How is the Reform of State-owned Enterprises Possible? / Sheng Hong


The reform of state-owned enterprises, which has been concerned for a long time, has become more important and urgent today because of two things. The first thing is the serious decline in China’s economic growth. According to the National Bureau of Statistics, in the first half of this year, China’s economic growth rate has dropped to 6.3%, the lowest in many years, while according to the Keqiang index, the growth rate is about 4.1%. Revising the quantity of power generation, the index is about 3%. Sales of new cars have fallen for 13 consecutive months. Real estate sales also showed a downward trend. From January to July 2019, sales area decreased by 1.3% year-on-year; while overall sales increased, office sales fell by 13.3% and commercial sales fell by 10.9%.

Accordingly, the vacancy rates of office buildings in Shanghai and Shenzhen are increasing. From January to July this year, the vacancy rate of office buildings in Shanghai has reached 18%. Although rents falling by 20-30%, the vacancy rate of Shenzhen office buildings has increased from 17-18% in the second half of 2018 to 25% in the first half of this year (“The rising vacancy rate of Shenzhen office buildings is a reflection of the real economy”, “Hexun News”, August 21, 2019). Real estate and automobiles are expensive commodities; Shenzhen and Shanghai are representative commercial cities in China. Together with macro data, these data tell us that, despite tax cuts, China’s economy is likely to decline.

In the process of significant economic slowdown, the performance of state-owned enterprises is an important factor. We can see that from January to June 2019, the growth rate of industrial added value of state-owned industrial enterprises was 5%, lower than the average level of 6%; the growth rate of total profits was – 8.7%, lower than the average level of – 2.4%; the growth rate of trade was – 5.4%, lower than the average level of 12%. (Dacheng Enterprise Research Institute, ‘The economy is stable and progressive, and the private enterprises are the backbone of the economy’) In 2019, the return on net assets dropped from 3.9% in 2018 to 1.9% (estimated according to the data of the Ministry of Finance).

Considering that state-owned enterprises enjoy free capital, free land, low-interest loans, low-cost rights to exploit resources, and monopolistic power, such “achievements” are even more problematic. According to our previous research, there is a difference of 12.77 percentage points between the nominal return on net assets and the actual return on net assets of state-owned enterprises. That is to say, the real return on net assets of state-owned enterprises has dropped to negative 10.8%. According to the owner’s equity of 69168.1 billion yuan, the loss is about – 7479 billion yuan, equivalent to 8.3% of last year’s national GDP. That is to say, the existence of state-owned enterprises has reduced the total economic output by 8.3%, and the opportunity loss is not only that. If we assume that these net assets of state-owned enterprises can bring about 6% net profit, it shows that their existence seriously drags down the economic growth of about 11%, which is the main reason for the economic downturn. Therefore, the reform of state-owned enterprises is not only a necessary pass for China’s market-oriented reform, but also a key measure to prevent further decline in economic growth.

On the other hand, state-owned enterprises are also an important obstacle to China’s improvement of international economic relations. In the Sino-US trade disputes, the name of “state-owned enterprises” appears from time to time. “From time to time” means that sometimes SOEs’ problems are replaced by other terms, such as “government subsidies”, “monopoly” or “compulsory transfer of technology”. This concern was clearly expressed in the ministerial talks held in Paris on 23 May this year between the United States, the European Union and Japan. They said:

Ministers are increasingly concerned that other countries will turn state-owned enterprises into “national champions”, undermine market-oriented trade and guide them to control global markets. Ministers are also increasingly concerned about the non-market advantages and non-market domestic behavior of state-owned enterprises, which have a distorted negative impact on farmers, workers and enterprises in the tripartite country.

The term “other countries” should refer to China undoubtedly. In addition to this, this statement is also “politically correct” in China, because the CPC has emphasized at the Third Plenary Session of the Eighteenth Central Committee that “the market plays a decisive role in the allocation of resources”, so it is wrong to “destroy market-oriented trade”. In fact, in China, the reform of state-owned enterprises is also a long-term concern of the government and the people.

However, for a long time, most of us have been pessimistic about whether the reform of state-owned enterprises can really be implemented. This is because, while enjoying tremendous state-owned resources preferences and government subsidies, the senior executives of state-owned enterprises are also a strong political group, so wanting them to give up their interests is almost to ask the tiger for its skin. However, this view may be wrong.

