Robert Hormats, Addressing the Challenges of the China Model, May 11, 2011

Addressing the Challenges of the China Model

As prepared for delivery

Introduction

Thank you for the kind introduction, Myron. Thank you also to AmCham China for organizing today’s discussion on the emerging “China Model” of economic growth. This discussion is particularly timely. The State Department has been doing a lot of thinking recently on the challenges that the so-called “China Model” presents to our competitiveness and the global system.

Over the decade and a half after the fall of the Berlin Wall and creation of international economic institutions, such as the WTO, the world economy experienced one of the fastest periods of growth since World War II. Access to new markets, accelerating international investment, innovation, and entrepreneurship characterized the evolution of a truly “global” economy. A near-universal acceptance emerged that open markets and private capital were the keys to economic growth and development.

Today, however, we are seeing a new challenge to the global consensus on open markets and competitiveness that helped fuel the tremendous growth of the global economy since the early 1990s. In the wake of the global financial crisis, the State’s role in the economy may be gaining more appeal throughout the world. And a new model different from the Western liberal model for self-development is emerging—‘state capitalism’. China’s economic policies are an example of this new model.

The financial crisis spawned critiques of the U.S. economic model, which many in China saw as validation of its own economic growth policies. Without a doubt, China benefited tremendously from the inflow of foreign capital and over the last 30-plus years. And as a result of decades of reform and opening in China and its industrial policies that focused on building national champions, Chinese companies are increasingly competitive. Some are emerging to become serious global competitors. For example, 41 Chinese State-owned enterprises are listed among the 2010 Global Fortune 500. Three of the top 10 Global Fortune 500 companies are Chinese SOEs—Sinopec was #7, State Grid was #8, and China National Petroleum Corporation (CNPC) was #10. Other companies in the top 100 include China Mobile Communications at #77 and the Industrial and Commercial Bank of China at #87.

Some of these emerging Chinese competitors are competitive because they are innovative and entrepreneurial. But other Chinese State-owned enterprises and State-supported enterprises enjoy financial support, regulatory privileges, and immunities not generally available to their privately-owned competitors. In China, we also see government support through efforts to limit foreign investment in certain SOE-dominated sectors to joint ventures. Or performance requirements to transfer technology or requirements to purchase certain amounts of product from the domestic SOE are a condition of investment.

Today, U.S. companies face stiff competition from around the world. It is imperative that our companies have a level playing field on which they can compete. Policies that give select foreign companies unearned competitive advantages, whether in their domestic market, here in the United States, or in third countries distort competition. Thus, they are harmful not only to our companies, but to domestic companies in China and other companies around the world that do not have such advantages. To address this emerging challenge presented by the “China Model”, the U.S. Government is taking both a multilateral and bilateral engagement approach.

Multilateral Approach

At the Organization of Economic Cooperation and Development, we are working with representatives of its Member States and the OECD Secretariat to develop a Competitive Neutrality Framework. This framework is a set of policy recommendations that address the corporate governance, trade, investment, and competition issues that “state capitalism” poses.

Our objective is to reform the environment in which public and private entities compete, equalizing conditions all economic actors face in the implementation of their business plans. We would like to increasingly heighten the profile and attention devoted to this subject and raise it to higher political levels—including the Ministerial level at the upcoming OECD Ministerial meeting in May 2011. Once OECD work on the competitive neutrality framework has been settled, we will need to begin the process of convincing emerging and developing economies that adoption of competitive neutrality principles is in their long-term interests.

Engaging organizations such as the UN Conference on Trade and Development, a forum that China uses to discuss their state capitalism economic model, will be crucial to finding additional allies to support multinational standards in this area. The Chinese are not yet participating in the competitive neutrality framework discussions, but the United States is working to get them to the table. We expect them to join the OECD discussion in the future.

Although China is not currently participating, we also want to address emerging investment issues in the Trans-Pacific Partnership (TPP) negotiations, which create binding trade, investment and competition commitments. USTR is currently negotiating the TPP with nine economies to be a high standard, 21st century regional FTA. As it is intended to be a vehicle for Asia-Pacific-wide economic integration, the TPP is a major priority for the United States. It is an opportunity to set high standards for subsequent trade negotiations, and as such, we view it as a significant opportunity to move the SOE issue forward.

