Why China Fails:
Innovation and Creative Destruction in the PRC
Paco VervaetInstructor: Dr. F. de Zwart
Leiden University - Political Science Bachelor Thesis Student number: s1745794
Word count: 7905
Table of Contents
Introduction ... 1
Method ... 2
Conceptualizing Innovation and Creative Destruction ... 3
Innovation: Combining the old into the new ... 3
Creative Destruction: The new rendering the old useless ... 4
Relationship to Development ... 5
Section I: The Chinese Economy: A Quantitative Analysis ... 6
Innovation ... 6
Creative Destruction ... 11
Section II: Control, Innovation and Creative Destruction in SOEs ... 14
Innovation in SOEs ... 15
SOE Ownership and Management Structure ... 16
Why the Low Innovation? ... 20
Discussion ... 24
Conclusion, limitations and further research ... 25
References ... 27
Introduction
Chinese economic growth is unsustainable. In their well-received book Why Nations Fail, Acemoglu and Robinson (2013, pp. 437-443) are clear in their claims about the People’s Republic of China (hereafter referred to as “China” or “PRC”): because of its extractive political institutions “the spectacular growth rates in China will slowly evaporate” (p.442). They purport that its recurring and profound state interference leads to a lack of innovation. As a result, the Chinese can only participate in catch-up growth, based on the adoption of existing technologies and rapid investment.
In this relatively short passage of their book, the two authors claim that there is no “real innovation” (p.442) in the Chinese economy, yet provide no countrywide quantitative proof for this. Contrary to their claim, we find that the spending of Chinese companies on Research and development has grown tremendously during the last decade (Fan, 2014, p.727), and that the Chinese government announced a colossal strategic plan “Made in China 2025”, that aims to foster innovation in the economy (Li, 2018, pp. 67-68). It is thus quite precarious to state that there is a total lack of Chinese innovation, and, admittedly, this is not entirely what Acemoglu and Robinson do.
The authors claim that China has an extractive system: political and economic institutions designed by the elites to extract resources from the rest of society. They purport that extractive institutions are the source of most – if not all - evil in development. In extractive systems, innovation does not lead to the destruction of earlier, less efficient and effective production factors. This lack of creative destruction is a result of the elite holding on to its economic power. It blocks innovation so its earlier investments remain lucrative and the balances of power stay unaltered. Consequently, not only is there a lack of innovation incentive within the economy, all obtained innovation will inevitably fail because the elite will block it.
If China does indeed lack innovation and creative destruction, the economic and geopolitical rise of the country will eventually fall short. A country lacking innovatory capacities will – by definition - lag behind the innovatory powers, and will never be able to become the global superpower it wishes to become. If we wish to comprehend China and its role in the future global order, it is thus of vital importance to assess its innovatory capacities. That is the main aim of this thesis and to do this, I will investigate two questions: (1) “To what extend does China innovate and creatively destruct?” and (2) “Is there a Chinese elite blocking creative destruction, and thereby innovation?”
Method
To come to a full understanding of China’s innovatory capacities, I use a sequential mixed method research design: a quantitative approach, followed by a qualitative one. First, I estimate the amount of innovation and creative destruction in the PRC through proxies based on country-wide economic data. This quantitative approach will help me answer the first research question and make broad statements about the whole country. While it provides hard data about the existence and non-existence of the concepts discussed, it exposes little of the mechanisms behind them. Therefore, the second section of this thesis is an in-depth research of the innovatory environment of centrally administered state-owned enterprises. This qualitative “most likely case design” will provide the information needed to map out the political powers at work. If we cannot find an obstruction of creative destruction in firms owned by the elite, chances are small we will find it anywhere. By combining these two approaches, I aim to come to a clearer view of China’s innovatory capacities, and the role of creative destruction in this respect.
Conceptualizing Innovation and Creative Destruction Innovation: Combining the old into the new
Humans have always innovated themselves out of problems. Ever since our ancestors developed the skills needed to use tools, innovation has been the key to improving our life standards. Nonetheless, defining and conceptualizing innovation is tricky. Schumpeter, the 20th century economist who created the academic field of innovation research, defined it as the act of carrying out “new combinations” of existing resources (1934; as described in Shah, Gao, &, Mittal, 2014, p.3). There is thus an important difference with the associated concept invention: while an invention is the first occurrence of a new idea, innovation is the act of actually carrying it out.
New ideas are not limited to new products. Schumpeter distinguished five different types of innovation: “new products, new methods of production, new sources of supply, the exploitation of new markets, and new ways to organize business” (1934; as described in Fagerberg, Mowery, Nelson, 2005, p.6). As can be seen, innovation is not always an unreservedly positive story; the disappearance of the Inca empire proves that Columbus’ discovery of new sources of supply and a new market was anything but a happily ever after story. Nevertheless, most innovation is assumed to have positive effects.
These potential positive effects are the innovators’ incentive. In capitalistic economic systems, firms compete for economic rewards, and do this by innovating. This innovation incentive plays a crucial role in development theories like Acemoglu and Robinson’s. These theories, based on the Marx-Schumpeter model of technological competition, adhere to the idea that, by promoting innovation, competition will drive the economic development of society as a whole (Fagerberg, Mowery, Nelson, 2005, p.14). An innovative environment is thought to be linked to a developing one.
