A Theory of Partial Property Rights and the Illusion of State-Owned Enterprises / Sheng Hong

Abstract: State -Owned Enterprises (SOEs)do not pay profits and rents, they pay much less interest than other types of enterprises, and they have monopolistic power, but they are not subject to restrictions on labor (including management) income, which seems very attractive. Because this very substantial benefit is not transferred to certain individuals, there is competition for this benefit. However, the competition for senior manager positions attracts individuals whose probability of being convicted of a crime is 94 times higher than that of executives of private enterprises; thus, it seems that the position of senior manager in an SOE with very substantial benefits is actually risky, and the expected benefits are much smaller than the intuitive benefits and are not worth fighting for. Once the illusion of SOEs is punctured, SOE leaders with higher education and long-term vision may become the driving force of SOE reform.

1、 Question raised

In the 40 years of China’s reform and opening-up, SOEs have played an important role. In the early stage of the reform, in which SOEs dominated, the reform of SOEs was related to social stability and the rate of economic growth. However, from the late-1980s to the 1990s, under competition from township enterprises, private enterprises and foreign-funded enterprises, SOEs faced a dilemma. Given that SOEs still bore the heavy responsibility of employment and economic development and lacked exit mechanisms, an important task at that time was that “SOEs extricate themselves from difficulties”. Finally, at the end of the 1990s and the beginning of the 21st century, a way out of the difficulties was discovered, which was to use nonmarket forces.

Of course, nonmarket forces are mainly government forces. In China, executives of SOEs and officials of administrative departments belong to the category of government officials, and their status are interchangeable. Thus, they are members of the same interest group. Today’s top executive of a central enterprise may become the vice governor of some province tomorrow. Likewise, administrative officials in charge of SOEs can become senior managers of SOEs one day. However, in China, the formulation of important economic policies and the granting of monopoly power are usually decided by the relevant administrative officials without the approval of the legislature. In the absence of constraints, administrative officials will make policy decisions that are beneficial to themselves but not to society. Although it is not convenient for them to use their power to directly act in their own interests, they can create a kind of “collective welfare” with their power, and each official is a member of the collective. “Making effort for collective welfare” is a virtue in the circle of officials and executives. A person is a hero if he or she strives for more benefits for the group. Therefore, administrative officials use their power to seek welfare for SOEs and thus indirectly pursue their own welfare, which is a behavior that is somewhat concealed.

Their efforts were “successful.” In December 1993, the State Council issued the “Decision on the implementation of the tax-sharing financial management system”, which proposed that “as a transitional measure,” most of the old state-wholly owned enterprises registered before 1993 did not need to hand over their after-tax profits in the near future according to specific conditions. It was not until December 2007 that the Ministry of Finance and the State-owned Assets Supervision and Administration Commission (SASAC) jointly issued the Interim Measures for the Collection and Management of State-owned Capital Gains of Central Enterprises, which stipulate that the SOEs of the central government should turn over their profits pursuant to a three-tier system, with a maximum of 10% and a minimum of zero. In fact, the profits turned over by SOEs are returned to the SOEs in their entirety in the form of investments or subsidies. For example, from 2008 to 2019, SOEs handed over profits of 2248.9 billion yuan, while the investments in or other subsidies to SOEs totaled approximately 1842.1 billion yuan. The difference is 406.8 billion yuan, which is equivalent to 2% of the total net profit of 20584 billion yuan in the same period; this result is not different from what the result would have been if no profit had been handed over. This means that, as a whole, SOEs do not pay in their profits.

Almost all the SOEs established in the period of planned economy use land allocated by the planned authority without charge. Since the reform and opening-up, the land institutions of SOEs have not been marketized, that is, they are still owned and used by the SOEs and can even be rented to obtain rental income. Only when SOEs enter into joint ventures with other enterprises do state-owned lands need to be priced as part of the SOEs’ assets. When SOEs are listed, state-owned lands are priced and become the assets of the listed companies. However, state-owned land is often regarded as a kind of land use right and is evaluated as zero due to the uncertainty of its duration. Another exception is that listed companies can rent land from their state-owned parent companies and pay rent, which is generally much lower than the market rent rate. On the whole, the land rent paid by state-owned listed companies stays within the SOEs. According to our estimation, in 2013, the allocated land occupied by state-owned industrial enterprises totaled approximately 26091 square kilometers, and the corresponding unpaid land rent was 547.9 billion yuan (Unirule Institute of Economics, 2015). Therefore, it can also be said that SOEs do not pay land rent.

As the banking industry is monopolized by SOEs and SOE groups have strong political power, the loans of state-owned banks are mainly to SOEs. According to the relevant statistics, in 2018, the loan balance of SOEs accounted for 85.08% of the total state-owned bank loan balance (Wind Information, quoted from Lujiazui Financial Port, 2018). Since the interest rate of state-owned banks has been the regulated interest rate for a long time, the interest rate difference between deposits and loans is relatively fixed, to the benefit of state-owned banks; the interest rate difference is 1-1.5 percentage points higher than that in market economy countries, that is, 50-100% higher. On the other hand, to take care of the interests of SOEs as borrowers, the deposit interest rate is lowered, which causes huge losses for depositors. Due to the large scale of SOEs, they are in an advantageous position in financial transactions with other enterprises. They often postpone payments to suppliers or ask buyers to pay in advance, so there is a large amount of commercial financing. According to Liu Xiaoxuan and Zhou Xiaoyan (2011), from 2000 to 2007, SOEs were only required to pay 1.6% of the financing rate, while the market interest rate was approximately 4.68%, or 2.92 times greater than the SOE financing interest rate. In other words, SOEs only paid financing costs at 34% of the average market interest rate.