On the surface, the special interests of state-owned enterprises are very striking. This includes, first, no duty to hand over profit, that is, zero capital cost. Although they seem to hand profits over tens of billions of even a hundreds of billions of yuans every year since 2007, they have returned to state-owned enterprises as a whole in the form of subsidies or reinvestments. Second, no rent is paid for the allocated state-owned land, that is, the cost of land is zero. Although some listed companies symbolically pay some rent to their parent companies, these state-owned parent companies take this as their income. Third, access to low-interest loans. According to Liu Xiaoxuan and others’ research, state-owned enterprises actually only need to pay 1.6% of the financing rate, while the market interest rate is about 4.68%. That is to say, state-owned enterprises only pay 34% of the financing cost of the average market interest rate. Fourth, monopoly power. According to our research, the monopoly power of state-owned enterprises increases their income by 4.8% of their business income, or by 22% of the value added of manufacturing industry, it is 21.8% of the value added. There are also low-cost access to state-owned natural resources for SOEs, and they often receive government subsidies; here we ignore.

Fig. 1 The share of labor income after deducting the share of various factors’ income and the share of monopoly income in the added value

SOE reform1

On the other hand, in 2001, opinions on deepening the reform of personnel, labor and distribution system in state-owned enterprises (State Economic and Trade Enterprise Reform (2001) 230), jointly issued by the then State Economic and Trade Commission, the Ministry of Personnel and the Ministry of Labor and Social Security, put forward that “the wage level of employees in enterprises shall be determined by enterprises under the macro-control of the state.” Industry is determined independently on the basis of local average social wages and economic benefits of enterprises. In a word, there is no limit on the remuneration of labor (including management) elements. Although in recent years, the government has set a ceiling on the income level of executives of state-owned enterprises, but mainly adopted the relative restriction of average wage multiples. It is easy for people to adopt the strategy of rising water and rising boats. They can also be allocated in the form of non-wages or even non-currency. They can enjoy benefits through on-the-job consumption, and at the worst, reduce work. Efforts directly consume the above benefits of reducing and exempting the cost of non-labor factors.

Thus, we can describe state-owned enterprises as enterprises with 100% reduction in capital cost, 100% reduction in land cost, 66% reduction in monetary cost and 21.8% increase in monopoly benefits. The benefit of cost reduction and exemption of these elements is converted into the share of added value, which is about 61.2 percentage points. We can also call it “state-owned enterprise rent”. But there are no restrictions on the cost of labor (management) elements. According to the current efficiency of state-owned enterprises, if the cost of these elements is fully paid and monopoly income is removed, the share of workers’ remuneration is -7.3%. According to the above-mentioned concessions, the workers’ remuneration will account for 53.9% of the added value. That is to say, even though the efficiency of state-owned enterprises is low, they have eaten many of the benefits of these exemptions, but because they do not pay or pay less the cost of other factors, the workers (managers) of state-owned enterprises can get more than half of the added value. Who doesn’t want to go to such an easy (and inefficient) and money-making place?

Figure 2 reduces the share of capital, land and monopoly earnings to zero and the share of monetary earnings to 34% of the original share of labor earnings.

SOE reform2.jpg

However, these factor cost reductions provided by administrative departments are not subsidized to certain individuals in state-owned enterprises. This has brought fatal subversion to the seemingly attractive state-owned enterprises. Why is that?  Economics has studied similar cases. Such as Professor Steven Cheung’s research on Taiwan’s “375 Rent Reduction” in his “Theory of Share Tenancy”. The so-called “375 Rent Reduction” means that the government has mandatorily reduced the market-formed rent rate (56.8%) by one third, or 37.5%. So the first question is, to whom is the reduced rent given? Professor Steven Cheung said that this should depend on circumstances. If the reduced rent is transferred to a certain tenant, the latter is equivalent to the acquisition of the corresponding part of the land property rights, and the result is the same as that under the normal property rights relationship. But if the reduced rent is transferred uncertainly to a certain person, the tenants will compete for this benefit, which will disappear in the competition. He calls it “rent dissipation”.

