China’s economy at crossroads between freer enterprise, state control

Editor’s Note: This story is part of a series from PRI’s The World, China Past Due.

Few places on earth have more entrepreneurial energy than China.

Since economic reforms first released that energy 30 years ago, hundreds of millions of Chinese have used their own efforts to improve their lives and raise themselves out of poverty.

China’s state sector has also played an important role in China’s extraordinary economic growth, allowing the government to make and carry out big plans — building highways, railways, subways and entire cities — in the time it would take some governments to simply agree to move forward.

But with economic growth slowing, the population aging, and the workforce shrinking, those entrepreneurs are being held back by a system trapped in transition, and China risks getting stuck in the middle-income trap — economic growth hitting a plateau and then stagnating before reaching developed nation status. A growing chorus of economists say the Communist Party needs to shift from the current system, favoring the state sector and Party elites, to one that releases the full potential of the private sector, with its demonstrated ability to create more jobs, GDP growth and innovation.

“You can never get a level playing field of a state enterprise of significance and a private enterprise in the same area,” said economist Yukon Huang, a former World Bank country director in China. “The private enterprise will not expand or do something, knowing there’s a state enterprise that’s potentially protected (because) if it tries, it could suffer some sort of a loss. So this is about the state getting out of certain kinds of activities, and saying, ‘I will not be involved in those areas.'”

China’s new leaders are at least talking that talk.

“Put simply, we need to leave to the market and society what they can do well, and for the government, we need to manage well those matters that fall within our purview,” Li Keqiang said in his first news conference as China’s new premier, at the end of the National People’s Congress session in March.

Even before that, Li encouraged the World Bank to write and issue the exhaustive 2012 report “China 2030,” which recommended a wide range of reforms China should enact to improve its odds of having sustainable economic growth and a stable society going forward. Perhaps he hoped to use this as leverage for what he knew would be a tough transition ahead, prying power from vested interests for the sake of China’s long term interests

“The reform is about curbing government power,” he said in his March news conference. “It’s a self-imposed revolution. It will require real sacrifice, and this will be painful. But this is demanded by development, and wanted by the people. And we are determined to make that sacrifice.”

Tell that to the vested interests in China who have grown wealthy through cozy deals and a rigged game. Among the National People’s Congress delegates, 83 are dollar billionaires. Another 52 billionaires are delegates to the Chinese People’s Political Consultative Conference, an advisory body. That’s more than half of China’s 251 billionaires. The 2.7 million dollar millionaires are well represented in the halls of power, too.

Many of the wealthy are relatives of Communist Party leaders. Former Premier Wen Jiabao’s extended family has controlled assets of at least $2.7 billion, a New York Times investigation found, and Bloomberg News Agency’s reporting found that President Xi Jinping’s extended family has amassed $376 million.

This, the Bloomberg report said, despite Xi’s earlier exhortation to officials in a 2004 anti-corruption conference call: “Rein in your spouses, children, relatives, friends and staff, and vow not to use power for personal gain.”

As president, he has pledged to make fighting corruption a top priority.

Neither report suggested that Wen or Xi themselves had been involved in unorthodox economic dealings, only that in a system that favors personal connections with the powerful, and also favors state enterprises — often run by the powerful, or their relatives or their friends — wealth can be and has been amassed quickly and easily.

This has led to one of the biggest wealth disparities in the world. A research team at Southwest University of Finance and Economics in Chengdu released a report in December, after an extensive national survey, that China’s current GINI coefficient is .61, one of the highest in the world. Anything over .4 is considered high inequality, The GINI index measures social equality, with 0 being perfect equality and 1 being absolute inequality.

“When the results came out, it was beyond our imagination,” said Yin Zhichao, deputy director of the university’s Survey and Research Center. “China’s income inequality is really serious.”

The Chinese government subsequently released its own GINI figure — .474. That’s still high, but looked good by comparison with the Southwest University number. Yin says he’s not sure how the government got that figure, since it didn’t release its methodology, but said it’s easy to skew closer to equality if the wealthiest refuse to participate or accurately disclose their assets. He says his researchers made a point of making sure China’s wealthiest were proportionately included.

Yin says his center’s survey results, taken from more than 8,400 home visits in 25 provinces, suggested that reasons for the disparity included low spending on social services as a share of GDP — 10 percent of China’s budget, versus 30 percent in the United States — and little use of progressive taxes to reduce the disparity.

