The poor performance of mainland state-owned enterprises (SOEs) and industrial firms points to a deepening economic slowdown in the world's second-biggest economy. Statistics bureau data released yesterday showed that combined profits at companies owned or controlled by the government dropped 12.2 per cent in the first seven months from the same period last year. But profits of private enterprises jumped 15.5 per cent over the period. At the same time, the National Bureau of Statistics said industrial companies' profits fell for a fourth month in July, adding to evidence that the mainland's economic slowdown is deepening. Income dropped 5.4 per cent last month from a year earlier to 366.8 billion yuan (HK$448.85 billion). That compares with a 1.7 per cent decline in June and a 5.3 per cent drop in May. SOEs are the instrument of choice whenever Beijing feels the need to rev up the economy. In the past decade, they have enjoyed the cheapest lending rates, myriad subsidies by way of land and other resources, and the monopolistic power to set prices. In the aftermath of the 2008 global financial crisis, banks lent record amounts to fuel expansion in the transport, construction and manufacturing sectors. The recipients were mostly from SOEs or the financing arms of city and provincial authorities and the goal was to tide the economy tide over a global recession. But declining profitability and a rapid build-up of debt in state firms indicate China can't afford a replay of the policy as the economy shows signs of another slowdown. Observers say private companies, which are more dynamic and productive, should play a greater role in the economy and demand greater policy support. Michael Pettis, associate professor of finance at Peking University, blames SOEs' falling profitability on "substantial capacity building" over the past few years and a "very weak" global environment, along with a rise in real interest rates amid easing inflation. Tsinghua University business professor Patrick Chovanec said: "A lot of people had said the second half would be good as the government would allocate resources to stimulate the economy." But, with SOEs incurring more losses, "much of the resources would be channeled to shore up certain struggling companies", including resources in the banking and fiscal systems, he said. Chovanec said there was evidence that many loans had been rolled over by banks for local governments, which, according to the National Audit Office, accumulated 10.7 trillion yuan worth of debt as of the end of 2010. Though many banks have so far reported a non-performing loan ratio of less than 1 per cent, Chovanec said 10 to 15 per cent of local government debt might eventually sour. State-run China Coal Energy said in its first-half results that oversupply caused a 4.1 per cent decline in net profit from last year. Fujian Cement, backed by the provincial government, said it suffered 96.6 million yuan in net losses in the first half compared with a 91.8 million yuan profit a year earlier. It forecast greater challenges for sales in the second half as cement prices kept falling. These are sharp reversals for the companies. In 2007, Fujian Cement had a 148 per cent rise in annual earnings while China Coal Energy's profit nearly doubled over the same period. Chovanec said SOEs had operated "as though the boom would never end", thanks to the low cost of expansion. "Now the boom has ended, and they find themselves very overextended." China's growth slumped from a sizzling 13 per cent in 2007 to just 7.6 per cent in the second quarter of this year as exports cooled amid the European debt crisis and a weakening domestic demand. Pettis said the SOEs also faced rising financing costs. He said the government ought to raise real interest rates sharply to force them to restrict expansion. In July last year, inflation surged 6.5 per cent, when the one-year lending rate was 6.56 per cent. The nominal lending rate has since dropped to 6 per cent, following two central bank cut rates to spur demand. But inflation eased faster to less than 2 per cent last month, indicating companies' real borrowing costs have risen sharply. But there's still no major overhaul of the state sector in sight. Professor Xu Chenggang, from the University of Hong Kong, said this was partly because of the "vested interest groups" among government bodies. "The substantial material benefit has made reforms difficult," he said. Independent economist Andy Xie said massive lay-offs at SOEs were unlikely. "The government will try to protect them for as long as possible. As long as the banking system has money, it will lend to keep SOEs alive," he said. Economists widely believe the best hope of reinvigorating the economy lies in private business, but Beijing's support so far has been inadequate. Beijing has launched trial programmes in Wenzhou, Zhejiang province, to encourage private financing. The Railways Ministry has also rolled out guidelines to involve private investors in railway construction, logistics, and equipment. But economists say the changes are too minor to encourage private investment. They say Beijing must legalise private financing, cut taxes, and let the market decide the cost of capital and where it should go. That would mean the government "must give up lots of controls", Chovanec said.