Provincial Snapshot—Liaoning: The Smothering Effects of Local Protectionism

When the Liaoning provincial government nationalized Brilliance Auto in 2002, the local private car maker was thought to be one of the most advanced and promising among China’s domestic brands. However, the government takeover proved to be the turning point in the company’s fortunes, as a once thriving company turned into another struggling and debt-laden state-owned firm.

The experience of Brilliance Auto is emblematic of a deeper problem that afflicts local governments throughout China: local protectionism. To be sure, China’s auto sector is no stranger to local protectionism—in fact, the industry’s notorious fragmentation is largely a result of fierce local competition to crown their own auto champion. Yet most of the local government-owned automakers do eventually become viable businesses. The difference in Liaoning is that despite the government’s generous support, Brilliance continued to hemorrhage money to the point where its sedan business became insolvent.

The proximate cause of Brilliance’s failure can be explained by the Liaoning government’s effort to localize the auto supply chain, which ended up hampering the quality of the cars. What happened to Brilliance isn’t unique, however. Rather, it reflects a broader trend: the gradual inward turn of the Liaoning economy. Indeed, since the early 2000s, Liaoning’s economy has become more closed—perhaps even tilting toward a mild form of autarky—as indicated by the rising share of local demand and the significant slowdown in export growth.

More fundamentally, Brilliance’s stagnation and the overall deterioration of Liaoning firms’ competitiveness can be attributed to a local government-driven investment model that has been practiced for the last 15 years. Allowing a local government that already had strong protectionist tendencies take charge of allocating capital only reinforced local protectionism and harmed the competitiveness of provincial firms. It became a self-fulfilling prophecy: the more the government protected local industry, the less competitive it became, which led the government to further support and protect it. In this environment, it’s the politically connected, rather than competitive, firms that become the “winners.”

Although this final chapter in the Liaoning series will focus on protectionism (see here, here, and here), a few concluding thoughts on what has ailed Liaoning’s and the broader northeast economies are in order:

– A heavily interventionist Liaoning government keen on driving local investment priorities ultimately led to a more closed and less competitive provincial economy.

– Neighboring northeast provinces, such as Jilin and Heilongjiang, are not exempt from this investment-driven model, though they are smaller economies than Liaoning.

– Beyond the northeast, 15 out of 31 Chinese regions still remain heavily dependent on investment for growth, with investment as a share of local GDP greater than 60%, about 15% higher than the national average.

– Beijing has long taken note of the northeast’s economic woes, but so far has found that reviving the region is more challenging than expected. The central government’s latest effort is to inject new blood into the provincial leadership by purging corrupt politicians, hoping that could lead to a turnaround.

– Another tactic the central government has employed is empowering the local court system and granting it more independence. Beijing hopes this will be effective in curtailing local government influence on the court system. Whether this experiment will succeed remains to be seen.

How Protectionism Ruined China’s Once Promising Car Maker

Yang Rong, a private entrepreneur, built China Brilliance Auto out of a nearly bankrupt Shenyang state firm he acquired in 1991. Initially, Yang owned Brilliance through a joint venture (JV) with a subsidiary of People’s Bank of China (PBOC), which acted as a passive investor and never exerted any authority over the firm.

Back then, all central government assets were ultimately owned by the National Bureau of State Assets Management (predecessor to the State-owned Assets Supervision and Administration Commission), which was then a Ministry of Finance (MoF) subsidiary. In the late 1990s, Beijing decided to transfer all but the most strategically important central state assets to local governments. Brilliance, too, was destined to be transferred wholesale to the Liaoning government. The only outstanding question was how much Yang would be compensated, as he only directly owned less than 3% of his company.

For the local government, it certainly picked a solid asset to takeover. By 2001, a decade after its founding, Yang’s auto venture had grown into a 20 billion yuan ($3.1 billion) business, riding on the rapid expansion of China’s auto market. At that time, Brilliance was widely seen as the most advanced and promising domestic car maker in China. In fact, Yang received enormous validation when Germany’s BMW decided to pick Brilliance as a local partner, against the advice of senior Chinese leaders who thought BMW should partner with a state auto maker. According to BMW executives, they were impressed by Brilliance’s state-of-the-art assembly line and efficient management.

