ambiguous capital ii

7/29/2019 Ambiguous Capital II

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Essay Number 14

August, 2000

Ambiguous Capital (Part II):

The Restructuring of China's State-owned Enterprise Sector

By Satya J. Gabriel

Reformers in the Communist Party of China (CPC) have recognized for yearsthe need to improve the performance of state-owned enterprises (SOEs).[1]

After two decades of experimenting with various restructurings, the condition of

these enteprises is worse than ever, despite steadily increasing labor productivity

(which has been more than offset by eroding market conditions and the strain ofbank loans dating back to a time when the obligations generated by such loans

were not taken seriously by senior SOE managers who had been accustomed to

grants from the central authorities). During that time, SOEs suffered sharp drops

in cash flow, interest coverage ratios, accounting profit margins (reflecting a

pervasive inability to generate sufficient surplus value to meet claims on enterprise

cash flow), and, on average, a more than fifty percent reduction in the value of the

surplus product (as measured by the residual over the wage fund plus depreciation

of existing machinery and facilities). Although some SOEs have prospered under

reform, most have suffered from the increase in competition over both output and

input markets, as well as constraints on their ability to raise the rate of exploitation

(mainly via a reduction in real wages and benefits). Thus, although the value of

labor power and the cost of means of production have increased somewhat, the

drop in the total value generated in SOEs has been much larger than might have

been anticipated at the start of the reform process. It is, therefore, insufficient to

rely on rising labor productivity to solve the problem. Some SOEs may be able to

generate increased sales simply by producing cheaper goods, but not all. SOE

senior management must improve their strategies for competing over output

markets in order to generate the necessary surplus value/cash flow to meet all

existing obligations and have sufficient retained value to finance a major

technological and marketing overhaul. Anything less will only lengthen the period of

pain in the SOE sector and present the possibility of a larger economic crisis.

Although the percentage of the labor force that is employed in SOEs has steadily

fallen (to around 41% in 1997, according to the State Statistical Bureau), it

remains clear that the success or failure of the SOEs is critical to the overall

success or failure of the Chinese economy and the legitimacy of the CCP's

continued monopoly control over government. The ability of the former commune

enterprises, now called town-village enterprises (TVEs), and private enterprises to

absorb the labor that is being made redundant (and subject toxia gang, formal

layoffs) by restructuring in the SOE sector has proven insufficient to maintain the

previous level of employment. The erosion in the financial position of small and

medium sized SOEs, those controlled at local levels and operating outside of

strategic sectors, such as mining and energy production, petrochemicals, steel and

other basic materials, and defense related manufacturing, has been particularly

rapid as the "Letting go of the small" policy has been implemented. Letting go of

the small (and medium) sized SOEs, which tend to have a higher debt-equity ratio

than larger, centrally controlled SOEs, is a priority for a central government that

wants to wean SOEs from state subsidies so that more funds are available for

value enhancing modernization projects. The cost is the displacement of larger

numbers of workers, since the small and medium SOEs often have higher labor to

total capitalization ratios than the larger more secure enterprises. Unemployment

rates and income inequality are both rising (along with the crime rate, which

remains relatively low by international comparisons, but has been positively

correlated to unemployment rates).

The cost of keeping the SOEs alive continues to rise, however, and the

government is becoming increasingly desperate to find a solution. The losses

suffered by the 46% of state-owned enterprises (SOEs) who are operating in

deficit is particularly frustrating to the Chinese government, which has been forced

to choose between providing heavy subsidies to these enterprises to keep them in

business (adding to a rising national government deficit) or closing them down and
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increase the level of unemployment dramatically. Given the weakness of China's

social safety net, which will be a subject of a future essay, a drastic increase in the

rate of unemployment carries the rather serious risk of generating social unrest and,

as previously indicated, delegitimizes one-party-rule in China.

Passage of the Corporation Law in 1994 (which received the official imprimatur of

the Fifteenth National People's Congress in 1997), established the notion of

"Keeping the large and letting go of the small," provided a legal framework for the

corporatization of SOEs (as well as the sale of non-strategic SOEs to private

domestic or foreign investors) and for discrimination against locally controlled/non-

strategic enterprises in determining which firms would gain subsidies. This law was

also designed to reduce the degree of ambiguity about control over enterprise

capital, fiduciary responsibilities of managers, and rights of owners to sell assets.

