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Cite this item: S. Shafqat (2021). State-directed capitalism. Risk Concern. Available at: link.
State-directed capitalism is not a new idea if we consider the use of the British East India Company to accomplish Briton's colonist agenda, or the policies of the first United States Secretary of the Treasury, Alexander Hamilton, in 1789, enacted to protect national industries. Thus, every emerging economy has, at one point, relied on the State to instigate & maneuver economic growth or to protect its industries from international competition (TE, 2012).
State capitalism (SC), as per its nature, isn't, & cannot be classified as, an economic system, such as capitalism or Marxist collectivism (communism); however, put succinctly, it can be described as a capitalist system with distinct inflections of communism like 'central planning.' Nonetheless, the objectives of SC's central planning aren't the strict organization of factors of productivity to—at least theoretically—enable/achieve equal distribution; hence it isn't a 'system' that centralizes all decisions regarding economic productivity.
It can be easily understood as a state's decision to influence, organic, market governed economic activity, for achieving its own strategic objective. Thus, SC, fundamentally, is a capitalist system with pressures of an underlying centralized agenda.
Interest in SC has increased in recent years, especially due to the meteoric rise of China's economic and strategic power. State-directed capitalism, as a phenomenon, has also come to greater prominence over the last 20 years due to the emergence of states with control or de facto control of one-third of their country's largest companies. (CFR, 2016).
The instrument of choice used by state-capitalist countries for influencing market-directed economic activity, for their strategic & financial objectives, is the State-owned enterprise (SOE), which the United Nations' conference on trade and development defined as "one in which the State owns more than 10% of shares" (UNCTAD, 2017; TE, 2012).
Arguably, the prevalent 'new form of state capitalism' first emerged in Singapore during the early period of Lee Kuan Yew's administration; Yew, the country's founding father, is considered to be an advocate for family values and a 'functional authoritarianism.' He rejected the laissez-faire approach that had succeeded in other great port cities of Asia like Hong Kong.
Influenced by the Singaporean model, Deng Xiaoping adopted the model for the transformation of China. Similarly, Russia adopted an SC approach after the fall of the Soviet Union and the ensuing economic depression during the 1990 to 1995 period.
The disorder (structural & economic)—caused by the collapse of the Soviet Union—created a requirement for a functional system, which, arguably, could only be achieved swiftly through a regression towards some level of re-centralization. During this period, Vladimir Putin reasserted control over the strategic industries; with oppressive tactics, the private sector and the oligarchs were also made to yield (TE, 2012).
Presently, a form of state-directed capitalism, most prominently, is executed in Venezuela, Thailand, Malaysia, Russia, China, Brazil, Saudi Arabia, and UAE. These countries can be further classified into two spectrums of efficient and inefficient ones.
Russia, for example, arguably, is an inefficient state capitalist, as the State has established control on significant portions of the corporate sector, resulting in a dangerous, predatory form of pseudo-capitalism. The second tier of countries are those that can be classified as efficient or somewhat efficient, i.e., Singapore, Thailand, Vietnam, and even China, to some extent, despite prevailing problems (Kurlantzick, 2016).
The current era of state capitalism, which started in the late 1990s, is the second significant era in modern history; the first major period of wide-scale adoption of SC was after the second world war, when countries adopted protectionist policies to shield domestic industries. (CFR, 2016).
The rise of China, the establishment of its economic model as an alternative path, & the financial crisis of 2008, which significantly deteriorated the appeal of western-style free-market capitalism, coupled with the desire of a number of governments, especially those in emerging economies, to influence market activity as a means to achieve strategic & political objectives, enabled this alternative to free-market capitalism, to emerge as a third option. (TE, 2012).
Philosophically, one can argue that the invisible hand, which is the aggregation of individual choices, as described by Adam Smith (1776), in an SC environment, can have a 'glove on' of the Regime in charge, so to speak. The natural or self-balancing economic activity in such countries is synthetically manipulated to favor or disfavor certain spectrums of organic economic activity (micro & macro), making it more compatible with the objectives of the Regime/State.
Governments through an SC system can possess more strategic & political options compared to a purely capitalist economy. This, of course, doesn't mean that such an approach isn't likely to have long-term repercussions, nor does it mean that it is an ethically or morally justifiable system; further exploration of ethical and moral issues with SC is another debate altogether & beyond the scope of this work.