Around the same time, Yang had also formed a JV with the then-struggling British car maker Rover. That strategy was a technology play aimed at bringing Rover’s research and production operations to China and giving Brilliance the technology it needed to produce better quality engines. Up until then, Brilliance had sourced older and unreliable engines from a Shenyang factory run by a JV between Japan’s Mitsubishi and a local Chinese partner.

The deal with Rover should have been a coup for Yang. But instead, it marked the unravelling of Brilliance’s relationship with the Liaoning government. The key tussle came when Yang wanted to establish a factory to make Rovers in Ningbo, a relatively prosperous port city in Zhejiang province that’s close to metropolitan Shanghai. Since Yang was planning to export his Chinese-made Rovers, it made sense to locate in close proximity to China’s biggest export hub. Moreover, about 75% of Brilliance’s supply chain was concentrated in the Yangtze River Delta, centered on Shanghai.

But the problem was that the Liaoning authorities didn’t like Yang’s plans. They wanted the new Rover plant in Liaoning.

As construction of Brilliance’s Ningbo plant drew closer, the Liaoning government launched what amounted to a hostile takeover, effectively confiscating Yang’s shares and taking control of his company. On March 11, 2002, MoF issued a notice to transfer all controlling shares in the Brilliance JV to the Liaoning provincial government. Yang sought to appease the government and cooperated with the process initially, while the authorities allowed him to remain as CEO and board chairman. But a few months later, the Liaoning police launched an investigation into Yang for “stripping state assets,” prompting him to flee to the United States where he has remained ever since.

On paper, the Liaoning government was the undisputed winner. Not only did it now own and control Brilliance, but that control allowed it to consolidate all of the firm’s operations and supply chain in Liaoning province. It demanded that the auto maker buy its components and materials from local suppliers, which negatively affected Brilliance’s own subsidiaries. In the year that Brilliance was nationalized, the company purchased just half as many auto parts as it did previously from its Shanghai subsidiary. After June 2002, Brilliance suspended purchases from the Shanghai subsidiary entirely.

When it came to sourcing inputs, Brilliance never used local steel in the past—despite Liaoning having a sizeable steel sector. But after the government takeover, Brilliance was pressured to buy steel from Benxi Steel, a local state-owned steelmaker. (Notably, Brilliance didn’t source from Anshan Steel, which is also based in Liaoning but owned by the central government).

And unsurprisingly, the Ningbo project also fell apart. As a result, not only did Brilliance eventually have to pay Rover more than 200 million yuan ($30 million) in damages, it was still stuck sourcing lower quality engines without the capability to make its own engines.

The Liaoning government’s treatment of Brilliance needs to be understood in the context of a province undergoing a painful economic transition that began in the early 2000s. As part of the transition, thousands of state-owned firms were shut down and millions of jobs were lost. The authorities were desperate to rebuild the local industrial base wherever possible. To that end, they heavily favored Brilliance in government procurement, and the company typically won generous contracts whenever taxis needed to be replaced, police cars upgraded, or garbage truck fleets expanded. And of course, Brilliance also received generous fiscal subsidies every year.

Even with such support, the Liaoning government’s embrace spelt disaster for the firm. For instance, China’s minibus market has grown by more than 300% since the Liaoning government took control of Brilliance, yet the company sold fewer of its flagship model, the Jinbei minibus, in 2016 than it did in 2001. Meanwhile, Brilliance’s domestic brand sedan business has lost so much money since it first entered the market in 2002 that the company’s debt now exceeds the value of its assets.[1] What makes that all the more extraordinary is that Brilliance’s losses have accumulated even as China’s auto market grew seven-fold since 2002.

It is tempting to explain Brilliance’s struggle as solely a symptom of state ownership, but it’s not that simple. To smooth the ownership transition and ensure the ongoing good management of the firm, the Liaoning government gave Yang’s former senior executive team stock options equal to 9.4% of the firm’s equity, something unheard of at state firms, even today. (To put this into perspective, in a deal meant to set an example for future state firm reforms, China Unicom recently gave 7,855 executives stock options worth less than 3% of the firm.) Even in public companies in advanced economies, senior management frequently owns less than 10% of the firm. But the fact senior management owned part of the firm didn’t matter much. The core problem was that their ownership didn’t translate into decision-making power and influence over the direction of the company.

