Competition policy promotes rivalry among firms to maximize societal welfare. In advanced economies competition policy includes antitrust laws that protect consumer welfare from monopolistic behavior and other rules to prevent firm collusion, unfair practices that restrict competition and other abuses, and barriers to market entry and exit. As China has reached a more advanced stage, it has ratcheted-up its competition policy objectives. Beijing passed a long-awaited antitrust law in 2008 after 13 years of discussion. The 2013 Third Plenum plan declared “developing an environment for fair competition” a priority, and making the market a decisive touchstone. However, long-standing instincts to do the opposite, and favor the interests of strong firms over consumers – and domestic firms over foreign – are still embedded in the Chinese system with little regard for consumer welfare. This fuels misgivings about China’s convergence with international norms.
Competition policy is an amalgam of law, economic analysis, and politics, and gauging outcomes is challenging. Our primary indicator looks for convergence in reviews of foreign versus domestic mergers conducted by the Ministry of Commerce (MOFCOM), one of the three Chinese authorities responsible for competition policy (along with the National Development and Reform Commission – NDRC – for price abuse of market power and the State Administration for Industry & Commerce for non-price-related behaviors). Supplemental data look at the number of merger cases reviewed; disclosure of results of competition court cases; new business starts and closures (entry and exit); and the ability of firms to recover a viable profit margin in healthy markets.
Quarterly Assessment and Outlook
Competition reform received some notable policy attention in 2Q2017, but the indicators of outcomes did not demonstrate a positive trend reflecting successful implementation. Foreign and domestic companies remained too differentiated in terms of merger review treatment, especially with an increasing volume of review work to be done with limited capacity. The government’s role in the economy remains heavily interventionist, picking which state-owned enterprises should be combined, often without effective competition policy review. Pricing power, as reflected in markup ratios, remains problematically low. Goals for 2017 have progressed on paper but systematic improvements require fundamental progress in the commercial legal system, and transparency for competition review processes.
This Quarter’s Numbers
In 2Q2017 the percentage of foreign-involved transactions subject to merger reviews increased from 17% to 19%, while for domestic-only pairing the rate fell back to 2014 levels at 3%. For foreign investors, this quarter does not differ significantly from previous pattern (38 cases reviewed compared with 34 last quarter, 54 in 4Q2016, and 36 on average in the last 5 years), as mergers involving foreign companies have also climbed from 195 to 205. On the other hand, the decline of reviews on domestic mergers is concerning – only 20 cases were reviewed this quarter, despite a record high number of domestic mergers, rising to 586.
These patterns suggest that capacity (personnel, political, financial, and/or technical) at MOFCOM to conduct merger reviews has weakened since 2016 when 83 cases in total were reviewed, 25 more than this quarter. More critically, foreign investors remained at higher risk for scrutiny by the regulators than their domestic rivals, even if staffing capabilities were limited. This does not indicate improvements in the competition environment. Higher rates of review are not necessarily a problem, in fact we would expect reviews overall to rise in the context of more active competition. That is not the problem. The problem is the fact that the rate of scrutiny for foreigners presently is six times higher than that for domestic firms – versus a much smaller differential last year when foreign scrutiny was double that of domestic scrutiny.
Our supplementary indicators flesh out the picture. Results of Merger Reviews reflects slow change on competition law enforcement. The 2Q2017 pace of reviews, like the first quarter, was low. With only 54 cases in the quarter, China saw the lowest level of half-year merger review activity since 2014. . Furthermore, the number of these cases subject to penalties remains modest, although the four deals penalized in the quarter marked a high number in the most recent five-year window we are tracking. One major problem in China’s competition law is unreported, unnotified transactions. In a nation reporting 1.6 million new business starts a quarter, only 53 merger reports and 4 penalties a quarter is striking. There is no significant shift in the overall numbers and pattern of review currently evident that would encourage would-be merger partners to fear the likelihood of suffering penalization for failure to notify the regulatory authorities, thereby subjecting them to the possibility of review. MOFCOM has appeared more active in this regard, issuing three notices for failure to report this quarter. That said, all three transactions were foreign-involved – reinforcing questions of fairness.
Transparency of Judicial System shows both slowing growth in the number of court cases involving competition policy matters, and a falling rate of disclosure for case materials. Despite the Chinese Supreme Court 2014 requirements to publish all cases within seven days of sentences, only a small portion of cases are published, and publication slowed in 2016. Both the volume of case load courts can handle, and transparency in proceedings are important to achieving China’s competition policy objectives. This data series provides general context only, not an up-to-date trend, given that relevant data are only released annually. With insufficient transparency, it is hard for interested parties to understand how well they can protect their legal rights applying relevant competition and intellectual property laws in the court.
