China’s Ownership Transformation: Process, Outcomes, Prospects

China’s Ownership Transformation China’s Ownership Transformation Process, Outcomes, Prospects Ross Garnaut, Ligang S...

Author: Ligang Song | Ross Garnaut | Stoyan Tenev | Yang Yeo

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China’s Ownership Transformation

China’s Ownership Transformation Process, Outcomes, Prospects Ross Garnaut, Ligang Song, Stoyan Tenev, and Yang Yao

International Finance Corporation Australian National University China Center for Economic Research Peking University 2005

© 2005 The International Finance Corporation and The International Bank for Reconstruction and Development/The World Bank 2121 Pennsylvania Ave., N.W. Washington, D.C. 20433 USA Telephone: 202-473-3800 Internet: www.ifc.org; www.worldbank.org All rights reserved 1 2 3 4 5 07 06 05 The findings, interpretations, and conclusions expressed herein are those of the authors and do not necessarily reflect the views of the Executive Directors of the International Finance Corporation or of the Bank for Reconstruction and Development/the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the International Finance Corporation or the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: 978-750-8400; fax: 978750-4470; Internet: www.copyright.com. ISBNs: 0-8213-6237-2 978-0-0-8213-6237-2 DOI:10.1596/978-0-8213-6237-2 Library of Congress Cataloging-in-Publication Data China’s ownership transformation : process, outcomes, prospects / Stoyan Tenev ... [et al.]. p. cm. Includes bibliographical references. ISBN 0-8213-6237-2 1. China—Economic policy—1976–2000. 2. China—Economic policy— 2000– 3. Industrial policy—China. 4. Privatization—China. 5. Free enterprise—China. 6. Government ownership—China. 7. Government business enterprises—China. 8. Unemployment—China. 9. Corporate governance— China. 10. China—Economic conditions—1976–2000. 11. China—Economic conditions—2000– I. Garnaut, Ross. II. World Bank. HC427.92.C42874 2005 330.951–dc22 2005047501

Contents

FOREWORD, Javed Hamid

vii

PREFACE, Stoyan Tenev

xi

ACKNOWLEDGMENTS

xv

ABBREVIATIONS AND ACRONYMS

1 2 3

xvii

INTRODUCTION

1

Overview of SOE Reform in China 2 Focus and Empirical Approach of the Study The Structure of the Study 24

11

THE MAIN PLAYERS IN GAIZHI How Far Has Gaizhi Progressed? The Key Participants 31 Theories on Incentives for Gaizhi Empirical Tests 42 Conclusion 45

25 25 38

THE GAIZHI PROCESS

46

Forms of Gaizhi 46 Sample Distribution of Forms of Gaizhi 50 Trends and Geographic Variations 54 What Determines the Form of Gaizhi Chosen? 59 The Process and Main Issues Surrounding the Transfer of State Assets 62 Asset Valuation 67 Dealing with Enterprise Debts and Other Obligations in the Gaizhi Process 76 Land-Use Rights and Gaizhi 81 Conclusion 86

v

CONTENTS

4

IMPACT OF GAIZHI ON LABOR

5

IMPACT OF GAIZHI ON CORPORATE GOVERNANCE

87

China’s Emerging Social Security System 87 Government Policy toward Unemployment in the Gaizhi Process 89 The Impact of Gaizhi on Employment and Labor Force Structure 95 Gaizhi and Obligations of Firms to Workers 103 Gaizhi and Changes in Compensation Schemes 108 Conclusion 111 113

Changes in Ownership Structure 114 Ownership and Control 121 Gaizhi and Traditional Stakeholders 127 Gaizhi, Managerial Autonomy, and Managerial Incentives 133 Gaizhi and Changes in the Relative Influence of Stakeholders 138 The Role of Outside Investors in Corporate Governance Conclusion 143

6

IMPACT OF GAIZHI ON FIRM BEHAVIOR AND PERFORMANCE

7

TOWARD A FAIRER AND MORE EFFICIENT GAIZHI PROCESS

145

Gaizhi, Internal Restructuring, and Financial Discipline Gaizhi and Firm Performance 158 Gaizhi and Time Trends in Performance 170 The Impact of Other Factors on Performance 172 Conclusion 174

The Public Debate about Privatization in China Regulating Gaizhi 181 Strengthening Enforcement 185 Reducing Transaction Costs for Outside Investors Enhancing the Role of the de Novo Private Sector in China’s Transformation 197 Conclusion 201

139

145

175

175

191

REFERENCES

205

INDEX

217

vi

Foreword

China’s emergence as a global economic player has been accompanied by a major internal transformation. Over the past decade or so, the economy has made the transition from complete reliance on stateowned and collective enterprises to a mixed economy where private enterprise plays a leading role. This remarkable transformation has been accomplished through the dynamic growth of the de novo private sector and more recently through privatization. IFC has been an active participant in this transformation process through investments and technical assistance for private companies and pioneering research on private sector development and enterprise reforms. In 2000, IFC published one of the first studies on the emerging domestic private sector in China. The study analyzed the structure of private enterprise, the enabling environment for its development, and access to financing. It outlined an agenda for entrepreneurs, the government, and the financial sector for addressing constraints to private sector development. In 2002, IFC jointly with the World Bank published a study on the status and evolution of corporate governance and enterprise reforms in China. The study explored the main corporate governance issues that China has encountered during the course of corporatization and ownership transformation of its enterprise sector. While China has been implementing reforms in its state enterprise sector over the past two decades or so, reforms have accelerated and have acquired new features since the start of the present century. First, the scale of change has expanded to affect almost every kind of stateowned enterprise—small, medium, large, and very large—under both central and local control. Second, ownership diversification has been so extensive that the role of the wholly state-owned nonfinancial company has declined substantially in many areas. Third, the range of restructuring mechanisms being used has expanded dramatically to include bankruptcies, liquidations, listings and de-listings, debt-for-

vii

FOREWORD

equity swaps, sales to private parties (domestic and foreign), and auctioning of state firms, their assets, or liabilities. Finally, large layoffs, something unheard of just five or six years ago, have become a regular phenomenon in corporate restructurings and privatizations. There has been no systematic study of the magnitude, forms, and consequences of this stage of enterprise restructuring. This book aims to fill this gap by looking at the process, the main players involved, and the outcomes. The empirical analysis is based on a survey of close to 700 enterprises in 11 Chinese cities. The study is a joint venture among the Australian National University, Beijing University, and the International Finance Corporation of the World Bank Group. The former State Economic and Trade Commission of the Chinese government facilitated the study for its successful implementation. Funding was provided by AusAid and IFC. The study sheds new light on the progress that China has made in enterprise restructuring and privatization and on the challenges that enterprises, investors, and governments are facing in the process. An important finding of the study is that among the various forms of enterprise restructuring, privatizations involving outside investors have had the strongest positive impact on firm performance. Furthermore, the analysis finds that outside investors deliver improvements in performance more quickly than other forms of restructuring. The study shows that the private sector is emerging as an important player in the restructuring of SOEs but argues that its role could be enhanced further. The International Finance Corporation has been playing an active role in supporting the growth of the private sector in China. Our cumulative investments in China since 1985 are approaching $2 billion in over 80 companies. The size and the breadth of IFC’s program in China are in many ways a function of the level of development of the private sector in the economy. When the private sector was mostly small and informal, and the industrial and financial sectors were dominated by SOEs and joint ventures with foreign private investors, IFC’s China program consisted largely of industrial projects sponsored by foreign investors. A number of these projects were in effect restructurings of state-owned enterprises through the injection of funds and modern technologies from foreign investors. IFC had an important role to play as a provider of long-term project financing that was not otherwise available for private projects. The emergence of the domestic private sector has given us new opportunities to broaden our program to include support for local fiviii

FOREWORD

nancial institutions, indigenous industrial and infrastructure enterprises, and small and medium businesses. The dynamic growth of the domestic private sector is creating the jobs needed to absorb laid-off workers from restructuring state enterprises. It is therefore a major positive force in the restructuring process. Today we see the biggest investment opportunities in China with domestic private companies. These businesses are driving the rapid growth of the economy as they strive to expand and become more sophisticated. Increasingly, domestic private companies in China are looking at acquisitions of SOEs as their main growth strategy. A number of our projects demonstrate how a privately managed company can transform an ailing state enterprise into a profitable business that contributes to the local economy. The study has benefited from the knowledge accumulated through our investment and technical assistance experience in China. Its findings also provide us with new ideas on how to continue to support the process of enterprise restructuring. I hope that investors, policy makers, opinion leaders, journalists, and all those interested in the status of China’s enterprise reform can also learn from the study. And I hope that this study contributes to the further progress of enterprise restructuring in China. Javed Hamid DIRECTOR EAST ASIA AND PACIFIC DEPARTMENT INTERNATIONAL FINANCE CORPORATION

ix

Preface

Gaizhi, a Chinese term meaning “transforming the system,” has become a major phenomenon in most parts of China. The restructuring of state enterprises has accelerated in recent years to include bankruptcies, liquidations, listings and delistings, debt-for-equity swaps, sales to private parties (domestic and foreign), and auctioning of state firms and their assets or liabilities. In many cases gaizhi has involved full privatization. Gaizhi programs in China have been gradual and low profile, but in many ways as far reaching as, and generally economically more productive than, privatization measures in Eastern Europe and the former Soviet Union. Reforms have been most dramatic in the industrial sector where the number of state-owned enterprises has declined from 114,000 in 1996 to 34,000 in 2003. According to our estimates, about half of the decline is due to privatizations. Privatization in China has not been limited to small enterprises only: the average size of privatized SOEs is about 600 employees. The process has been socially painful: around 30 million SOE workers have been laid off since 1998. A dynamic de novo private sector has been able to absorb most of the laid off workers, thus alleviating the social cost of restructuring. Gaizhi and the growth of the de novo private sector have transformed the structure of the Chinese economy. Over the past decade or so, the economy has made the transition from complete reliance on state-owned and collective enterprises to a mixed economy where private enterprise plays a leading role. We estimate that the private sector, narrowly defined, has become the largest sector of the Chinese economy, accounting for about 37 percent of gross domestic product in 2003. Overall, the nonstate sector accounted for two-thirds of China’s GDP in 2003. Gaizhi is not a one-off event but a continual process of reforms and restructuring. As of October 2004, about 40 percent of SOEs were

xi

PREFACE

making losses, compared with 18 percent for the nonstate sector. Enterprise reforms in China still have a long way to go. There has been no systematic study of the magnitude, forms, and consequences of gaizhi. This book aims to fill this gap by looking at the process, the main players involved, and the outcomes of gaizhi. The empirical analysis is based on a survey of close to 700 enterprises in 11 Chinese cities. Because gaizhi involves a comprehensive transformation of the state sector, which had been the foundation of the Chinese economy, a number of players have stakes in the process. Our analysis shows that local governments and enterprise managers have been the most active proponents of reforms with managers assuming a leading role in later rounds of restructuring. The government considers preserving social stability and protecting the welfare of state employees a top priority in SOE restructuring. Therefore, concerns about the social and fiscal implications of redundancies tend to constrain the pace of privatization. Consistent with this finding, firms with greater net assets are easier to privatize because they can compensate workers. Similarly, cities with stronger financial capacity tend to privatize more aggressively because they can absorb a greater portion of the social costs of restructuring. As a result, better-performing SOEs are likely to be privatized first, and there are significant regional variations in the pace and scope of enterprise reforms. A dynamic de novo private sector makes it easier to absorb redundant workers and therefore reduces the cost of restructuring. We find that the level of development of the de novo private sector has been the most important macroeconomic factor leading local governments to release SOEs into private hands. While gaizhi can be held back by fear of labor redundancies, it is often the only way to check job losses in the state enterprise sector. An important result of our analysis is that gaizhi and privatized firms have maintained a lower rate of employment reduction and a higher rate of wage growth than non-gaizhi and fully state-owned firms. Consistent with the conventional belief, gaizhi firms discharged more workers in the year when gaizhi was implemented, but in subsequent years and overall they were able to retain more workers than non-gaizhi firms. Gaizhi firms were able to limit job losses because restructuring has brought efficiency gains. We find that gaizhi has a positive impact on firm profitability, although a weak or insignificant impact on unit cost and labor productivity. Privatizations involving outside investors have the strongest positive impact on firm performance. Furthermore, outxii

PREFACE

side investors deliver improvements in performance more quickly than other forms of gaizhi: their positive impact tends to appear early in the reform process. Interestingly, we find that SOEs as outside investors also tend to have a strong positive impact on firm performance. China’s experience shows that SOEs with a relatively high degree of autonomy in the market process may have difficulty in putting reforms into effect in their own enterprises but can be effective agents of change in other state enterprises. Gazhi has brought efficiency gains by aligning incentives and reallocating decision-making powers within the firm. We find that gaizhi firms are more likely than non-gaizhi firms to provide managers with shares and bonuses. Shareholder representation on the board of directors of gaizhi firms has improved, and power sharing among the shareholders’ conference, the board of directors, and the management has begun to occur. The influence of the Communist Party over the firm tends to decline after gaizhi, but the role of the labor union in collective wage bargaining is more clearly defined and enhanced. We find that the government is retreating from the privatizing firms by reducing its ownership share, while the share of insiders has been increasing rapidly. The dominance of managers appears to be the main corporate governance issue of gaizhi firms. Managers tend to be overrepresented at the boards of directors and maintain decisive influence on key issues. What players and institutions are emerging to control the agency costs of managerial autonomy? Survey results indicate that outside investors are more likely to use and rely on the new mechanisms of corporate control, to provide effective checks and balances on managerial discretion, and to offer high-powered incentives to senior managers. In general, the presence of outside investors is associated with a reduced role for traditional stakeholders such as the government, the Party, and the labor union. These traditional stakeholders have less significant roles in outsider-controlled firms than in insider-controlled firms. Thus one important result of our analysis is that privatizations involving outside investors are generally more productive than other forms of privatization and gaizhi. Yet, privatization in China does not exhibit a clear trend in the direction of a greater role for outside investors. While on average the ownership share of insiders has grown rapidly in recent years, outsiders’ share has remained largely stagnant. In our sample of firms, insiders held 5 percent of privatizing firms’ shares in 1995. In 2002, their share had risen to 32 percent. Over the xiii

