The Impact of The People’s Liberation Army’s Business Activities on China’s Economic Development 

I.    Introduction
II.   China's Defense Conversion
    A.    The Conversion Process
        1.    The Rationale for Conversion
        2.    Many Roads to Conversion
        3.    "Everybody is Diversifying Like Crazy"
        4.    Inherent Advantages and Disadvantages of Conversion
    B.    The Report Card
        1.    Mixed Success
        2.    Impact of Conversion on Defense Industrial Base & its Economic Implications
        3.    Impact of Conversion on Local Economies
        4.    Sustainability of Conversion
III.    PLA-Run Businesses
    A.    The Evolution
    B.     Business Development or Chaos?:  A Progress Report
        1.    Incredible Growth
        2.    The Soldier-Businessman:  A Conflict of Interests
        3.    Impact on Local Economies
        4.    Sustainability of PLA-Run Enterprises
IV.    Policy Implications
    A.    Defense Industry Conversion
    B.    PLA-Run Enterprises
V.    Conclusion

     Over the past twenty years, China’s People’s Liberation Army (PLA) and its defense industry have become increasingly active in the economic sector. Since the beginning of the economic reforms of 1978, the Chinese defense industry and the People's Liberation Army have used business to sustain themselves economically.  Initially to compensate for declining defense budgets, both the defense industry and military units themselves have branched out to the civilian commercial sector.  However, if China and its military continue their present economic development, defense industry conversion will contribute to the overall economic reform of the country, while the growth of PLA-run businesses will impede economic development, political stability and military effectiveness.  Structural reform in both types of enterprises is necessary to achieve sustained economic progress and maintain social stability.

    "Defense industry conversion" is the process of transforming civilian-run factories headed by military officers with sole production of military goods to civilian-run factories with production lines, capital and/or personnel producing goods for civilian use.  Profits from these factories may or may not be funneled into the PLA depending on central control and personal networks.  This economic strategy of military integration, according to the State's Commission on Science, Technology and Industry for National Defense (COSTIND) in 1990, should "'gradually...reform and convert the past unified military product system into an integrated military-civilian national defense scientific research and military-industrial production system.'"¹    Like other state-owned enterprises, these factories will be transformed to meet public demand and supply dictated by the market, thereby reducing dependence on the central government.

    "PLA-run enterprises" are businesses that are owned by commanders, agencies or personnel of the military that feed profits back into the PLA.  These enterprises can employ current or former military personnel, military personnel's family members or civilians.  Stemming from years of self-sustaining agriculture and animal husbandry, these businesses have expanded into every sector of the economy from heavy to light industry to service sectors.   Because the roles and vested interests of business and the military have been blurred, the military readiness of the PLA has been reduced.

    This paper examines this trend in two sections:  1) defense industry conversion; and 2) PLA-run businesses.  Each section will relate the history of this transformation, the extent of the activities, and their progress.  Analysis of the impacts of these economic trends on both local and national economies will describe how these businesses contribute to or detract from China's overall economic development.  Each section will conclude by detailing the probabilities for sustaining these business activities.  The last section of the paper will discuss the policy implications for both defense industry conversion and PLA-run businesses.

    In researching this subject, one severe handicap stands out among all sources.  The military's secrecy and its resulting lack of information provides incomplete pictures and analyses.  Hopefully, by spanning many different authors and sources and drawing comparisons with other state-owned enterprises and military history, these gaps can be reduced.  I apologize now for any contradicting reports or ambiguous information:  alas, that is the nature of the military, regardless of the country.
 

II.    China's Defense Industry 

                            Combine the military and civil,
                            Combine peace and war,
                            Give priority to military products,
                            Let the civil support the military.

                                                        -Deng Xiaoping, "16-Character Slogan", 1978

     The defense industry is composed of about 2000 enterprises in addition to research institutes and three million workers, most of which are located in the third line.²  Since 1978, China's defense industry converted into multiple sectors of the emerging market in response to a slow down in military orders and a decrease in budgetary funds.  The industry encountered both success and failure in its conversion into civilian production.  Almost twenty years later, the smaller firms have been forced into large conglomerates to increase economies of scale and vertical integration to compensate for fluctuations in the market.  These future of these industries tend to parallel that of other state-owned enterprises; however, the national security demands on the defense industrial base will continue to interfere with their conversion processes and their adaptation to the market economy.

  A.    The Conversion Process

    The conversion of the defense industry has spanned two decades with many different paths.  The following discussion highlights the general trends within the industry and why this industry in particular has converted.

 1.    The Rationale for Conversion

    Deng Xiaoping placed the military last in his four modernizations program unveiled in 1978.   As government defense budgets decreased in the early 1980s to redirect resources to other sectors, orders for military equipment declined.  Although the following table shows small increases in the official defense budget from 1981 onwards, these figures are not adjusted for inflation and in real terms, defense budgets decreased throughout this period until the early 1990s.
 
 

Additionally, manpower reductions in the military left the industry less units to supply.  The defense industries accumulated vast under-utilization, lower revenues and extra manpower. In 1984, the central government authorized the production of civilian goods by underutilized capacity.³  Previous to and then coupled with this official encouragement, these industries began producing civilian goods.  The military's production of civilian goods surpassed their production of military goods in 1987.

    China remained a world arms dealer, especially to developing nations such as Iran and Iraq in their war during the 1980s.  However,  the Persian Gulf War's demonstration of American high technology arms revealed the weakness of China's relatively low technological arms with a resulting decrease in arms sales.  These revenues dropped from a late 1980s high of about $2 billion annually to less than $1 billion in 1991.⁴  In 1995, China earned about $200 million in arms sales which is one-fifteenth of its revenue from arms sales in 1988.  Decreasing profits from arms exports lent further impetus to defense enterprises to convert some of their production to civilian goods.

    The lack of a large threat to Chinese sovereignty, (i.e., the Soviet Union and the United States), pushed down domestic arms sales as well as drawdowns in manpower.  The objective of war had officially changed from a people's war to a limited war with high technology, thereby cutting the numbers of arms needed in a conflict.  However, the government wants to retain some defense production capability and therefore seeks to keep these key enterprises under state control for the foreseeable future.

