The Resurgence of the State in the Chinese Economy?

Date

February 7, 2017, 12:15 PM to 1:30 PM EST
PIIE Webcast, Washington, DC

Event Summary

PIIE experts assessed the degree of resurgence of the state in the Chinese economy at an event held on February 7, 2017. Senior Fellows Caroline Freund and Nicholas R. Lardy presented their respective new analyses of Chinese state-owned enterprises (SOEs), state assets, and their implications for global competition. Visiting Fellow Rory MacFarquhar gave his perspective on negotiating with China over SOEs and their impact based on his experience serving the Obama administration.

Caroline Freund, senior fellow at the Institute since May 2013, works primarily on long-run economic growth and international trade, and their interaction. She was chief economist for the Middle East and North Africa at the World Bank from 2011 to 2013. Prior to that she was lead economist from 2009 to 2011 and senior economist from 2002 to 2009 in the research department of the World Bank. She was also senior economist at the International Monetary Fund 2006 to 2007 and economist at the Federal Reserve Board from 1997 to 2003. Her book, Rich People, Poor Countries, broke new ground in the understanding of the role of creative destruction and business leadership around the world, including China.

Nicholas R. Lardy is the Anthony M. Solomon Senior Fellow at the Institute, and one of the world’s leading experts on Chinese economic development. He joined the Institute in March 2003 from the Brookings Institution, where he was a senior fellow from 1995 until 2003. Before Brookings, he taught at the University of Washington, where he was the director of the Henry M. Jackson School of International Studies from 1991 to 1995. From 1997 through the spring of 2000, he was also the Frederick Frank Adjunct Professor of International Trade and Finance at the Yale University School of Management. His latest book is the widely-cited Markets over Mao: The Rise of Private Business in China.

Rory MacFarquhar joined the Institute as a visiting fellow in February 2016. For the preceding six years, he worked in the Obama administration and most recently served as special assistant to the president and senior director for global economics and finance in the White House National Security Council and National Economic Council. At the White House, he led policy teams on a wide range of international economic and trade issues, including US-China economic relations and addressing global economic vulnerabilities. Before entering the US government, he worked for eight years at Goldman Sachs in Moscow, most recently as managing director and director of economic research for Central and Eastern Europe, the Middle East, and Africa.

Video

Unedited Event Transcript

Adam Posen: Good afternoon, ladies and gentlemen. And welcome back to the Peterson Institute for International Economics. I'm Adam Posen, president of the Peterson Institute. And it’s great to see another crowd despite today a very attractive weather outside and great to welcome our friends around the world on the live web stream, and everyone who will be watching this and I hope on the website download at their convenience.

Today, we're going to talk about the resurgence of the state and the Chinese economy. Before I get to that, which is of course a critical topic, I just want to make clear a couple things. We, at the Peterson Institute, have ongoing discussions with officials in the Chinese government, business leaders, both state and private sector in the Chinese economy and with colleagues and scholars in Chinese academic world as well as government world.

My colleagues and I all have different views on various aspects. But we are committed, I think, all of us to two points. The first being that it is in the interest of the world as well as China that the Chinese economy continue to develop and grow in a sustainable rapid pace that part of that is marketization, but in a measured and planned way. And that we believe that there is a reform effort that has been ongoing in China that has paid enormous dividends to date, but that seems to have slowed at some point in the last couple of years.

The second point that, I think, all my colleagues would agree on and that I want to point out in the current political environment is that when we make critiques of Chinese economic policy or raise questions in the data or talk about its effects on the rest of the world. It is not with an eye to punching the Chinese government. It is not with an eye to providing ammunition for those who, in a blinded way, assume that everything the Chinese government does is harmful to the US and is unfair. I don’t believe that and the facts don’t support that.

We continue to call things as we see them. And so, we are talking about the Chinese economy today with that in mind, but not to provide ammunition to those who wish to simply attack the Chinese economy and the Chinese leadership whatever the case.

One thing that my colleagues and I all agree on even if we have differences occasionally about tactics or about the severity of certain situations is that issues between the US and China in the economic sphere are best resolved through a combination of the rules-based system that the US created over the last 70 years that China has increasingly and largely adhered to over the last 40 years, as well as constructive bilateral dialogue.

That leads me to mention the people we have with us today, but also a new person coming. As many of you saw last week, we had the debut of Jason Furman, the Honorable Jason Furman, the former Council of Economic Adviser's chair as a senior fellow at the Institute. I'm delighted today to reiterate the announcement that the Honorable Dr. Nathan Sheets who recently concluded his public service as undersecretary of the Treasury for International Affairs and was at the heart of constructive US-China dialogue both bilaterally and in the G20 process has now joined the Institute as a visiting fellow for at least the next several months.

And he will be continuing to write and think about these issues. And we want to welcome Nathan and beyond the speakers want to encourage him, all of you, to take advantage of Nathan's new presence here at the Peterson Institute.

Let me now turn to today's topic more specifically. As I remarked, a number of observers starting with our own colleague, Nicholas Lardy, have of course noticed that the role of the sector in the Chinese economy seems at least to have risen in recent years. And this is probably harmful to Chinese productivity growth and will have both direct and indirect implications for the rest of the world.

We have today three of our scholars who have different views on how this is going to play out and what the state of affairs is and obviously some differences between them. But I think together, the three speakers today I'm very proud to have, all part of the Peterson Institute, who will give us a picture of what lies ahead in terms of challenges for China and what's the reality for the US and other governments facing the Chinese economy.

We will start off with a presentation by Nicholas Lardy who is, of course, the Anthony M. Solomon senior fellow here at the Institute and the bedrock of our China work has been with the Institute since 2003, of course, is the leading American analyst of longstanding and scholar of the Chinese economy and development including previous distinguished post at Brookings Institution as dean at the University of Washington School of International Studies and at Yale.

His latest book for us a couple of years ago now is the widely cited, "Markets over Mao: The Rise of Private Business in China." And therefore, I think, it is all the more important that as Nick and all of us recognize the enormous benefits the Chinese business development has had for the world economy and for China to mark when he says there is something going on that affects the private sector.

Our second speaker today is Caroline Freund. Dr. Freund has been a senior fellow at the Institute since May 2013. I'm proud to say she was the first person I hired full time when I took over as president. She works principally on long-running economic growth, international trade, and the interaction of these two forces. Her extremely creative book, "Rich People, Poor Countries, that came out last year broke new ground on the understanding of the world creative destruction of business leadership around the world including China.

