Seafarer®

Pursuing Lasting Progress in Emerging Markets®

Prevailing Winds

China’s Complicated Relationship with the Private Sector

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

China’s private sector appears to be under an unprecedented assault. Over the past year, the Chinese government has embarked on a wide-ranging regulatory crackdown, targeting the technology, e-commerce, education, fintech, and real estate sectors. The Communist Party is demanding “golden shares” and party committees within companies to better exert control over the private sector.1 Access to finance remains difficult for many private companies in China, with banks preferring to lend to state-owned enterprises. Xi Jinping’s new rhetoric around “common prosperity” has stoked fears that a broader shift against market reforms is underway.2 To understand the risks and challenges of the current moment, it’s helpful to review the complicated and often contentious relationship between the Chinese government and the private sector.

A Slow and Uneasy Acknowledgment of the Private Sector

China’s economic transformation has been a mix of both bottom-up liberalization and top-down policy reforms. In 1978, farmers in the province of Anhui took the lead in dismantling China’s collective agricultural system, dividing the land among themselves in violation of the rules.3 Chinese leaders permitted the experiment to continue and then allowed it to spread across the country.

Throughout much of the 1980s, private companies were still illegal in China. Savvy Chinese entrepreneurs launched businesses through town and village enterprises that were nominally owned by collectives or local governments. This process, known as wearing the “red hat,” provided legal cover for private companies that had no legal basis to exist.4 As this activity proliferated, these quasi-private firms were acknowledged and later approved by the Chinese government.5

Under Deng Xiaoping’s rule, the mantra “to get rich is glorious” became a shorthand representation for the Chinese government’s growing acceptance of the private sector and private wealth. Despite this rhetorical support, the institutional environment for the private sector was difficult. Small private businesses were limited to employing a maximum of five employees and were only allowed to operate in certain sectors.6 In 1988, the Chinese government published the “Tentative Stipulations on Private Enterprises,” formally acknowledging the existence of private firms and approving some private ownership structures.6 Yet, private companies continued to be subject to a host of discriminatory taxes, fees, and restrictions compared to state-owned enterprises.7

With the passage of the 1994 Company Law, private companies were granted a more formal legal basis and many collective firms “took off the red hat” and registered as private.8 In 1999, the constitution was amended to acknowledge the private sector as an “important component” of the economy, rather than a mere “complement” to the public sector.9 However, to this day, China’s constitution still states that the state-owned economy is “the leading force in the national economy” and that the government will ensure its “consolidation and growth.”10

While private companies began to proliferate throughout China in the 1990s, entrepreneurs were not invited to join the Communist Party until 2001.8 This marked a begrudging acknowledgement that the Party couldn’t govern the newly emerging China without co-opting the increasingly influential private sector.

In 2004, China’s constitution was amended to enshrine the right to private property. Despite this and other reforms, private entrepreneurs continue to complain vociferously about discriminatory legal treatment compared to SOEs.7

Reforms Are Driven by Necessity, Not an Ideological Commitment to Free Markets

In the late 1990s, China was faced with significant challenges that acted as a catalyst for economic reform. A non-performing loan crisis and the Asian Financial Crisis spurred Chinese leaders to restructure the financial system and state-owned enterprises. The banks were cleaned up, recapitalized, and publicly listed. Thousands of inefficient and loss-making SOEs were shuttered. These reforms led to better access to financing and more space to compete for the private sector.

Even during this period of bold reforms, China’s leaders never supported large-scale privatizations. The policy of that era was called “Grasping the Large, Letting Go the Small.” As the name indicates, China was focused on shuttering smaller state firms while consolidating and strengthening large ones.

As acute threats to the economy waned, so too did China’s commitment to meaningful economic reforms.11 There were modest and incremental reforms during the 2000s, but nothing on the scale of the massive reforms of the late 1990s. By the mid 2000s, Chinese policymakers were designating large swathes of the economy as strategic industries to be led by the state and consolidating state-owned enterprises into ever-larger conglomerates.12 Critics have referred to the end of Hu Jintao’s tenure in power (2002-2012) as a “lost decade” for reform.13

At the start of Xi Jinping’s administration, and amid a period of relative economic weakness, the Chinese government made a bold declaration that it would allow the market to play a “decisive role” in the economy. However, economic reforms since then have been halting and disappointing.