    Mao had instituted a industrial strategy, based on Soviet advice in the 1950s, that placed defense factories all throughout the nation.  This "third line" protected the military's ability to retaliate since not all of the defense industrial base could be destroyed in a single attack.  Consequently, 55% of defense industries are located in remote areas of southern and western China removed from both markets and resources.⁵  With the reduction in military spending and exports, these distant factories looked to conversion to civilian goods for their own survival.  However, it is these businesses that are suffering the most from this regional disparity, much like the rest of the nation.
 
 2.    Many Roads to Conversion

     When initiating a defense conversion program, there are three main strategies to employ.  First, the factory may use existing military technology and equipment to produce civilian goods.  These lines of productions have dual capability; they can produce both civilian and military goods on the same lines.  A second strategy would use existing lines of production and retool them to produce only civilian goods.  These lines could be used later to produce military goods, but only after being converted back to defense production.  The other strategy would require purchasing new lines of production for civilian use only.  These lines can not be used for defense production.  Therefore, this last strategy implies lost defense capabilities for the individual factory and a clear break from defense production.  Military factories have used a combination of all three strategies in their conversion process.

    In conjunction with production line transformations, factories have also moved from their "third line" positions in remote areas of western China to the coastal regions.  Some special economic zones (SEZs), such as Shenzhen, have offered tax incentives, reduced fees and less onerous rules to attract relocating industries in an effort to boost their own local economies.  Additionally, the factories gain the transportation, communication and trade infrastructure absent in the inner regions of the country.  Booming coastal cities also provide important market signals to these companies which guides production choices and technology development.⁶  Since defense industries received production quotas from the government for so many years, much of the management in these factories cannot accurately interpret market signals, thereby creating redundancy or gluts in the economy.  The strategy of relocation has given many factories new opportunities for growth that are not available inland.  If the primary factory cannot relocate to the coast, "window" subsidiaries or partners of these industries have been established there instead.⁷  These provide an opening for the factory to import raw materials and export its goods to stronger domestic and international markets.  This coupling with SEZs has created tighter bonds between local governments and factory managers which also exacerbates tension between these two groups and the central government.  At a local level, however, this relationship has helped defense industries to receive preferential treatment to convert with less risk.

   The central government has actively promoted defense conversion since the early 1980s when it allowed more than 2500 defense technologies to be released for civilian use.⁸  The Central Military Commission (CMC) has pushed for "cross fertilization" of the civilian and military sectors to reduce redundancy in the economy.  Through information and technology sharing, both sectors can profit from the progress of one through this strategy.⁹  In 1991, a central government plan applied that same military technology to local economies in hopes of spurring local development and reducing unemployment.  To coincide with national economic development, the central government organized groups of liaisons from the major military industries to coordinate efforts between local economies, local governments and defense conversion industries.¹⁰

    In addition to official government policies, high political pressure has come to bear upon banks to lend significant amounts to these enterprises.  Similar to most state-owned enterprises throughout China, the defense industry still incurs much debt and many factories have gone bankrupt over the past decade in failed attempts to convert.  During the Five Year Plan of 1986-1990, 121 bankrupt plants were closed "at a cost of more than 3 billion yuan (approximately US $550 million in 1992 dollars) and another 115 projects were designated for 'readjustment' during the Eighth Five-Year Plan (1991-1995) at a similar cost."¹¹  The active participation of the central government in defense conversion strategies has a high price.

    The government ministries that have oversight authority over the defense industry has also undergone a transformation to develop accountability and efficiency in conversion.  Beginning in the early 1980s, the defense ministries have undergone several reorganizations.

From the above chart, the corporatizing trend in the ministries reflects the government's goals for the defense industries.  Most of the ministries have been converted into corporations to consolidate their operations and oversight.  The defense industries are now only under the supervision of the State Council, and not jointly with the Central Military Commission, indicating their growing separation from the military.  These businesses, although still largely state-owned, have acquired "state administration and profit-making duties" rather than production quotas.¹²

    Ultimately, the size of the business determines the strategy for conversion.  Depending upon the size, geography, production lines, capital, management, infrastructure, and financial well-being of the factory, the plant will employ one or several of the above strategies and policies to convert to civilian production.  As will be discussed in greater detail below, there are inherent advantages and disadvantages to certain industries.  The result of these strategies has been very individualistic to each plant.  On the path of defense conversion, each factory must choose the approach that best suits its own characteristics.

 3.  "Everybody is Diversifying Like Crazy"
                        --John Frankenstein, University of Hong Kong ¹³

    When the initial conversions to civilian production began, most factories chose their civilian goods by following what was already available on the market.¹⁴  The management's ability to read market signals and predict public demand was quite unsophisticated since their previous customer base consisted solely of the government.  However, as the early profits from civilian production accumulated, these profits were reinvested into the industries to expand production capabilities.  Now the defense industries produces thousands of different civilian goods.  From cars to firearms to small electrical appliances to aircraft to textiles to medicines, the defense industry spans every sector in every region. By the middle of the 1990s, one-fifth of the cameras, 65% of the motorcycles and three-fourths of the passenger vans in Beijing alone were made by the defense industry.¹⁵  The abundance of scientists and researchers in the defense industry, (about 300,000) has supplemented the extraordinary magnitude of conversion. Surprisingly, only 10% of the defense research in China has civilian application in comparison to 80-85% crossover in the United States and 50-60% crossover in Europe. That phenomenon results from the low technological level of most of the civilian goods produced by the defense industry.  Less than 20% of the production makeup of the industry uses high technology.¹⁶   Therefore, the majority of these civilian goods are low-value added products that are affordable to the majority of the Chinese people.

    The amount of civilian production actually being produced by defense industries, (some estimate that two-thirds of the defense industry production is for civilian consumption), varies according to different "experts".¹⁷  Still, all the scholars agree that the defense industry devotes more than half of its production capability to civilian goods.  Following this trend, as the defense industry expands its presence in all of China's economic sectors, it will devote more of its resources to civilian production.
 
 4.    Inherent Advantages and Disadvantages of Conversion

    Advantages

    Because of its preferential treatment by the government, the defense industry has several advantages vis-a-vis other private businesses.  These factories have a high "concentration of technology and skilled labor" which provides vast resources for conversion and expansion.¹⁸  As these factories grow into other sectors, they can absorb the unemployed or demobilized soldiers, thereby contributing to their human capital.  This huge and cheap labor force gives the management an unique advantage for production of civilian goods, most of which are labor-intensive.  For the industries that develop higher technology products, the skilled labor that has been trained in these factories can be more quickly retrained for civilian production than workers without previous experience in complicated technological processes.  The defense industries have also had a history of preferential access to supplies which has been easily exploited for civilian production.¹⁹  Large tracts of land are another resource that the government previously transferred to this industry during its years of only military production.