PREFACE

same period, the combined share held by domestic and foreign private companies has remained at about 20 percent. Insider privatization could be subject to greater conflicts of interests than other forms of gaizhi, especially given the major role that enterprise managers play in initiating and implementing restructuring programs. Media reports on irregularities in insider privatizations and particularly management buyouts (MBOs) have raised public concerns about lack of fairness and transparency of the privatization process in China. In response, the government has promulgated a host of regulations aimed at establishing an orderly process of ownership transformation, and at expanding the role of outside investors. A policy priority is to enhance the involvement of the private sector, both domestic and foreign, in the restructuring and privatization of SOEs. We already observe a change in the role that the domestic private sector is playing in China’s state enterprise reform. Historically, the private sector has been supporting restructuring largely indirectly by creating the jobs needed to absorb laid-off workers. While this indirect role will continue to be important, domestic private enterprises are emerging as significant players in the privatization process. A growing number of de novo private firms have begun to look at acquisitions of SOEs as their main growth strategy. These private companies have been injecting capital and dynamism in moribund state enterprises thus helping to preserve jobs. While private enterprises are becoming more active in acquiring and restructuring state-owned enterprises, they still account for a small share in all gaizhi cases. China’s approach to state enterprise reform has been extremely pragmatic. Ownership change is not seen as an end in itself nor is it seen as the automatic solution to inefficiency problems in the state enterprise sector. Local governments are primarily interested in aspects such as tax revenues, growth and employment. Looking for ways to obtain these results, they have been experimenting with institutional reforms. In the process, local governments have found that the way to deliver tax revenues, growth and employment to their constituencies is by opening more room for private enterprise. Enhancing the role of private companies in SOE reform will require, however, sustained efforts from both the government and the private sector to improve the business environment for entrepreneurship and move private enterprises toward global best practice. Stoyan Tenev INTERNATIONAL FINANCE CORPORATION xiv

Acknowledgments

The State Economic and Trade Commission (SETC, now part of the National Development and Reform Commission) facilitated this study. Wang Hailin, director, and other SETC staff provided valuable guidance and support throughout. Extensive assistance was provided by Karin Finkelston, IFC’s associate director for China in Beijing. IFC staff Jianguo Cui and Wenqin Zhu played a key role in organizing and coordinating the contributions of the various parties involved. Rana Ganguly managed the project from the Australian National University side. The study was funded by AusAid and IFC’s Trust Funds. Xiaolu Wang (Australian National University and the National Economic Research Institute), Yu Sheng (Australian National University), and graduate students from the China Center for Economic Research at Beijing University contributed to the technical report on the field work. Survey findings were presented and discussed at a workshop organized by the International Finance Corporation in March 2003 in Beijing. Wang Hailin and Tian Chuan (SETC), Chunlin Zhang and William P. Mako (World Bank), Omar Chaudry (IFC), and Robin Scott-Charlton and Michael Willcock (Australian Embassy in Beijing) provided valuable comments at the workshop. A draft of the study was presented and discussed at a workshop in Beijing organized by the International Finance Corporation in March 2004. At the workshop, An Chongli (Asian Development Bank), Liu Xiaoxuan (Chinese Academy for Social Sciences), Davin Mackenzie (iVentures L.L.C.), Ping Xingqiao (China Center for Economic Research), Tian Chuan (National Development and Reform Commission), Richard Yu (AusAid), Strahan Spencer (Department for International Development), Wang Liming (National Development and Reform Commission), Wang Xiaolu (National Economic Research Institute), Wang Zhongjing (Ministry of Finance), Yang

xv

ACKNOWLEDGMENTS

Yiyong (Central Party Academy), Zhang Chunlin (World Bank Group), Zhang Shuguang (Chinese Academy of Social Sciences), and Zhang Weiying (Guanghua School of Management, Peking University) made useful comments and suggestions. Andy Rothman of CLSA provided valuable comments that enriched the final study. The study also benefited from comments and insights from IFC and World Bank staff, including Bernard Sheahan, Sanjay Grewal, Sunita Kikeri, and Peter Taylor. Udayan Wagle, Mwaghazi Mwachofi, Mariko Higashi, Maria Cussianovich, Aminata Mbodj, Michael O’Neill, Bayo Oyewole, Amber Turner, Wai-Keen Wong, and Frederick Wright supported the study through funding from IFC Trust Funds. Lixing Li from the University of Maryland provided valuable research assistance. Robyn Flemming edited the text, and Garry Cousins prepared the index. Special thanks to Dana Lane for her excellent management of the publication process.

xvi

Abbreviations and Acronyms

ABC AMC BOC CCB CCP CEO CSRC DCD DCF DRC ETC FDI FIE GDP ICBC IPO M&A MBO MOF NPC NPL PAYE PER R&D ROA SARS SASAC SASMC SETC SME SOE SPC TVE

Agricultural Bank of China assets management companies Bank of China China Construction Bank Chinese Communist Party chief executive officer China Securities Regulatory Commission discounted dividends discounted cash flow Development Research Center economic and trade commissions foreign direct investment foreign-invested enterprise gross domestic product Industrial and Commercial Bank of China initial public offering mergers and acquisitions management buy-out Ministry of Finance National People’s Congress nonperforming loan Pay As You Earn price-earnings research and development return on assets Severe Acute Respiratory Syndrome State-owned Assets Supervision and Administration Commission State Asset Supervision and Management Commission State Economic and Trade Commission small and medium enterprises state-owned enterprise Supreme People’s Court township and village enterprise

xvii

1

Introduction

The recent emergence of China as a global manufacturing powerhouse and the world’s top destination for foreign direct investments (FDI) is attracting considerable attention from policy-makers and the media. In fact, China’s rise to economic prominence is viewed as the economic event of our age (Wolf 2003). Chinese companies are expanding their presence abroad, building internationally known brand names and transforming global production networks. China’s emergence as a global economic player has been accompanied by a major internal transformation. Over the past decade, the economy has made the transition from complete reliance on stateowned and collective enterprise to a mixed economy where private enterprise plays a leading role. This is an ongoing process, during which the economy will remain structurally a very diverse one. While some Chinese companies are in the vanguard of globalization, many are struggling with old legacies of planning. And to use a military metaphor, it is dangerous for the vanguard of the army to get too far ahead of the rear-guard. Thus, in these times of optimism and dynamism, increased attention must be given to solving the problems of the state-owned sector. Gaizhi, a Chinese term meaning “transforming the system,” has become a major phenomenon in most parts of the country; in many cases it has involved full privatization. Unlike the mass privatization programs that have occurred in Eastern Europe and the former Soviet Union since the late 1980s, gaizhi programs in China have been gradual and low profile. The significance of the Chinese reforms should not be underestimated, however. In many ways they have been as farreaching as, and generally more economically productive than, those in Eastern Europe and the former Soviet Union.

1

CHINA’S OWNERSHIP TRANSFORMATION

Overview of SOE Reform in China Reform of China’s state-owned enterprises (SOEs) has been a major aim since urban reforms began in 1984. Although there were calls to privatize the SOEs, the government’s initial emphasis was on boosting performance by changing the internal governance of SOEs and improving the market environment in which they operated. Inspired by the success of the rural household responsibility system, the government introduced a contracting system into the state sector that required SOE managers to meet various performance targets— including targets for sales, profitability, and capital accumulation—in return for a share of the profits. The success of the enterprise thus depended on the efforts that managers were prepared to make. The main problem with this system was that managers were rewarded for their successes but not credibly penalized for their failures. By the late 1980s the government had decided that the best way to reform small SOEs was to lease them out, with the manager paying the state a fixed proportion of the firm’s profit. The first significant lease contract was to the Wuhan Motor Engine Factory in 1986, when three people put up RMB34,000 as collateral to lease the factory. In May 1988 the State Council issued a regulation on the leasing of small SOEs.1 A direct consequence was that managers could be recruited from outside the enterprise. In many cases, leasing led to the de facto privatization of township and village enterprises (TVEs). After several years the accumulated and contributed capital of the manager would outweigh that of the local government, and the firm would be effectively owned by the manager. Incorporation was another significant measure that led to privatization. At first the government restricted incorporation to the exchange of shares among the SOEs; soon, however, private shareholding was allowed. The first cases of private shareholding were in three Guangzhou SOEs in 1986, when the employees bought 30 percent of the shares of their firms. The first large SOE to be incorporated was the Shenyang Motor Corporation, which became Shenyang Jinbei Motors when it issued shares to the public in August 1988.

1. The Tentative Regulations on the Lease of Small State-Owned Industrial Enterprises, State Council, May 20, 1988.

2

INTRODUCTION

The opening of the Shenzhen Stock Exchange in 1990 and the Shanghai Stock Exchange in 1991 enabled SOEs to issue shares to the public. The Chinese government ensured that it would not lose control of listed SOEs, however, by requiring that a proportion of the state’s shares in the firm could not be sold. Privatization started in earnest after a visit by Deng Xiaoping to southern China in 1992. As with many other reform initiatives, privatization started at the local level and was later sanctioned by the central government. The most important impetus for privatization in the localities was the large amount of debt built up by the state sector. The level of debt was a more pressing problem in small cities. For example, in Zhucheng city, Shandong province, 103 of the 150 SOEs were in the red at the end of 1992, with losses amounting to RMB147 million— equivalent to the revenue of the city government over 18 months (Zhao 1999). The Shunde government, in Guangdong province, also encountered a debt problem when it first started privatizing its SOEs in 1992. Most local governments decided that it would be possible to privatize only small firms, but Shunde and Zhucheng went further by privatizing almost all of their state and collective firms (Huang and Wei 2001; Yao 2003). In 1995, after extensive discussion, the central government decided on the policy of zhuada fangxiao, or “keep the large and let the small go.” The state decided to keep between 500 and 1,000 large state firms and to allow smaller firms to be leased or sold.2 There were good reasons for this decision. In 1997 the 500 largest state firms, most of them controlled by the central government, held 37 percent of the state’s industrial assets, contributed 46 percent of the taxes collected from state firms, and earned 63 percent of the profits of the state sector. Small firms owned by local governments had been performing poorly. In 1995, 72.5 percent of local firms, but only 24.3 percent of central government firms, were unprofitable (Zhao 1999). As Vice Premier Wu Bangguo said in a speech in December 1997, “Control of

2. In 1994 the ministry in charge of government economic affairs, the State Economic and Trade Commission (SETC), sent a report entitled “Suggestions on Revitalizing Small State-owned Enterprises” to Vice Premier Wu Bangguo, who was in charge of enterprise reforms. In September 1995 the policy was formally announced by the Central Committee of the Chinese Communist Party (CCP) in one of its plenaries and went forward as a suggestion for the ninth five-year plan.

3


the [500] largest firms means we have a control of the largest chunk of the state economy” (Zhao 1999). From the “let the small go” part of the policy came the term “gaizhi,” meaning “transforming the system.” An important part of gaizhi was the order issued in March 1998 for “red hat” firms—that is, firms registered as collectives but in reality privately run3—to “take off their red hats” by the following November. Privatization first commenced in rural areas. Many localities— including those renowned for the success of their collective enterprises, such as Shunde and southern Jiangsu—implemented privatization on a massive scale. Early in the reform era, the impressive growth of the TVEs had been hailed as proof that, contrary to conventional economic theory, clearly defined property rights were not essential for development (for example, Weitzman and Xu 1994). As the growth of the TVEs slowed, the disadvantages of their vaguely defined property rights became clearer. Like their urban counterparts, the TVEs faced soft budgets, and the resulting build-up of nonperforming loans (NPLs) placed a considerable burden on local governments (Zhang 1998). By the end of 1998, more than 80 percent of state and collective firms at the level of the county or below had gone through gaizhi, which involved direct privatization in most cases (Zhao 1999). Most of these firms were TVEs. The pace of reform has accelerated in recent years, and it is likely that TVEs will soon disappear, proving to have been an important but transitional institution in China’s march to market. In the cities, gaizhi has occurred in two waves. Reform started in the mid-1990s and followed the model of employee shareholding adopted by Zhucheng. When Zhucheng abandoned this model and moved toward concentrated ownership through management buy-outs (MBOs), other cities followed suit. The trend reflected the belief that, for an enterprise to be truly transformed, it is necessary for management to own the majority of shares. Forms of MBO have been the most common model in the second wave of gaizhi and have spread to very large firms, such as the SOEs listed on the stock market. Privatization has been accepted as the key for urban reform, and the slogan “the state retreats and the private sector moves forward” has become common in many cities.

3. On the “red hat” phenomenon, see Gregory, Tenev, and Wagle (2000).

4

INTRODUCTION

Since the start of the present century the reform of China’s state enterprise sector has accelerated and acquired some qualitatively new features. First, the scale of change has expanded to affect almost every kind of SOE—small, medium, large, and very big; under both central and local control. Second, ownership diversification has been so extensive that the wholly state-owned nonfinancial company has become an endangered species in China’s business ecology. Third, the range of restructuring mechanisms being used has expanded dramatically to include bankruptcies, liquidations, listings and de-listings, debt-for-equity swaps, sales to private parties (domestic and foreign), auctioning of state firms and their assets or liabilities, standard corporate governance techniques, and so on. Finally, mass layoffs—unheard off just four or five years ago—have become a widespread phenomenon. At the grassroots level, local governments have been particularly active in implementing corporatization and ownership diversification in SOEs—the most decisive actions for grappling with the financial burdens and unemployment pressures resulting from loss-making SOEs. A national survey in 1998 showed that a quarter of China’s 87,000 industrial SOEs had been through some phase of gaizhi, while another quarter planned to take some measure of gaizhi. Among the gaizhi firms, 60–70 percent had been partially or fully privatized.4 A 2001 national survey of industrial SOEs estimated that 86 percent had been through gaizhi by the end of 2001 and about 70 percent had been partially or fully privatized.5 The research in this book will show that half of the six cities chosen for interviews planned to go through gaizhi by the end of 2003. In addition, the share of partially or fully privatized firms had risen to more than 70 percent. If this performance typifies that of the rest of the country, then privatization in China has already gone further than in many Eastern European and former Soviet Union countries. In terms of larger SOEs, around 1,400 companies have been listed over the last decade. Their market capitalization is about 40 percent of gross domestic product (GDP),6 and their 65 million or so individual shareholders have become increasingly assertive over the years.

4. Unpublished report of the National Bureau of Statistics. 5. Unpublished report of the SETC. 6. Standard & Poor’s, “Emerging Stock Markets Review: Performance, Valuations, and Constituents,” Emerging Markets Database, December 2004.

5


The regulator, the China Securities Regulatory Commission (CSRC), has stepped up efforts to strengthen corporate governance practices among Chinese listed companies. Of systemic importance for China is the process of divesting state assets through initial public offerings (IPOs) to fund the national social security system. Some restructuring of SOEs is occurring through the four asset management companies (AMCs) that have been created to take more than $170 billion7 in nonperforming loans from the big four stateowned banks.8 As part of their program, 580 SOEs, accounting for about 40 percent of the state sector’s assets and sales, have been selected for debt-equity swaps. The AMCs have emerged as important, and often majority, shareholders in a number of large SOEs. The AMCs have multiple objectives; thus the desire to maximize immediate financial returns to government may conflict with the need for meaningful restructuring of the firms in their portfolios (Steinfeld 2001). Recent regulatory measures, however, that make it easier for foreign investors to buy significant and controlling shares in SOEs are likely to expand the exit options for these AMCs and to create more opportunities for diversification of state ownership through them. The Chinese government has implemented industry rationalization programs in a number of industries, closing obsolete plants and reducing capacity to combat oversupply and deflationary pressures. The initiative has so far shown mixed results. In many industries, for each unit of closed capacity several additional units have been created. For example, in the glass industry, in the past few years the government has closed down 240 small production lines, reducing capacity by 28 million-weight cases. In the meantime, however, 39 bigger and more modern production lines have been built that will increase capacity by 88 million-weight cases, or 32 percent of total production in 2000. Similar stories are reported in textiles and other sectors. In the strategically important infrastructure and energy sectors where the regulatory framework is still evolving, monopolies have been broken and competition has been introduced. Many companies have been corporatized, and some have been listed on local and inter-

7. All dollar amounts are U.S. dollars. 8. The “big four” are the Agricultural Bank of China (ABC), the Bank of China (BOC), China Construction Bank (CCB), and the Industrial and Commercial Bank of China (ICBC). Together they account for about two-thirds of China’s financial assets.

