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JohnSmith
5May2015

ReconcilingtheChinesePrivateandPublicSectors
Underitseconomicreformsthatbeganinthe1970s,communistChinahasswiftlygrown
asapoliticalandeconomicforce,hasbecomethelargestmarketintheworld,andisrapidly
producingwealthforitscitizens.Itistheserichesthathavemoveddisproportionatelytothenew
entrepreneursofChina,andtheresultingimbalancecouldleadtowhatSamuelHuntington
suggestsin
TheThirdWave
:economicandpoliticaleliteswhospringoutofcivilizationsoften
alteroroverthrowauthoritarianregimes(Huntington1991,p.36).However,Chinahastaken
stepstoavoidsituationsthatmightleadtodestabilizingchanges,includingitsincorporationof
businessmenintotheChineseCommunistParty(CCP).Althoughthesereformshaveworkedso
farintheshortterm,Chinaslongtermpoliticalandeconomicstabilityhasleftmuchpowerin
thehandsofthecapitaliststhatChinaoncevehementlyopposed.Chinastransitionfroma
statecontrolledeconomydrivenbystateownedenterprises(SOEs)toanunplannedmarket
economydrivenbytheprivatesectorhasledtoSOEprivatizationandgivenrisetoentrepreneurs
asastrongpoliticalblocwithintheCCP.
Firstofall,IwillprovidehistoricalcontextfortherolesthatSOEsandtheprivatesector
playedwithinChinaseconomictransitions.Then,IwillexplainChinasconcernsabouta
growingprivatesectorandthefutureofSOEs.IwillalsodescribehowChinahasrespondedto
thosefears.Finally,IwillintroducesolutionsthatresearchershavesuggestedtoSOEproblems,
andexplainthereformseffectsonthefutureofChinaseconomy.
ThehistoricalevolutionofChinaspublicandprivatesectors


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AnunderstandingofthemodernChineseSOEsandprivatesectorrequiresahistoryof
Chinaseconomyinitsearlystages.WhentheChineseCommunistPartywontheChineseCivil
Warin1949,Chinafacedanumberofmajorproblems.WorldWarIIandtheCivilWar
destroyedmuchofthecountrysalreadylackinginfrastructure.Westernaidtothecountryceased
astheColdWarintensified,andforeignaiddecreasedfurtherwhenrelationswiththeSoviet
Unionbrokedown.Asthecountryapproachedbankruptcy,therewerealsoheavyfood
shortages.Torespondtotheseproblems,Chinainitiatedtownshipandvillageenterprises
(TVEs),whichprovidedcommunesthatgrewfoodforthecountry.TVEsprovidednecessities
fortheirworkers,likehousing,food,andeducation.Thisprovisionofresourceshelpedmaintain
stabilityinChinaduringthistumultuousperiodofnationalrebuilding.Inaddition,China
socializedprivateenterprises,creatingasecondtypeofstateownedenterprisethatwasstrictlya
governmentownedandcontrolledentitythatfilledPartysetquotasforindustrialdevelopment.
ThiscentralcontrolandproductivitythroughtheSOEsallowedforthenationbuildingthat
modernChinadesperatelyneededinitsearliestdays(GangandHope2013).
WhenDengXiaopingcametopowerin1978,heinitiatedeconomicreformbasedonthe
ideologyofsocialismwithChinesecharacteristics,whichentailedincreasedcapitalismand
privateentrepreneurshipintheChineseeconomy(SzamosszegiandKyle2011).Initially,these
economicreformsallowedprivatelyownedenterprisesincertainsectorsoftheeconomywitha
limitednumberofemployees(Young1989).Moreover,therewaslittletonolegalsupportfor
thesefledglingfirms,solocalgovernmentsoftenharassedthem.Someoftheseprivate
companiespubliclyregisteredthemselvesasSOEsinordertoavoidharassment.Despitethe
challenges,however,theseprivatebusinessesgrewsignificantlythroughthe1980s.Atthesame


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time,SOEscontinuedtostimulatetheChineseeconomythroughpartnershipswithWestern
companies,whichwerebeginningtoinvestinthecountry.SOEswerestillrequiredtoprovide
housing,medicalsupport,andothernecessitiestotheiremployees,whichprovidedstabilityin
thecountryasSOEgrowthintensifiedandsetthestageforimmenseprivateexpansioninthe
1990s.