    Some analysts have added the defense sector's "reputation for quality and credibility" as an asset for the defense industry conversion.²⁰  Another intangible advantage of the defense industry is its protection from bankruptcy if one sector turns down.  By diversifying, the factories can remain solvent by spreading the risks across several sectors.   The advantages of this particular sector converting to civilian production has both tangible and intangible components that create a dynamic stage for this transformation.

    Disadvantages

    The defense industry's history is its biggest disadvantage.  Since it had previously possessed a "monopsonistic demand structure," the industry cannot read market signals well and has little knowledge of how the market actually works.²¹  The defense factories have been "isolate from the true costs of production" that they cannot accurately price inputs or goods.  Since most prices in China also don't reflect the actual demand and costs of the market, this further distorts the ability of the industry to adapt to the economic environment.²²  The defense industry is vertically organized; in other words, a single enterprise does not cooperate with other enterprises to take advantage of economies of scale and division of labor.  Rather, the system creates an entire industry that is highly redundant.²³  Therefore, in the conversion process, many industries suffer needlessly by not consolidating with other businesses to share the costs of the transformation.  Lastly, the industry's history of providing an enormous social security system for all its workers drains many of the profits that civilian production creates.  Consequently, resources to reinvest in the factory to improve technology, equipment, or safety standards cannot be undertaken.  The results are low quality goods with small profit margins.  A declining circle of dwindling resources begins.

    The operational setting of the defense industry adds to the disadvantages within the conversion process.   Most defense industries used to buy their supplies from the government.  However, due to the substandard quality of those inputs, the industry now purchases those materials in the open market which costs the business even more money and places additional strain on the process.²⁴  Civilian production is largely labor-intensive.  Therefore, the defense technologies that would typically be an advantage in conversion to civilian production cannot be utilized.  This resource cannot be exploited and deteriorates over time.²⁵  Most defense industries are geographically isolated, which places greater strain on the infrastructure of the factory since it must reach the markets on the coasts and provide for its workers since the local economy cannot.  This system has created a reliance on middlemen for exports which reduces the profit margins for the industry.²⁶  The operations of the defense industry give it several disadvantages not only to civilian production but also to any business undertaking.
 
B.    The Report Card

 1.    Mixed Success

    The initial conversion was very slow and laborious.  However, as profits continued to attract the attention of management, the momentum for conversion grew.  Additionally, Deng Xiaoping's Southern Tour in 1992 reaffirmed the industry's search for profits, thereby giving greater legitimacy to the conversion.  Yet, bureaucrats and managers recognized the infrastructure constraints on the industry, such as communications and transportation, early on in the process.²⁷  Institutional obstacles also loomed large.  For example, military pricing was typically set at costs plus 5% for profit.²⁸  But as input costs adjusted to market prices, the pricing scheme produced losses and forced some businesses into bankruptcy.

    The success of defense industry conversion has been mixed.  While some reports have indicated a growth in profits, other sources quote declines in output and bankruptcies.  Overall, the conversion reflects the national Chinese economy.  While the defense industry grew at an annual rate of 327 from 1978 to 1992, with an annual profit of US$6 billion, the industry as a whole has begun to decline over the past two years.²⁹  By the end of 1997, 80% of defense industries are in debt and more than 400,000 workers have been fired.³⁰  By and large, the success of conversion also reflects the economic development of the state-owned enterprises (SOEs).  The value-added output of all Chinese factories fell to 10.9% in 1997, mainly due to SOEs of which the defense industry is a large portion.  Again, while the economy grew by 8.8% in 1996, SOE output only increased by 7.1%.³¹  The majority of the SOEs that are in financial trouble are in the defense sector, according to Zhu Rongji, China's new Premier, with plant capacity utilization rates at 10-30%.³²

    There have been some successes too.  The output value of civilian goods rose on average 25% from 1979 to 1989.³³  Therefore, more value-added products are being made which can create more profits for the factories.  The defense industry has also spread out into the international markets.  In 1989, more than 100 types of products were exported with a value of over US$300 million.³⁴   Joint ventures have also emerged in the conversion process.  By the end of 1994, 51 defense industries were part of joint ventures with total foreign investment of about US$1.5 billion.³⁵  The main foreign investors in China's defense industry conversion originate from Japan, German, the United States, Britain and the Republic of Korea. ³⁶  Additionally, due to diplomatic and political obstacles, China has found Russia to be a willing source for technology transfer.³⁷  Still, private and foreign investment is not as strong as the defense industry would wish.  The deteriorating infrastructure, geography, loss of skilled labor, and debt have discouraged investment.  The average rate of return on foreign investment in 1.8%; not a promising venture for many investors. ³⁸  The defense industry has incurred additional problems with a lack of understanding of the market, poor financial systems, triangular debt, uncompetitive pricing of goods and unknowledgable management.³⁹  In sum, defense industry conversion creates some individual successes, but more often, the process encounters too many institutional and historical problems to overcome without radical restructuring.
 
     Because of the advantages of size in conversion, some defense plants have consolidated to create economies of scale and spread risks.  Large factories possess much more capital and skilled labor than smaller operations.  The small defense industries lack the capital, credit and resources to survive conversion by themselves.⁴⁰   They also lack the political power, personal networks, the research and development structure and international market presence to sustain themselves in a market economy with growing competition from privately-owned companies.⁴¹  Therefore, these companies have formed conglomerates similar to Japanese keiretsu which increase horizontal integration of several companies across different sectors.  In this manner, the risks of one venture or one sector failing can be spread out over several sectors and factories to mitigate losses.  Additionally, the central and local governments take a greater economic and political interest in these conglomerates since they impact the economy on such a larger scale than individual factories.⁴²  However, these groups have looser ties than other similar business arrangements in other nations.  Many subsidiaries in these conglomerates act independently of the parent company without their knowledge or consent.  This chaotic characteristic of conglomerates makes consolidation of resources and management more difficult, but still helps to spread risks among several actors.
 