In the banking, oil, telecommunications, railway, power and salt industries, SOEs have monopolistic powers. Most of these monopolistic powers are not granted by the legislature but established by an administrative document of the executive organ. In many cases, the implementation of monopolies depends on the control of price and the entry of government departments. Therefore, monopoly and government regulations are mutually coordinated. In the field of oil products, for example, the National Development Commission sets prices. According to our estimation, in 2013, the pretax price of China’s oil products was 16.7% higher than the average price of oil products in major countries; thus, monopoly enterprises gained monopoly profits of 301.5 billion yuan. Another example is banking. Based on the 50% difference between the normal interest rate and the monopoly regulated interest rate, the monopoly income in 2013 was approximately 483.5 billion yuan. When the losses that we can estimate from the monopolies of the banking, oil, telecommunications, railway and salt industries in 2013 are added up, they total approximately 2273.4 billion yuan (Unirule Institute of Economics, 2015b), or 4.8% of the total operating income of SOEs in that year, which was higher than the SOEs’total profits of 19000 billion yuan in that year. It can be said that SOEs can obtain monopolistic power to increase their income by an amount equivalent to at least 4.8% of their operating income, or 21.8% of the added value of the manufacturing industry calculated by 22% of the added value ratio of the manufacturing industry.

Of course, SOEs still have the advantage of low-cost access to natural resource exploitation rights, they often receive government subsidies even if they make book profits, and they pay enterprise income tax at a rate of approximately 10%, which is significantly lower than the statutory rate of 25%. To simplify the discussion, we will ignore these policies that favor SOEs.

Conversely, the “Opinions on deepening the reform of personnel, labor and distribution systems within SOEs,” issued by the State Economic and Trade Commission in 2001, provides that “under the state’s macrocontrol, the wage level of enterprise staff and workers shall be determined by the enterprise on the basis of the local social average wage and enterprise economic benefits.” The basic meaning of this provision is that the income of the labor force, especially the managerial employees, of SOEs is actually unlimited. Since 2015, the central government has imposed restrictions on the salaries of senior managers of central enterprises, and the upper limit is not more than 8 times the average income; however, this relative proportion restriction can be avoided by raising the salary of management through an increase in the average income and can also be bypassed in the form of nonwage benefits or even noncurrency benefits. Managers can also enjoy benefits through on-the-job consumption and consume rent by reducing their efforts. In short, there is still no real restriction on the income of labor forces.

Thus, we have provided a rough description of SOEs. In summary, an enterprise may not pay land rent or its net profit, may only pay 34% of the market interest rate, and may obtain monopoly income equivalent to 21.8% of the added value, while the income of the enterprise’s labor force is not limited. The problem is, if there is such an enterprise, how will people behave? This is a question of institutional economics. The purpose of this paper is to analyze such an enterprise using the method of institutional economics, verify whether the result is correct, and roughly estimate the kind of behavior this enterprise will lead to and its impact on China’s reform and opening-up and political and social trends.

2. Theory of partial property rights

Imagine an enterprise in a pure market where the prices of its various factors are determined by the market and paid to the factor owners. Now suppose that there is a government that regulates the price of one of the factors; for example, the government sets the rent rate of land as two-thirds of the original rate. This is exactly what Professor Steven Cheung discussed in his book, The Theory of Share Tenancy, that is, the rent reduction of the “three seven five” in Taiwan, through which the land rent rate was reduced from 56.8% to 37.5% (2000, P. 88).

One question is who will obtain the reduced rent. Steven Cheung discussed two situations. The first situation is that a landowner’s land is vacant, and anyone can compete to rent the land to obtain the additional benefits brought about by the rent reduction. In other words, the reduced rent does not belong exclusively to a particular person. In this scenario, to obtain an additional 1/3 of the land rent above the original labor income, more tenants compete to rent the land, and the landowner is willing to increase the number of tenants because of the lack of 1/3 of the land rent. This changes the original optimal allocation of land and labor formed under the market by increasing the amount of labor under the condition of an unchanged amount of land. In this case, the total output will increase, but the marginal productivity of the labor will decrease. On the whole, it will cause a loss of resource allocation. This efficiency loss is equivalent to reduced rent. In other words, the benefits that rent reduction seems to bring to tenant farmers are all dissipated in the competition for rent because rent is not an exclusive interest.

In the second situation, the reduced rent is clearly and exclusively transferred to a specific individual. For example, a landlord clearly transfers this part of the rent to Peter. Regarding this scenario, Steven Cheung stated that if “the portion of rent were assigned exclusively to an individual tenant (tenants), say, through the issuance of stocks against the market value of the given land, joint ownership of the land would be established. With the entire return to the ownership right assigned to private parties, each joint owner would thereby be granted authority to make decisions concerning his share of the resource. “(2000, P. 116) The result is just like a transfer of property rights, which does not weaken the property-rights institution. “Therefore, the use of resources after rent reduction is exactly the same as that before rent reduction.” In other words, the efficiency of the allocation of resources will not be reduced after the transfer of land to specific individuals.

The distinction made by Steven Cheung is actually based on the theory of property rights. In his opinion, if a rent reduction regulated by the government is not transferred to specific individuals, then the interests represented by that part of the rent have no property owner. In this situation, people’s behavior is similar to the competition for ownerless resources, and the rent value of the resources ultimately will be dissipated. If the rent reduction is clearly transferred to specific individuals, then the interests represented by that part of the rent are subject to a clear, exclusive property right, and people will act as they would in a situation with clear property rights. That is, the issue of rent reduction is a property rights issue. However, in this situation, if the income from the property rights is restricted and there is no exclusive right to the restricted income, there will be no rights to a certain proportion of the original property rights. In other words, this is a “partial property rights issue”. According to Steven Cheung, “[a]ttenuating the right to derive income from resource use on a percentage basis will produce the same effects as attenuating the exclusive right to use the resource. “(2000, P. 115)

In another article, “The Structure of a Contract and the Theory of a Non-Exclusive Resource”, Professor Steven Cheung argued that if a bounded resource does not have exclusive property rights, people will freely enter into the market to compete for the rent value until the rent value dissipates to zero (Steven Cheung, 1970). See the figure below.

