Over the past 40 years a truly dynamic private sector has emerged from nothing and now dominates the Chinese "world factory" of manufacturing exports. But while the Third Plenum of the 18th Party Congress in 2013 declared the market to play a "decisive role" in the economy, it also reasserted the "dominant position of public ownership."

The most visible manifestation of China’s public ownership is its state-owned enterprises (SOEs). At home they dominate key upstream sectors such as energy, resources, telecommunications, and banking. Abroad, they are the vanguard of Chinese overseas direct investment.

But given the oft-reported problems of China’s state sector, is maintaining public ownership consistent with China’s aspiration to become a high-income market economy? To answer this, we must be clear on what meant by "state," "ownership" and "enterprise."

China’s political system is often caricatured as a system of red telephones all ultimately connected to the desk of Chinese Communist Party General Secretary Xi Jinping. But while the general secretary is a powerful man, a more accurate description of China’s political governance is "fragmented authoritarianism." Power and responsibility are delegated downward to provincial and local levels of government, as well as horizontally between state ministries with different, often competing functional responsibilities.

On paper, SOEs are owned by "the people as a whole," but in practice each of the more than 100,000 SOEs is under the administration of a particular body within this matrix. Some 104 of the most important SOEs are under the administration of the State Council’s State Asset Supervision and Administration Commission (SASAC). This body is responsible for China’s flagship projects as well as its key infrastructure and defence industries.

There are also 900 other ‘central’ SOEs that report to the Ministry of Finance via other state and party agencies and ministries, including China’s biggest banks. Profits from these central SOEs contributed 8 per cent of the central government’s 2015 budget, of which the lion’s share came from finance.

Thousands more SOEs are under the practical control of provincial and even county-level governments. These SOEs report through provincial and sub-provincial SASACs and finance bureaus rather than the central finance ministries. The huge variance in local interpretation and implementation of central government directives creates a greatly fragmented SOE model. For instance, cash-strapped provinces such as Liaoning take SOE reform as something along the lines of privatization, while financial services frontrunners such as Shanghai interpret it as creating state capital management.

When we consider the notion of ownership, for an SOE this can mean giving some owners the right over an enterprise’s financial profits, others the right to appoint or supervise management, and others the right to approve certain domestic or overseas investments. How these rights are distributed affects the incentives and therefore the behavior of SOEs. The creation of SASAC in 2003 was partly motivated by a desire to consolidate previously dispersed rights to decide employment, investment and other key decisions into a single decision maker that could be held accountable.

Even this consolidation of rights is incomplete — the right to appoint the top leadership of China’s most important SOEs rests not with SASAC but with the party’s Organization Department, while revenues ultimately flow through the Ministry of Finance.

In other cases, agents of the state actually give up some rights in order to achieve access to outside capital, technology and even supervision. For example, publicly listing SOE subsidiaries not just on stock markets within China, but on international markets in Hong Kong, New York and London introduces new transparency issues and outside constraints. So it should not be surprising that the boss of a minority-state-owned subsidiary of a provincial SOE might think and behave quite differently from the head of a central Chinese oil SOE whose next career move may be into the Politburo.

The final fragmentation relates to role of the enterprise itself, in particular the relationship between business and the party itself. According to its constitution, the party’s role in a public company extends to participating in major final decisions. In private business, the party has a narrower role to provide guidance in observing state laws and regulations. But in both cases the existence of party cadres and party discipline within ostensibly independent economic entities muddies any clear distinction between politics and business.

Chinese SOEs are not unique in terms of their relation to the state. In any environment that gives officials or politicians discretion to create rents, adjust regulations or spend money, even private companies have a strong incentive to develop close relationships and networks with current and prospective government officials. Consequently, while non-state companies in China lack formal ownership links to the state, any large and successful private or foreign firm needs to keep the state and party on side.

What are the implications of this fragmentation for China’s economy?

There is no such thing as a representative "state-owned enterprise," and there is no simple "ownership reform" that would cure China’s economic maladies. While state ownership creates a conflict of interest between the state as owner and the state as regulator, turning lazy state monopolies into private profit-seeking monopolies not only makes things worse for consumers but would also create a new force for political opposition to reform outside the current political structure. Converting all of China’s SOEs into private owned-enterprises would be to shift from "state capitalism" to "crony capitalism."

Milton Friedman, who advised post-Soviet governments to "privatize, privatize, privatize," ultimately conceded that privatization was not enough, and that "rule of law is probably more basic than privatization."

Fragmentation of ownership allows for practical privatization by ensuring that the regulating agents of the state are politically superior to the owning agents. If pro-competition policies are applied to all market participants regardless of ownership, it is entirely possible to reconcile a large state share with an efficient market economy. The necessary condition for prosperity is not ownership but rather that state intervention proceeds according to transparent, prospective and generally applicable laws.

The News Lens has been authorized to republish this article from East Asia Forum. East Asia Forum is a platform for analysis and research on politics, economics, business, law, security, international relations and society relevant to public policy, centered on the Asia Pacific region. This article appeared in the most recent edition of the East Asia Forum Quarterly, "Managing China."

TNL Editor: Edward White