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No meaningful change in China without state sector reform

You can’t deny it.  Along with the high PM counts, there’s something positive in the air here in Beijing.  Recently, I’ve had more than a few conversations that demonstrate some kind of an uptick in confidence in China’s prospects post 18th party Congress.  Housing sales are rebounding which could suggest that the dismal drop in retail sales for the first 3Q in China could bounce back in the run-up to Spring Festival.  Xi Jinping is telling us about a China Dream and a Great Revival.  The ice seems to be cracking over the One Child Policy, and corruption exposés are on the rise.  It kind of feels like Christmas is coming in China.  And China’s Santa can buy a few more imported goodies this year for girls and boys given recent appreciation (less than 1%) of the RMB.

But the road to real change in China is a long one and can’t be equated to a once a year visit from a fairy tale character.  Real change in China will involve putting the country back on the road to reform and undoing many of the imbalances, failures, and negligence of the Hu-Wen regime.

I believe the most critical sector to watch is reform of China’s State Owned Enterprises (SOEs).  In 10 years, the Hu-Wen government essentially did nothing to deepen or strengthen the 1994 Company Law which set out to privatize and bring efficiencies to the state sector.   Now with the Youth League clique backpedaling, Xi and the Princelings will have a chance to rein in state-owned industrial sector. – after all the Princelings built the party profit machine in the 1990s vis-à-vis the SOE system.  The new leadership team will have direct line to 100+ central level SOEs in strategic industries as the Politburo holds power over the SOEs by guiding State Council policy and appointing firm managers.    Some firms rank among the largest and most powerful firms in the world.  In 2008, SOE profit alone made up 3.7% of GDP before the global economic meltdown and profitability increased at 10% rates year-on-year in 2010 and 2011.  SOEs are taxed at an extremely low rate so in a sense they are free to plow their profits back into their enterprises which helps sustain inefficiencies.

A successful SOE reform plan would seek to reduce corruption and inefficiencies while increasing profits.  Currently it is too simple for SOE managers and high-ranking officials to set up loose subsidiaries owned by their own relatives who then have access to state channeled resources and monopolistic conditions.  Further failures of the Hu-Wen reign are evident. In the prior decade SOEs and the party machine were unable to function on the world stage and purchase a foreign major firm like Unocal or move on Rio Tinto.  China is still a low-middle income country by most standards, but SOE executive salaries (government officials) now match the earnings of Western Fortune 500 CEO salaries, and they enjoy a grey bonus/share ownership structure that may eclipse those of their Western counterparts.  Stories abound of SOEs using their foreign subsidiaries or construction investments in Africa and Southeast Asia to funnel money to tax shelters in the Caribbean. Despite expressed government oversight, SOEs have been accused by domestic critics of conducting their own foreign policy.  And despite government demands to invest with overseas partners to promote learning by doing, reportedly the only recent successful partnership to date is the joint investment with Holiday Inn.   Here in Beijing, the largest food-producing SOE in China gets a majority of its income through real estate development.  How’s that for Socialism with Chinese Characteristics?

Richard McGregor reveals in his book The Party that CCP officials in the post-Tiananmen 1990s took on a  new philosophy towards party survival: the linchpin of further economic reform was maintaining public ownership of certain industries.  In other words, despite the downsizing of the state sector in the last twenty years, the Party will not survive without the state sector.  If the Party could come good on its commitment to curb corruption, close the income gap, and increase wealth and opportunities in the country’s interior, perhaps normatively the cacophony of discontent from the masses might simmer down.  In other words a new social compact would arise that permits the Party to get rich as long as it governs well.  But easier said than done.  And in China there exists an obligatory and moral code of obligatory helping your friends get rich (family run subsidiaries), and conspicuous consumption (hence the luxury watches and Ferraris).  Patronage lines will only be strengthened and fattened until death (or China Spring) do they part.

A major obstacle to reform is CEOs of SOEs are governed by two masters:  the State-owned Assets Supervison and Administration Commission (SASAC), the nominal owner and legal supervisory body over SOEs plays second fiddle to powerful CCP.  CEO appointments of the biggest SOEs are directly made by the Politburo.  SASAC is ill-funded and not able to set up respectable advisory organizations with teeth to fulfill its mandate, so it’s squeezed to satisfy a single function: ensure profitability of the SOEs.  With the profit motive and loose supervision, CEO’s can steer their firms virtually any way they wish as long as they please the Party patrons who put them in the driver’s seat.  Essentially, CEOs’ motivations are only curbed by the Party controlled selection system which determines their promotional prospects and political careers.  Party groups also penetrate deeply inside of the structure of SOEs to force party based decisions on the SOE’s business model.  Check out the story of Singapore Airline’s failed bid for China Eastern in 2007 to further understand the mechanics of how the Party trumps SASAC.

Many reform-minded critics have chastised Li Rongrong, former head of SASAC for his 2003 declaration that a state controlled economy was the foundation of CCP governance (p27), but perhaps Li is remembering lessons taught by Deng Xiaoping who implied in the post-Tiananmen era that party survival is based on forms and degrees of public ownership. Perhaps Li was really pointing a finger at the Party by implying SASAC needs to do be more effective in making sure the Party does not go too far in its abuses of SOES.  Misusing the state sector for personal gain threatens Party survival.

So from our perspective standing outside of the walls of the big black box, there are a few indicators worth keeping our eyes on over the next year that will demonstrate whether or not the darling Party Princelings act to continue to fatten themselves or choose the more tempered route of sticking to the SOE reform plan as laid out during the Jiang era for the sake of Party survival.  We should be watchful of regulations or announcements that boost the supervisory power of SASAC.  Check on the strength and composition of listed SOE’s boards of directors to get a feel for the rise or falling power of the Party’s grip on SOE leadership.  We can monitor whether SOEs are diversifying or consolidating core business competencies to correct market failure.

Further, it’s easy to follow changes in the corporate income tax rate (to SOEs or firms in general) or the profit dividend rate to SOEs.  Both taxes have been suppressed and low through the Hu era providing SOES with nearly bottomless and unchecked war chests. Increases in either of these rates would demonstrate a rising negotiating power of SASAC and provide SASAC with funding it needs to set SOEs on a pathway that would better ensure Party survival not party implosion.  Allowing the RMB to appreciate will force efficiency measures in SOEs and deepening financial institution liberalization could decrease the cash injections easily delivered to SOEs through the party patronage system.  Thus opportunities leading to corrupt practices could be curbed.

Let’s also watch for the first mention of the 1994 Company Law from official Chinese media outlets.  It’s been nearly 20 years since introducing the law which promised to deliver the good results listed above but it hasn’t been touched in a decade.  At the 2012 Caixin Summit, top China economist Barry Naughton received an accordant round of applause when he said that if executives of CEOs cannot implement the Company Law in their SOEs they should be fired. Kudos to Naughton for a bold and simple statement, and I couldn’t agree more.

Perhaps we should also use this measure to appraise Li Keqiang’s performance as well.  If Li can’t do it, then he can take a hike or what’s known in China as a ‘vacation style medical treatment.’

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