Figure 1 Process of rent dissipation

Note: Suppose there is a bounded fishing ground where Q/L and ( Q/ L) are the average and marginal income curves, respectively, and W is the market wage rate. When the fishing ground is exclusively owned by one person, the optimal amount of labor input by the fisherperson (α) is L1, which is determined by the point where his or her marginal income curve ( Q/ L) α) is equal to the wage rate (W); the maximum rent obtained is ABCD. However, if the fishery does not have exclusive property rights, anyone can enter freely. When the second fisherperson (β) enters freely, he or she will reduce the rent value of the first fisherperson, and the latter will reduce his or her input. The joint input of the two people is L2, and the rent value of the two people is AEFG, which equals half of the rent for each person. The total rent value and average rent value are significantly lower than those values when there is one person. When the third person, the fourth person, etc. enter, the total rent value and average rent value will gradually decrease until they are completely dissipated (Steven Cheung, 1970).

Obviously, rent reduction can be generalized. “Rent reduction” can be broadly understood as a restriction on the income of resources. Resources can include capital, land, money, natural resources and even labor. The restriction can range from 1% to 100%. Based on this definition, we can analyze all similar phenomena. That is, when a government controls the price of resources formed by a market, a similar phenomenon will appear. For example, in the regulation of the income of capital, the reduced part of the income is equivalent to the restriction of the property rights of the original owner. As the limited part increases gradually from 1% to 100%, the original owner’s property rights gradually decrease proportionally until the property rights are completely lost.

However, whether the reduced part of the rate of return on resources is transferred unexclusively to uncertain competitors or to certain individuals exclusively affects the result of the restriction. These are two extremes. The outcome in the former situation is equivalent to the resources being without property rights; people will rush in for free use, and the resource rent will soon be dissipated. The outcome in the latter situation is equivalent to the resources being subject clear property rights; people will use the resources as if the resources are subject to normal property rights and thus will not cause rent dissipation. Between these extremes, there is a broad, continuous spectrum. People will try to establish a certain degree of exclusiveness to occupy and retain the rent created by the government regulation, thus producing a variety of complex behaviors and consequences. In the extreme situation in which many competitors compete for ownerless resources, the result is that the difference between the regulated price and the market price is completely dissipated; in the extreme situation of the exclusive transfer of the price reduction to specific individuals, there is no efficiency loss. In the situations between the two extremes, part of the rent will dissipate, and some will be retained through various ways or means.

Steven Cheung cited such an example. The British Hong Kong government once regulated the rent of residential buildings to 1/10 of its original value. Steven Cheung predicted that the depressed 9/10 rent value would dissipate but later found that the rent value was still 3/4 of its original value. After investigation, it was found that the owners sublet or built wooden houses on rooftop to retain part of the rent (2000, F25 ~ 28). I call these two ways “neighboring contracts”. That is, besides the object range of the government’s price control, part of the rent was retained by forming a contract. For example, subletting means that a house owner rents the house to a secondary house owner according to the price regulated by the government, and the secondary house owner divides the house into several smaller units for rent, which are not subject to government price control. There is competition between secondary house owners, so they will transfer part of the rent left over to the original house owner in other ways. For example, the original house owner can charge higher fees for furniture in the rental rooms. A wooden rooftop house is a kind of wooden house built on a roof; these houses are not regulated, so they can compensate for the rent loss of the house owner.

In an article entitled “A General Theory of Rent-seeking”, I divided the methods of retaining rent into two general categories. One category is called the “contract mode”; that is, under the premise of price control, two parties agree to retain the rent. Of course, since the price regulations do not allow this kind of situation, it is not protected by law. In addition to the abovementioned subleases and wooden rooftop houses, there are also things such as selling food coupons during the planned economy period, sending red envelopes to doctors, patients in remote areas going to large cities with extensive medical resources, administering college entrance examinations to immigrants, cooperating with monopolistic enterprises, and providing retail or services for monopolistic enterprises. The other category is called the “government mode”, which uses government power to gain certain exclusive power in the competition for rent value; this rent value may be dissipated due to regulation, such that some rent value is retained. For example, officials put their children in famous schools by paying “management fees” or bribing officials and thus obtain part of the rent value by entering the areas controlled by the government (Sheng Hong, 2016).

In fact, there is a wide range between the two extremes, with or without property rights over the regulated part, allowing people to use various means to retain the rent values to be dissipated, which leads to tortuous and complex individual situations. In turn, these complex stories can be logically linked together to provide a powerful explanation. Of course, this includes SOEs.

3. Analysis of SOEs under the theory of partial property rights

According to the logic in the previous section, we will summarize SOEs again. At present, China’s SOEs are described as follows:

1. For the capital factor, the regulated price is zero; that is, the price is reduced by 100%;

2. For land resources, the regulated price is zero; that is, the price is reduced by 100%;

3. For monetary resources, the regulated price is 34%; that is, the price is reduced by 66%;

4. Through monopolization, SOEs increase the price of their products by 4.8%, which is equivalent to 21.8% of the added value;

5. There is no limit on the price of labor (including management).

Professor Steven Cheung’s theory of price control and theory of partial property rights can be applied to this type of enterprise. In other words, what is the result if the prices of capital, land and money are regulated but the price of labor is not regulated?

We first assume that controlling the price of the nonlabor factors is equivalent to increasing the income of the labor factor. Without any barriers to entry, and with free competition of labor, what will happen? According to Steven Cheung’s theory, the extra benefits will be dissipated by the competition.

According to our estimation of the industrial added value of SOEs from 2001 to 2013 (Unirule Institute of Economics, 2015), we convert the income of various factors and the monopoly income into the share of industrial added value, but the income share of the labor factor is the surplus after deducting the income share of all of the other factors. Assuming that the share of income distribution is determined by marginal productivity, then the share of labor may be negative, as shown in the figure below.

Figure 2 The share of labor income after deducting the share of income of various factors and the monopoly income in the added value

Considering the current situation of SOEs, in which the industrial added value remains unchanged, if the shares of business profit (i.e., capital return) and land rent are reduced to zero, the interest is reduced to 34% (that is, 5.2 percentage points), and the monopoly income is reduced to zero, then the share of labor income will increase by 61.2 percentage points to 53.9%. See the figure below. The 61.2 percentage-point-profit is the rent generated by the system of SOEs, so it can be called “SOE rent”.

Figure 3 The share of labor income after reducing the shares of capital, land and monopoly income to zero and the share of monetary income to 34%

We construct a production function of SOEs according to the Cobb-Douglas production function:

Y=K0.7*L0.3

We take the total assets of SOEs in 2018 as the base of the fixed amount of capital investment (k) in the above production function. Labor input (L) is a variable.