This idea is supported by Schumpeter’s (1939) and others’ (f.e. Carter, 2007, p.13) observation that innovation is geographically clustered: there is a difference between countries in the amount of innovation done. In his influential paper “International trade and technical change”, Posner (1961) first theorized that fluctuations in the economic output gap between developed and underdeveloped countries are a result of two processes: innovation and imitation. The first one enlarges this gap, as rich countries innovate and become richer; the second one reduces the gap, as poorer countries “catch up” with richer ones. Acemoglu and Robinson (2013, p. 442) claim that China lacks innovation and will consequently be stuck in a phase of imitation. If this is true, it would mean that the country will forever have to catch up with its geopolitical rivals in the West.
Creative Destruction: The new rendering the old useless
Progress in modern economies inevitably involves the destruction of older industries to make room for new ones (McKnight & Kuehn, 2012, p.105). Mechanic watches were replaced by electric ones and in turn, electric watches were replaced by quartz ones, consistently rendering the newly outdated industry obsolete. This is creative destruction. Innovative methods of production give competitive advantages to firms using them. Consequently, these (mostly new) firms will overtake their less competitive rivals, and the less productive methods of production will become useless and disappear. Just like he did with innovation, the great economist Schumpeter (1943) opened up this field of research. Since then, the literature on this interesting subject has grown tremendously.
One area within this field that is of explicit interest to our research question is the influence governments can and should have on the amount of creative destruction done. It seems that policies can enhance or decrease it, by for example influencing the demand for new technologies (Langlois & Steinmueller, 1999; Hargadon & Douglas, 2001). The United States are a renowned example of an environment in which creative destruction is governmentally
supported - almost stimulated (Nemet, 2009). Conversely, there are various cases of governments blocking creative destruction (Acemoglu & Robinson, 2013, pp. 213-245). Overall, there is a scientific consensus that the amount of creative destruction can be influenced by governments. Whether creative destruction should be welcomed or rejected, however, is a more challenging question. It has been found to be a double-edged sword: on the one hand, innovative entrepreneurs bring economic development; on the other hand, they bring the destruction of existing production facilities. While we often look down on historic reactionary forces battling innovations, like the automation of the textile industry, influential 21st-century thinkers (f.e. Harari, 2018, pp. 19-44) warn us for social unrest following the waves of creative destruction of the fourth Industrial Revolution. Creative destruction was, is and always will be a process of winners and losers.
Relationship to Development
Innovation and creative destruction are two concepts inextricably intertwined; some authors even go as far as incorrectly using them coterminous. Nevertheless, a conceptualization of the two would be useless without a discussion of their relationship. It is important to understand that these are two distinct phenomena: innovation is the act of implementing new combinations of existing resources; creative destruction is the former’s negative externality to already existing industries. In this sense, creative destruction is thus an effect of innovation. However, it is also a prerequisite of it: without creative destruction, no true innovation. We cannot have one without the other.
As long as the existing ways of doing things are protected, new inventions cannot be implemented. In systems with extractive institutions, like many authoritarian states such as China, the existing production facilities generally belong to a powerful elite. So as not to lose the return on their investments, the elite will block any kind of innovatory activity. As such, the absence of creative destruction prevents innovation.
Subsequently, without innovation, development and economic growth will cease. The effects of the former on the latter have been shown by various writers. Greenstone and Looney (2011) provide an interesting overview. Research shows that “innovation drives economic growth and raises wages” (p.3), which can be seen in the enormous rise of real hourly compensation of workers due to technological innovation and productivity growth between 1947 and 2011. This productivity growth is vital to the causal model of innovation driving development: innovation enlarges the economic “pie” to share.
This train of thought is used by Acemoglu and Robinson (2013) to put forward a theory on the development of China: through its all-encompassing political power, they argue, the Chinese Communist Party will protect its investments by consistently blocking innovation. As a result, only catch-up growth (or: imitation growth) can be achieved, inevitably leading to an eventual stand-still of the Chinese economy. The Chinese miracle would come to an end. That is what this thesis is about: the existence or non-existence of innovation and creative destruction in the PRC, and the role the Chinese Communist Party (CCP) plays in this.
Section I: The Chinese Economy: A Quantitative Analysis
In this section, I quantitively assess the amount of innovation and creative destruction in the entire Chinese economy.
Innovation
Can we observe innovation in the PRC? With relative ease, one can find anecdotes of recent Chinese innovations, opposing those used in Why Nations Fail: in 2016, Chinese scientists built the Sunway TaihuLight, at the time the world’s fastest computer, relying only on domestic technology (Vincent, 2016); the world’s top drones are created by the Chinese company DJI; and while many claim that the Chinese ride-sharing app Didi has copied Uber, the app has gained its dominance on the Chinese market by providing innovative features, such as a service to pick up your car when you have had too much to drink (Wenderoth, 2018).
