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China's economy is at a critical juncture. Over the past three decades, the country has witnessed unprecedented growth, fueled largely by heavy investment in infrastructure and strategic industries. But now, the engines that powered China's growth are sputtering. Annual GDP growth has drifted downwards from over 14% in 2007 to 6.7% in the second quarter of 2016.

Part of this slowdown is natural, and expected. China is transitioning from an economy dominated by state-directed investments in infrastructure and heavy manufacturing into one driven by consumer demand and service industries. That necessarily means a slower rate of growth: It is quite easy to grow an economy by adding investment - building a bridge here, opening a factory there - but consumer demand is generally less responsive to these kinds of tools.

In order for China to continue to grow, then, it needs to unlock the potential in its State Owned-Enterprises (SOEs) - the organizations that have helped power its growth since the 1990s but are now suffering from massive inefficiencies and debt.

This is, in fact, a path China has traveled before. In the late 1990s, under the direction of Premier Zhu Rongji, China launched a wholesale restructuring of its ossified state industries - breaking up the most bloated, privatizing the most competitive and opening whole new industries to market competition. The result: a near decade of double-digit economic growth.

But despite this success, the reform of China's SOEs has stagnated in recent years, and in some cases even reversed - adding salt to the country's economic wounds and exacerbating the difficulties the country faces today.

There are practical reasons for this. China has responded to the slowdown in the economy by lowering interest rates, loosening bank restrictions and boosting spending on public infrastructure. These steps have created unprecedented levels of debt: In the first quarter of 2016, Chinese banks released a record RMB4.6 trillion in credit, more than it did at the height of the global financial crisis in 2009.

China's SOEs are overwhelmingly the beneficiaries of this cash. While they are generally poor users of capital compared to private enterprise - by one estimate, China's private companies deliver three times the return on investment, while requiring only half the cash - they are also seen as safe bets by cautious mainland banks. The implicit assumption is that the government will step in to rescue any SOE that finds itself unable to pay its loans. Meanwhile private companies, faced with slowing demand and existing overcapacity, are not spending. As a result, China's state spending on fixed asset investment is up nearly 25% year-on-year, while private investment has flatlined.

China's government still maintains that it is dedicated to the reform of its bloated and inefficient enterprises, but its actions currently suggest the opposite. The government continues to insist that it will not shore up heavily indebted companies, but actual examples of firms being allowed to go bankrupt or shut down are rare. In one reported incident, a steel company in China's northeast defaulted on much of its $6 billion in debt this spring - and still has yet to take any steps to restructure its business or close units. Overall, nonperforming loans have exceeded 2 trillion RMB, according to one senior banking regulator. While the NPL ratio of Chinese banks remains modest even after doubling, currently at above the 2 percent mark, the actual number is likely to be much higher, prompting the new policy change to allow banks to own equity, converted from debt from their customers who cannot pay back.

All indications are that China's reform push is taking a backseat to short-term concerns over economic and political stability. Despite problems of overcapacity and under-delivery, SOEs are perceived to be one of the Chinese government's levers of control over the economy. Far more than private companies, SOEs can direct investment into strategically important areas, and provide jobs and investment in cities and industries wracked by economic uncertainty. But absent reforms or restructuring, China's SOEs will continue borrowing money at market rates and delivering below-market returns. Such a situation is inherently unsustainable, and this debt-fueled investment will only leave an even bigger problem of debt and inefficiency that must ultimately be dealt with -- even if that means an even lower rate of overall economic growth in the short term.

The direction of SOE reforms of 1980-90's was to free the enterprises from government and party control, to separate state-ownership from professional management and to privatize those SOEs in competitive industries. These policies seem to have recently stopped or reversed course. Now once again in major SOEs, party secretaries are made de facto CEOs and the compensation system for senior management is pegged against that of government officials, as opposed to against performance-based market rates. These counter-reform policies are likely to make SOEs more of a drag on the efficiency of the Chinese economy. The stated objective of these policies is to make SOEs "bigger and stronger" as they are deemed to be the foundation of the rule of the Communist Party. These policies, however, are likely to produce the opposite effect than intended and to make the state-owned sector weaker, less efficient and therefore more wasteful.

The legitimacy of the government and the leadership is in fact built on the strength of the entire economy, not just through the control of the state-owned sector. History has proven that market reform is the only way to make the Chinese economy, and therefore China, stronger.

The real engine of growth has shifted to private consumption fed mostly by the private sector. In the first half of 2016, private consumption contributed to more than 70% of economic growth, far outstripping the contribution made by investments for the first time in history. This trend will continue irrespective of laggard and moribund SOEs. China can grow much stronger if it follows through its rhetoric on SOE reforms. But even if it does not, China will continue to grow, albeit at a relatively tepid pace, as led by private consumption and the private sector.

Weijian Shan is the Group Chairman and CEO of PAG.


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