6

INTRODUCTION

national exchanges. China has nurtured over 20 giant corporations and conglomerates that have proven competitive in the international market. Some of these companies are laying off tens—or even hundreds—of thousands of employees, not because they are in financial distress (some of them are hugely profitable) but because they wish to position themselves as important international players. As of 2002 the top 12 Chinese transnational corporations, mainly SOEs, controlled over $30 billion in foreign assets and had some 20,000 foreign employees and $33 billion in foreign sales. To address the issue of fragmented management of state assets (Tenev et al. 2002, 26), China established the State-owned Assets Supervision and Administration Commission (SASAC) in March 2003. SASAC acts simultaneously as a shareholder, regulator, manager, and supervisor of state assets. Thus both the scale and scope of transformation have been extraordinary. Table 1.1 illustrates the changes that have taken place in China’s industrial sector and in the relative position of SOEs in the economy. Since 1999 the number of SOEs has been reduced dramatically and they now account for only 15 percent of all industrial enterprises. The decline in the SOEs’ share in total industrial assets has been much less dramatic, however. As of October 2004, SOEs still accounted for more than half of total assets. Although fewer in number, SOEs have become bigger in China. Already larger than the average nonstate enterprise, SOEs have grown much faster over the period—2.5 times, versus 1.4 times for nonstate enterprises. Their share in total enterprise assets has remained roughly constant over the period, at about 50 percent. One notable achievement of enterprise reforms has been the improved profitability of the SOE sector. The return on state-owned assets has improved, and the profitability gap between state and nonstate enterprises has narrowed somewhat. Reforms still have a long way to travel, however: as of October 2004, about 40 percent of SOEs were making losses, compared with 18 percent for the nonstate sector. This process of transformation of China’s state sector has led to social unrest and will continue to be socially painful. Around 30 million SOE workers have been laid off since 1998 and, according to the official government statistics, 8.7 million of these have not found new jobs. The number of labor disputes of all kinds rose by 12.5 percent in 2000, and by another 14.4 percent in 2001 to reach 155,000. In 1999 there were 6,767 collective actions (usually strikes or go-slows with a minimum 7

8

TABLE 1.1 NUMBER OF STATE-OWNED ENTERPRISES IN CHINA’S INDUSTRIAL SECTOR AND RELATED FINANCIAL DATA, 1999–2004 Lossmaking Average Lossnonstate SOE asset size Average SOE ROA making enterprises Total Total SOEs as assets as nonstate asset size profits as nonstate SOEs (% of No of assets profits % of all % of total enterprise SOEs % of total enterprise ROA (% of all nonYear enterprises RMB bn RMB bn enterprises assets (RMB mn) (RMB mn) profits sector SOEs all SOEs) SOEs) 1999 2000 2001 2002 2003 2004

154,882 158,749 168,799 178,876 193,483 212,648

11,238 12,398 13,418 14,479 16,707 18,984

220 426 466 562 815 913

37 34 28 24 19 15

68 67 65 62 57 53

36 39 39 40 46 50

134 155 184 210 260 317

NOTES: Data for 2004 are until October 2004; ROA is Return on Assets in percent. SOURCE: CEIC.

44 56 50 47 46 49

3.5 4.6 5.0 5.4 6.1 5.2

1.3 2.9 2.7 2.9 4.0 4.5

41 35 36 35 36 40

22 19 19 17 15 18

INTRODUCTION

FIGURE 1.1 Number of People Employed and Number of Collective Labor Disputes in State-Owned Enterprises in China, 1995–2003 Labor disputes 14,000

Million workers 120 SOE employment

12,000

100

10,000

80

8,000 6,000

60

Collective labor disputes

40

4,000

20

2,000 0 1995

1997

1999

2001

2002

0 2003

Note: Data for 2003 are extrapolated from half-year data. Sources: CEIC, National Bureau of Statistics of China; People’s Daily.

of three people taking part) involving 251,268 people, an increase of 900 percent relative to 1992. Since 1999 the number of collective disputes has been increasing by about 20 percent per year (see figure 1.1). In the first half of 2004 alone, labor dispute arbitration committees at various levels accepted 135,000 labor dispute cases and handled 6,440 collective labor disputes, which involved 184,000 persons—considerably more than in the past.9 Given the magnitude of the layoffs, however, the level of labor unrest is not extraordinary. In fact, labor seems to be accepting these changes. State employees—perhaps the most powerful interest group in China—refused for some time to accept layoffs but now accept the severance packages. What might explain the change in attitude? Two economic factors have emerged as being of critical importance in alleviating the social cost of restructuring: the development of the national social security system (there has been a significant increase in central budget expenditures in social security in recent years: from 1 percent in 1997 to 6.3 percent in 2002), and promotion of the 9. “Labor disputes on the rise,” People’s Daily, November 1, 2004, http:// english.people.com.cn/200411/01/eng20041101_162341.html.

9

10

TABLE 1.2 COMPOSITION OF CHINA’S GDP BY OWNERSHIP TYPES, 1998–2003 (percent) Year

State controlled

Collectives (official)a

Domestic private (official)b

Foreign (official)

Private (official)c

Domestic private (real)d

Private (real)e

Agriculture

Nonstate

1998 1999 2000 2001 2002 2003

41 40 39 38 36 34

22 20 18 17 14 13

12 13 14 16 19 22

8 10 12 13 14 15

20 23 26 29 33 37

26 26 28 29 31 34

31 33 36 38 40 44

18 17 17 16 16 15

59 60 61 62 64 66

a. Official collective firms include “red hat” firms as well as gaizhi firms that are actually private firms. b. Domestic private firms include formally registered private firms and getihu. c. Includes official domestic and official foreign private firms. d. Includes collective firms that are in effect private, assuming they account for half the official collective firms (Gregory, Tenev, and Wagle, 2000) and foreign firms that are in reality domestic private firms, assuming they account for a third of the official foreign firms. e. Includes real domestic and real foreign private firms. f. Includes agriculture, which is almost 100 percent private, collective and private firms. SOURCE: Calculated according to a sector-based approach, which derives ownership shares in GDP based on their shares in each of the following sectors: farming, forestry, husbandry, and fishery; mining and quarrying; manufacturing; production and supply of electricity, gas, and water; geological prospecting; transportation and communication services; retail trade and catering services; finance and insurance; real estate; social services; education; scientific research; government services; and others. Estimates about ownership shares in the GDP of the respective sectors are based on available official data on ownership: shares in sector employment and/or sector output, in effect assuming similar levels of productivity across ownership types. All the original data are from Stastical Yearbook of China, 2004. The methodology and approach are similar to the ones used in Gregory, Tenev, and Wagle, 2000, who provide estimates for ownership shares in GDP for 1998. Here, calculations for 1998 are redone using latest available data. Differences between the current estimate for 1998 and the estimates in Gregory, Tenev, and Wagle are also due to some changes in assumptions; for instance, shareholding firms were included in the private sector share in the 2000 estimates, while here we count shareholding firms as state controlled.

INTRODUCTION

growth of the new private enterprises to absorb workers laid off from the state sector. Gaizhi and the growth of the de novo private sector have transformed the structure of the Chinese economy. Table 1.2 presents estimates on the composition of China’s GDP by ownership types for the period 1998–2003. Over the period the share of the official private sector in GDP increased from 20 percent in 1998 to 37 percent in 2003. The private sector is now the dominant sector of the Chinese economy. The share of the private sector is probably even larger if we take into account that a significant percentage of the collective firms are in effect privately controlled and that the private sector is in general more productive than the other sectors of the economy. The main question posed by this major, and still unfolding, transformation is whether China will succeed in its efforts to reform the state sector and to maintain the delicate balance between tackling its legacy problems while promoting the new sources of growth. Focus and Empirical Approach of the Study To shed some light on this question we need a better understanding of the gaizhi process. There has been no systematic study of the magnitude, forms, and consequences of gaizhi. This book aims to fill this gap by looking at the types of reforms, their evolution, the key players and the motivations for their decisions, and some outcomes of the gaizhi process. The analysis is based on a survey of close to 700 enterprises in 11 Chinese cities. The survey was conducted from December 2002 to April 2003. The latest accounting data that most enterprises were able to provide, however, was for year 2001. The survey adopted a research strategy that combines the use of a structured questionnaire given to firms selected by random sampling, with face-to-face interviews with government officials and enterprise management selected to provide insights into the privatization process and its outcomes. While the sampling provides quantitative data, the interviews reveal rich qualitative information regarding different government policies and various problems that have been encountered in gaizhi. The Sample Cities. A major feature of the gaizhi process is that it is largely decentralized.10 Therefore, a significant regional variation in the forms and outcomes of gaizhi was to be expected. To account for this 10. This is changing with the establishment of SASAC.

11


FIGURE 1.2 Geographic Location of the Eleven Sample Cities

variation, cities of different sizes and from different regions were selected for the survey and interviews. These 11 cities were, from north to south: Harbin, Fushun, Tangshan, Lanzhou, Weifang, Xining, Zhenjiang, Huangshi, Chengdu, Hengyang, and Guiyang (see figure 1.2). Harbin and Fushun are located in the northeast, China’s industrial powerhouse in the central planning era. Harbin is the capital of Heilongjiang province, and Fushun is a medium-size city in Liaoning province. Tangshan is an old industrial city, the second largest in Hebei province, about 120 kilometers north of Beijing. It survived a severe earthquake in 1976. Xining and Lanzhou are two western cities, the capitals of Qinghai province and Gansu province, respectively. Lanzhou is an important industrial base in the northwest, renowned for its heavy chemical industries, while Xining is less industrialized. Chengdu and Guiyang are the capitals of two south12

INTRODUCTION

FIGURE 1.3 Population of the Eleven Sample Cities, 2001 Chengdu Harbin Weifang Hengyang Tangshan Guiyang Lanzhou Zhenjiang Huangshi Total population Urban population

Fushun Xining 0

2

4

6 Millions

8

10

12

SOURCE: Survey data, provincial bureaus of statistics.

western provinces, Sichuan and Guizhou, respectively. Weifang is a medium-size city in Shandong province. Its industry is mainly made up of small and medium enterprises (SMEs). Zhucheng, one of the two cities that initiated privatization in China, is located in this province. Zhenjiang, in Jiangsu province, Hengyang, in Hunan province, and Huangshi, in Hubei province, are medium-size cities. Figure 1.3 shows the urban population of the 11 cities and their peripheral counties. Levels of economic development and growth varied among the 11 cities. Figures 1.4 and 1.5 compare per capita incomes in 2001 and per capita growth rates between 1995 and 2001. With a per capita income of RMB18,900, Zhenjiang was the most affluent city. Harbin was the second wealthiest, with a per capita income of RMB11,800. Fushun, Lanzhou, Weifang, Guiyang, and Chengdu had incomes in the range of RMB8,000 to RMB11,300. Tangshan, Xining, Hengyang, and Huangshi had the lowest incomes, between RMB5,000 and RMB6,000. Per capita GDP grew at an impressive pace in some of the cities over the period. Harbin, Hengyang, Guiyang, and Huangshi registered 13


FIGURE 1.4 Per Capita Income in the Eleven Sample Cities, 2001 Zhenjiang Harbin Fushun Lanzhou Weifang Guiyang Chengdu Tangshan Xining Hengyang Huangshi 0

5,000

10,000 RMB

15,000

20,000

SOURCE: Survey data, provincial bureaus of statistics.

double-digit growth rates between 1995 and 2001. Per capita GDP growth was also high in Zhenjiang, Fushun, and Chengdu, with growth rates in the range of 9 to 9.7 percent. Tangshan, Lanzhou, and Weifang grew considerably more slowly, with growth rates less than half those of the fastest-growing cities. Xining was the slowest-growing city, with an annual average growth rate of 1.5 percent. Other economic conditions also varied significantly. Per capita government revenue is an indicator of a city’s fiscal capacity and will affect how local governments are able to assist workers laid off through gaizhi. Chengdu had the healthiest per capita government revenue, easily surpassing the second-wealthiest city, Guiyang (see table 1.3). Per capita government revenue was similar across Guiyang, Zhenjiang, and Harbin. Revenue was lower in Fushun, Xining, Tangshan, and Weifang, and lower still in Huangshi and Hengyang. The Hengyang government collected only RMB200 per person in revenue. The provincial capitals generally had larger services sectors than the other cities. The services sector was particularly underdeveloped in 14

INTRODUCTION

FIGURE 1.5 Per Capita Growth of Gross Domestic Product in the Eleven Sample Cities, 1995–2001 Harbin Hengyang Guiyang Huangshi Zhenjiang Fushun Chengdu Tangshan Lanzhou Weifang Xining 0

2

4

6

8

10

12

14

Percent SOURCE: Survey data, provincial bureaus of statistics.

Tangshan and Weifang. SOEs still provided most of the employment in all cities except Xining and Zhenjiang, although the data are not strictly comparable across localities. The data on industrial output are more reliable. They show the dominant role of SOEs in the industrial sectors of Fushun, Guiyang, Hengyang, and Huangshi. The data show that large numbers of workers had been laid off in Fushun and Lanzhou. The category of xiagang represents a type of interim unemployment whereby an SOE worker has been laid off but maintains the relationship with the firm. A massive 44 percent of Fushun’s SOE workers and 25 percent of Lanzhou’s SOE workers were classified as xiagang in 2001. The situation was also of concern in Tangshan, Chengdu, Harbin, and Weifang, where xiagang rates were all above 7 percent.11 11. Caution needs to be taken when interpreting data on xiagang or unemployed workers. It is possible that many of these workers have found other jobs but continue to register as xiagang or as unemployed in order to obtain benefits.

15

16

TABLE 1.3 SELECTED ECONOMIC INDICATORS FOR THE ELEVEN SAMPLE CITIES, 2002 Per capita Employment State share in State share in Registered Xiagang government in services employment industrial output unemployment ratec revenue (RMB) sector (%) (%) a (%) rate (%)b (%) Chengdu Fushun Guiyang Harbin Hengyang Huangshi Lanzhou Tangshan Weifang Xining Zhenjiang

1,424.8 574.4 832.9 698.0 199.7 330.7 n.a. 511.2 482.3 540.5 813.6

33.9 33.9 35.0 33.4 34.3 33.7 47.2 2.3 7.3 58.8 28.8

63.7 55.7 69.1 53.0 40.0 60.9 80.9 73.0 50.1 48.0 35.2

10.8 82.0 72.7 10.7 53.1 61.2 n.a. 28.6 13.9 20.9 18.3

3.5 2.7 4.0 3.0 2.6 1.4 2.6 2.8 3.0 3.1 3.6

7.9 43.5 4.0 8.8 3.1 n.a. 25.0 10.0 7.0 n.a. n.a.