How Investment Driven Growth Exacerbated Liaoning’s Protectionism Tendencies

The point of highlighting Brilliance’s collapse is not that it is unique, but that it is the norm for Liaoning. Indeed, many other industrial firms in the province have seen their share of China’s national market decline since 2000 (see Figure 1). In part that’s because of protectionism, but specifically it’s the combination of protectionism with an economic growth model that relies too heavily on investment, which amplifies the deleterious effects of protectionism.

Figure 1. Declining Market Share of Liaoning’s Industrial Goods
Note: The figures in the chart are calculated by dividing 2016 market share by 2002 market share. A figure greater than 100% indicates increasing market share. Market share is calculated as Liaoning’s production divided by national production.

Source: National Bureau of Statistics.

Between 2002 and 2009, investment had contributed to more than 75% of Liaoning’s cumulative economic growth (the ratio is 46% nationally) and it very likely remained the largest driver of economic growth until at least 2013.[2] (2002 is the year Beijing made the revitalization of the northeast a top priority, resulting in a number of plans for increasing investment in Liaoning.) In fact, there is strong evidence to suggest that the majority of this investment is driven by the local government. By the end of 2016, the Liaoning government’s on-balance-sheet debt was 38% of GDP, almost double the national average of 20%.[3]

With plenty of investment projects available, the Liaoning government could deliver growth without worrying about fostering competitive firms. Rather, it coddled local firms, directing government procurement contracts to them, and by farming out fiscal resources to local interests.

This also meant that Liaoning firms didn’t have to be competitive with firms from elsewhere in the country and the world, to the detriment of the local economy. After 2002, Liaoning province’s export growth significantly lagged compared to the national average. Between 1993 to 2001, the province’s exports cumulatively grew 10% slower than China as a whole (see Figure 2). But between 2002 to 2016, the growth gap widened to more than 100%. Once Liaoning’s exports to the rest of China are taken into account, the decline is even more startling. Before 2002, Liaoning used to have a trade surplus with the rest of the world—that is, both greater China and foreign countries—of about 12%, but today it has a trade deficit (see Figure 3). Over the course of the last 15 years, the province has experienced a massive shift in the structure of demand.

Figure 2. The Growth Gap Between Liaoning Exports and National Exports has Widened after 2001
Note: Positive value indicates how much faster national exports grew than Liaoning’s exports since 1993.

Source: National Bureau of Statistics.

Figure 3. Liaoning’s Investment Spikes, Exports Plummet
Notes: Trade balance also includes inter-regional trade within China, as well as to foreign markets.

As post-2010 figures are known to be inaccurate, they are omitted here.

Source: National Bureau of Statistics. 

This decline in the importance of the outside market comes with negative side effects. Selling goods outside your home market requires your goods to be of higher quality and lower cost than your competitors. In other words, even a Liaoning state firm needs to demonstrate its goods are better when it is competing outside of its home court. Exports introduce meritocracy into the local economy, and the declining importance of outside markets meant that Liaoning firms were subject to less market discipline.

Conclusion

Throughout this series, I’ve examined Liaoning’s deep and varied problems, including an over-reliance on investment-led growth, soft budget constraints on state firms, a lack of economic diversification, a disproportionately large role for meddling provincial authorities, and protectionist proclivities.

In the face of this litany of factors, reviving Liaoning’s economy will prove particularly challenging. The province’s woes have not been lost on Beijing, which has been wracking its brain on how to turn things around. So far, the tactic seems to be injecting new blood into the provincial leadership, in the hopes that new talent can lead the province out of its economic morass. Indeed, since 2013, seven vice-minister and above officials in Liaoning—the most of any province and tied with Shanxi—have been investigated for corruption. Still, without corresponding institutional fixes that can improve government accountability, the impact of such a draconian campaign will likely fade over time.