    As with other state-owned enterprises, many defense industries acquired vast amounts of debt.  During the 1980s, the central government urged factories to take out bank loans to lessen government assistance.  With the costs of retraining workers, retooling production lines and relocation, many of these industries built up large quantities of debt.  Besides bank loans, triangular debt between companies has added greater stress to the financial environment of the defense industries.  In conjunction with redundancy in low value-added and low technology markets, these defense industries are unable to repay their loans.
 
 

Debt and Redundancy:  The Perilous Financial State of Defense Industries

	Yuan	% of GDP	% of Industry Value Added
1994 Industrial Debt	631 billion	14%	34%
Unsold Inventory	401 billion	9%	22%

Source:  John Frankenstein, "China's Defense Industry Conversion:  A Strategic Overview,"  Mixed Motives, Uncertain Outcomes:  Defense Conversion in China  (Boulder, Colorado:  Lynne Rienner Publishers) 1997:  33.
 
Since the defense industry's output was only less than 2% of the GDP in 1993, the 14% of GDP debt indicates a looming crisis in the defense industry.  Today, 70-80% of all bank loans in China are made to the defense industry.  The estimated total of bad debt held by banks in the country is US$200 billion.⁴³  Analysts have raised similar concerns in reference to the Southeast Asian banking crisis of 1997-1998.  However, the size of the population and the economy should temporarily cushion these shocks.  Yet, the long term deleterious effect of the triangular and bank-owned debt will undercut the ability of the defense industries to sustain their conversion.

    The profits from defense industries are allocated into several components of the factory.  A large part of the profits sustain the huge social security system within the industry.  Housing, medical care, and food absorb much of the profits that defense conversion generates.  Other surpluses make individual managers and local bureaucrats wealthy, thereby perpetuating the industry's and governmnet's interest in conversion and civilian production.  The government still provides some administrative and financial assistance, althougth its total share is declining.  In 1997, the State Planning Commission approved funds to help airlines finance the domestic rental of their planes.⁴⁴  Even with dwindling official assistance from the government, other government contacts, such as political pressures and personal networks, facilitate a smooth conversion process for many industries.  The government also provides financially for these plants when they declare bankruptcy.  With the growing debt owed by and the social burdens on most factories, they can declare bankruptcy and reopen another plant in the near future with no debt and less workers.  The government must cover the outstanding loans.⁴⁵  Although the official financial support by the government has decreased, most defense industries still rely upon the government for other sources of funds and types of assistance.

 2.    Impact of Conversion on Defense Industrial Base & its Economic Implications
 
    Because of the opportunities for personal wealth, most managers of defense industries do not want to devote any portion of their factory to defense production.  With a lack of central government's oversight and profit-making capabilities of civilian production, managers' vested interest in conversion erodes the defense industrial base.  The central government mandates that some military production lines  remain open, but they are economically inefficient and provide no incentives for managers to maintain them.  The lost potential for profit and the losses incurred when producing military goods discourages defense industries from sustaining the defense industrial base.  The defense production lines could be converted to civilian use and generate more profits for the industires, the managers and the bureaucrats.  These institutional obstacles add to the deterioration of the defense industrial base of China.  Some bureaucrats hoped that conversion to civilian production would compensate for the costs of military production, but that has not occurred primarily because military production is being pushed aside completely.  There is not military production for which to compensate in most factories.  Because of the vested interests of all the actors and the decentralization trend within the government itself, the central authorities do not have the leverage to maintain the defense industrial base required for their desired military development over the next twenty years.  Rather, more and more military systems will have to be imported to meet the military's goals.

    The arms industry is unique since it remains under tight control of the government through the auspices of the Commission on Science, Technology and Industry for National Defense (COSTIND).⁴⁶   Some profits from the civilian production of arms for exports have been funneled back to the PLA.  Xinshidai, the group that oversees these weapons trading companies, has some connections with the PLA, but they are indirect and speculative due to the secretive nature of the industry.⁴⁷  The arms industrial base maintains its military production although it increasing caters to exports rather than domestic demand.  The central government does not have the military modernization funds to support every arms factory in China which leads these plants to export production.
 
    The research and development sections of this industry parallels most other defense industries;  the foundation for military technology stems from the commercial sections of the defense factories.  Very little money is being allocated for military research and development.  Therefore th innovations of civilian production in the defense industry supports the military production and technology.⁴⁸  In conclusion, the defense industrial base is deteriorating as more factories switch entirely to civilian production because of economic gains.  The military modernization programs of the PLA will not be supported financially by conversion.  Rather, overall economic development of the nation will create more resources to be allocated for modernization.

 3.    Impact of Conversion on Local Economies

    Following trends of decentralization throughout the government, the defense industries have created closer ties to local governments.  Profit-sharing systems have cemented the local government's vested interests in sustaining conversion to civilian production.  Local governments offer tax incentives and administrative assistance to attract converted industries.  The defense industries absorb unemployed workers and demobilized soldiers.  With Jiang Zemin's goal of reducing the Army by 500,000 soldiers, this advantage will become more attractive to local authorities.  At times, the management of factories have been  turned over to local governments fostering even closer bonds between industry and government.⁴⁹  The benefits to the local economy and overall economic growth make these industries an often coveted asset to any village or province.  The industries that remain strictly under central control do not receive any assistance from local authorities since no profits are shared with the local government.⁵⁰  The vested interests of local governments in defense industry conversion exacerbates the tensions between local and central government.

    Defense industries also can negatively impact the local economies.  Domestic, private businesses grew rapidly in the 1980s and now dominate some sectors of the Chinese economy.  With the entrance of converted defense industries, the competition for resources and markets rises.  The advantages of defense industries in civilian production, as discussed above, distorts the true operation of the market.  Therefore, the defense industries can push out private businesses and quickly overtake a sector, much as they have in electronics, motorcycles and automobiles.  However, conversion has also opened the defense industry's advantages to the rest of the market.  Skilled labor has been fleeing to private business where wages are typically higher.⁵¹    As the defense industries face increasing competition from domestic and international business, it will have to shed itself of extra labor and inefficient processes that were hidden under central production.
 