If SOEs openly recruit according to market rules, people will flood in; “SOE rent” is similar to ownerless property, dissipating in competition, as shown in the figure below.

Figure 4 Schematic diagram of the labor force freely entering state-owned enterprises

Note: The horizontal axis represents the number of workers, and the unit is one million people; the vertical axis represents marginal income or marginal cost, and the unit is 1 trillion yuan. In the absence of these restrictions on the price of nonlabor factors, that is, no “SOE rent”, the number of workers is approximately A; when there is “SOE rent”, if people can freely enter the SOE, the number can be as high as B. In that case, the marginal productivity of labor is reduced by C multiplied by B-A, which is approximately C (B-A). These values have been completely dissipated.

However, SOEs have less open recruitment, so the above assumption does not appear. Therefore, do SOEs have exclusive access to the benefits from the regulation of the prices of capital, land and other factors, as Professor Steven Cheung said? If so, the efficiency of resource allocation will not be reduced.

We find that SOEs are not enterprises into which the labor force can freely enter, nor are they composed of individuals who hold clear exclusive rights; they are in a certain intermediate state. Theoretically, SOEs are enterprises owned by a state, so no one has exclusive property rights. Employees, especially managers, of SOEs are labor factors employed by property owners. None of them will stay permanently in the SOEs. In particular, managers are more mobile. Similarly, SOEs are not allowed to be entered at will, and managers also have a certain term of office, during which they can actually determine the distribution share of income. Therefore, an SOE’s existing employees and managers can obtain part of the “SOE rent”.

Thus, the actual SOEs in the study demonstrate an intermediate state. First, there is a certain degree of redundancy, but it does not affect the amount of the labor force that should be free to enter, such as in the case of B mentioned above. Accordingly, the rent brought about by the price control of the nonlabor factors does not completely dissipate in the competition but is partially retained. This part is approximately equal to the amount by which the average income of employees in SOEs is higher than that in other enterprises. For example, according to our estimation, in 2013, the average income level of employees in SOEs was 330% higher than that of employees in non-SOEs (Unirule Institute of Economics, 2015). In an ideal labor market, the average income of employees in SOEs should be equal to that of employees in other enterprises.

In summary, China’s SOEs are enterprises that can be 100% free of capital costs, be 100% free of land rent, pay only 34% of monetary costs, and obtain a monopoly price 4.8% higher than the market competition price. Such an enterprise has a large “SOE rent” and attracts a large number of people to enter. However, in the existing system, it is impossible to enter completely freely. Therefore, these SOEs are in the intermediate state identified by Professor Steven Cheung. The controlled parts of the factor prices are not subject to ownership, but the competition for them is restricted. As a result, part of the rent created by the regulations is dissipated, and the rest remains and is occupied by the current SOE management and employees, making their average income level significantly higher than that of the average income in other enterprises.

4. Seeking and limiting of “SOE rent”

Since this kind of enterprise has so many advantages, it is natural for people to flock to it. However, newcomers cause the “SOE rent” originally enjoyed by the existing employees or management to be divided, so the existing personnel do not want people to flood into the SOEs without limit. Therefore, SOE employment and personnel systems are formed in the fight between these two forces. On the one hand, the issue of redundant staff in SOEs is serious; the number of technical and managerial-level staff in SOEs obviously exceeds a reasonable number of employees in those positions. On the other hand, the existing management and staff in SOEs resist the employment of a large number of external people.

For the issue of redundant staff, we compared Sinopec with Shell Company, two companies with similar sales volumes. The former has 9.6 times more employees than the latter (Unirule Institute of Economics, 2013). If Shell’s staff size is appropriate, Sinopec’s redundancy is approximately 90%.

In contrast, SOEs consciously control their numbers of employees. For example, the total assets of nonfinancial SOEs was 116.2 trillion yuan in 2014 (Li Yang, 2015) and 210.4 trillion yuan in 2018 (State Council, 2019), which equals an increase of 81%, while the number of employees in nonfinancial SOEs decreased from 45.81 million in 2014 to 38.22 million in 2018, which equals a decrease of 19.8%. In other words, the number of employees per unit of assets decreased from 390 per billion yuan of assets to 180 per billion yuan of assets. This is remarkable.

Therefore, are there redundancies in SOEs or not? Specifically, in light of the very substantial benefits of exempting capital costs and land rent and paying only 34% of loan interest, the management of SOEs can adopt more complicated personnel systems. They should not only retain the very large rents but also let their relatives and friends enter the enterprises to share the benefits and ensure that the SOEs’ work is completed. The observations of some enterprises, such as PetroChina, show that there are three kinds of employment systems, namely, contract employment, market-oriented employment and labor dispatch. So-called contract employment refers to the employment of the original employees and important technical and management personnel of an enterprise, that is, the formal employees of the enterprise; contract employment is actually a special contract deviating from market pricing. So-called market-oriented employment refers to the recruitment of unemployed children and college graduates through talent centers. So-called labor dispatch workers are personnel exported to the oilfields through third-party labor service companies and are mainly recruited from the public. The wages of the latter two kinds of personnel are mainly determined by the market pricing of the labor force. In terms of personnel salary and income, contract employment ranks the highest, and the income in the market-oriented and labor dispatch systems is approximately 1/4 to 1/2 of the income in the contract employment system (Unirule Institute of Economics, 2013).

Although there are people who are employed based on power or relationships, due to the limitation of the number of regular employees, there is no excessive redundancy in the total number of employees. However, these people can actually use those who are employed in the market to perform practical work while enjoying the advantage of SOE rent. Their income includes not only wages and capital but also nonmonetary material income, such as low-cost housing and on-the-job consumption. We take market-oriented employment and labor dispatch as one kind of employment. We assume that the employees’ income is half that of regular employees, or only slightly higher than the market price of the labor force.