Caroline had a distinguished career as a trade and research economist at the World Bank, the IMF, Federal Reserve Board, and previously as chief economist for the Middle East and North America at the World Bank. In particular, today, Caroline is going to be presenting new research she's doing that is driven by a cross-national interest and agenda in her wheelhouse of economic growth and trade, but which turned out to have important information about China. And I will allow her to explain that today.

There is her new working paper which we released today and which is available, "Global Competition and the Rise of China," with Dario Sidhu, one of our young researchers here. And we encourage you to take a copy or download it. It’s a very rich paper not just about China.

Finally, I'm delighted to welcome back to our podium, Rory MacFarquhar who joined the Institute as a visiting fellow just a year ago now. We're delighted to have Rory as a colleague. In the previous six years before he joined us, he worked in the Obama administration including for an extended period as a special assistant to the president and that senior director for global economics and finance in the White House NSC and NEC.

He led policy teams on a range of issues. But I think most of us know him as having played a key role in all US-China bilateral economic relations over the last several years supporting the NSC, and the NEC, and the president. He's an outstanding colleague and has a background not only at the practical side of US-China policy relations, but in markets having previously worked for Goldman Sachs in Moscow and director of economic research for Central and Eastern Europe, Middle East, and Africa.

So we have a very distinguished group today. All comments are, of course, on the record. I'm going to ask my three colleagues to come up and present in sequence. And then we will have an on-the-record discussion with the distinguished audience here today. Nick, thank you very much.

Nicholas Lardy: Thank you, Adam. I want to begin by just briefly reviewing the attitude that the people like me had a few years ago when Xi Jinping, their current leader first came into power. We have the famous 3rd Plenum of the 18th Party Congress that seemed to set a tone that suggested that economic reform was going to accelerate. And I just want to read—it’s a very long document extremely detailed. So I'm not going to give you the details. But I am going to read three parts of it, which I think give you the flavor.

The first is the simple sentence. We must ensure that the market has a decisive role in the allocation of resources. That sentence had never appeared in a party document in China since reform began in 1978. They said the market could play a supplementary role and this kind of a role and that kind of a role. But it never said it had to be a decisive role.

And then further expanding on that, we must substantially reduce the direct allocation of resources by the government and promote resource allocation based on market principles, market prices, and market competition.

And then there was a longer statement that I think could have been made in any market economy that we're familiar with that goes as follows: "The functions of the government are mainly to maintain macroeconomic stability, strengthen and optimize public services, guarantee fair competition, strengthen market supervision and management, safeguard market order, and promote sustainable development," a lot of it goes that I don’t think many people would disagree with.

So this led to a tremendous wave of optimism that reform would reaccelerate, and we'd see a very transformed economy in a short period of time, but very shortly thereafter sees a tensions turned from economic reform to his anti-corruption campaign to enhancing the role of the party at the expense of the government and at the expense of civil society and substantially enhancing the role of state-owned companies. And this was very clearly reflected in the 13th five-year plan, which is rolled out only two years later that had a lot of very status elements I won't go into. But it was a very different tone.

And what we've seen is that not very much of the 3rd Plenum reform agenda has actually been introduced or adopted or implemented. And people have become much more pessimistic. And it’s not just people like me looking at it. But I think foreign firms operating in China have had a significant change of attitude.

I'll just quote from the most recent survey by the American Chamber of their firms in China which was just released a few weeks ago. 80 percent of its members said that they "feel foreign firms are less welcome in China than before." And 60 percent expressed a lack of confidence that the Chinese government was committed to further opening up a reform. And I think this was a natural reaction to some of the industrial policies that have gotten more emphasis.

For those of you who know me, I like to look at the numbers. So I'm trying to look at what's the evidence that there's been a resurgence of the state in the last few years. And I'm going to look at two potential indicators. One has to do with profits of state companies particularly in the industrial sector. And the other has to do with the role of the private sector and state sector in terms of investment.

Now, on the profit side, 2016 was the first time in several years that the growth of profits of state companies surpassed the growth of profits of private companies. You can see that private company profitability has declined. But it turns out that I think this is primarily recovery. 2015 was a terrible year for state-owned companies in China. Their profits declined by more than 20 percent. So even though they've had a pretty smart recovery this year their profits in 2016 were actually below the level of 2014. The profits of private companies grew by 5 percent in 2015. So they were starting from a much higher base. And their profit growth may be somewhat behind that of state companies, but they're doing pretty well.

If you look at it in terms of the share of profits, again, you get a very different picture than the first diagram because registered private companies are producing a pretty constant share of profits in the industrial sector. And you don’t see much of a resurgence of state-owned companies.

If you add in the profits limited liability companies that are controlled by private players, the share of private profits in Chinese industry is about three times that of state companies, something in the neighborhood of 50-55 percent and that that has not eroded very much. So I think this is cyclical recovery, not an indicator of a resurgence of the state.

The second indicator is a much more serious one and one which has, I think, much more negative implications. And that is that the role of the state companies in investment has increased quite substantially. You can see that the trends here between state and private. And 2015 was the first year since the global financial crisis in 2009 when state investment ramped up. This is the first year that state investment has grown more rapidly than private investment in recent years. And then you can see the gap has widened substantially in 2016 with a very sharp ramping up of state investment relative to private investment. And I think these numbers have some shortcomings. So I'm not going to spend too much time on them. I want to give you my estimate of the growth of state versus private investment.

The blue line is showing us the share of investment undertaken by private companies. The 2.6X simply means that private company investment in the period 2006 through 2011 was 2.6 times of that of state companies. That accounts for the rising share of investment undertaken by private companies. Starting in 2012, it dropped down to 1.4 times. And so far, the data that we have, it’s running at about 0.3 times the growth of state investment.

So this is a very substantial increase in the relative importance of state investment as compared to private. But those are just the numbers. What I'm going to spend most of my time on is looking at a couple of possible explanations of why this might be the case. Just to put them out there, the first one is that there are fewer profitable investment opportunities for private firms. And the second one is that there has been a substantial amount of crowding out of private investment over the last few years particularly starting in 2012.

Now why might it be the case that private firms see fewer investment opportunities? Well, private firms face the fewest barriers to entry in the manufacturing sector. And private firms already account for about 80 percent of investment in manufacturing. The share of state firms is under 10 percent. The balance of investment in manufacturing is undertaken by foreign affiliates. So the state has pretty much faded away from the manufacturing sector. You can point to a few exceptions like automobiles where you can only do 50-50 and so forth.

