champions that China so badly craves. Instead, it risks amplifying existing operational inefficiencies and creating even more difficult challenges of oversight. The fundamental problem is that it’s the government, not market forces, determining which state-owned companies are restructured and how.

Beijing should cut state firms’ privileged access to bank loans and specify which protected sectors will be opened to greater competition. It should establish a standardized and transparent process to close struggling firms and privatize their assets, instead of simply merging or bailing them out.

If the Xi administration isn’t ready to give markets a decisive role, it should at least start with targeted reforms to improve oversight and incentives. For example, Beijing could hold executives accountable for their progress in strengthening boards of directors and internal audits.

The majority of centrally-owned firms set up boards of directors only within the past five years, many of which are packed with insiders. State firms lack the capacity to monitor their expansive operations and personnel, a point underscored by reported $3,600 lunches and recent retention of seven Chinese and international firms to audit their overseas holdings.

Even more importantly, Beijing should relink compensation with market performance, rewarding top managers who achieve productivity and profitability gains. However, instead of creating such merit-based incentive structures, Party elites have unveiled plans to reduce company leaders’ pay by up to 50 per cent. Slashing executive salaries amid an anti-corruption crackdown may appeal to public sentiment, but it certainly doesn’t motivate urgently needed performance gains.

The success of Beijing’s new program to reform state industry depends on the government relinquishing control to market forces. Refusal to cede the reins of reform amid ongoing policy paralysis will drag China’s slowing economy down even further. Nor is this simply a narrow issue of domestic restructuring.

Failure to act will limit state-owned companies’ competitiveness in overseas markets and threaten their growing partnerships with governments and companies abroad. If Chinese leaders continue to block market forces in favor of government control, the price of this decision will far exceed the cost of reform.

This piece was originally posted in the Financial Times
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