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How China Will Reform State-owned Enterprise Overcapacity

Dec 12 , 2016
When President Xi Jinping and Prime Minister Li Keqiang initiated their reforms a few years ago, state-owned enterprises (SOEs) were targeted as one of the key areas. In summer 2015, Xi called on officials to further deepen the SOE reforms.
Last May, the influential People’s Daily published a highly influential cover story, which explicitly associated the role of the SOEs with China’s rising leverage. In the article, a top government source called for root-and-branch reform of the SOE's with an assault on "zombie companies.” While the source was anonymous, the views could have been those of Liu He, Xi’s highly-regarded economic adviser.
Most importantly, the interview reflected high-level dissatisfaction with the pace of changes. Nevertheless, there are sound reasons for Beijing’s preference for pragmatic, gradual change in the state-owned sector.

Lessons of Chinese SOE privatization
In the 1990s, Western "shock therapy" advisers promoted rapid privatization of state-owned companies in Boris Yeltsin’s Russia to maximize productivity benefits. The net effect was an economic disaster that still suppresses Russia's growth potential.
In China, reformers have favored incremental change. In the process, the share of state-owned enterprises in industrial output has declined from 75% in the late 1970s to 25% today. The net effect has been an economic success that is widely studied around the world.
According to market prophets, China's industrial revolution reflects the triumph of "markets over Mao," as the sinologist Nicholas Lardy puts it. In this narrative, it is privatization that fuels productivity at successful state-owned firms, while the closure of the loss-making SOEs unleashes resources that have profitably employed by private firms. In contrast, statist advocates argue China's industrial revolution succeeded because SOEs remained under state overview. In reality, neither markets nor Mao has triumphed; Deng Xiaoping has. Much of Chinese success in the SOE reforms can be attributed to pragmatic gradualism.
In the past two decades, the policy of "grasping the large and letting the small go" has characterized Beijing's efforts to corporatize SOEs and downsize the state sector. While state control has prevailed over the largest SOEs, central government has relinquished control over the smaller ones. That has allowed local governments to restructure and privatize firms and to shut them down.
According to academic research on aggregate growth in the industrial sector between 1998 and 2007, it was the reform of the surviving SOEs that accounted for the greatest growth boost (over 13%), while the release of labor and other resources into the more productive private sector made the lowest contribution to growth (3.2%).
The Chinese SOE reforms offer many lessons. One is that simplistic views ("market or state!") are not helpful in understanding the reform impact. Details matter. Another is that state ownership alone does not account for the success or failure of these enterprises. What's far more meaningful is the nature, pace and direction of reforms in the sector. Execution counts.
The textbook case is the steel sector – the first major target of Chinese SOE reforms.
Steel overcapacity crisis - déjà vu
While Washington, Brussels and Tokyo have been vocal in demanding SOE privatization in China, their own track-record in the state sectors is mixed, as evidenced by the steel industry.
Before the G20 Summit last September, President Barack Obama was urged by U.S. lawmakers, unions and trade associations to blame China’s trade practices for U.S. mill closures and unemployment. They stressed the need for aggressive enforcement of U.S. trade remedy laws. In Brussels, European Commission president Jean-Claude Juncker seconded US concerns. In Japan, Prime Minister Abe called for structural reforms to address China’s steel overcapacity.
Yet, as history shows, the first major steel crisis occurred already in the 1970s, thanks to the policies in the U.S., EU and Japan. During the past four decades, crude steel production has grown in three quite distinct phases. In the postwar era, global steel production grew an impressive 5% annually. It was driven by Europe’s reconstruction and industrialization, and catch-up growth by Japan and the former Soviet Union.
As this growth period ended with two energy crises, a period of stagnation ensued and global steel demand barely ticked 1.1% annually, amid the collapse of the Soviet Union and the asset crisis in Japan.
A third period followed around 2000 and 2015 when China’s entry into the World Trade Organization initiated a period of massive expansion in steel production and demand fueling annual output growth by 13%. While China’s industrialization and urbanization is likely to continue another 10-15 years, the most intensive period of expansion is behind – which means that the sector is facing overcapacity and stagnation for 5 to 15 years.
So how did the U.S. and Europe resolve their challenges of steel overcapacity after the mid-1970s? In effect, the open trading regime took a step back as aggressive trade practices arose in the U.S. and Europe. As Washington and Brussels sought to protect their market through non-tariff barriers, they engaged in protectionist external policies, which imposed substantial costs on economies and consumers.
In contrast, China seeks to sustain globalization and to accelerate world trade and investment, as evidenced by the China-led G20, the One Belt One Road (OBOR) initiative and the creation of the Asian Infrastructure Investment Bank and the BRICS New Development Bank.
Nevertheless, China's northeast cannot avoid pain. If current overcapacity is reduced by 30% in steel, coal mining and cement, up to 3 million workers will be laid off in China in the next 2-3 years. In the coal and steel sectors, Beijing is allocating $15.4 billion in the next 2 years to help laid-off workers find new jobs.
A balancing act
China’s U.S., European and Japanese steel critics urge Beijing to take stock of the late 1990s, when Premier Zhu Rongji shut down the SOEs, which left 40 million workers redundant. But would it work today?
When Zhu began his stabilization program in the mid-90s, China’s urbanization rate was 30%; somewhat like India’s today. There was great potential for industrialization, urbanization, export-led expansion and thus for catch-up growth. So between 1995 and 2015, China shifted more than 300 million people to the cities.
Assuming stability and steady growth, China can still move more than 290 million people to the cities by 2050. Yet, double-digit catch-up is no longer possible. Moreover, as advanced economies including EU linger in secular stagnation, export-led growth is no longer in the cards.
Chinese efforts reflect new realities. Between 2016 and 2020, full-scale privatization will not be the central part of the SOE reform plan. Instead, the SOE reforms, which are supported by China’s aging demographics and the RMB 100 billion ($14.5 bn) compensation fund, are likely to feature mergers and acquisitions, asset restructuring, mixed ownership, and employee share incentives.
As the U.S. and European steel crisis policies indicate, neither a rushed nor a deferred privatization have been successful in the West. However, gradual reforms and restructuring before privatization have resulted in successful reforms in other countries, particularly Singapore.
Instead, a single-minded privatization would only turn the inefficient SOEs into monopolistic private-sector giants that would be controlled by local oligarchs. That scenario is not favored in Beijing. Rather, China is opting for gradual SOE reforms, as many other nations before - from Europe to Asia. 
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