During an interview with Forbes in 2015, the chief executive of Tsinghua Unigroup, one of China’s leading semiconductor firms, laid out his grand strategy for building a world-class company. “The goal,” Zhao Weiguo said, “is using foreign know-how as a shortcut to build an advanced chip sector for China.”
Over the next several years, Zhao made good on his promise with a string of acquisitions that led mainland Chinese media to dub him the “acquisition-maniac.” In 2015, his company bought a majority stake in HP’s China-based server business for US$2.3 billion. Three years later, it acquired a French semiconductor manufacturer for US$2.5 billion. In 2015, Unigroup attempted to acquire Micron Technologies, a leading US chip maker, for US$23 billion. However, in a harbinger of things to come, the Obama administration axed the acquisition citing concerns over national security.
The more vigorously Zhao pursued foreign acquisitions, the more state support Unigroup, a state-owned enterprise (SOE), received. The company received US$1.61 billion from a government-run industry fund in 2015 in addition to US$3.22 billion in loans from the China Development Bank. Two years later, it received US$22 billion from state-backed investors. Beijing can claim some victories for its approach – Unigroup has since pioneered China’s progress in critical semiconductor technologies such as flash memory.
Beijing believes that SOEs like Tsinghua Unigroup will accelerate China’s march toward technological autonomy. However, Beijing also allowed this veritable symbol and vehicle of China’s economic and technological ambitions to default on US$2.5 billion worth of bonds in December 2020. In addition to Unigroup, several other SOEs in strategic sectors like energy and transportation have also since been allowed to default.
The defaults of strategic SOEs have revived hopes of less government involvement in China’s mixed economy and a more important role for the free market in allocating resources. Such hopes are not new. A communique from a high level communist party policy plenary in 2013 declared that the market should play a “decisive” as opposed to “basic” role in resource allocation, a sentiment that future plenaries also affirmed.
Still, Beijing’s actions betray its true intentions of pushing for the creation of large, powerful SOEs that dominate strategic sectors and advance reforms that place SOEs under the firm control of the state. These policies have led to wasteful investments and will act as a near-term burden on China’s economy.
Impetus for Reform
2013 marked a newfound openness in Beijing toward market reform, and the shift in sentiment coincided with a shift in economic thinking. The year before, China’s export and investment-oriented development model had reached an inflection point. China’s trade surplus with the world had shrunk and the pace of economic growth had slowed. Critically, the efficacy of public investment in projects such as infrastructure had begun to wane. New thinking in Beijing argued that the government needed to pursue market reform in order to transform China into an advanced, industrialized nation, and this put the country’s lumbering SOEs squarely in the reformers’ sights. The clearest manifestation of this new thinking appeared in the 13th Five-Year Plan, which claimed to assign “markets rather than politicians… a more decisive role in resource allocation.”
SOE Balance Sheet Woes and Attempts at Resolution
Across a multitude of indicators of financial health, China’s SOEs underperform relative to privately-owned enterprises (“POEs”). According to a 2019 IMF report, the return on assets of SOEs are just a third of that of POEs. Furthermore, SOEs’ share of loss-making firms has not changed substantially since 2015 and remains twice that of POEs. Because SOEs benefit from subsidized access to factor inputs and government-sanctioned monopolies, they can afford to exercise less capital discipline than POEs.
Persistent overcapacity is one of the most visible consequences of SOE inefficiency. Global concerns about Chinese overcapacity are not without merit – after pledging in 2015 to reduce steel production by 100-150 million tons over the next five years, Chinese SOEs, which already contribute to 50% of global steel overcapacity, have increased production from 803.8 to 996.3 million tons between 2015-2020.
At a glance, Beijing has recognized these weaknesses and acted proactively to resolve them. In December 2015, Premier Li Keqiang dramatically stated that, “For those ‘zombie companies,’ we must ruthlessly bring down the knife.” Two highly visible and trumpeted approaches used by Beijing to reign in bloated SOEs have been President Xi’s flagship deleveraging campaign and a higher tolerance for SOE defaults. In both of these efforts, Beijing can claim success. Leverage ratios, which measure a company’s ability to meet its debt obligations, have fallen steadily and sharply for SOEs since the campaign’s announcement in 2016. After peaking at around 180% in 2016, the debt-to-asset ratio of SOEs fell to about 160% in 2018.
In allowing the market to drive inefficient enterprises toward default, Beijing can claim even greater success. In October 2018, 28 SOEs defaulted, an increase from just two the year before. Furthermore, the recent default of Tsinghua Unigroup suggests that Beijing is less willing to interfere in the affairs of SOEs, including enterprises it deems strategic. The combination of rising defaults and tighter access to credit should incentivize previously pampered SOEs to better manage their resources to avoid facing the sort of consequences of which weak POEs must contend. In the words of Premier Li, these reforms are meant to help SOEs “lose weight and get fit.”
