Yi Gang, Governor of the People’s Bank of China, has recently called for steadily getting over the idea that state-owned enterprises are necessarily capable of paying back debts. Then in the space of eight days, three state-owned enterprises, namely Yongcheng Coal & Electricity Holding Group Co. of Henan Province, Brilliance Auto Group of Liaoning, and Tsinghua Unigroup under Tsinghua University in Beijing, respectively announced that defaulted on a bond, meaning they had missed a combined principal and interest payment. The news undermined the general belief that China’s state-owned enterprises are necessarily capable of repaying debts. Apparently Yi’s call has yielded some results already.

Chinese media reports on debt defaults of state-owned enterprises described the widespread belief in these enterprises’ ability to pay back debts as a form of “faith” in state-owned enterprises. This goes to show that Yi’s call is not only about reforming China’s financial policy but is an attempt to eliminate a myth surrounding state-owned companies. But why should this blind faith be eradicated?

Having blind faith in state-owned enterprises’ ability to repay debts can cause investors to be misled and eventually lead to wastage. As the saying goes, high risks come with high returns. If a state-owned enterprise that borrows money will no doubt repay the principal and interest, no risk is entailed in lending money to the enterprise, and the cost of lending money to it is relatively low compared with that of lending money to private companies. Eradicating the myth that state-owned companies can necessarily pay back debts is tantamount to warning investors that buying bonds issued by state-owned companies also comes with risk. To appease investors, state-owned enterprises will need to increase the returns of their bonds as a form of compensation, and doing so will increase their cost of borrowing money. If that is the sole objective, Yi would only have had to raise interest rates, given that the central bank has the power to adjust interest rates. He needed not go so far as to try to dispel the myth surrounding state-owned enterprises.

However, adjustment to the interest rates affects not only state-owned enterprises but also private companies. To dispel the myth that all state-owned enterprises can pay back debts, their cost of taking out loans has to be increased. The idea is to push them to improve the way they manage their business. If that fails, the cost of capital will increase for these enterprises and they will suffer greater losses. As it is commonly known, state-owned enterprises, which leverage the widely held belief that they are capable of paying back debts and facing a lower cost of taking out loans, tend to invest their money arbitrarily, thus causing significant wastage. In the past, despite losses caused by poor management, state-owned enterprises had state support and could easily ask state-owned banks for money or issue bonds to sustain their businesses. At the end of the day, state backing needs to be removed in order to dispel the myth that these enterprises can always pay back debts. This way, enterprises that are unable to improve their operations and have long been running at a loss will be forced to go under. Yet all this is easier said than done though. Why?

There are two reasons. First, buyers of bonds issued by Yongcheng Coal & Electricity Holding Group Co. and Tsinghua Unigroup, for example, include institutional investors such as banks and funds, as well as a considerable number of retail investors who have unwavering faith in state-owned companies. In other words, in case of bond default of a state-owned enterprise that collapses, many parties will be affected. Second, all state-owned enterprises are large in scale with numerous employees. If they go under, what will happen to the employees? Failing to handle the aftermath properly can easily lead to social unrest, thus threatening social stability. Which is why Yi emphasized the importance of taking steady steps to break the myth - the possible political consequences must be considered. Meanwhile, one may ask why the authorities choose to tackle this thorny issue now?

This was not the first time that attempts were made to dispel the myth surrounding state-owned enterprises. At the beginning of the reform and opening up more than 40 years ago, the reform of state-owned enterprises was a key task. It involved adopting a profit-driven management approach, selling the equities of state-owned enterprises and turning the enterprises into private entities after the approach yielded some positive results. According to the propaganda of the Chinese Communist Party (CCP), the reform was highly successful. Today, state-owned enterprises account for less than 50 percent of the Chinese economy, and the remaining companies are all privately owned. One of the conditions for China’s accession to the World Trade Organization in 2001 was that it would continue to carry out the market-oriented reform of state-owned enterprises, so as to prevent unfair competition fed by state subsidies that would otherwise have a negative impact on the global market.

Since Xi Jinping came to power in 2012, however, state-owned enterprises have been having the upper hand and private companies dwindling in importance. Today, all enterprises, be they private or state-run, have their own party committee, and everyone in the enterprise are at the CCP’s command and has to obey its rules. The definition of these companies is essentially different from that of private enterprises as understood by the outside world. Market-oriented companies are subject to shareholders’ supervision, and their raison d’être is to strive for returns for shareholders. If they fail to deliver, shareholders will be punished - share prices will go down and, at worst, the company will collapse. But when an enterprise that is at the CCP’s command fails to perform, who should be held accountable? Will it be at risk of collapsing?

Poor management can cause an enterprise to collapse even if it obeys the party. In 1986, China passed the bill on the Enterprise Bankruptcy Law. It was implemented after a revision in 2007. More than 10 years on, people’s faith in state-owned enterprises has not been undermined. Long-term losses have not led to insolvency of these enterprises. Rather, they can actually get the blessing of credit agencies. A few months before their default, Yongcheng and a few other state-owned companies received the highest rating of AAA and they continued to issue bonds to raise funds. Needless to say how effective is the Enterprise Bankruptcy Law and how credible are those rating agencies.

The result? There have been countless state-owned enterprises that met the fate of Yongcheng, Brilliance and Tsinghua. The debts they have accumulated grew like a snowball and eventually turned into a huge time bomb. Once the time bomb is set off, the whole financial structure and even the country’s economy will be in peril. Perhaps Yi intended to set off a small, relatively safe explosion through the bond defaults of Yongcheng, Brilliance and Tsinghua, so that investors would be more vigilant. Yet no one can guarantee that the small blast will not trigger collective panic that will get out of control. Following the three bond defaults, 53 bond issuance plans, involving a total sum to the tune of RMB28.5 billion, were called off. Whether there will be more such cancelations is hard to predict.

Since all enterprises need to obey the party’s orders, the party should simply issue an order requiring all enterprises to make money and prohibiting them from making losses, shouldn’t they? All those superficial reforms only leave people doubting the effectiveness of the party’s commands.

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