China's World Trade Compliance

How pervasive are subsidies in China?

Our research has shown that despite recent deregulation efforts, state consumption through its SOEs dominates the Chinese economy. Figure 1 indicates difference in state domination of the Indian and Chinese economies. Subsidies permeate SOEs and well-connected private companies but do not extend to the bulk of private companies.

The subsidies appear huge. According to a World Bank study, 51 percent of all SOEs are losing money. Average current assets had risen to 319 days of annual sales, suggesting that most of the SOEs' assets lay in uncollectible bills or unsaleable inventory. In short, most SOEs were illiquid and massive injections of government money kept them alive.

Are they specific to certain industries, or are they broadly available?

The state offers subsidies to specific sectors and across sectors. Generally, SOEs and well-connected private companies with strong government network connections can access subsidies. The state is more likely to offer subsidies to private companies that promote strategic development efforts. The 11^th Five-Year Plan identifies the following foci for development:

1. Advanced computing.
2. Internet.
3. Programming.
4. Environmental services & resource conservation.
5. Energy production and reserves.
6. Value-chain positioning of Chinese manufacturing.
7. Space, satellite and space-launch related capabilities.

What policies underlie the subsidies? Are they primarily targeted at companies that export or are they available to companies that serve the domestic market?

The state grants subsidies to companies that export as well as to those that serve the domestic markets. Political rather than primarily economic considerations guide policies on subsidies. For example, many provincial governments offer subsidies as rewards to those that successfully manipulate government and business networks.

SOE reforms and strategic goals also shape policies on subsidies. However, for China's leadership, SOE reforms do not include concerns about profits or privatization. The reforms do not have as their goal reducing the state's control over key sectors of the economy, but rather making that control more effective. Consequently, the policies aim to make SOEs efficient and big enough to have a strong international presence such as the foreign multinational companies do. Specifically, the Chinese government wants its own global stars. The SASAC, which oversees SOEs, has the mandate to transform 30-50 SOEs into globally competitive national champions by 2010. These include PetroChina, ChinaMobile, Sinopec, CNOOC, Baosteel, China Aluminum, Shanghai Auto, Lenovo, TCL, and Quingdao Haier. Korea's chaebol, rather than Japan's keiretsu provide the guiding model for China's policy on industrial subsidies: through subsidies, the state helps the national champions to diversify their range of businesses and to link more closely to the state.

Some of the policies on subsidies stem from long and mid-range strategic plans; others derive from emergent planning and mistakes. For example, responding to the massive NPLs accumulated by Chinese banks in the 1990s, the government ordered they reduce their NPL ratios – bad loans as a proportion of total loans. However, this policy had unintended consequences. China's banks are technically insolvent but enjoy high liquidity. To cut NPL ratios, the banks merely increased the denominator of the ratios: their loans. Lending rose rapidly, driving growth as a side effect as NPL ratios fell from 28 per cent in 2002 to 13.2 percent at the end of 2004. Assisting the process were transfers of old NPLs, made before the recent credit drive, to newly minted asset management companies (AMCs). The largest banks shifted an initial $169 billion in 1999-2000 and another $50 billion last year. The AMCs have become dumping grounds not just for commercial banks' NPLs but also for the assets of failed investment conglomerates, securities businesses and government-infrastructure projects. The state makes the AMCs issue interest-bearing bonds for which it refuses to accept explicit liability. Separately, Beijing has raided tens of billions of dollars of foreign exchange reserves to shore up banks' capital.

Policies regarding subsidies become difficult to unravel as the Chinese state encompasses central and local governments, with competing and often conflicting agendas, and different bureaucratic and political factions at the national level. Subsidies and the policies behind them reflect this fragmentation and conflict. Thousands of warring units that cohabit under the umbrella of the Chinese state control the SOEs. Consequently, SOEs enjoy direct subsidies stemming from state directives and elicit varying degrees of support.