Now what's the nature of the slowdown in the Chinese economy since 2010? It’s concentrated primarily in industry and construction. And manufacturing is far and away the biggest component of that. So you see that the growth has declined from roughly 16 percent down to 6 percent, a relatively large deceleration of growth in manufacturing. And in the service sector, the reduction has been substantially less. I've talked about this before how the service sector has become more important. But given the fact that private firms have the best investment opportunities in the manufacturing sector, maybe the slowdown means there are just fewer opportunities available.

If you look at investment in services, the role of the state is about 5-1/2 times what it is in the manufacturing sector, just a lot of barriers to entry. And you can see that a decade ago, the private share was rising slightly. But since around 2011, it’s been completely flat. And if you look closely at 2015, I think it went down somewhat. So the state is very, very dominant in investment in services business sector that has been growing. But it’s not so open to private players. Yes, you can open up a personal service business. You can open a restaurant and things like that. But private firms have a very difficult time investing in finance, telecoms, transport, and a few other very important sectors.

So the first explanation or hypothesis is there are just fewer profitable investment opportunities for private companies. So they've cut back on their investment. The second explanation is crowding out. This is a diagram showing us that the absolute amount of investment undertaken by state companies between 2007 and 2014 very close to doubled. But their retained earnings, that is, their after-tax profits only went up by about 50 percent.

If you updated this diagram to include 2015 and 2016, investment went up more. But total state profits last year were less than they were in 2014. So that suggests that investment by state companies is increasingly financed by funding. It doesn’t suggest, I think it basically proves that investment by state companies is increasingly being funded by sources that are external to the firm.

Now what might those be? Again, this is going back to the long term. You can see in the long term the share of loans outstanding to state companies had been going down for a couple of decades. And the private share had been rising. That's one of the reasons that the private sector had been doing relatively well.

And if we look at it on an annual basis for more recent years, you get a very different picture. The state share bottomed out in 2011 then began to rise gradually. And in 2014, it jumped by 25 percentage points. This is the most recent data that has been published. This is not my estimates of this. These are the official data of the People's Bank of China. I had a little bit of difficulty with the 2014 numbers. But I don’t think there's any question that the long-term rise in the share of bank credit going to private companies has been reversed in recent years. And state companies have been getting better treatment. That’s roughly consistent with the investment pattern. They start getting better access to credit in 2012. That's when their share of investment is going up.

A second component of this crowding out is the corporate bond market. The corporate bond market has expanded quite dramatically in China in recent years. It has become a much more important a source of external funding for firms. More than 90 percent of issuance by value is by state corporates, not by private corporates. So private corporates can do some issuance, but they're relatively small part of the market. So that's the second component.

And then the third component is the role of the budget in financing investment has increased quite significantly. This has not gotten much notice. In the old days, about 90 percent of investment was financed through the budget. And that declined dramatically in the '80s and '90s. But it’s now going back up. And I estimate that about 30 percent of all state investment is now being financed through the budget. So that's another example of crowding out.

So I think I can't tell you whether crowding out or the lack of profitable investment opportunities for private firms is the most important. But undoubtedly, there's some of both. Now, let me add quickly that the footprint of private firms at least in the industrial sector where we have the best data is still growing very rapidly.

When you look at the growth over this four-year period, the expansion of private firms in terms of value added in constant prices is roughly—it’s close to twice that of state firms. So, state firms are still growing very, very slowly relative to private firms. The cumulative growth figures are really quite striking. So it's not that the private sector is fading away. It’s that the investment flows look like they're increasingly going to state companies.

So let me conclude. I think the resurgence of state profits in the industrial sector appears to be largely cyclical, not any evidence of a state resurgence. But given the huge productivity gap between state and private firms which now stands at roughly 3 to 1, the continued resurgence in the state investment relative to private I think is quite unfavorable for China's economic recovery in at least two respects.

Number one is the obvious one. If it’s continued, it would mean lower growth. And secondly, it means the quality of the portfolios of the China's financial institutions will continue to deteriorate because they're lending too much money to state-owned companies that have very, very low returns. So it’s adverse for growth and it’s adverse for financial stability.

I think the slowing of private investment relative to state is as I said before some combination of entry restrictions in services and crowding out of private investment. And I think the policy response that is appropriate I would argue is pretty simple. It should further liberalize entry for private firms in services. And I would say not only indigenous private firms but foreign private firms as well. And they should create a more competitive financial sector which would lead to a substantial reduction in the lending to the state sector. Thank you.

Caroline Freund: So let me start by saying where this work came out of because the original title of this work was, "Global Competition." And it became "Global Competition and the Rise of China" when China became the key change to global competition that I saw looking at the data.

And the reason I wanted to look at this question of what's happening to global industrial competition and I'm going to focus on concentration and also allocative efficiency is that there's a body of new research by Jason Furman who's now with us and Peter Orszag and others showing that in the US, industrial concentration has risen. And this raises concerns about monopoly power. Although, some recent evidence also shows that it’s efficient. The more efficient firms are growing faster and getting bigger. So that's a good thing by David Autor and others.

But if you think about these firms competing in a global environment, looking at individual country data isn't the right thing to do because you could have, for example, a textile and apparel firm that's the only firm in the United States. It would look like a monopoly. But it would be hard to say that that firm has any kind of market power.

So what I wanted to look at was global concentration and global allocative efficiency. And as I said so given trade and investment, global concentration should capture market structure and market competition to a much greater extent than looking at an individual country. And it’s going to raise the same kind of issues or concerns.

So if there was a lot of concentration globally in one industry especially if it was concentrated in a specific country, you might be worried about volatility because what if something happened in that region or country or some sort of shock to the industry. You could also be worried about market power if some firms grow too large and have too large a share of the market. But, again, it could reflect efficiency. And a lot of the work from the 1980s on this topic showed that the largest—the most productive firms actually do grow larger. And that industrial concentration is a big part of efficiency gains.

So one reason this topic kind of attracts attention is because of these kind of comparisons saying, "Oh the big firms have gotten so large. They're as large as the governments of big countries." So there are these kinds of rankings that rank firms in countries or government revenues in countries. And this is a ranking of government revenues and firms' revenues together. And Wal-Mart is the 10th biggest country in the world according to this ranking. And if you look at the companies and in parenthesis is where they would rank. Three of the top firms are Chinese and they're Chinese state-owned enterprises. So this is already where China's starting to come into the story that they have a lot of these large firms.