However,therapiddevelopmentofChinaseconomyattributedtotheprivatesectordid
nottrulybeginuntilXiaopingstourofSouthernChinesecitiesthathadembracedmarket
capitalism.Afterhisencouragementofprivateentrepreneurshipandconfirmationthatitwas
necessaryforsocialismwithChinesecharacteristics,theprivatesectorbecameaccepted,
becominganevenlarger,stillgrowingpieceofthenewChineseeconomy.SOEsprovided
stabilityasChinaslowlybegantodecentralizeitseconomyoveralongperiodoftime.

WhyareSOEsinneedofreform?
Intheprecapitalistic,statemanagedeconomy,SOEsincreasedChinasindustrial
productionandensuredsocialandpoliticalstabilitybyprovidingfortheiremployees
necessities.TheyreflecttheoriginsoftheeconomicpolicythatChinahasfollowed:rapid
statecontrolledindustrialization.Forthisreason,Chinaspurredeconomicgrowthmuchmore
quicklythanWesterncountrieshaveinthelast30years.AsChinadecentralizeditseconomy,
SOEsbecamelessimportanttomaintainstabilityastheprivatesectorhasbeguntogrowand
creatework.Thehistoricemphasisonimmenseproductivityismovingtowardstheprivate
sector,leavingSOEswithmanythreateningimbalances(Chen1998).ChensstudyofsixSOEs
inChongqing

thefirstmajorcitytoexperimentwitheconomicrestructuring

foundthatthe
majorityoftheproblemsfacedbySOEsstemmedfromacommoninabilitytoadapttothe


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reformingeconomy.MiZhouandXiaomingWangfurtherfoundthatagencycosts,thecosts
requiredbygovernmentmandates,playedthelargestrolesinSOEfailuretoturnprofitsand
incentivizecompanygrowth(ZhouandWang,2000).GovernmentmandatesforSOEsrequired
untilveryrecentlythattheyprovideemployeeshousing,pension,andotheraccommodations.In
addition,theregulationsonSOEspreventedthemfromfiringemployees,sothemajorityof
SOEsare2030%overemployed(ZhouandWang2000).
ManagementalsosuffersinSOEs.BothShiandLiu(2012)andZhouandWang(2000)
arguethatmanagersofChineseSOEshavenoincentivetomakeeconomicallystrategic
decisions.Sincetherearestrictboundsonwagesandhighopportunitycostsformanagers
throughtheprivatesector,talentedleadersinChineseSOEstendtomovetootherareasofthe
market,whiletheremainingmanagerstendtobelessable.Furthermore,thesemanagershaveno
incentivetopreservetheSOEsassets,andmanyoftenuseSOEassetsforunauthorizedsecond
businessesorbribery.CorruptionisaculturallypervasivefeatureinChinathatstemsfrom
anotheraspectoftheculture:giftgiving.InChina,giftgivingformspartofalargerpicture:
belongingtoanetworkofpersonalrelationships(Steidlmeyer1999,p.122).However,the
problemofcorruptionbeginswhenthesegiftsareactuallyformsofextortionandbribery
(Steidlmeyer1999,p.124).Corruption,especiallyinmanagement,weakensSOEsbyreducing
profitmarginsandencouraginglaziness,whichreducesinnovation.
Overemploymentandoverproductiondirectlycause60%ofChineseSOEstolosemoney
(Chen1998).Tomakeupforthis,theChinesefinancialsystemmustprovideloanstothese
SOEsinordertoallowthemtosurvive.However,sinceSOEsarecontrolledatdifferent
governmentalandregionallevelsoftheCommunistParty,thelowerlevelSOEstendnotto