AVIC, the national aerospace group, provides a good example of subsides to an SOE serving a domestic market. Urged by Deng Xiaoping in 1985, AVIC had designed a civil airliner from scratch in less than 5 years. However, it only built two planes and even China's nationalized airlines refused to buy them. Two decades later, AVIC has received several tax breaks to build a small regional jet but has no idea of its commercial prospects

Generally, despite stated policies, outsiders cannot ascertain the true policies that underlie subsidies. A secretive and authoritarian organization with unclear aims, closed to scrutiny and debate, controls the Chinese state. More effectively placed subsidies appear in the SOEs that the Beijing central government has classified as global champions. However, recent examples illustrate their complexity. CNOOC, whose $19 billion bid for Unocal touched off volcanic reactions, is a Hong Kong-listed firm 70 per cent owned by an unlisted parent company, all of whose shares are owned by the central government agency, SASAC. Beijing has helped CNOOC to acquire contracts to control foreign-energy reserves and the company heavily relies on subsidized finance from SASAC. Local governments control other SOEs. These include white goods maker Haier (owned by the Qingdao city government), which launched an unsuccessful bid for Maytag, and the municipally owned Shanghai and Nanjing car companies that have spent the last several months picking through MG Rover. These companies also receive subsidies in line with Beijing's stated goals of creating state-owned multinationals and retaining domestic control over key sectors, such as car making. The demands of both the central government, which sets industry policy, and their local government overlords, whose interests may conflict with Beijing's industrial-policy goals, shape the subsidies the SOEs receive, as well as the SOEs' evolution, strategies and policies. Huawei, a maker of telecoms-network equipment, illustrates a third level of policies and subsidies. Huawei is ostensibly privately owned, although many of its shares are owned by the local state telecoms authorities to whom it has sold equipment. It enjoys a $10 billion low-interest credit line from the China Development Bank, whose mission is to make concessional loans in support of the state's policy goals. Huawei also has strong ties to China's military.

How profitable are companies that serve the China market?

Few multinational corporations disclose the real performance of their Chinese operations. Most estimates have relied instead on business surveys and anecdotes. Our research reveals that only about one-third of the foreign companies operating in China have ever made a profit there, and profits have been concentrated in the hands of a few companies. In addition, historically, foreign affiliates in China have lower profit margins than their global average.

In 1998, a survey of 229 foreign-invested companies by management consultants A. T. Kearney showed that only 38 percent of all manufacturers were covering their operating costs. If the companies had included their borrowing costs, or costs of capital, fewer still could have claimed to have broken even.

Another study done at the Chinese Academy of International Trade and Economic Cooperation showed that about one-third of the 354,000 foreign companies operating in China in 2001 turned a profit. Yet, a 1999 survey by the American Chamber of Commerce in China showed that, while 58 percent of its member companies had lower profit margins there than in other global operations, 88 percent had plans to expand. Deloitte & Touche's survey in 2002 confirmed that 90 percent of foreign-owned companies in China planned to expand their operations within the next three years. In 2003, about 424,196 foreign companies, big and small, operated in China (MOFTEC). Michael Furst, Executive Director of the American Chamber of Commerce, Beijing, informed us that about two-thirds of its member companies were making some profits but not up to anticipated levels, while about one-third were making losses. These figures correspond to those from 2004.

A 2004 survey by China Economic Quarterly shows that the earnings of US affiliates in China, which includes the affiliates' profits, and earnings booked through Hong Kong and Singapore, rose to $4.4 billion. When all other sources of profit are added ' including royalty and licensing fees and income from private services ' these affiliates earned $8.2 billion in 2004. However, US companies made $7.1 billion in Australia, a market of only 19 million. They earned $8.9 billion in Taiwan and South Korea, emerging economies with a combined population of 70 million and earned $14.3 billion in Mexico. Most respondents could not achieve profit margins above their global average.

A large proportion of the earnings end up with a small number of foreign companies that enjoy lucky breaks in China's heavily regulated operating environment. For example, Mobile Telecommunications encountered no vested interests in China and contributed about half of the US companies' mainland-reported earnings as recently as 2001. However, from 2002, Chinese companies, subsidized by the state, moved into mobile handsets and their cutthroat pricing destroyed profits in that sector.

More recently, a consumer loan boom financed by state-run banks underwrote an explosion in car sales that dropped later like a brick — but Volkswagen, the market leader, still earned $1.2 billion in China in 2003.