There also was this kind of weird economist versus economist story about large firms on the one hand saying in the US the rise in industrial concentration in corporate profit is too much of a good thing. There's too much monopoly power in the US; on the other hand, saying something's happening in Europe. And their large firms are losing market share to firms from elsewhere. So something's wrong in Europe. Well, which is it? Are large firms good or are losing them a bad thing? But you can't have it both ways. So let's understand what's really happening with big business.

China's effect is interesting because what we see is a huge rise in the number of Chinese firms in any list you look at of top firms. And it could have different effects, right? So, on the one hand, since the largest firms in the past typically came from Europe, Japan, and the US, the rise of Chinese firms could reduce industrial concentration because now they're taking some of the market share from the incumbent industry leaders. On the other hand, Chinese firms are somehow different either because the country is so large so the firms have been able to grow large. Or because they're state owned, then you could see that the rise of China is associated with an increase in industrial concentration.

So just to tell you very briefly, this project is using data from the Orbis database. And the interesting thing about this data is that it doesn’t just have publicly listed companies. It also has privately-owned companies and state-owned enterprises and includes ownership information on these companies. I'm going to do two splits; one looking at the 84 broad industries and then do a little bit of work on tradables because we might think that global industrial concentration matters more in tradable sectors.

So I started by saying you look at this and immediately China jumps out. So these are three lists of top firms; the top 1000 from the data I'm using, the top 500 FT has a list, and the top 2000 Forbes. They ranked them a little bit differently. I'm just ranking them based on revenues. The others also look at market value in particular. But, anyway, you caught it, one thing jumps out. The number of Chinese firms in the world's largest has grown dramatically. So in the Orbis data in 2006, 41 firms were in the top 1000; now 136 are. And within the top 500 or top 2000, we've also seen the number of Chinese firms grow by more than a factor 3.

The measures I'm going to focus on are the four-firm concentration ratio, which is just the four-firm share. And it’s not going to be the full list of firms in an industry because that's not available. So while the data is complete, there are reasons that it changes over time and such. So we're going to do the top four firms out of the top 650 firms in the industry to keep it constant across industries or the Herfindahl index which is just the sum of the squares of market shares.

And this is a picture showing the share in 2006. And each circle is an industry. And the size of the circle represents how large the industry is in total revenues and the share in 2014. And if we insert a 45-degree line so if the share had stayed the same, then the share in 2006 would be the same as the share in 2014. And all the points would line up along the 45-degree line. Actually, most of the points fall below the line. And if you do an average or a weighted average, what you'll find is that industrial concentration fell by 4 percentage points. And in terms of when we look at the US data or something that's the same increase that, for example, Furman and Orszag were worried about in the US data, which was over a much longer period. This is a pretty big drop in a relatively short period of time in industrial concentration. So here's the fitted line. And as I said, the average decline is 4 percentage points in industrial concentration.

And again to highlight the rise of China, if you look at who these superstar firms are, so if we take the top four firms by the 84 industries so 360 some superstar firms. These are the firms that are the largest in their sector. What you see is a jump in China. So China has increased its share of these super large firms. And the area that's declined the most is the European Union, so mainly at the expense of European firms that used to be in the top four.

So what I did with this data is some regression analysis to look at what is the effect of new emerging market firms on overall industrial concentration. So this idea that as these firms grow they take share from the incumbent industry leaders from Europe or Japan or Europe. And there is that effect. So an additional 10 emerging market or Chinese firms that work with China as well reduces concentration on average by half of 1 percentage point.

But the one thing that stood out was it’s different when state-owned firms are at the top. So there was a very large increase relative to what was happening everywhere else when a Chinese firm was in the top four. So having a Chinese firm among the top four firms that industry was likely to increase concentration by about 5 percentage points relative to other industries.

So this just shows—I think it’s 13 or 15 industries with and without SOE. So another way to look at it to see if this is really a causal effect. Maybe Chinese SOEs are in industries that are becoming more concentrated. Or maybe firms are emerging to respond to the SOEs. What this does is I looked at what actually happened to concentration. And I looked at what would have happened at concentration if the SOEs hadn’t been there.

And what is on the vertical axis is what actually happened and the horizontal axis shows what concentration would have looked like in the absence of SOEs. And what you see is that in some industries in particular civil engineering which is basically construction is the top-left point; Concentration in that sector increased by more than 5 percentage points. Without the SOEs, it would have actually declined by more than 5. And as you see, most of the sectors are above the 45-degree line. There was an increase in concentration because the SOEs were there. Without them that increase wouldn’t have happened.

I want to give you some idea of who these firms are and the sectors they're in. So as I said, and these are all sectors where including the SOEs concentration increased by more than 4 or 5 percentage points relative to what it would have been if those SOEs had not been included. And some of the sectors are, as I mentioned, civil engineering, mining support, mining of coal and lignite, professional services, petroleum and natural gas.

So you might say, well, this doesn’t really affect global competition because these are largely import-competing sectors. Civil engineering and construction grew up in part with the fast growth in infrastructure in China. But as infrastructure has slowed down in China, these firms have started to look outward. So we see them building the metro system in Mecca, refurbishing a bridge in New York, building a tower in Moscow, building a resort in Jamaica, et cetera, et cetera.

So these firms are competing with the former leaders from Europe, in Japan, and US, and they're state owned. And in that field in particular, it’s going to have a big impact on trade because once you win those contracts, a lot of the machinery and materials are going to be imported from China. I'd also like you to keep in mind that even in an import-competing sector; a large state-owned firm can have monopsony power in terms of setting prices and such, which can affect buyers in other parts of the world.

And finally when we look at a more disaggregated group of tradable sectors, what you see is some industries where China is growing fast and there are concerns about competition including metals that everybody knows about, manufacture of railways, auto parts as a sector that has been growing extremely fast, and so forth.

So let me just say a few words about efficiency. So we've seen that overall concentration has declined, but it’s increasing in some industries. The other question is to say, is the world becoming more efficient? Is it the most productive firms that are big and getting larger? And when we look at this question, we do find that the most productive firms are larger.

So this is just a simple percentile taking out industrial differences. So the 100th percentile or 99th percentile firms are the top 1 percent in size and going down. The top firms are indeed more productive so that's a good thing.