While such anecdotes can be quite convincing, they should not be used to classify China as being innovative, and neither should countervailing examples be used to classify it as lacking innovation.
Unfortunately, reliably measuring innovation is hard. While earlier indicators relied on productivity gains, Coombs and Miles (2000) note that this has become unwarrantable due to the rising importance of service industries in modern-day economies. Modern agreed-upon indicators are based on the in- and output of the innovation system (Greenhalgh & Rogers, 2010, pp. 58-64). While these measures are currently the best available, they should be used with caution for two reasons. First, the data lack a globally agreed upon measurement system: different countries use slightly different methods, causing slightly differing results. This makes cross-country comparisons risky. Secondly, data is potentially misleading because it is territorially-based. It includes foreign companies with Chinese headquarters, but excludes nationals living abroad.1 Even so, the in- and output measurements provide a far more accurate
1 A variety of authors have persuasively criticized the practice of measuring innovation on a national
level (see f.e. Asheim & Coenen, 2005; Angel, Wieczorek, Berkhout, 2009; Binz, Truffer, & Coenen, 2014). Following the globalization of large parts of the world’s economies, innovatory activities have become increasingly internationally oriented. Although most of corporate Research and Development (R&D) is still done in firms’ home countries, foreign R&D increases rapidly (Wieczorek, Hekkert, Coenen, Harmsen, 2015, p.132). If we take a closer look at China, we see that Chinese companies have built and acquired R&D-facilities in multiple European countries, while at the same time the number of foreign R&D-centers in the PRC has gone from 600 to 1200 during 2004-2010 (Abrami, Kirby, & Mcfarlan, 2014). Similarly, non-company-based university research has acquired an increasingly international character with researchers moving and cooperating around the globe. As a result, innovation is becoming less and less of an old-school national activity and territorially-based data loses some of its relevance.
view on innovation than anecdotes do. Greenhalgh & Rogers (2010, pp. 58-64) provide a useful overview of innovation measurement methods used. I will follow this view and apply it to China.
In- and output indicators.
The amount of resources spent on Research and Development (R&D) (i.e. the input) serves as a useful proxy for the innovatory activities of an economy. One can straightforwardly compare this input of financial as well as human capital between countries. While Chinese expenses on R&D were negligible during most of the 1990’s, they showed a remarkable growth during the 2000’s (Figure 1). In 2009, R&D comprised almost 1.8% of the GDP. Around the same time, the mean R&D expenditure rate in OECD countries was 2% of the GDP (OECD, 2013, p.82). A remarkably small difference.
Figure 1. China’s R&D expenditure and Its Percentage of GDP, 1991-2009 (Fan, 2014, p.727)
If we look at the amount of human capital used in Chinese R&D, we see a similar phenomenon: an extraordinarily small number of researchers per million inhabitants until 2000, but a doubling of said number in the next decade (Fan, 2014, p.728). As a result, China had already surpassed the United States in total number of researchers in 2007. At the same time, considering the Chinese population is significantly larger than the American one, the relative
number of Chinese researchers is still quite low. This is but a fourth of the US (Fan, 2014, p.729).
Secondly, it is interesting to examine the output of R&D-projects. The most-used proxy for this is the amount of patents issued (Greenhalgh & Rogers, 2010, p.60). One must be particularly wary when talking about Chinese patents; the country implemented modern patent law less than three decades ago and has repeatedly received criticism on its protection of intellectual property rights. Therefore, I focus on patents issued by the World Intellectual Property Organization (WIPO), an internationally recognized institution of the United Nations.
From 2001 to 2011, Chinese patent applications rose by an astonishing 1400% (Fisch, Block, & Sandner, 2016, p.62). Nevertheless, in comparison with its demographic and economic size in 2009, the amount of WIPO-patents issued to Chinese inventors remained rather low; China ranked but fifth globally (WIPO, 2010). In recent years, the roaring growth of patent applications by and patents issued to Chinese inventors continued. While the worldwide number of yearly applications fell by 4.5%, the number of Chinese applications rose by almost 30% (WIPO, 2010). Giant leaps are taken, and it is quite clear that in the near future, China will claim its logical place in the global patent rankings.
The surge in patent applications and grants following China’s 2001 WTO-entry opened an academic discussion about how this could happen and whether this meant that China had become an innovatory power. Li (2012) examined various posited hypotheses for the increase, like intensification of R&D investment, the pro-patent legal change, and the emergence of fertile (i.e. promising) technologies. While all these were found to contribute, none could comprehensively explain the whole picture. She found that the upsurge can be best attributed to local government programs subsidizing patent-applications, programs much-criticized for putting quantity over quality. This conclusion spoke for the critics, claiming that the increase in volume does not represent an increase in quality. They purport that China is far from being
intellectually dominant and that the actual cutting-edge innovation patents are still primarily given to North Americans and Europeans (Cyranoski, 2010). To accurately assess the innovation output, it is thus of vital importance to not only look at the amount, but also at the quality of Chinese patents.