Many argue that we are currently in the zenith of the era of state capitalism. In China alone, "the central government owns about 51 000 state-owned enterprises (SOEs), valued at $29.2 trillion and employing approximately 20.2 million people and across the OECD, governments are majority owners of more than 2467 commercially-oriented enterprises valued at over $2.5 trillion, employing over 9.2 million people" (OECD, 2017).
SOEs have historically been less efficient than truly private enterprises, but their return on assets (ROA) has been improving gradually (Xiaozu Wang, 2004). This fact can be interpreted as: governments' are pushing firms under their influence to use more sophisticated methods of control, and the assets such firms hold are being used in more productive ways (Cuervo-Cazurra, 2014).
There is also pruning of portfolios by the States; a push towards more international ventures also seems to be a current agenda, in conjunction with a focus on creating and maintaining national champions (Ciprian V. Stan, 2014).
Such practices have further supported SC as a viable modus operandi; its apparent success gradually furthers its influence. As the percentage of SOEs in the Fortune Global 500 grows (from 9% in 2004 to 23% in 2014) (PwC, 2015), arguably, so too shall the allure of the SC system for those presently on the 'bench,' still contemplating the system's viability. It should be noted that the optics, at times, can matter more than facts, and currently, the wind seems to be 'blowing in favor of SC,' or so it seems.
Nevertheless, SOEs and the State's strategic involvement in economic activity creates complex relationships that shareholders/investors/stakeholders must understand. The accounting, financial, strategic & risk-related entanglements that are created through the involvement of governments in businesses, as a quasi-controlling block, create entanglements as complex to decipher as the intrinsic value of fiat currencies (the other major engineered, State-run operation).
Questions such as:
Who are the actual residual risk-takers of SOE's?
Are businesses that a government influences, as per the definition of an associate (an entity over which the investor has significant influence [IAS 28, para 3]), actually part of a group, of which the government should be considered the parent?
Shareholders that own shares in entities, as described above, should consider their shares as belonging to a class below what is officially assigned, due to the influence of the government on such firms?
Is the risk profile of the firms—influenced by a state—different from firms lacking such influence or endorsement?
Are firms in competition with SOEs actually more risky than what the fundamentals suggest due to being in competition with the State itself?
What are the true objectives of the State's involvement in business activity?
Are the executive board members of corporations that are influenced by governments, through ownership or otherwise, actually less empowered in the strategizing process?
Questions such as the ones stated here (& many others) arise in a state-capitalist environment.
Furthermore, we may never have definitive answers to such questions, as governments may purposely choose to keep such topics obscure for 'strategic ambiguity,' a common practice. Nevertheless, history teaches us that investors should always be skeptical when the nature of the investee's workings & business model isn't clear.
Investors and investment managers have to navigate a complex environment with conventional assets, as it is; the further complexity added through exposure to SOEs, & an SC environment, creates an additional layer of 'murkiness' that makes it challenging to model portfolio parameters such as risk, long term prospects, strategic direction, etc.
When the State influences businesses through part ownership or otherwise, due to its ability to influence & control matters internally as well as externally (tax rates, regulations, etc.), the influence or authority it actually possesses over such businesses, even with minority ownership, is far more significant than what an ordinary shareholder block can possess.
The State can override decisions made by the executive committee, oversight committee, risk committee, etc., not only for alternatives it sees best for the corporation but also when it deems alternatives to best suit its own strategic or political objectives.
Thus, external shareholders, that, theoretically, are the residual risk-takers and the ones that elect the members of the board, don't wield their full statutory powers in such firms. Even if shareholders elect a new board, the State can coerce the newly elected members to enact policies prescribed by the Regime through its internal and external powers.
Hence, at the very least, shares of such entities, or entities that may be influenced by the State, in ways that aren't purely beneficial for the strategic objectives of the entity and its shareholders, should be considered of a lower class, i.e., the actual voting power of each share being lower than what is stated.
Moreover, In an SC environment, the debate concerning the fundamental beneficiaries of the firms, as discussed under the three main models: the shareholder model, the stakeholder model, and the ecosystem model, is also rendered unnecessary. Corporations that are influenced by the State—in ways that alter their strategic and financial objectives—are in a de facto condition of favoring (or being obligated to favor) stakeholders' interests, i.e., such entities don't exist for the sole purpose of benefiting their shareholders (as is the case under the shareholder supremacy model).