Unemployment + xiagang (1,000)

Real unemployment rate (%)d

261.3 177.1 95.5 263.1 111.4 n.a. 146.1 81.1 144.8 n.a. n.a.

4.7 43.8 4.7 5.3 3.0 n.a. 22.8 9.1 3.4 n.a. n.a.

a. There are no consistent data for state share of employment for all the cities. The table reports three sets of data for the figure. One is the state share in total urban employment. Harbin, Hengyang, Lanzhou, and Weifang use this definition. The second is the state share in all wage employees. Fushun, Huangshi, Tangshan, and Xining use this definition. The third is the state share in the manufacturing sector. Chengdu, Guiyang, and Zhenjiang use this definition. b. The unemployment rate is registered unemployment as a percentage of total city employment. c. The xiagang rate is the number of xiagang workers as a percentage of total SOE employees. d. The real unemployment rate is the sum of registered unemployed and xiagang workers in the city labor force. SOURCES: National Bureau of Statistics of China, China’s Statistical Yearbook: 2002; authors’ estimates.

INTRODUCTION

The official unemployment rates (the share of registered unemployment in the total workforce) in these cities were lower than the xiagang rates. Unemployment is undesirable for both workers and the government, because it severs the links workers had to the old danwei (work unit) and often leads to social unrest. Most unemployed workers are therefore classified as xiagang and placed in a reemployment center (see chapter 4 for details). To the extent that “xiagang” and “unemployment” both refer to the situation of being laid off, it is sensible to combine those two categories to estimate the real unemployment rate in a city. This is reported in the last two columns of table 1.3. The large cities of Chengdu and Harbin registered the highest numbers of total unemployed, with more than 260,000 unemployed workers. Fushun had the worst unemployment rate, at 43.8 percent, followed by Lanzhou with 22.8 percent. This was consistent with the large numbers of xiagang workers and the dominance of the state sector in the two cities. Sampling Methodology and Interviews. The reform of China’s SOEs began in earnest in 1996 after the experiences of Shunde and Zhucheng were supported in the central government policy of “keep the large and let the small go.” For this reason, it was decided to survey all the industrial firms that were owned by the 11 city governments at the end of 1995 before gaizhi began. The survey was administered by the SETC of the State Council and its counterparts in the sample cities. The city economic and trade commissions (ETCs) sent out around 1,100 questionnaires to firms and 683 were returned. The intention of the survey was to sample current and former industrial SOEs owned by municipal governments; however, because district and county governments were involved in the survey in some cities, some district and county firms, including collectives, were included in the sample. These firms were retained in the sample because many of them employed urban workers and had similar practices to the SOEs in terms of relationship with the local government, internal governance structure, employment, and remuneration. A small number of questionnaires were also sent to trading and services firms. Many of the firms had changed considerably since 1995. All significant gaizhi events in a firm’s history, such as bankruptcy, mergers, acquisitions, and spin-offs, were recorded. In terms of data collected, if the enterprise had merged with another firm, the new firm was surveyed and data were recorded from the year of the merger. If the firm had 17


been split up, the largest of the new active firms was surveyed and data were recorded from the year of the split. It was often the case that the old firm had moved production to a new spun-off firm, leaving the old firm only with the name, debts, and the burden of retirees. As a result, the new firm was typically the only active firm. The survey strategy results in an unbalanced panel of firm data, because some firms had a shorter life span. Sample selection has some special complications in governmentassisted surveys. Self-selection by firms, and selection on the part of the city ETC, can bias the results. For instance, local officials may put pressure on firms with close ties with the government, usually larger enterprises and nonprivatized SOEs, to fill in the questionnaire, causing oversampling of nonprivatized SOEs. Where bias may be a problem, national data will be used to support the discussions on the extent of gaizhi, or adjustments will be made to the data. In addition to the survey, research teams interviewed government officials, bank managers, and firm managers in seven cities: Harbin, Tangshan, Chengdu, Guiyang, Chongqing, Zhenjiang, and Hengyang.12 In each city the research team met with officials from government agencies such as the ETC and the bureaus of finance, labor and social security, and land administration. This gave the teams valuable insights into government policies and the methods of gaizhi in each city. The information also served as a reference point for the firm interviews. The teams also met with the local managers of the four major banks and the city commercial banks. A total of 270 firms were interviewed across the seven cities. The firm interviews provided important qualitative information regarding gaizhi. They revealed the different attitudes of SOE managers in different cities, and provided examples for some of the patterns analyzed in the study. Sample Distribution. The distribution of the sample firms, shown in table 1.4, varies across the cities because of differing structures of enterprise ownership and differing response rates. Response rates were poor in Fushun, which returned only 10 questionnaires, Weifang, and Lanzhou. In Xining the total number of firms was small. It is important to keep in mind the uneven distribution of the sample whenever geographic distribution is important to the interpretation. 12. Chongqing was not on the list of the sample cities, but a few firm interviews were conducted there.

18

INTRODUCTION

TABLE 1.4 DISTRIBUTION OF SOES AND FORMER SOES SURVEYED IN THE ELEVEN SAMPLE CITIES, DECEMBER 2002–APRIL 2003

Harbin Fushun Tangshan Weifang Lanzhou Xining Huangshi Zhenjiang Hengyang Guiyang Chengdu Total

Number of firms

Percent of sample firms

120 10 59 30 39 26 79 70 57 149 44 683

17.6 1.5 8.6 4.4 5.7 3.8 11.6 10.2 8.3 21.8 6.4 100.0

SOURCE: Survey data.

Most of the sample firms are categorized by Chinese statistics as SMEs.13 A comparison with national statistics, however, suggests that the sample average was nearly four times the national average over the period 1998–2001 (see figure 1.6). This might be a result of the restructuring brought about by gaizhi but could also reflect a sample bias toward larger firms. This is likely to be because the survey included mainly industrial firms owned by city governments, and these firms are usually larger than firms owned by district and county governments, which would be included in the national survey. There might also have been a higher response rate from the larger firms with connections to city governments. Within the sample firms, there was a slight decline in the average number of workers employed by firms from 1995 to 2001, as shown in figure 1.6. Most of the sample firms were in manufacturing, especially in petrochemicals, electronics, machinery, and textiles (see figures 1.7 and 1.8). This distribution agrees with the national data (see figure 1.9). 13. According to a recent SETC document, an industrial firm is an SME if one of three conditions is met: (1) annual sales revenue is less than RMB100 million; (2) registered capital is less than RMB20 million; or (3) fewer than 2,000 workers are employed

19


FIGURE 1.6 Average Number of Workers in the Sample Firms and in Firms Nationally, 1995–2001 Number of workers 1,000 800 600 400 200 0

1995

1996

1997

Sample average

1998

1999

2000

2001

National average

SOURCES: Survey data and China Industrial Yearbook, various years.

A comparison with a national survey by the SETC, released in early 2002, suggests that the 11-city survey oversampled non-gaizhi SOEs. In the 11-city survey, 370 firms (54 percent) reported having gone through gaizhi by the end of 2002. The data reported to the SETC by 54,644 small and medium-size industrial firms at the end of 2001 showed that 86.1 percent of firms had finished gaizhi by the end of 2001. These firms made up approximately 62 percent of all registered industrial SOEs and can be regarded as representative of the SOE population. In other ways the 11-city survey is representative of the experiences that SOEs have had with gaizhi. The extent of different forms of gaizhi reported by the survey matches the findings of national surveys in 1998 and 2001 (see figures 1.10, 1.11, and 1.12). The 1998 survey, carried out by the National Bureau of Statistics, sampled 57,881 firms, or approximately 67 percent of registered industrial SOEs. The 11-city survey showed that 30 percent of gaizhi cases involved either a public offering or an internal restructuring. A similar share (27 percent) had become employee shareholding firms, 28 percent of firms had been sold or leased out, 11 percent were bankrupt, and the remaining 4 percent had become joint ventures. The 1998 survey revealed broadly similar patterns. The two categories of “introducing new investment” and “spinning off” were largely equivalent to the sur20

INTRODUCTION

FIGURE 1.7 Percentage of Sample Firms in Primary Industries, Manufacturing, Utilities, and Services, 2001 Services 13%

Primary 5%

Utilities 1%

Manufacturing 81% SOURCE: Survey data.

FIGURE 1.8 Distribution of Sample Firms by Industrial Sector, 2001 Electronics 16%

Food and tobacco 10%

Textiles 14%

Machinery 19%

Furniture and printing 6%

Medicines 4% Steel and metal products 6%

Petrochemical industry 25%


21


FIGURE 1.9 Distribution of Firms by Industrial Sector in 2001 National Survey. Electronics 10%

Food and tobacco 12%

Machinery 15%

Textiles 16%

Steel and metal products 10%

Furniture and printing 10%

Medicines 2% Petrochemical industry 25%

Note: Including all SOEs and any other firm with a sales volume of more than RMB5 million. Source: China Industrial Yearbook: 2002.

FIGURE 1.10 Forms of GAIZHI in 375 Sample firms, 2001

Leasing 15%

Joint venture 4%

Public offering 7%

Internal restructuring 23% Open sales 13%

Employee shareholding 27% Source: Survey data.

22

Bankruptcy and reorganization 11%

INTRODUCTION

FIGURE 1.11 Forms of GAIZHI in 2001 National Survey Joint venture and other 13%

Internal restructuring 18%

Leasing 14% Merger 14% Open sales 11% Bankruptcy 11% Employee shareholding 19% Source: SETC.

FIGURE 1.12 Forms of GAIZHI in 1998 National Survey Joint Other venture 4% 3%

New investors 23%

Leasing 20%

Spinoff 7% Open sales 7%

Merger 10% Employee shareholding 21%

Bankruptcy 5%

Source: SETC.

23


vey’s categories of “internal restructuring” and “public offering.” Together they made up 30 percent of all gaizhi cases, which is what is found in this study. The figure for employee shareholding, 21 percent, was also comparable to the 27 percent reported here. The share of sales and leases (27 percent) was almost identical to this study. The share of joint ventures was 3 percent, close to the 4 percent found in this study. Incidences of bankruptcy differed: only 5 percent of the gaizhi cases were bankruptcies in the 1998 survey, compared with a share of 11 percent in this study. The difference might be because the 1998 survey had a separate category for mergers, and 10 percent of the gaizhi cases were reported as mergers, while this study combines mergers with bankruptcies. The results of the 2001 survey differed again, but the reporting of sales and leases matched both of the other surveys and the incidence of bankruptcy was similar to the 1998 survey. The Structure of the Study This study applies descriptive and econometric analysis to survey and official statistical data to examine the progress of gaizhi over the years and across regions. Chapter 2 discusses the main players in the process, their motivation and incentives. Chapter 3 examines the process: the forms, scope, and timing of gaizhi. It also looks at the incentives for firms and local governments to undertake a specific form of gaizhi. Chapters 4, 5, and 6 look at the outcomes of gaizhi. Chapter 4 focuses on employee issues. It outlines China’s social security system and discusses its function in the gaizhi process. Chapter 5 examines changes in the corporate governance of gaizhi firms. It studies the dynamics of the share structure and the changing roles and influence in the course of gaizhi of various stakeholders. Detailed statistics are presented on the distribution of control rights inside the firm, comparing gaizhi and non-gaizhi firms. Chapter 6 looks at the impact of gaizhi on firm performance. Chapter 7 concludes the study by discussing issues related to the fairness and efficiency of the gaizhi process, particularly concerning the role of management buy-outs and outside investors. These issues are at the center of a lively public debate in China, which is likely to influence future Chinese policies toward gaizhi.

24

2

The Main Players in Gaizhi

Gaizhi1 is a comprehensive transformation in which many parties have a stake. The process is inevitably complicated and involves compromises among different stakeholders. This chapter looks at the main players in gaizhi. It examines their incentives, concerns, and objectives, and considers how they determine the timing and scope of the process. Various hypotheses on the interactions between incentives and the scope of gaizhi are expounded and tested empirically. How Far Has Gaizhi Progressed? National data show that there has been a rapid decline in the number of state-owned or state-controlled enterprises across all regions in China. Between 1996 and 2001 the number of SOEs declined at an average annual rate of 9.1 percent, from 207,166 to 128,445 (see figure 2.1). The sharpest fall was in 1998. An SOE may cease to exist for three main reasons: because it is privatized, merged with another SOE, or liquidated. The data show that around 42 percent of the SOEs that existed in 1996 were privatized, merged, or liquidated over the period. The western provinces were the most active in the restructuring process. Approximately half of the region’s SOEs had been reformed by the end of 2001, 22.4 percent of them in 1997 alone. Chongqing was the main engine behind this performance, with 76 percent of the city’s firms being reformed in that one year. By the end of 2001, only 15 percent of Chongqing’s SOEs were still fully state-owned or majority controlled. The eastern provinces were slightly below the national average before 1999 and then slightly above after 1999. The central provinces tracked the national trend throughout the period. 1. The term “gaizhi” has a broader meaning than simply “privatization,” in that gaizhi includes privatization but also many other methods of restructuring.

25


FIGURE 2.1 State-Owned Enterprises in China as a Percentage of 1996 Number, by Region, 1996–2001 Percent East

100

National 80 Central

West 60 40 1996

1997

1998

1999

2000

2001

Note: Number of firms fully owned or controlled with dominant shares by the government. East: Liaoning, Beijing, Tianjin, Shandong, Shanghai, Jiangsu, Zhejiang, Fujian, and Guangdong. Central: Heilongjiang, Jilin, Inner Mongolia, Shanxi, Hebei, Henan, Hubei, Anhui, Hunan, Jiangxi, Hainan, and Guangxi. West: Xinjiang, Qinghai, Ningxia, Gansu, Shaanxi, Tibet, Yunnan, Guizhou, Sichuan, and Chongqing. Source: China Industrial Statistical Yearbook: 2002.

