The SOE Sideshow
SOEs were latecomers to the process of marketization. In terms of resource allocation they were the main beneficiaries of the central planning system (Naughton 1995; Riskin 1987). Resistance from vested interests in the party- state bureaucracy, coupled with greater organizational complexity and concerns about potentially adverse impact on economic stability, held off the full start of reforms in the state sector until the mid-1980s (Naughton 1995; Perkins 1988). In the following decade, however, SOEs gradually moved away from central planning and became active participants in the new, market- oriented domain of economic activities.
Under the political performance assessment system and the fiscal contract arrangements in the 1980s and early 1990s, the behavior of the supervising officials of SOEs grew increasingly similar to that of township officials overseeing TVEs. Expanding output through sales growth became the dominant strategy, and financial leverage facilitated its implementation. Before the massive wave of privatization in the late 1990s, the overwhelming majority of
SOEs were “owned” by local governments. Yet they had a major difference with TVEs, which were also situated under (even lower) local government authorities. That is, TVEs had weak bonds with the central planning system and thus quickly became market-oriented players after the start of reforms. In contrast, SOEs carried more baggage from the old system, where fulfilling output targets set by the government had been their main task. This preoccupation with output was also reinforced by the fact that output was recast as an important indicator under the new political performance assessment system.
A 1991-1992 CASS-World Bank survey of 967 SOEs in 40 cities of 10 provinces found that the top three objectives specified in the managerial contracts with government supervising authorities were output (35.4%), total taxes and profits (34.7%), and taxes and profits handed over to the government (27%). Although the first objective might still be reflective of the lasting impact of the old mentality, the latter two both pertained to revenue concerns. More importantly, the operating environment that these enterprises had been used to was no longer there. Of these enterprises, 95% indicated that they faced competition; 66% of those facing competition said it was very intense and formidable. The growth of output, therefore, could not be sustained without selling products for the same reasons that drove TVEs to focus on sales growth. This is reflected in the remarks made by a top economic official (who had previously been the director of a large SOE) I interviewed in Foshan of Guangdong (informant, 19/1995):
Things were quite routinized in the planned economy. There was no competition. The government arranged all the supply of input and capital; the [state-owned] enterprises followed the output plan to make our products and sold them to users specified by the government. The reforms have changed all that. Input supplies are no longer arranged by the government; enterprises have to find buyers for their products. If they are to expand their output, they have to push it out to the market. Otherwise they will be dragged down. There is only so much capital they can spare for products sitting in the warehouse, not to mention it’s difficult and costly to borrow money from banks now.
For the [local] government, output growth among SOEs is a top concern, because they are the leading force of the [local] economy and have an uplifting effect on everything—our image, revenue, and even employment. But we do not focus on output per se. What we strive to do is to grow output based on sales. This is very different from producing output for the sake of doing it before the reforms.
The pattern of output and sales growth among the 967 SOEs mentioned above is consistent with this observation. There is no evidence of output expansion outpacing sales growth. In fact their growth rates were almost identical (at 10.5% and 10.9% respectively) during 1985-1990, when SOEs were brought under reform (and when pertinent data are available). Figure 4.6 shows the overall trend of sales growth for all industrial SOEs, which has a Pearson correlation of .99 with output growth rate. It was similar to that of TVEs shown in the preceding section—rising sharply in the early to mid-1980s, hovering at high levels for about a decade, and then dropping
FIGURE 4.6 Sales growth rate (five-year moving average) ofindustrial SOEs, 1980-1997 Sources: CIESY(various years); FYC (various years).
precipitously in the mid-1990s. While the absolute level of growth rate was less spectacular than that of TVEs, it is important to note that SOEs had a much larger initial base of sales value than TVEs and every percentage point of growth carried much greater weight. Also noticeable is the fact that during the high-growth period of 1985-1995 industrial SOEs maintained an average sales growth rate of 15.4%, which was higher than the GDP growth rate of the economy as a whole (FYC1999, 484).
