Does the state still love state-owned enterprises even after they’re not state-owned anymore?

That is the question raised in an interesting new NBER paper on the aftereffects of China’s privatization of SOEs in the late 1990s: “Can a Tiger Change Its Stripes? Reform of Chinese State-Owned Enterprises in the Penumbra of the State,” by Ann Harrison and four coauthors.

They report that in 2013, 45% of industrial SOEs received government subsidies, but only 15% of private industrial firms received them. Privatized SOEs, however, are different: 25-35% receive subsidies, much more than firms that were always private. Similar results show up in access to finance: privatized SOEs pay higher interest rates than current SOEs firms but lower interest rates than firms that had always been private.

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Their hypothesis is that “allocation of government support in the form of subsidies, tax breaks or low interest loans favors both SOEs and former SOEs.” They conclude that while SOEs do change their behavior after being privatized, the government does not change its behavior toward those companies: “former SOEs retain ready access to large loans, concessionary interest rates, and outright subsidies.”

But why should this be the case? The paper is curiously silent on this.

The whole point of the SOE privatization over 1998-2003 (after that, privatization basically stopped) was so that the government would not have to keep giving free money to money-losing SOEs. Privatizing the SOEs, and then continuing to give them lots of free money, rather seems like the worst of both worlds. So it seems rather unlikely that this pattern is the result of a deliberate, centralized policy choice.

My hypothesis would be: it’s about people. Let me propose that the managers of SOEs understand the government pretty well and are pretty good at extracting benefits from the system. Since, after all, that is a good part of their job.

Furthermore, the managers of privatized SOEs are often going to be the same people who managed the firm when it was state-owned. One survey of SOE privatizations found that sales to insiders (aka management buyouts) were by far the most common type of deal, accounting for 47% of their sample.

Therefore, privatized SOEs are often going to be run by people who have established relationships with government officials and managers of state banks. It stands to reason that they are going to be better at working those relationships than the executive of a run-of-the-mill private company. And that companies that have been able to obtain subsidies in the past would know best how to continue obtaining those subsidies in the future.

On the financial front, this behavior by state banks is not irrational. If a state bank has an established relationship with an SOE, that relationship doesn’t just evaporate once the SOE is privatized. The bank will still have a lot of knowledge about its customer, and have a history that makes it more comfortable continuing to lend on favorable terms.

So the persistence of favorable treatments for SOEs after privatization is probably mostly about the persistence of relationships–and firms’ understandable unwillingness to relinquish established sources of commercial advantage.

A preview of Nick Lardy’s new book *The State Strikes Back*

A new Nick Lardy book comes along regularly every few years, and each one is an event for the China-watching community. Anyone who cares about the Chinese economy will find The State Strikes Back: The End of Economic Reform in China? interesting and provocative. This is a preview, not a review, since the book is not officially out until next week and so my Kindle pre-order hasn’t downloaded yet. But I saw his book talk in Seattle last night, where he gave a characteristically clear and concise summary of the argument (he also has an op-ed in the FT.)

The new book has to be understood in the context of Lardy’s previous book from 2014, Markets Over Mao: The Rise of Private Business in China. In that book he argued that it was the rise of increasingly efficient and productive private-sector companies that has driven China’s economic growth over the last four decades, not state-owned enterprises, government planning and industrial policy. In contrast to the view in some quarters that China remains a fundamentally state-controlled economy, he laid out all the ways in which markets have been liberalized and competition increased since 1978.

A lot of the key changes in the relationship between the state and private sector happened in the 1980s and 1990s, and are well explained in that book. But Lardy also engaged with the argument that, as he put it, “state-owned firms returned to prominence of the decade of leadership of President Hu Jintao and Premier Wen Jiabao (2003-12)”.

While acknowledging that the Hu-Wen government wanted to make state enterprises and industrial planning play a a bigger role in the economy, he argued that the data showed they had not succeeded. In fact, the private sector’s share of economic aggregates had continued to increase, not because of continued privatization but because private firms are more efficient and grow faster than SOEs. This process was aided by a substantial increase in private firms’ access to bank credit.