But when we compare overall firms with SOEs, what you see is that the SOEs are too big given their productivity. Or put a different way, for any size ranking of an SOE, it’s less productive than a similar firm in the same industry. And we did a lot of regression analysis. I mean these are just sort of baseline figures. There are a bunch of different reasons why you might see this, maybe just because China has more labor.

But when you do the empirical work, what you do find is controlling for country effects, country industry effects, any other things that may be inherent to those firms comparing state-owned firms and other Chinese firms. More productive firms are larger and grow faster overall in the data, which is good. This is especially true in tradables. So global allocative efficiency is stronger in the tradable sector, which is what you'd expect. But Chinese SOEs are too large and growing too fast given their productivity.

Just to say a few words about putting this in context, we've seen that Nick Lardy and other people's work has shown that the private sector has grown faster in China. I won't go through everything here but just to say these results are for a handful of sectors and they're for a very specific time period. So there's no inconsistency here. Other work also finds that SOEs are large and growing in some sectors and gaining importance as the smaller SOEs have been privatized but the larger ones—this grasp the large and let go of the small kind of policy.

And finally, this is my last slide to conclude. So an aggregate global concentration is falling. So we don’t need to worry as much about a rise in market power, for example. And part of this is because of emerging market firms that are now taking share from the incumbent industry leaders from US and Europe and Japan. But Chinese SOEs, in particular, raise global concentration whether you look at broad sectors or tradables in a handful of industries. And finally that the evidence for allocative efficiency is strong, but SOEs are distorting it.

And I think one concern about this is that from trade policy perspective, a worry is that firms from US and elsewhere feel like they're not competing in a level playing field. This is going to raise pressure for protection. And that's something we've seen recently and I think does need to be addressed. And I'll stop there. Thank you.

Rory MacFarquhar: So I am going to be quite brief because I am not presenting new research results. In fact, what I would speak to you today is largely based on what I would call stylized facts, but others might call clichés about China's SOEs, but basically to give a policy gloss on why US officials and officials from other parts of the world should also care.

So what we've heard from Nick today and I think is well established in the literature is that SOEs are a concern for China. They are less profitable, more indebted, and ultimately less productive. And so China has a very significant interest in figuring out how to reform the sector. As we all know, it has grappled with the challenge that the SOE sector is very core to the Communist Party's ideology, the Communist Party's perception of its role in that society and its grip on power. And we also know that there are some very significant vested interests among leading party families and their close relationship with significant SOEs, which appear to act as obstacles to the kinds of rapid reforms that were promised in the 3rd Plenum document that Nick read from a little earlier.

But what I'm going to talk about today is that while we should all hope for China to be successful in its reforms, it will bring it closer to the kind of rules-based global economy that I think we're all interested in seeing in the decades to come. But it’s also a very specific concern for the policymakers in other countries in the nearer term.

So the issues I'll flag today; number one, the macro economic issues raised by the SOE sector; number two, the trade distortions which Caroline described in greater detail; and three, some of the national security issues that are raised by foreign direct investment by SOEs. And then finally, I'll talk about a couple different approaches that policymakers might consider. One is essentially encouraging further reform in China. And the other is trying to insulate one's own economy from the spillover effects of the SOE distortions.

So first of all, macro-economically, the issue here is that SOEs are part of the problem of China's excess saving. We know that the dividends that SOEs pay to the Chinese government are extremely low. And moreover, at this point, almost all of those dividends are then recycled within the state sector. They are not transferred to the budget for use, for example, on social programs or other spending items.

And so, essentially, the fact that SOEs have this incentive to retain their earnings and to save too much is part of this overall problem, which contributes obviously to China's current account surpluses, more recently to China's capital outflows.

Now, one of the very few specific numerical pledges in the 3rd Plenum document was that by 2020 China would start remitting 30 percent of its SOE dividends to the budget, which I think a lot of us were very encouraged by. But what we've discovered over time is that pledge has to be understood very specifically as that is the share of the dividends that will go to the budget. It is not the share of the profits that will be paid out in dividends. And the share of the profits that's paid out in dividends is still very low in the order of 15 percent. And so we're talking about 30 percent of 15 percent, not 30 percent of SOE profits.

And I think perhaps very intuitively, we have a concern that SOEs would distort trade. In so far as they receive privileged access to financing, they underpriced inputs, low-priced land, better regulatory treatment. Then clearly that creates a competitive distortion in the Chinese market, but frankly also a spillover distortion to anyone competing with these firms or trying to provide goods to China.

Now, we also know that SOEs aren't unique in this respect. There are national champions and frankly local champions within China, which also receive privileged treatment. But I think it’s fair to say and most people believe that SOEs routinely receive benefits far beyond what most private firms in China receive.

Now, a specific distortion that has, I think, a very direct political concern for the US and for other governments lately has been the issue of excess capacity. And specifically the fact that in so far as SOEs face softer budget constraints and hence are able to run losses for longer, they will be under less pressure to adjust to reduce capacity relative to their market competitors in other countries. And as a result, the companies that will be forced to remove this excess capacity will be the market ones and not the Chinese ones even though the big ramp-up in capacity came in China. So that's a very specific concern.

Then in addition and this comes to some extent to the point that Caroline was making now, SOEs in China obviously by definition all report out to some level of the Chinese government. And in principle, the Chinese government can also direct them to collude. Now, there have been cases in the US courts where this has proven to be a very specific problem with respect to price fixing. And so this is an additional challenge that we need to grapple with. And finally as I said, this is in China, but it’s also something that affects behavior here in the United States.

National security, I think that this has been an area of back and forth between the United States and China for many years. China has told us that we should consider state-owned enterprises to be commercial operating without government direction entirely following business logic. There have been certainly some cases of investments that have caused us all to scratch our heads and wonder whether that's really all that's going on.

Clearly, there are larger geopolitical competitive issues between the two countries. And so in the statute of the Committee of Foreign Investment in the United States, there is a requirement of higher degree of scrutiny for direct investment by state firms that already exists. But now I'm sure many in this room are aware that there have been a chorus of calls for somehow a tougher approach or even an outright ban on state-owned enterprise investment in the United States.