Moreover, since around 2015, a clear shift towards supporting state-owned enterprises has been evident. Rather than shutting down failing SOEs, the Chinese government arranged for mergers to create ever-larger state conglomerates. Additionally, credit has increasingly flowed away from the private sector and toward state-owned enterprises.14 As shown in Figure 1, the Xi administration’s support for SOEs has led to a decline in private capital as a share of total fixed asset investment.

Figure 1. Private Sector Share of Fixed Asset Investment in China
Sources: CEIC, Seafarer.

A Private Sector-driven Economy

From the start of the reform era through to the present day, the private sector in China has succeeded despite a difficult legal environment, continued government support for state-owned enterprises, and a ruling party that views private capital with suspicion.

When given a chance, private companies in China often displace their state-owned competitors through faster growth and greater efficiency. Private companies overcome the banking system’s tilt towards SOEs by self-financing their growth with retained earnings and borrowing through non-traditional channels, such as microlenders.8

In China’s impressive manufacturing and construction sectors, private enterprises have supplanted state-owned enterprises to a large extent. Reflecting this shift, Figure 2 shows that private enterprises are now the dominant source of China’s total exports.

Figure 2. Chinese Exports by Firm Type
Sources: CEIC, Seafarer.

China’s service sector has more barriers to entry for private firms. Nonetheless, the private sector has still made significant inroads into the real estate, wholesale and retail, information technology, business services, and hotels and catering industries.15

The net result is that despite many obstacles, private companies are now the leading force in the Chinese economy. This is a fact that Xi Jinping and other top Chinese leaders, perhaps grudgingly, have acknowledged repeatedly. According to Xi, private companies pay 50% of tax revenues, account for 60% of gross domestic product, 70% of technological innovation, 80% of employment, and 90% of total enterprises in China.16 These statistics may even underestimate the private sector’s contributions, as other credible estimates show an even higher share of economic activity stemming from private companies.15

China’s economy would not be the powerhouse it is today without the country’s dynamic and adaptive private sector. China’s constitution may declare SOEs as the leading force in the economy, but the private sector has claimed that title for many decades.

Putting the Bird Back into the Cage

In the early days of China’s reforms, the market was described as a bird to be kept within the confines of a cage. That cage was the Party’s plan for the economy. The bird could fly freely within the cage, but never outside it.

Since then, China’s economy has grown well beyond the control of central planners. Through bottom-up entrepreneurial drive, private companies have transformed the economy in ways unforeseen by China’s leaders.

In response to a large and freewheeling private economy, the Chinese government is trying to force private companies back within the confines of the cage. The private sector should obey the leadership of the Party and support national goals and policies.

Certain industries are guilty of “barbaric growth” and “disorderly expansion,” to use the Party’s own parlance.17 The Chinese government is now engaged in a widespread rectification campaign to bring these industries to heel. The size of the cage for companies operating in the industries has suddenly become much smaller.

Some analysts have claimed that China is in the midst of a regulatory cycle that will soon wind down.18 However, there’s little evidence that the actions underway are a one-off episode or have a predictable endpoint. The lack of checks and balances within China’s legal and regulatory system mean that shifts in policy can be dramatic and occur without advance notice. Moreover, affected companies have extremely limited legal recourse to challenge the government on policies that negatively impact them.

While many questions remain about the present situation, what can be said with certainty is that China’s entrepreneurs have succeeded in the past despite an intensely challenging political and legal environment. China’s economic transformation is as much a story of private enterprise thriving in difficult circumstances as it is the government leading through top-down policy reforms.

China’s early entrepreneurs were adept in working around legal barriers, competing with subsidized state-owned enterprises, and placating a suspicious ruling party. The entrepreneurs of today may be forced to relearn many of these same skills.

While private companies are no longer prohibited, they are forced to show obeisance to the Party and its goals for the country. Private companies face pressure to establish party cells within their corporate structure and government-linked investors are taking ownership stakes in strategically-important private companies.

