Unlike industries controlled by a few giants such as oil, railway, utilities and telecommunication, the industrial sectors in China are actually highly fragmented.
According to neoclassic economics theory, perfect competition will lead to ideal “market equilibrium” where supply and demand are equal and economic resources are allocated under Pareto efficient allocation. It also suggests that any one firm or customer is so small relative to the whole market that their presence or absence leaves the equilibrium very nearly unaffected. There are other theories which tend to emphasize the fact that the more competition there is, the more customers will benefit from constant product improvement with minimum premium in compensation.
But in real life, we are compelled to deal with imperfection where most theoretical assumptions cannot be met and will consequently affect each other. Although market fundamentalists will most likely disagree, leaving the philosophy debate behind, the point to be made here is that competition is sometimes itself inefficient. This is not only due to the common worry with respect to oversupply, but also the concern regarding over-fragmentation, which means resources are not allocated effectively. In a world of imperfection, bounded by both economic and non-economic restrictions, such inefficiency cannot be eliminated spontaneously or instantaneously by the market’s self-adjusting mechanism. Therefore, by wisely consolidating vertically or horizontally within certain value chains, economic resources can be reallocated to improve utilization leading to critical mass and overall efficiency improvements.
As the world’s No. 1 manufacturing country, China has massive industrial sectors where inefficient fragmentation is almost the norm. In most of the industrial world—albeit not in every sector—we are hard-pressed to name a leading company from China. Many Chinese industrial companies are competing against each other at the bottom part of the value chain resulting in modest margins. While Chinese companies in emerging industries like electronics and the Internet are booming, traditional industrial sectors are still struggling.
In particular, these difficulties are often associated with state ownership and biased local administrative protection. It is not embarrassing to admit that SOEs in China are not the most efficient on operational levels; this is more or less universally true. It is also understandable that, due to their half-enterprise-half-administration feature, commercial goals are often distracted by social responsibilities, such as job creation and health insurance for retired staff. It is not surprising to see some large SOEs run their own hospitals, banks, and sometimes even police stations and courts. These almighty all-around-mini-society-like SOEs are actually the legacy of the central planning economy and still exist despite the fact that aggressive reforms have taken place since the late 80s. In return, the large social-burdening industrial SOEs usually enjoy two privileges: protection from the local government and easy access to financial support from the commercial banks, both of which enhance each other reflexively. Moreover, since there is too much to take care of well, many SOE managers care less about operational optimization (no layoffs, of course), technology innovation and product diversification (they are unwilling to take risks unless it’s a political assignment). Therefore, it’s quite common to see SOEs within a certain industry end up very similar in terms of product line and large size. That is how overlaps and fragmentation occur.
Consolidating overlapping fragments under such circumstance has turned out to be quite difficult. To acquire or merge with an SOE always looks challenging. There can be painful regulatory approval processes, the local government’s reluctance to face potential spinoffs, layoffs and even closures, and extensive hard work after the acquisition to fully consolidate the acquired target.
For years, the central government has urged SOEs to carry out consolidations to build stronger companies and achieve industry upgrades. This is also one of the priorities in the 12th-5-year-plan. But bad news has arisen from time to time.
One recent example of such bad news is the automotive industry. China is now the world’s largest auto producer and consumer yet it lags behind in automotive technologies although all of the major companies are huge in terms of size. The central government has prioritized the consolidation within this particular strategic industry. With encouragement from Beijing, Changan Auto, one of China’s major automakers, managed to close the acquisition of Jiangxi Changhe Auto. Both the buyer and the seller are owned by the state. However, the post deal consolidation has turned out to be quite challenging. One of the major overlaps is in the minivan product line, which Changan has been trying to cut down. The buyer should have expected a boycott, and the Changhe workers staged a four-day strike leaving Changan no choice but give up the reduction attempt. According to Chinese media, the recent interference from the Jiangxi government will very likely waste Changan’s integration efforts. The ironic fact is that Changan itself is also a consolidation of the spin-off auto business from two major SOEs, China South Industries Group and Aviation Industry Corporation of China. Although the combined company has been trying hard to integrate, similar obstacles still exist, resulting in considerable overlaps among its subsidiaries in different places.
It is not unusual for such a massive country managed by such a complicated bureaucratic hierarchy to have difficulties enforcing the central government’s decisions, since balancing local interests is not remotely easy. A number of initiatives have been launched and ended in barely satisfactory results in industries like steel, cement, electrolytic aluminum, automotive, fertilizer, rare-earth metal, LED, textiles and so forth.
While it takes time for SOE managers to become willing and capable of making the companies leaner, more efficient, and for them to care more about product diversification, we also need to pray that local governments back away from market activity, which would rely on the central government’s efforts and political reforms.
Homogenized fragmentation also exists in the private sector, but things are quite different for private companies. China has quite a young private sector that has been booming since the “open and reform” policy introduced by Chairman Deng Xiaoping in late 1970s. The founders of private companies are, of course, not keen to sell their business, but they are retiring. The “2nd generations” are taking over, but some of them are not as passionate as their fathers. As a result, acquisitions have become possible. Moreover, private companies are much more agile and flexible than SOEs so we don’t have to worry as much about redundancy, internal overlaps and integration failure. Although local governments’ protection of large companies (i.e. major local tax payers) and their reluctance to accept layoffs or even closures still remain a problem, this could be far less painful compared to the resistance towards the consolidation of a major local SOE.
In order to facilitate consolidation, among various factors, encouraging policy reform and human capital are the most important. We are glad to see, for example, the development of the capital market driven largely by evolving policies that has enabled such consolidation to speed up. On the other hand, we have nurtured considerable human capital including bankers, accountants, lawyers, PE professionals, etc in the last 10 or 20 years, who can act as competent deal facilitators and keep companies from the unnecessary agony of painful deal-breaking and integration failure.
All in all, industrial sectors are not the only sectors which need serious consolidation. Nevertheless, it’s very urgent for industrial sectors since China, the biggest manufacturing country in the world, needs an immediate upgrade. China’s real economic growth in the next few years will rely less on raw accumulation of resources, such as capital, land, and labor, and more on productivity improvement. It is certain that a very important part of this improvement will occur as a result of industrial consolidation.