Figure 5 The number and income of regular employees and market-recruited employees under the two employment systems of SOEs

Note: In the figure, the marginal labor cost of SOEs refers to the marginal labor cost of people who have the status of formal employees of SOEs. It refers to the income level of SOEs; the marginal cost of labor in the market is the labor price in the market. The equilibrium number of formal employees in SOEs is at point A, where the marginal output of labor intersects the marginal cost of formal employees of SOEs. However, due to the existence of “SOE rent”, people can obtain more income at point A, so there will be a large number of people pouring in, which will make the equilibrium point move in the direction of B. However, the addition of employees will be resisted by the existing employees and will not exceed point B. The equilibrium point should be at point C, between A and B. While full-time employees enjoy the benefits of “SOE rent”, SOEs can also employ workers according to the labor market price. These people, called labor dispatch workers, will decide whether they enter the labor market according to the market price of labor and will not stop entering until equilibrium point D. They do not enjoy the benefit of “SOE rent.”

Therefore, to maintain the maximum interests of its regular employees, an enterprise should control the number of regular employees at point A in the figure above and enjoy the benefit of “SOE rent”, which is equivalent to the dark gray rectangle in Figure 5. However, such substantial interests will attract outsiders to enter. To enter, these outsiders must have the power to make the SOEs obey or have some relations; some people even pay to buy the right to enter an enterprise as regular employees. Therefore, employees in SOEs cannot be controlled within point A but will expand to point B. As the number of people increases, the per capita “SOE rent” will decrease, so within point B, there are two opposing forces. Suppose the final number of regular employees is at point C, between A and B. In this situation, due to the decline in marginal productivity, some “SOE rents” have been eaten up, and the remaining marginal “SOE rents” are reduced. The total amount is shown as the light gray rectangle.

In addition, on the basis of such substantial assets, new labor will bring positive marginal productivity to an SOE and increase the SOE’s total output. Therefore, enterprises will recruit employees at a slightly higher income level than the labor market price. However, these market-oriented employees cannot enjoy the income level of regular employees; that is, they cannot participate in the sharing of “SOE rent” and can only obtain a wage level approximately equal to their marginal productivity. In this case, the number of employees in SOEs can theoretically be increased to point D. Since SOEs generally control quantity even if they recruit in the market, the actual number of SOE employees may be lower than the above estimate. We already know that the number of employees in nonfinancial SOEs is approximately 38.22 million. However, we now know that dispatched workers are not included in the statistics of employees of SOEs. It is said that there are approximately 60 million dispatched workers. These dispatched workers are part of the employees of SOEs who cannot enjoy SOE rent. The two numbers add up to approximately 100 million people. Including these workers is equivalent to extending the number of personnel in SOEs to point D.

5、 The game of management

Among regular employees, there is also a group of people who are the largest beneficiaries of “SOE rent”. They are the managerial employees. They are at the top of the employee hierarchy in SOEs and determine their own income. Even when the central government limits the annual salary level of SOE executives, they can still obtain the benefits of “SOE rent” through nonmonetary income such as housing and on-the-job consumption.

Figure 6 Schematic diagram of SOE management obtaining “SOE rent”

The gray bar at the bottom of the above figure represents the SOE rent obtained by regular employees other than management; the gray box at the top left is the SOE rent obtained by management. Suppose there are 200000 people in management positions in SOEs, and they enjoy SOE rent of 500 billion yuan. This is a very substantial benefit, attracting thousands of people to come in and fight for it. A simple logic is that if you want to enter the management team of an SOE, you have to reduce the number of existing management personnel. There are two ways to achieve this: one way is to change the post in a normal manner, and the other way is to withdraw the existing management staff in an abnormal manner. At present, China’s SOEs have a normal system of turnover of senior managers, whose tenure is generally three years. This length seems to reflect the urgent mood of the people outside the SOEs who want to enter, and it is applied to the political process to form this shorter term. Of course, some executives can hold three consecutive terms in their SOEs. In any case, however, the three-year term gives outsiders a chance to enter. This leads to the frequent replacement of senior managers in SOEs, especially in central enterprises. For example, in 2018, at least 97 heads of central enterprises were transferred. However, there were only 96 central enterprises; thus, the average transfer rate was 100%.

Even so, the term seems too long. Another way to eliminate incumbents, the data suggest, is to impeach them on the basis of corruption or serious mistakes. There are two reasons why this elimination tactic may be successful. First, the executives of SOEs realize that the three-year term is too short, so they may take illegal actions to obtain benefits in addition to their legal income. According to an analysis by the China Entrepreneur Crime Prevention Research Center of Beijing Normal University, corruption crimes of SOEs, including bribery, corruption, misappropriation of public funds, private division of state-owned assets and duty encroachment, account for 81.3% of all kinds of crimes, while the proportion of such crimes committed by private enterprises is 30.7% (Hexun Mingjia, 2018); this difference obviously reflects the property rights characteristics of SOEs. That is, SOE executives will take all kinds of legal or illegal actions to obtain benefits for themselves in the case of the temporary exclusion of outsiders from the rich benefits of “SOE rent”. Because their terms are not long, they often look at the present, underestimate the negative consequences and engage in crime.

Second, their positions are coveted by powerful administrative officials, who use political means to influence the judiciary and frame SOE managers. They do this because SOEs are economic entities with “SOE rent”, and they are eager to squeeze in. There is a possibility that some people will take advantage of their public power to frame the current enterprise leaders in order to seize positions in SOEs with rich interests.

In any case, the result is that executives of SOEs are more likely to be convicted. Moreover, according to the above logic, the richer an enterprise is, the higher the probability of its senior executives being convicted; the higher the position of the executive, the more likely the executive is to fall. For example, because of monopolistic and other preferential policies, the oil industry has a high crime rate. For example, from 2014 to 2015, 12 senior executives of “three barrel oil” companies, including PetroChina, Sinopec and CNOOC, were convicted of crimes (Legal Evening News, 2015). Sinopec has had three consecutive general managers, Chen Tonghai, Wang Tianpu and Su Shulin, who have successively fallen out (Cheng Zhen, Lu Mengjun, Guo Chen, 2015). According to statistics on this issue, from the date of the 18th National Congress of the Communist Party of China to November 2015, a total of 171 senior executives of SOEs were convicted, including the following: 15 chief accountants and office directors, accounting for approximately 9% of the total number; 52 deputies and other team members, accounting for approximately 30%; and 104 presidents, general managers or party secretaries, accounting for 61% (Zhao Zhenyu, 2015). Obviously, the higher the position held by the employee, the higher the probability of being convicted.