A further step in weening the vast majority of SOEs from government support was

the establishment in 1998 of a recapitalization program modelled after the US

government's rescue of the savings and loan sector in the 1980s. The Chinese

government established four asset management companies to take over assets of

SOEs who were unable to pay existing debt. The state-owned banks holding

these non-performing loans were allowed to write-off debt related to these asset

transfers, providing the banks with improved balance sheets and more liquidity for

making future loans. The hope was that the SOEs, with reduced existing debt,

would take this opportunity to get their financial houses in order and focus on

improving profitability to avoid future problems. The banks had an incentive to

improve their lending practices, providing future loans only to those firms who

could demonstrate the capability to generate sufficient cash flow to pay such loans,

providing an additional incentive for SOE managers to improve their strategic

planning and implementation.

What is the likelihood that SOE managers will succeed at improving their firms?

What was wrong with these enterprises in the first place? Are the problems faced

by the SOEs unique to state-owned enterprises? In order to answer these

questions we need to examine the operating conditions of state-owned enterprises,

to uncover the problems that generate poor operating results, and compare these

conditions and problems to the environment in other firms, including the highly

successful town-village enterprises (TVEs) discussed in the previous essay.

In Western corporate finance it is usually assumed that the primary mission of

corporate management is value creation: managers are assumed to select those

assets and activities that will generate the higher net present value for the

enterprise. Never mind that this may not always be the case. If agency problems

were not so serious in the United States, the subject of agency costs would not be

so prominent in the b-schools. In any event, if managers are to be valuemaximizers, they must be able to identify and then implement investment projects

and restructurings of present assets that result in higher overall net present value for

the portfolio of enterprise projects/investments. Are managers in the SOEs both

motivated and empowered to do this?

For most of the history of the SOEs the answer was an unambiguous no. SOE

managers were neither rewarded for nor empowered to engage in value creation.

SOE managers were governed by the dictates of a central plan created by

bureaucrats and political leaders in Beijing and provincial capitals. Managers were

simply informed of output quotas and other outcomes expected to be generated by

their firm. The managers had very little influence over either the choice of inputs

and outputs, output targets, prices set forth in the plan, or the parameters used in

the design of the plan. Managers also had very little influence over investment

decisions that would determine their relative success at meeting plan targets.

Nevertheless, because managers operated within a noncompetitive market undersoft budget constraints, these institutional rigidities and inefficiencies did not pose a

serious threat to enterprise survival. Perhaps even more to the point, managers'

performance evaluation was based largely on political factors, so the existing

environment also did not impede their attainment of personal success.

The pragmatic modernist leadership in Beijing was, however, concerned about the

growing drain on national budgetary resources and the pace of technological

innovation and invention (which is rising, but not quickly enough to guarantee the

future success of Chinese firms in global competition with "Western" capitalist

transnationals). They had the example of the USSR to demonstrate the risks of not

solving the problems created by centralized planning and market monopolies. And

they had the example of the rural reforms to demonstrate that changing incentives

could result in positive changes in output and reduced dependency on national

budgetary funding. It was, therefore, clear that something had to be done to

change the incentives for SOE management. It is not surprising, then, that much ofthe early tinkering with the way SOEs operate involved shifting more decision-

making authority to managers and away from the external bureaucracy.

The first attempt at decentralizating authority took place in Sichuan Province. It

was another of the "crossing the river by feeling for stones" experiments that has

come to epitomize the reform era. In 1979, managers in 84 industrial enterprises


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were given decision-making powers --- in both investment and operating areas ---

that had previously been vested in the external bureaucracy. In particular, the

managers were given partial authority over equipment and materials purchases,

labor hiring and assignment, and pricing. As an incentive for the managers to make

good decisions, they were also allowed to retain, for use in the enterprise, a larger

share of the surplus generated. Whether the authority or the incentive was

sufficient to result in value maximizing behavior is open to debate. However, the

pragmatic modernists who were then in power in Beijing decided the results were

sufficient to generalize the reforms. Gradually other managers were granted the

same powers that had allowed the Sichuan managers to gain greater control over

their enterprises.

