China's private sector still in the shadow of the state

   South China Morning Post, 19 Dec. 2013

In an essay published eight years ago (Financial Times; October 5, 2005), I said that China’s private sector was in the shadow of the state.

I can make the same argument today with one significant difference: the state sector’s dominance in China has grown considerably in the last eight years.

The last decade has almost completely undone the reforms of the two previous decades.

The consensus in the West is that China’s state sector is corrupt, inefficient and ideologically inferior, so it must be losing ground against private enterprise which is steadily chipping away at the communist, state-backed old guard.

That is just not the case.

Nicholas Lardy, in a recent Bloomberg Brief piece, compared the financial performance of China’s state sector with the private sector. Citing the National Statistics Bureau, his numbers were predictable: last year, the state sector return on assets (ROA) was merely 4.6 per cent and well below the private sector’s 12.4 per cent.

I think those numbers are biased and wrong.

The biggest components of the state sector are the banks, which account for almost half of the domestic stock market valuation, and about half of the total net profit of all the listed companies. Other big components in the stock market, or in the unlisted universe for that matter, are state-controlled big insurance companies, big oil corporations and telecommunications operators.

Chinese banks have an average return on equity (ROE) of about 20 per cent – twice the level of their global peers. Insurance companies do well in general, and telecoms operators enjoy exorbitant privileges. How can the state sector underperform the private sector in financial terms?

Of course, you can argue that the banks’ profits are entirely due to the government’s control of interest rates. That is a true and fair assessment, but the fact remains that the state sector has a much higher ROE than the private sector.

Lardy’s use of ROA is meaningless because banks by definition are highly-geared business and their ROAs are low in nature (around 2-3 per cent). The nature of the banking business is such that you cannot usefully compare bank ROA with other sectors. ROE is the appropriate benchmark.

The other problem with Lardy’s comparison is that tens of thousands of private sector companies go bankrupt, or voluntarily close each year. Once that happens, they exit from the statistics. So there is a “survival basis”. But you do not hear any state-owned enterprise being shut down.

Uneven playing field

The state sector not only benefits from the economies of scale, but also from the economies of scope. The state sector as a whole is like a giant conglomerate company that benefits from diversification, the low cost of plentiful funding and political favours.

The playing field is unfair and aligned against the private sector.

Moreover, there are many hybrid joint venture companies in China that blur the distinctions between the two sectors.

Finally, the state sector takes on many social functions, and their existence and activities provide a positive spillover effect for the whole economy and society.

While liberal commentators may disagree with this, the state sector is designed to achieve more than just financial ratios.

Utilities, (power, water, natural gas and public transportation) for example, where the state sector dominates, are not charged at full price because of affordability and other social reasons. That drags down their financial returns, but the financial ratios do not reflect their efficiency.

More state involvement

It is wrong for liberal economists to say that the dominance of the state sector goes against the public’s wishes.

In China, the public wants more, not less, involvement by the state sector. The public wants a bigger state sector to tackle the many challenges China faces, even if many of these challenges are by-products of the state sector (inequality, overpopulation and pollution).

Even the recent third plenum does not mention the private sector, a point Lardy acknowledges.

The official data shows that the government tax revenue as a percentage of gross domestic product almost doubled from 12 per cent a decade ago to 22.3 per cent last year. This is almost a wholesale reversal of the economic liberalisation of the previous two decades.

But Western economists do not mention this uncomfortable fact.

The state dominates strategically important sectors – essential infrastructure and sectors with pricing power – while the private sector is left to fight it out in fiercely competitive sectors such as low-end manufacturing, retail, service industries and (some) real estate.

The writing is on the wall: the score of the past decade’s match of the private sector versus the state sector in China is “private sector - zero” and “state sector - one”.

Joe Zhang is a corporate adviser based in Hong Kong, and the author of Inside China’s Shadow Banking: The Next Subprime Crisis?