Economic reform in China in the past decade has resulted in a vibrant business environment, but the playing field is far from level. While many of the country's state-owned enterprises (SOEs) are reporting soaring profits, small- to medium-sized private enterprises (SMEs) are reportedly experiencing serious financial woes. This not only has rekindled an old debate about SOEs and the state squeezing out private entities, it also has prompted a new debate over whether this particular path to economic reform is viable for China. In an attempt to defuse the debate, the government repeatedly has cited official numbers that paint a different picture. According to the National Bureau of Statistics, the number of "scaled" SOEs (those with revenues of at least 5 million yuan, or $780,000), their profits and their employee head counts declined 4.7 percent, 26.9 percent and 20.4 percent, respectively, from 2005 to 2009. National Bureau of Statistics figures show that for SMEs during that period, the same metrics rose 58.9 percent, 28 percent and 33.7 percent. While it is true that the number of private firms listed among China's top 500 enterprises increased from 13 to 184 from 2010 to 2011, they fell further behind SOEs in terms of revenues and profits. Total revenues and profits for private enterprises account for only about 15 percent of the total listed and do not exceed the total revenues and profits of the top 10 enterprises on the list, all of which are SOEs. Still, even these numbers do not tell the whole story.

Reacting to the Recession

While it is not the first time private enterprises have gone through difficulties, the current problem is largely the result of the government's effort to overcome the 2008 financial crisis, when most of Beijing's stimulus funds flowed into government-led investments. Many manufacturing and export-oriented SMEs were hit hard by the global downturn due to the diminishing demand for their products. At the same time, many SOEs began to enjoy highly favorable policies and subsidies that significantly boosted their economic performance. For some, in industries such as oil, telecommunications and rail, these policies strengthened their positions as monopolies. For others, the policies enabled them to enter industries that previously had been dominated by private enterprises, such as construction, services and real estate. This resulted in a distinct disadvantage for private enterprises, which had to compete against government-supported SOEs for market share and financing. 
 Under the tightened monetary policy environment and rising costs of 2011, financing has become critically important for all enterprises, both state-owned and private, so the competition has become even more intense. Small- to medium-sized private enterprises that were already more vulnerable to the state's macroeconomic policies are going head-to-head with state-owned counterparts for a limited loan pool. For the most part, state banks are opting to lend to SOEs, which have political connections and a greater capability to repay the loans. This has driven more and more private enterprises to informal private lending and intertwined capital chains that have placed a greater financial burden on SMEs. Official statistics are very vague concerning SME bankruptcies, but local reports indicate they are increasing and affecting local economies.

Underlying Problems

But the problems for China's SMEs go far deeper than the 2008 financial crisis. Private enterprises emerged in China's state-planned economy in the early 1980s during China's "opening up" under Deng Xiaoping. Many SMEs originated as family- or township-village factories, made possible in large part by the availability of surplus rural labor as large swaths of the countryside were urbanized. More focused on local markets, these SMEs contributed to local economies and individual wealth. The process intensified in 1992 when market-oriented policies cleared various legal and ideological hurdles. Between 1989 and 1992 an ideological struggle ensued over whether the government should allow the private sector to grow. Deng finally proclaimed that the government did not favor one sector over the other. As long as it boosted the Chinese economy with employment and revenues the government would support it. 
 Viewing the export sector as a critical pillar of economic growth, Beijing encouraged SMEs to broaden their market focus, and many engaged in low-end and labor-intensive manufacturing. Meanwhile, new tax laws in 1994 gave more autonomy to local governments and a greater percentage of local revenues to the central government, prompting local governments to promote private enterprises in order to sustain their income streams. During this time, China's SMEs flourished, as did a large number of entrepreneurs. 

They continued to do so throughout the 1990s, even as the central government restructured SOEs in the mid-1990s, consolidating the weaker ones and giving SOEs greater financial and political support. Clearly delineating certain boundaries between SOEs and SMEs, the government made sure that the rising status of SOEs in the country's economy did not hamper the growth of SMEs. Still, the state's concern over private enterprises' being outside of Beijing's political control never eased. It seemed that the more people private enterprises employed and the more these enterprises contributed to the economy the greater the government's desire to maintain control of the economy. Then in 2004, Beijing stopped construction of a locally approved project by Jiangsu Tieben Steel, a private iron and steel company in Jiangsu province, for violating environmental protection laws and state industrial policies. In the government's eyes, the real problem was the expansion of Tieben and other private enterprises at a blinding pace and the support they were receiving from local governments. This marked a turning point in the development of private enterprise in China. Since then, Beijing has gradually reduced its support for private enterprises and shifted its attention to state-owned entities that it could more directly control. Along with a reduction in financial support for private enterprises, regulations tightened and the connection between political elites and business elites became more complex. All of this culminated in the outpouring of financial support for SOEs during the 2008 financial crisis. The problem for Chinese private enterprises is that, while the country went through a series of privatization and market-oriented reforms, changes in the political system were minimal. Rather than promoting a free marketplace, political intervention created links between politics and business that made the promotion of SOEs the primary engine for economic reform. Political officials became deeply involved in the country's business affairs, with many business leaders being relatives or patrons of the political elite and many shuffling back and forth from one sphere to the other. This created a kind of "elite capitalism economy," one still very much directed by the central government. 


Lessons from the Qing Dynasty

Beijing was alerted to this phenomenon by Chinese academics, who repeatedly reminded the government of lessons learned by the Qing dynasty in the early 20th century, when it supported a state-owned economy at the expense of the private sector. With the Western incursion through China's "Open Door" in the 1840s, Qing rulers realized the importance of introducing foreign ideologies and technologies that could both modernize China and help it resist these Western forces when the time was right. In this process, a large number of entrepreneurs strongly backed by the dynasty created a form of "bureaucratic capitalism." At the same time, private enterprises also emerged, creating a group of national capitalists that wanted less government control. Still, the dynasty remained uncertain of the proper course and continued to vacillate between these two groups, frequently switching ownership of big projects and enterprises, particularly in a period with massive foreign exposure. In 1911, Qing rulers decided to nationalize China's railway system, in part using foreign loans. The system had been privately owned, financed in large part by local farmers who invested their proceeds from grain sales. The nationalization of the system sparked local protests that began in Sichuan and eventually spread nationwide. Although there were many other factors that undermined the dynasty's rule, the nationalization of the railway was the catalyst for the downfall of the Qing dynasty that same year. Currently, Beijing is facing enormous socio-economic challenges, with inflation and employment topping the list. Academic studies show that China's total private sector — small, medium and large enterprises — accounts for nearly half of the country's economy and 80 percent of its employment, so it is by no means insignificant. While a long-term goal for Beijing is to restructure SMEs and reinvigorate that part of the private sector, the situation may require more immediate attention. History shows that the predicament of private enterprises in China is not only an economic issue but also a political one. For a meaningful solution to the country's economic problems, Beijing may have to focus, once again, on supporting the private side of the economy as well as its SOEs.