Figure 7 Frequency of SOE executive convictions (from the date of the 18th CPC National Congress to November 2015)

According to the statistics of the China Judicial Document Network, from December 1, 2013, to November 30, 2018, 2337 entrepreneurs committed crimes, including 1569 private entrepreneurs and 768 SOE executives (Hexun Mingjia, 2018). In 2017, the number of SOEs was only 1946, while the number of non-SOEs was as high as 371054. Assuming that each enterprise had 10 executives, the probability of being convicted for SOE executives was 0.039, while that for private entrepreneurs was 0.0004. The crime rate of SOE executives was 94 times that of private entrepreneurs. Although the scale of SOEs is relatively large and the number of branches of an enterprise may be several times greater than that of private enterprises, the senior managers of SOEs are not only individuals but also have the characteristics of a “recessive family”. A person’s corruption or collapse often manifests as a “family case”, which involves a group of people. As mentioned above, the higher a person’s position is, the higher the person’s probability of being convicted. As shown in the table above, assuming that an SOE has 10 executives, the top 2 of which are leaders (the president, general manager or secretary of the Party committee), the probability of the top leaders being convicted is 623% greater than that of the other executives and 307% greater than that of the average-level employees.

In this situation, on the one hand, SOE executives should act cautiously; on the other hand, they should take measures to prevent being replaced or framed. There are generally two courses of action. One course is to strive for more political resources because the appointment and removal of SOE executives are not within the SOEs but within the political process. The senior managers of central enterprises are generally appointed and removed by the Organization Department of the CPC Central Committee, and the senior managers of local enterprises are appointed and removed by the organization department of local Party committees. The organization departments’ rules for appointment and removal are not the rules of the enterprise or the market but the political rules. Therefore, it is impossible for an executive of an SOE to believe that his efforts to do well in the enterprise and obtain more profits are the means to keep his position. SOE executives even engage in bribery for political resources or asylum. For example, in the case of Liu Zhijun, Ding Shumiao spent 44 million yuan to be the “rescuing person” for Liu Zhijun and 5 million yuan to serve Liu Zhijun as secretary of the provincial Party committee, and he arranged for a certain person to continue bribing relevant departments (Beijing Morning Post, 2013).

However, in addition to political efforts, the only way to hold a position is to make no or little profit for an enterprise. Only in this way will the enterprise look less attractive to outsiders. A common saying is “to be big and to fail”. It means that if you want an enterprise to look unprofitable and unattractive, you should borrow a large amount of money, raise the enterprise’s asset-liability ratio, and increase the enterprise’s financial risk. High debt will increase financial costs and squeeze out profits, and the projects being invested have risks, all of which will deter those who want to enter the enterprise, thus allowing the existing executives to keep their positions. The high asset-liability ratio of SOEs is confirmed by the data. According to the Ministry of Finance, by December 2018, after two years of “deleveraging”, the asset-liability ratio of SOEs was 64.7%, of which 67.7% was due to central enterprises. According to Gelonghui, at the end of February 2019, the asset-liability ratio of private enterprises was 58.2%. This ratio is significantly higher than the 51.5% asset-liability ratio of private enterprises at the end of 2016 (2019).

Due to excessive borrowing and underestimating the risk of investment, the assets of SOEs grow rapidly. For example, from 2014 to 2019, the average annual growth rate of state-owned assets was 15%, far faster than the growth rate of GDP in the same period and faster than the growth rate of the total assets of private enterprises. According to data from the Dacheng Enterprise Research Institute, from 2015 to 2018, SOE investment increased by 7.8% annually, while that of private enterprises only increased by 2.7% annually (2019). Moreover, the excessive investment of SOEs shows that the return on net assets of SOEs is lower than that of private enterprises even in nominal terms, and the expected return on investment for new projects is more likely to be lower for SOEs. These outcomes are reflected not only in domestic investment projects but also in foreign investment projects. Domestically, SOEs with monopoly power can obtain monopoly income, but in foreign countries, they do not have monopoly power. With the low efficiency of SOEs, their expected income will be lower. However, the foreign investment of SOEs exceeds that of private enterprises. In 2006, SOEs accounted for 81% of the total foreign investment, and they accounted for 51.3% in 2017. In the same period, their domestic investment accounted for less than 40%. In addition to the other reasons for corruption, SOEs are not concerned about high risks of investments.

The high asset-liability ratio of SOEs and the rapid growth of total assets generally prove the existence of the “to be big and to fail” strategy. However, judging from the fact that the crime rate of executives in SOEs is much higher than that of private entrepreneurs, it is not clear whether this strategy works.

6. The fate of state-owned enterprises

Through the above analysis, we find that “beautiful” SOEs are actually an illusion. On the one hand, SOEs do not pay profits, do not pay land rent, only pay 34% of interest, and have a monopoly interest equivalent to 21.8% of the added value, which increases the “SOE rent” accounting for 61.2% of the added value. On the other hand, the senior executives of SOEs have a three-year term limit, and their probability of being convicted of a crime is 94 times greater than that of private entrepreneurs. The two sides may be offset as  being negative.

Assuming that there are 20000 top executives in SOEs, each of them can share approximately 4 million yuan of “SOE rent” every year, and they share approximately 80 billion yuan in interest. Their opportunity cost, i.e., the income they will obtain as executives in private enterprises, was approximately 500000 yuan/year in 2018. The legal income of SOE executives is slightly higher than this amount. Assuming that the average tenure of these executives is five years, they will gain 20 million more yuan than a normal manager. However, once they are convicted, they will not only lose these benefits but also go to prison. Based on the existing sentences of SOE executives, the average sentence is one year for every 500000 yuan obtained illegally; the sentence for obtaining 20 million yuan illegally is 40 years. If we assume that the value of one year of imprisonment is -4 million yuan, then 40 years of imprisonment is valued at -160 million yuan. Regarding the head employees of SOEs, 12% have a probability of losing 160 million yuan of their income, and 88% have a probability of losing 20 million yuan; their expected return is -1.6 million yuan, which is a negative value. Obviously, it is not worth giving up a position in a private enterprise for such an “expected income”. In fact, this calculation is very conservative. Four million yuan a year is far from sufficient to compensate for the prison scenario. If a rational person makes such a calculation, he or she will not rush into an SOE.

