Perhaps the most commonly-heard criticism these days of the Chinese government’s economic policy is that secret policies favoring State-Owned Enterprises (so-called “SOEs”) are becoming more numerous, heavy-handed and harmful to the prospects of private business in China. This criticism, like others of China,  gains strength and credence because it is basically unfalsifiable. Since the policies are secret and the impact hidden from direct view, the only evidence offered is the continued growth and profits of SOE giants like China Mobile, ICBC, Sinopec and others.

While it’s undeniable that SOEs do enjoy a lot of advantages private companies can only dream of, often including easier access to bank loans and markets rigged to prevent free competition, I’m dubious that a real shift really is taking place, and that the Chinese government is wholesale turning its back on private business in order to make life easier for SOEs.

Not all SOEs are living a life of wine and roses. For them, government support is limited, haphazard, often counterproductive. There are hundreds of such SOEs in China. They aren’t the giant companies many foreigners have heard of. These SOEs are surviving, but not really prospering, with clapped-out equipment, low profits, bloated workforces and balance sheets larded with debt. It’s by no means clear that having a government owner is more of a benefit than a liability.

These SOEs have no real pressure to optimize profits and increase efficiency.  Their government owners, to the extent they even notice these smaller industrial SOEs,  are mainly concerned that they should continue to provide jobs, hand over a bit of money each year in taxes and dividends, and continue to increase output. In many ways, for all the epochal changes over the last 30 years in China, many SOEs are still run much as they were during the days of complete central planning:  growing bigger is still more important than growing more profitable, innovative, dynamic.

Thirty years ago, all of Chinese industry was state-owned and most urban Chinese were employed by the state. Then came the private sector reforms and liberalization under Deng Xiaoping, the rise of private business (which officially now contribute more than 70% of China’s gdp) and the bankruptcy of thousands of large SOEs, when many of the largest loss-making SOEs were forced to close. This process of culling the loss-making SOEs is often called “淘汰” (“taotai”) in Chinese, a term I quite like. It literally means to “wash clean” or “wipe out”.

But, many thousands of smaller, barely-profitable SOEs survived “taotai”. They are the ones now often living in a state more akin to Dickensian squalor than the plush recipients of government favor. Visit, as I did recently,  one of the “un-taotai’ed”  SOEs, and you will soon be disabused of the idea that all SOEs are prospering and that the Chinese government is running an economy to benefit SOEs at the expense of private business.

The SOE I visited is in Shaanxi province, about an hour’s drive from the capital, Xi’an. The factory was established in 1966, at the start of the Cultural Revolution, by a team of thousands of workers forcibly relocated from Tianjin. It manufactures certain special types of fiberglass, including some used by China’s military and space program. The SOE still produces many of the same products, on 45 year-old equipment, in a sprawling and broken-down facility the likes of which I’d never seen before in China. Most of the buildings are dilapidated, the roads inside potholed. Polluted waste water belches from pipes into overflowing holding pens.

This company, in one sense, is lucky. It has no competitors inside China, and only two elsewhere, Soviet-era factories in Byelorussia and Latvia. Saddled with unnecesarily large payroll and other ancillary costs not related to producing fiberglass, profit margins are low. But, the company earns money most years, including about $1 million in profits in 2011.

The problem, though, is that the company can’t get the capital to modernize, expand or rationalize its workforce of almost 2,500. It’s still responsible for the running costs of a local hospital, school and kindergarten. When the company’s boss goes to the government for help, he’s mainly told to fend for himself. The company is too small to get any attention from its government owners. So, it floats along in a kind of sad limbo.

With money and profit-seeking owners, the company could probably grow into a quite successful industrial business. The market for its products is actually growing. If they could let go excess payroll and obligations, margins would likely rise above 15%, generating sufficient surplus to finance the large expansion plans and upgrade the company’s boss has been trying, unsuccessfully, to implement for six years. The government says it has no cash to inject. State-owned banks, for all their supposed leniency towards SOEs, won’t increase lending. Instead, the government is urging the factory boss to find a private investor, to put together some kind of privatization plan.

But, in this case and many like it, whenever the Chinese government won’t invest, few if any sane private investors will. Any new investor would have to fund the cost of layoffs of up to 1,800 people. Most are entitled to one month severance for every month of employment.  Average salary is around $500 a month.

The new investor would also, according to Chinese law, probably need to buy its shares from the provincial arm of SASAC at a price tied to the company’s net assets, not its rather dismal operating performance. The entire business may be worth only $10 million. But, using the net asset formula, which includes a big chunk of valuable land, the price almost triples. After all this money goes out the door, the new investor would need to pump another $12mn-$15 mn into the company to finance improvements and expansion.

For any investor seeking to buy control of the company, the likely rate of return after all these outlays, even under the most optimistic scenarios, would be under 10% a year.  That’s a deal that few investors would consider. Along with the need to shell out all the money, a new owner would also acquire lots of contingent liabilities of unpredictable size and severity, including the cost of an environmental clean-up, repairs to company-owned housing where most of the current 2,300 workers, as well as retirees, live.

After spending the day with him, I sympathize with the company boss’s plight. He wants to run an efficient operation, turn it into a leading producer of certain high-technology fiberglass materials, and maybe earn his way into owning a small piece of the company. But, the current mix of policies in China will make that hard, if not impossible, to achieve.

While big SOEs do enjoy a lot of political clout, with sparkling new headquarters, and a low cost of capital that other companies envy, these smaller SOEs inhabit an altogether different and inhospitable world. Government ownership is far more of a hindrance than a help. And yet, they have no real way to free themselves.  These SOEs are, as Americans would say, SOL.

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