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receivethefinancialsupportthattheyneed,whilethenationalSOEstendtogainamplesupport
fromthenationalgovernment.
WhilethesestatisticsportrayanimageofSOEsasharmfultotheChineseeconomy,
SOEsplayavaluableroleintermsofstability.Baietal.arguesthatasChinaseconomy
develops,SOEsprovidethesecondbestwayofmaintainingsocialstabilityaftereconomic
growth,especiallyintimesofsocialoreconomicunrest(Baietal.2006,p.354).Notonlydo
theyprovideameansbywhichtheemploymentrateiskeptlow,buttheyallowforspeed[ing]
uptheprocessofprivatization,especiallywhenthelevelofsocialstabilityishigher.(Baiet
al.2006,p.354).

WhydoestheprivatesectorconcerntheChineseCommunistParty?
Chinasdualsystemofauthoritariancommunismandcapitalismrequiresaveryspecific
balanceofgovernmentpowerandprivatesectorallowances.Economicgrowththroughthe
1980sand1990sballoonedtheprivatesectorfromasmallsetofeightpersoncompaniestoa
modernmixoflargeandsmallenterprises.Withthisemergenceofastrengtheningmarket
economycameanew,powerfulclassinChina:theprivateentrepreneur.Inrecentdecades,these
Chineseredcapitalistshaveseenanamazingincreaseintheirfinancialresources(Dickson
2007).AsMiltonFriedmanexplainsinhisbook
CapitalismandFreedom
,
economic
arrangements[are]importantbecauseoftheireffectontheconcentrationordispersionof
power[themarket]separateseconomicpowerfrompoliticalpowerandinthiswayenablesthe
onetooffsettheother
(Friedman1962,Ch.2).AlthoughFriedmanwritesprimarilyaboutopen
marketsinhisbook,thegeneraleffecthementions

thatmarketsdispersepowerandenable


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economicpowerstooffsetpoliticalpower

stillholdstrueinChinasmarket.Theinfluxof
resourcesandeconomicpower,especiallyamongtheChinesebusinesselite,couldhaveeasily
predatedamoredangerouseffectfortheCommunistParty:anincreaseinpoliticalpoweramong
thenewentrepreneurialelite.Huntingtonclaimsin
TheThirdWave
(1991)thatthisverygroup
oftenleadspoliticalchange.IntheChinesecontext,redcapitalistscoulddivergepoliticallyfrom
theoldpoliticaleliteintheParty.TheCCPunderstoodthatthisneweconomicpowercouldhave
ledtotheentrepreneursbandingtogethertoformanoppositiontochallengetheauthorityofthe
government,apotentiallydevastatingeventinacountrythatneedsitsstabilitytomaintainits
amazinggrowth.
Hadthishappened,thestatewouldhavelikelycrackeddownonthesepeopleand
companiestoavoidfurtherinstability.However,theuseofcoercioninthiscourseofaction
wouldunderminethelegitimacyoftheChineseregime.Governmentlegitimacycanbebuilt
throughconsentorcoercion,andcoerciondecreasesthelegitimacyofthegovernmentamongits
people.(Zhong1996).

However,iftheChinesegovernmentcracksdowntoohardontoomany
companiesorentrepreneurs,thenitcouldleadtoadecreaseineconomicgrowthasastigma
againstprivatebusinessrisesagainasitdidinthe1980s.Thestagnationingrowthwouldslow
theChineseeconomy,whichhasbeenregularlygrowingatratesbetween7and15%forthelast
thirtyyears1,asaresultoflessprivatesectorinvestmentandgeneralbusiness.Accordingto
AlbertKeidel,aneconomistatGeorgetownUniversitysMcCourtSchoolofPublicPolicy,
economicslowdowncorrelateswithanincreaseinpublicunrest(Keidel2005).Therefore,a
slowerChineseeconomywouldlikelyleadtosocialunrestandthepotentialdownfallofthe

