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SOE reform should provide right managerial incentives

By GONG GANG | 2016-10-20 | Hits:
(Chinese Social Sciences Today)


Workers at Shenyang Machine Tool Group prepare for a youth vocational skills contest.


The CPC Central Committee has repeatedly pointed out that the reform of State-owned enterprises should adhere to principles of the socialist market economy. In other words, the reform aims to make state-owned enterprises compatible with the market economy.

Currently, the Chinese economy has entered a new normal. The country no longer has the great surplus of labor that drove the previous stage of development, meaning that technological progress will be the sole engine of continued per capita GDP growth.

Technological progress can be divided into two aspects: progress based on foreign technology and progress through independent research and development. China’s technological development is closing gaps with the international frontier, while the space for imitation and introduction is shrinking.

Particularly in the high-tech field, introduction of technology is becoming more difficult due to stronger technology monopolies, stricter security measures as well as the increasing technological constraints of developed countries. Under the new economic normal, the main driver of China’s technology is independent research and development.

Innovative enterprises
Innovation is a process of transforming technology or knowledge gained through research and development into productivity. In the process, the knowledge framework includes basic, applied and enterprise-specific knowledge.

Technological innovation involves various entities, such as government departments, educational institutions, enterprises as well as professional sectors for research and development. In the entire innovation system, enterprises play a key role because they not only apply innovation to production but also engage in the development and accumulation of enterprise-specific knowledge.

Practice shows that unique technology reserves and knowledge stocks are essential if enterprises wish to maintain the lead in their respective sectors. Successful enterprises usually have their own research and development departments and invest a great deal of funds in them each year, accumulating a large amount of enterprise-specific technology or knowledge, such as designs, schematics and software.

Companies may not immediately put these technologies and ideas into production. They may not even apply for a patent, but choose instead to strictly guard them as trade secrets.
However, reserves of such kind ensure enterprises will maintain long-term technological leadership in the sector. Whenever products start to become obsolete in the market, companies will use other technologies in the reserve to develop or upgrade them.

The process of technological accumulation and innovation was dubbed “creative destruction” by Joseph Schumpeter, an Austrian-born American economist and political scientist. Such a process enables enterprises to continuously upgrade products and stand at the sector frontier.

Under the new economic normal, what kind of enterprises is most compatible with the socialist market economy? It should be noted that numerous private enterprises have been eliminated through market competition. At the same time, a number of State-owned enterprises—even those in sectors where competition is most fierce—have achieved healthy growth because they are suitable for the market economy, meaning that the form of ownership is not the decisive factor for survival.

For example, the State-owned Shenyang Machine Tool Group has managed to thrive in a competitive field. It developed the “i5” numerical control system, the world’s first intelligent and interconnected computer numerical control system, which is an epoch-making innovation in Chinese industry.

The following factors have contributed to the success of Shenyang Machine Tool Group. First, its cadres have stayed in the same positions for a long time. Also, the enterprise’s leadership originally relied on foreign and cooperative research in the early stages, but it came to recognize that independent research forms the bedrock of sustainable development.

A large investment in research and development contributed to its success: It spent a total of 1.1 billion yuan over five years. In addition, Shenyang Machine Tool Group has  patiently worked toward outcome from 2002 to 2016. Its success is a glimmer of good news for other State-owned enterprises, giving them hints on how to survive in the market economy.

Long-term profits
Whether a company is fit for the market economy is determined by corporate behavior. In standard economics textbooks, it is common to assume that the goal of a firm is to generate profits, and corporate behavior is guided by the idea of profit maximization.

It seems that the pursuit of profit maximization is the only way for enterprises to stay competitive in the market economy. However, the situation is by no means so simple. Economics textbooks usually focus on static analyses while paying no attention to different historical circumstances.

In fact, profits have two forms. Short-term profits refer to the current or near-term gains, and long-term profits are the sum of gains from now on until an indefinite time in the future.

These two kinds of profits cannot be complementary. They are contradictory and mutually exclusive in many cases. An increase in short-term profits may even harm the long-term interests of enterprises to such a degree that they will be eventually eliminated by the market. For example, companies can obtain more short-term profits by reducing investment in research and development of new products and technologies.

But the constant launch of new products and technologies is the source of competitiveness. Therefore, in order to survive in the market economy, enterprises must aim to pursue long-term interests rather than focus on the near future.

Unfortunately, many State-owned enterprises in China do not operate in this way. Some, myopically chase short-term profits at the expense of long-term interests. Some enterprise leaders have made wrong economic decisions because they lack an understanding of the market economy. But in more cases, the current cadre system is to blame.

At present, there is no clear division between political and commercial fields in China’s cadre system. Throughout their entire political careers, cadres are constantly cycling between positions at government agencies and enterprises. They are labeled “economic experts” due to their experience in enterprises, so they can work as both politicians and entrepreneurs.

While this cadre selection mechanism has cultivated countless professionals and cadres for the country, it sacrifices the long-term interests of enterprises in most cases.

Admittedly, all people aim to pursue some kind of self-interest when engaging in economic activities, and leaders of State-owned enterprises are no exception. The cadres tend to be more interested in political careers than serving the people. According to the cadre training system, the term of cadres in a work unit is generally six years. They are promoted according to indicators of job performance.

Such rules send a strong message to cadres that performance during the six-year term is the most important thing, so the pursuit of short-term interests will naturally become the goal of economic activities. In circumstances like this, few companies will be inclined to follow the path of Shenyang Machine Tool Group and make massive investments in research consistently over a decade.

Cadre appointment mechanism
A permanent cure is better than a temporary solution. The root cause of State-owned enterprises’ inability to adapt to the market is the cadre appointment mechanism, which encourages enterprises to chase short-term profits. Such economic behaviors are not suitable for the new normal.

To improve this situation, an optimized incentive mechanism is required so that leaders of State-owned enterprises can behave like private entrepreneurs, treating business growth as their long-term pursuit and the object of their political careers. At the beginning of appointment, the leaders of State-owned enterprises should acknowledged that it is no longer possible to leave the enterprise, unless they are downgraded due to sluggish business.

At the same time, State-owned enterprises should be allowed to gradually award administrative ranks—even to ministerial positions—as employees improve performance and vice versa. In this way, the leaders of State-owned enterprise can be encouraged in two aspects. First, their social status and influence will grow in tandem with business. Also, their administrative level will become higher in the process.

Behavioral changes with State-owned enterprises are necessary if China wishes to sidestep the middle-income trap and build an innovate economy . State-owned enterprises have unique advantages in terms of scale and financial capacity, so they are destined to become the innovative backbone of China.


Gong Gang is from the Financial Research Institute at Yunnan University of Finance and Economics.