Despite China Favoring State-Owned Enterprises, Its Private Companies are More Innovative and Productive

November 29, 2016

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China’s continued favoritism for its state-owned enterprises (SOEs) goes against its promises to embrace market-based economic trade policies when it joined the World Trade Organization (WTO) in 2001. China may believe that SOE-driven innovation is the path toward becoming a global leader, but there may be a more effective path for it to take—China’s privately-owned companies are more innovative and more productive than their state-owned counterparts.

China’s tepid steps to shrink SOE’s share of the Chinese economy since it joined the WTO have done little to reduce SOE’s dominance in the Chinese economy. Instead, Chinese policymakers continue to implement policies that directly or indirectly favor SOEs. In total, SOEs account for 30 percent of all Chinese firms, but collect 45 percent of all revenues. Furthermore, the largest of these SOEs come in 1 through 12 for Chinese firms on Fortune’s Global 500.

If Chinese policymakers do not make greater efforts to reduce SOEs’ presence in China’s economy, it will only make it harder for China to reach its economic growth target of 6.5 percent per year. This arises because SOEs consistently underperform their private-sector counterparts across a wide range of economic metrics—such as financial returns, research and development (R&D) investments, productivity, and innovation.

Financially, SOEs perform worse than private firms. In 2015, private Chinese firms generated 9 percent return-on-assets compared to 5 percent for SOEs (a measure of a firm’s profit, specifically, a firm’s net income as a share of invested capital). This is not some new occurrence, with data showing SOEs poor financial performance, compared to private firms, going back at least 25 years.

Metrics that determine long-term economic growth—productivity and innovation—show even more evidence that SOEs do not sustain robust innovation-led economic growth. Private firms not only invest more intensely in innovation activities than SOEs, they are more capable in translating their R&D investments into productivity gains.

By analyzing stock market data and annual reports of 1,900 Chinese firms between 2001 and 2011, three economists show the negative drag SOEs have on Chinese innovation. After classifying firms by their ownership structure, they find that as a share of revenue, SOEs invest 0.57 percent into R&D, while private firms invest 0.95 percent into R&D. In other words, private firms are 67 percent more R&D intensive than SOEs.

Private firms are not only more R&D intensive than SOEs, they too are better able to translate these R&D investments into productivity growth. Every 1¥ invested in R&D by a private firm returned an additional 0.16¥ in output, while every 1¥ invested in R&D by a SOE returned an additional 0.12¥ in output—approximately a 30 percent difference.

China’s own experience with privatizing some SOEs since joining the WTO in 2001 should give them even more reason to fully embrace market-based economic trade policies. A separate economic analysis covering firm data between 1990 and 2013 shows that, on average, when a SOE switched to private ownership, R&D as a share of net assets doubled, or an increase of 0.14 percentage points. This surge in innovative activity also explains why patenting increased by 7.2 percent, which was accompanied by high-quality patents and more collaborative R&D with international companies.

Market dynamics explain most of this sizable difference in productivity and innovation outcomes between firm ownership types. Privately-owned firms tend to operate in more competitive industries, which forces them to make more effective R&D investments to stay ahead of other firms. Conversely, state-owned firms tend to operate in less competitive industries or are insulated from market competition induced through SOE-favoring policies that limit competition in such industries and create an uneven playing field for both domestic and international private companies.

China’s continued favoritism toward SOEs ignores the very evidence that its private firms outperform SOEs in productivity growth and innovation. If China is serious about developing an innovation-based economy, it must fulfil its WTO obligations and phase out policies that directly or indirectly benefit its SOEs.