The average rate of reform of industrial firms was faster than the average for all firms (see figure 2.2). A total of 59 percent of industrial firms were privatized, merged, or liquidated over the period 1996–2001. By 2003, the percentage had increased to 70. The two national surveys of industrial firms undergoing gaizhi, mentioned in chapter 1, used the end of 1996 as their reference point, providing data that can be compared with the national statistics on SOE reform. Among the 57,881 firms sampled in the 1998 survey, 24 percent were reported to have finished gaizhi by the first quarter of 1998, 27 percent were in the process of gaizhi, and 26 percent were planning to start gaizhi in the coming year. As shown in figure 2.2, the number of industrial SOEs in 1997 was 87 percent of the number in 1996. Therefore, 13 percent of industrial SOEs had been privatized, merged, or liquidated by the end of 1997. From the results of the 1998 national survey reported in chapter 1 we know that 15 percent of all gaizhi were mergers and bankruptcies. This implies that of the 13 percent reduction in the number of SOEs, 3.6 percent was due to mergers and bankruptcies and 9.4 percent to privatizations. Therefore, close 26

THE MAIN PLAYERS IN GAIZHI

FIGURE 2.2 Industrial State-Owned Enterprises in China as a Percentage of 1996 Number, by Region, 1996–2003 Percent 120 100 80 60

Central

East National

40

West

20 0 1996

1997

1998

1999

2000

2001

2002

2003

Note: Number of firms fully owned or controlled with dominant shares by the government. East: Liaoning, Beijing, Tianjin, Shandong, Shanghai, Jiangsu, Zhejiang, Fujian, and Guangdong. Central: Heilongjiang, Jilin, Inner Mongolia, Shanxi, Hebei, Henan, Hubei, Anhui, Hunan, Jiangxi, Hainan, and Guangxi. West: Xinjiang, Qinghai, Ningxia, Gansu, Shaanxi, Tibet, Yunnan, Guizhou, Sichuan, and Chongqing. Source: China Statistical Yearbook: 2004.

to 40 percent of all the gaizhi cases had been privatizations by the time of the 1998 survey. The share of gaizhi firms would have reached 80 percent by 1999 if the gaizhi plans revealed in the 1998 survey had all been carried out. This prediction seemed to have been fulfilled, as the 2001 survey showed that 86 percent of the 54,644 sample firms had completed gaizhi by that year. Of all the completed cases of gaizhi, 25 percent were through mergers and bankruptcies, as reported in chapter 1. This estimate implies that 21.5 percent of all industrial SOEs had gone through mergers or bankruptcies by 2001. The national data presented in figure 2.2 show that 59 percent of all industrial SOEs had been privatized, merged, or liquidated by 2001. Therefore, about 38 percent of all SOEs had been privatized by that year. This, in turn, implies that 44 percent of all gaizhi cases were privatizations. The estimates about 27


the extent of privatization are lower-bound estimates, as often bankruptcies do not involve liquidations. In any event, the estimates suggest that privatization has been significant in China and that gaizhi has become more radical in recent years. The 11-city survey reveals a similar pattern. Figure 2.3 shows the pace of reform in four cities and the sample average over the period 1995–2001. Just as the national data illustrated, restructuring and privatization had barely begun in 1996 and 1997, but they accelerated considerably in 1998 and 1999. The most dramatic case was Huangshi, where nearly 70 percent of SOEs disappeared in 1999 alone. The most sluggish city was Lanzhou, where reforms and privatization started to take off in 1997 but then stalled, leaving about 80 percent of SOEs still in state hands. Generally, the southern cities privatized at a faster rate than the northern cities. With the exceptions of Hengyang in the south, all the southern cities had a lower percentage of nonprivatized SOEs than the average and all the northern cities had a higher percentage than the average (see figure 2.4). On average, the number of SOEs in the sample cities decreased by 50 percent in the period 1995–2001. The firm survey shows that the timing of gaizhi broadly followed a similar pattern to that described in the national statistics and surveys. There were 370 firms that had undertaken gaizhi by the end of 2002

FIGURE 2.3 Privatized State-Owned Enterprises as a Percentage of 1996 Number in Four Chinese Cities, 1995–2001 Percent 120 100

Harbin Lanzhou

80 Average

60 Chengdu

40

Huangshi

20 0 1995

1996

Source: Survey data.

28

1997

1998

1999

2000

2001


FIGURE 2.4 Number of State-Owned Enterprises as a Percentage of 1996 Number in Sample Chinese Cities, 2001 Hengyang Lanzhou Guiyang Fushun Average Harbin Zhenjiang Tangshan Weifang Xining Chengdu Huangshi 0

20

40

60

80

100

Percent SOURCE: Survey data.

(see figure 2.5). Less than 10 percent of them had completed gaizhi by 1994, but by the end of the period about 80 percent of firms had done so. Although the pace slowed in 2002, more than 30 firms completed gaizhi that year. The 11-city survey shows geographic differences in the pace of gaizhi. Figure 2.6 groups the 11 cities into three regions: northern (Harbin, Fushun, and Tangshan), western (Xining, Lanzhou, Chengdu, and Guiyang), and southern (Weifang, Zhenjiang, Huangshi, and Hengyang) and shows the number of gaizhi cases in each region each year. Although the southern region did not start gaizhi as early as the other two regions, its cities moved much faster in terms of numbers of firms and the scope of gaizhi. In the southern cities, gaizhi grew steadily to reach a peak in 2000. The pace in the northern and western cities has been slower and more variable. 29


FIGURE 2.5 Number of Firms Undertaking GAIZHI in Sample Cities, Before 1990–2002 Number of firms

Cumulative percentage 100

60

80 Number of firms

40

60 40

20

Cumulative percentage

0 Before 1990

1992

1994

1996

1998

2000

20 0 2002


FIGURE 2.6 Number of GAIZHI Cases by Region, Before 1990–2002 Number 40 30

North West South

20 10 0

Before 1990

1992


30

1994

1996

1998

2000

2002


The Key Participants Because gaizhi involves a comprehensive transformation of the state sector, which had been the foundation of the Chinese economy, a number of players have stakes in the process. The seven key participants in gaizhi have been the central government, the local government, the management, employees, creditors, outside investors, and the public. The interactions among these players shape the form of gaizhi undertaken. The Central Government. In the early stages of urban reform, gaizhi was a bottom-up process. During his tour of southern China in the spring of 1992, Deng Xiaoping encouraged several localities to experiment with SOE reform. Gaizhi was given greater prominence at the end of 1992 by the 14th Party Congress, when the decision was made to build a socialist market economy with Chinese characteristics. Although the central government had no grand plan to reform the whole SOE sector, more localities were encouraged to undergo gaizhi. For several years the central government did not make official pronouncements on the reform initiatives, but simply observed the consequences. The zhuada fangxiao policy in 1995, which sanctioned local initiatives, was a result of those observations and marked the beginning of active support by the central government for gaizhi. The 15th Party Congress in 1997 formally acknowledged the role of the private sector by stating that private enterprises were an indispensable part of the national economy. In 1999 the National People’s Congress (NPC) changed the Constitution to endorse the decision made at the 15th Party Congress. Further amendments to China’s Constitution, including explicit clauses on protecting human rights and private property, were passed at the full session of the NPC in March 2004. The central government’s support for gaizhi came from its desire to transform the planned economy into a market economy. The Chinese government realized in the early 1980s that price liberalization and SOE reform were the two fundamental tasks of that transformation. Price liberalization was completed in the early 1990s (the most significant event was perhaps the abolition of food quotas and price controls in 1993), after which SOE reform became the government’s foremost concern. Although efforts to improve SOE efficiency had continued since the mid-1980s, the government realized that gaizhi had the most chance of solving the SOE problem. The central government also real31


ized at the beginning of gaizhi that “letting the small go” would improve its fiscal situation. Under the decentralized fiscal system, the central government has a strong incentive to transfer the management of smaller firms to local government. The use of the term “gaizhi,” instead of “privatization,” illustrates the cautious approach taken by the central government. Even that term does not appear frequently in the official media, however, because of a desire to avoid an ideological backlash. The central government’s main concerns are that gaizhi may lead to the loss of state assets (bank loans, in particular), result in massive unemployment, and cause social unrest. In terms of state assets, the real problem is the conflict of interest between the central government and local governments. While most SOEs belong to local governments, the four major commercial banks belong to the central government. These four state banks are by far the largest creditors to the SOE sector. Since the Chinese fiscal system is highly decentralized, and local and central budgets are largely separate, the central government is able to guard its own interests if it protects the banks. The central government is very keen to maintain social stability and keep unemployment to a minimum. It therefore pressures local governments to adopt every possible means to maintain employment, and thus social stability, during gaizhi. This creates a conflict of interest between the central and local governments over responsibility for the costs of gaizhi. The interests of the various government agencies involved in gaizhi may differ and in some cases be contradictory. Prior to the last government reorganization, the SETC was in charge of SOE operations. It favored a faster pace of privatization and more generous deals for the management. The Ministry of Finance (MOF) was more concerned about whether the value of the assets could be fully recovered. The most significant conflict is between the Ministry of Labor and other government agencies. The Ministry of Labor is responsible for unemployed and xiagang (temporarily laid-off) workers, so it resists rapid privatization. The trade unions are allied with the Ministry of Labor and also emphasize the rights of workers. These conflicts translate at the local level as well. The slow progress of gaizhi in some cities can be attributed to the conflicts of interest among the different government agencies, especially in cases when the government needs to provide compensation to redeploy workers. The establishment of the State-Owned Assets Supervision and Administration Commission (SASAC) had as 32


one of its objectives the creation of a government agency that would assume ownership over SOE reform. While the new agency addresses some of the issues related to fragmented authority over the management of state assets, it cannot eliminate all the potential conflicts between various government agencies regarding SOE reform. In summary, the central government sees gaizhi as a necessary step toward a market economy, but its interests are more complicated than they appear. The conflict of fiscal interest between the central government and local governments plays an important role in shaping the methods and speed of gaizhi in the country. The Local Government. The local government plays three roles in regard to local SOEs: as the original owner of the SOEs,2 as an employer and therefore the provider of social stability, and as a collector of tax revenues used to provide public services. These three roles are not always complementary, but the top priority of local government is stability. As owners of state firms, local governments have a big stake in SOE assets. The wage arrears, bank liabilities, and tax arrears of poorly performing SOEs place a burden on local governments, however. In addition, with progress in market liberalization local governments have less control over firms as managers have become more powerful. Managers are more prone to steal from firms if they have significant control rights but no ownership rights. Local governments must weigh the costs and benefits of retaining ownership against those of letting the firm go into private hands. If the firm is retained, there is a risk that its assets will dissipate through poor management and theft, but if the firm is privatized the government may obtain some value out of the assets. More importantly, the government can shake off the firm’s liabilities after privatization and may gain from increased tax revenues if the firm’s performance improves. Although these incentives may vary among the cities, many local governments have made the pragmatic choice to privatize the SOEs. In many cases of gaizhi, the local government is unable to cash in on the sale of state assets. Many SOEs already have negative net 2. In theory the central government owns every SOE, but in reality SOEs are effectively owned and controlled by local governments. The official document of the 16th Communist Party Congress signaled a formal transfer of ownership to localgovernments.

33


assets at the time of gaizhi. Many owe wages, social security payments, taxes, or health insurance premiums. These debts have to be settled before the firm is privatized. Gaizhi often involves layoffs, and layoffs create obligations on local governments to support workers who lose their jobs. With a shortage of cash, the local government has to use the firm’s assets to meet these obligations. A constraint on gaizhi practices is the government’s wish to maintain employment and reduce the risk of social instability. This is the overriding concern of local governments. The Management. The firm’s managers usually have a strong incentive to support privatization if they believe that they are likely to be beneficiaries in terms of increased autonomy and investment gains. Prior to gaizhi, the authority of managers rests on their ability to please both the government and the firm’s employees. Although managers’ control rights may be strong, they are not backed by any ownership rights and this creates a sense of insecurity. After gaizhi, managers may have, in addition to their decision-making power, ownership stakes that could bring rewards if the firm is run successfully. Managers may face conflicts of interest when they perceive themselves as prospective buyers of the enterprise. Some managers may deliberately run the firm down before privatization in order to lower the privatization price, or they may strip the assets out of the firm. Questions have been raised about whether managers should be allowed to buy the firm at a discount to firm valuation, as those same managers may have been responsible for the failure of the SOE. Managers bear a significant risk when they buy a firm, especially when they pay cash. Increasingly they are competing against outside buyers, who have the financial resources to redeploy redundant workers and inject new investment into the firm but may not want to retain the old management. If an outside buyer is competing to purchase the firm, the managers may oppose gaizhi. Employees. Many SOEs have tended to overhire, despite the fact that they operate in traditional industries where markets have been shrinking. Privatization is an opportunity to downsize the workforce, but then laid-off workers become a burden on the government. Thus employees often have mixed feelings toward gaizhi. It may be seen as the only way to revive the firm, but there is also the risk of redundancy. If gaizhi must 34


proceed, redeployment after gaizhi becomes the employees’ central concern. Workers have considerable bargaining power because they are able to resort to collective, sometimes violent, action to force the government to satisfy their demands. Their position has also been strengthened by the government’s aversion to social unrest. The central government requires that every gaizhi plan must be approved by a conference of the employees. The Supreme Court requires that the settlement of labor claims is the first priority when a firm undergoes gaizhi or bankruptcy. Employees therefore are in the position of secured creditors vis à vis their firms. The top priority given to workers’ claims tends to dampen employees’ incentives to monitor management for asset stripping during and before gaizhi. In most localities, employees who will be continuing with the firm receive compensation, usually a number of free shares, for losing their status as state employees. As such, they receive a share of the profits on top of their regular wages and thus can be a positive force pushing for gaizhi. Creditors. Banks have a huge stake in gaizhi, as most gaizhi firms are in serious debt. Because many firms attempt to evade the repayment of debt—for instance, by falsely declaring bankruptcy and registering a new firm—banks often see gaizhi as being synonymous with attempts at debt evasion. Banks—and the national banks, in particular—have an intrinsic interest in monitoring gaizhi to ensure that the value of their collateral is not eroded in the process. In this sense, their interests tend to coincide with the central government’s concerns about the loss of state assets during gaizhi. Although the four major state commercial banks are owned by the central government, they are vulnerable because the firm and the local government often collude to squeeze their interests. Furthermore, the central bank leaves little room for commercial banks to write off loans or renegotiate payments. Banks’ quotas for write-off are therefore a constraint on the pace and scope of gaizhi. The debt problem does not lend itself to a simple solution, such as strengthening the role of the banks during or after gaizhi. The accumulation of nonperforming loans is a consequence not only of the soft budget constraint faced by SOEs and their poor performance but also of failed government policies. The central government has deliberately channeled bank loans to priority sectors, and many of 35


the selected projects ended in failure. Local governments also persuaded banks to issue loans to favored firms. When state firms are declared bankrupt, social obligations usually have priority over secured creditors, and commercial debts are seen as a problem of secondary importance. Outside Investors. Private business owners, other SOEs, and foreign companies did not play a large role in the early stages of gaizhi, but the participation of outside investors—particularly private business owners—has grown in recent years. A large number of private entrepreneurs have acquired SOEs in the belief that they can make money if the firms are properly managed. Local governments used to play an active role as far as the involvement of outside investors in the gaizhi process is concerned. They can engage in matchmaking or instruct successful SOEs to take over loss-making SOEs. According to unofficial estimates, about half of all mergers involving SOEs as outside investors are administered mergers. This practice has diminished in recent years, partly as a result of reforms and a more liberal mergers and acquisitions (M&A) regime, and partly due to the fact that local governments have to compete more and more with each other to attract outside investors of all stripes and colors. Outside investors are more likely to care about efficiency, and to want to lay off workers and strengthen internal management, than are existing managers who take over firms. Because they bring new investment into the firm, outside investors are in a strong position to negotiate with the government on redeploying the employees. The old management typically has a more benign attitude toward employees because of their prior relationship with the firm. The Public. The central government has maintained a low profile over privatization, and the general public is not well informed about the gaizhi process. Most people, however, associate gaizhi with unemployment problems and with the need for structural adjustments in the state sector. The public—and intellectuals, in particular—worry about equity issues and the loss of state assets. Heated debates have broken out in several cases and have influenced the attitude of the central government toward gaizhi. The most notable occasion was the 1997–98 debate following the 15th Party Congress. Following the rapid privatization of TVEs throughout the country, many of which were sold to their 36


managers, the intelligentsia expressed concerns as to whether such massive sales to the elite were fair to ordinary workers (Qin 1997). Their doubts were quickly echoed by the central government, which cooled the discussion of gaizhi and began to talk about preventing the loss of state assets. All seven players discussed above exert an influence on gaizhi. The central government has been a strong force in pushing for gaizhi since the mid-1990s, because of its desire to establish a market economy to ease the burden on the state budget. Aware of the potential loss of state assets, especially bank loans, it has also been keen to regulate the gaizhi process through laws, directives, and other regulations. At the local level, gaizhi promises to exempt the local government from responsibility for loss-making SOEs and gives managers controlling ownership, which explains why both parties support gaizhi. Employees are often divided. Those who expect to stay in the firm usually favor gaizhi because they gain an ownership stake, while those who expect to be laid off often oppose it. Outside investors welcome gaizhi because it provides them with new investment opportunities. The intelligentsia is actively involved in debates over gaizhi and can be influential with the public and the central government. Creditors are mostly passive in the gaizhi process, despite their large financial stake in gaizhi firms. This is mainly because of China’s banking regulations, bankruptcy law, and current government policies. A salient feature of China’s reform policies has been the focus on avoiding losses. In the case of gaizhi, this has meant socialization of losses through the banking system and the budget. It is important to note, however, that gaizhi is a dynamic process and that the incentives of the parties involved may shift as the process evolves. The identity of the party initiating restructuring reveals a lot about who is supporting gaizhi at various stages of the process. According to survey results, local governments initiated around twothirds of the first round of gaizhi, while enterprise managers initiated around one-fourth (see figure 2.7). In the most recent round, however, enterprise managers were the leading party, initiating about half of all gaizhi cases (see figure 2.8). Interviews revealed that local governments supported strengthening the position of managers in order to add efficiency and to raise tax revenues from the firm. The fact that the employees seldom initiated gaizhi is not surprising, given that it often results in massive layoffs. Despite the government regulation that any gaizhi plan must be approved by the 37