The main point of Lardy’s new book, based on his slides and talk, is that the positive trends he had emphasized in his last book are now going in reverse. The data now show that private firms’ access to bank credit has sharply declined, and that their share of various economic aggregates is also falling. He puts particular emphasis on the drop in lending to private firms:

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(Note: Lardy has a chart like this in his slides, but this is my chart not his. It is based on the same underlying data but my estimates come out slightly different.)

The big decline in bank lending to the private sector (the absolute volume of new loans to private companies shrank, not just the share) had major consequences. It forced private firms to rely even more on shadow finance. But in 2016 the government also decided (correctly) that the rapid expansion of shadow finance posed systemic risks. The tightening of regulation led to an outright decline of shadow financing in 2018, putting many private firms into dire financial straits. The financial pressure on private firms has allowed their state competitors to expand at their expense: SOEs in industry are growing faster than their private competitors. Lardy said this is the first time this has happened since 1978.

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(Again, this is a re-creation of one of Lardy’s charts using public data.)

Lardy thinks all this is bad for China. He is right! He also puts most of the blame on the policies of Xi Jinping–tolerating SOE inefficiency, encouraging the creation of larger SOEs, tightening Party control over private firms–since these trends in the data did not show up until a few years into his administration.

Essentially, both of Lardy’s recent books are about the use of economic data to support a narrative about the direction of reform in China. In Markets Over Mao, he argued that the data did not support a narrative of the resurgence of the state sector, and in fact supported a narrative of the rise of the private sector to new heights. I think it is fair to say that a number of people felt that Lardy in that book was too forceful in downplaying trends that were in fact important, but perhaps were difficult to tease out in the aggregate economic data. Now, Lardy is arguing that the data support a narrative that the state is resurgent and the private sector is losing out. Since this is a recent reversal of a positive long-term trend, he thinks that if China changes course it could significantly boost its economic growth rate, by as much as 2 percentage points.

My own view is more that economic policy under Xi Jinping represents an intensification of trends that were already playing out under Hu Jintao. I think this is pretty clear if you pay attention to China’s official rhetoric and try to understand the underlying political economy. Since I think the problems go back further than 2015, I am less optimistic than Lardy about China’s longer-term growth prospects (thanks to Greg Ip of the WSJ for including a summary of my views in his latest piece).

I also think that it is tricky to tell a clear story about the rise or fall of the state sector using the official economic data–having spent a lot of time and effort trying to do that myself. As someone who very much appreciates Lardy’s careful work with Chinese data, let me offer a couple of caveats to the charts above, in the spirit of seeking truth from facts.

First, on the bank lending data. Lardy is right to highlight the sharp downturn in lending to private companies in 2015-16. But it is not clear to me that this is a result of government policy to favor SOEs. Recall that there was a pretty serious economic downturn in 2014-15. It would make sense for banks to respond to that by trying to reduce the risk in their loan books, and one obvious way to do that would be to curtail lending to smaller and riskier companies, i.e. private ones. (The fact that SOEs are seen as less risky than private companies is a structural problem, but it’s nonetheless true that banks are correct to make this judgment given the realities of China’s political economy.) In other words, the change may have been more cyclical than structural.

There is some preliminary evidence that supports this interpretation. The data that Lardy and I use to calculate lending to state and private firms is released with a long lag, and recent figures aren’t out yet. But banking officials disclosed last year that lending to private firms totaled 30.4 trillion renminbi as of September 2018. This is equivalent to 38% of outstanding corporate loans–which is roughly the same level as in 2013, and a big increase from the 32% in 2016 (again, this is the share of outstanding loans; the chart above is the share of new loans made each year). This suggests that new loans to private firms rebounded in 2017-18 (probably more in 2017) as the economy recovered.

