Many factors contributed to the poor performance of the SOEs in the 1990s.

Firstly, because of historical reasons, SOEs bear a heavy responsibility of providing its employees with a host of social services and securities, including housing, education, health insurance, and pension provision. Each large- and medium-sized SOE essentially functions very much like a city within a city and the leader of the enterprise working like a mayor of the city. It has a community that includes all the amenities that one needs and can normally find in a city. The costs of running a SOE therefore go way beyond the normal operations of a business, causing profitability to be persistently depressed. It has been estimated that about 40% of the difference in profitability between SOEs and TVEs can be attributed to social welfare provision (Xiao, 1991). Since most of the workers are on tenured basis, SOEs in effect have been providing support even for redundant workers. Even though their sales have declined over the years as a result of competition from new enterprises, SOEs had to keep on its payroll staffs that it employed before the start of the reform. Bell (1993), for example, estimated that about 20% of employees in the SOE sector are redundant.

Another area which worked as a disadvantage to SOE was their tax liability at least until tax reforms were implemented in 1994. Before 1994, the nominal tax rate of corporate income for large- and medium-sized SOEs was 55%. Private enterprises and foreign-investment enterprises paid 35% and 33% respectively while small SOEs and collective enterprises paid tax rates ranging from 7% to 50 %. After the tax reform in 1994, the corporate tax rate for all domestic enterprises was unified ay 33%. Notably, despite the adjustment in the tax rates, SOE’s tax contribution constituted 71.1% of total government revenue, unchanged from those of the previous years. One possible reason to explain the persistently high percentage of tax revenue contribution by the SOEs was that tax evasion for non-state enterprises could be easier for the non-state enterprises. This ease of tax evasion by the non-state enterprises put the SOEs in a relatively unfair possible.

Thirdly, being disadvantaged by the tax policies, SOEs also lost out because price control on selected products was still in force. As a result of the low prices, SOEs in industries such as energy, grain storage and processing, and the weapon sector were deprived of the opportunity to make a reasonable profit.

Another factor which contributed to SOEs’ losses was the failure of the state investment system within which investment decision-making boiled down to distribution of rights to the possession and use of scarce state assets including budget funds, bank loans, land, quotas of power, oil, and other key materials (Sun 1998s). The objectives of local governments and SOEs were therefore to obtain and occupy as much investment and property from the distributive negotiation process as possible so that they can reap future benefits and justify their power base. In other words, SOEs took on investment projects with little concern over profitability. In any case, losses would be borne by the state. In the end, the disregard of project viability and the persistent soft-budget constraints resulted not only in explosive growth of inefficient investment projects but also widespread duplication of efforts at the national level. The duplication led to industrial overcapacity which led to enterprise failures when market became saturated amidst strong competition. In 1993, for example, China had 126 automobile factories and 5,000 re-equipping automobile factories with a theoretical capability of producing 1 million automobiles per year. However, most of these factories had no economy of scale by any standard and the average utilization ratio of capacity was less than 50 per cent (Sun, 1997a).

Not surprisingly, the investment inefficiency exacted its toll on the capital efficiency of the SOE. During 1985 – 1992, for example, even though the net value of fixed assets industrial SOEs with independent accounting systems increased 700 billion yuan from 398 billion yuan to 1,098 billion yuan, their realized pre-tax profits rose by only 61 million yuan from 133 billion to 194 billion yuan. The incremental ratio of fixed assets to pre-tax profit of 11.5 indicated that every 11.5 yuan increase in fixed assets (net of depreciation) resulted in only one yuan increase in pre-tax profits. (SSB, 1993)

Despite the abundance of statistics indicating the poor performance of the SOEs, however, it had been pointed out the actual performance might not be as bad as it looked because of several irregularities in the ways SOEs operated (Jefferson, 1993).

One such irregularity was the diversion of SOEs’ assets and profits through backyard profit centres. In order to create jobs for the children of their employees, many profitable SOEs set up new branches, using the equipment and technologies of the parent SOEs free of charge. These branches were often registered as collectives and therefore assumed independent identities. Profits were also often diverted to such branches to avoid tax and to increase the incomes of the managers and employees. Over time, however, many SOEs also transferred profits to firms set up by sons and daughters in the name of subsidies and employment creation (Qian, 1995). Very often, such branches also make profits by simply selling the low-price planned goods from the parent SOEs at going market prices.

Besides the creation of backyard profit centres, many SOEs also set up joint ventures with foreign firms to take advantage of preferential policies meant for such Sino-foreign ventures. Even though SOEs were the majority investors, such ventures were not counted as part of the SOE sector officially. Over time, many of them, especially the more successful ones, were transformed into joint stock companies and classified into the category of ‘other ownership firms’. Hence, it could be possible that official statistics suffered selection bias in reporting the results of mostly SOEs that performed poorly.

Next, another reason SOEs under-declared profits could be attributed to the ratchet effect. Since a higher profit attained in one year was likely to invite a higher target the following year, there is a motivation for SOEs to under-report. In the end, many SOEs reported profits as merely break-even so that they were in a better position when negotiating for future profit targets.(Zhou 1993).

Finally, many managers of SOEs also undeclared their profitability so that they could benefit from the organizational restructuring of the state sector that had been taking place since the early 1990s. In 1992, the enactment of the Ordinance on Restructuring the Management Mechanisms of State-owned Industrial Enterprises, for example, greatly expanded the autonomy of the state enterprise leaders. On the other hand, however, state enterprise leaders’ financial rewards continued to substantially trail behind those received by non-state enterprise leaders. To enrich themselves, many state enterprise leaders began to make opportunistic use of their increased autonomy for private gains, often at the expense of their enterprises.

One commonly used approach was to seize control of the state enterprises through management buyout. Managers would first intentionally cause company to underperform so that the assets of the loss-making enterprise could be undervalued. After buying over the company at low price, the company could start making profit again or the assets could be sold at much higher price. The problem was that there was neither proper valuation of assets by a third party nor a transparent process of open bidding for the assets. As a result, the management could set a price they wished to pay for the assets and acquired the assets. It was reported that, in 1996 alone, over 6,000 small and unprofitable state enterprises were closed down and their assets were liquidated. The self-seeking behavior of corrupt state enterprise leaders explains why performances of state enterprises markedly deteriorated in the 1990s even though their decision-making authority significantly increased.

Hence, corruption in China was not confined to government officials. In fact, 1990s marked the beginning of extensive managerial corruption especially of state enterprise leaders.