China’s leaders have made it abundantly clear to domestic and international audiences that market forces will have a greater impact on the country’s economy going forward. More weight will be given to the autonomous interplays of supply and demand. But not all market forces are the same. Some even move the economy in the wrong direction, such as shady transactions between corrupt buyers and sellers. And those market forces should be uprooted, not championed.
Many buyers in Chinese markets behave just like any other buyer in the world—they don’t want to pay any more than necessary. Urban shoppers at vegetable markets haggle vigorously to drive prices to rock-bottom levels. Family enterprises put family members in charge of making purchases to keep procurement costs in check. And purchasing managers working in the China operations of multinational corporations as well as international sourcing companies buying from Chinese manufacturers drive a hard bargain and explore all cost-cutting opportunities.
But an inconvenient truth about the Chinese market is that not all buyers are interested in paying a lower price. It is no secret that some purchasing managers at large state-owned enterprises take kickbacks. The size of the kickback increases with the value of the purchase, so corrupt purchasing managers at state-owned enterprises routinely turn down low-price offers from suppliers. Instead, they solicit higher prices to maximize their under-the-table rewards. Rather than pushing the purchase prices down, as buyers would universally do in conventional markets, they push them up by haggling in reverse. This practice is also seen in the bidding process for government-sponsored investment projects.
In such a relationship, the buyer is typically aware of the price of the product on the competitive market but doesn’t bother to pick the lower bid to generate savings for his company. He advises the seller to quote a price that is many times greater than the market rate. The seller is tempted to become a co-conspirator in the scheme, not least because he does not have to be concerned about lowering his own price to please a cost-sensitive buyer. The inflated purchase price allows the buyer to take a larger kickback while allowing the seller to generate more revenue.
According to public records, the ratio of the reversely haggled price to the price on the competitive market for the same product—call it the dirty-price multiple—differs by sector. Lighting products, for instance, are typically twice as expensive as the market rate, while for industrial chemicals, there is a five-to-one ratio. The dirty-price multiple for oil-producing equipment is nine, for security products is ten, and for steelmaking equipment is 100. The kickback rate, calculated as the kickback to the buyer divided by the amount of the buyer’s purchase, also varies. Kickback rates of 40 to 60 percent are not uncommon.
This amounts to significant shares of money. For example, at a kickback rate of 40 percent, a corrupt buyer would pocket $400,000 from a purchase of $1,000,000. If the dirty-price multiple were just four in this case, the cost of the product on the competitive market would be only $250,000.
Reverse haggling occurs daily and is not an isolated phenomenon. Suppliers offering lower prices to kickback-conscious buyers from state companies are seen as naive and inexperienced. Buyers turn them away. Criminal cases involving reverse haggling and kickback taking are often reported in upstream industries, such as gas, power generation, chemical manufacturing, steelmaking, and heavy equipment manufacturing, in which either one large state-owned conglomerate enjoys a monopoly or a few state-owned enterprises firmly dominate. Studies indicate that as much as $2.34 trillion a year is unaccounted for in official Chinese income statistics and that over 50 percent of the economic crimes committed by convicted state-owned-company executives are related to graft and bribery in procurement and bidding processes.
This is a high price to pay for China. Imagine that purchasing managers in reverse-haggling schemes pocketed $800 billion in kickbacks. Assuming a kickback rate of 40 percent, the transactions would have amounted to $2 trillion in total. If the reversely haggled prices are assumed to be three times as high as the competitive market prices for the same products, customers should have only paid slightly less than $670 billion. Instead, they put down $2 trillion and overpaid by approximately $1.3 trillion—equivalent to about one-fifth of the total revenue of the top 300 largest state companies in 2011.
Reversely haggled input prices erode the profitability and competitiveness of organizations, upset markets, and unsettle economies. The purchasing manager’s personal gain is extracted at the company’s expense. This process makes it practically impossible for profit-seeking organizations to earn a surplus in a competitive market. What’s more, dirty prices, however spontaneously negotiated between willing parties, send the wrong signals to the rest of the market and drive more resources to upstream industries than true customer demand would dictate.
The colossal overcapacity in industries dominated by state-owned enterprises is often attributed to local governments’ urge to boost the local GDP. But the buyers at state companies who purchase inputs to build up that capacity and never turn down a highly priced offer are the real culprits.
Reverse haggling has implications for other sectors as well. Downstream industries—such as export-oriented manufacturing, consumer-goods manufacturing, retail, shipping, and e-commerce—are examples. These industries are primarily populated by private companies and shaped by the free entry and exit of market participants. Competitive input and output prices are subject to domestic and international forces of supply and demand. The reversely haggled high input prices are channeled into the system when administrative price controls are lifted and monopolistic pricing has its way. The extra costs get passed to the downstream. Consumer-oriented businesses could be much more prosperous if the purchasing managers in upstream industries haggled like regular buyers and kept their input prices at a fraction of their current levels.
China is the world’s largest exporter. Industrial inputs are transformed into finished goods on a massive scale, and China-made products are shipped to the far corners of the globe. The reversely haggled input prices in China’s upstream industries drive up the cost of direct materials used by Chinese manufacturers downstream, such as metals and plastics, as well as the cost of indirect materials, such as gas and power. That squeezes manufacturers’ margins so much that rising labor costs become a secondary consideration.
Compounded by the downturn in developed markets and the downward pressure on end-product prices, reversely haggled input prices in upstream industries could stifle China’s economic growth and end the “Made in China” phenomenon.
Previous rounds of economic reform failed to root out the corrosive practice of reverse haggling. But things could change. If engineered properly, the widely anticipated expansion of market forces in China will put the corrupt purchasing managers on guard. Profit-seeking businesses owned privately by domestic and international interests will enter formerly off-limits industries. By doing so, they will not only forbid their own purchasing managers from buying high but also strive to undercut their incumbent competitors by selling low. To maintain their margins and stay afloat, state-owned-enterprise executives will have to be more mindful of how much they pay for inputs.
Reverse haggling is in part a sign of broader organizational failures. When conglomerates become dysfunctional, either because they are too large, too poorly managed, or a combination of both, this kind of practice prevails. The cost of dysfunction is thus extremely high. One possible solution would be to break state-owned behemoths into more commercially viable companies of manageable size so they can more effectively exercise oversight. Ensuring that businesses account for all of the money they spend is an effective way to end reverse haggling.
Private Chinese companies should also be allowed to take an equity position in companies in their own state and conduct mergers and acquisitions, as they are beginning to do in the U.S. and European markets. The ownership changes brought about by this process will help end reverse haggling in upstream industries and make finished products—including consumer goods—more affordable everywhere.