Five US companies, including three car makers, accounted for one third of equity profits that mainland affiliates reported. General Motors alone booked $437 million in earnings. Fast-food companies Yum Brands – owner of KFC – and McDonald's topped off the list. Fast-food companies have consistently made profits in the Chinese domestic economy. They face no competition from state interests and, as services, are less prone to intellectual property abuses. Yum Brands, which has 1,200 restaurants in China, and McDonald's, probably earned about $200 million and the US car companies in excess of $500m – equivalent to about one-third of mainland equity income of $2.4 billion. These figures underline how small China's domestic markets may be.

The exaggerated economic data can have significant effects on perceived performance and projected performance of FDI in China. The successful companies in our research did not rely on economic and industrial data. As Elmar Stachels, Managing Director of Bayer China Company, Ltd., told us 'You manage by objectives, objectives that must be clearly stated ' then determine what kind of tools you can use to determine if you achieved them, but stick with your objectives. However if it comes to financial figures, it will be challenging. What good will numbers be if the base rates used for comparison of performance are not reliable.'

China remains embroiled in overcapacity and excess production as state investment and subsidies move across sectors, and companies' profits correspondingly whipsaw. A year ago in the auto sector, sales growth for many car models dropped from three digits to less than zero in a few months. In steel, China flipped from a massive net importer to a net exporter in less than a year. In the past nine months, the global price of ethylene ' a base constituent of plastics ' dropped by half as Chinese production capacity expanded 35 per cent this year and will probably double in the next few years. Soon, smelted copper will join the ranks: China has 2.5 million tons of annual production capacity and another 2.5 million tons under construction. Similarly, in stainless steel, China's annual production capacity approximated 2.5 million tons at the end of 2004. Industrial projects and subsidies will expand this to 10 million tons in five years.

Thank you again for having me, and I look forward to your questions.

(The entire US-China Commission hearing record for April 4, 2006 is available at http://www.uscc.gov/hearings/2006hearings/transcripts/april_4/06_04_04_trans.pdf.)

How pervasive are subsidies in China?

Our research has shown that despite recent deregulation efforts, state consumption through its SOEs dominates the Chinese economy. Figure 1 indicates difference in state domination of the Indian and Chinese economies. Subsidies permeate SOEs and well-connected private companies but do not extend to the bulk of private companies.

The subsidies appear huge. According to a World Bank study, 51 percent of all SOEs are losing money. Average current assets had risen to 319 days of annual sales, suggesting that most of the SOEs' assets lay in uncollectible bills or unsaleable inventory. In short, most SOEs were illiquid and massive injections of government money kept them alive.

Are they specific to certain industries, or are they broadly available?

The state offers subsidies to specific sectors and across sectors. Generally, SOEs and well-connected private companies with strong government network connections can access subsidies. The state is more likely to offer subsidies to private companies that promote strategic development efforts. The 11^th Five-Year Plan identifies the following foci for development:

1. Advanced computing.
2. Internet.
3. Programming.
4. Environmental services & resource conservation.
5. Energy production and reserves.
6. Value-chain positioning of Chinese manufacturing.
7. Space, satellite and space-launch related capabilities.

What policies underlie the subsidies? Are they primarily targeted at companies that export or are they available to companies that serve the domestic market?

The state grants subsidies to companies that export as well as to those that serve the domestic markets. Political rather than primarily economic considerations guide policies on subsidies. For example, many provincial governments offer subsidies as rewards to those that successfully manipulate government and business networks.

SOE reforms and strategic goals also shape policies on subsidies. However, for China's leadership, SOE reforms do not include concerns about profits or privatization. The reforms do not have as their goal reducing the state's control over key sectors of the economy, but rather making that control more effective. Consequently, the policies aim to make SOEs efficient and big enough to have a strong international presence such as the foreign multinational companies do. Specifically, the Chinese government wants its own global stars. The SASAC, which oversees SOEs, has the mandate to transform 30-50 SOEs into globally competitive national champions by 2010. These include PetroChina, ChinaMobile, Sinopec, CNOOC, Baosteel, China Aluminum, Shanghai Auto, Lenovo, TCL, and Quingdao Haier. Korea's chaebol, rather than Japan's keiretsu provide the guiding model for China's policy on industrial subsidies: through subsidies, the state helps the national champions to diversify their range of businesses and to link more closely to the state.