“Income disparity in the United States is pretty high before taxes – about .49,” Yin said, citing OECD statistics. “But after taxes, the GINI drops to .38. And in Germany, the GINI drops from 0.50 pre-tax to 0.30 after.”

Some of the “extra” tax collected in other countries goes into social services like health care and education, which in turn helps to keep the population healthy, productive and stable.

In China, by contrast, it goes into the pockets of the wealthy, while ordinary people struggle to find the money to pay medical bills, their kids’ tuition and soaring prices for housing and food. Growing resentment over the lifestyles, flashy cars and designer brands of the rich and powerful prompted China’s new leaders to impose a degree of austerity on wealthy party elites. No more gaudy floral arrangements at government gatherings. No more expensive restaurant banquets of sharks fin soup and other endangered delicacies. Some officials at state enterprises have reportedly responded to the new rules by transforming their on-site canteens into their own private luxury restaurants, far from the envious eyes of the laobaixing — the ordinary people.

Zhao Youshan used to be one of those, before he became a multimillionaire as a private businessman. He grew up in China’s frosty northeast, near the Russian border. He was a soldier, and then a cop, before he opened China’s first private gas station in the late 1980s, then got deeper into the oil and gas distribution business. He’s now a gruff 63-year-old, who dresses simply and talks plainly. And he’s got some advice for China’s new leaders.

“If the corruption problem isn’t dealt with, it will affect the economy, and the government will lose popular support,” he said. “And that will bring up the question of whether the government can continue to exist, if the people will no longer listen to you. If there’s no corruption, people will unite together to develop the country. But if there’s corruption, people will think, ‘if you bribe, I’ll bribe too.’ It’s every person for themselves.”

That’s a scenario the government is desperate to avoid. It’s already contending with tens of thousands of demonstrations a year — one academic estimated the total in 2010 to be in excess of 180,000. Plus, there are half a billion Chinese now online, sharing ideas, information and complaints.

In the midst of all this, an economic system that more or less worked over the past 30 years — heavy infrastructure spending, low-wage labor, cheap manufacturing and a coddled but not particularly profitable state sector — has reached the end of its useful life.

Economist Yukon Huang says, think of China’s economy as being like a big round Chinese dining table with one central pillar. The pillar is the state enterprises, the state banks that fund them, the Communist Party, the government and the courts, all working together to support a common objective – the table top. The economy itself.

“But a Chinese dining table, once it gets too big, with one pillar, collapses,” Huang said. “So the real struggle in China is to move to a Western dining table, where the key players become different legs. They can hold up a much bigger table.”

That would mean a loss of control — something the party’s been none too keen on allowing. But evidence is mounting that such change is necessary for China’s long-term interests.

Start with state banks. They keep interest rates low so state enterprises and local governments can get cheap loans — which often aren’t paid back. But this comes at the expense of ordinary Chinese, who get lower interest on their savings than they might otherwise. Without that extra money in their pockets, they have less to spend, which slows China’s desired transition from export-led growth to growth driven by consumer demand.

State enterprises in China have already gone through one wave of reform. Back in the late 1990s, Premier Zhu Rongji allowed tens of thousands of money-losing state enterprises to go bankrupt, and forced most of the survivors to clean up their acts and start trying to turn a profit. State banks got new infusions of capital from the government, which moved their embarrassingly high number of non-performing loans off their books. The central government took direct control of 121 state enterprises in key sectors, since reduced to 117, including transportation, and oil and gas. And things suddenly looked better for the state sector.

“These are the big monopolies; these are the companies that are on the Fortune 500” said Jim McGregor, a business consultant at APCO in Beijing, who has worked in China for 20 years. “And to give these companies their due, China would never be where it is today without them. Without state planning, state banks and all these state-owned enterprises in construction and rail, you would never have the infrastructure we have today in China. The problem is, their day has now run out. Because they add zero growth.”

A 2011 study by the independent economic research group Unirule in Beijing found the average return on equity for China’s state-owned enterprises in 2001-09 was 8.16 percent, compared to the non-state enterprise return of 12.9 percent. Factor in the subsidies and free land state enterprises get, and their real return, Unirule said, was -6.2 percent. In other words, their very existence was costing the economy.

Yet, when the international financial crisis hit in 2008, and the Chinese government infused $600 billion in stimulus money into the Chinese economy, most went to state enterprises. There was even a name for it: “guo jin min tui” — “the State advances, the private sector retreats.”

