What McDonald’s can teach Donald Trump about the value of China’s state-owned enterprises

At the heart of the trade war between the United States and China is Washington’s vehement objection to the prominence of state-owned enterprises in the Chinese economy. To the US, SOEs smack of unfair competition and represent a blatant violation of the rules of free and global trade. 

China, unsurprisingly, begs to differ. Beijing is so adamant about SOEs that it is doubling down, intensifying the role of the state-owned sector in open defiance of the US.

And in an ironic twist of economic logic, McDonald’s – the quintessential symbol of American capitalism – helps to explain why SOEs play a crucial role in China’s economy.

First, consider the problems of unmotivated managers, mediocre profits and low efficiency in state-owned enterprises, especially in comparison to other businesses, including foreign multinationals and private indigenous Chinese firms.

Indeed, these are the same challenges faced by McDonald’s – specifically, the inefficiency of its company-owned units in comparison to its franchised units.

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While the overwhelming majority of McDonald’s stores around the world are franchises, around 8 per cent of stores remain company-owned as of 2018. Under its franchising business model, McDonald’s trades access to its brand, operating infrastructure and resources to franchisees – and charges the restaurant operators a percentage of revenue in exchange, including rent (which could also be a percentage of revenue) and a royalty fee based on a percentage of sales.

Franchisees are therefore pressured but also supercharged to maximise sales to recuperate their hefty initial investments, pay McDonald’s royalty fees, and still keep a share of the sales. Indeed, from a purely profit maximisation perspective, it is generally more efficient to let franchisees run stores, freeing up investment costs and scaling up operations to cash in on the value of the brand name.

But if franchisees are more efficient and profitable than company-owned units, why not be 100 per cent franchisee-owned? It turns out that, while franchisees have good incentives to maximise sales, they are not as interested in building a strong company brand that ends up benefiting all other stores. This is where company-owned units come in.

To motivate managers of company-owned units to brand-build, however, McDonald’s has to discourage them from maximising sales by offering those managers remuneration packages that are not based on sales.

As a result, those managers will not be as hard-working as franchisees, which partially explains why company-owned units are less profitable, but they will spend more of their time and resources to build up McDonald’s brand, which in turn will help drive business to the franchises, ultimately benefiting all of the company’s stores. With both franchisees and company-owned stores, McDonald's can pursue both efficiency and brand building.

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In the same way, the Chinese government has chosen to keep both SOEs and private enterprises because SOEs provide a vital public good: social stability. Although SOEs are less efficient, the social stability they uphold creates an environment that all businesses benefit from.

When China began its economic reforms in 1979, the country had no social security system independent of the SOEs. Had the government quickly closed or privatised the SOEs en masse, a huge segment of the labour force would have been put out of work, with no safety net to catch them, posing a serious social problem for the state – not to mention the very real political risks it would face if widespread discontent were to bubble up across the country.

And so, despite the SOEs being much less efficient, with as much as 30 per cent surplus labour, the government chose to very gradually privatise them, keeping a fraction of SOEs as a second-best way to maintain social stability. In effect, the Chinese government is multitasking, juggling between social stability and efficiency.

After the 2008 global financial crisis, the US tried to encourage investment by firms and consumption by households with cheap credit. Success was limited because forward-looking firms and households would not invest or spend solely based on the availability of cheaper credit.

However, under China’s hybrid ownership structure, state-owned enterprises kept hiring and investing, offering the much-needed counter-cyclical balance and helping the Chinese economy rebound much faster than the rest of the global economy.

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Still, SOEs have their downsides. While providing much-needed social stability, SOEs have low efficiency and profitability. The advance of the state sector after 2008 gave the economy an immediate boost, but presaged the gradual slowing of the economy. And SOEs have a tendency to lobby for discriminatory policies against private firms. In particular, they have easy and cheaper access to bank loans, while private enterprises have to resort to underground banking and pay much higher interest rates.

However, private businesses have figured out how to survive and thrive in spite of an uneven playing field dominated by SOEs. One such strategy is pursuing large-scale philanthropic activities. Research by one of the authors of this article [Zhigang Tao] has found that corporate donations by private Chinese firms in the aftermath of the 2008 Sichuan earthquake led to strong positive reactions in the stock market for such firms.

The positive market responses were particularly pronounced for firms operating in regions with a higher degree of government intervention and perceived corruption. These findings suggest that non-state-controlled firms probably used their earthquake donations, which helped the local, regional and central governments in disaster relief (crucial for humanitarian reasons, but also to cement their political legitimacy), as a tool to win the favour of bureaucrats, improving government-business relationships and regaining some form of a level playing field under an authoritarian state capitalism model.

As the trade war intensifies, we can expect the US to continue clamouring loudly for a rollback of China’s SOEs, while China, precisely because of the slowing and uncertain economy caused by the trade war, will respond by strengthening the state-owned sector’s role in the economy. But the US must also understand that there is a long history behind China’s logic for maintaining SOEs – a logic that finds a curious counterpart under the golden arches of McDonald’s.

Zhigang Tao is professor of economics and strategy and director of the Institute for China and Global Development at the University of Hong Kong. Mary Hui is a writer based in Hong Kong