To emerge with their businesses intact, private companies in Beijing’s crosshairs are donning a new “red hat.” China’s tech giants Alibaba and Tencent are a case in point. They graciously thank the government for its guidance even when new regulations damage their business, co-invest with the state to support national projects, and proclaim their enthusiasm for increasing the role of the Party within their company. All the while, they desperately seek to retain control over business empires that the government is increasingly set on breaking.

Other Chinese private businesses have adopted a different tactic: keep a low profile and try to avoid undue attention from the government. The extent to which this is possible depends on their size and the political sensitivity of the industries they operate in.

For investors, some analysts have argued that the path forward is to “invest with the state” and put capital into government-favored industries. However, this approach is difficult given that favored industries often change and new regulations can bring previously favored industries to their knees with little warning. When the Chinese government has embraced private companies, it has done so when they can serve as a tool to advance national goals. There has never been an ideological commitment to private enterprise for its own sake.

The best approach is to find companies with good core businesses that can hopefully succeed in a variety of environments. That is not a guarantee of success, but it is a stronger foundation than trying to read the tea leaves of Beijing’s intentions.

The current situation for the private sector in China is complex, difficult, and fraught with risk. In that sense, it shares much in common with the past.

Nicholas Borst,
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of June 30, 2021, the Seafarer Funds did not own shares in the entities referenced in this commentary.
  1. Zheping Huang, “Beijing Tightens Grip on ByteDance With Rare China Board Seat,” Bloomberg, 17 August 2021.
  2. “Xi Jinping’s Talk of “Common Prosperity” Spooks the Prosperous,” The Economist, 28 August 2021.
  3. Xiaolu Wang, “China's Macroeconomics in the 40 Years of Reform,” in China's 40 Years of Reform and Development: 1978–2018, edited by Ross Garnaut, Ligang Song, and Cai Fang (Australia: ANU Press, 2018).
  4. Yasheng Huang, “How Did China Take Off?,” Journal of Economic Perspectives, November 2012.
  5. Chenggang Xu and Xiaobo Zhang, “The Evolution of Chinese Entrepreneurial Firms: Township-Village Enterprises Revisited,” International Food Policy Research Institute, April 2009.
  6. Ross Garnaut, Ligang Song, Yang Yao, and Xiaolu Wang, “Private Enterprise in China,” Australian National University E Press, 2012.
  7. Victor Nee and Sonja Opper, “Capitalism from Below: Markets and Institutional Change in China,” Harvard University Press, 2012.
  8. Nicholas Lardy, Markets Over Mao: The Rise of Private Business in China (Washington, D.C.: The Peterson Institute for International Economics, 2012).
  9. “National People's Congress, 1999 Amendments to the PRC Constitution, March 15, 1999,” University of Southern California US-China Institute, Accessed 6 September 2021.
  10. “Constitution of the People's Republic of China,” The National People’s Congress of the People’s Republic of China, Accessed 4 September 2021.
  11. Barry Naughton, “A Perspective on Chinese Economics: What Have We Learned? What Did we Fail to Anticipate?,” in Engaging China: Fifty Years of Sino-American Relations, edited by Anne F. Thurston. (New York: Columbia University Press, 2021).
  12. Ligang Song, “State-owned Enterprise Reform in China: Past, Present and Prospects,” in China's 40 Years of Reform and Development: 1978–2018, edited by Ross Garnaut, Ligang Song, and Cai Fang (Australia: ANU Press, 2018).
  13. Cheng Li and Eve Cary, “The Last Year of Hu’s Leadership: Hu’s to Blame?,” The Jamestown Foundation, 20 December 2011.
  14. Nicholas Lardy, The State Strikes Back: The End of Economic Reform in China? (Washington, D.C.: The Peterson Institute for International Economics, 2019).
  15. Chunlin Zhang, “How Much Do State-owned Enterprises Contribute to China’s GDP and Employment?,” The World Bank, 15 July 2019.
  16. Xi Jinping, “Speech at the Private Company Symposium,” Xinhua, 1 November 2018.
  17. “Uphold Regulatory Standards and Promote Development with Both Hands, Both Hands Should be Hard (坚持监管规范和促进发展两手并重、两手都要硬)” People’s Daily, 8 September 2021.
  18. Livia Yap and Jeanny Yu, “China Tech Crackdown Cycle Nearing an End, Top Investor Says,” Bloomberg, 3 June 2021.