http://data.worldbank.org/indicator/NE.GDI.FPRV.ZS


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CCP.Additionally,thecurrentflowofskilledChineseworkersandbusinessmentoWestern
democracieswouldincreasefromthealreadyrecordlevelsthattheyareatrightnow,causing
Chinatolosevaluabletalentthatcouldfurtherbolsteritseconomy.
TheissueofentrepreneurswasahotlydebatedtopicintheCommunistPartyduringthe
1990s.Intheearlypartofthedecade,localgovernmentsbegantocircumventstatelawsagainst
capitalistmembershipinordertoincorporatebusinessmenintotheiradministrations.Dickson
(2007)foundthatafterthelawbanningentrepreneursfromservinginthePartywasrepealedin
2000,theCCPbegantocooptentrepreneursintothePartyinescalatingnumbers.Furthermore,
theytargetedtheownersofthelargestprivateenterprisesformembershipbeforeothersubsetsof
thedemographicandencouragedtheirownmemberstogointobusiness.Infact,Chinese
entrepreneursnowmakeupadisproportionatesegmentoftheCCPasofthelate1990s,20%of
themwerePartymembersascomparedtoa6%averagemembershipacrossallChinese
demographics,atrendthatseemstoshowtheCCPtryingtomergethepoliticalandeconomic
elitesinthecountry(Dickson2007).Onelargequestionremainsunanswered:whatifthe
entrepreneurstrytochangestatepolicyfromtheinside?Dickson(2007)foundthrough
interviewswithmanyofthesenewcapitaliststhatthemajorityofthem,irrespectiveofParty
membership,arecontentwiththecurrentprogressofreformintheChineseregime,which
signalsverylittlediscontentintermsofthenearfuture.Inaddition,theCCPprefersthat
politicalparticipationbeunderpartycontrol,andprefersthatthosewhoareactiveinpoliticsbe
trustedPartymembersunlikelytochallengetostatusquo(Dickson2007,p.847),whichmeans
thatbygivingentrepreneursPartymembership,theCCPindicatesthattheywouldlikethe
businessmentochaseanyreformstheymightdesirethroughinternalPartypolitics.


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WhatsolutionshavebeenproposedforSOEs?
AnincreasinglyselfsustainingChineseeconomygreatlylessenstheneedforSOEsto
providestability.Furthermore,manycitedstudieshaveindicatedthatmanysmallerSOEsare
nowbecomingdetractorstotheeconomyduetotheirinabilitiestosupportthemselves.Zhouand
Wang(2000),Chen(1998),Baietal.(2006),andShiandLiu(2012)allsuggestpartialsolutions
totheSOEproblemthateachseemtohinttowardsincreasedprivatizationastheoverallsolution
toChinasSOEproblems.
ZhouandWang(2000)proposesasolutionthatincreasesmanagerialoversightand
incentives.Intheshortterm,thegoalwouldbetoincreasemanagerialincentivesinorderto
drawbackthetoptalentthatleft.Thiscouldbedonebymakingthemanagersalaryproportional
totheprofitmarginsoftheSOE.Thelongtermgoalwouldbetoincreaseoversightand
accountabilityofmanagement,toensurethatcorruptiondoesnotbecomeassystematicofa
problemasitcurrentlyis.Byincentivizingperformancewithincreasedwages,thatthemarket
mechanismwouldencouragemoretalentedmanagerstoreturntothepublicsectorbyincreasing
theopportunitycostofaprivatesectorjob.
Chen(1998)suggestsasolutionthatincreasescompetitionbetweenSOEsandnonSOEs
inordertofurtherdevelopSOEs.Chenarguesthatthegovernmentmustencouragethe
expansionoftheprivatesector,whichwouldmeanthatSOEswouldhavetoconstantlyadaptto
survive.Increasingcompetitionwouldallowfor,asFriedmanarguesin
CapitalismandFreedom
(1962),themarketmechanismtochoosethebettercompaniesasthewinners.SOEswouldhave
toadaptordieconstantly,anideathattheChinesegovernmenthasallowedsinceittransferred


