China economy

China’s innovation drive should first target its grossly inefficient state-owned companies

Winston Mok says improving the productivity of these lumbering giants, many in sectors that affect the entire economy, will bring more benefit than just nurturing start-ups

PUBLISHED : Tuesday, 23 February, 2016, 10:18am
UPDATED : Wednesday, 26 October, 2016, 2:59pm

Why has Beijing set innovation as the next growth engine? There may not be many other options left. With the working population now declining, there are no more surplus farmers to be converted to factory workers. Many hidden costs, such as poor safety, are coming into the open and migrant workers expect fairer treatment. Citizens no longer accept the high costs of pollution, and China is suffering from chronic overcapacity.

China got to where it is not just through cheap labour and investment, but also through innovation

China got to where it is not just through cheap labour and investment, but also through innovation. Innovation need not come from new technologies or even new business models. As defined by economist Joseph Schumpeter, innovation is the creative destruction of inefficient enterprises by more productive ones.

Since the implementation of economic reforms, many inefficient state-owned enterprises have first been replaced by more nimble township and village enterprises and, later, by private enterprises. In 1978, nearly all urban residents were employed by the state. Now that figure is fewer than 20 per cent. What remain of the state-owned enterprises are giants in protected industries such as resources, heavy industries, banking and telecommunications. But they remain far less productive than private enterprises.

READ MORE: Why China cannot repeat the success of US’ Silicon Valley model of innovation

The service sector, which has surpassed manufacturing to become the largest part of the economy, may represent the biggest opportunity for productivity improvements. Compared to manufacturing, it has lagged behind in productivity growth. One reason may be the continued state dominance in many service industries.

Making China’s state-owned enterprises more efficient will be a better way to improve productivity than mass start-ups – most of which will fail. And reforming the state-controlled telecoms and banking sectors will improve the odds for start-ups to succeed. Inefficiencies in these sectors have widespread ramifications. As the whole economy depends on them, poor, limited or expensive services in banking and telecommunications inhibit overall growth.

READ MORE: Profits at China’s state-owned enterprises poised to plunge further

Other than by privatisation or introducing fully fledged direct competition, one important way to promote efficiency is through better regulations to protect consumer welfare. International benchmarking can be used to set tariffs, and hold managers of state-owned enterprises accountable to world-class efficiency standards. Importantly, China needs more independent regulators.

Mobile providers leasing network resources – like Virgin Mobile – could be encouraged. Since 2013, many such licences have been granted in China. The regulatory framework should ensure a level playing field. Through advanced mobile services, Japan has developed a vibrant mobile game industry whose players dominate the world.

READ MORE: Chinese banks hand out record HK$3 trillion of loans in bid to bolster mainland’s slowing economy

The state-dominated banking industry can cause serious harm to healthy private firms, beyond insufficient lending. For example, cross guarantees among unrelated companies have allowed banks to expand their credit while avoiding proper credit analysis. Such an irresponsible approach, unheard of outside mainland China, has created the risk of contagion, causing the downfall of otherwise sound companies. This has happened because of the unchecked power of major state-owned banks.

China’s state-owned enterprises are half as efficient as their private counterparts. Closing this gap is a huge opportunity for productivity growth

Some state-owned banks continue to prefer lending to state-owned enterprises. In addition to allowing more private sector banks to be established, there are other measures to encourage lending to private enterprises. A new policy bank targeting small and medium-sized enterprises could be set up.

Innovation is not just about some young kids attempting to create the next Apple. It is about working smarter across all sectors more productively. China’s state-owned enterprises are half as efficient as their private counterparts. Closing this gap is a huge opportunity for productivity growth. Fixing China’s state giants is just as important as letting thousands of start-ups bloom. Improving the governance of state-owned enterprises is a key step in China’s path to innovation.

Winston Mok, formerly a private equity investor, is a private investor