The result has been less than uplifting. The percentage of total industrial output

attributable to SOEs continues to decline. In 1978, at the beginning of the reform

process, SOEs generated about 78% of industrial output. By 1997 the SOE

share had fallen to about 27%. Overcapacity in the SOE sector has gone from

problem to crisis proportions. Attempts to sell off SOE assets to reduce this level

of overcapacity has also been met with less than stellar success.

To put it in blunt terms, SOEs continue to bleed red ink. Gross margins have

fallen steadily over the past two decades. I would estimate that the surplus

generated by SOEs (using data from the State Statistical Bureau) has fallen by

more than half since 1980. In 1997, 46% of SOEs were operating in deficit.

Based on the failure of some SOEs to even meet wage obligations to their current

work force or to satisfy tax demands from state officials (who managers would

rather not antagonize), a subset of SOEs are not generating a surplus at all (or just

enough to pay those managers). In any event, the falling surplus (realized in cash

flow) is insufficient to meet the claims arising from SOE's debt meaning that the

SOE crisis is also a banking crisis.

It is not surprising that the reengineering of SOE management processes has been

relatively ineffective. SOE management culture, shaped in the context of

monopoly, soft budget constraints, and political rewards, was well ingrained in

management. It should not be surprising to find that many "old school" managers

would be resistant to changing their ways. And even those managers willing to

change may have very little training in new ways of doing things. In the absence of

an active market for corporate control, change in management behavior is likely to

remain sluggish, leading to more negative net present value decisions, destroyed

surplus value, and lost time in the race to transform China's SOE sector into one

comprised of world class firms capable of competing with Western transnationals.

The experience of the SOEs has many parallels in the United States and other

more technologically advanced capitalist nations. For example, the experience ofutility companies post-regulation is, to a significant extent, analogous to that of

these SOEs, where utility managers faced with competition and changes in the

regulatory environment have had to learn new management practices. The

transition is neither easy nor pleasant and some utility companies are likely to run

into trouble. The relatively high amounts of debt carried by traditional utilities has,

to a significant extent, shielded them from the market for corporate control,

creating a resemblance to the conditions faced by SOE managers. As with the

SOEs, it will take time to weed out those utility company managers who are

unable to effectively adapt to the changing economic and political environment.

The utilities do, on the other hand, face the very real prospect of bankruptcy,

which provides an important disciplinary mechanism for utility company managers.

They can only destroy so much value before they are forced out.

Most SOEs, on the other hand, continue to be protected from the sharp edge of

hard budget constraints. It will take time to create the proper political conditionsfor some SOEs to exit industries where there is sizable overcapacity and for

surviving firms to undergo the necessary technological and cultural transformation.

In the real-world Darwinian struggle for survival those firms that adapt best to the

changing economic, political, and cultural circumstances are more likely to survive,

if not prosper. Adaptation is not simply a question of shifting economic practices

from less to more efficient, however. It never is in any capitalist social formation.

SOE managers who can decode the new rules of the game and figure out how to

manipulate not only economic variables but political parameters will have an

advantage over those managers who continue to act as if the present mirrors the

past. Nevertheless, some economic institutions have been born or reborn into this

new environment (the government is restructuring many of the larger SOEs into

keiretsu-like multi-enterprise groups) and do not have the burden of adjustment.

In this context, the crisis for SOEs (the dinosaurs in this Jurassic landscape)

provides opportunities for newly evolved firms, whose managers are unburdened

by the old rules or the old obligations. [2] To be more specific, the crisis in theSOE sector has created enormous opportunities for the TVE and private sectors

in a process analogous to, although on a much grander scale than, the

opportunities created in telecommunications by the breakup of AT&T.