“It’s understandable that the government would want to give the stimulus money to enterprises it knew,” said Qi Jingmei, who heads the Economic Forecasting Department in the National Development and Reform Commission’s State Information Center. “These enterprises listened to the state would do what the state asked them to do, and they could do it fast.”

And suddenly, these large state enterprises were flush. Young college graduates started seeking work with them, because they were suddenly offering much higher salaries and better benefits than private sector jobs. But these state enterprises weren’t sharing enough of their new affluence with the rest of society, says Qi Jingmei.

“Some state enterprises make their money off of state resources, like oil, electricity and telecommunication, but they pay very little tax or dividends,” Qi says. “They’ve seen rapid growth in their profits, and have huge disposable income, and senior executives of the state enterprises in monopolized industries have gained enormous wealth. It’s time for them to share it.”

The percent of profits China’s state enterprises pay in dividends — 5 to 20 percent — is about half that paid, on average, by state-run companies in other countries. The government has now imposed an across-the-board increase of 5 percentage points. Qi says this came in the face of considerable resistance from state enterprise executives.

“They’re strongly against it,” Qi explained. “The reason reforms of income distribution have taken so long is precisely because of this. Vested interests, including oil, chemical and electricity state enterprises, have a strong voice. When the central government is coming up with a policy, they all weigh in. That’s why it’s hard to make progress.”

State enterprise executives are often political up-and-comers, appointed by the Party, and sometimes outranking the government officials tasked with regulating them.

China’s oil and gas state enterprises have been keeping their money close in other ways — by choosing not to refine gasoline to a higher standard than the minimum China requires, even though doing so could dramatically cut down on pollution.

The story, when it broke in late January, after Beijing experienced one of its worst bouts of smog in recent memory, stirred public derision.

“I’m not happy to hear this,” said taxi driver Liu Xiuling. She puts in 12 hours a day in Beijing traffic, and says the smog is getting to her. “I used to have good health, but now every day I feel uncomfortable — I feel it in my throat.”

Sure, refining gas to a higher standard costs money, she says, but so does paying for the damage this is doing to her health.

No kidding. A recent study by the University of Washington and others found that outdoor air pollution played a part in 1.2 million premature deaths in China in 2010, with car exhaust and coal burning being two main sources of the fine particulate matter that lodges in lungs and eventually kills.

The chairman of the state enterprise Sinopec, Fu Chengyu, was quoted by the state news agency Xinhua as acknowledging that only fuel in Beijing was refined up to European standards; in the rest of China, there was 15 times more sulfur in the gas than in Europe. However, Xinhua quoted him as saying, the fault doesn’t belong to the state enterprises, but to the government, for setting the standard so low. How could a business be expected to spend more money to refine to a higher standard if it wasn’t required to?

Sinopec later denied that Fu had said any such thing. But he told Shanghai’s Dragon TV in March that the government needed to act.

“We need to raise the national standard of fuel quality,” Fu said. “No matter how high the cost, there should be no excuse. State enterprises are supposed to help people have better lives. People shouldn’t be made victims because we’re looking at the bottom line.”

All very laudable, but many Chinese are skeptical that state enterprises really have their interests at heart. State enterprises might have started decades back with the mission of serving the people — but they’ve developed a flair for serving themselves.

This frustrates Zhao Youshan, the gas station entrepreneur. He says this isn’t what former leader Deng Xiaoping had in mind when he started economic reform more than 30 years ago.

“Deng said resources should be shared fairly, and enterprises treated equally,” he said. “But China’s state enterprises are the only ones allowed to import crude oil, and they don’t always make it available to private refineries.”

And then, he says, the private sector is put at a disadvantage in other ways. He cites the additional bureaucratic hoops that private companies have to jump through, like having to pay high fees for reports and stamps of approval from politically connected agents who know little or nothing about the industry. He sees it as a form of corruption, because their fees can be as high as half the value of the project. He’s seen some private companies walk away, because they can’t afford to pay these fees.

Zhao now heads an association of private businesses in the oil and gas industry, the Commerce Petroleum Flow Committee of China. It represents 660 wholesalers and refiners, and 43,000 gas stations, and lobbies the central government for a fairer deal for these private entrepreneurs.

“We’ve drawn the government’s attention to our reports,” Zhao said. “We’ve been able to submit them directly to ministers. We’ve even seen some new policies passed that we’d recommended. The problem is in carrying them out. The vested interests are still winning.”

If China wants to win in the long run, he says, that equation needs to change. Releasing some of the Party’s control over the economy is long past due.