Second, on the industrial data. The fact that industrial SOEs are increasing their value-added faster than private companies is certainly notable. But SOEs and private companies tend to operate in different industries, so it can be hard to tease out the difference between sector effects and ownership effects. Industrial SOEs are concentrated in upstream, commodity-producing sectors, while private firms are more in downstream manufacturing sectors. It seems quite likely to me that the big decline in SOE value-added in 2015-16, and its rebound in 2017-18, have the same source: swings in commodity prices that had big effects on their profitability (value-added is basically profits plus labor compensation). The chart below uses monthly rather than year-to-date data, and we can see that the growth in SOE value-added has recently fallen back below that of private firms as steel and oil prices have come down.

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Lardy is right that the fact that in these charts the red line (SOEs) is above the blue line (private firms) is significant and concerning. But if this year or next the blue line moves back above the red line, will that mean China’s private sector is out of the woods, and all is fine? I suspect not.

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What will it take to lower China’s investment rate?

The below is from Paul Krugman’s latest on China, an argument also strongly endorsed by Brad Setser:

China really can’t keep investing 40-plus percent of GDP. It needs to shift over to higher consumption, which it could do by returning more profits from state-owned enterprises to the public, strengthening the social safety net, and so on. But it keeps not doing that.

Myself, I think it’s weird that people who want China to invest less tell it to do all these structural reforms rather than just, you know, invest less.

They miss the point that much of the low-return investment in China is done by the government and the state sector: it’s all those local infrastructure projects. That’s really where the buildup of excess investment is happening, not so much in the private business sector (which faces hard budget constraints and often tough access to credit). According to the World Bank’s latest China Economic Update, China’s public investment has averaged 16% of GDP since 1978, while OECD countries spend about 3.7% of GDP.

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So if the government wanted to make a policy choice to invest less, it can just directly make the state sector invest less in those crappy low-return projects. It doesn’t have to overhaul social policy first.

The point of strengthening the social safety net, in this framework, is to reduce precautionary household savings. But high household savings don’t directly lead to excess investment. They do help keep the banking system liquid which enables a lot of borrowing by SOEs.

But trying to impose financial discipline on SOEs by improving the safety net and lowering household savings is pretty indirect. The central government could just require investment projects by SOEs and local governments to clear more hurdles.

Fundamentally, the reason that China invests a lot is that the government has made a decision to keep public-sector investment high in order to boost aggregate demand. If/when that changes, the investment rate will come down. And so will growth. Which is why China is not in a rush to make that call.

The hard choice that China has to make is not whether to undertake complex and difficult technical reforms to social policy. The hard choice is to decide when the efficiency losses from forced high investment start to outweigh the benefits of the boost to aggregate demand.

Some people are interpreting the government’s recent pledges to avoid “flood- like” (大水漫灌) stimulus as a sign that they have in fact reached this conclusion, and want to wean the economy off low-return infrastructure projects. Maybe a bit, at the margin. But the leadership is also going to a lot of trouble to create new funding mechanisms to ensure local infrastructure projects can continue, so it seems clear they don’t want this shift to happen right now.

Redirecting some fiscal resources from investment to consumption (i.e. more social programs) could certainly help soften the blow. But this is a compelling argument only to macro people; the Chinese interest groups that would lose out from less public investment are not going to feel compensated if more social benefits go to households.

Xi vs. Stalin: What drives the reversal of economic reforms?

In the parlor game of finding historical analogies for present leaders, Chinese leader Xi Jinping is often compared to Mao Zedong. This is not very apt: Xi is an organization man, whose overriding desire for order is quite different from Mao’s love of chaos. After spending some time with Stephen Kotkin’s Stalin biography, StalinParadoxes of Power 1878-1928, I am surprised more people do not compare Xi to Stalin (though of course some have). Both men rose in an authoritarian system formally run by a collective leadership, and shifted it in the direction of more personalized rule for themselves and tighter political controls on everyone else.

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Stalin, of course, also unleashed a historic economic catastrophe upon the Soviet Union, when he abandoned the market-tolerating New Economic Policy and embarked on a crash course of agricultural collectivization and forced industrialization. Xi has not done that! His endorsement of industrial policy and favoring of state enterprises has disappointed many liberal economists. He wants a strong state, has re-emphasized Marxist ideology and clamped down on public policy debate. But it is also worth remembering that he has allowed technocrats to liberalize the exchange-rate regime and tighten up financial regulation, two long-needed reforms.