Despite measures taken since 2016 to improve SOE performance by making them more responsive to market forces, SOEs continue to underperform relative to POEs on a scale that is extremely distortionary even while receiving state support. Return on assets (ROA) for SOEs has not increased meaningfully since the start of President Xi’s deleveraging campaign, which signifies that tighter access to credit has not led to savvier resource management by SOEs. This is partly attributed to SOEs’ continued preferential access to factor inputs such as land and natural resources. Adjusting for this so-called “implicit support,” SOE return on equity falls from an average of 8% to about −1.3% from 2011 to 2015.
To make matters more complicated, the deleveraging campaign simultaneously hurt POEs by indiscriminately targeting access to credit. According to a 2019 IMF report, “Financial regulatory tightening…has had the unintended consequence of constraining credit to private corporates.” In fact, bond defaults by POEs climbed almost in sync with SOE bond defaults. The IMF has succinctly summarized the impact of Beijing’s loudly advertised deleveraging campaign and efforts to create a level playing field for domestic firms: “Deleveraging has not changed the overall allocation of credit in China.”
Beijing’s Consolidating Grip
In stark contrast to these efforts and public statements claiming that the market will play a “decisive” as opposed to “basic” role in resource allocation moving forward, Beijing seems intent on consolidating its grip on SOEs and ultimately protecting the final say it has on resource allocation in China’s economy. A communique from the 2013 Third Plenum announcing that China must “unswervingly consolidate and develop the public economy, persist in the dominant positioning of public ownership, give full play to the leading role of the state-owned sector, and continuously increase its vitality, controlling force, and influence,” left little to the imagination. Instead of market-driven SOE reform, Beijing’s emerging vision for China’s SOE sector emphasizes mergers and acquisitions, partial privatization, and party control over management, oftentimes – as Tsinghua Unigroup’s financial woes demonstrate – at the expense of economic efficiency.
Since 2003, the number of central SOEs, mammoth enterprises owned by the central government, has fallen from 189 firms to 97 in 2018 thanks to merger and acquisition activity with SASAC, the powerful body in charge of managing central SOEs, that continues to call for even further consolidation. Beijing claims that consolidation of the state sector will improve state performance by increasing economies of scale, cutting industrial capacity, and minimizing competition among SOEs. However, M&A activity has failed to generate the sought-after synergies, particularly in labor. Premier Li has insisted that “when cutting excess capacity, superfluous workers must be transferred to other jobs instead of being laid off,” a directive that has spurred significant internal redundancies and resource allocation inefficiencies.
Party control over management has also tightened in recent years, a reflection of President Xi’s belief that “Party leadership and building of the role of the party are the root and soul for state-owned enterprises.” Through SASAC, the Party reserves the right to appoint leadership to central and local SOEs. The party’s grip tightened in 2016 when SASAC announced that all major decisions by SOEs would be subject to Beijing’s approval. While a party presence does not necessitate interference, this level of party power and presence within SOEs makes interference likely since the party often has non-commercial interests that can clash with the profit-making mission of market-driven enterprises.
On the gold standard of market reforms, privatization, Beijing has sent mixed signals. While Beijing has welcomed private capital in exchange for equity, majority control of SOEs by private entities remains out of the question. A 2015 headline from state-owned media outlet Xinhua – “We must unequivocally oppose privatization” – conveys Beijing’s skepticism of more dramatic reform for these mammoths.
This is not to say that Beijing is as wholly opposed to growing the private sector’s stake in SOEs. Eager to reduce the burden on state-owned banks, Beijing has approved the sale of stock to non-SOE economic entities to raise capital from private investors. However, Beijing consistently relegates private ownership to a minority stake.
Even in cases where an SOE appears to cede the government’s controlling stake to the private sector, the state’s penetration into economic life means that the government indirectly retains control. Jiangxi Salt, a legal monopoly in China’s salt market, offers a case in point. Initially held up as an example of mixed-ownership after outside investors bought a majority stake in the company, Jiangxi Salt remains firmly in state hands. Of the four new investors, three are SOEs themselves and a fourth is 83% owned by the Ministry of Finance.
This is to say nothing of SOEs’ continued reliance on subsidies credit. A Gavekal Dragonomics report featured in an IMF study concluded SOEs’ benefit from interest rates are estimated to be 150-250 basis points lower than those for their private sector peers for bonds with similar maturities. While deleveraging has induced SOEs to find alternate sources of financing such as private equity, banks still provide over 70% of corporate financing.
For Western observers who equate economic health with market reforms, defaults by inefficient state firms and falling leverage ratios may suggest a strong commitment to liberalization. However, Beijing’s track record of encouraging M&A activity among SOEs to create mega-SOEs, increasing the party’s presence in corporate leadership through party committees, and using opaque mixed-ownership deals to direct private capital toward SOEs while maintaining majority control suggests that Beijing is not as committed to giving the market as “decisive” of a role in resource allocation as it claims.