Some of the policies on subsidies stem from long and mid-range strategic plans; others derive from emergent planning and mistakes. For example, responding to the massive NPLs accumulated by Chinese banks in the 1990s, the government ordered they reduce their NPL ratios – bad loans as a proportion of total loans. However, this policy had unintended consequences. China's banks are technically insolvent but enjoy high liquidity. To cut NPL ratios, the banks merely increased the denominator of the ratios: their loans. Lending rose rapidly, driving growth as a side effect as NPL ratios fell from 28 per cent in 2002 to 13.2 percent at the end of 2004. Assisting the process were transfers of old NPLs, made before the recent credit drive, to newly minted asset management companies (AMCs). The largest banks shifted an initial $169 billion in 1999-2000 and another $50 billion last year. The AMCs have become dumping grounds not just for commercial banks' NPLs but also for the assets of failed investment conglomerates, securities businesses and government-infrastructure projects. The state makes the AMCs issue interest-bearing bonds for which it refuses to accept explicit liability. Separately, Beijing has raided tens of billions of dollars of foreign exchange reserves to shore up banks' capital.

Policies regarding subsidies become difficult to unravel as the Chinese state encompasses central and local governments, with competing and often conflicting agendas, and different bureaucratic and political factions at the national level. Subsidies and the policies behind them reflect this fragmentation and conflict. Thousands of warring units that cohabit under the umbrella of the Chinese state control the SOEs. Consequently, SOEs enjoy direct subsidies stemming from state directives and elicit varying degrees of support.

AVIC, the national aerospace group, provides a good example of subsides to an SOE serving a domestic market. Urged by Deng Xiaoping in 1985, AVIC had designed a civil airliner from scratch in less than 5 years. However, it only built two planes and even China's nationalized airlines refused to buy them. Two decades later, AVIC has received several tax breaks to build a small regional jet but has no idea of its commercial prospects

Generally, despite stated policies, outsiders cannot ascertain the true policies that underlie subsidies. A secretive and authoritarian organization with unclear aims, closed to scrutiny and debate, controls the Chinese state. More effectively placed subsidies appear in the SOEs that the Beijing central government has classified as global champions. However, recent examples illustrate their complexity. CNOOC, whose $19 billion bid for Unocal touched off volcanic reactions, is a Hong Kong-listed firm 70 per cent owned by an unlisted parent company, all of whose shares are owned by the central government agency, SASAC. Beijing has helped CNOOC to acquire contracts to control foreign-energy reserves and the company heavily relies on subsidized finance from SASAC. Local governments control other SOEs. These include white goods maker Haier (owned by the Qingdao city government), which launched an unsuccessful bid for Maytag, and the municipally owned Shanghai and Nanjing car companies that have spent the last several months picking through MG Rover. These companies also receive subsidies in line with Beijing's stated goals of creating state-owned multinationals and retaining domestic control over key sectors, such as car making. The demands of both the central government, which sets industry policy, and their local government overlords, whose interests may conflict with Beijing's industrial-policy goals, shape the subsidies the SOEs receive, as well as the SOEs' evolution, strategies and policies. Huawei, a maker of telecoms-network equipment, illustrates a third level of policies and subsidies. Huawei is ostensibly privately owned, although many of its shares are owned by the local state telecoms authorities to whom it has sold equipment. It enjoys a $10 billion low-interest credit line from the China Development Bank, whose mission is to make concessional loans in support of the state's policy goals. Huawei also has strong ties to China's military.

How profitable are companies that serve the China market?

Few multinational corporations disclose the real performance of their Chinese operations. Most estimates have relied instead on business surveys and anecdotes. Our research reveals that only about one-third of the foreign companies operating in China have ever made a profit there, and profits have been concentrated in the hands of a few companies. In addition, historically, foreign affiliates in China have lower profit margins than their global average.