Dang and Motohashi (2015) provide thorough research on the methodology of measuring patent quality in Chinese context. The most widely-used proxy for patent quality, originally put forward by Trajtenberg (1990), is the amount of forward citations. Dang and Motohashi (2015) chose to use data from the Chinese patent office (SIPO). Compared to WIPO data, this provides a better view on Chinese patents because it can be connected to other data of the firms, which in turn provides new methods for research. Unfortunately, it does not contain any citation information and they were therefore unable to examine the amount of forward citations as a proxy for patent quality. However, they found that the amount of acquired patents by a firm correlates with its R&D expenditure and financial output, and is thus a useable, yet only informative, indicator of innovation in Chinese context. When they put the data and following methods to the test, they concluded that the patent quality represents problems, but did not totally fall behind. While we should thus take the upsurge in patents with a pinch of salt, it does represent an increase in Chinese innovatory activities.
In the paragraphs above, we gained a quantitative understanding of innovation in China. It was striking to see that, after the turnover of the century, Chinese innovatory activities have grown at such an impressive rate. The country has surpassed many developed countries in absolute numbers of innovatory in- and output. Nevertheless, relative numbers concerning human capital and patents remain low, and there are doubts about the innovations’ quality. In this regard, China is still catching up with the West.
Creative Destruction
Can we observe creative destruction in the PRC? Acemoglu and Robinson would not entirely object to the claim that some amount of Chinese innovation exists. Within extractive institutions, it is possible to have catch-up growth, followed by something that might make us think of innovation. The authors do however claim that, as long as it has extractive political institutions, China will not have “real innovation” (2013, p.442). The reason for this: a lack of creative destruction.
Operationalization.
Measuring creative destruction is even riskier than measuring innovation. Statistics of the amount of capital, labour, or any other measure of economic value that is lost due to rival innovatory activities are hard –yes, nearly impossible- to find. Few victims of creative destruction know exactly how much they have lost and close to none will report it. Direct, exact statistics simply do not exist. In-depth research attacking this methodological problem is rare. Scientific articles primarily focus on the relationship between Total Factor Productivity (TFP) and creative destruction (e.g. Brandt, Van Biesebroeck, & Zhang, 2012; Bosma, Stam, & Schutjens, 2011; Bartelsman & Doms, 2000). There, they pay a lot of attention to the correct measurement of productivity, while quickly forgetting creative destruction. Most authors use the amount of firms entering and exiting the market, i.e. turbulence, as a proxy for creative destruction. However, this approach has its limitations.
For instance, it does not take into account the magnitude of the creative destruction that is happening. The (dis)appearance of a multi-billion-dollar company is counted as one unit of creative destruction - exactly the same as the (dis)appearance of a medium-sized one. Fifty-thousand colleagues losing their job are given the same weight as one local entrepreneur going bankrupt. This absurdity has profound implications on the relationship between Acemoglu and Robinson’s conceptualization and the turbulence-operationalization: they measure something
plainly different. In the authors’ model, creative destruction is implicitly valued at the amount of social unrest it creates and the effect this has on the elite’s clout; important are the changes in political relations. In the turbulence-operationalization, however, creative destruction is valued in a non-political way: the number of firms that enter and exit the market. While this could be said to be related to social unrest, it is in no way the same. Consequently, there is a difference in the relationship between creative destruction and the elite that is assumed in the conceptualization and the one assumed in the operationalization. In Acemoglu and Robinson’s model, the elite is the victim of creative destruction. In the turbulence-operationalization, however, this is not the case. There, more weight is given to the disappearance of small firms than to the disappearance of big ones. If we assume the elite generally owns larger firms, a lot of turbulence is not necessarily a problem for them. If they can use their extractive institutions to protect their own, bigger, companies, they can allow for some turbulence at the bottom. Creative destruction, in this sense, would not affect their political power. There is thus a misfit between Acemoglu and Robinson’s conceptualization and the turbulence-operationalization.
In addition to this, the turbulence-operationalization does not take into account creative destruction happening within companies. Say, an invention renders a large firm’s production facilities useless. If the same firm has developed that invention or if they can replicate it, this does not necessarily lead to the firm’s bankruptcy. If its reserves are large enough, if they are “too big to fail”, the company might be able to adapt to the new circumstances. Nevertheless, the innovation will lead to a significant shift in production facilities – some people might be fired, the company might lose previous investments, and it might lose money for a while. Creative destruction would be happening without firms entering or exiting the market, and would thus be invisible in the turbulence-operationalization data.
Nevertheless, I aim to investigate Acemoglu and Robinson’s claims about innovation and creative destruction in China in the best way possible, a way that goes beyond anecdotal
evidence. While the turbulence-operationalization has its limitations, creating a new and better measurement of creative destruction goes far beyond the reach of this project – and, indeed, my capabilities. I will therefore use this measurement that, even though it has its downsides, gives an indication of Schumpeter’s concept.
Turbulence in the Chinese economy.