Nonetheless, the slowing economy has recently led to more public discontent with Xi’s policies. Xiang Songzuo, the former chief economist of Agricultural Bank of China, is one of those arguing that there is a connection between Xi’s aggressively Marxist rhetoric and weaker growth: he thinks a loss of confidence and fear of expropriation among private entrepreneurs is aggravating problems caused by the buildup of debt and misallocation of investment (see this translation of a speech he gave in December). Some foreign commentators are also warning that there is a “big danger that China will re-nationalize much of its economy.”

So it seems worth posing this question: what caused Stalin to abandon pro-market policies, and could similar factors be at play in Xi’s China?

Continue reading →

The origins of the Communist party-state dual structure

One of the many fascinating tidbits scattered through Stephen Kotkin’s Stalin: Paradoxes of Power 1878-1928the excellent first volume of his Stalin biography, is an explanation of where the unique “party-state” Communist political structure comes from.

In China today, as in the Soviet Union in the past, the Communist Party and the government exist as parallel, intertwined institutions, with Party clearly politically superior even as government bodies do most of the practical work. In the Soviet case, this resulted from the fact that the Bolsheviks had seized power as a minority party but were nonetheless attempting to exercise absolute control over the entire country:

Party thinking equated Bolshevism with the movement of history and thereby made all critics into counterrevolutionaries, even if they were fellow socialists. Meanwhile, in trying to manage industry, transport, fuel, food, housing, education, culture, all at the same time, during a time of war and ruin, the revolutionaries came face to face with their own lack of expertise, and yet the solution to their woes struck them with ideological horror: They had to engage the class enemy—“bourgeois specialists”—inherited from tsarist times, who often detested socialism but were willing to help rebuild the devastated country. …

But the cooperative tsarist experts were not trusted even if they were loyal, because they were “bourgeois.” Dependency on people perceived as class enemies shaped, indeed warped, Soviet politics and institutions. The technically skilled, who were distrusted politically, were paired with the politically loyal, who lacked technical competence, first in the army and then in every institution, from railroads to schools. The unintentional upshot—a Communist watchdog shadowing every “bourgeois expert”—would persist even after the Reds were trained and became experts, creating a permanent dualist “party-state.” …

“The institution of commissars” in the Red Army, Trotsky had explained of the political watchdogs, was “to serve as a scaffolding. . . . Little by little we shall be able to remove this scaffolding.” That dismantling never happened, however, no matter how often commissars themselves called for their own removal.

China went through a similar dynamic as the Communist Party took over government and nationalized companies after 1949: Party figures were installed to oversee managers and technical experts. As in the USSR, this dual party-state structure persisted long after its immediate justification had passed, even when the majority of government officials and company leaders had become Party members. In other words, the Communist Party has continued to treat its own country as a hostile environment that could not be trusted.

The fact that the dual Party-state structure is, essentially, institutionalized mistrust, is one reason why this system is hard to defend on principle. Chinese scholars have been discussing the need for the Communist Party to adapt from being a “revolutionary” party to a “governing” party for decades. In the liberalizing 1980s, there was the beginning of a movement to formally separate the Party and government, but this was reversed in the post-1989 return to conservative politics. Xi Jinping also seems to want to clarify the relationship between the role of the Party and government. But he has taken the opposite approach: formalizing the Party’s leadership over the government (see my previous post on this topic).

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Ideology and the sources of policy error

Stephen Joske has an essay at War on the Rocks that makes a good point about the possibility of a Chinese financial crisis:

We commonly hear that China cannot have a financial crisis because the government owns all the banks and can control them. … In theory, government control is good for stability. In practice, however, two things have to happen to avoid a crisis: First, the government has to use its power to make the right policy choice, and second, it has to avoid making a Lehman-style regulatory mistake. …

While the government owns the banks, that does not stop officials from making regulatory mistakes. We have already seen regulatory mistakes such as mishandling of RMB market volatility in 2015. We have also seen well-handled, timely, and complex crisis management failing financial companies. But that does not mean they always handle every crisis well and will continue to do so. The law of probability indicates that eventually something will go wrong and, like every other country, China will have a financial crisis.

