Are China's Big State Companies a Big Problem for the Global Economy? Nelson Ching / Bloomberg via Getty Image The headquarters of Cnooc Ltd. stand in Beijing, China, on Oct. 11, 2010 The most important economic story of the first half of the 21st century is how China is changing the global economy. There are a lot of benefits to this change - hundreds of millions of new consumers to drive global growth, fresh opportunities for entrepreneurship and job creation and heightened demand for everything from American corn to Australian iron ore. But not all of the impact is seen as positive. Low-skilled workers in the West have already felt the pain of competition from China's manufacturing machine. As Chinese industry advances, it will present an even stiffer challenge to the competitiveness of the U.S, Europe and Japan. And as the Chinese economy continues to develop, new threats to the world's established economic order will emerge. One of those new challenges is the global advance of China's big state-owned enterprises (SOEs). The global economy has never seen anything like them. The advantages they possess - in some cases, unfair advantages - are extremely difficult for governments or private companies to counter. Simply put, China's SOEs are potentially poised to alter the rules of global economic competition. PHOTOS: China Celebrates 90 Years of Communism We usually assume SOEs are bloated behemoths too inefficient to compete with private firms. That is not always the case, of course - look at state-linked firms like Dubai's airline Emirates, for example. But for every one well-managed state enterprise there are countless others that deserve their feeble reputation. China's SOEs have improved their performance over the past decade, but at the same time, they are definitely not the brightest stars in the rising economy. Studies consistently show that China's SOEs aren't as profitable as the country's private firms. However, the SOEs in China have been awarded perquisites that allow them to overcome their competitive weaknesses. Many operate in protected industries - from telecom to finance - allowing them to reap profits from rapidly expanding industries without worrying about too much competition. They often tend to have rock-solid support from the nation's bureaucrats. And in some cases they benefit from special financial support. In other words, the government owners of these enterprises make sure they get a leg up in the Chinese economy. Here's how Robert Hormats, Under Secretary for Economic, Energy and Agricultural Affairs at the U.S. State Department, put it in a speech last year: Some of these emerging Chinese competitors are competitive because they are innovative and entrepreneurial. But other Chinese State-owned enterprises and State-supported enterprises enjoy financial support, regulatory privileges, and immunities not generally available to their privately-owned competitors. In China, we also see government support through efforts to limit foreign investment in certain SOE-dominated sectors to joint ventures. Or performance requirements to transfer technology or requirements to purchase certain amounts of product from the domestic SOE are a condition of investment. Of course, there is nothing particularly new about protection of state-owned national champions. Governments all over the world have historically supported the firms they own. But China's SOEs are a different breed, says Christian Murck, president of the American Chamber of Commerce in China. Unlike, say, the state firms of the former Soviet Union, which did most of their damage within the country's own borders, China's SOEs are being encouraged to go global. We can already find them operating just about everywhere. China's energy giants, like CNOOC, have made investments and acquisitions from Argentina to Canada; a Chinese state-controlled firm recent outbid German and Brazilian rivals to acquire a stake in the Portuguese energy firm EDP, which the Lisbon government auctioned off as part of its austerity program. "We have never been confronted by the situation we have now," Murck says about China's SOEs. It is a serious issue we need to do something about. PHOTOS: China's High-Speed Rail That's because the Chinese SOEs aren't necessarily playing the global competition game using the same rulebook as everyone else. Of course, there is nothing inherently wrong about Chinese SOEs expanding or investing abroad. We should actually encourage it. Such investment can create jobs in the U.S. and elsewhere. But China's SOEs can also leverage the goodies they get from the Chinese state to their advantage in foreign markets. Since they don't have to be as concerned about profitability and efficiency as their non-subsidized private compatriots, they can expand overseas more aggressively. So what we have here is a new type of state company - one with grandiose ambitions supported by government policy that funds and aids those ambitions. It is a potentially powerful mix that can reshape the global competitive environment. Here's more from Hormats: It is imperative that our (U.S.) companies have a level playing field on which they can compete. Policies that give select foreign companies unearned competitive advantages, whether in their domestic market, here in the United States, or in third countries distort competition. Thus, they are harmful not only to our companies, but to domestic companies in China and other companies around the world that do not have such advantages. A report from the European Council on Foreign Relations entitled "The Scramble for Europe," which focused on growing Chinese economic influence on that continent, expressed special concern about how China's subsidized SOEs can tilt the scales of fair competition: The corporate structure of Chinese companies presents a special problem. In particular, state-owned enterprises receive massive state subsidies and can therefore compete unfairly with European companies. ... Chinese banks have received huge and permanent relief since 1998, far beyond recent American or European emergency measures. According to a recent and controversial Chinese study, China's state enterprises and holdings would have made losses since 2001 if direct and hidden subsidies (for example, the true costs for land use and the massive under-pricing of natural resources) were taken into account. That takes us to the big question: What in the world can be done to re-balance the playing field against Chinese SOEs? In theory, the problem should solve itself. The Chinese government has been pressing its SOEs to become more commercially oriented for the last 20 years, and as that process continues, they should be weaned off state aid and forced to compete on their own. Yet that process is likely to be slow. SOEs have become fantastically powerful in the Chinese economy, and they will concede their special privileges only grudgingly. MORE: Despite Xi Jinping's Visit, the U.S. and China Are Still Wary After All These Years Any effort to counteract the distorting effect of Chinese support for these companies, however, faces high hurdles. The usual way countries combat unfair trade practices - punitive tariffs - would be terribly hard to fairly calculate in the case of a subsidized state firm, and would probably spark trade conflicts anyway. The Obama administration is trying to set new standards on restricting the ability of state firms to use preferential treatment to outcompete private enterprises through multilateral organizations, like the OECD, and the free-trade Trans-Pacific Partnership, which is now being negotiated. Yet convincing China and other countries to abide by such measures will not be easy. The European Council on Foreign Relations advocates reciprocity. At a minimum, its argument goes, foreign firms should be permitted the same access to China as the U.S. and Europe give to Chinese firms: The problem presented by Chinese direct investment in Europe becomes even clearer when one considers Europe's limited access to similar opportunities in China. China's capital market remains largely closed in sectors that the government deems important for its economic development strategy. ... In many sectors, ranging from air transport to banks and alternative energy, foreign stakes are limited to 20 percent of capital. The barriers to foreign capital have in fact increased with the passing of legislation favouring "domestic innovation." (Europe's policymakers) should unify around their collective interests and take steps to create a rules-based and level playing field on which European firms are able to compete in China in the same way that Chinese companies can in Europe. The fact that governments in the U.S. and Europe have the same blood on their hands is making the issue much more complicated to tackle. It is difficult for policymakers in Washington to point fingers at Beijing's support for industry when the American government bailed out General Motors. The bigger issue here is that states of many ideological persuasions are intervening to overturn the verdict of markets, and that alters the competitive landscape. China engages in such market-bending activity on a grand scale, however. As China remains wedded to its version of "state capitalism," Beijing's support for large SEOs, and the impact that has on global economic competition, is likely to become an even bigger issue in the years to come. PHOTOS: China Goes to Africa MORE: The Coming U.S.-China Solar War