 4.    Sustainability of Conversion

    The defense industry's conversion to civilian production has had some initial successes and failures.  To further develop this sector, the industry must overcome historical and structural weaknesses.  The distorted price structure of the industry reveals a management that cannot read market signals accurately.⁵²  The management of the defense industries need to be retrained to gain knowledge of market economies and mechinations, labor relations, price reform, marketing strategies, and financial managment.  Managers need to understand and institute a corporate culture in the factories to respond to the market.  The financial environment of the defense industry must be immeditely altered to decrease debt and provide fiscal stability.  Private and foreign investment will not make large contributions to joint ventures due to the many structural weaknesses of the industry.  Especially in defense industries, foreign investors find it difficult to determine who is controlling the industry:  the PLA, the management or the government.⁵³  One of the keys to these reforms and sustaining conversion is the flexibility of managers and bureaucrats to slowly adjust the defense industries to market development within the entire country.⁵⁴  Restructuring of the institutional aspects of the defense industries, particularly the management system, will be one of the greatest challenges to sustainability.

    The industry as a whole must make significant investment in capital and infrastructure of communications and transportation to upgrade and sustain its technological base.  Only then can the industry can move into higher technology and value-added goods which would increase profits margins for further reinvestment and debt repayment.  International marketing strategies need to be exploited in conjuction with production of higher technology goods since domestic demand for such production is too low.⁵⁵    The success of this conversion will reflect the economic development of China.  As the national economy grows, more markets and funds will open for the defense industries.  With institutional reform in the national economy, such as intellectual property rights protection, more investors will be willing to create joint ventures with factories, thereby providing more opportunities for growth.

    The defense industry is becoming more independent of the government.  By widely ignoring military production lines, the industry is destroying the nation's defense industrial base.  This may be economically beneficial for the industry but makes the military rely more heavily on foreign weapons and arms.  If the PRC suffers an economic recession, this will stymie military modernization programs.  In the industry's growing ties with the military, the PLA has a vested interest in defense industry conversion and will assert itself politically to maintain its development.

    Consequently, as the defense industry converts to civilian production, such development can contribute positively to national economic growth.  The generation of profits and the reduction on government assistance frees up resources to be reallocated to other sectors.  As these factories become more self-sustaining, they can solidify their expansion into other sectors and boost domestic production of more civilian products, thereby reducting reliance on imports.  The impact on the defense industrial base and the problems indicative of all state-owned enterprises, such as large amounts of debt, could cause the collapse of the industry.  Only with significant restructuring and reform of these businesses will defense industry conversion be sustained.
 

III.    PLA-Run Businesses 

 A.    The Evolution

    Since its inception in the 1930s, the People’s Liberation Army has always been engaged in some economic activity to sustain itself instead of taking from the civilian population, (a move which would likely foster opposition to the military). When Deng announced his four modernizations in the 1970s, the military fell to fourth place in prioritization of the country’s development. Accordingly, the military’s share of the government budget also fell. With official encouragement, individual units opened up enterprises to supplement their budgets. The Information Office of the State Council of the PRC, in its paper on China's Arms Control and Disarmament, defends PLA-run businesses by noting that they provide "employment for the families of military personnel, . . . improve life culturally and materially, . . . and support the nation's overall economic construction."⁵⁶  The initial success of these enterprises propelled the PLA-run business sector into  the Chinese economy.  Most PLA-run businesses are small, barely profitable units that employ the soldiers' families.⁵⁷  However, the latest trend indicates that military authorities are combining these enterprises into conglomerates or groups to take advantage of economies of scale.

    Today there is estimated to be about 15-20,000 PLA-run businesses.⁵⁸  However, that quantity is deceptive.  Once the individual military units began to receive profits from their enterprises, they evaded financial control by higher military authorities and the central government.  Many enterprises created their own subsidiaries without the military's approval.  Even local commanders typically do not know the extent of the PLA-run businesses within their own regions.  To complicate the quantity even further, some analysts have accused the PLA of deliberate deception by changing enterprises' names and hiding their true activities, such as in the arms export industry.⁵⁹  There has not been a unified management structure and attempts by the military command and the central government to control these businesses have failed.  Additionally, some of the PLA-run businesses have civilian components together with military-operated enterprises which makes control even more difficult.  This chaotic system of quasi-control has reduced accountability within the enterprises.

    The entire military is involved in the business sector.  (For a map of China's military regions, please click here.) From top commanders to individual units to military departments, each group has its own enterprises.  The General Logistics Department, which is reponsible for the oversight of these PLA-run businesses has its own ventures, including the China Xinxing Corporation which engages in much international trade. COSTIND, whose departmental responsibilities include weapons research and development, has several high technology companies.⁶⁰  This conflict of interest emerges between the regulatory aspects of commanders and departments and their own self-interest in profits and personal gain.

    The PLA-run business activities reach into every sector of the economy.  Civilian production, much along the same lines of the defense industry, has expanded into electronics, food, medicine, appliances, and textiles.  Also, the military has used its own resources for commercial uses.  The Airforce has converted some military planes for commercial use and allows non-military planes to land at and take off from its airports.  In 1986, the Airforce created China United Airlines along these lines and in 1992, the airline transported 400,000 passengers and about 8 millin tons of frieght.⁶¹  The Navy has created new transportation services using its fleet as carriers.  The PLA also has branched into the service sector and real estate.  The PLA inherited prime real estate in Hong Kong after the transfer, some of which has been converted into hotels.  These enterprises have also produced value-added goods, demonstrating their own economic development and not merely exploiting pre-existing resources.

    The arms industry remains under the PLA's control.  As mentioned earlier, this sector has been selling of its stockpiles and producing new weapons for export.  Mostly through reverse engineering, the Chinese arms industry copies Western technologies and sells these older generation systems to developing and sometimes hostile nations.  This again creates a conflict of interest between business profits and national security.  Polytechnologies (Baoli), the main arms distributor in China, has flourished over the years despite the shock of the end of the Cold War.  From 1990 to 1993, the Poly Group Corporation, the exporting arm of Polytechnologies, expanded its revenue from civilian business from 20% to 80% of its total revenue.⁶²  The arms industry is generating profits and expanding into international markets, unlike other SOEs.