Like TVEs, though, SOEs experienced a gradual delinking of profitability from the taxes generated through expanding sales. Figures 4.7 and 4.8 illustrate this phenomenon based on the data for the 967 SOEs covered by the CASS-World Bank survey and for all industrial SOEs. The lack of detailed data on tax exemption renders it infeasible to make adjustment for the distortions caused by the practice of booking exempted taxes as profits. But even with the inflated profits the pattern is still clear. That is, while taxes held steady relative to sales (which were expanding, as shown in figure 4.6), profits declined over time. SOEs, especially industrial SOES, tended to be more concentrated in sectors (e.g., tobacco) where indirect tax rates were higher than those where TVEs were concentrated (Lin and Liu 2000). This is probably why the problem looks more pronounced in figure 4.5 than in figure 4.4, though the underlying story remains similar. In fact despite their significant role in fiscal revenue generation, the profitability of SOEs seriously deteriorated into the 1990s. In 1985 9.6% of the industrial SOEs under state budget incurred a loss; the percentage rose to 29.8% in 1992 and further to 43.9% in 1997 (FYC 1998, 482). In 1996 the financial losses incurred by SOEs totaled 112.7 billion yuan, exceeding the net profits of SOEs (FYC 1998, 482). The rationale for this seemingly irrational behavior resembled that for TVEs, as explained by the director of a state-owned machine tool maker in Nanjing that had been in the red during 1992-1995 but continued to operate and even expand (informant, 3/1995):
As a key enterprise (zhongdian qiye) of the city we probably overexpanded in the 1980s, with an increase of capacity by almost threefold.
FIGURE 4.7 SOE taxes, profits, and sales (n = 967) Source: Survey data.
FIGURE 4.8 Taxes and profit as percentage of industrial SOE sales, 1978-1998 Source: FYC1997,1999.
But the government does not want us to reduce or stop production because it would affect the overall economic performance of the sector, which has certain binding targets to achieve for the city. Although we can barely sell our products at cost now, the [sales] volume itself generates fiscal revenue. We also have seventeen hundred-plus workers and staff, plus some 160 retirees. We cannot transfer them to other places or lay them off. We have no choice but to keep going. Hopefully we will be able to overcome the short-term difficulties with more reforms.
A major difference between TVEs and SOEs is that SOEs had easier access to bank lending. This was a legacy from the central planning era, when the entire state banking system was primarily geared toward serving SOEs.  In 1985, SOEs accounted for 77% of all the non-fixed-assets lending extended by state-owned banks. The percentage trended down but remained above 67% through 1995, whereas the percentage of TVEs never exceeded 10%. In comparison with TVEs, which (as shown in the preceding section) managed to minimize the principal repayment for their debts as a way to leverage funds for short-term growth, the principal repayment by SOEs was considerably larger. In 1995, for example, the repayment amount of industrial SOEs for their long-term loans was equivalent to 15% of the outstanding balance (FYC1999, 485). This, however, was not the result of robust financial health, but rather the greater availability of bank loans and soft financial discipline imposed by their lenders. The repayment of the principal of 126 billion yuan in 1995 was largely covered with newly borrowed loans (totaling 200 billion yuan) (FYC 1999, 485). According to the 1991-1992 CASS-World Bank survey of industrial SOEs mentioned above, some 73% of the respondents indicated that when they had difficulty servicing their loans on time, they were able to either get an extension to the existing repayment schedule or obtain a new loan to address the immediate shortfalls.
The consequences of the financially leveraged expansion of SOE sales were similar to those of TVEs. Table 4.1 shows that in the early 1990s SOEs had accumulated massive financial liabilities. Their overall debt-equity ratio was higher than that of TVEs. Local SOEs had even higher ratio than central SOEs, which weighed heavily on their “owners,” as can be seen from the high debt-revenue ratios. The seeming “improvement” during 1993-1998 was in part due to the dropout of large numbers of failing SOEs from debt statistics. During 1995-1998, for example, the total number of industrial SOEs declined from 118,000 to 64,700 (CIESY 2001, 16). Also, during 1994-1995 SOEs underwent a major overhaul of their accounting practices. One of the major changes was the inclusion of assessed land value in enterprise equity, which had not been counted as such before. That led to an upward adjustment to enterprise equity value and thereby had an offsetting effect on the debt-equity ratio.
Furthermore, before the debacle of public enterprises in the mid to late 1990s, the sales-driven expansion of SOEs also helped grow their workforce, hence alleviating the mounting demographic pressures (discussed in chapter 2) that the country faced during the two decades after the Cultural Revolution. In 1981 the total employment of industrial and commercial SOEs was 49 million; in 1994 it rose to 116 million (SFYCICA, 3; SICA 199s, 21). This job creation effect quickly dissipated and reversed as SOEs’ sales expansion faltered in the mid-1990s. Finding alternative placement for the large numbers of workers in overexpanded SOEs soon became a hard constraint that CCP leaders could not afford to evade.