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ownershipofnonvitalSOEstolocalgovernments.Sincethatreform,whatChensuggestedhas
happened:SOEshavebeenallowedtofailinsomecases,andinothers,theyarerestrictedtoone
industry,forcedtomergewithotherSOEs,orprivatizedoutrightaslocallegislatureshave
workedtoincreaseefficiencywhiledecreasingcost.
Baietal.(2006)focusesdirectlythetrendtowardsprivatizationofSOEsencouragedby
regionalgovernments.Aspreviouslydiscussed,SOEsownedbyregionalgovernmentsaremuch
lessfunded,andtheseregionalgovernmentsareheavilyloadedwithdebtfrompreviously
attemptingtofinancetheirSOEs.SinceChinareformedSOElaws,thesegovernmentshave
receivedtheabilitytoprivatizeordissolvetheSOEs.SincethecostoffundingSOEsishigher
thanthealternatives,locallegislaturesareincreasinglychoosingtoprivatizeSOEsundertheir
control.TheproblemdoesnotcurrentlyaffectlargerSOEsbecausethoseSOEsarethemost
successfulandoftenmonopolizeindustries.TheyprovidemuchmoreofthejobsintheChinese
economythanthesmallerones.However,asentrepreneursgainpowerintheCommunistParty
andChinaadjustsmoretoamarketeconomy,thenextstepindecentralizationmightentail
reformationofthenationallyownedSOEs.
Untilnow,SOEshavebeendefinedassolelygovernmentownedcompanies.However,
Chinacreateditsfirststockmarketin1990,andSOEscannowhaveforeigninvestors,which
furtheropensChinasSOEstointernationalinvestors.Lastly,ShiandLiu(2012)proposea
solutionbasedonasocializedstockmarketthatbuildsonwhatcurrentlyexists.ShiandLiu
arguethattheStateAssetsCommission,whichwascreatedin2003tomanageSOEs,willnot
solvetheSOEproblem.Rather,theymaketheobservationthatChinadoesnothavetodevelop
largebusinessesthroughtheindividualownershipmodelthatmanyWesterneconomies


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developed.ChinahastheabilitytomovestraighttoastockmarketeconomyinwhichSOEfund
managerswouldtradestocksinotherSOEs.Thissystemwouldincentivizefundshavingbetter
returnsoninvestmentsinordertomanagemoreofthestatesmoneythenextyear.Furthermore,
nonfinancialSOEswouldalsohavetoprovetheirbusinessmodelsinordertomakeprofitsand
receiveinvestmentsfromthesefunds.ShiandLiualsohaveproposedaneffectivemechanismto
incentivizesuccessinfinancialSOEs,whichmayalsobeasuccessfulwaytoprovidethe
competitionnecessarytoincentivizegrowthinmanySOEs.

WhatcomesnextforSOEandprivatesectordevelopment?
OneofthemostimportantissuesforChinagoingforwardishowfarthecountryis
willingtomoveawayfromsocialisminitssearchforsocialismwithChinesecharacteristics.
Chinahasshownthatitwantsconsistenteconomicgrowthwhilemaintainingstability.The
decisionstoopenuptheChinesemarketandallowentrepreneursintotheCommunistPartywere
madewhentheCCPbelievedthatChinawasstableenoughtomoveanothersteptowards
decentralization.Inthefuture,twomainfactorswillaffectthespecificsofChinaseconomic
policyofmaintainingstabilityandgrowth.ThefirstisthepresenceofentrepreneursintheCCP.
EntrepreneurswerecooptedintotheCCPinparttoprovidethegovernmentwithwaystoensure
thatprivatebusinessesremained,insomesense,underCCPcontrol.Asmentionedearlier,they
currentlyseemcontentwiththepaceofrapidgrowthandmaintenanceofstabilityinChina,so
theyareincentivizedtoworkwiththeCCPinordertoimprovethecountryseconomy.
However,whatmighthappeninthefuturewhentheCCPpasseslegislationthatmightheavily
regulatebusinesses,suchasthroughenvironmentalregulation?Entrepreneursmakeupalarge