Now, my argument would be that, well, first of all that as I was saying earlier. The distinction between SOEs and private is not quite as hard and fast as you might think. And so, certainly, there's reason for continuing to scrutinize both private and state enterprises, but not particularly blocking either. And second with respect to SOEs in particular given that China has expressed a very strong interest in maintaining SOE access to the US market. That is in itself a point of leverage even if, we, in the United States believe that fundamentally FDI is positive for the United States. It creates jobs here. It improves productivity in the United States. The fact that China wants it is a rare bargaining chip that should be used very wisely. And we should think very hard about to what end we should use that and certainly not give it away by blocking FDI from SOEs altogether.

So finally in terms of the broad policy space as I suggested at the beginning, really, there are two approaches that one could take. In the United States, we have been negotiating a bilateral investment treaty with China for many years that the text of the treaty includes a number of provisions that would address some of these specific distortions and create a much more level playing field for investment but also for trade.

And also in the Trans-Pacific Partnership, there was a whole chapter on state-owned enterprises. As you know, China is not a party to the Trans-Pacific Partnership. But it certainly was scrutinizing the text very closely with an eye either to potentially joining the TPP at some point in the future or simply understanding that this was our effort to lay out what a 21st century trade agreement and what a 21st century trade world should look like. And therefore that at one point or another, they're going to have to comply with it, so essentially using the rules by system to encourage reform by the Chinese.

The other approach that they're saying earlier is essentially to wall off the US economy to try to address the spillovers without actually paying any attention to whether China was moving forward with the reform or not. And the kinds of tools that then would be used would be trade remedies, anti-dumping countervailing duties, may be revamping US competition policy to address some of the competition issues that are raised by SOE collusion, and finally by toughening the CFIUS rules to either block SOE FDI or subject it to even tighter scrutiny.

Now in the Obama administration, we certainly didn’t foreswear the enforcement-based approach. But fundamentally, we relied, to a large degree also, on trying to create these new sets of international rules, the sense, at least from the early rhetoric of the Trump administration, that it’s going to be very heavily focused on an enforcement-based approach.

The real concern there is that if anything if they were to go too hard on that to provoke a Chinese backlash we might actually get a backing away from the path of SOE reform in China rather than progress in that area. So thank you.

Adam Posen: As you can see, random abuse occurs at the Peterson Institute. Thank you, Rory. Thank you, Caroline. Thank you, Nick. These are very rich topics, Rory drawing on very good reflections about his experience and, of course, Caroline with her research in progress, and Nick in his ongoing research.

I just want to re-emphasize before we open it up for questions and comments a couple of things. First, in line with Nick's long-term research and taking Rory's comments into account, I think we all believe that there is some distinction between the true private parts of the Chinese economy and the public sector and that the private parts of the Chinese economy have been hugely beneficial to China and the world.

I think the second thing I want to stress is there are different ways of looking at the data. And so there are obviously different perspectives. I’d like to ask Nick, Caroline and in that order—Rory got the last words so I'm going to skip him—if they want to offer any reflections on their colleagues' comments before we open it to the floor. Nick briefly.

Nicholas Lardy: Okay. There's no question that Chinese SOEs are bigger than ever. This is, as I said, partly organic growth and partly the huge number of mergers. The organization that controls the 200 largest state-owned non-financial corporations which was created back in about 2003 and 2004 has subsequently merged down the number of these firms to about 102.

So they've all been growing, but there's a tremendous amount of mergers. And when you rank these firms by revenue, they are gigantic. If you rank them by return in assets, they'd probably be at the bottom of the list. But if you rank them by revenue, they're very, very large. So any inclusion of these firms in measures of global concentration obviously it's going to raise up global concentration because they're so large.

Going to the question of whether or not they're distorting global markets, I think these firms in and of themselves I agree with a lot of what Rory said. The state itself introduces a certain amount of distortions. I'm not sure if the SOEs themselves do. They're not very big exporters. They account for about 1.5 percent of global exports. They used to do two-thirds of Chinese exports. Now, they do about 10 percent because they're less competitive. Their returns have gone down. So they're not successful exporters anymore.

They're very big on the import side. But when you start looking at the commodities, it's oil, iron ore, coal. Oils have very competitive global markets. China's two big oil companies are only importing about 15 percent of globally traded oil. I think you would have a very hard case to make to say they're somehow influencing the global price.

Iron ore, they're a huge importer. A very large share of globally traded iron ore goes to China. But there are hundreds and hundreds of steel companies doing the importing and they're not colluding to try to influence the pricing. And if you talk to people in the industry, I think they believe it's a fairly competitive market.

I could go on. But I'm just saying there is—I think our presumption, as economists, is to think if concentration is going up something bad could be happening. But showing in specific cases that's actually happened is sometimes difficult.

Adam Posen: Okay. Caroline, do you have anything you want to offer on this?

Caroline Freund: I would just say I think I largely agree with Nick. And I think the problem isn't that large right now. I would add though that often you’re an importer before you’re an exporter. As recently as 2004, China was a net importer of steel. And we all know it’s happened since. So I think just saying, well, if you’re an importer, I mean, in addition to the potential pricing issues, that's not necessarily enough.

The other thing is the SOEs tend to be an upstream industry. So then it ends up feeding down into the pricing of all sorts of industries. So I think there are different ways in which it does. And finally and I think this is the area where we'd agree the most is that the other point of the analysis is to say these firms are too big given how productive they are or they're not productive enough given how large they are. And either way you caught it, China would be better off if they had a smaller share of the economy.

Adam Posen: Very well said. Let me open it up to questions and comments. Our usual drill, Brad, do you want to go to the mic back there—probably still in the first question?

Our usual drill, please identity yourself. Please make it a question, not a statement. Otherwise, I’ll cut you off. There is a roving mic with Jessica at the front of the room. There's a standing mic at the back of the room. Please. Please identify yourself.

Brad Setser: Brad Setser of Council on Foreign Relations. One of these stylized facts about the Chinese economy over the past three years is that the growth in goods imports has significantly lagged overall growth. So the goods import share of the Chinese economy has gone down. Given that the argument here is that SOEs are less prevalent on the manufacturing side than on other sides, do you think that this phenomenon is associated with the rise of the Chinese state—?

Adam Posen: Thank you. Sorry. Could you repeat the last line? This phenomenon is associated with the rise of—?

Brad Setser: Chinese state enterprises their strengthening role in the economy.

Adam Posen: Thank you.

