For all its successes, state capitalism has fatal flaws

And the winner is…

Jan 21st 2012 | The Economist

THE RISE OF state capitalism constitutes one of the biggest changes in the world economy in recent years. Twenty years ago state firms were nothing more than parts of the government machine. Ten years ago there was widespread doubt about whether they could succeed. Today they include some of the world’s biggest companies, sucking up profits at home and taking on the world market with a will. Between 2005 and 2011 four of the world’s top ten stockmarket flotations involved Chinese state companies (and collectively raised $64.5 billion).

Is state capitalism the wave of the future, or is it simply one in a long line of state-sponsored failures? Some commentators have seized on the riots in Russia in December as evidence that it is already on its way out. Others point to the continuing problems with global capitalism, arguing that the state variety is winning the war of ideas. Andy Stern, a former boss of the powerful Service Employees International Union, argues that China’s economic model is superior to America’s and quotes Andy Grove, the founder of Intel: “Our fundamental economic belief …is that the free market is the best of all economic systems—the freer the better. Our generation has seen the decisive victory of free-market principles over planned economies. So we stick with this belief largely oblivious to emerging evidence that while free markets beat planned economies, there may be room for a modification that is even better.”

But state capitalism nevertheless suffers from deep flaws. How can the state regulate the companies that it also runs? How can it stop itself from throwing good money after bad? How can it remain innovative when innovation requires the freedom to experiment? MIT’s Mr Steinfeld argues that state capitalists are learning to play “our game” by listing their shares and engaging in mergers and acquisitions. That, he says, makes them a “self-obsolescing” ruling class. But state capitalists are surely playing “our game” in order to strengthen their political positions.
This special report has argued a different case. State capitalism is sufficiently good at mimicking the market to ensure it has plenty of life left in it. It is learning how to manage ideas from the West and impose some discipline on its favoured companies. It is also putting down ever stronger roots. There are state-capitalist banks, billionaires, bureaucrats and even paid-up ideologues (one Chinese analyst, having listed all of the system’s inefficiencies, says that he gives it “no more than 50 years”).

The future shape of state capitalism will be determined by two things. The first is rent-seeking on the part of the corporate elite. Management theorists have long agonised about the “principal-agent problem”—the tendency of managers to run companies to suit their own interests rather than the interests of their owners or customers. Under state capitalism this problem is as acute as anywhere. Politicians are too distracted by other things to exercise proper oversight. Boards are weak and disorganised. And the company’s mission tends to be a confusion of the commercial and the social.

There are plenty of examples of good practice for state capitalists to draw on. Singapore’s sovereign-wealth fund, Temasek, is a model of good management. Brazil has pioneered the use of the state as a minority shareholder. Norway has successfully shielded its sovereign-wealth fund and state oil company from political interference. But in both China and Russia the principal-agent problem is powerfully reinforced by the idea that state owned companies are great sources of jobs and patronage.

Secondly, state capitalism suffers from the misfortune that it has taken root in countries with problematic states. China combines admirable mandarin traditions with a culture of guanxi (connections) and corruption. Russia has the nepotism and corruption without the mandarin traditions. Brazil puts all the cards in the hands of insiders from both capital and labour. Transparency International, a campaigning group, ranks Brazil 73rd in its corruption index for 2011, with China 75th and Russia an appalling 143rd. State capitalism often reinforces corruption because it increases the size and range of prizes for the victors. The ruling cliques have not only the government apparatus but also huge corporate resources at their disposal. The People’s Bank of China estimates that between the mid-1990s and 2008 some 16,000-18,000 Chinese officials and executives at state-owned companies made off with a total of $123 billion.

The defining battle of the 21st century will be not between capitalism and socialism but between different versions of capitalism. And since state capitalism is likely to be around for some time yet, Western investors, managers and policymakers need to start thinking more seriously about how to deal with it.

Too visible, too strong

Investors are currently infatuated with emerging markets because they are growing rapidly at a time when rich markets are stagnating. But for the most part those investors are blind to the risks posed by the excessive power of the state there. Companies are ultimately responsible not to their private shareholders but to the government, which not only owns the majority of the shares but also controls the regulatory and legal system.

This creates lots of risks for investors. SOEs typically have poorer cost controls than regular companies. They also routinely pursue social as well as business goals. Investors can probably live with all this because at least it is predictable. More worrying is the potential for capriciousness. Politicians can suddenly step in and sack the senior management or tell companies to lower their prices.

Western managers also find it hard to deal with state-controlled firms. They tend to fall into one of two traps. Either they treat state companies as if they were exactly the same as private ones, and get caught out when policymakers swap company bosses around or redefine industries. Or they treat state companies as irredeemably second-rate—and may find themselves bought out by them or having their markets swamped.

In the past Western firms have been on the offensive; today they are increasingly warding off emerging champions. They used to have their pick of the best and the brightest people when they went into emerging markets; now they have to compete with local champions that can offer not only similar salaries but the chance to play for the home team.

CEOs in particular will have to start paying more attention to politicians in countries with state capitalism. Over the past 30 years bosses there gained greater freedom to run their own affairs. Some of them even began to imagine that they were “running a sovereign entity”, as Indra Nooyi, the boss of Pepsi-Cola, has put it. But in China and Russia ultimate sovereignty lies with the political class.

Western policymakers face even more difficult decisions than businesspeople. They will find their voices diluted as China and other state-capitalist countries play a more active role in multilateral institutions. And the rise of state capitalism in the East may encourage imitation in the West. The European Commission’s directorate for enterprise and industry has mused on the need to create European champions to fight “unfair competition” from overseas. Nicolas Sarkozy, the French president, has created a French sovereign-wealth fund. Alexandre de Juniac, as chief of staff to Christine Lagarde, then France’s finance minister, ascribed his country’s renewed enthusiasm for dirigisme to China’s influence. Japan’s Ministry of Economy, Trade and Industry in 2010 named the rise of state capitalism as one of the drivers of a newly interventionist industrial strategy. Worse, the rise of state capitalism in the East may encourage a trade war as liberal countries attack subsidies and state-capitalist countries retaliate.

But state capitalism’s biggest failure is to do with liberty. By turning companies into organs of the government, state capitalism simultaneously concentrates power and corrupts it. It introduces commercial criteria into political decisions and political decisions into commercial ones. And it removes an essential layer of scrutiny from central government. Robert Lowe, one of the great Victorian architects of the modern business corporation, described businesses as “little republics” that operate as checks and balances on the power of the big republic of government. When the little republics and the big republic are one and the same, liberty is fatally weakened.

from the print edition | Special repor