In 1998, a survey of 229 foreign-invested companies by management consultants A. T. Kearney showed that only 38 percent of all manufacturers were covering their operating costs. If the companies had included their borrowing costs, or costs of capital, fewer still could have claimed to have broken even.

Another study done at the Chinese Academy of International Trade and Economic Cooperation showed that about one-third of the 354,000 foreign companies operating in China in 2001 turned a profit. Yet, a 1999 survey by the American Chamber of Commerce in China showed that, while 58 percent of its member companies had lower profit margins there than in other global operations, 88 percent had plans to expand. Deloitte & Touche's survey in 2002 confirmed that 90 percent of foreign-owned companies in China planned to expand their operations within the next three years. In 2003, about 424,196 foreign companies, big and small, operated in China (MOFTEC). Michael Furst, Executive Director of the American Chamber of Commerce, Beijing, informed us that about two-thirds of its member companies were making some profits but not up to anticipated levels, while about one-third were making losses. These figures correspond to those from 2004.

A 2004 survey by China Economic Quarterly shows that the earnings of US affiliates in China, which includes the affiliates' profits, and earnings booked through Hong Kong and Singapore, rose to $4.4 billion. When all other sources of profit are added ' including royalty and licensing fees and income from private services ' these affiliates earned $8.2 billion in 2004. However, US companies made $7.1 billion in Australia, a market of only 19 million. They earned $8.9 billion in Taiwan and South Korea, emerging economies with a combined population of 70 million and earned $14.3 billion in Mexico. Most respondents could not achieve profit margins above their global average.

A large proportion of the earnings end up with a small number of foreign companies that enjoy lucky breaks in China's heavily regulated operating environment. For example, Mobile Telecommunications encountered no vested interests in China and contributed about half of the US companies' mainland-reported earnings as recently as 2001. However, from 2002, Chinese companies, subsidized by the state, moved into mobile handsets and their cutthroat pricing destroyed profits in that sector.

More recently, a consumer loan boom financed by state-run banks underwrote an explosion in car sales that dropped later like a brick — but Volkswagen, the market leader, still earned $1.2 billion in China in 2003.

Five US companies, including three car makers, accounted for one third of equity profits that mainland affiliates reported. General Motors alone booked $437 million in earnings. Fast-food companies Yum Brands – owner of KFC – and McDonald's topped off the list. Fast-food companies have consistently made profits in the Chinese domestic economy. They face no competition from state interests and, as services, are less prone to intellectual property abuses. Yum Brands, which has 1,200 restaurants in China, and McDonald's, probably earned about $200 million and the US car companies in excess of $500m – equivalent to about one-third of mainland equity income of $2.4 billion. These figures underline how small China's domestic markets may be.

The exaggerated economic data can have significant effects on perceived performance and projected performance of FDI in China. The successful companies in our research did not rely on economic and industrial data. As Elmar Stachels, Managing Director of Bayer China Company, Ltd., told us 'You manage by objectives, objectives that must be clearly stated ' then determine what kind of tools you can use to determine if you achieved them, but stick with your objectives. However if it comes to financial figures, it will be challenging. What good will numbers be if the base rates used for comparison of performance are not reliable.'

China remains embroiled in overcapacity and excess production as state investment and subsidies move across sectors, and companies' profits correspondingly whipsaw. A year ago in the auto sector, sales growth for many car models dropped from three digits to less than zero in a few months. In steel, China flipped from a massive net importer to a net exporter in less than a year. In the past nine months, the global price of ethylene ' a base constituent of plastics ' dropped by half as Chinese production capacity expanded 35 per cent this year and will probably double in the next few years. Soon, smelted copper will join the ranks: China has 2.5 million tons of annual production capacity and another 2.5 million tons under construction. Similarly, in stainless steel, China's annual production capacity approximated 2.5 million tons at the end of 2004. Industrial projects and subsidies will expand this to 10 million tons in five years.

Thank you again for having me, and I look forward to your questions.

(The entire US-China Commission hearing record for April 4, 2006 is available at http://www.uscc.gov/hearings/2006hearings/transcripts/april_4/06_04_04_trans.pdf.)