Positive aspects of State Capitalism (for firms)
It can be argued that the direct or indirect involvement of the State in enterprises can reduce transaction costs as such 'oversight,' in effect, reduces fraudulent/deceitful behavior by firms. The active participation of the State, due to ownership of equity positions in the firms and the alignment of interests, can reduce transactional fiction.
Now, states are also aware that some degree of their involvement in the decisions taken by, for example, SOEs & others under their proxy influence (notable example: Huawei Technologies Co., LTD) is understood by external stakeholders/actors holding power. Thus, as they presumably cannot direct considerable controversial actions, their involvement, it can be argued, is limited to facilitating business activities, in ways described above, for example.
Due to this, their involvement can also assist in improving corporate monitoring, internal audit & control, in SOE & others under their influence, aligning activities so the overall efficiency is improved. The State can also have considerably more resources (diverse and multifunctional) than what an individual firm can possess; such resources can provide firms a substantial competitive advantage, especially in the international arena.
For example, governments possess far greater capabilities to conduct economic analysis, mimicking which may be practically impossible; when they share such resources with firms of strategic importance, they provide them with a vital competitive advantage, most prominently in the international arena.
For example, let's suppose that the US government acquired a 10% stake in, say, Microsoft Corp. and provided it with insights that FED's hundreds of Ph.D. analysts generate, coupled with other government resources. In such a condition, Microsoft would, of course, gain a very significant competitive advantage (as long as the government's influence is in the best interest of Microsoft).
Arguably, in such a hypothetical condition, the shareholders' power of ownership may be diluted more than the official figures, as explained above; however, they would also gain materially due to the significant competitive advantage provided by the government through access to resources otherwise unavailable. Individual shareholders, or blocks of shareholders, cannot provide such benefits to firms through ownership or association.
Arbitration & mediation provided by the State in conflicts & negotiations is another important benefit. The Regime's involvement in favor of such firms can provide a significant advantage. This can be a crucial benefit in the developing world, especially the middle east. For example, suppose that 10% of a firm is owned by the ruling family of, say, Saudi Arabia or the UAE; such a firm would, of course, have a position of substantial strength when negotiating or handling an external conflict.
Another benefit for the firms is that fully or partially state-owned firms can enjoy better access to valuable resources that the State has command over. This means that the State, as a shareholder, is more engaged in removing potential constraints such firms might have; such access can also broaden the productive capacity of favored firms, also removing the fiction related to strategizing regarding securing resources.
Furthermore, the State influences strategic thinking at the governance level to be more long-term; Hence, while the firm may have short-term pressures, the government's influence can broaden the planning horizons, preventing strategic myopia.
The SOE's can also enjoy subsidies or can influence the government to introduce tariffs to ensure success in the domestic or international market; gaining such favors conventionally through lobbying, etc., can be very expensive; however, as the government is a shareholder in the SOEs, it may see the facilitation of such entities as an extension of its own self-interest.
Governments that are in control of monetary policy & can also influence a substantial percentage of business activity at a micro-level—theoretically—can maneuver the pricing strategy of a significant portion of most prominent business entities. Such powers can assist a government in controlling factors like inflation, deflation, & disinflation more than those that can only control the monetary & fiscal policy. Stable inflation, of course, is beneficial for economic activity & businesses in the long term.
The Problems businesses face under State-directed capitalism
The role of the State, both as a regulator and as a shareholder, brings forth a clear conflict of interest; the defined boundaries or scope of the State as an overseer become unclear under such conditions, which is especially problematic for entirely privately-owned firms, as the regulator, clearly, can have a conflict of interest to side with the enterprise in which the regulator owns shares. This compromises the role of the State to be an unbiased regulatory authority and arbitrator in a conflict between purely private firms & those favored by the government.
The competition for capital can also be tilted in favor of SOE's & those favored by the Regime; on the other hand, privately owned firms competing against SOE's are more likely to be disfavored, especially if the State, as a regulator of the banking & finance sector, through formal actions or signaling, favors the SOEs.
