The EconomistJuly 22nd 2017 Finance and economics 572 win business, as had happened with rail-
way-equipment makers.
In the 1990s, when SOEreforms began,
the vision was of the state controlling
whole industries butwith the companies
in them battling each other to promote bet-
ter management. The imperfections of this
scheme are clear, judging by weak returns
in the state sector. But the government’s re-
sponse is to create even bigger monsters.
Chinese economists have described them
as “red zaibatsu”, a reference to Japan’s
sprawling, slow-moving conglomerates.
Yanmei Xie of Gavekal Dragonomics, a re-
search firm, is even blunter: policymakers
“are trying to create conglomerates that
can dominate domestic and international
markets through sheersize”.
The risk is thatsuch supersizedSOEs
could hurt the global economy. In a paper
published earlier this year, Caroline
Freund and Dario Sidhu of the Peterson In-
stitute of International Economics, a think-
tank, argued that businesses around the
world were operating in more fragmented
environments, with the exception of sec-
tors in which Chinese SOEs have large foot-
prints. In these sectors, such as mining and
civil engineering, concentration has in-
creased as China’s state firms have bulked
up. Normally, it is the most productive
companies that grow the fastest. China’s
SOEs, by contrast, are much less efficient
than their international counterparts, even
when they are growing more quickly, ac-
cording to Ms Freund and Mr Sidhu.
The business of state
The saving grace in the past was that the
vast majority ofSOEbusiness was within
China. That is changing: industries from
construction to steel to railways are look-
ing abroad. The “One Belt, One Road” strat-
egy—the core of Mr Xi’s foreign policy—has
made foreign expansion an explicit part of
their mandate. The danger is not just that
they will elbow Chinese private-sector
competitors aside but that in doing so, they
will provoke a backlash. Big firms in other
countries will demand state backing in or-
der to level the playing field. Foreign regu-
lators, already wary ofChinese capital,
will turn more hostile. The drift away from
free trade could easily gather steam.
This is not the only worry. One of the
keys to China’s economic rise hitherto has
been its success in restricting the sprawl of
state firms. They control the commanding
heights of the economy, from transporta-
tion to power, but have largely been con-
fined to these sectors. Hard-charging entre-
preneurs have been free to break into new
businesses around them. The manufactur-
ers that led China’s exportassault on glo-
bal markets were private. The tech firms
that dominate the internet are private. The
restaurants, cafés and shops that line city
streets are private.
This model still works, for now. Withinthe MSCIindex of large listed Chinese
firms, the state accounts for more than 80%
of market capitalisation in sectors such as
energy, industry and utilities, according to
Morgan Stanley. But the state accounts for
40% or less of market value among con-
sumer, health-care and ITcompanies, says
the bank. With these newer sectors grow-
ing far more quickly than smoke-stack in-
dustries, private companies may well con-
tinue to outflankSOEs.
There is a big looming worry, however.
One aspect ofSOE reform is in fact making
quick progress: the creation of what are
known as “state capital investment and
operation” companies (SCIOs), to help
manage existing state assets and invest in
new ones. This initially looked like part of
the solution for China. It borrows an ap-
proach honed in Singapore, where Tema-
sek, a government-owned holding com-
pany, manages a portfolio of state firms but
does not meddle in their operations, apart
from demanding that they deliver good re-
turns. It is now clear that this is not what
China has in mind. Government officials
say thatSCIOs should not seek to make
money in their investments; rather, they
are meant to be more like “policy funds”,
seeding firms and industries with govern-
ment cash or money raised from SOE divi-
dends without worrying about profit.
The other striking feature ofSCIOsis
that they are expressly enjoined to breakinto new high-tech sectors. Provincial gov-
ernments around the country have pub-
lished plans over the past two years in
which they promise to guide more than
80% of their funds into infrastructure, pub-
lic services and, crucially, “strategic emerg-
ing industries”, a category that refers to
new energy, biotechnology andIT, among
other areas. The upshot is thatSCIOs,
armed with cheap capital, seem set on ex-
panding the state’s reach into the private
sector. “We should anticipate the emer-
gence of literally thousands of well-re-
sourced SCIOs,” says Barry Naughton at
the University of California in San Diego.
State-backed private-equity funds,
which can be seen as forerunners to the in-
vestment function of the SCIOs, are al-
ready making a big impact. To give three ex-
amples from last year: the city of Shenzhen
launched a 150bn yuan fund; Jiangxi, a rel-
atively poor central province, created a
100bn yuan fund; and the city of Chengdu
set up a 40bn yuan fund. This influx of
cash is pushing up valuations. Bain & Co, a
consultancy, calculates that private-equity
deals in China were priced last year at a
frothy 26-times earnings before interest,
tax, depreciation and amortisation, com-
pared with ten times in America. The state
may turn out to be a wise investor but ex-
perience suggestsotherwise. More likely,
the state will crowd out private investors,
hogging capital and allocating it poorly.
The outcome does not have to be this
bleak. Optimists still think that Mr Xi could
spring a surprise after a big Communist
Party congress later this year. With his au-
thority firmly entrenched, he might feel
emboldened to unleash the market forces
that he spoke of four years ago. But based
on his rhetoric and actions so far, this looks
like wishful thinking. SOEs, far from re-
treating, are on the march, drawing on gov-
ernment support to compensate for their
weakness. They are making conquests at
home and abroad. Cutting state firms
down to size and opening them up to com-
petition ought to be the point ofSOE re-
form. Instead, China is beefing them up
and driving them into new territory. 7Borrowing binge^3Source: Wind InfoChina, companies’ liabilities as % of equity1001201401601802003 05 07 09 11 13 15Non-state-controlledState-controlledCan anything cure China’s SOEs?