So what does the turbulence-operationalization display when applied to China? Brandt, Van Biesebroeck, & Zhang (2012) investigated the relationship between creative destruction and productivity growth, and by this provide useful data on Chinese creative destruction. Using firm-level data, the authors measured creative destruction with a turbulence-operationalization. Everything considered, they found that, between 1998 and 2007, China had a relatively high firm turnover rate (i.e. turbulence) (p.342; p.345), and thus creative destruction. Furthermore, the resulting resource reallocation contributed positively to aggregate productivity (p.347). In their conclusion, the authors go as far as claiming that Chinese productivity growth, especially at the industrial level, is “reflecting the dynamic force of creative destruction” (p.351). They claim that creative destruction was the source of two thirds of China’s productivity growth - an even larger part than in for example the US industry (p.340). Thus, not only did they find creative destruction, they also found its effects.
Aware of the power of the Chinese government, one might suspect this destruction to be only happening in private companies. This, however, seems to be untrue. The reforms of State-Owned Enterprises (SOE) during the turn of the century resulted in mass SOE market exits, all in the aim of improving efficiency (Ho & Young, 2013). The Chinese bureaucracy closed many old and unproductive firms. So much that between 1998 and 2008 the exit rate for SOE’s was higher than for private companies (Zhou, He, & Zhu, 2017). Where the state left the industry, entrepreneurs could fill its shoes. Compared to younger firms, the exit of firms older than four years - like SOE’s - reallocates more resources, thus causing a larger amount of new private
firm entries (Zhou, He, & Zhu, 2017, p.291). As a result of massive SOE market exits, the cycle of firm entry and exit was able to take off, and the effects of creative destruction can be seen.
I conclude that –largely due to the privatization of many SOE’s- creative destruction started and can now go on affecting the whole economy. While this data does not provide any evidence of the elite not blocking any innovations, it does indicate that at least part of the economy is subject to creative destruction.
Section II: Control, Innovation and Creative Destruction in SOEs
The quantitative data and results above teach us something about the Chinese economy as a whole – private, public as well as semi-public firms. Nevertheless, it teaches us little about the innovation-influencing mechanisms at work. Quantitative measures are seldom perfect and those used earlier were shown to have substantial shortcomings. As a result, to comprehend the mechanisms of the Chinese innovatory environment, one has let go of the broad picture and use more focus.
Centrally managed SOEs offer a perfect subject for this purpose. First, they account for 30-40% of China’s observable GDP 2, have been claiming an increasingly important role in the last decade, and are expanding their activities towards superfluous sectors (Yu, 2013, p.180-182). SOEs are of significant importance in the current -and future- Chinese economy. In addition to this, their relationship with the elite (the CCP), which is claimed to influence innovation, is slightly more straightforward than private companies’ CCP connections – a characteristic that offers research perspectives. While there is a large number of SOEs (19 273
2 Measuring the state sector is a nearly impossible endeavor. While everybody agrees on the
importance of SOEs to the Chinese economy, definitive numbers are hard to find. For an interesting discussion on this, see: Lin & Milhaupt (2013, p.702).
in 2016), only 102 are central SOEs. The latter are administered by the national State Council, through its State-Owned Assets Supervision and Administration Commission (SASAC) (National Bureau of Statistic of China, 2016); these are the (in)famous ones like China Mobile and Sinopec. My research will focus on central SOEs.
In this section, I answer the question: Is there an elite controlling the SOEs, and if so, does this influence innovation in the respective sectors? First, I briefly compare SOEs to private firms in terms of their innovatory capacity. This will be followed by a description of the ownership structure of SOEs. The section concludes with an analysis of the mechanisms that affect the innovation in industries in which these SOEs operate.
Innovation in SOEs
The post-1993 SOE-reforms are claimed to have significantly enlarged their innovation capacity (f.e. Jefferson & Rawski, 1994; Lundvall, 2016, pp. 282-289). Acemoglu and Robinson (2013, pp. 437-443), too, describe how Deng Xiaoping’s “Open and Reform” move towards more inclusive institutions has significantly improved the Chinese economic environment – and, to some extent, the innovatory one. Nevertheless, in comparison with private sector industries, SOE-dominated ones are still noticeably lacking innovation. Various research has demonstrated the innovation disparities between Chinese SOE- and private-led sectors.3 A plethora of indicators show that SOEs lag behind in innovation capacity. For example, the average growth of total factor productivity in the state sector was 1.52 percent/year, whereas in non-state sectors this was 4.56 percent/year (World Bank & Development Research Center of the State Council, 2013, p.186). This, albeit an imperfect one, indicator of innovation capacity shows us that SOE sectors still have some way to go. But why
3 f.e. Chang, Wang, & Cui, 2019; for an interesting discussion see: World Bank & Development
is this the case? To understand this, we need to look at their ownership and management structure.
SOE Ownership and Management Structure
State-Owned Enterprises are enterprises owned by the state. It is vital to keep this tautology in mind, as the complexity of SOE-structures might sometimes prompt one to lose oversight. In the end, the ideological mission of SOEs is the empowerment of the Chinese people – or at least, it should be. As explained in this section’s introduction, aiming to surface some of the mechanisms behind innovation blockages, I focus specifically on central SOEs.
A brief history of Chinese SOEs.