However, this is not consistent with what we see. Most people still fly as moths to a fire, one after another into SOEs, and then to prison. Why? It is because people do not calculate rationally. Adam Smith once said that people’s self-love is usually manifested in “overweening conceit which the greater part of men have of their own abilities” and “absurd presumption in their own good fortune” (quoted from Coase, 1994, P. 111). Cognitive psychology tells us that people often make the psychological mistake of “ignoring the basic ratio”. That is, people only see the apparent frequency of occurrence, without considering the basic ratio of these phenomena. For example, a phenomenon that people see is that the frequency of accidents involving red cars is twice that of blue cars; then, without knowing that the number of red cars is twice that of blue cars, they conclude that red cars are more likely than blue cars to be in accidents. In the abovementioned investigative report on entrepreneurs’ crimes, 67.1% of those convicted were private entrepreneurs, while 32.9% were SOE executives. It seems that the latter are less likely to be convicted. However, if we know that the number of private enterprises is 191 times greater than that of SOEs, this view is totally wrong. In relevant psychological experiments, 45% of Harvard students made the mistake of “ignoring the basic ratio” (Eysenck and Keane, 2009, P. 578). If SOE executives assume that SOEs and private enterprises each account for half of the total number of enterprises, they will think that their probability of being convicted is only one-third of that of private entrepreneurs.

Adam Smith also said, “Avarice overrates the difference between poverty and riches; ambition, that between private and public station; vainglory, that between obscurity and extensive reputation. “(Quoted from Coase, 1994, p. 112) This sentence is suitable to describe the scramble for senior management positions in SOEs. These positions can not only bring more economic benefits but also allow service as a public servant belonging to the same group as senior government officials. With money and power, you can gain fame. For example, in recent years, some SOE executives have applied for academician positions in the Academy of Science or Engineering. However, the value of top management positions in SOEs may be greatly overestimated. If SOE executives gain power and reputation in addition to the 4 million yuan a year in rent and regard the value of their positions as 10 million yuan a year, even if there is a 12% probability of being convicted, the expected return will be 24.8 million yuan. In this way, people’s behavior is not likely to depend on rational calculation but is driven by their own psychological weakness, which leads to them making an incorrect estimate.

Furthermore, people’s calculations are limited by their vision of time. Short-sighted people often cannot see long-term results. There is always a first act of illegal gain, followed by the disclosure and punishment of the illegal behavior. Benefits and costs do not occur at the same time. Benefits come first, costs later. Short-sighted people are more likely to calculate only the benefits of taking advantage of SOEs and ignore the cost of being punished later. In my article “Vision and Calculation”, I pointed out that life is made up of a series of games. Big games include small games. When people enter into a game, they are temporarily limited by the boundaries and rules defined by the game. They generally do not consider the world outside the game. However, in fact, various factors in the outside world will affect the real cost-benefit ratio of the game’s results. For example, a person cheated in order to obtain high scores on an exam, but in the person’s actual work, the person was defeated. In other words, he won the small game and lost the big game (Sheng Hong, 2013). This is where many criminals, though “rational”, miscalculate. This is also where many people in the SOE-top-manager and administrative-official interest groups miscalculate. However, it is precisely because of this mistake of the majority that the illusion of SOEs is maintained.

More importantly, people often cannot see the institutional reason for this illusion. Due to the existence of a strong interest group of senior executives in SOEs and administrative officials, these individuals can often carry out their activities “in house” in the absence of institutional structure constraints on the actual “legislation” of the administrative departments; that is, within the administrative departments, they can directly formulate and issue preferential policies or grant monopoly powers in favor of SOEs. However, when they do so, they cannot transfer the benefits of the preferential policies and monopolies to one or more individuals among them. They can only assign the benefits to the SOEs under the label of “bigger and stronger” SOEs and act as the interest group members who are qualified to enter the SOEs as senior executives. This kind of practice creates the problem faced by all SOEs. That is, it constructs a situation described by Steven Cheung. The benefits of nonlabor factors that are controlled to lower prices are not transferred to certain individuals but to a group in which the members can compete with each other for these very substantial benefits. Thus, the members became competitors, or even enemies, with each other. The loss of the loser or the victim of the competition constitutes the negative benefit expectation of the whole group of SOE executives, and it is uncertain who the victim is, such that every senior manager who enters the SOE may lose more than he or she gains.

Specifically, in the stage of setting up rents, due to the lack of respect for and implementation of the legislative authority and due process stipulated in the Constitution and the legislative law, there was a habit in China that the administrative departments stipulated the matters that should have been stipulated by the Constitution or an administrative document. The administrative departments related to SOEs often issued administrative documents and provided preferential policies for SOEs, such as not requiring SOEs to pay profits, not limiting SOE salaries and bonuses, or granting monopolistic powers like those granted to PetroChina and Sinopec through “Document No. 38”. Those who transition from roles as executives in SOEs to roles as officials in administrative departments, as well as those who hope to cash in policy dividends from SOEs in the future, will promote institutions and policies in favor of SOEs. Potential SOE members believe that it is in their own interests to do so. Currently, it is impossible to transfer the rent part of interests to certain individuals because such transfers are a naked abuse of public power and constitute corruption. However, these very substantial benefits can be transferred to a group. In addition, in their culture, it is shameful to seek benefits for individuals, but it is heroic to seek benefits for the collective. Therefore, the abuse of administrative power to set up significant interests for SOEs is inevitable.