One modest institutional fix that Beijing is experimenting with is to improve the local judicial system. The central government has installed circuit courts that are directly managed by the Supreme People’s Court, to create some distance between local authorities’ influence on courts. In 2015, the northeast was chosen as one of two regions to engage in a trial of creating more independent courts. In theory, the introduction of circuit courts can serve as a check on local governments’ ability to intervene in judicial decisions that might affect the economy. Given that this is a relatively new experiment, it is still too early to tell how effective these circuit courts will be.

But despite the depth of Liaoning’s problems, it’s important to bear in mind that Liaoning is not alone. The rest of the northeast region, Jilin and Heilongjiang, also has been heavily reliant on investment to generate growth. Beyond the northeast, other regional economies, too, have been relying on investment. In 2016, 15 out of 31 Chinese regions saw investment as a share of GDP greater than 60%, which is about 15% higher than the national average, in a country already considered to have a high investment rate.[4]

In the past few years, thanks to an easy credit environment, many of these high investment regions managed to sustain, or even double down on, their investment-driven growth model. This resulted in those regions achieving higher growth rates than their peers (see Figure 4). But as the analysis in this series has demonstrated, this seeming prosperity is misleading. First, the high-growth figures are, in some sense, illusory. As the Dandong case showed, once investment evaporates, GDP growth can virtually collapse overnight. Second, as this final chapter has demonstrated, an investment-driven model exacerbates existing distortions in the economy, which leaves lasting negative consequences. As a result, the afflicted region may have to cope with the loss of economic competitiveness for many years after the investment boom ends.

Figure 4. Growth of High Investment Regions Outperform National Average
Notes: High investment region is defined as having an average investment share greater than 60% between 2007 to 2016.

Source: National Bureau of Statistics.

Some of these high-investment regions, like Tianjin and Gansu, have already exhibited signs of repeating Liaoning’s economic stagnation. We will likely see the experience of Liaoning replicated elsewhere in China in the coming years.

On the positive side, there are also many regions that have a healthier economic model. And it is those regions that have been propelling the Chinese economy forward despite all the challenges. Up next in this provincial series is Guangdong, the posterchild of China’s market economy and its technological future. Please stay tuned.

[1] It should be noted that Brilliance’s JV with BMW still exists because the deal was struck before the nationalization of Brilliance. The venture is actually profitable, largely because BMW has kept tight control over production. In 2016, BMW contributed almost 90% of the revenue and all the profit to Brilliance.

[2] There is no direct way to determine the investment share in Liaoning post-2010 because during that period, the province’s GDP figures are known to be manipulated. But since the central government continued to promulgate policies to bolster the northeast economy in 2009 and 2012, it is reasonable to assume that the investment boom lasted at least until 2013.

[3] The scale of government-controlled investment is much bigger than what the Liaoning government debt figure suggests. Unfortunately, high quality data for off-budget government-backed investments are not available. But applying the estimate of national off-budget local government debt—roughly about three times on-budget local government debt—to Liaoning, the government’s total debt-financed investment is very likely to be more than the provincial GDP. In addition, state firm and private firm investments that are heavily influenced by local authorities may also contribute to debt, but it’s impossible to say with certainty.

^[4] China’s provincial economic statistics are known to be significantly exaggerated, and this creates difficulties for estimating the share of investment in local GDP. For example, in 2016, the sum of regional gross fixed capital formation (the technical term for investment in GDP accounting) is nearly 30% larger than the national figure. In the meantime, there is also exaggeration in regional GDP. In 2016, total GDP reported by the provinces added up to 4.5% larger than the national GDP.

Using the conservative assumption that all regional investment and GDP figures are equally overestimated by the levels cited above, then we should discount local investment share in GDP by 25%. As such, in 2016, only provinces with more than 60% of investment share in GDP are considered more over reliant on investment than the national average.

Nonetheless, provinces with exaggerated investment figures usually also have exaggerated GDP numbers. Liaoning’s GDP figure has been revised down by more than 20%. And if we believe the GDP of over-investment regions are similarly exaggerated as Liaoning’s, then the regional investment share is overstated by around 5%, rather than 25%.

Notably, the 60% threshold excludes many regions, like Tianjin and Chongqing, which are known to rely on investment for growth. Practically speaking, we can say with high confidence that regions with an investment share greater than 55% of GDP as over reliant on investment than the national average. In 2016, 19 provinces met this threshold.