Nicholas Lardy: I don’t think so. I think the biggest reason for declining imports relative to the size of the economy is the localization of production chains. And this is primarily an area of the economy that's dominated by foreign affiliates operating in China. In other words, they used to buy other parts and components from Malaysia and Taiwan and Korea and so forth. But more and more of those firms have moved their production facilities to China to be closer to their clients.

And the result is this processed imports as which they call them, processed imports as a share of total of imports has declined quite significantly. It used to be almost 50 percent. I think now it’s about 35 percent. So imports relative to GDP have declined mostly through the role of foreign affiliates and where they're sourcing their imports from.

Adam Posen: Thank you. Rory or Caroline, anything else?

Caroline Freund: I'll just add to that that part of it is the slowdown in global trade altogether. So, trade everywhere has slowed down dramatically. And so, China needs less of these imports in part just because it's trading less and exporting less just like everybody or it's not growing as fast as it was in the past.

Adam Posen: Okay. Next question also at the back mic. Jessica could you—?

Male Speaker: I'm [inaudible 1:02:41] with Washington Post. It’s a question for everybody. You've described something that happened, the retreat or the slowing down, the expansion of the private sector. But you haven't explained why it happened. Is this reflecting some sort of a political decision at the top that was communication throughout the economy? Or is this simply the peculiar workings of the marketplace in China or something else?

Nicholas Lardy: Well, I think from the output point of view the private sector, as I showed by, I think, second to the last slide has not really slowed down. In the industrial sector, private firms are still growing twice as fast as state-owned firms. Where the change has come is investment. And if that were to continue, it could feed through the growth of output. But so far, it’s been of relatively short durations. So that's why I think it’s potentially a problem in the future.

But I think the slowdown in private investment is due to the factors that to a considerable extent are the result of state policy. Number one, not liberalizing access of private firms including foreign firms to the service sector and allowing a financial system that directs a disproportionately large share of credit to money-losing state-owned companies. So I think policy is very much involved.

Rory MacFarquhar: Right. I agree that policy is involved. But I think that the key lens to understand that is that what we've been seeing over the last two or three years is an effort by China to avoid too sharp an economic slowdown. And fundamentally that effort has manifested itself through various stimulus policies that have disproportionately benefitted the state sector.

So while there may not have been a policy meeting of the state council or the standing committee saying we need to increase the state share of profits or output of whatever that was what followed from policies that were aimed at supporting the economy.

Male Speaker: Thank you.

Adam Posen: Next question, the gentleman with the mic.

Male Speaker: Thank you. I'm the Brazilian ambassador and I'm very pleased to be here and seeing some people I used to meet when I was a visitor of IIE. Over the last year, I was the chairman of the China Brazil Business Council. And we did a very comprehensive study on Chinese investment in Brazil. And that to a large extent, it did not reflect the trend which has just been presented with a lot of evidence. It need not to reflect. It used to reflect. But on the contrary now, the growth of the share of the private sector is increasing.

Now, I come back to the question which was put by my colleague from the Washington Post. Is this the deliberate result of a change in policy? Because you may remember the 13th Plenum emphasized the exposure to market practices. Or may it also be the result of some different development? First the restructuring of—

Adam Posen: Please don’t make a speech. Please ask a question.

Male Speaker: The question is, is it the result of other practice like the restructuring the concern of banks in lending to the private sector for [inaudible 1:06:31] risk, the expansion of Chinese investment abroad which was basically in the area of infrastructure and heavy equipment?

Adam Posen: Thank you.

Nicholas Lardy: Well in terms of the outbound investment, I think a few years ago it was mostly natural resources. It was mostly by state companies. But in the last few years that's changed. There's much less investment in natural resources and the role of state companies as a result has diminished substantially.

If you take the case of the US which is now one of the largest destinations for outbound investment, something like two-thirds of all the investment is being done by private companies. Now, there's still some headline cases that involve state companies. But if you look at the aggregate numbers, the role of private companies in outbound investment into the US market has increased quite substantially.

Adam Posen: Let me just add something from a perspective of someone who does research on financial crisis and fragility, not so much as a China expert. We have to understand that this is not an entirely different pattern than we saw in Korea or in Japan or for that matter in the USA savings and loan crisis.

As Nick has written about in the past also including with our colleague, Morris Goldstein, if you have a financial system which has limited investment opportunities for savers and for perhaps legitimate reasons has limits on capital outflows. You’re going to end up with distortions at a fundamental level in the market.

And so, the idea that there isn't some policy decision as just sort of organically growing up has to be seen against that background. That if you have a government that is committed to retaining a convoy system de facto and de jure for government-protected financial institutions, you will automatically have this kind of corruption misallocation over investment. That was true in Korea. That was true in Japan. That was true in Oklahoma. As our colleague, Monica de Bolle, has pointed out with BNDES and it’s like in Brazil that's been true in Brazil.

And so, not everything fits the same pattern. But I think it is worth reminding people that this is a part of a general picture of the banking problems in China and financial development issues that Nick and other colleagues have worked on. It’s not just about the party plenum. Next question please, there at the gentleman in gray.

Tony: Hi I'm Tony with China Daily. I want you as an economist to comment on Donald Trump's sort of measure to tell US companies now to relocate abroad or outsource abroad. Is this some kind of a rise of a state in the US? Thank you.

Adam Posen: Okay. Rory, you can start.

Rory MacFarquhar: So what we've seen so far is some rhetoric and threats that companies would face a border tax, but no clarity as to whether beyond the tweeting companies will face a real shift in their incentives about where to locate production.

The most specific proposal out there is the border adjustment tax proposal coming out of the House of Representatives that the administration seems partially to be embracing. And that would indeed have some effect on incentives for where companies will locate their production. That's not the same thing as state planning to put it mildly. That would be creating a new set of rules that would affect incentives. That's very much in the classical mode how the US has done economic policies for years. It’s certainly new that we have a president who is attacking individual companies. But for the moment, we haven't seen any consequences beyond the rhetoric.

Adam Posen: Caroline, do you want to add anything on this point?

Caroline Freund: I would just say that it is having an effect. So we’re hearing in different circumstances from different companies that for right now they're putting plans on hold if they're thinking about moving for labor cost issues. They might still move if it’s about market access. But it does seem to be having an effect whether it’s a macro effect or an individualized micro effect we don’t know.

And the long-term consequences of that are likely to be negative on productivity if you have this group of companies that aren't doing what's most efficient especially if at some point the policy changes. Then you could have a sudden and far more disruptive change in company behavior. So I think it’s a concern for a lot of reasons. But talk whether it's cheap or not remains to be seen.