Why is that? This is because if people compete for a “cost-free” interest, they can take uneconomical actions. For example, if the government decreases the price of a commodity to 50% of the market price, consumers will respond by rushing to buy, and they will spend their time in queuing. Queuing does not produce goods. But because goods are 50% cheaper, consumers as economic persons may spend as much time as the value of cheaper part to queue. Thus, the reduced rent is dissipated. Similarly, in the case of “rent reduction in the year of 375”, it is assumed that the income of the tenant farmer before rent reduction is 100 yuan, which is determined by his marginal labor productivity and is equal to the average wage rate of the society. After the rent reduction, he can get 50 yuan more. But at this time, if we can freely compete for the Tenancy Right of this land, many workers with original income of 100 yuan will invest in the competition of the land tenancy right. Even if they join or the original tenant farmers increase their labor input, the marginal productivity will decrease, so that the actual income of tenant farmers will be reduced to 90 yuan, 80 yuan, 70 yuan. … But with the 50 yuan rent reduction, it is still higher than 100 yuan, that is, their opportunity cost, so it is worthwhile until the benefits of rent reduction are completely offset by the reduced marginal productivity of labor.

So, which of these two situations is state-owned enterprise? Neither should be said to be true, but a state between the two. “State-owned enterprise rent” is not transferred to certain individuals, so it is not the first case. On the other hand, state-owned enterprises are not easy to access, nor is it the second case. In theory, the property rights of state-owned enterprises belong to the state. The management team and ordinary employees are employees. They have tenure or contract period. They cannot have long-term interests of state-owned enterprises. But they must have been clear that during their term of office, they can obtain the huge benefits of “state-owned enterprise rent”. So they have enough motivation to resist the influx of people from outside of enterprises. They use the normal labor and personnel system to limit the number of employees in enterprises. However, due to the intervention of a large number of powers and relationships to place more employees, state-owned enterprises will present a certain degree of redundancy. The redundancy of individual enterprises such as Sinopec can reach as high as 90%, but in general, it has not reached the level of free entry. Therefore, state-owned enterprises maintain a significantly higher income level than the average social level. According to our estimates, the average income level of employees in state-owned enterprises in 2013 is 330% of that in non-state-owned enterprises.

On the other hand, because state-owned enterprise executives and administrative officials belong to a group, they often exchange their identities, and the huge benefits of “state-owned enterprise rent” will arouse the strong motivation of administrative officials. According to our official resume statistics in 2011, out of 183 officials at or above the Deputy ministerial level in 19 ministries, 56 have working experience in state-owned enterprises. According to the statistics of Executive Resumes of 123 central enterprises, 115 senior executives of 47 enterprises with information disclosure have government working background. According to the system, senior executives of state-owned enterprises have tenure, and the normal replacement will bring opportunities to the administrative officials who attempt to enter. Therefore, in the political process, the tenure of senior executives of state-owned enterprises is compressed very short, about three years, which is obviously not conducive to the continuity of an enterprise’s operation, but conducive to creating more access opportunities for external administrative officials. In reality, state-owned enterprises, especially central enterprises, frequently change their executives. For example, in 2018, there will be at least 97 redeployments of the positions of heads of state-owned enterprises. There are only 96 central enterprises, with an average mobility rate of 100%.

Non-procedural and abnormal entry is another entry opportunity. That is, the existing executives of state-owned enterprises are vacant because of crime. There are two reasons. First, executives of state-owned enterprises will realize that there will be few three-year terms, so in addition to legitimate income, they may also take illegal measures to seize profits. Secondly, their positions are coveted by powerful administrative officials, who use political means to influence the judicial structure and trap them. In any case, the result is that state-owned executives are more likely to be convicted. And according to the above logic, the richer the enterprises, the higher the probability of executives being convicted; the higher the position, the more likely they are to fall. For example, because of monopoly and other preferential policies, the petroleum industry is a rich industry, so PetroChina and Sinopec executives have a high rate of conviction. According to statistics, from the 18th National Congress of the Communist Party of China to November 2015, there were 171 senior executives of state-owned enterprises to fall, including 15 chief accountants and office directors, about 9%; 52 deputies and other team members, about 30%; 104 of chairmen, general managers or Party committee secretaries, accounting for 61% of the total (Zhao Zhenyu, “some of the state-owned enterprises were investigated and punished.” Case Study of Executives”, Journal of Discipline Inspection and Supervision of China, No. 6, 2015.) Obviously, the higher the position, the higher the probability of conviction.

Figure 3  The frequency of executives convicted in state-owned enterprises (from the 18th National Congress of the CPC to November 2015)

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Data Source: Zhao Zhenyu, “Case Analysis of Some Senior Executives of State-owned Enterprises Investigated”, China Journal of Discipline Inspection, No. 6, 2015.