    The PLA-run businesses' development have reflected trends within the nation as a whole.  Since many high technology goods are not supported by domestic demand, export businesses have been increasing to all of China's trading partners.  Most PLA-run successes are in the southeastern regions of the country that disproportionately possess much of the necessary infrastructure to reach domestic and international markets.  Military units in remote areas of the country still are suffering from malnutrition and poverty because their enterprises cannot survive in those regions.  The most profitable PLA-run businesses are located in SEZs where tax incentives and other awards encourage business development.  (Click on a map of China's Special Economic Zones for designations of the SEZs).  The Shenzhen SEZ houses many PLA-run businesses, including the 999 Corporation which produces pharmaceuticals.  The PLA also is establishing its own development zones in the region, Guangdong, to further support economic growth.⁶³

    The PLA exploits the preferential treatment accorded to the miltary for business development.  Transportation, labor and capital resources that the military is normally given by the state have been commercialized for profit.  The military has created monopolies in certain regions and sectors because of its natural advantages over private enterprises.  Coals mines in the Shanxi province and transporation services in the Guangdong province are two examples of military monopolies extending from preexisting miltiary structures that have been exploited for commercial uses.⁶⁴   However, the rapid growth and decentraliziation of the miltary has created a chaotic system.  There is no overarching authority with real power to regulate and reform these enterprises.  The PLA does not have the institutions nor the political will to assert control over these businesses.  Therefore, while these businesses may help the miltiary to rely less upon the government budget, the profits and potential taxes are lost among individual commanders and units.

    The profits from these enterprises have a dubious connection to the military.  Some experts venture that the profits are "being invested in new commercial activity or are being spent on the welfare of the military units that control [these] businesses."⁶⁵  Obviously, the profits are distributed in many ways particular to the business.  The outstanding characteristic of this financial structure is the total lack of control by higher state and miltary authorities.  30% of the profits are to be turned over the General Logistics Department, but it is rarely done.⁶⁶  In 1989, the PLA instituted accounting centers in which all enterprises were to deposit their funds, but that attempt also failed.  Because of the opportunity for personal gain of profits, the PLA combats attempts to regain control over the profit structure and exploits the confusion surrounding these businesses currently.

    The PLA has strengthened its hold on its business enterprises.  Because of the decline of ideological unity, decentralization in the government, and decreasing miltiary budgets, the oversight structures for the PLA has deteriorated.  The funds that the central military authorities do receive from these enterprises can fund modernization efforts.  Additionally, many of the managers of these businesses are the sons and daughters of the central government's elite which bonds the government and the military together.  For example, "COSTIND which carries oversight of exporting activities, and Poly Group, the principal PLA arms exporter, employ relatives of [the] Central Military Commission [CMC] members and other aging leaders."⁶⁷  Both military and government leaders have recognized the danger in continuing these enterprises and have attempted to create more accountability and separation between the military and its businesses, but all efforts have failed.  The PLA is too dependent and possesses too much vested interests in its businesses to abdicate any power.

       B.    Business Development or Chaos?:  A Progress Report

 1.    Incredible Growth

    Estimates of the growth of PLA-run businesses vary widely. The pace and extent of the increase of businesses makes any accurate assessment impossible not only for outside analysts but also for commanding officers and state bureaucrats. What is revealing is the level of growth from small farms to large conglomerates and international trading companies.  One source suggests that the PLA grossed US$13 billion from international arms sales to 25 countries from 1985 to 1994.⁶⁸    Often enterprises are revealed first when bills go unpaid and suppliers come to the miltiary authorities to regain their money.  The General Logistics Department (GLD), which oversees the PLA's commerical enterprises, does not have the resources to effectively regulate this growth.  Therefore, much of the expansion of PLA-run businesses occurs ad hoc without oversight and accountability.

    More growth is expected in the coming years as government officials move to open the PLA to the market.  COSTIND and the GLD are to open their electronics sector to the public this year to acquire technological innovation.⁶⁹  The current trend will create many more subsidiaries, conglomerates and joint ventures in this area.  Because of the growing independence of the PLA from the central government and of the indiviudal units from the CMC, efforts to regain oversight of these businesses will fail.  The lines between military and business will continue to blur with the rapid growth of these types of enterprises.

 2.    The Soldier-Businessman:  A Conflict of Interests

    An entire generation of soldiers is emerging in the PLA that have more business experience than soldiering experience.  They are focused mainly on profits to sustain the PLA rather than maintaining military readiness.  These managers typically have less knowledge of the market and pricing systems that private sector managers.  However, the soldiers-managers have learned quickly the mechinations of an open market system and are quickly making profits for these enterprises.

    Because they are caught between roles of the soldier and the businessman, it is difficult to resolve their conflicting interests.  Rather than devote time to developing grand strategy and military operations, most of the resources of the PLA are concentrated on business plans.  Training of personnel and overall miltiary preparedness has substantially suffered.  Most commanders have greater financial incentives to devote manpower to business than to military exercises.  Some experts quote "rough estimates that about half of the members of the PLA are pursued [in] non-military activities." ⁷⁰ The conflicts of interests also arise in the types of deals that the miltiary conducts.  Arms sales regularly encounter this dilemma when exports of weapons go to potentially hostile or internationally destabilizing nations.  An unified managment structure would perhaps clarify some of this confusion.  However, many soldier-businessmen operate independently of the formal military command structure thereby negating any opportunities for uniformity and structure.  Also, this would not eradicate the inherent conflicts between the duties of a soldier and the duties of a businessmen.

    Many of the PLA-run enterprises also engage in illegal operations.  The black market flourished in China with large support from the PLA.  Accounts of piracy at sea and Mafia-style operations have emerged as these PLA-run businesses expand without any accountability or central control.  The corruption within the military has damaged its reputation throughout the public and within the government.  In 1989, the state leaders issued the "Ten No's" which was a list of prohibited activities to stop the illegal business activities of the PLA.  Like other reform movements before and after this event, it failed to have any serious impact on the military's operations.  Corruption and illegal activities continue to be rampant within these enterprises.

    Some analysts have called for a separation of the military from its business operations.  Thomas Bickford proposes four areas for division:
    1) ownership from management;
    2) active duty from enterprise personnel;
    3) combat from economic units; and
    4) enterprise names from military code names.⁷¹
The probability of this type of reform succeeding within the current PLA system is highly unlikely.  Rather, the years of neglect by the central government and the sudden profits of these enterprises perpetuates the legitimate and illegitimate business activities.  Meanwhile, military preparedeness will continue to suffer as more and more resources of the PLA are devoted solely to its businesses.