It is a fair point that humans are fallible and will eventually make a mistake, and we should not presume that the Chinese financial authorities are more or less fallible than all other humans.

But I think it is a bit of a cop-out to just say, oh, policy errors happen, and not to inquire more deeply into the actual causes of policy error. I think if we look at the recent history of financial policy mistakes, many them were in fact not driven by random errors but by ideology.

It is hard to separate the US policy errors in the global financial crisis from the strong ideological value placed on the government abstaining from intervening in markets. The day after Lehman Brothers failed, then-St. Louis Fed president Andrew Bullard said: “By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture.”

There would have been technical and legal difficulties to mounting a rescue of Lehman, but these could certainly have been surmounted if officials had been really worried about the impact of a failure on the financial system. They were not that worried (which in hindsight was clearly an error) and were preoccupied with sending signals about the correct relationship between the government and the financial system.

Most financial crises take the form of a “run on the bank,” even if the bank is not called a bank and those doing the running are not retail depositors. When investors no longer wish to hold bank liabilities, the bank cannot fund itself and experiences a liquidity crisis. But if investors know or believe that the government will rescue the financial institution, they are less likely to be so fearful of failure as to stop holding its liabilities, and less likely to fear that the problems of one institution will spread to others.

So a system in which the government is ideologically committed to maintaining a separation between the public sector and a private financial sector, and a system in which the government is ideologically committed to maintaining the union of the public sector and the financial sector, are not at all equivalent in terms of financial risk. In the former, there is much more of a risk that private investors will become worried about the failure of banks and stop funding them. (The latter, of course, has the problem that banks will tend to abuse government support and take more risk than they should.)

So it seems to me that, while Chinese officials are not more or less fallible than other humans, they do operate in a system that tends to minimize one major source of the policy errors that tend to lead to financial crises. Simply put, Chinese officials are more likely to err in favor of providing government support to a failing institution than in favor of denying it. This does not mean that Chinese banks cannot fail–it seems quite likely to me that some smaller institutions will eventually go under–but that such failures are much less likely to cause contagion and a crisis of confidence in the financial system.

Arguably Chinese financial policy is in fact less ideological than American. That may seem a strange thing to say about a system in which ideology is highly formalized and there is a large institutional structure for ensuring compliance with ideology. But the ideology of the Communist Party is inflexible only about ends, rather than means. Continuation of Party rule and its ability to direct social and economic development cannot be questioned.

But China is fairly flexible about the means employed to achieve those ends. American political ideology by contrast puts strong constraints on means: there are often intense arguments about why various things cannot be done or should be done in order to maintain the self-image of the US as a free-market economy.

The US-China trade war as a conflict of values

The tariffs that the Trump administration has imposed on Chinese goods are seen by the Chinese government as unprovoked and unjustified assaults. So there are few opinions more unwelcome right now than that China brought the trade war on itself. Yet that is more or less what a couple of Chinese liberal intellectual are saying openly: that trade conflict with the West is the inevitable result of China’s promotion of a state-centered development model.

One of these voices is Sheng Hong of the well-known Unirule Institute, who published an interesting article on US-China relations on FT Chinese on October 19. The Unirule website has helpfully provided an English translation, but I have re-translated the portions below myself for greater clarity:

China’s reform and opening up is the guarantee of strategic cooperation between China and the US. Such strategic cooperative relations would never have been possible if China was still stuck in the Cultural Revolution, when it practiced class struggle and a planned economy domestically, and exported revolution abroad. Reform and opening up not only brought people economic freedom, but also changes in the political structure. The emancipation of thought has to some extent loosened controls over the freedom of speech, and the freedom of the market economy has allowed people to throw off the shackles of their work units. As the market played a greater role in more areas it reduced government’s direct control over society. Implementing market regulation relied on a just legal system. Only a China that is in this way progressing toward marketization, rule of law and democratization can be accepted by the US on a strategic level, and create the framework for strategic cooperation with the US.