Market Entry and Exit continues to show what we consider to be a desirable quarterly trend. Efforts to streamline business registration procedures continues to propel new business starts (or at least the registration of existing businesses) to record levels (1.6 million in 2Q2017). Reducing barriers to exit – i.e. the legal dissolution of firms – is just as important as lowering barriers to entry. “Zombie companies,” which are impossible to shut down even when they are in a financially hopeless situation, all for the sake of preserving the illusion that they will pay off their debts someday, represent a problem for the overall economy because of the continued misallocation of capital. Nonetheless, the dissolution of firms hit a record of 700,000 in the second quarter. As is clear in the chart, this spike also occurred in the same quarter in 2016. The second quarter has been the annual highpoint throughout our five-year window, although the size of these seasonal spikes has grown significantly. Both these trends are positive from the perspective of consumer welfare, but the fact that new starts are outpacing closures by four to one over the past five years raises questions about the actual operating status of many of these firms, and what proportion of them are fully financially viable.
Our Pricing Power chart shows average firm markup ratios for listed Chinese firms – a measure of pricing power and hence overall market conditions from the firms’ perspective, as firms make judgments about the overall profitability of remaining in business, or putting their capital elsewhere. At a profit ratio of around 12%, Chinese firms are demonstrating only half the pricing power of their OECD counterparts. Counterintuitively for many who assume that China’s main competition problem is monopoly, and hence too much pricing power for firms, the data suggests that the general trend is of a different nature: that competition is in fact damaged in China by the presence of still too-high barriers to exit that prevent rationalization. Too many firms are being “evergreened” and kept in place, taking up market share and preventing others from recovering more sustainable margins. Nonetheless, we will need to see more data for future quarters to confirm whether these trends are robust over time. Supply-side restructuring campaigns by the government in steel are designed precisely to address these problems, thus permitting a pruned-down number of healthy firms to weather tax and compliance obligations, to properly provide for employee benefits, and to invest to reduce environmental liabilities. Such expenditures are beyond the financial capacity of firms which need to be able to be dissolved. But top driven rationalization, as is being attempted for steel, will not work for most industries, and certainly not for the whole economy.
Policy Analysis: 2Q2017
Premier Li Keqiang’s March 2017 government work report set the tone for the year, including on competition policy. In addition to continued calls to “improve the competitiveness” of China’s economy, the 2017 report has three specifics: (1) establish a “fair competition review system,” (2) “open-up” commercial industries, and (3) “prohibit all unreasonable behaviors affecting fair market competition.” This put fair competition back on the agenda. The question is what is considered “fair” and how this agenda is being implemented.
The “fair competition review system” goal dates to June 2016, but has gotten little attention since then. Recognizing controversies over the nature of various industrial policies pursued by various ministries and provincial administrations, the State Council issued a “Guidance Opinion to Establish a Fair Competition Review System,” requiring all government agencies to self-review both new and existing policies to make sure they are not anti-competitive, effective as of July 1, 2016. This document has been reposted by most provinces. Nonetheless, but new regulations without evidence of competition review continue to be produced out at both central and provincial levels. In May 2017, the NDRC led a first joint meeting of 28 ministries to draft implementation details and tasks for 2017–18. Yet the “2017 work priorities” released in the third quarter were mostly repeating what was said in the June 2016 State Council Guidance Opinion, while also calling for more documents to be issued and responsibilities to be clarified. In short, we have seen little evidence to date of the actual implementation of the “fair competition review system” on the ground.
The second task – to “open-up” commercial industries – is also relevant to real changes in the competition policy environment. This part of the policy process is framed in a way that points to state-owned enterprise (SOE) reform, which is critical for leveling the competitive playing field, and for improving resource allocation efficiency. In addition to pledging to “corporatize” SOEs and encourage mixed ownership, it specifically requires “opening-up” the commercial business elements of the electricity and oil/gas industries, the two most state-dominated and monopolistic industry sectors in China. There was some progress on this in the quarter. Benchmark cases saw some changes in the food, airlines, telecom, and oil industries. However, these restructurings are still in early stages and there are more questions than answers on how investors can respond to and make use of these apparent policy changes. (See our SOE Reform section for more detail.)
The third goal of tackling “unreasonable behaviors affecting fair market competition” is multidimensional. Unreasonable behavior can range from overcapacity, to predatory price competition, to business collusion, bribery, and violation of intellectual property rights. The NDRC has renewed capacity-reduction goals in steel and coal; the National People’s Congress has discussed (but not passed) a revised unfair-competition law with additional clauses on bribery and internet companies; and the Supreme Court has published new guidance and a casebook on intellectual property protection. More time is required to discern which of these development will translate into changed outcomes and market behavior on the ground. Most importantly, it is unclear how meaningful punishments will be for companies (particularly SOEs) found to engage in unfair competition. Or whether the proposed changes to the law will end up being a paper tiger.