It is impossible to meaningfully demonstrate the structure of SOEs without first discussing their history. Most of the SOEs find their origin as relatively small firms under the highly centralized, planned economy of Mao Tse Tung (Sheng & Zhao, 2013, p.2). With its hierarchical focus, where SOE managers were solely executors of political orders, this regime failed to incentivize; productivity and efficiency were at an unsustainably low level (Sheng & Zhao, 2013, p.1). In 1978, under the watchful eye of Deng Xiaoping, local governments were encouraged to start audacious pilot projects in firm privatization (World Bank & Development Research Center of the State Council, 2013, p.4). In the development of a socialist economy, a two-fold path was to be used: on the one hand, liberalization and the promotion of private sector development, on the other hand, the protection and support of SOEs in priority sectors (World Bank & Development Research Center of the State Council, 2013, p.4). SOEs would only be kept in monopoly industries and in industries with scarce strategically significant resources4 (Sheng & Zhao, 2013, p.23). In 1992, on the 14th Party Congress, the official aim of the reforms became the establishment of a socialist market economic system – far away from the originally planned one (Sheng & Zhao, 2013, p.28).
The remaining SOEs went through a transformation: with the intention of streamlining control and increasing the effectiveness of state policies, the formation of national champions became an explicit goal of the central government (Lin & Milhaupt, 2013, p.714). These national champions were to become the crown jewels of China’s state capitalist economic system. Through a massive amount of mergers and acquisitions, small SOEs were put together into colossal holdings - holdings eventually owned by SASAC.
SASAC and central SOE structures.
As was explained earlier, to uncover the mechanisms behind innovation blockage, in this section I focus on central SOEs (i.e. those owned by SASAC). The ownership structure that will be discussed in the next paragraphs is exclusively applicable to those. Nonetheless, there is a variety of management methods of Chinese SOEs. While it is not vital to the research question of this section, it is important to understand that the structures discussed do not apply to the whole Chinese public sector5.
In central SOEs, SASAC is the “ultimate controlling shareholder” on behalf of the state (Lin & Milhaupt, 2013, p.697). The agency was created in 2003 with the aim of furthering the People’s interests by bringing quality management to SOEs. Its official objective is “to make sure that the value of state assets in corporatised enterprises are [sic] maintained and increased” (Sam, 2013, p.776). It is a ministry-level agency, but nevertheless faces quite some resistance from the SOEs it owns, as 53 of them are too (Lin & Milhaupt, 2013, p.736).
Lin & Milhaupt (2013, pp. 717-719) provide a helpful overview of the components of a SOE in a stylized model of a prototypical central SOE (Figure 2). In comparison with other state capitalist countries like Japan and Korea, this system of shareholding is quite hierarchical.
5 For more information about the other possibilities, Appendix B offers a succinct management
SASAC acts as investor on behalf of the State Council, and owns a holding company that was created through mergers and acquisitions. This holding acts as the intermediary between SASAC and the holding’s group members; it promotes the information flow by translating policies downward and bringing information upwards.
Figure 2. Stylized model of the prototypical ownership structure of a central SOE (Lin & Milhaupt, 2013, p.710).
The group members within the holding can be divided into four categories. First, the major subsidiaries: publicly traded firms acting as the external face of the holding company. For example, on the New York and Hong Kong stock exchange one can buy stocks of “China Mobile Limited”, which is the core subsidiary of the holding “China Mobile Communications Corporation”. Through the holding, SASAC keeps control of its listed companies. Secondly, large holdings have their own finance companies: a nonbank financial institution. This offers them a variety of benefits that are hard to achieve via commercial or investment banks. For example, only through a finance company it is legal to engage in interfirm lending. Thirdly, holdings have their own research institutes. This is a result of State Council policies aspiring to promote innovation. By working together with non-economic institutions like universities, research institutes conduct R&D, furthering the development of the sector in which the holding has its activities. Finally, there is a fourth category: other subsidiaries. This differs from sector to sector and is of little interest to our quest.
The CCP: an elite control of SOEs?
One thing in figure 2 is striking: the CCP-arrow. Looking at the hierarchical formal ownership structure, one could already expect CCP-meddling in SOE’s affairs. In various research, the CCP’s influence on SASAC was made clear (f.e. Chan, 2009; Lin, Ma, Su, 2009). Nevertheless, the Party’s control is more complex than this: it’s there at all levels. So how does it control the SOEs? In their outstanding analysis, Lin and Milhaupt (2013, pp. 707-709) come up with two concepts to understand this: networked hierarchy and institutional bridging.
Earlier, we examined the formal structure of SOE-ownership and found it to be exceptionally hierarchical. The top-down vertical ownership structures provide a direct and flexible way for the CCP to affect the SOEs. This creates a networked hierarchy: through SASAC, and the various vertical linkages it has with SOEs and their partners, the CCP can enforce its preferred decisions. Its main power? Appointments. Because SASAC is a ministry-level agency, the State Council (which is dominated by the CCP) appoints its management; and since these managers aim to climb their way up the hierarchical state ladder, they follow party’s orders blindly (Sam, 2013, pp. 774-778). Thus, the Party’s power of appointment is a major influence on SASAC’s, the holding’s, and SOE’s activities. Policies are not only implemented through a hierarchical downstream, there is also a network of ambitious and reward-seeking party members proactively promoting party interests.
