Long after the start of the reform period – and well after the proven success of the private sector – the fate of the state-owned sector in China continues to disturb the sleep of policymakers in the Chinese central government.

During much of the 1990s, the problem was nightmares, largely because of the government's dependence on an ever-weakening state sector. Unlike in rural areas, where the non-state sector transformed the labor force, in the politically sensitive urban areas, the state sector continued to employ a relatively stable share of the workforce until 1995. At the beginning of the reform period, SOEs employed 78% of urban workers; in 1995, despite a dramatic decrease in output, they continued to employ 65%. In urban areas the state sector accounted for half of the new jobs created between 1978 and 1995. Similarly, the SOEs, despite their declining share of output, continued to contribute 71% of the Chinese government's revenue. This dependence on state-owned firms would not have been a problem if these firms were healthy, of course, but unfortunately this was far from being the case. In 1996, the number of loss-making enterprises began to exceed the number making a profit, and the ratio of liabilities to assets for the sector as a whole was at an all-time high of 85%. Fortunately, the locus of job creation moved away from the state sector after 1995, and toward private and foreign-invested firms. It became increasingly common for SOEs to lay off or furlough (xiagang) workers.