FIGURE 2.7 Party Initiating the First Round of GAIZHI Other Central government 5% 1%

Firm management 24%

Employees 2%

Local government 68% SOURCE: Survey data.

employees or their representatives, around one-quarter of gaizhi firms reported that employees did not play a significant role in the gaizhi plan. In more recent rounds of gaizhi the incidence of employee initiatives was higher (see figure 2.8), perhaps because prior experience with gaizhi has reduced uncertainties for workers who have preserved their employment status. Theories on Incentives for Gaizhi In contrast to Eastern Europe and the former Soviet Union, where privatization was initiated in a top-down fashion to speed the political transformation (Boycko, Shleifer, and Vishny 1996), privatization in China emerged spontaneously. Gaizhi was initiated by several localities and later sanctioned by the central government. Different regions had different experiences with gaizhi. An interesting question is, which political, social, and economic conditions are most conducive to gaizhi? And how did the interactions among the main players influence the course of gaizhi? 38


FIGURE 2.8 Party Initiating the Last Round of GAIZHI Other Central government 4% 0%

Local government 40%

Firm management 49%

Employees 7% SOURCE: Survey data.

Four theories have been advanced to explain the incentives for gaizhi: the efficiency hypothesis, the financial crisis hypothesis, the fiscal decentralization hypothesis, and the market liberalization hypothesis. Efficiency Hypothesis. The efficiency hypothesis asserts that privatization is initiated by the government’s desire to improve firm efficiency. Under this theory, gaizhi is promoted by the desire of the central government to encourage a market economy and improve firm efficiency, thereby increasing tax revenue. Glaeser, Johnson, and Shleifer (2001) argue that rational political systems lead to the selection of efficient economic institutions. This can explain the central government’s support for gaizhi since the mid-1990s, but it cannot explain the timing of gaizhi: if efficiency was the government’s main concern, why did it not start gaizhi in the 1980s when the inefficiencies in the SOE sector became widely known? One way of measuring the efficiency of a state firm is by comparing the average value-added per unit of assets of an SOE against those 39


of private firms in the sector (Li and Liu 2004). The larger the efficiency gap between the two, the more likely the SOE is to gain from privatization and so the more likely it is to undertake gaizhi. Financial Crisis Hypothesis. In examining privatization programs in industrialized countries, some researchers have found that privatization was often induced by a financial crisis (see, for example, North and Weingast 1989). China’s experience suggests a similar rationale. Financial crisis was cited by local officials in Shunde as one of the most important reasons why SOEs in that city were privatized (Yao 2004). Gaizhi took off in the mid-1990s when profitability in the state sector was declining rapidly. The profit rate of SOEs declined from 3.8 percent in 1994 to 1.5 percent in 1996 and 1997, and the return to capital fell to around 0.7 percent.3 This theory does not explain why Zhucheng and Shunde were such early reformers (Huang and Wei 2001; Yao 2004), or why progress was so slow in the northeast and northwest where there were a large number of failed SOEs. The financial situation both of the local government and of its firms is likely to be important to this hypothesis. The per capita government revenue of a city is adopted to indicate a city’s financial capacity, and two lagged firm performance indicators—the debt-equity ratio and value-added output per worker—control for the financial performance of firms. If the hypothesis holds, firms with poor financial performances and those in cities with a weak financial situation will be privatized first. Fiscal Decentralization Hypothesis. Other theories emphasize the importance of fiscal decentralization in inducing privatization (Li, Li, and Zhang 2000; Dougherty and McGuckin 2002). The decentralization of fiscal power creates strong incentives for local governments to compete for tax bases and leads to the privatization of inefficient SOEs. Dougherty and McGuckin (2002) find evidence of greater privatization at the level of the county and below. This does not explain, however, why privatization did not occur in the 1980s when the introduction of the fiscal responsibility system allowed local governments to retain more of their tax revenues. 3. Although SOE profitability has increased since 1998, the petrochemical sector contributed more than half of the increase.

40


Fiscal decentralization does not necessarily lead local governments to be more responsible and may create adverse effects such as regional protection. When comparing fiscal decentralization in China and Russia, Blanchard and Shleifer (2000) find that China performs better because central government control mitigates the adverse effects of fiscal decentralization. Blanchard and Shleifer do not, however, consider the problem of the central government’s incentives to pass down difficult tasks to local governments. The same top-down relationship exists between provincial governments and county governments. Yao and Yang (2003) use the examples of rural tax reform and privatization to show how higher-level governments pass down responsibilities, inducing lower-level governments to behave more predatorily toward the private sector.4 This results in the underprovisioning of public goods on the part of higherlevel governments (Wang and Wang 2001). Chen, Hillman, and Gu (2002) found that local governments became more predatory after the 1993 fiscal reform that established an American-style central–local system of tax sharing. Market Liberalization Hypothesis. A fourth set of theories links privatization to market liberalization. Tian (2001) shows that market liberalization changes the cost-benefit balance of various forms of ownership relative to central planning. Central planning creates a situation where local government ownership is optimal because the local government has the advantage over entrepreneurs in accessing resources. As the planned economy gives way to the market economy, entrepreneurs and entrepreneurship become more critical and privatization more necessary. Li, Li, and Zhang (2000) find that market liberalization results in more intense product market competition, squeezing profit margins and improving incentives inside the firm. Their analysis suggests that a fiscally independent local government will be more willing to privatize its SOEs. Guo (2003) points out that when the market plays a greater role in resource allocation, governments have less information with which to assess SOE performance and the manager acquires more control 4. Rural tax reforms aim to unify the taxes and fees into a uniform 5 percent tax on households’ average net income. The tax rate is currently higher, making it difficult for local governments, especially township governments, to implement the new tax.

41


over the firm. The government transfers ownership to the manager to better align control and ownership. Sonobe and Otsuka (2004) find that firms that are more involved in market transactions are more successful after privatization, providing indirect evidence for this theory. Complex measures have been developed to measure the degree of market liberalization.5 This study uses the lagged employment share of the private sector in a province as the indicator, because a larger private sector in surrounding areas implies a more liberalized market (Gregory, Tenev, and Wagle 2000; Li, Li, and Zhang 2000). Empirical Tests In this section we test for the efficiency, financial crisis, and market liberalization hypotheses. We do not test for the fiscal decentralization hypothesis, as this test would require a different sample and a different approach.6 We are looking for empirical evidence regarding the impact of factors such as the efficiency gap between state-owned and private firms in the respective sectors, the fiscal capacity of local governments and the financial strength of firms, and the effect of the degree of privatesector development on the extent of gaizhi. We measure gaizhi by the share of government ownership at the firm level. We assume that the lower the level of government ownership, the further the firm is along the path of restructuring. In addition to analyzing the impact of the above-mentioned factors on the extent of gaizhi, we consider other variables that may play a crucial role, such as the number of retired and redundant workers, assets per employee, firm size, market competition, and time and regional variables. A firm is more difficult to privatize if it has a large number of retirees and redundant workers who need to be redeployed. Although China is moving from a firm-based pension system to a new unified 5. For instance, the National Economic Research Institute publishes a market liberalization index for Chinese provinces. This index includes both policy indicators and performance indicators and thus suffers from possible endogeneity problems when used in regressions. 6. Ideally one would like to compare situations before and after the reform of fiscal relationships between the center and the localities, or compare localities with different degrees of fiscal independence. Since 1995, however, the relationship of the center with the provinces and the other administrative units is more or less uniform.

42


system, the system that is evolving is in a significant deficit. A privatizing SOE is often given the option of paying all retirement premiums in advance or of continuing with the old firm-based system. In either case the retirees are a social burden on a privatizing firm. Redundant workers include workers dismissed from the firm, xiagang workers, and those who have been “internally retired” (see chapter 4). It is a common practice for local governments to discount the price of state assets to compensate either the privatized firm for taking care of redundant workers or the workers for giving up their state employee status. The net worth of a firm can be a determining factor in gaizhi, so, to account for this possibility, the variable of net assets per worker is added to the regression. We also control for firm size and industrial competition in the analysis. Casual observation suggests that larger firms are less likely to be privatized. The industrial competition variable controls for sectoral specificities and is represented by the average profit rate in a specific industry. Finally, year dummies and a regional dummy distinguishing the south and the north are added into the regression. All the explanatory variables (except the regional and year dummies) used in the analysis are three-year lagged averages.7 The findings are presented in table 2.1. Contrary to the prediction of the efficiency hypothesis, the government share does not decline when there is a larger potential gain to a firm from privatization. The result shows exactly the opposite with a high statistical significance: better-performing firms are more likely to be privatized. The financial crisis hypothesis is likewise rejected. A firm with a higher net return to its assets tends to have a lower government share. In addition, in cities with strong public finances, local governments tend to hold a lower share in their firms. A firm’s debt-equity ratio does not play a significant role in the regression. This result might be related to the weak position of the creditors in the privatization process. There may be several reasons behind the rejection of the two hypotheses. First, governments tend to privatize the better-performing SOEs first. Second, it is easier for a city with strong public finances to support privatization, because it can provide financial concessions and 7. The use of three-year lagged averages partially addressed any endogeneity problems.

43


TABLE 2.1 FACTORS INFLUENCING GAIZHI AS DETERMINED BY REGRESSION ANALYSIS Variable Efficiency hypothesis variable Average private-sector value added in the sector as a percentage of sample firm’s value added per unit of assets

Expected sign Negative

Financial crisis hypothesis variables Positive Per capita local government revenues (RMB) Negative Debt-equity ratio (%) Net return on assets (%)

Positive

Market liberalization hypothesis variable Negative Share of private-sector employment in provincial employment Control variables Worker redundancy (%)

Positive

Net assets per worker (RMB10,000 ) Number of workers (1,000)

Negative

Industrial profit rate (%)

Negative

Northern city Year dummies

Positive

Actual sign and statistical significance Positive, statistically significant

Negative, statistically significant Positive, not statistically significant Negative, statistically significant Negative, statistically significant

Positive, statistically significant Negative, statistically significant Positive, statistically significant Positive, not statistically significant Positive, statistically significant Positive, statistically significant. 1995 is the reference year

NOTE: Sample size is 1,100 cases. Method of estimation is weighted least squares to correct for the oversampling of unreformed SOEs relative to gaizhi firms. Dependent variable is share of governement ownership. SOURCE: Authors’ estimates.

44


subsidies to redeploy redundant workers and to compensate the buyer for purchasing state firms. Of the three hypotheses, the market liberalization hypothesis is the only one that is not rejected. This result is consistent with the observation that provinces that have a larger private sector have been more active with gaizhi. The level of private-sector development in a city may influence gaizhi in several ways. It is presumably easier for redundant workers to find other jobs in a city with a larger private sector, so the problem of worker redeployment is less severe. Furthermore, the public’s acceptance of privatization is likely to be higher in a city with a large private sector, and this can reduce the obstacles to privatization. As for the other variables, all but the variable for industrial profit are significant and hold the expected signs. A higher level of redundancy does slow privatization, but a greater net assets position accelerates it. In addition, larger firms, and firms in northern China, are harder to privatize. A firm in the north of China has on average about a 7 percent higher share of government ownership. Conclusion Gaizhi has changed China’s economic landscape. The number of SOEs has been reduced dramatically. Nationwide, about 80 percent of SOEs had gone through some type of gaizhi by the end of 2001, and 70 percent reported that partial or full transfer of ownership had taken place from the government to private hands. Gaizhi has been assuming more radical forms, with privatizations accounting for an increasing share in recent years. A number of players have a stake in the gaizhi process. Local governments and enterprise managers have been the most active proponents of reforms, with managers assuming a leading role in later rounds of restructuring. The empirical analysis shows that market liberalization is an important macroeconomic factor leading local governments to release SOE shares into private hands. The analysis also shows that the fear of redundancies hinders the pace of privatization. Consistent with this finding, a firm with greater net assets is easier to privatize because it can compensate workers, and a city with a better financial record is more likely to privatize because it can afford to pay concessions and subsidies. Cities tend to privatize the better-performing SOEs first.