Furthermore, it is helpful to note the impressive amount of institutional bridging (or: horizontal linkages). One way in which this is done is the plethora of (unmistakably obscure) positions for SOE managers in various state and Party organs; they receive seats in for example the National People’s Congress, China’s official legislative body, but also in the People’s Political Consultative Conference (PPCC) (Lin & Milhaupt, 2013, p.727). The PPCC is an important, yet relatively unknown, organ of the Chinese government. After researching the function and working methods of it, Xiaojun (2011) concluded that the PPCC has two
functions: first, it gathers societal feedback for the Chinese government to facilitate higher quality policy; secondly, it is a “channel through which the Party-state dispenses spoils, rents, privileges and protection to influential members” (p.73). The PPCC is a perfect example of how the Chinese elite conspires in a way that encompasses very different fragments of society; they form horizontal linkages. A second way in which the CCP promotes institutional bridging is the institutionalized exchange of personnel between SASAC and SOEs (Lin & Milhaupt, 2013, p.697). Every year, fifty to sixty SASAC managers do an exchange year in a SOE, while the same amount of SOE managers go the other way. This way, links between the various institutions are stimulated. These two examples considered, we find that, through institutional bridges, the CCP facilitates links between various fragments of society - links that effectively create an elite grounded in Party power.
All in all, it is clear that the CCP has retained institutional and informal power over the SOEs. Now that we have established that SOEs suffer from a lack of innovation and that we have uncovered the ways in which these firms are managed and controlled, it is time for the ultimate question: Why the low innovation?
Why the Low Innovation?
In their book, Acemoglu and Robinson (2013, p.437-438) recount the story of a Chinese private entrepreneur who was competing with the local steel SOE and thereby endangering its position. This, of course, was unacceptable to the national Party cadre, and eventually the man was given home detention on minor, non-relevant charges. This is a striking example of the national Party obstructing creative destruction in SOE-sectors. However, this bold use of the judicial apparatus is not the Party’s usual strategy in blocking creative destruction; it uses far more profound, effective and subtle methods. In the following paragraphs, I put forward a theory on the mechanisms through which party politics (i.e. the existence of an elite) negatively affect innovation within SOE sectors. This theory is visualized in figure 3.
F ig u re 3 . Visua li za ti on of the me cha nism s throu gh whic h pa rt y poli ti cs ne g ati ve ly a ff ec t i nnova ti on withi n S OE se ctors.
SOEs influence policy.
Earlier, the ownership structure of SOEs was described as a networked hierarchy with many institutional bridges; this effectively created an elite, exchanging favours. SOE managers, generally prominent Party members and former government officials, have the ability to influence political as well as bureaucratic policy-makers (Sheng & Zhao, 2013, pp.187-189). They contact the political ones at Party meetings, and know the bureaucrats as former colleagues. Since many government officials aspire future jobs at SOEs, they are happy to offer preferential treatments. The amount of policy influence by SOEs is enhanced by the latter being unproductive and lacking innovation, leading their managers to seek additional preferential treatments.
Preferential treatments.
SOEs receive a variety of preferential treatments: tax deductions, favourable loans, land use rights, etc. (Sheng & Zhao, 2013, p.189; Yu, 2013, p.176). Due to the preferential treatments, profitability of firms is only of minor importance. Since the reforms, the Chinese government has recurrently given financial aid to loss-making SOEs. These firms claim that they need extra resources because they provide vital public services, but often they are just plain inefficient (Sheng & Zhao, 2013, p.45-91). The recurring help has taken away much of the incentive to increase productivity and innovate.
Nevertheless, there are some SOEs that make profit. Many of these, however, have their profitability grounded in the monopoly rights granted to them by the Chinese government (Sam, 2013, pp. 197-198). The many monopolies of SOEs are a result of SASAC’s objective to lower the amount of SOEs through mergers and acquisitions. The remaining national champions became so big they have lost practically all competition. While the Chinese judiciary does practice anti-trust laws, Mavroidis, Janow and Kovacic (2017) found that SOEs
are often exempted from this. As a result, the amount of monopoly power of SOEs is rising significantly (Sheng & Zhao, 2013, p. xxiii).
Essentially, preferential treatment of SOEs is omnipresent. These policies lead to unequal competition in the sectors where SOEs operate, which in turn leads to a vast lack of creative destruction resulting from possible entries of new and innovative firms.
Remuneration corruption.
