Eye on China: Private profits overcome politics

The rise of China's private sector is one of the most dramatic aspects of the mainland's economic story.

It is so compelling because a strong private sector confronts the Government with the dilemma of how to maintain its power, while unshackling the wealth-generating drive of the private sector.

Broadly speaking, a strong, properly regulated private sector has been shown to work best in creating wealth. (Japan, Korea and Germany - countries where the Government plays a powerful role - may be partial exceptions. But the first two saw a great deal of inefficiency uncovered in the Asian financial crisis of 1997-98. Germany is also going through a period of economic uncertainty, which is raising challenges to its own softer version of capitalism).

The issue is not so much China's communist ideology - an increasingly nominal phenomenon. It's more that the traditional system, with the economy in state hands, enabled the Government to dominate the economy, and hence the country.

However, the Government knows that its legitimacy is increasingly tied to improving the living standards of its people. When Deng Xiaoping succeeded Mao in the wake of the Cultural Revolution, he put into practice sweeping economic liberalisation measures. His belief that increasing prosperity was a duty of the Government was spurred after the excesses of Mao threatened the collapse of the country.

A just-published book by Stoyan Tenev, a researcher at the International Finance Corporation, part of the World Bank group, provides some valuable indications as to who is winning this private-public war, and what tactics are being used.

Tenev concludes that destiny seems to be siding with the private sector. The state sector is fighting back, but progress appears modest.

According to Tenev, the Government has been willing to allow the privatisation of those parts of the economy in which it has no comparative advantage, such as small-scale, service operations.

As a result, by the end of 1998, almost 80 per cent of all Government firms had gone through total or partial privatisation. A common policy has been to allow managers to buy the company. The Government believes it can attain the best result by aligning ownership with management.

But the Government has also tried to build up an elite group of 500 to 1000 large, state-owned, capital-intensive industries, especially in extractive industries such as coal and oil.

The distinguishing mark of members of this group is that they are run by central Government ministries; they are not run by the far less expert and far more corrupt local, provincial governments. Thus, in 1995, 74 per cent of provincially run companies were unprofitable, compared with 24 per cent for centrally run firms.

Following this process, state-owned enterprises (SOEs) now account for only 15 per cent of the total number of companies. But they account for more than half of total assets. The process whereby "good" SOEs take over weaker SOEs, and/or grow under their own steam, means that the SOE growth rate outpaced that of privately owned enterprises (POEs) by almost two to one between 1999 and 2005.

Unfortunately, the mainland Government's plan to dominate the economy through this elite group is being held back by one crucial weakness: the very slow improvement in SOE profitability.

Profitability among SOEs has improved from contributing 44 per cent of total enterprise profits in 1998 to 49 per cent of a much bigger total today. But the number of unprofitable SOEs still hovers at 40 per cent, just one percentage point better than 1998.

SOEs' return on assets (a measure of the amount of money and resources they need to generate profit) has risen steadily from 1.3 per cent to 4.5 per cent, but POEs have gone from an already high 3.5 per cent to over 6 per cent in 2004, a figure the public sector hasn't come close to.

Ironically, it is precisely the access to plentiful, cheap financing from state-owned banks that may be the undoing of SOE profitability, since it encourages waste. POE profits have fared much better because they have been forced to use capital very efficiently

Stenev concludes that the private sector now constitutes 34 per cent of China's urban GDP, or 44 per cent if you take the private foreign sector into account. The total rises to 66 per cent if you include agriculture, now almost completely privatised.

The impact of foreign firms is a fascinating aspect of the China puzzle. One could speculate that the Government is far less worried about the intrusion of foreigners than one might expect from such a nationalist Government. After all, foreign firms pay solid taxes and are only interested in profits, not in clamouring for political rights.

On the other hand, the strong foreign presence makes the Government vulnerable to the xenophobic hard left of the party, and among foreigner-haters in the population at large.

These forces will certainly be destabilising. But if everything works out, China will be a profoundly different place in five years time.

* The writer remains anonymous to protect his position in China.