The last time China got serious about reforming its state-owned enterprises (SOEs) was nearly two decades ago when hundreds of firms were privatized or liquidated annually under the mantra of “grasp the large and release the small”. But with the turnover in leadership to Hu Jintao in 2003, Beijing became less willing to close poor performers and relied on the newly created State-Owned Assets Supervision and Administration Commission (SASAC) to instil a stronger commercial orientation among those not let go. SASAC, however, only served to protect their existence through cross subsidization of loss markers by the more profitable firms, who benefited from their monopoly positions in key sectors. Under pressure, Beijing has now proposed a new strategy of mixed ownership to improve SOE performance, but this will not solve the problem.

Profitability differences between private firms and SOEs mattered less before the global financial crisis, when return on assets was increasing steadily for both groups. But since 2008, returns for private firms have surged to 11 per cent while those for SOEs have fallen and stagnated at around 5 per cent (Figure 1). Policy makers and academics point to this widening gap as evidence of the poor performance of SOEs. Few, however, have noticed that the firms’ profit margins, another commonly used measure of profitability, have converged in recent years. Prior to the crisis, SOEs were actually more profitable than private firms (Figure 2).

How can one reconcile these contrasting results? We can express the return on assets as the product of two ratios: the profit margin (profits/revenues) and asset turnover (revenues/assets). When we deconstruct the return on assets of state and private firms this way, it immediately becomes apparent that the big difference is in asset turnover, where private firms are far more productive. In other words, private firms generate much more revenue from a given asset base, even though the profit they earn on each dollar of revenue is about the same as for state firms. The source of this discrepancy was the government’s 2009 stimulus, which was channelled mainly through SOEs and encouraged them to create redundant capacity that persists even today. Meanwhile, private companies have done well in adjusting to shifting market realities.