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amountofpowerintheCCP,andtherehasntyetbeenasituationinwhichtheydifferwiththe
restofthePartyoversignificantmatters.ItisthiscaseinwhichHuntingtonsargument

thatthe
wealthychangethegovernment

mightdestabilizethecentralgovernment.
ThesecondistheissueofprivatizationofSOEs.SOEswereinitiallythebestmeansto
achievegrowthwhilemaintainingstability.However,astheprivatesectorboomed,theybecame
aweightontheeconomythatneededreforminordertomaintaingrowth.Now,Chinaspublic
sectorSOEsareslowlybeingprivatizedandlistedinthestockmarket,whereboththestateand
foreigninvestorscanmaintainownership.Thismeansthatthedefinitionofstateowned
enterpriseischanging,andwhiletheCCPdoesnotnecessarilydirecttheactionsofSOEs,they
dohavestakesintheresults.Inthelongterm,itseemsasthoughChinaspublicandprivate
sectorwilllookidentical:theywillbemadeofbusinessesthatareindependentintermsof
decision,butheavilyaffectedbythegovernmentintermsofworkers,employers,orowners.
Inadditiontotheover100,000stateownedcompaniesthatarebeingreformed,there
existlargeSOEswhichcontrolentireindustries.Throughthesemonopolies,theChinese
governmenteitherhasabsoluteorstrongcontrol(Chen2013,p.2)overthesefields.Inthese
industries,thegovernmentdoesnotallowfreeentryforcompetitors(Chen2013,p.23)yet,
ratherfocusingongovernmentdevelopmentofeachprioritizedindustry.Onelikelyfuturestep
inSOEreformseemstobetheprivatizationoftheselargeSOEsintolarge,wellregulated
privatecompanies.However,iftherampantcorruptioninChinaaffectstheleadershipofthese
SOEs,thenitcouldcauseamassivecollapseintheChineseeconomy.Oneofthemainactions
thatChinesePresidentXiJinpinghastakensincehetookthemantleofleadershiphasbeena
crackdownoncorruptioninthegovernment,startinginthemilitaryandhighlevelSOE


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executives.Whiledoingthis,hehasbeguntopromotetheviewsofConfuciusasawayto
changethemoralsituationinChina.Heseemstobetryingtodifferentiategiftgivingand
bribery,adistinctionthatmustbemadeinordertoensurethesuccessofprivatizationinthe
futureofChina.

ClosingRemarks
Formuchofitsmodernhistory,Chinahasmadedistinctionsbetweenstateowned
enterprisesandprivateenterprises.Ihavearguedthatthisdistinctionisbeingremovedasmarket
decentralizationcontinues.Therewillsoonbeonetypeofenterpriseleft:privatelyownedwith
governmentinfluence.CoretothisargumentisthebiggerquestionofhowChinawillcontinueto
developitssocialismwithChinesecharacteristicsinthefutureundertheinfluenceofprivate
SOEsandCCPentrepreneurs.AsChinaseconomygrowseverfaster,bringingrichestothe
state,theprivatecompanies,andthecitizens,theCommunistPartycontinuestojuggle
communismandcapitalism.Althoughthepossibilityofareconciliationexists,Chinasdual
systemofcommunismandcapitalismwillnotlastthiscenturywithoutmajorchangestothe
system.RegardlessofhowChinadealswiththeissuesthatitsgrowingeconomyrequires,
especiallySOEs,itmustdealwiththem,orriskdestabilizingthecountryandlosingeverything
thatithasgainedoverthelastcentury.

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