 3.    Impact on Local Economies

    The normal advantages of the military for national security reasons has transferred into a monopoly structure within the business world.  This has pushed out private competitors in several sectors and regions.  This type of preferential treatment has distorted the normal operations of the market.  The relationship between the military and the public has eroded as corruption and illegal activities ruin the historically good reputation of the PLA.    Some business activities have helped the local economies by providing goods to meet local demand.  However, most of the impact of PLA-run businesses on the local economies is negative and serves to destabilize market transformations in these sectors.
 

  4.    Sustainability of PLA-Run Enterprises

    Politically, the PLA will more actively support its business enterprises as they expand throughout the national economy.  To consolidate its political power, more military officers are entering the Central Committee, one of the state's main ruling bodies.  Of its 190 members, one-quarter are officers.⁷²  As long as the central government continues to support these enterprises, the military will remain loyal to the government.  The President of China, Jiang Zemin, urged at the National People's Congress in early 1998 that the "PLA  . . . throw its weight behind market-style reforms because economic might [is] essential to building a powerful army."⁷³  This symbiotic relationship between the miltiary and the state will continue if the current path of economic progress is sustained.

    Militarily, PLA-run enterprises will erode military readiness as more human and material capital is dedicated to business.  As an increasing number of soldiers become better trained in the market than in the battlefield, the ability of the PLA to effectively posture as a fighting force will deteriorate.  The goals of the military modernizations of the current Five-Year Plan are to create an effective and high technological force.  But, that requires much investment and training to have a credible force.  The PLA will deteriorate militarily while improving economically to become another large corporation within Chinese society.

    Economically, the military is learning about the market and its operations as other managers throughout China.  However, its preferential treatment and political clout give it advantages that distort the normal operations of the market.  A foreign joint venture partner of a PLA-run business stated that "the courts don't dare interfere, and even the police don't dare bother them, so any dispute involving a company with ties to the army usually ends quickly and in their favor."⁷⁴  While this provides an incredible economic edge for the PLA over its competitors, it does not contribute to overall economic development.  Instead, these businesses hinder the transformation of China's closed, centrally-planned economy to an open market system.
 

IV.     Policy Implications

 A.    Defense Industry Conversion
 
         The conversion of the defense industry has some major positive impacts on the national economy.  By expanding its production, it can then retain workers and reduce the potential for unemployment.  Additionally, as the standard of living grows throughout China, the domestic production of civilian goods meets local demand which creates a beneficial effect on the country's balance of payments.  Underutilized capital is retooled for civilian production.  Overall, this conversion contributes to the nation's successful economic development.

    However, some drawbacks exist, such as the amount of redundancy in civilian production among defense industries and private factories.  This does not lead to competitive pricing or technological upgrades.  This may foreshadow economic downturns once exposed to greater international competition.  The military also suffers as more production lines are utilized for civilian goods, thereby reducing the defense industrial base of the nation.  The economic incentives to convert the military production lines are not compensated by civilian production profits or government funds.  Though some generals within the PLA are calling for a reduced dependency on imported weaponry and systems, this has not had any dampening effect upon the conversion process.⁷⁵  The PLA has two choices in relation to its decaying defense industrial base.  The military can either 1) allow the industries to convert according to their own economic desires and pay market prices for domestically-produced military goods; or 2) force some factories to maintain their defense industrial base and eventually pay for their losses by covering defaults on bank loans.  Both of these options will cost the central government significant monies.

    Significant restructuring is necessary within the defense industries to avoid the above scenario.  Management styles, corporate culture, pricing systems, marketing strategies, research and development plans, capital allocation and infrastructure development must all be undertaken to avoid the fate of many other SOEs.  The vast quantities of debt that these industries owe one another and banks will lead to their collapse unless these industries are given more opportunities to adjust slowly, unlike the Soviet Union's rapid transformation, to the market economy.  Indications of this downfall are appearing throughout the economy as more of these factories are consolidating for survival or declaring bankruptcy.  These reforms must be carried out fully and immediately to sustain the positive economic growth that these industries can generate.
 
 B.    PLA-Run Enterprises
 
    Economically, the PLA is distorting market operations with its advantages in inputs, costs and political connections.  This monopolistic edge over competitors is pushing out other businesses in the same sectors or regions.  The profits from these enterprises are not being routed to the central government since so much corruption pervades the PLA.  Much of these profits are not being used for military modernization, but rather for personal gain and to cover rising costs of living for soldiers.  To integrate these enterprises into the local and national economies for further development of the nation, these businesses need to be separately managed from the miltiary command structure and adapt standard business practices of the rest of the Chinese economy.

    Politically, the PLA will gain more strength as its business activities grow.  The PLA is a central support for the central government which will give the military much leeway in its business practices to maintain its backing.  The military is becoming increasingly independent of the central authorities as it relies less upon the state for its economic survival.  Through formal and informal structures, the PLA will assert itself aggressively to maintain its preferential treatment and sustain its economic growth.
 
    Militarily, the PLA-run enterprises are ruining the military's capability to wage war.  The force is devoting much more of its resources to business and less to training and readiness.  Current PLA goals to achieve a modern fighting force is being sidestepped for the more immediate goals of profit.  The conflicting interests that arise between the business and the military realms reveal the hypocrisy throughout the PLA.  In continuing this dangerous trend, the PLA will not be able to achieve a credible military presence as it shifts its focus to the economy rather than national security.
 

V.    Conclusion

    Since the economic reforms of 1978, the military and the defense industry have altered their roles within the Chinese economy.  The defense industry's conversion process has created positive contributions to national economic development.  Its utilization of slack resources, continued employment of labor, and profits add to the economic progress within the country.  However, the defense industry's contribution to regional disparities and its growing debt highlight structural weaknesses that must be addressed immediately to avert disaster.  PLA-run businesses have only one significant advantage to the national economy:  they decrease reliance on the state for the costs of supporting a huge standing army.  However, militarily, economically and politically, these enterprises destabilize the country and hinders its transformation to a market economy.
Structural reform that creates accountability and separation of authority in PLA-run enterprises is necessary to achieve sustained economic progress and maintain social stability.  Ultimately, the success of both of these types of business activities will reflect the development of the national economy.  The remaining question is this:  Can the Chinese military maintain its economic successes in the face of overwhelming structural obstacles to its growth and stability?

1.    Mel Gurtov, "Swords Into Market Shares", China Quarterly.  Jun 1993, n. 134, p. 213-214.  Back to text.

2.    Ellis Joffe, "The PLA and the Economy," Chinese Economic Reform:  The Impact on Security  (New York:  Routledge)  1996:  14.  Back to text.

