SOE reform key to technology upgrade

State-owned enterprises have played central roles in China's development as providers of utilities such as electricity and communications and of key goods such as steel and coal. They have also been instrumental in industries that require large amounts of long-term capital or scientific and technological research and development. They will continue to be critical players as China's tech and industrial structure is upgraded over the next decade.

An oft-asserted critique is that China's SOEs have a lower return on capital than private companies do, implying that the SOEs use resources less efficiently. It's true that the return on assets in the private sector was 7.6 percent versus 3.3 percent for SOEs in 2019, according to the National Bureau of Statistics. But the claim that this implies that these lower capital returns reflect poor efficiency is simply an inaccurate interpretation of economic theory.

Measured ROA is the monetary return to capital owners, not the total benefit to society. In a market, monopolistic firms have higher returns to capital owners but are actually less efficient users of capital. ROA also ignores the social benefits of capital investment.

SOEs have turned out to be a rational way to deal with some of the most difficult contradictions of microeconomics: How can a nation prevent large firms in naturally monopolistic industries from exploiting their power over consumers while at the same time taking advantage of economies of scale? How can a country make very long-term, large capital investments in infrastructure or technology development that benefit the country but are not attractive to private investors? How can a country incentivize companies to consider concepts of total social benefit in their plans?

Despite the theoretical benefits, the problem with SOEs is that the lack of market pressure and competition can lead them to be bloated and inefficiently organized. So, as part of a wide variety of market-oriented reforms, China has been pushing its large SOEs to become more responsive to market realities and competition and to be more effectively organized.

Last week, the Central Committee for Deepening Overall Reform approved a comprehensive three-year plan for SOE reform designed to steer the economy toward innovation and technology-driven high-quality growth. The plan stressed efforts to optimize the layout and structure of the State-owned portion of the economy to make it more competitive, innovative, controllable, influential and more resilient to risks.

The SOE reform is also tied to a guideline of upgrading China's manufacturing and industrial structure to produce higher value-added, more technologically sophisticated products. The guideline will support efforts to accelerate the integration of new information technology and manufacturing, speed up the innovative development of the industrial internet, hasten the fundamental transformation of manufacturing processes and enhance the level of digital, networked and intelligent modes of manufacturing.

From the point of view of economic theory, using SOEs to make the large investments needed for this technological transformation is an effective and efficient plan.

Research by former United States Treasury secretary and Harvard University president Lawrence Summers and University of California professor Bradford DeLong concluded that 35 percent of the benefit of additional physical capital investment is external to a company. This research used US data, so the external benefits to a developing country are even higher. The externalities of infrastructure building or of technical or scientific research are also large. In the process of further development and industrial upgrading, China's SOEs are a reasonable way to ensure that the country does not underinvest.

There is a Silicon Valley myth that change comes from small companies started in garages. That may have been true at one time, but certainly not today. Even in the entrepreneurial heyday of the 1960s through 1980s, almost all the investment needed to develop integrated circuits and internet technology was paid by the government. Now, a few large, monopolistic tech firms use their market power and extensive resources to either buy out or quash potential competitors.

Many sectors of the Chinese economy are extremely competitive, but there are some capital-intensive or naturally monopolistic sectors where a highly competitive market structure is impossible. The central conundrum of microeconomics is that the only purely market-based way to incentivize companies to make risky, large, long-term investments is to allow the winning firms to receive monopolistic profits. But these very monopolistic profits greatly reduce the benefits of a market economy.

Governments have tried lots of ways to deal with this contradiction. Building and regulating railroads was the first time the US federal government intervened heavily in the economy. The idea of treating railroads as regulated utilities has since served as a model for all regulatory schemes. Without government help, railroad companies would have been unable to raise the huge capital needed to lay tracks and would also be unable to access to the right of way. So, the government gave them the land, plus a strip of valuable land on either side of the tracks.

The danger then became that a railroad enterprise could extort all profits from farmers and producers along the way, so the government regulated the rates railroads were allowed to charge. Essentially, this model gave the regulated utilities a fixed return on capital. Railroad companies were private, but they could not have existed without vast government support and extensive regulation. The problem with this model is that it created little incentive for innovation, efficiency or customer service.

Similarly, electricity distribution and communications are "natural monopolies". That is, it makes little sense to run multiple lines to each house. Electricity or phone suppliers will thus obtain monopoly power over their customers. Even mobile phone service, which can support multiple service providers, is very capital intensive, so competition will be limited.

Comparing mobile phone service in the US versus China tells us a lot about the relative efficiency of nearly monopolistic private companies compared to SOEs. Both the US and China have three large phone service companies－AT&T, Verizon Wireless and Tmobile/Sprint in the US and China Mobile, China Telecom and China Unicom in China.

My personal experience is that mobile phone service in China is much better than in the US. Coverage is much better. Technology is more advanced. Prices are much lower and service is much more efficient.

There is a good reason that the phone companies, along with similar cable and internet provider firms, are among the most disrespected companies in the US. There is a phrase there: "We don't care because we don't have to. We're the phone company."

Countries also try to use antitrust laws to control monopolies. But, as we've seen in the US, it is difficult to control companies who have expensive legal teams and are able to spend billions of dollars lobbying politicians.

From a theoretical point of view, and from international experience, there is no reason to think that SOEs are less efficient than large private firms in naturally noncompetitive markets. Actually, government access to information about details of an SOE can allow the government to better protect consumers and smaller private firms.

Nobody thinks SOEs are highly efficient. That is why the government is strongly pushing for their reform. They will continue to serve as essential providers of goods and some services that are not efficiently produced in highly competitive sectors.

The writer is a senior staff commentator at China Daily.