The Chinese economy continues to transform rapidly with SOE restructuring

speeding up (providing lucrative opportunities for consultants), TVEs (which are
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also government-owned) expanding and also undergoing structural changes, and

rapid growth in private enterprises, as well as new competition from foreign and

joint venture firms. Joint venture firms, in particular, have been gaining market

share in the domestic market since the central government changed its 1980s-era

policy of requiring these partnerships of foreign and domestic firms to orient their

production to the export market. The overcapacity in the SOE sector can be

resolved (as opposed to reproduced) by a combination of exit and Keynesian

macroeconomic management (increased aggregate demand can help some SOEs

to become profitable, although this is not a panacea --- firm management must

develop an effective strategy for taking advantage of the market opportunities

produced by higher demand). In other words, even in an environment of increasing

aggregate demand, a lot of firms need to disappear altogether, some need to be

merged or taken over. The resulting unemployment problem can be partially

solved by creative government policies that encourage more entrepreneurship,

particularly self-employment (the ancient class process), including partnerships of

ancient producers.[3]

China's entry into WTO will provide an additional institutional setting for continued

movement along the current path of reform --- away from the old state monopoly

capitalism towards decentralized and competitive capitalism. As firms become

subject to the discipline of hard budget constraints and exit, management incentives

to focus on generating value (through positive net present value investments and

management practices) are likely to increase. This will mean that Chinese firms are

likely to become leaner and meaner, posing an even greater challenge to their

competitors in other nations. Perhaps firms in the "West" and"East" should look

at the problems in the SOE sector in China and count their blessings.

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NOTES

[1] State-owned enterprises are herein defined as enterprises owned and under the

bureauc ratic control of either central or provincial govern ment authorities. These en terprises

are component parts of the overall governmental bureaucracy. The managers of SOEs

received instructions/commands related to investment, the acquisition and use of technology

and inputs, and the composition of output from higher level authorities within the context of

the overall national plan. State owned and controlled banks were closely linked to these

SOEs and providing necessary financing for investment. (Additional comments added on

December 7, 2003): In later essays a distinction is made between state-owned and state-run

(directly controlled) enterprises. This amendment was made after reading Stephen A. Resnick

and Richard D. Wolff's 2003 text, Class Theory and History. There is no reason to ass ume

that the simple fact of state ownership of all or a majority of shares in an enterprise should

necessarily imply that the s tate controls the appropriation and distribution of the s urplus

value generated within that enterprise. However, when the s tate does directly control the

appropriation and d istribution, as in the cas e of ent erprises that are integrated within the

state bureaucracy (state-run enterprises), then this has important implications that warrant

categorizing such enterprises in a different way than enterprises that are s imply state-owned

(or privately owned, for that matter). State-run enterprises (SREs) employ workers to createvalue in circulation of products or intermediate goods or machines, bu t they are also often

commanded to create use values that are not realized in the market or in other forms of

circulation, such as in the provision of health care, education, housing, food, and clothing to

employees and their families. Thissocial welfare function of SREs creates a very different

type of balance s heet, income, and cas h flow statement than might be the case under an

arrangement where the firm is not required to serve such a social function. Thus, the flow of

surplus value back into the firm in the form of these social welfare use values may be an

important reason that the firms operate in deficit (when viewed in income statement terms).

You can read more on this in later essays .

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[2] (note add ed 4 Febru ary 2004) Yi-min Lin makes the a rgument th at th e growth in relatively

autonomous capitalist firms in China has led to a transformation in political processes within

the state and Party such that the agents of the state (and Party) have become more

independent of central authority and free to trade public authority and assets for personal

gain. Thus, agents of the s tate become de facto agents of capitalist firms, receiving shares of

distributed capitalist surplus value in exchange for providing the managers in these firms

with acces s to pub lic as sets and/or guarantees that public authority will be exercised in ways

beneficial to these managers. SeeBetween Politi cs and Ma rket s: Firms, Competitio n, and

Institui onal Chang e in Post-Ma o Chin a; Cambridge: Cambridge Univers ity Press, 2001.

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[3] It seems unlikely that the number of communal enterprises will expand. The Chinese
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government has shown little or no interest in communism and this is unlikely to change.

Indeed, reliance on the rhetoric of communism has already largely given way to nationalism

and modernism as justifications for the existing political arrangement.

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Copyright 2000-2005 Satya J. Gabriel, Mount Holyoke College. All

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