Xi’s centralization of power makes SOE reform easier

Much has been said and will continue to be said about President Xi Jinping’s decision to remove the two-term limit on Chinese President and Vice-President. It is his latest in a series of moves that have centralised power. While there are a number of ramifications that result; one is that Xi now has more control over state-owned enterprises (SOEs) and their reform. In October, we argued that following the 19th Party Congress, by enshrining his own Political Thought, as well as the BRI into the constitution, Xi has given himself free reign to make the BRI succeed. SOEs are the primary vehicle through which BRI investments are conducted, particularly in the construction and engineering sectors. More than 60% of Chinese outward investment is undertaken by SOEs, and SOEs have over 15,000 overseas branches. Yet, SOEs face two major challenges related to 1) finances and 2) corporate governance that will lead to significant operational difficulties unless resolved.

Firstly, financial challenges of SOEs are highlighted by growing debt levels and lower profitability in comparison to private peers. SOE debt has exploded in the aftermath of the global financial crisis, increasing from 50% of GDP to over 100%, as local governments pumped in a 20 trillion-yuan stimulus (five times greater than the central government stimulus of 4 trillion yuan) to maintain GDP growth rates. They did this with a disregard for the medium term implications of growing debt; and that same debt now threatens the entire Chinese financial system and, by extension, the stability of the whole economy. The link between local governments and SOEs was a classic case of vested interests – the promotion structure of local government officials rewarded the highest growth rates while SOE executives were in no position to turn down substantial soft loans, even if these were bound to result in overproduction and falling profitability. Moreover, a revolving door relationship between SOE officials and local government officials has existed for decades, creating even stronger vested interests and barriers to reform.

Secondly, SOEs are vast organizations. It is not uncommon for an SOE to have tens if not hundreds of subsidiaries. This makes oversight problematic; there is little accountability and much scope for corruption. This has implications overseas, as the Chinese government saw with the cancellation of the Myitsone Hydropower Project undertaken by the China Power Investment Corporation (CPIC) in 2009. CPIC neglected environmental regulations, failed to follow protocol and consult the Chinese embassy in Myanmar prior to signing the deal and did not undertake the necessary due-diligence. The dam became the epitome of a backlash towards China in Myanmar. Ultimately, the project had to be cancelled and China-Myanmar economic relations have soured ever since. Clearly, SOE corporate governance has implications for the BRI.

Centralization of power, of which the removal of the two-term limit is the latest example, can make overcoming these two challenges slightly less difficult. SOE reform requires time, and Xi now has it. In 2015, Xi spoke of consolidating more SOEs, making them bigger and stronger, but under tighter oversight of the Party. This was followed up in 2016, when he stated: “Party leadership and building the role of the party are the root and soul for state-owned enterprises”. With more central oversight, Xi may have found a formula that can help to crack vested interests and warped corporate governance incentives in China’s SOEs. With central government able to push through financial and SOE reforms, and through giving less operational scope to local governments, future debt levels can be managed in a more controlled manner. Moreover, the weaknesses of an overly-decentralized system allowed corporate governance deficiencies to be exploited and lead to reckless, if not corrupt, behavior – both at home and overseas. A centralized system should see fewer such problems. We’re not saying abolishing the two-term limit is universally a good move, but in the case of pushing through SOE reform, it may well make the challenges ahead slightly less difficult.