As long as the senior executives of SOEs and administrative officials are rational economic persons, they are bound to be tempted by the very substantial benefits of SOEs. They compete for “SOE rent”, which is equal to 61.8% of the added value, as farmers compete for 1/3 of the land rent share. However, competition rules are not market rules but political rules. That is, the Party Organization Department appoints the senior managers of SOEs, while the Organization Department of the CPC Central Committee appoints the senior managers of central enterprises. In the organization department, the real rule is not that an enterprise must select excellent leaders, nor is it that democratic voting is required; rather, it is a rule of power. Therefore, competition for SOE executive positions becomes competition for power. However, in the competition for power, there is also a lack of fair and moderate rules, sometimes even in cases of life and death, so it is impossible to have a stable equilibrium in which SOE executives can stay in office for a long time. Equilibrium can only exist in short periods of time; when political personnel change, the original balance is broken. Moreover, as the benefits of SOEs are very attractive, the impulse of administrative officials to break the existing balance is increased. Therefore, there is no real equilibrium in the appointment of SOE executives. In contrast, the instability of the position of SOE executives is normal under this rule.

As a result, as we have observed, the crime rate of SOE executives is much higher than that of private entrepreneurs, and the average term of office is far lower than that of private entrepreneurs. However, because this information is not very clear and lacks statistical support, people tend to believe the information that is beneficial to them and underestimate the information that is unfavorable to them. For example, they overestimate the benefits obtained from SOE senior executive positions and underestimate the probability that they will be punished as a result of engaging in criminal behavior. SOEs are illusory images representing people’s common interests. They think that it is in their common and greatest interest to deliver benefits to SOEs and defend the interests of SOE executives. Therefore, in various political processes, they put SOEs in a politically correct position and above the interests of all people, which causes public decision-making to deviate, but they themselves are ultimately harmed. This kind of ending is inevitable and tragic. If you enter the top management of an SOE, no matter where you are, you cannot get rid of the negative expectations that this group faces. The tragic fate brought about by the SOE system, which SOE members set up, is that, similar to “natural punishment”, no individual can escape from it.

7. Solutions to the problems of state-owned enterprises

When we say that because of their short-sightedness, SOE executives and administrative officials cannot see the real, tragic fate of SOEs, there is a hidden possibility. That is, if some of them break through this short-sightedness and have long-term vision, they will see the unfortunate results and know that the apparently substantial interests of SOEs are, in fact, the reason that they compete with each other and even act with hostility toward each other. In this competition, they will lose more than they will gain, and they will even suffer from extinction. The bright surface of an SOE is actually an illusory image that is a trap full of bait, and the bait is put out by the SOE executives and administrative officials; they set the trap for themselves. They know that it is a trap, but they scramble for it. When someone proposes dismantling the trap, they stand up to defend the trap; in fact, they are defending their tragic fate.

It is possible to see the true face of SOEs. Studies have shown that people with more education are more patient (Burks, Carpenter, Gotte, and Rustichini, 2012). In other words, they have greater long-term vision, and they calculate not only in terms of immediate interests but also in terms of future interests. In the SOE executive and administrative official group, there are a large number of highly educated intellectual elites. They have long-term vision. They will look at the problem from the perspective of repeated games rather than only seeing the result of one game. Moreover, as mentioned above, the higher an individual’s position is, the greater the individual’s risk and the higher the probability of being convicted. We can more clearly see through the bait nature of “SOE rent”. Therefore, they can see through the illusion of SOEs and put forward reform demands from inside SOEs. In this situation, the political dynamics of SOE reform will develop in a positive direction and ultimately make the reform of SOEs politically feasible. Under this premise, the remaining problem is the reform program.

Since the fatal problem of SOEs is the unclear ownership of the very substantial benefits brought about by the price reduction of nonlabor factors, the solution seems to be to clarify the property rights over this part’s interests. There are two ways to do so. The first way is to cancel the price control of all relevant nonlabor factors, that is, to cancel the favored policies that no profit or land rent need be paid, and the control or monopoly of interest rates and interest rate differences. However, this requires SOEs to pay according to market prices. In this way, there will be no weakening of property rights, as Steven Cheung said. In the market, SOEs will become fair competitors of non-SOEs.

The second way is to clearly assign the interests that have no clear ownership, that is, the nonpayment of profits, the nonpayment of land rent, the underpayment of interest and monopoly income, to specific people or enterprises. In fact, this is the privatization of state-owned capital, state-owned land, part of the property rights of banks, and monopoly interests.

There are two options on this path. One option is to assign this part of the substantial interests to the identified individual SOE executives and administrative officials; however, it seems impossible to do so because it is extremely politically incorrect to assign the property rights of SOEs to those in power without compensation. Of course, this action will also be opposed by the overwhelming majority of people and thus is not feasible politically.

The second option is to sell this part of the interests in the markets, and the persons who offer the highest price may obtain them. For example, the value of the income of state-owned enterprises from free state-owned land and free-to-pay profits of state-owned capital is actually the market value of land and capital, which is equivalent to the privatization of state-owned land and capital. More broadly, it is the privatization of all factors of production, including natural resource exploitation rights and low-interest loans, which is an effective and fair privatization. In this way, the new owners of these factors will demand their rights, and the SOEs will have to pay the market price of these factors. As a result, SOEs will become fair competitors in the markets. Politically, this should be acceptable to most people.

The reason why SOEs have not been effectively reformed is mainly because of the opposition of SOE executives and administrative officials. The reason why they oppose reform, as mentioned in the above sections, is that they are confused by the illusion that SOEs offer very significant benefits, believing that it is good for them to safeguard the beneficial interests of SOEs. When we expose this illusion, this interest group can see that what they are trying to maintain is a trap to capture themselves. However, although others have said they want to abolish this trap, they rise up against reform. If they realize that SOE reform is intended to remove this trap, which is an outcome that is actually good for them, they will stand on the side of SOE reform. Perhaps this will eventually promote the reform of SOEs so that China’s reform and opening-up can cross this seemingly insurmountable obstacle.

Reference

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Steven Cheung, Theory of Share Tenancy, Arcadla Press, 2000.

Steven Cheung,The Structure of a Contract and the Theory of a Non-Exclusive Resource,Journal of Law and Economics, Vol. 13, No. 1 (Apr., 1970), pp. 49-70.

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Published firstly in Man and the Economy, 2021, vol. 8, issue 1, 21-45

Author: flourishflood

Economist, Confucianist

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