China’s State Capitalism: the Real World Implications

MARCH 1, 2012   THE WALL STREET JOURNAL

By Stanley Lubman

Chinese leader-in-waiting Xi Jinping’s visit to the U.S. last month and the recent release of a World Bank report on the future of China’s economy have helped to once again revive debate around the state-led “China model” as an alternative blueprint for economic development. As these debates unfold, it has become clear that China’s version of “state capitalism” (as opposed to “market capitalism”), still is not adequately understood abroad.

Reuters

The need to better understand China’s system goes beyond abstract arguments about the future of the global economy. The continuing expansion of the state sector of China’s economy limits the private sector and favors state-owned enterprises (SOEs) over foreign companies in some domestic markets. As SOEs extend their investments abroad, nations in which China seeks to invest need to become more aware of frequent links between state ownership and state control.

A recent paper by Curtis Milhaupt, a scholar of comparative corporate law at Columbia Law School, and Li-Wen Lin, a graduate student in sociology at Columbia University, sheds useful light on what they call the “black box” of SOE organization.

As Lin and Milhaupt note, the Chinese system is based on “vertically integrated groups” of large state-owned and related companies. Each group has a “central holding company,” the State-Owned Assets Supervision and Administration Commission (SASAC), which is the majority shareholder in a “core company.” That company, in turn, owns a majority of shares in the state-owned companies that comprise the group, including a finance company that is a source of finance for members.

Altogether, these vertically integrated groups control some 120 SOEs, all subject to government control via SASAC. According Lin and Milhaupt, total SOE assets equaled 62% of China’s GDP in 2010.
There are intra-group linkages via joint ventures, alliances, and shareholding. Also, the Chinese Communist Party (CCP) structure exists parallel to the structure noted above. The Organization Department of the Party is decisive in choosing top managers of the SOEs, and in turn some managers hold positions in government and the CCP. The authors emphasize that more than a chain of command from top to bottom is implied by this structure: “These hierarchical structures are embedded in dense networks –not only of other firms, but also of party and government organs,” and exchange and collaborate on many matters of production and policy implementation.

The implications of this system for market competition run deep. One is that SOEs are exempt from anti-trust enforcement. Also, as the Economist noted in a recent overview, the government “enforces rules selectively, to keep private-sector rivals in their place” and foreign firms can be blocked from acquiring local firms.

Understanding the governance of SOEs is difficult. Lin and Milhaupt state that SASAC has control rights over the transfer of shares in SOEs. Most SOEs have no board of directors, and shareholder rights are “downplayed.”

A recent study of shareholders’ derivative suits in China by the University of Michigan’s Nicholos Howson and George Washington’s Donald Clarke finds that although there is a “robust” use of such suits against insider and controlling shareholder abuse in limited liability companies (closely-held companies), derivative lawsuits involving listed companies limited by shares (which include the SOEs in the groups described) are “strikingly absent.” At the same time, in the private sector some gains from transparency have been found to result from shareholder suits against closed corporations which are known as “limited liability companies” under Chinese law.

Although the strength of SASAC’s control over the companies it oversees may vary in practice, insiders exercise control in each SOE, which means that corporate governance is very weak. Shareholders have no voice in corporate affairs and can not access the courts. Lack of transparency means that corporate misgovernment is easy to hide.

Questions surrounding Chinese laws and corporate governance within China may seem remote, but they are not. If any SOEs intend to invest in the U.S., they must be reviewed by the Federal Interagency Committee on Foreign Investment in the United States (CFIUS), which is charged with evaluating mergers or takeovers that ”threaten to impair the national security.” Legislation specifically requires that foreign investment transactions in which the foreign entity is owned or controlled by a foreign government must be reviewed. Foreign firms have the burden of proof to demonstrate they are not “a threat to national security.”
Not only is this standard vague and undefined, but the process is politically charged, as demonstrated by two notable cases.

Perhaps most notable is the attempt state-run Chinese oil firm China National Overseas Oil Corporation (CNOOC) to acquire Unocal, a U.S. subsidiary of the Union Oil Company, in 2005. The attempted acquisition set off a storm of Congressional criticism while the transaction was being reviewed by CFIUS, eventually leading CNOOC to withdraw its bid. “The national security argument gets bound up in a zero-sum view of China: the idea we can’t give them any advantage, any edge, if they are going to be a future enemy,” Georgetown Law School China exerpt James Feinerman was quoted as saying at the time.

That views were underscored in 2011 when Huawei, a Chinese telecom company that claims to be publicly owned rather than state-owned, sought to purchase a small California company. As the deal was being considered by regulators, a Bloombergreport quoted cited intelligence officials as saying Huawei maintained “close ties and what appears to be regular communication with officials of the People’s Liberation Army and the Ministry of State Security in China.” The outcry from Congress was so great that the offer was withdrawn.

A Wall Street Journal report at the time of the Huawei fracas predicted “the environment for Chinese companies in America is only going to worsen as the 2012 presidential election nears and politicians look for targets to criticize.” The accuracy of this apprehension has recently been demonstrated in the rhetoric of some of the candidates in the Republican primary. “Mitt Romney and other Republican candidates have stepped up their denunciation of China’s trade practices, casting the country as predatory and a culprit for lost jobs at home,” the New York Times noted in November. The Republicans, however, are not alone. In the same article, a former adviser on China to President Obama was quoted by the New York Times as being “hard-edged” on economic issues that trouble U.S.-Chinese relations.

While much of the recent political rhetoric surrounding China can be written off as election-year bluster, China’s “state capitalism” will continue to be number among those issues on which leaders in Washington are likely be “hard-edged,” and rightly so. If an SOE appears as a possible investor, CFIUS will most likely have difficulty probing its relations to Chinese government agencies of concern. And the Chinese side will most likely not display satisfactory transparency.

Stanley Lubman, a long-time specialist on Chinese law, is a Distinguished Lecturer in Residence at the University of California, Berkeley, School of Law and is the author of “Bird in a Cage: Legal Reform in China After Mao,” (Stanford University Press, 1999).