According to statistics from the Center for Crime Prevention of Chinese Entrepreneurs of Beijing Normal University, from December 1, 2013 to November 30, 2018, there were 1569 private entrepreneurs and 768 senior executives of state-owned enterprises (Hexun Jia, 2018) to be convicted. In 2017, there were only 1946 state-owned enterprises and 37,1054 non-state-owned enterprises. In these five years, the average probability of executives of each state-owned enterprise being convicted was 39%, while that of private entrepreneurs was 0.4%, 94 times that of the latter. Although the scale of state-owned enterprises is generally large, due to the “recessive family” characteristics of state-owned enterprises, a person’s corruption or collapse is often manifested as a “nest case”, involving a group of people. Especially as mentioned above, the risk of conviction will increase with the rise of position. If 768 senior executives of state-owned enterprises are multiplied by 61% (the proportion of top heads in all convicted persons), the probability of top heads of state-owned enterprises being convicted is about 24%. Considering that the so-called “top head” generally refers to the chairman and general manager, while the Secretary of the Party Committee is part-time, so the top heads are usually two people, so as to individual, the probability of the top head being convicted is 12%.

Once the risk of conviction is taken into account, the huge benefits of these state-owned enterprises will be offset, or even negative. Assuming that a senior executive of a state-owned enterprise can get an additional income of 4 million yuan from the “state-owned enterprise rent” every year, he will serve for an average of five years, totaling 20 million yuan, but the probability of being convicted is 12%. Once sentenced, according to the existing experience, it is about 500,000 yuan for a year in jail, a total of 40 years may be sentenced. We also assume that the loss of one year in prison is 4 million yuan, and the expected value is – 1.6 million yuan, which is obviously not worth. So why do people still flock to state-owned enterprises like moths? It is because for quite a long time, many people can not understand this because of psychological deviation. Adam Smith said that people are often shown as “overweening conceit which the greater part of men have of their own abilities” and “absurd presumptions in their own good fortune”. He added, “Avarice overrates the difference between poverty and wealth; ambition, that a private and public station; vainglory, that between obscurity and extensive reputation.” In fact, these two weaknesses will lead people to overestimate the value of executive positions in state-owned enterprises, because they have the advantages of money, status and reputation, and underestimate the risks they face, thus making wrong judgments.

Modern psychology confirms Adam Smith’s observation. Cognitive psychology has done experiments and found that people are prone to make the mistake of “ignoring the basic ratio”. That is, people only pay attention to the surface proportion of a phenomenon, such as red car accident probability is twice as blue, people often do not consider the number of red cars is twice the number of blue cars, and draw the conclusion that red cars are more prone to accidents. This is a common mistake. Even among Harvard students, 45% of them made the mistake of “ignoring the basic ratio” (Eysenck and Keith, Cognitive Psychology, East China Normal University Press, 2007, P. 578). In the case of state-owned enterprises, people mistakenly assume that the latter is safer only when they see that the number of convicted private entrepreneurs is larger than the number of executives of state-owned enterprises. In fact, this is due to the neglect the “basic ratio” that the number of private enterprises is 191 times of that of state-owned enterprises. Executives of state-owned enterprises should have made more mistakes than Harvard students.

However, some executives of state-owned enterprises with long-term vision realize this. They take various measures to avoid risks. Such as investing and accumulating more political resources in order to maintain their position and gain more security in the appointment of senior managers, or making high-risk investments to put the enterprise’s finances on the margin of risk, so that those who aspire to positions feel unprofitable and stop. But these are all technical responses. A smarter response is to be self-disciplined and cautious, not to pursue the interests of the moment, but to seek long-term peace. However, this is only a personal level of prevention, and will not change the average negative expected returns faced by the executive group of state-owned enterprises. This is because if they are really defensive and dare not step over the thunder pool, they will also reduce the number of “state-owned enterprise rent”. In the meantime, it reduces the possible benefits, and pays a heavy psychological cost. It can not even get rid of the malicious trap, and its income expectation will not increase. Any executive of a state-owned enterprise who has not yet fallen, still has the same chance of being in jail one day, even after retirement.

