internet companies vs. state-owned enterprises in China

Recently Beijing announced it wants to take equity positions in the major internet companies in China and place Communist Party officials on their boards of directors.

What’s going on?

I see two general possibilities.

Some background first.

Deng’s economic reform

In the late 1970s, Deng Xiaoping realized that the Chinese economy was too big to be controlled through central planning.   To grow it had to adopt Western economic (but not political) methods.  So he began to allow the market, not doctrinally-correct political cadres, to dictate the direction of expansion.

A major issue he faced in doing so was that, say, three-quarters of Chinese industry was owned by the state.  These companies were rudderless, and hopelessly inefficient–but they employed tons of people.  If large numbers lost their jobs all at once, the ensuing social instability might threaten the rule of the Party.  Therefore, economic progress had to be tempered by the need to avoid this outcome.  And this in a nation without sophisticated macroeconomic tools to control the pace of growth.

The result over three+ decades has been a Chinese economy that lurches between boom and bust, depending on the temperature in the state-owned enterprises.  The strategy has generally been successful, I think, with the state-owned sector now representing less than a third of China’s overall output.

possibilities

–China’s internet companies have become large enough that their actions, intentional or not, can accelerate the speed at which state-owned companies shrink.  So they need to be monitored much more carefully than in the past.  This is the benign interpretation, and the one which share prices suggest the market has adopted

–China’s internet companies have become large enough to generate “creative destruction” in large enough amounts to threaten the economic control over China exercised by the Communist Party itself.  If this is the case, then the oversight over domestic internet conglomerates will be much more draconian than the consensus expects.  That would presumably result in considerable PE contraction for the firms being controlled.

My guess is that the first possibility is much more likely to be the case.  But I think we should watch the situation closely for new hints about Beijing’s intentions.

the Chinese economy (i): background

size by GDP

According to the CIA World Factbook, the US is the largest economic power on the globe, with 2013 GDP (calculated using the Purchasing Power Parity method) estimated at $16.7 trillion.

The EU is a close second, with GDP of $15.8 trillion.

China is in the #3 spot, with GDP of $13.4 trillion.

Together, the trio make up about half the world’s GDP.  (A quarter century of stagnation has left former co-#1, Japan, a mere shadow of its former self, with GDP of $4.7 trillion.)

China’s economic strategy

Since turning away from central planning toward a market economy under Deng Xiaoping, China has faced two related issues:

–creating enough new jobs to absorb new entrants to the workforce, thereby avoiding political instability, while at the same time,

–reining in the inefficient, loss making, often corrupt state-owned industrial sector, which accounted for three-quarters of all employment in the late 1970s.

Two other constraints:  China had to do this without an effective central bank and with a cadre of state and local government officials who thought (many still do) that the fastest and most lucrative road to the top was to create more labor intensive, inefficient (and corrupt) local analogues of big state-owned enterprises.

China has achieved spectacular economic growth by embracing capitalism.  To some degree, the remaining state-owned sector, which now accounts for just over one quarter of the economy, has also shaped up.  But while doing this, China has tended to lurch between periods of substantial credit restriction to try to force state-owned enterprises to become more efficient or die, followed by excessive expansion when layoffs become too severe.

the latest wrinkle

Emerging economies, following the post-WWII Japan model, start by offering cheap labor for simple manufacturing businesses, so that they can acquire training and technology from foreign firms.  At some point, a given country will run out of labor.  It must then transition to higher value-added endeavors.  Few succeed without a lot of heartache, because–I think–vested interests attached to the status quo are so powerful.

China now finds itself at this transition point, an issue which dominates its current economic policy.

More tomorrow.