Outside the System in China

Does Private Enterprise Have a Chance in Today's China?

China is in the midst of testing economic theory. By current estimates more than 70% of China's economic output is controlled by the government. Yet China's economy has prospered in recent years while other economies have floundered, leading some to say that China offers an alternative economic model. Thus the question: Can a country prosper if its government-backed enterprises are allowed to control the lion‘s share of its economy and its private enterprises are stifled? Some might rephrase the question. How long can China's savings be used as the cushion for massive state controlled inefficiency and political patronage? While policy wonks, politicians and economists debate, the conditions on the ground for China's private enterprises are bad and getting worse.

Most debate regarding State control of the economy has focused on the role of China's SOEs (State Owned Enterprises) and strategic sectors such as finance & banking, telecommunications, transport, and energy. The reality is that these companies and sectors represent only the most visible components of state and SOE control. Like the visible part of the iceberg, thereunder hides the really dangerous part.

Inside the System; Outside the System (Xitong Nei, Xitong Wai)

The recent emergence of the phrase, "Inside the System; Outside the System" accurately describes the current environment. This phrase has emerged in recent years to describe Party control over the economy in particular and the society in general. "Inside the System" refers to SOEs and all other enterprises that are firmly under Party supervision of one form or another. "Outside the System" refers to sole proprietors, private enterprises and non-state vested foreign enterprises. This frame of reference is highly descriptive of China's current economic structures, management attitudes and methods. The implication is that those inside the system are participants and those outside the system are tolerated, squeezed, and sometimes co-opted. 

The government wants to build national SOE champions into international conglomerates on a par with Siemens, GE, Toyota or Samsung etc. Private companies, on the other hand, are seen more as a collection of family run cottage industries. SOEs have other virtues: guaranteeing employment for a large block of local citizens; providing a reliable tax base; and, remaining politically dependable. Private companies are seen as unstable, undependable, less than honest and difficult to control. Certain powerful political factions believe that state control is desirable and constitutes a social "good". It clearly consolidates power and wealth in the hands of the Party.

The actual contribution of Private Industry

Determining what is inside logically defines that which is outside. What is outside is a combination of Individuals, Private Companies (both domestic and foreign) and the various forms of underground economy.

Simple math shows the story in broad outline. Based on government statistics, the Chinese government itself accounts for approximately 20%+ of GDP. SOEs account for an estimated 50% of GDP. This leaves approximately 30% of GDP in non-government controlled hands. Subtracted from this is the unknown contribution of the underground economy and we can roughly estimate that private business accounts for something in the 20% range of Chinese GDP.

Assuming this, then in historical terms little progress has been made toward greater privatization. By 1998 the domestic private sector had grown to about 27 percent of GDP, making it second only to the state sector in economic importance.

According the National Bureau of Statistics, Private Enterprise accounted for 41% of China's Gross Industrial Output (not GDP) in 2009. In the same year, domestically funded fixed investment by Private Enterprise accounted for 22% of the National total. Compare this with employment, where a total of 52% of total urban employment comes from "Outside the System"; 25.1% from private companies, 19.2% from sole proprietors and 7.7% from foreign funded enterprises. At the same time, the proportion of urban wages paid by SOEs accounted for 54%. In terms of taxes paid, SOEs accounted for 48% in 2009. Thus while accounting for a stark minority of investment, private enterprises carry a disproportionately large share of employment and taxes.

Recently GCiS queried the last two years of industrial in-house project data from the GCiS Research Data Set. The data below is not representative of China's economy as a whole, or even China's industrial sector as a whole. The results are interesting.

Profit Margin by Ownership Type - GCiS China Market Research

The first shows profit margins by ownership types. Private companies operate on the smallest margins. This is not surprising when considering the actual conditions in which these companies operate. Foreign companies have various advantages in management, product and ex-China market participation. Listed companies enjoy political and capital support, often combined with monopolistic or oligopolistic market advantages. Joint stock companies are typically converted SOEs yet remain firmly Inside the System. SOEs enjoy all of the advantages described above, thus the performance is not surprising.

Revenue per Employee by Ownership Type - GCiS China Market Research

Looking at Revenues per Employee as a proxy for efficiency is also interesting. Foreign companies, which are predominantly private companies, are by far the most efficient followed by Listed Companies and Joint Stock companies. That SOEs are the least efficient is also not surprising. That private domestic companies are less efficient on this measure is on the surface surprising until one considers that they are largely excluded from markets where capital might provide leverage and are concentrated in low margin, labor intensive industries.

The Big Squeeze

While much is written of the growth of Private Enterprise in China, today it is becoming very clear that most of the early progress has been halted or reversed. In today's environment private enterprise faces a wide variety of obstacles.

According to OECD statistics China's 2008 Index of Product Market Regulation is 3.31. This compares with the OECD average of 1.35. This index measures formal regulations in the following areas: state control of business enterprises; legal and administrative barriers to entrepreneurship; barriers to international trade and investment. Tellingly, China's rank is also last among the so-called BRICs. Brazil, Indonesia, India and Russia all rank ahead of China.

Such an Index greatly understates the difficulties faced by private companies in China. While most of the current attention is focused on access to capital, this actually represents only one component of the difficulties private companies face. An abbreviated list serves:

  • Regional and administrative protectionism;
  • Capricious enforcement without recourse or oversight;
  • Official (individuals/groups) rent seeking;
  • Local collusion and ad-hoc local monopolies;
  • Periodic, ad-hoc revenue campaigns;
  • Unpublished administrative guidelines;
  • Rampant administrative jurisdictional overlap; and,
  • Rapidly changing regulatory requirements - among others.

Where the customer is a government department or other SOE, SOEs are heavily favored, both formally and informally, over private firms. SOEs have much more leverage with government regulators. In commercial disputes, the head of a larger SOE will be in the same circle of influence as the judicial authorities. The dynamics here are clear.

Progress is slow and uneven. SOEs are able to avoid these issues because of scale, administrative priority and Party integration. Private companies that get "too large" often find the going more difficult, due either to limits in access, problems with finance, administration pressure or a combination. It is a well known but little discussed trend in China's domestic M&A market for private companies to sell out to SOEs.

In Conclusion

The pre-eminence of private enterprise in the US and other countries is taken for granted, but the opposing viewpoint in China is real and backed by factions having great influence. On the face of it, SOEs deliver the growth, tax revenues, and allow for state control. Many ask: If the SOE driven economy has been growing by 10% per year, then why change?

There are also many influential parties in the country that understand the real benefits of private enterprise in creating employment, providing tax revenues, and innovating, even incubating new industries. They also are clear on the massive waste that the current SOE dominated system enables.

This squeeze has been accelerating over the last eight years and has now reached a critical point. The Chinese may be proven entrepreneurs, but continuing on current trends will soon leave them permanently "Outside the System". China will pay a heavy price for decades to come.