Adam Posen: One more, again, reminder about putting this in a general context, for more than 30 years going back to when Fred Bergsten commissioned work on FDI in the US by Paul Krugman and the late Monty Graham. The Institute has been doing studies on the two-way benefits; the obvious benefits to developing economies of technology transfer best practice in competition when they receive foreign direct investment, but also the obvious benefits to the US and other rich countries when they receive FDI.

More recent studies we published by Ted Moran and Lindsay Oldenski of Georgetown, for example, on the employment effects and R&D benefits of FDI into the US. Again, going back to some of the specifics Rory mentioned, we know in this congressional environment there will be concerns and possibly even broadening of the CFIUS process definitions. There will be these quid pro quo reciprocal threats.

But we should not lose sight of the fact that fundamentally FDI two ways in the US-China relationship especially when done on a private sector to private sector basis is a mutual benefit. And that's why the Chinese government and the previous administration were interested in the China-US bilateral investment treaty.

Let me ask the audience for a final question, the gentlemen over there, Jessica please.

Adam Sigal: Hi. Thanks for taking my question. My name is Adam Sigal, not from CFR. I'm a reporter with MLex Market Insight. My background is a trade attorney. And we all like to read economists and pretend like we know what we’re talking about. So I'm going to ask you two questions. Feel free to take either one of them anyone on the panel.

The first major trade issue for trade attorneys going on is rising role of Chinese state in the economy. Is China trading toward against market economy? Are they market economy? And the second question, we've had a complaint at the ITC by US Steel recently where they alleged anti-competitive behavior by Chinese firms in the steel sector. I'm curious for Nick and Caroline how you differentiate truly private firms from firms that are registered as private entities in China, but how associations with often state-controlled iron and steel organizations that are allegedly, according to this case, involved in these anti-competitive practices.

And Rory, I'm curious from you whether or not you feel like US trade remedies and trade agencies are nimble enough to deal with the rising world of SOEs. Thank you.

Adam Posen: Okay. Thank you. Given the limits of time but also because my colleagues really set out their more nuanced views rather than yes-no of whether China is moving away from the market, I'd suggest that they answer the second of Mr. Sigal's questions, please, starting with Caroline, then Rory, then Nick.

Caroline Freund: Well, I don’t know if I can answer your precise question. I just would say that I think we're going to see a lot more contingency protection. So I think there's going to be a lot more anti-dumping and countervailing duty cases, safeguards, and maybe some industry agreements.

And just one thing to add in terms of talking about the SOEs that I looked at is they are sometimes in the tradable sectors in the type that you would see this type of protection against. So in addition to the metals and stuff we all know about, auto parts, for example, is another area where they've been growing not just dramatically fast but now have a big share of the US market. And there's a few other sectors like that in the tradables where I think contingency protection is exactly what's going to happen.

Adam Posen: Rory.

Nicholas Lardy: Well, I think the criteria for ownership in China are fairly clear. State company is one that's totally owned by the state or majority-owned by the state or dominant owner is the state. There can even be firms in which the dominant owner is private, but by agreement, they let the state company take the lead. And it would be classified as a state-owned company. And there are similar rules for private firms based on ownership shares.

So, yeah, some private firms have close connections with the government. But there's a fundamental difference between private companies in China and state companies in China. That is in the industrial sector, for example, private companies are earning a return on assets of around 8 or 9 percent depending on the year. And state companies are earning 2 to 3 percent.

So you put these industries in different ownership categories. The performance is fundamentally different. So I think there's a difference between these two types of companies.

Adam Posen: Very good. Rory, do you want to add anything?

Rory MacFarquhar: Yeah. So first on the question of market economy status, clearly, state ownership what it means to production is one of the US statutory criteria that will remain a problem. And unless Congress decides to amend those criteria, I guess we're heading to a WTO dispute.

On the issue of whether US agencies are nimble enough to use trade remedies and there's certainly a lot of discussion of whether there should be more resources made available to the commerce department to bring these kinds of disputes. I will say that a challenge that we face consistently was that we would be asked often by the labor movement to self-initiate anti-dumping or countervailing duty cases.

The problem there is that all of the data that is needed to do so is in the hands of private industry. And frankly, US industry is extremely ambivalent for the most part with the exception of certain key sectors. It’s extremely ambivalent about the use of these trade remedies often because it straddles the Pacific. And the same companies have operations in China, in the United States for supply chains that they do not want to disrupt.

So even adding a lot of manpower to the commerce department would not overcome fundamental resistance from the industries themselves to bringing more cases. So I think that it’s very easy to think about enforcement as a slogan. But in practice, it’s going to be much harder.

Adam Posen: One final note on steel before we close, I mean steel like textiles and certain agriculture is one of those industries that keeps being with us of disproportionate importance politically and in trade negotiations even though it is not a huge source of employment, a huge source of value added, or a huge source of innovation.

As our colleagues at the Cato Institute have estimated, restrictions on US steel very expensively would protect jobs when there are 40 jobs using steel throughout the rest of the economy. And our colleague, Gary Hufbauer, at intervals throughout the last 10 years goes through the exercise of showing how US government protection efforts on steel costs the American taxpayer vast amounts. I realized, Mr. Sigal, that was not your point. But it has to be said.

And similarly picking up on Nick's point about the very obvious differences in productivity on very prima facie labels, it is very important to recognize that companies even in the US can have undue political ties even without, strictly speaking, being state owned if they serve the interest of people, ownership interest of people in positions of high power. And we should worry a little bit about not being too sanctimonious to other countries when we are going down a path that seems to favor accumulations of private power and connection to government positions.

Finally, I think it is important, however, to recognize that China all this other stuff aside has added more steel capacity in the last few years than the rest of the world combined at a time when its domestic needs for steel are declining. And so, there is legitimate room for the US and other western economies plus India and others too and Brazil to engage with China about ways of working off this vast overcapacity.

That is something where if the US administration wishes to serve the interest of the people in the world rather than a very narrowly defined vision of what the steel industry in the US should do, they could constructively pursue at the G20. And that is something that I believe I’ve given my discussion through Chinese and European officials, others would be very open too.

On that note, let me turn to my colleagues and thank Caroline Freund, Nicholas Lardy, Rory MacFarquhar who I think took us through an excellent set of research and views on how to think about the resurgence of the state and the Chinese economy. This meeting is adjourned.