State/private banks, pension funds, and other capital allocating entities can be influenced by the regulatory authority, which itself is a stakeholder in the application of the loan. It can "pull the strings behind the curtain" to favor enterprises it holds interest in. Unfortunately, such practices have resulted in suicides committed by many Chinese small-business-owners, as—for all practical purposes—they aren't in competition with other firms, but in competition with a State-backed Structure, with resources that small-to-midsized firms cannot practically possess (Orlandi, 2013).
Thus, there are many hurdles faced by entirely private firms in such environments; questionable practices used by the State in its quest to create 'national champions' are also common (Anna Grosman, 2016).
The emergence of state capitalism has also revived the relevance of concession or fiat theory (the sovereign offering incorporation as a privilege through a charter, incorporation not being a right), as state capitalists bring the involvement of the 'sovereign' in the macro & micro-level back into relevance.
Just as before the 19th century, when incorporation was a privilege granted by the State, with the State viewing the granting of such privilege through the prism of its own self-interest (Galanis, 2009), the same is the mentality of the state capitalists of the current era; though incorporation is a right in SC countries, to be successful & for securing & maintaining a position of strategic dominance in most SC countries, firms & entrepreneurs, unfortunately, need a functional understanding of how the quid pro quo relationship, so to speak, works in such environments.
Such relationships needn't be with those wielding the highest political power, as long as an understanding is established at the level relevant to the firm.
For example, to do business in China, one must understand the concept of 'guanxi': a relationship of reciprocity or—put another way—'quid pro quo,' that ideally must be established with authority at the level relevant to the firm. If this isn't done, the subject may not hold an equal playing field with the competition that is in a quasi-alliance with the relevant level of authority.
The transactional nature of such 'obligated' relationships with the authority further festers cronyism and nepotism in such companies.
The case gets extreme with middle eastern countries, such as UAE, Bahrain, & Qatar, where international companies need a local sponsor to do business (preferably part of, or connected with, the ruling family [monarchy] in these regions). Indeed, such an environment cannot be classified as 'optimal for conducting business.'
Arguably, state capitalists' apparent desire to participate in micro-level affairs, as done in middle eastern countries, illustrates a tilt in favor of the pre-nineteenth-century like system, where all incorporation and major activities of commerce had to have a seal of approval from the sovereign; nonetheless, the dynamics of the international economic system prevents them from furthering such agendas.
SC is a third option available to emerging economies; it is neither full-fledged Marxist collectivism nor a purely capitalist system. Clearly, the principles of free-market for all firms are not achieved under such an environment, as the State creates a disequilibrium in favor of the SOEs & others under its influence, in a quest to develop national champions, or for achieving its own strategic or political objectives; it can then use such entities as an extension of itself.
Ownership and control are further complicated in such environments as the State, even with a minority position, can maneuver organizational direction as a de-facto owner, regardless of the majority owners' interests; the State, through its inherent power, can overrule all decisions as well, in a variety of ways, this also means a divergence from shareholder supremacy model.
Thus, it can be argued that SC is a 'mentality' that favors corporate nominalism as theoretical legitimacy of executive power, as under corporate realism and managerialism, is compromised through the State's superseding managerial/oversight power and discretion.
The powers that the States gave up by making incorporation a right, through general incorporation statute, is, in a sense, reclaimed under SC; this condition revitalizes the importance of concession theory for understanding the SOEs objectives.
SC raises serious questions that don't have straightforward answers; investors and analysts must understand such complexities; adding SOEs or entities exposed to such environments can complicate modeling of risk, returns, interrelations, etc. Such obfuscations can create further challenges for portfolio managers with exposure to such regions.
Firms can, theoretically, benefit from the advantages offered by the State through its involvement with businesses; these are discussed in this work; nonetheless, SC can create insurmountable challenges/problems, especially for purely private firms.
Whether SC, as a system, would pass the test of time is still open to debate. However, arguably, its success or failure, crucially, would depend on the degree of involvement governments hold in strategic & economic decisions made by those under their influence in such regions. If the governments act as a facilitating and maneuvering agent that works in the best interest of economic activity, long-term success would be more likely.
Nevertheless, if regimes overuse such powers for, primarily, their own self-interest, with reflexive myopia, this 'experiment' may not go well for them for long.
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