The fast expansion of SOEs under the sales growth strategy also exacerbated governance problems. Like TVEs, local SOEs were often used by their supervising officials as instruments of revenue manipulation. In 1995, for example, the total taxes due for industrial SOEs were 256.3 billion yuan, but the taxes actually paid were 195.8 billion yuan, or 76.4% of the amount due (FYC1999, 483; SSIC 199s, 23). The exempted taxes were often parked in enterprise accounts, which were at the discretionary disposal of their supervising authorities. This practice blurred the boundaries between formal and informal resource pools and between public and private uses, which had a negative spillover effect on the financial health and independence of SOEs, as partly reflected in the growing complaints about local officials’ encroachments into enterprise funds in the early to mid-1990s (SJSFGS 1995; see also Lin 2001). The softening of arm’s-length relationships with enterprise managers also weakened the resolve and ability of supervising officials to monitor the behavior of enterprise managers, which as in the case of TVEs became
even more difficult because of an increase in information asymmetry associated with fast-growing organizational scale and complexity. From 1985 to 1995 the total assets of industrial SOEs increased by thirteen times—from 402.6 billion to 4.8 trillion yuan (SSIC 198s, 3:565; SSIC1995, 25). It was during this period of time that the saying qiong miao fu fangzhang (“impoverished temple under self-enriched master”), which depicts asset stripping by public enterprise managers, gained currency. In a 2004 CASS-HKUST survey (n = 510) of private enterprises, 45 respondents indicated that their companies were former SOEs; 36 of them agreed that overexpansion and poor monitoring over managers were among the major factors contributing to the decline and eventual privatization of SOEs. I will further discuss this issue in chapter 7.
-  Even central SOEs had a “local” character of sorts due to the lack of a highly coherent line of command. Before the establishment of the SASAC in 2003 as the unified authority in charge of all nonfinancial SOEs directly controlled by the central government, central SOEs were affiliated with variousindustry-specific ministries and bureaus.
-  The information reported here is derived from the survey data set. Documentation of the survey isposted at the book site. The survey also covered 366 urban collective enterprises. Considering the limitation of space and given that these enterprises behaved like small SOEs (Lin 2001), I do not includethem in the analysis here.
-  The gap between output and sales among SOEs was actually narrower than that among TVEs. In1985, for example, the ratio of sales to output for industrial SOEs was 94.3%; in 1995 it rose to 97.1%(SSIC i98s; SSICi99s).
-  In 1980 the total sales value of all TVEs was 5.96 billion yuan (SCTE, 253), which was equivalent toonly 24% of the sales value of industrial SOEs alone (CSA1987, 48).
-  Since the losses had already been factored in before the reporting of net profits in aggregate, whatthis means is that the total losses of SOEs were equivalent to more than 50% of the after-tax profits ofSOEs. See Holz and Lin 2001 for a discussion of the pertinent accounting practice.
-  The strategy would look less irrational if one made a close examination of its revenue implications.According to the summary statistics of the 1995 industrial census (SSIC1995, 23), for example, industrial
-  SOEs generated a total of 256.3 billion yuan in taxes. Profit tax accounted for only 11.3% of this total,where the lion’s share of the total consisted of various indirect taxes generated in or through sales. Thetotal net profit of industrial SOEs, after deduction of a total operating loss of 36.5 billion yuan, was only36.1 billion yuan (FYC 1999, 486). The short-term utility of maintaining sales growth despite poor profitability was obvious from a fiscal point of view.
-  Before 1983 most (approximately 80%) of the working capital of SOEs consisted of fiscal grantsfrom the Ministry of Finance, whereas a small fraction (about 20%) took the form of basically interest-free loans from state banks. In 1983 the government decided to turn all working capital grants of SOEsinto bank loans and to charge interests on such loans. See Shang Ming 1989 for an account of the prereform system and the subsequent changes.
-  Over time SOEs also became more dependent on borrowings to address their cash flow needs. In1985 funds owned by industrial SOEs themselves was equivalent to 35% of the quota working capitalthey took out from state banks; in 1992 this percentage dropped to 22% (FYC 1993, 686).
-  Urban collective enterprises, agriculture, foreign-invested companies, and domestic private enterprises made up the remaining percentages.
-  During 1995-1999 I interviewed thirty-six SOE managers in seven different cities (details aboutthe interviews are posted at the book site). Twenty-eight of them indicated that their enterprises hadreceived tax exemptions with the help of their supervising authorities. They also acknowledged havingprovided various “bursary services” to government officials in connection with this special treatment.
-  Details about the survey are posted at the book site.