3.    Solomon Karmel, "The Chinese Military's Hunt for Profits," Foreign Policy.  Summer 1997, p. 104.  Back to text.

4.    Joseph E. Kelley, et al., "National Security:  Impact of China's Military Modernization in the Pacific Region,"  Chapter Report, 06/06/95m GAO/NSIAD-95-84 (Washington, D.C.: GAO) 1995.  Back to text.

5.   John Frankenstein, "China's Defense Industry Conversion:  A Strategic Overview,"  Mixed Motives, Uncetain Outcomes:  Defense Conversion in China  (Boulder, Colorado:  Lynne Rienner Publishers) 1997:  10.  Back to text.

6.     Gurtov, 231.  Back to text.

7.    Gurtove, 222.  Back to text.

8.    Information Office of the State Council of the People's Republic of China, "China:  Arms Control and Disarmament,"  November 1995.  Back to text.

9.    Bates Gill and Lennie Henley, "China and the Revolution in Military Affairs:  Part II,"  U.S. Army War College May 20, 1996.  Back to text.

10.    Information Office of the State Council of the People's Republic of China.  Back to text.

11.    Michael Brzoska, et al., Conversion Survey 1996.  (New York:  Oxford University Press) 1996:  135.  Back to text.

12.    Wei-chin Lee, "China's Defense Industry invades the Private Sector,"  SAIS Review.  Summer 1995:  181.  Back to text.

13.    Sheila Tefft, "In China, Weapons Exports More Alluring Than Nighties,"  Christian Science Monitor.  May 30, 1996:  6.  Back to text.

14.    Arthur S. Ding, "Economic Reform and Defense Industries,"  Chinese Economic Reform:  The Impact on Security  (New York:  Routledge) 1996: 84.  Back to text.

15.    Joffe, 15.  Back to text.

16.    Lee, 190.  Back to text.

17.    Lee, 177; and Information Office of the State Council of the People's Republic of China.  Back to text.

18.    Brzoska, 115.  Back to text.

19.    Lee, 182.  Back to text.

20.    "Defence sector--not just weapons,"  China Daily.  Oct. 2, 1997.  Back to text.

21.    Brzoska, 116,  Back to text.

22.    Brzoska, 119.  Back to text.

23.    Gill, et al.  Back to text.

24.    Ding, 85.  Back to text.

25.    Ibid.  Back to text.

26.    Sheila Tefft, "China's Military Grapples With Conversion,"  Christian Science Monitor.  Feb. 7, 1994:  4.  Back to text.

27.    "China Seeks Aid From West in Shift From Military to Commercial Manufacture,"  Aviation Week & Space Technology.  Dec. 11, 1989.  Back to text.

28.    Ding, 84.  Back to text.

29.    Lee, 177.  Back to text.

30.    Ma Lie, "Shaanxi to step up reforms of State companies,"  China Daily.  Jan. 10, 1998.  Back to text.

31.    "Chinese Factory Output Grows,"  The Washington Post.  Jan 13, 1998.  Back to text.

32.    Frankenstein, 23.  Back to text.

33.    Joffe, 15.  Back to text.

34.    Ibid.  Back to text.

35.    Lee, 184.  Back to text.

36.     "Defense Industry Conversion Attracts Foreign Investors,"  Xinhua.  Nov. 23, 1997.  Back to text.

37.    Tefft, "China's Military Grapples With Conversion":  4.  Back to text.

38.    Frankenstein, 26.  Back to text.

39.    Frankenstein, 24-25.  Back to text.

40.    Lee, 185.  Back to text.

41.    Gurtov, 221.  Back to text.

42.    Lee, 186.  Back to text.

43.    "Privatizing the People's Republic."  National Center for Policy Analysis.  1997.  Back to text.

44.    Shen Bin, "Avic to pursue foreign co-operation;  Reform to focus on aeronautics."  Sept. 28, 1997.  Back to text.

45.    James Flanigan, "China's Reform:  Peril, Promise in the Heartland,"  Los Angeles Times.  Oct. 26, 1997:  D1.  Back to text.

46.    Joffe, 15.  Back to text.

47.    Thomas J. Bickford, "The Chinese Military and its Business Operations,"  Asian Survey.  vol. XXXIV, no. 1, Jan. 1994:  464.  Back to text.

48.    Gill, et al.  Back to text.

49.    Lee, 183.  Back to text.

50.    Ding, 85.  Back to text.

51.    Ibid.  Back to text.

52.    Frankenstein, 119.  Back to text.

53.    Karmel, 111.  Back to text.

54.    Lee, 189.  Back to text.

55.    Ding, 88.  Back to text.

56.    Information Office of the State Council of the People's Republic of China.  Back to text.

57.    Tai Ming Cheung, "Serve the People," Far Eastern Economic Review. Oct. 14, 1993: 65. Back to text.

58.    Karmel, 105.  Back to text.

59.     David Isenberg, "The PLA and the Arms Trade,"  Journal of Public and International Affairs.  1996.  Back to text.

60.    Cheung, 65.  Back to text.

61.    "China's Changing Military Strategy."  1994.  Back to text.

62.    Cheung, 64.  Back to text.

63.    Cheung, 65.  Back to text.

64.    Karmel, 110.  Back to text.

65.    Patrick E. Tyler, "Chinese Military's Business Empire Puts Profits into Commerce, Not Arms,"  New York Times.  May 24, 1996:  A6.  Back to text.

66.    Cheung, 65.  Back to text.

67.    Isenberg.  Back to text.

68.    Karmel, 105.  Back to text.

69.    "China Opens Defense to Overseas Investors,"  Xinhua.  July 13, 1997.  Back to text.

70.     "China's Changing Military Strategy."  1994.  Back to text.

71.    Bickford, 471.  Back to text.

72.     "China's Changing Military Strategy."  1994.  Back to text.

73.    "General Warns Army Against Sloppiness,"  Inside China Today.  Mar. 16, 1998.  Back to text.

74.    Ted Plafker, "Chinese army tied to thousands of business operations,"  Boston Globe.  Sept. 22, 1996:  A6.  Back to text.

75.    "General Warns Army Against Sloppiness,"  Inside China Today.  Mar. 16, 1998.  Back to text.
 

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