Without a doubt, reform and opening up eliminated the ideological conflict between China and the US, as well as the whole Western world, and gradually brought convergence in terms of values. … Some of the so-called “socialist core values” promoted by the Chinese Communist Party overlap with values recognized by the US and the western world, for instance freedom, democracy, rule of law, equality and justice; while other values, such as civilization, harmony, integrity and dedication, are not in conflict with the values of the US and the western world.

We must clearly recognize that such convergence of values is the basis for strategic cooperation between the US and China. Only through a convergence of values can China be deemed a factor of peace and stability in international relations, and be seen as a trustworthy nation with which close cooperation is possible, rather than one that proclaims the overthrow of the capitalist world and does not renounce the use of violence. Only such a country that advocates peaceful means to resolve disputes between nations,  and does not resort to the threat or use of force, can provide the world with a stable and just international order.

Therefore, China’s reform and opening-up and the China-US strategic cooperation are two inter-related things. That is to say, there is no strategic cooperation without reform and opening-up, nor is there reform and opening up without China-US strategic cooperation. … China should not, and cannot, seek hegemony over the world by going against the rules of civilization accepted by China and most of the countries in the world. Only on the basis of respecting the consensus rules of human civilization can China overcome the mistakes and deviations of the US, and become a civilizational center with moral legitimacy and great economic strength. Today, China faces the risk of leaving the path of reform and opening up, which would risk the loss of strategic cooperative relations with the US. Such a result would be a complete failure.

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Sheng Hong

Somewhat similar sentiments appear in an October 14 speech by Zhang Weiying, a prominent liberal economist at Peking University (liberal in the Chinese sense of favoring free-market policies; Zhang is more of a Hayekian libertarian). The following is my translation of some portions of a summary that was posted on the website of the National School of Development (it was later removed after attracting press coverage).

The rapid development of China’s economy and the improvement of people’s living standards over the past 40 years are facts denied by no one, but there is still controversy over how to understand and interpret these facts. At present, there are two interpretations of China’s growth in the past few decades, the theory of the “Chinese model” and the theory of the “universal model.” The former holds that China’s economic development benefited from a unique Chinese model, with a strong government, many large state-owned enterprises, and wise industrial policy.

The latter holds that China’s remarkable achievements are, just as with the rise of Britain, France, postwar Germany, Japan and the Asian tigers, based on the power of the market and the creative and risk-taking entrepreneurial spirit. China also made use of the technologies accumulated by Western developed countries over the past three hundred years. As I explained in an article published early this year, China has in the past 40 years of reform and opening up experienced the three industrial revolutions that took the Western world 250 years. The latecomer’s advantage means that we have avoided many detours and directly share the technological achievements that others have already obtained through experiments of great cost. …

The above evidence shows that the theory of the “Chinese model” is seriously inconsistent with the facts. China’s high growth over the past 40 years has come from marketization, entrepreneurship and the technology accumulated by the West over three hundred years. The bigger problem is that using the “Chinese model” to explain the achievements of the past 40 years is not beneficial for China’s future development.

Domestically, misleading yourself means a future of self-destruction. Blindly emphasizing the unique Chinese model means going down the road of strengthening state-owned enterprises, expanding government power, and relying on industrial policy. This will lead to a reversal of the reform process, the abandonment of our predecessors’ great cause of reform, and ultimately economic stagnation.

Externally, misleading the world leads to confrontation. From the Western perspective, the “China model” theory makes China into an alarming outlier, and must lead to conflict between China and the Western world. The unfriendly international environment we face today is not unrelated to the mistaken interpretation of China’s achievements over the past 40 years by some economists (both Chinese and foreign). In the eyes of Westerners, the so-called “China model” is “state capitalism,” which is incompatible with fair trade and world peace and must not be allowed to be advance triumphantly without impediment.

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Zhang Weiying

In some ways it is not surprising to hear such statements from Sheng and Zhang, whose views are well established, and also far out of the mainstream of Chinese intellectual opinion. What is interesting is that these views are coming out at this moment–although since the comments of both authors are regularly scrubbed from the Chinese internet, it is hard to know how much impact they have.