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3

The Gaizhi Process

The central issue of gaizhi is the reallocation of property rights over enterprise assets and liabilities. A variety of forms and mechanisms have emerged to accomplish this task. In this chapter we look at the different forms of gaizhi and at their structure, evolution over time, and geographical distribution. The chapter also discusses the factors influencing the choice of different forms of gaizhi in China. It focuses on the common issues that most types of gaizhi have to address, such as valuation of assets and liabilities, particularly of enterprise debt and land-use rights. Forms of Gaizhi The term “gaizhi” is used to mean any structural change to a firm, including public offering, internal restructuring (incorporation, spinning off), bankruptcy and reorganization including through debt-equity swaps, ownership diversification by introducing new investors, employee shareholding (limited liability companies or cooperatives), open sale (to management, employees, outside private firms, or another SOE), leasing (to management, employees, outside private firms, or another SOE), joint ventures, or a combination of the above. Internal Restructuring. Internal restructuring does not change the identity of the owner. A form of internal restructuring is incorporation, which started en masse soon after the Company Law came into force in 1994. According to the Company Law, if an SOE is to be reorganized into a company, it must change its operating mechanism, identify and verify its assets and determine their respective owners, settle its creditors’ rights and liabilities, conduct an assets appraisal, 46

THE GAIZHI PROCESS

and set up standard internal management organs. The law requires a company to have at least two shareholders, but it allows SOEs to register as limited liability companies with the state as the sole owner. Therefore, while incorporation may not involve any change in ownership, it does change the formal relationship between the state and the enterprise through the concept of limited liability. Incorporation draws a line, typically not very thick, between the state and the company. It also prepares the ground for ownership diversification, because the firm can now avail itself of a legal framework for bringing in new investors. Another common way to revitalize an SOE has been to split the firm into several smaller firms that begin to manufacture new products. The old firm becomes a holding company that owns the new spun-off firms and maintains a contractual relationship with them by charging a fee for the use of buildings and equipment. Another practice of spinning off has been to set up a new company that takes the good assets of the old firm, including buildings, equipment, and capable personnel, and leaves it with the nonperforming assets, bank and commercial debts, retirees, and redundant workers. It is this form of gaizhi that creditors, particularly banks, fear most. Since spinning off does not change the ownership, it can be seen as a form of internal restructuring, although reform measures within the new firms can be quite radical. Initial public offerings by state-owned companies in China have been typically preceded by the types of internal restructuring described above. Bankruptcy and Reorganization. Although China’s Bankruptcy Law came into force in 1988, it applied only to SOEs and was not widely applied until the mid-1990s, when the central government began to adopt bankruptcy as a means to restructure SOEs (Gao and Yao 1999). Since that time the program of “policy-oriented bankruptcy” has resulted in 3,377 bankruptcy cases, RMB223.8 billion in write-offs, and 6.2 million layoffs. The program is expected to be phased out by the end of the decade, when the last batch of 2,000 cases of policy bankruptcy is closed. A new Bankruptcy Law is reportedly nearing completion after 10 years of drafting. In many instances, the framework of policy bankruptcy has been abused by SOEs, which, often in conjunction with the local governments, have viewed the procedure as a mechanism for evading debt payments. Cases of abuse involving collusion between local govern47


ments and local banks have also been reported.1 Bankruptcy often occurs with gaizhi that diversifies the ownership of the firm. Therefore, bankruptcy and subsequent reorganization often imply partial or full privatization. Debt-equity swaps were introduced by the central government in 1999 to alleviate the huge nonperforming loan problem. NPLs were officially estimated at 25 percent of outstanding loans, but the true share is likely to be higher. In 1999, four asset management companies were established to tackle the problem. One task of these companies has been to implement the debt-equity swaps. While the merits of the plan are debatable, it has alleviated the burden on participating SOEs and, in some cases, has improved their corporate governance. By the end of March 2004 the four AMCs had disposed of RMB528.7 billion of NPLs (excluding policy-oriented debt-equity swaps) in total, with a cash recovery rate of 20 percent. The government plans to allow the AMCs to exist beyond the initial 10-year period. After the disposal of NPLs is completed, the AMCs will undergo a transformation in the direction of “commercialization.” Ownership Diversification. Ownership diversification involves bringing in outside investors while maintaining majority state ownership. Diversification could occur by means of an initial public offering, a private placement, or a private offering. IPOs in China have been used as a mechanism to bring new owners in, rather than enabling existing owners (in this case, the state) to exit. Following the IPO the firm’s ownership becomes more diversified, but the public offering typically does not change the dominant position of the state as an owner. The state, directly or indirectly, still holds about two-thirds of the shares of Chinese listed companies. State-owned enterprises have been the main participants in Chinese stock markets as, until recently, sales of

1. A report issued by the National Auditing Office disclosed a fraud case involving collusion between court officials and a bank in Jinzhou, Liaoning province. Local judges and managers of the local branch of the Bank of Communication fabricated 346 false cases with the names of 285 debtor firms in order to obtain approval for write-offs of RMB532 million in loans. RMB221 million had been approved. When the debtor firms paid interest and principal amounts to the bank, the money went to a private “treasury.”

48

THE GAIZHI PROCESS

shares were a low-cost way of financing SOEs. Tenev, Zhang, and Brefort (2002) provide an overview and analysis of the corporate governance aspects of the IPO process in China. Employee Shareholding. Employee shareholding has been by far the most popular form of gaizhi throughout the country. Although proven to be a suboptimal arrangement in other transitional countries, this form of gaizhi entailed the least political risk in the early stages of urban reforms. Indeed, many employee-shareholding firms were still registered as collectives in the early 1990s. Perhaps it is also the most politically feasible form of privatization in terms of the power structure within an SOE. The central government requires that each gaizhi plan be approved by a conference of employee representatives. Because it allows ordinary employees to have more voice within the firm and to share in its future profits, employee shareholding is the form of privatization most likely to be approved by employees. To be registered as a limited liability company, the maximum number of shareholders must be below 50, as stipulated by the Company Law. Firms with a larger number of shareholders, but which cannot meet the requirements for a joint stock company, can assume the status of employee shareholding cooperatives. Shareholding cooperatives have been an innovative mechanism for the transformation of township and village enterprises in China. Some employee-owned firms with more than 50 shareholders have been able to register as companies by forming block shares; that is, groups of employees elect a representative or trustee and register all the group’s shares under that person’s name. Many employees gained shares through compensation given by the local government in exchange for the removal of their state employee status (see chapter 4). As a result, in the early stages of gaizhi, shares were widely dispersed throughout the firm. In recent years, managers have been able to buy a larger number of shares in newly privatized firms. Some gaizhi firms have gone through second and third rounds of gaizhi, further increasing the number of shares owned by managers. Management buy-outs have become quite controversial in China, given the growing number of cases of reported abuses. In response to public opinion, the SASAC has issued regulations discouraging MBOs of large companies.

49


Open Sale. This form of gaizhi has become more popular in recent years. The firm is openly sold to insiders or outsiders, perhaps through auction. This is the most radical form of privatization because it can involve the transfer of the firm to a single private owner or a management group. Leases. The lease contract now commonly used in gaizhi is quite different from that adopted in the early years of SOE reform. The early leases acted as incentives within the SOE, but leases are now used to break up the SOE. Under current leases the lessee is a legal entity independent of the government. Some lessees are outsiders and own their own firm, while others are former employees who have set up new companies and lease the buildings, land, and equipment from the government. Leasing is often adopted in cases where the lessee does not have enough money to buy the firm. It is another radical form of gaizhi. Joint Ventures. Forming a joint venture with a domestic or foreign firm is another approach to gaizhi. It may involve separating assets from the existing firm and forming a new entity; that is, a spin-off. Mergers can also be included in this category. Firms undergoing gaizhi may adopt a number of the above measures. The various forms of gaizhi form a spectrum incorporating different degrees of change of ownership. At one end of the spectrum is internal restructuring, where no change of ownership takes place. At the other end is open sale. In between are: ownership diversification, where there is a change in the ownership structure but assets are not transferred from the state to the new owners; bankruptcy, reorganization, and leases, which can lead to significant ownership changes involving the transfer of assets from the state to the new owners; and employee shareholding and joint ventures, where new owners are introduced and this is accompanied by a transfer of assets from the state to the new owners. Sample Distribution of Forms of Gaizhi Of the 375 cases of gaizhi in the sample, 20 percent (74 cases) went through internal restructuring (see figure 3.1). About 8 percent of the gaizhi firms (30 cases) went through ownership diversification, including 25 cases of public offering and 5 cases of private placement to outside investors. A total of 27 percent (103 cases) introduced em50

THE GAIZHI PROCESS

FIGURE 3.1 Distribution of Forms of GAIZHI in Sample Firms Joint venture 4%

Public offering 8%

Leasing 15% Internal restructuring 20% Open sales 13%

Bankruptcy and reorganization 13% Employee shareholding 27% Source: Survey data.

ployee shareholding, 28 percent of firms (105 cases) were sold or leased out, 13 percent (49 cases) went through bankruptcy and debtequity swaps, and the remaining 4 percent (14 cases) became joint ventures. Therefore, more than 70 percent of gaizhi cases involved the transfer of ownership from the state to private hands. Of the 74 cases of internal restructuring, 53 were simply incorporated, 16 involved spin-offs, and 5 were unclassified. Of the 103 cases of employee shareholding, 53 percent of the firms became limited liability companies, 34 percent became shareholding cooperatives,2 and the remaining 13 percent were unclassified. 2. Chinese law does not grant legal status to cooperatives. Interviews with the firms found that most cooperatives wanted to register as limited liability companies, but the limit on the number of shareholders (under 50) prevented them from doing so. As indicated above, employees in some firms have solved this problem by pooling their shares under the name of an entrusted member.

51


The significant presence of employee shareholding firms in the 11-city survey indicates the prevalence of insider control in China’s privatization. Insiders also took over a large proportion of those firms that were sold or leased out: 16 of the 49 sales and 15 of the 56 leases involved insiders, mostly managers (see figure 3.2). Only 16 sales and 20 leases were exclusively directed to a private firm. Overall, sales or leases to an outside private firm comprised only 10 percent of the 375 cases of gaizhi. There were 10 sale and 19 lease cases that were classified as “other types” of sales and leases. These cases are probably a blend of insider control and outsider participation. If these cases are included, the share of gaizhi cases that involved at least partial outsider participation rises to 15 percent. This shows that the private sector has become an active player in gaizhi. Box 3.1 provides evidence of this trend from Tangshan and Hengyang. Although the classifications of the forms of gaizhi used by the two national surveys are different from those adopted by this study, there are some comparable results. The 1998 survey revealed broadly simiFIGURE 3.2 Structure of SOE Sales by Type of Purchaser (percent) Other 21%

Sold exclusively to the old management 26%

Sold to another statecontrolled firm 9%

Sold to another insider(s) 9%

Sold to a private firm 35% SOURCE: Survey data.

52

THE GAIZHI PROCESS

BOX 3.1 PARTICIPATION OF THE PRIVATE SECTOR IN GAIZHI Among the six cities where interviews were conducted, the private sector was very active in participating in gaizhi in Tangshan, Chengdu, Guiyang, and Hengyang. Open sales and leasing made up 33 percent, 43 percent, 37 percent, and 55 percent of gaizhi cases in those cities, respectively. Many of the leases and sales were to a private company. In Tangshan, many private entrepreneurs accumulated their wealth in the coal mining industry. As the central government began to limit the development of small coal mines, private owners looked for investment opportunities in SOEs. Many SOEs in Tangshan were poorly performing or had ceased production several years earlier. One factory producing mining machinery had been out of production for three years and had accumulated large bank and wage debts. The local government found a private businessperson who was willing to purchase the factory if half the 1,000 workers could be laid off. The government agreed and sold the factory for a substantial discount on book value. In 2002, most of Tangshan’s 15 gaizhi SOEs were sold to private businesspeople. In Hengyang, leases were more common than sales. An example is a factory that had produced industrial alcohol for 45 years. The factory had been renting out part of its buildings and equipment to employees to produce by-products such as carbon dioxide, but in 2001 it still carried a large debt, with a debt-equity ratio of 200 percent. In June 2002 a private businessperson took over the rental of most of the factory facilities and started new production. Sales doubled in the two months after the lease began. Selling or leasing to an outside private firm has increasingly become the main choice of local governments, for three reasons. First, private firms offer cash payments to buy an SOE, so the government is able to redeploy workers relatively easily. Second, private buyers exempt the government from having future obligations to the workers. And third, private owners are typically able to improve performance quickly.

lar patterns to the 11-city survey (see figures 1.10 and 1.12). Its two categories of “introducing new investment” and “spinning off” were largely equivalent to “internal restructuring” plus “public offering” in this study. Together they made up 30 percent of all the gaizhi cases, which agrees with the finding in this study. The figures for employee shareholding were also comparable: 21 percent in the 1998 survey 53


compared with 27 percent in this study. The share of sales and leases was almost the same in the two surveys: 27 percent in the 1998 survey and 28 percent in this study. The share of joint ventures was also similar: 3 percent in the 1998 survey and 4 percent in our sample. The incidences of bankruptcy differ. Only 5 percent of gaizhi cases were described as bankruptcies in the 1998 survey, but in our sample the share was 11 percent. This may be because the 1998 survey had a separate category for mergers, and 10 percent of gaizhi cases were reported as mergers, while this study combined mergers and bankruptcies. The 2001 national survey had some significant differences from the 1998 national survey and this study, although in some categories there were similar results (see figures 1.11 and 1.12). The incidences of open sales and leases were similar to the findings of the other two surveys, and the incidence of bankruptcy was comparable to that found by the 1998 survey. The 2001 national survey, however, reported more mergers and bankruptcies than either the 1998 or the 11-city survey. Trends and Geographic Variations There has been a clear trend toward selling or leasing out SOEs in recent years (see table 3.1). Before 1995 no firms were sold openly. In 2001 and 2002, open sales, leasing, and employee shareholding were the three most common forms of gaizhi, together making up more than two-thirds of gaizhi cases. More than one-fifth of gaizhi cases were open sales. The popularity of employee shareholding has declined somewhat. It was the dominant form of gaizhi in the late 1990s, representing nearly one-third of gaizhi cases in 1999. That share declined to less than one-quarter in 2002. Cases of internal restructuring were common in the 1990s but have declined rapidly since 2000. Joint ventures were popular before 1996 but have since declined. Public offering was a significant form of gaizhi in the mid-1990s but has declined considerably since then (see figures 3.3 and 3.4). The decline of public offering is perhaps due to the poor performance of China’s stock market. One measure of government support has been to control the supply of new shares by restricting the number of new IPOs. Bankruptcies were quite common in the mid-1990s, coinciding with the passing of the Bankruptcy Law and the provision of central government funds to write off the bank debts of bankrupt SOEs. 54

TABLE 3.1 FORMS OF GAIZHI BY YEAR, BEFORE 1995–2002 (percent)

Number of gaizhi

Public offering

Internal restructuring

Bankruptcy

Employee shareholding

Open sales

Leasing

Joint venture

30 13 40 32 50 53 54 64 34

6.7 0.0 15.0 18.8 8.0 9.4 5.6 3.1 2.9

20.0 23.1 22.5 37.5 34.0 34.0 20.4 7.8 11.8

3.3 23.1 27.5 12.5 2.0 1.9 7.4 18.8 11.8

30.0 7.7 17.5 25.0 28.0 30.2 31.5 29.7 23.5

0.0 7.7 7.5 3.1 12.0 5.7 14.8 20.3 23.5

16.7 7.7 10.0 3.1 16.0 17.0 18.5 20.3 23.5

23.3 30.8 0.0 0.0 0.0 1.9 1.9 0.0 2.9

Before 1995 1995 1996 1997 1998 1999 2000 2001 2002 SOURCE: Survey data.

55


FIGURE 3.3 Forms of GAIZHI in the First Round of GAIZHI Leasing 18%

Public offering 9%

Open sales 5% Internal restructuring 30% Employee shareholding 18%

Bankruptcy and reorganization 20% SOURCE: Survey data.