Therefore, the situation of state-owned enterprise executives is an institutional paradox. This is the tragic fate of state-owned enterprise executives, which is caused by their own group. The reason why SOEs have so many policy interests is that the group of SOEs’ executives and administrative officials overlap highly, or is caused by a group. It is precisely because SOE executives can swap identities with administrators that an administrator may one day become a SOE executive, so when he formulates policies, he is more likely to prefer SOEs. In our country, because of the historical inertia of “departmental legislation”, the decision of exempting profits or granting monopolistic powers to state-owned enterprises, which should have been approved by the legislature, is made by the administrative department. For example, the monopoly power of the oil industry is endowed by the administrative provisions known as Document No. 38, without any legitimacy. But when they make decisions in a secret room, they cannot blatantly attribute these interests to themselves, but they may attribute the interests to a group of people, and they are members of the group. They mistakenly thought that it would be good for them, but in fact, they dug a trap for themselves.

This is because, as long as they cannot directly assign this huge interest to themselves, they are facing competition from others in the same group. Unlike competition in the free market, peaceful competition that follows the rules of the market, competition among themselves may take a more intense form, such as political or legal competition, and even become “enemies” with each other. Such a state-owned enterprise system is a confusing and deceptive trap. When people get caught up in it, and even go to jail, they still don’t understand how they get in. As long as the state-owned enterprise system remains unchanged, they will not be able to get rid of that inescapable fate, just as Monkey King cannot jump out of the palm of the Buddha. The paradox is that this trap is precisely set by the group of SOE senior executives and administrative officials themselves. The bait is the coveted “SOE rent”, and the trap is the institutional environment in which the ownership of the “SOE rent” is not determined, which leads to the struggle among them. It is precisely because the state-owned enterprise system itself violates the basic justice of the human world and transfers the great interests of the country and the people to their own group without due process, that it will inevitably lead to  devouring themselves by the system, just like “God’s  punishment”.

Nevertheless, the truth of state-owned enterprises is ultimately recognized by the people in state-owned enterprises. This is because, on the one hand, the truth of state-owned enterprises is constantly unfolding, and those shocking corruption cases are hitting people’s minds; on the other hand, economic psychology finds that the more educated people are, the more patient they are, that is, they have the longer-term perspective. The longer you look, the more you can see the hidden costs behind the apparent benefits. There are a lot of talented persons gathered in state-owned enterprises, many of them know that unjust wealth is not wealth, but evidence of crime, which will be directly punished by the supervisory organs; some of them can understand that the institutional injustice is broad and more covert injustice, it may conform to the literal laws, but the “SOE rent” they captured is also unjust wealth at broad sense, which will still be punished in a broad sense, that is, the greed and malicious struggle caused by the wrong institutions. The more “SOE rent”, the more attractive, and the more severe the punishment will be. The fundamental way to end the tragic fate of state-owned enterprise executives is to carry out a thorough reform of state-owned enterprises. First of all, we must remove the “SOE rent” and make them equal competitors in the same market as other enterprises. Even if they only start from their own interests, they should remove the trap of state-owned enterprises, which creates illusions.

Thus, we can see the dawn of the reform of state-owned enterprises. The reform of state-owned enterprises depends on the internal motive force of state-owned enterprises. In the past, when we proposed the reform of state-owned enterprises, the top management of state-owned enterprises would oppose it unanimously. At that time, they did not realize that they were defending the trap of trapping themselves to death. It should be a turning point now. The nature of the trap of the state-owned enterprise system has been revealed, and more and more state-owned enterprise executives have realized this. And the higher the position, the greater the risk, the higher the average level of education, the longer the vision, the more motivation to reform the existing system of state-owned enterprises. They will be the main force in the reform of state-owned enterprises in the future. Moreover, the reform of state-owned enterprises is in the interests of the Chinese people and the state. If we take five years to complete the reform of state-owned enterprises and finally completely eliminate the “rent of state-owned enterprises”, we can enjoy two percentage points of economic growth per year. In international economic relations, because the interest group that hinders international fair trade actually finds that their interests are false and have negative consequences, the interest group will collapse, and they will not use their administrative power to defend the trap of state-owned enterprises. Fair trade agreements are easier to reach between China and other major trading partners. This is the result of great joy among the people, the society, the state and the state-owned enterprises. What other forces can prevent the reform of state-owned enterprises?

[Note] In the first half of 2019, Keqiang index estimates: the growth rate of cargo turnover, 5% (weight 25%); the growth rate of money supply, 4.4% (weight 35%); the growth rate of electricity generation, 3.3% (40%), and the revision, 0.6%.

Fivewoods Studio, September 14, 2019

First Published in FT Chinese, September 20, 2019

Author: flourishflood

Economist, Confucianist

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