The current system of SOEs in China, wherein ownership and control rests in the hands of the government, could ensure better corporate governance in the community interest than the privatized system.

It is a truth universally acknowledged that a Chinese state-owned enterprise (SOE) in possession of industrial assets must be in want of reform. China’s reforms have released many assets into private ownership, but large blocks remain in corporations linked either to the central government or to a local government via chains of corporate ownership.

These state-linked enterprises (SLEs) can have minority private shareholders, but all key decisions are made by a Party Committee of top officers; senior appointments are made by the Party Organization Department; the ultimate responsibility for punishing corporate corruption is the Party’s Central Commission for Discipline Inspection. The State Council’s latest guidelines on the reform of SLEs envisage more private ownership, some mergers, and a greater role for state asset management companies in the control chain, but no significant changes in their governance. This has disappointed international observers such as The Economist, which pronounced the reforms “A Whimper Not a Bang”.

Would Privatization Strengthen Corporate Governance?

The only “bang” that would satisfy such prejudice is total privatization of state corporations. However, this would improve corporate governance only if private shareholders were better able to hold management to account than China’s current system. This would require a long list of institutional advances: an independent legal system, good accounting standards, independent, experienced business regulators and a government that is independent of corporate interests in drafting and enforcing corporate law. Such institutions would take China a long time to build. Until then, more and faster privatization need not improve corporate governance.

By contrast, Party control of top appointments ensures some accountability and punishment of truly egregious cases of corporate corruption—because this is in the interest of Party leaders seeking to maintain the legitimacy of Party rule. Moreover, China’s immature business institutions would allow the wealthy and well-connected to loot state assets during a Big Bang privatization. This happened in Russia, tipping its political economy into the downward spiral that continues today.

Although China’s private corporations earn a higher return on capital than SLEs, total privatization need not raise SLE returns. The typical private corporation in China was created by an entrepreneur who remains dedicated to building its business. By contrast, each of China’s remaining SLEs is so large that no private individual is likely to buy all its shares; ownership would likely be fragmented amongst individuals seeking to diversify their portfolios. Whoever ends up in control of a corporation that s/he had not built up personally might well focus on expropriating minority shareholders through subterfuges like related party transactions. Scholars have documented how this has happened repeatedly in other East Asian economies—when their business institutions were more advanced than that of China today.

China has embarked upon a serious attempt to improve accountability and eliminate corruption within the Party. Success is not assured, but is much more likely than that China will set up an independent legal system that could hold corporate management to account. For, strengthening the Party’s internal governance allows top leaders to keep control while enhancing Party performance and legitimacy, whereas strengthening an independent legal system would require top leaders to relinquish some control. Therefore, in SLE supervision, it is surely more realistic to rely upon a Party organization that is strong at the top and strongly motivated to improve than to rely upon private shareholders who would have to operate via a legal system that is weak and unlikely to improve anytime soon. China’s tradition of tight supervision of its state officers goes back to the Legalism enunciated by Han Fei in 233 BC and practiced by the Qin state; it makes no sense to now rely instead upon quick implantation of a legal system whose institutional and political roots in the West go back at least that far—to the Roman Republic.

The US has business institutions much more advanced than China’s, yet scholars have documented hundreds of failures of US corporate governance. These include: excessive executive salaries that bear no relationship to performance, interlocking directorships, accounting manipulations to maximize the value of executive stock options, etc.. The most notorious example is the 2008-09 financial crisis: Wall Street executives brought this on with massive deception and fraud that destabilized the global financial system, yet they kept their bonuses and evaded punishment. This was because they had made financial transactions so complex that to prove any individual’s culpability would have required legal processes that would have been prohibitively expensive, given the multiple opportunities to stall and manipulate those processes. China’s has less mature institutions to support shareholder supervision of top executives, so faster privatization of SLEs might well worsen corporate governance.

Taxation and Globalization

All taxation of ongoing economic activities creates economic inefficiencies by distorting price signals between buyers and sellers. Yet, all governments need revenue. So if a government currently owns assets that yield a decent return and it is not clear that the return on those assets would be raised substantially by privatization, then this would be unwise since the later extraction of tax revenue from the privatized assets would certainly lead to inefficiencies.

Even worse dangers from total privatization are illustrated by the collapse of US government revenue from corporate taxation (from about 30% of total revenue in 1955 to about 11% in 2014), which has exacerbated its budget deficits. This collapse reflects increased corporate use of creative accounting to exploit loopholes in the complex tax system, especially the manipulation of transfer pricing amongst subsidiaries to shift profits to offshore tax havens: US corporations hold an estimated $2.1 trillion there. By retaining state ownership and central control of corporate appointments, China could guard against such revenue losses: as owner, the state could insert inspectors directly into corporate accounting offices, insert representatives directly into corporate boards to report to party disciplinary committees and summarily dismiss corporate executives who engage in subtle forms of corruption and tax avoidance, without having to demonstrate culpability via a legal process.

The globalization of US corporations has enabled top corporate managers to elude the supervision of their national regulators and the control of their shareholders by buying off and manipulating their boards of directors. The same would surely happen in private Chinese corporations as they globalize. These more general concerns provide more general reasons to retain state ownership and central control of top corporate appointments in order to retain the useful powers noted above.

The End of the Invisible Hand

US political economy seeks to separate politics from economics by law, which is inherently national in reach. This has allowed the US to grow into the most powerful economy. The result is pride and prejudice in favor of the Invisible Hand: the notion that business leaders have no responsibility to their community, only a responsibility to get rich. However, the invisible hand of the market works in the community interest only when buyers and sellers share the same information. This is not true of complex products, such as financial instruments and executive leadership.

In the important cases noted above, US corporate governance has failed and US corporations have evaded their communal responsibilities. What these cases share is the exploitation of complex legal and accounting rules to increase the asymmetry of information between shareholders and national regulators on the one hand, and the corporate elite on the other. This problem will only get worse with advances in information technology and the globalization of business, which increase the corporate elite’s informational advantages over shareholders and taxpayers.

In these circumstances, China’s system of state ownership and control of strategic assets and centralized appointment of corporate managers could end up ensuring better corporate governance in the community interest than the privatized system advocated by Western critics.

Leslie Young is Professor of Economics at CKGSB.