The number of incentives for SOE managers and employees to innovate and increase productivity is brought down even more because their remuneration hardly depends on it. Instead, they can arbitrarily decide for themselves or they have to use preferential government treatments for it. In a remuneration analysis, Sheng and Zao (2013, 95-112) found some interesting facts about the income of SOE employees. First, SOE wages are significantly higher than their private sector counterparts. Secondly, SOEs use various loopholes to ameliorate the remunerations. By giving non-monetary benefits, they circumvent the official wage levels of employees. One example of this is the housing subsidy. Many Chinese employees receive benefits to help them find a place to live near their workplace. However, SOEs use their links with the government to exploit this. They build houses on state-owned land, to subsequently sell them to employees at low prices. Through this, they effectively turn collective resources into private ones, without paying the full price. Corruption goes even farther at management level. Many SOE senior executives receive zero remuneration for their work; instead, they can have their “position-related” expenses reimbursed. These hard-to-regulate expenses reach sky-high levels and were found to be 11.8 times sky-higher than average annual official remunerations. While measuring the amount of corruption on this level would be a futile endeavour, one can safely assume that it is a significant problem in SOEs. The fact that personal gains are acquired by finding loopholes or through party influence -instead of firm results- leads to a lack of (innovation) incentives.
Weak Watchdog SASAC.
As the formal owner of the firm, SASAC’s mission is to serve as a watchdog for the business practices of its investments. However, due to two reasons that find their origin in party politics, it is rendered powerless.
First, because SASAC itself is heavily influenced by Party politics, its actions and SOE evaluations are rifled with favouritism towards CCP members. Du, Tang and Young (2012) analysed these evaluations, held in-depth interviews with employees and concluded that “the political connection of SOE CFOs, the geographic proximity of SOE headquarters to the SASAC central office, and political rank of the firm affect the SASAC's evaluations” (p.1). Secondly, even if SASAC would want to effectively serve as a watchdog, it lacks the political power to do so. Because many SOE managers are prominent Party members with seats in various important institutions, the lower-ranking SASAC officials find it hard or even impossible to discipline them (Yu, 2013, p.180). This results in a toothless watchdog, unable to perform its duties. While it was designed as the solution for many of SOE’s problems, it is now widely perceived as a fundamental problem of it (Yu, 2013, p.182)
Discussion
In this section, I intended to answer the question: Is there an elite controlling the SOEs, and if so, how does this influence innovation in the respective sectors? By analyzing the ownership structure, which was found to be a networked hierarchy with many institutional bridges, the influence of the CCP became clear. Through a variety of formal and informal institutions, the power of the Party elite is sustained.
I identified the mechanisms through which Party Politics lead to a lack of innovation. SOE managers’ ability to influence policy was found to cause the SOEs to lose all (innovation) incentives. In the end, they do not have to compete with new firms, and do not need to innovate themselves as their profitability is often of an only minor importance. This leads to a situation
where there is only incentive to use personal clout to influence SASAC evaluations and government policy – detrimental for the SOE innovatory environment. Through these policies, all competition and subsequent creative destruction is blocked. My results indicate that the claims made by Acemoglu and Robinson (2013) are true for central SOEs: the elite blocks creative destruction in the sectors where it gains profit, which in turn leads to a lack of innovation.
Conclusion, limitations and further research
This thesis used a sequential mixed-method research design to assess the Chines innovatory environment. Consequently, it consisted of two distinct research projects. In section I, the quantitative evaluation of innovation and creative destruction, I found that, although it is still relatively lagging behind, China is taking big steps at becoming an innovatory power. This is likely to be connected to the creative destruction that was also found. In section II, the qualitative assessment of innovation and creative destruction in central SOEs, I found that the existence of a Party elite negatively affects the amount of innovation done by SOEs. Using preferential governmental treatments, SOEs take part in unfair competition and consequently block all creative destruction. All in all, we see two divergent observations. On the one hand, a growing amount of innovation and creative destruction in the economy as a whole; on the other, an elite-controlled non-innovative SOE-environment.
One can ask oneself the question: Are Acemoglu and Robinson right? Will China continue suffering from a lack of innovation? My research indicates that this is indeed the case. While I did find a growing amount of innovation, this was not the case in SOE-sectors, where party politics have taken away all incentives for it. Since these SOEs make up a large part of the economy, have recently been growing in amount of revenue, and are expanding their activities towards superfluous sectors, the non-innovative firms might increasingly push away the remaining innovative ones. This would reverse the growing amount of innovation and
creative destruction we found in section I, and condemn China to a never-ending cycle of imitation. Nonetheless, I refrain from making any predictions; only the future shall bring the truth.
While this thesis succeeded in assessing the Chinese innovatory environment, it did have some limitations. First, as with nearly all quantitative research, its measures were far from perfect. This has been discussed in detail in the operationalization section, but should always be kept in mind when discussing the results. Secondly, there is the unique position of central SOEs in the state structure. Research focusing on the state sector might overlook relevant mechanisms only applicable to the private one. Further research should look into the innovation-influencing mechanisms of Party politics in private firms. Furthermore, it is possible that SOEs worldwide lag behind private firms in terms of innovation. In this respect, it would be interesting to compare Chinese SOE-structures to foreign ones. Finally, the predictive power of this thesis is limited as it largely focused on the last decade. The Chinese government has announced ambitious plans for fostering innovation (f.e. China 2025). To make predictions about the country’s future, it is necessary to assess the possible impact of these plans.
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Appendixes
APPENDIX A: Visualization of industries in which central SOEs operate Source: China Institute - University of Alberta (2018)
APPENDIX B: SOEs classified by Government Management Method Source: Sheng & Zao (2013, p.38)
