Why China's State-owned Companies Are Making a Comeback

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A migrant worker assists at the Wuhan North Railway Marshalling Station on April 10, 2009 in Hubei Province, China

The news about China's efforts to recover from the global financial crisis can cause whiplash. A government research center announces that thirty million migrant workers may be unemployed — 50% higher than the previous estimates — but Chinese Premier Wen Jiabao says the economy is doing "better than expected." Exports plummet and GDP growth grinds to a 10-year low, but fixed-asset investments and Shanghai stocks are headed up. It often looks like there are two Chinese economies.

In a sense, there are. China's long economic rise began in the 1980s when the communist government began dismantling inefficient state-owned companies and expanding the private sector, allowing greater scope for unfettered capitalism. But in recent years, the pendulum has begun to swing the other way. Many of China's state-owned enterprises (SOEs) have grown into giants, eclipsing the relatively young, private companies that have contributed heavily to the country's progress. That trend is being reinforced as China implements economic stimulus measures that in practice boost state-owned giants while private companies are left largely to fend for themselves. (See pictures of China's electronic waste village.)

Companies that are majority owned by the government include some familiar names, among them China Mobile, the world's largest mobile phone company by subscribers, Baoshan Steel and China National Petroleum Corp. The role they play in China's hybridized economy appears to be expanding due to the global slump. As Beijing fights recession with a $586 billion stimulus package and as banks boost lending at the behest of the government, the private sector looks to be getting squeezed out. Loans to private firms in January totaled $61.7 billion, down $102.5 million from the previous month, even as total lending has swelled, according to the All China Federation of Industry and Commerce. It isn't just financing that is flowing to SOEs. So are revenues from Beijing's infrastructure-heavy stimulus package. State-owned companies maintain a strong presence in construction, the sector that will gain the most from the surge in government spending.

The sector that is suffering the most is manufacturing, which is dominated by private companies. In 2008 an estimated 300,000 small and medium-sized firms collapsed; from January to March this year, exports fell by 19.7%, putting more pressure on the survivors. "The crisis hits China's private sector really hard because China's private sector accounts for a larger share of China's manufactured exports," says Yasheng Huang, an MIT professor who wrote about the rising power of SOEs in his 2008 book [Capitalism with Chinese Characteristics]. "So essentially you have a private sector whose main source of customers has just disappeared."

Because SOE revenues depend less on internal and external demand and more on government spending, Huang says, "the state sector can simply produce without regard to market demand whereas the private sector cannot. This is why in a situation like this when the market demand has just collapsed the only one that is left standing is the state sector."

Recent corporate performance underscores this growing divide. Li Rongrong, chairman of State-Owned Assets Supervision and Administration Commission, which runs more than 150 companies, recently told the state-run Xinhua news service that SOE profits surged 86% in March compared with the previous month. Li attributed the increase to government stimulus spending.

Huang says the trend is worrisome, partly because it could undo progress made in freeing up China's economy. "In the short run, the numbers may look good ... (but) a year or two from now, if China only relies on the state sector to drive growth, the fundamental distortions in the Chinese economy today will get worse."

One of the chief concerns is that over-reliance on government spending for growth will undermine a Chinese economic goal: boosting consumer spending to achieve a more balanced economy, one that is less dependent upon consumer demand from the U.S. and Europe for growth. "The biggest problem with the state-centric growth model is it does not put much income into the pockets of the average Chinese and therefore it does not raise consumption," says Huang. "A year or two from now, suppose that the U.S. does not resume its previous pace of consumption —which is very likely— then the huge state-sector investments will create another round of excess capacity."

If SOEs in heavy industries like steelmaking increase production at a time when ordinary market demand is falling, they could be driven to dump their products cheaply abroad when government spending stops. This could touch off protectionism in other countries, which would ultimately harm China, says Michael Pettis, a professor of finance at Peking University.

Huang also worries that by making state-owned enterprises a priority for stimulus efforts, the government could undermine the productivity gains made by China's increasingly competitive private sector. He says that it is "quite likely that productivity growth will completely disappear this year ... then all you have is this brute-force investment growth which always leads to a crash."

At a time when credit in China is rapidly expanding —loans in the first quarter totaled $670 billion, almost equaling total lending for all of 2008— the risk of bad loans is increasing. With small and medium-sized private firms collapsing with disturbing frequency, SOEs offer Chinese banks a margin of safety: an implicit guarantee that the government will ultimately make good on their loans. This is making it harder for China's banks to adopt modern risk-management practices and diversify their traditional customer base, which is largely SOEs. "It's difficult to go on a massive spending binge and at same time create new channels," says Pettis. "The easiest thing to do is more of the same."

So long as the global financial system is in disarray, China will be hard pressed to withdraw its support for SOEs and stem the private-sector decline. But if it wants to ensure that an economic recovery lasts, it may have to. "If you believe one of China's problems over the last 10 years is a large misallocation of capital ... the debate is that you're seeing a continued misallocation," says Pettis. Some argue this matters little amid the global recession "when the house is on fire," he says. The risk is that in China's push to extinguish the worst of the flames, it may be setting itself up for a long, slow burn. —with reporting by Lin Yang

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