Why do many Chinese SOEs fail to achieve their ambitions?

Written by Jing Cai.

China’s remarkable economic growth since the late 1970s has been accompanied, and in some degree caused, by changes in ownership and corporate governance. A large private sector grew up, partly through the founding of new firms, and partly through privatisation. But (full) privatisation was confined to small and medium state-owned enterprises (SOEs). According to the Chinese Second National Economic Census, by 2008 there were 154,000 SOEs left. These accounted for 3.1% of the total enterprise number; however they controlled nearly 30% of total enterprise assets. Accordingly the changes which took place in their corporate governance (and partial changes in their ownership) are also of great significance. The most significant of these changes came in the mid-1990s, when a modern corporate governance structure and property rights were gradually introduced to the SOEs (Aivazian et al. 2005). Corporate governance was seen as a key element in strengthening SOEs.

On the face of it, the reforms may be taken as highly successful. The average rate of economic growth (GDP) between 2010 and 2014 was 8.49%, and the revenue of high-technology goods (mostly electronics) in total exports reached 1108 billion USD in 2012 – an increase of 9.5% from 2011. However between 2009 and 2013 the share of Chinese-owned firms (aside from joint ventures) in exports of high-tech products fell by more than half; in 2013 90% of IT equipment and 61.8% of high-tech electronics exports were produced by either fully or partly foreign-owned firms.

Why after more than 3 decades of economic reform, are most Chinese firms still stuck in the lower parts of the value chain? Tylecote, Cai and Liu (2010) argued that the SOEs which once dominated the economy have changed in two directions. First, many, particularly smaller SOEs, have been privatised, wholly or partly. This may in many cases have involved an unacceptable transfer of wealth from government to private hands (Hua et al., 2006), but from a corporate governance point of view it must be generally an improvement. Second, those SOEs which remain, particularly those under central government ownership, are being governed in an increasingly conventional Anglo-American manner, with their performance being evaluated by normal Western financial accounting measures, and with the stress on their responsibility to shareholders (including the state). ‘Chinese authorities generally consider the Anglo-American legal and regulatory systems to be the prototype for their “modern” institutional and enterprise reforms’ (Hua et al., 2006, p.412). To this extent, there should be a positive impact on firms’ technological development.

There is still a major problem associated with the current arrangement: the short-termism issue is not fully addressed. According to the recent measures for assessing “persons in charge of central enterprises” (Chief Executives and Chief Operations Officers) (Li, 2007b), if within three years a firm fails to reach the target (70% of which is composed of financial indicators, and <5% based on innovation performance), the person in charge runs the risk of losing their job. Such financial pressures can be highly positive in bringing a new emphasis on efficiency through the reduction of waste, and focus on what is commercially rewarding. The difficulty is that if a CEO has a relatively short time to make his or her mark on a firm, and that mark will be measured financially, slow pay-off investments in technological capability will be discouraged. This CEO thus has higher incentives to invest in buying large, highly-visible ‘bundles’ or packages of technology and equipment from abroad, thus putting the firm in a position of continuously relying on external supports (foreign suppliers) for technology upgrading. In this instance firms don’t develop their own indigenous technological capabilities and their final products (even in a most advanced form) don’t represent their own technological competence.

In contrast to SOEs, privately-owned firms (POEs) in China are in a very different situation. Being very recently established (since 1980) they have fully-engaged shareholders since the CEO is usually the majority, often sole, shareholder. So POEs have the most incentive to invest in ‘unbundled’ packages, to identify some combination of sourcing from abroad, sourcing domestically, and self-reliance, which is both relatively cheap and will increase the firm’s technological capability in the future. The main problem for POEs has been poor access to finance (as with other resources such as land and licenses). The discrimination against the private sector in this respect has dwindled over time but is still apparent. If SOEs invest in low and medium-technology sectors that already have spare capacity, simply in order to get orders and thus employment regardless of price, they drive down the sales and profitability of private firms operating in those sectors. Yet (lacking external finance) it is only through the reinvestment of profit earned in lower-technology sectors that privately owned firms can develop the competences – and acquire the equipment and make the promotional expenditures – required to establish themselves further up the value ladder. No profit: no climb. This is why we rarely see large POEs competing against SOEs in strategic industries – Huawei being the exception of finding itself ‘accidentally in the wrong industry’ – according to its founder Mr Ren.

We can now sum up the conclusions as to the advantages and disadvantages of different forms of ownership. We have seen that private firms are disadvantaged in terms of poor access to resources. They do not have what can be called a strong technology base, because their poor access to resources prevents them from spending heavily on R&D. Majority state-owned enterprises are clearly very much better off in these respects. On the other hand, they have to pay a price in terms of bureaucratic meddling that constrains their actions and diverts their energies. Majority SOEs and private firms are thus at opposite ends of the Chinese scale. We thus propose the most optimistic scenario; the hybrid type – a minority state shareholding, and otherwise owned by private shareholders and employees. The state’s equity stake in the firm gives good access to resources and a good technological base, while the dominant private equity participation makes it resistant to bureaucratic meddling and responsive to the market.

This much reduced state shareholding among shareholders has helped to make the new governance regime a reality, because no one player holds all the cards. This type of ownership firm has engaged shareholders (including its employees) and is able to appreciate and support opaque and slow-pay-off activities such as investment in unbundled technologies and system improvement, which are key to indigenous technological development. It is striking that while this type of ownership can be regarded as peculiarly Chinese in the specific institutions involved, the outcome is not very different from the practices in many US firms, where employee inclusion is achieved, as here, largely through substantial employee shareholdings (Tylecote and Ramirez, 2006). These elements within the corporate governance systems of many Chinese SOEs, which tend to confer engagement and inclusion, are necessary.

It is very unlikely that the Chinese government will take any radical privatisation of the current, wholly state-owned enterprises in the near future. So, what can be done to remedy deficiencies in SOE corporate governance? A clear and detailed specification of the duties of boards of directors could be helpful. The key requirement must be that SOE managers be accountable to agencies which have a clear institutional interest in their long-run performance. SOEs need protection from ‘administrative intervention’ by the ministries — which can only be achieved if the path of promotion into those ministries is cut. If state shareholding in SOEs were controlled by agencies with a genuine and overriding interest in their long-run profitability, minority shareholders would have a more comfortable and more productive role in them. They could then share in their corporate governance on the basis that both sides had the same objective. The minority shareholder might well have developed a more firm-specific understanding of a firm’s technological development trajectory which thus may be fit to take the lead — by providing non-executive directors and even chairmen of the board. This new hybrid corporate structure has contributed to the successes of the technological development of some Chinese minority SOEs, and it will be necessary to foster this approach in order to facilitate further success.

Dr Jing Cai is a Senior Lecturer at the University of Aberdeen, this article is a summary of a joint research project with Professor Andrew Tylecote of the University of Sheffield. Image Credit: CC by Chris/Flickr.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s