A History of Twisted Interests
The seemingly contradictory promises of party officials in China are not new, and for long, observers have had doubts about the authenticity of Beijing’s market-oriented reforms. The influential European Chamber of Business complained in a 2020 report that “SOE reform remains in a place where Beijing must close the gap between rhetoric and reality.” However, despite appearances to the contrary, Beijing’s reforms and messaging follow a coherent pattern, and a great deal of confusion stems from different understanding of what “reform” means and who should benefit from it.
SOEs allow Beijing and local officials to channel resources toward realizing a number of critical political objectives. That the interests of both local and national leaders align on this matter contribute significantly to SOEs’ staying power. China’s coal-fired power generation industry, which is dominated by SOEs, offers an excellent case in point. Despite suffering from overcapacity, China has added 50% more coal-fired capacity over the past five years than the rest of the world combined. Importantly, after the central government devolved the authority to approve permits to provincial governments in 2014, approval rates for new coal-fired plants tripled despite capacity already stripping demand.
Provincial administrators were quick to issue approvals since they were promoted on their ability to hit short-term economic and employment goals within their jurisdictions, and power plant construction boosts economic activity and employment in the short run. By the time overcapacity becomes evident, the administrator in question has already been promoted. By facilitating the upward trajectory of local party careers, SOEs serve a political purpose that is difficult to substitute.
At the national level, SOEs serve the interests of China’s top leadership by playing a pivotal role in great power politics – China’s economic transition – and China’s rapidly expanding power projection efforts. In the race to reach technological parity with and eventually surpass the US, China has given several high-tech industries a “strategic” designation in its recent five-year plans. Semiconductors fall under this designation, and in order to accelerate their development, Beijing is pouring resources into such industries. As Tsinghua Unigroup’s journey demonstrates, this approach can generate results at the risk of massive inefficiencies.
However, Beijing strongly believes that while these inefficiencies create a short-term cost, the results that this approach generates, such as the world’s largest solar industry, have long-term strategic value that tilt the balance of power away from the US and toward China. President Xi’s exhortation to analyze China’s economy from a “comprehensive, dialectical, long-term perspective” stresses this point and hints at the growing role for SOEs in China’s strategic industries, a fact that is borne out by the data. The share of China’s SOEs in “normal” and “pillar” industries declined from 2016 onward; meanwhile, in “strategic” industries (defense, oil and gas, telecom, coal, aviation, etc.) the state’s share increased to 85.7% in 2018.
The growing international presence of Chinese SOEs in infrastructure development as a result of Beijing’s “Going Out” strategy is yet another critical way in which SOEs prove their usefulness in balance of power calculations. Formulated as a means to reduce overcapacity, acquire foreign technology, reduce reliance on Western markets, and secure access to vital resources, the “Going Out” campaign’s most prominent manifestation is in Africa, where FDI inflows from China in 2019 totaled US$72.2 million, more than double that of France, the next largest investor. However, by number of projects in Africa, China only has 259 compared to France, which has 329, and the US, which has 463. The small number of projects relative to the large amount of capital invested speaks to China’s strength and interest in infrastructure and resource extraction megaprojects. Western firms, hesitant to commit to long-term projects in a region lacking political and regulatory continuity, lack the appetite for the risk that megaprojects carry.
This gives China, with its ravenous appetite for resources, extensive experience in infrastructure development, and desire to win international goodwill the opportunity to channel investment into these strategic areas via SOEs. Given the already dominant role of SOEs in sectors like energy, construction, and resource extraction, the role of POEs in China’s growing African footprint is minimal.
China’s Veiled Intentions and Long-Term Mindset
Beijing’s words and behaviors often indicate that the market will play an increasingly decisive role in resource allocation, yet party control over SOEs only seems to increase. SOEs serve a strategic political purpose that other institutions struggle to fulfill and for which China’s leaders are willing to tolerate a high level of economic inefficiency. The feverish pace of consolidation, the growing role of SOEs in strategic industries, and the presence of party committees within SOEs are all examples of Beijing’s tightening grip over the state-owned sector, and so far, these reforms have failed to produce more efficient enterprises. Instead of putting pressure on SOEs to “lose weight and get fit,” the recent string of defaults by companies like Tsinghua Unigroup simply shed light on the underlying structural issues that China’s SOEs face.
As long as SOEs are inefficient, they will consume resources that could have gone toward the development of a vibrant, consumption-driven economy. Stunting the growth of a multitude of industries that would better serve the needs of China’s consumers in order to accelerate the development of strategic capabilities in aviation, defense, and electronics may turn China into a world-class technological heavyweight in the long-run. However, in attempting to chart China’s near-term economic trajectory, China’s current SOE policy is increasing rather than reducing the burden that SOEs place on growth.