Bilateral

The role of SOEs in China's economy is an issue we continue to address in our bilateral exchanges. One of our challenges is to frame our concerns in a way that resonates with China's policymakers. Our goal is not to lecture China on what it should do, but to bring them into the discussion on norms and the international system as a whole. And demonstrate how China stands to benefit from being a responsible player in the existing global system.

Our Bilateral Investment Treaty (BIT) is another avenue in which I am hopeful we will be able to work on resolving some of the issues related to the function of SOEs. While our existing agreements provide important tools, we have been considering proposals by stakeholders in the Administration’s model BIT review to do even more to address the challenges faced by our investors in state-led economies.

The protections afforded by these agreements, such as those related to national treatment, market access and performance requirements, promote a level playing field for all investors and traders. Both President Obama and President Hu reaffirmed our countries’ commitment to the BIT negotiations during the State Visit last January. Also, we used the Investment Forum last May as an opportunity to continue discussion on SOEs, focusing on corporate governance and competitive neutrality concepts.

Questioning the China Model

In the medium to long-term, the inefficient allocation of capital to SOEs and SSEs, combined with preferential regulatory treatment and discriminatory market practices, will likely be unhealthy for China’s overall economy. It disadvantages smaller Chinese companies and an increasing number of vigorous private entrepreneurs that are becoming an increasingly powerful force in driving innovation, balanced economic growth and job creation. There is evidence that in China, the leadership and policy community recognize that the China model is not a sustainable proposition in the long run, despite its $2 trillion in reserves.

I was impressed by an interesting study from Unirule, an independent economic think tank in Beijing. The group recently released a study that argued that absent subsidies and preferential treatment, most of the over 120 SOEs studied had a negative net return on assets in 2009. According to the report, from 2005-2009, the average nominal net return on assets for Chinese SOEs was lower than that of non-SOEs. The ratios averaged 9.2 percent for SOEs and 13.3 percent for non-SOEs between 2005 and 2009. The profitability gap was significantly more pronounced when preferential subsidies and other assets were deducted from SOE nominal net return on assets ratio. The nominal net return on assets ratio for SOEs, calculated without preferential subsidies, yielded an average 2005-2009 ratio of 1.03 percent and a negative ratio of -2.44 percent in 2009. This study concluded that the performance of State-owned enterprises is not reflective of their true performance.

We are also seeing more calls for domestic SOE reform due to recent media reports of excessive compensation and reports of corruption. One Chinese media report that attracted significant attention stated that although SOE personnel represented 8 percent of urban workers, SOE personnel earned 50 percent of the wages and benefits of urban workers.

Another recent news exposé of SOEs using government money to buy liquor incited public outrage. During his press conference following the closing of the 2011 National People’s Congress, Premier Wen took a question from a CCTV reporter. The reporter asked the Premier to comment on a widely-held view that in China, the state-owned enterprises are forging ahead but private ones are falling behind. In response, Premier Wen stated that China’s “…policy is that we will unswervingly consolidate and develop the public sector of the economy and at the same time, unswervingly support, encourage and guide the development of the non-public sector of the economy.” Wen stressed that “we will treat all enterprises of different ownerships in the same way in terms of laws and policies, including fiscal, taxation, financial and market access policies”. Premier Wen also noted that while “the proportion of the public sector in the total economy is coming down; however, the public sector still holds the lifeline of the national economy. [But] State-owned enterprises are deepening their reform.”

The growing recognition of the necessity of SOE reform presents an opening for the United States and the multilateral system as a whole to engage China in a meaningful dialogue on this issue. We believe that China will ultimately find it beneficial to be a part of the international system, adapting it to the new challenges it faces and assuming greater responsibility within the system. Countries that pursue their own goals at the expense of the global system risk stifling the innovation and entrepreneurialism that they seek to cultivate.

Conclusion

The biggest challenge in addressing these issues effectively is forging a common understanding that state-controlled competition is not competition, and that competitiveness cannot be bestowed by decree. The trade distortions created by the “China Model” are disadvantageous to our U.S. companies trying to compete for opportunities around the world, and a direct threat to U.S. jobs and competitiveness. We will continue increase our dialogue with the Chinese on this high-stakes issue, and I look forward to feedback from AmCham China and the rest of the business community in the process. Thank you.