China’s state owned enterprises (SOEs) became profitable following the enactment of reforms to “grasp the big and let go of the small” in the mid-1990s. However, profitability is not necessarily indicative of restructuring because SOEs may receive preferential treatment from the state including bailouts, access to cheap inputs, and product market protections (Kornai, 1990; and 1992, Part III). Did China’s SOEs become profitable because of their connections to the state or because they operated more productively? This paper shows that SOEs in the manufacturing sector became more profitable for two reasons. First, because the elasticity of substitution between capital and labor exceeds unity and the SOEs’ cost of capital fell over time, SOEs earned profits by both drastically cutting labor and replacing labor with capital. Second, SOEs were under less political pressure to hire excess labor. While SOEs became more profitable, their productivity was lower than in private and foreign firms.
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