Many SOEs abused the bankruptcy system to avoid paying back bank debts. The common practice was to file for bankruptcy and then establish a new company under a different name on the same site (Gao and Yao 1999). The central government tightened up bankruptcy regulations, and incidences decreased in the late 1990s. As the number of cases of gaizhi rose again in 2000–01, however, so did the number of bankruptcy cases. The 11-city survey found that 19 percent of gaizhi cases in 2001 and 12 percent in 2002 were bankruptcies. It became clear during the field interviews with government and bank officials and enterprise managers that evading bank debts was still a significant motivation for gaizhi. The central government issued several decrees to discourage this trend, and the Supreme Court issued a decree that defined the evasion of bank debts through bankruptcy as an offense. There were significant variations among the cities in the forms of gaizhi (see table 3.2). Generally, internal restructuring was more popular in the northern and western cities. This was particularly true in Harbin 56

THE GAIZHI PROCESS

FIGURE 3.4 Forms of GAIZHI in the Most Recent Round of GAIZHI Public offering 11% Leasing 31%

Internal restructuring 14%

Bankruptcy and reorganization 4%

Open sales 21%

Employee shareholding 19%


and Fushun, where more than 40 percent of firms undertook this form of gaizhi. More than 50 percent of gaizhi cases in Xining and Lanzhou were bankruptcies. Employee shareholding was popular in Chengdu, Weifang, Huangshi, and Zhenjiang. Chengdu and Huangshi had high incidences of open sales. Leasing was heavily used in Hengyang. Most of the leases were signed between an SOE and an outside private company. (See box 3.1 for an example of leasing.) In general, gaizhi was more likely to result in real privatization in the fast-growing south and southwest (for example, Chengdu and Guiyang), while in the lagging north and northwest (for example, Xining and Lanzhou) gaizhi was more about internal restructuring. Restructuring is not a one-off event, but rather a continuous process. A total of 64 firms (24 percent) undertook two or three rounds of gaizhi. Among these 64 firms, 39 percent decided on public offering or internal restructuring in the first round of gaizhi (see figure 3.3). Another 20 percent went through a bankruptcy. All of the bankrupt firms were later sold or leased out. The remaining 41 percent 57

58

TABLE 3.2 GAIZHI BY CITY AND METHOD OF FORMATION (number and percent)

Harbin Fushun Tangshan Xining Lanzhou Guiyang Chengdu Weifang Huangshi Zhenjiang Hengyang

Number of gaizhi

Public offering (%)

Internal restructuring (%)

Bankruptcy (%)

Employee shareholding (%)

Open sales (%)

Leasing (%)

Joint venture (%)

40 10 57 18 11 41 21 34 54 45 49

7.5 0.0 8.8 11.1 0.0 4.9 4.8 14.7 7.4 8.9 4.1

47.5 40.0 26.3 22.2 9.1 26.8 14.3 14.7 11.1 26.7 16.3

2.5 20.0 10.5 50.0 54.5 7.3 0.0 11.8 5.6 2.2 16.3

22.5 20.0 15.8 16.7 27.3 19.5 38.1 50.0 38.9 44.4 6.1

10.0 0.0 15.8 0.0 9.1 19.5 38.1 2.9 22.2 2.2 6.1

10.0 20.0 17.5 0.0 0.0 17.1 4.8 0.0 13.0 6.7 49.0

0.0 0.0 7.0 0.0 0.0 4.9 0.0 5.9 1.9 8.9 2.0


THE GAIZHI PROCESS

TABLE 3.3 TRANSITION MATRIX BETWEEN TYPES OF GAIZHI IN THE FIRST AND MOST RECENT ROUND OF GAIZHI Last round First round

Bankruptcy and Employee Public Internal reorgani- share- Open offering restructuring zation holding sales Leasing

Public offering Internal restructuring Bankruptcy and reorganization Employee shareholding Open sales Leasing

4

1

0

0

0

0

0

4

1

4

5

6

0

0

0

2

2

7

1

1

0

5

4

1

0 2

0 0

1 0

0 1

1 2

0 6


adopted employee shareholding, or were sold or leased out. In the second and third rounds of gaizhi the combined share of public offering, internal restructuring, and bankruptcy declined to 29 percent (see figure 3.4). The share of employee shareholding was about the same as in the first round, but sales and leases made up 52 percent of all the cases. This shows that gaizhi has become more radical in recent years. Table 3.3 presents a matrix that compares the most recent round of gaizhi with the first round. The decisions taken in the most recent round were skewed toward the northeastern part of the matrix, meaning that they were more radical than in the first round. Of the 20 cases of internal restructuring in the first round, 16 firms adopted a more radical form of gaizhi in the second round, as did all 11 of the bankruptcy cases and 5 of the 12 employee shareholding firms. What Determines the Form of Gaizhi Chosen? In this section we analyze the factors that may have influenced the choice of different types of gaizhi. We group the forms of gaizhi into four categories: internal restructuring; employee shareholding; sales, 59


leases, and bankruptcies; and IPOs and joint ventures. Sales, leases, and bankruptcies are grouped together because they represent the most radical form of gaizhi. One difficulty with a regression analysis of firms that have undertaken gaizhi is that multiple rounds of gaizhi have occurred, with second and third rounds being usually more radical than the first. We deal with this difficulty by treating each round of gaizhi as a separate case. Internal restructuring is used as a reference group. The choice of the form of gaizhi results from the interaction of local governments and SOEs under their jurisdiction. Therefore, as explanatory variables we use sets of government/city and firm characteristics. The firm characteristics we use in the analysis are productivity gap,3 social burdens, net assets per worker, firm size, debt-equity ratio, and return on assets. The use of these variables in regression analysis will allow us to shed some light on questions regarding the factors influencing the forms of gaizhi. Does higher productivity of private firms in the same industry stimulate more radical forms of restructuring? How does the extent of redundant labor influence the form of restructuring undertaken? Are bigger firms more or less likely to undertake radical restructuring? What are the effects of capital per worker, financial leveraging, and profitability on the form of gaizhi chosen? Among the local government/city characteristics, we include fiscal capacity, level of private-sector development in the locality, and regional dummy. Are richer municipalities more likely to adopt radical forms of gaizhi, presumably because of higher capacity to absorb the short-term costs of layoffs and higher unemployment? Does a higher level of private-sector development make deeper restructuring more or less likely? Are regional factors important in determining the choice of gaizhi forms? The results are summarized in table 3.4. The productivity gap between private and state firms seems to be positively associated with more radical forms of gaizhi; however, the results are not statistically significant. More profitable firms are less likely to adopt employee shareholding relative to internal restructuring. They are more likely to adopt a form of gaizhi that falls in the cat-

3. For definitions see the notes to table 3.4. Productivity gap combines firm and sectoral characteristics.

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TABLE 3.4 FACTORS INFLUENCING THE CHOICE OF FORMS OF GAIZHI

Factor Productivity gapa Debt-equity ratio Return on assets Social burdensb Net assets per worker Firm sizec Private-sector developmentd Municipality fiscal strengthe North dummyf

Employee shareholding vs. internal restructuring Positive, not statistically significant Negative, not statistically significant Negative, not statistically significant Positive, not statistically significant Negative, not statistically significant Negative, statistically significant Positive, statistically significant Positive, statistically significant at 10% Negative, statistically significant

Lease, sales, and bankruptcies vs. internal restructuring

IPOs and joint ventures vs. internal restructuring

Positive, not statistically significant Negative, not statistically significant Positive, not statistically significant Positive, not statistically significant Negative, statistically significant Negative, not statistically significant Positive, statistically significant Positive, not statistically significant

Positive, not statistically significant Positive, not statistically significant Negative,not statistically significant Negative, not statistically significant Negative, not statistically significant Negative, statistically significant Positive, statistically significant Negative, not statistically significant

Negative, statistically significant at 10%

Negative, statistically significant

NOTE: All explanatory variables are lagged three-year averages. Method of estimation: multinomial logit. a. Productivity gap is equal to the relative difference between an SOE’s gross profitability and the average gross profitability of private firms in the same industry. b. Social burdens are worker redundancies, defined as the share of retirees and xiagang workers in the total labor force. c. Firm size is in thousands of employees. d. Private-sector development is measured as a percentage of private-sector employment in total employment in the respective locality. e. Fiscal strength of local government is in terms of government revenues per capita. f. The north dummy assumes a value of one if the firm is in the northeast of China. SOURCE: Authors’ estimates.

61


egory of sale, leasing, and bankruptcy. Neither result is statistically significant, however. Firm size has the opposite type of association with gaizhi. Larger firms are significantly less likely to choose employee shareholding or other forms of gaizhi over internal restructuring. Net assets per worker has a similar effect: it makes it less likely that more radical forms of gaizhi will be adopted. While the coefficients for both financial leverage and social burdens are statistically insignificant, it is interesting to note that they have opposing signs. It seems that debt burdens and social burdens have contrasting effects on the extent of restructuring and the form of gaizhi chosen. An important result is that the level of private-sector development makes it more likely that deeper and more meaningful forms of restructuring will be adopted. Municipal fiscal capacity has an impact on the forms of gaizhi. The stronger the fiscal position of the local government, the more likely it is for firms to go through employee shareholding, sales, leases, and bankruptcy relative to internal restructuring. Only the result for employee shareholding, however, is statistically significant at the 10 percent level. Finally, northern cities are more likely to restructure a firm internally than to adopt any other form of gaizhi, which is consistent with the geographic variations presented in table 3.2. In summary, it seems that government/local factors tend to have a larger impact than firm characteristics on the form that gaizhi will take. In particular, the regional dummy and the level of private-sector development in the region seem to have an important influence on the choice of gaizhi. Size is the most important factor among firm characteristics. The more radical forms of gaizhi involve the transfer of state assets to private owners. The rest of the chapter focuses on the aspects of the gaizhi process that deal with valuation and transfer of state assets. The Process and Main Issues Surrounding the Transfer of State Assets “State assets” refers to all productive and nonproductive assets that belong to the Chinese state, including natural resources such as un-

62

THE GAIZHI PROCESS

explored land, mining, and forestry.4 At the end of 2002, state assets were estimated to be around RMB12 trillion,5 excluding natural resources. Of this amount, about 65 percent (RMB7.7 trillion) were productive assets.6 Of the total, the central government’s share was 48 percent and that of the local governments 52 percent.7 The government normally requires nonproductive assets such as guest houses, hospitals, schools, and dining halls to be separated from productive assets by handing them and their employees over to local governments to manage. Local governments can turn nonproductive units into business entities through gaizhi after operating them for three years. In some cases, enterprises separate out nonproductive assets by establishing independent services firms with little help from local governments. The gaizhi programs can then focus solely on dealing with the firms’ productive assets. Firms beginning the process of gaizhi are required by local governments to follow an application and reporting process. Gaizhi firms must have their assets valued by an asset valuation agency and verified by the local asset management agency. A proposal should then be submitted to the local office of state enterprise ownership reform (see box 3.2). Local governments have used a number of methods to handle the transfer of state assets in gaizhi. These variations can be attributed mainly to their discretionary power, rather than to differences in policy frameworks, although there are some policy differences across regions. What follows is a stylized description based mainly on prevailing practices in the localities visited and existing regulations. The main approach for better-quality SOEs has been to package them for listing on the stock market. Firms must comply with stringent rules to qualify for an IPO, meaning that only the better-performing ones can avail themselves of this method. Until recently, a quota sys4. The definitions of central government and local government assets are vague. It is difficult to determine which assets resulted from central government investments and which from local governments’ subsequent investments (China Business Weekly, May 27, 2003). 5. GDP at market prices was RMB10.48 trillion at the end of 2002. 6. People’s Daily (overseas edition), June 5, 2002. 7. The real value of state assets could be higher because of the existence of extrabudgetary assets held by various levels of governments, as these are not included in official statistics.

63


BOX 3.2 A TYPICAL GAIZHI PROPOSAL A gaizhi proposal usually has the following elements: 1. A summary of the enterprise Name, sector, affiliation, main product, number of employees (including laid-off and retired workers), occupied land area, asset structures. 2. Performance Key indicators of performance during the past three years. 3. Enterprise assets: Current status and proposal for disposal Total assets, debts and net assets (both book value and market or current valuation), proposal for dealing with the net assets and the land. 4. Redeployment of workers Proposal for redeploying workers, contract for redeploying workers, pension, and medical coverage for retired workers, etc. 5. Form of gaizhi Form, scope, and content of gaizhi (e.g., governance structure). 6. Post-gaizhi business operation 7. Post-gaizhi development planning and forecast of economic efficiency Investment plan, governance structure, efficiency and risk analysis.

tem for listing was in place, which implied that only well-connected companies had a chance of accessing the market.8 The government has also encouraged strong SOEs to take over poorly performing SOEs through mergers and acquisitions, which have been occurring mainly among small and medium-size SOEs. If firms have negative net assets and have not qualified for bankruptcy because some of their assets are still valuable, they are allowed 8. The quota system began to be phased out in 1999 with the implementation of the Securities Laws. Many elements of the system continue to be in place, however (Cooper 2003).

64

THE GAIZHI PROCESS

to separate out their operating assets and set up a new legal entity. The new firm takes over part of the debts of the old firm in agreement with the major creditors.9 In most cases the new firm will raise funds for development through issuing shares to employees, managers, and outside investors. The government encourages managers to buy the majority of their firm’s shares.10 A government guideline, for example, suggests that shares sold internally should be distributed according to rank in the order of senior management, technicians, and ordinary employees. As a measure to encourage the purchase of shares, employees are able to defer payment of two shares for each share that they buy. If shareholders defer payments, they are able to receive dividends and have voting rights, but they have no rights of heritage or transfer over those shares. The deferred payments have to be settled within five years. Shares have also been distributed to employees in lieu of unpaid wages or retirement benefits. Government regulations also allow inventions and other intellectual property to be converted to shares after they have been properly valued and priced, dependent on the agreement of the shareholder conference. The principal managers of the new state-controlled shareholding companies can receive loans to buy up to 50 percent of the shares allocated to them from the state asset exit funds (see below) and are obliged to pay back the loan and the interest within five years. The new firm can start production by leasing some of the assets of the old firm. The leasing fees are used to pay allowances to laid-off workers, pensions, and medical expenses, and to repay debts. The old firm is allowed to go bankrupt when certain conditions are met. When an SOE is sold under the condition that the buyer takes over the debts and the responsibility for redeploying all the employees, there are several ways of deciding the price of the assets.11 When net assets are positive, the sale price will be determined according to the value of the net assets. (See the next section on asset valuation.) 9. During interviews it became apparent that some firms have tried to rid themselves of old debts, especially bank loans, either by establishing new firms or by going through bankruptcy (discussed above). 10. Recently, the central goverment has made pronouncements discouraging management buyouts of large firms. 11. Although the government prefers firms to sell their assets through auction, with a view that competitive bidding can determine more appropriate prices, in reality auctions are rare.

65


When a firm’s assets and debts are more or less equal, the firm could be sold based on a zero asset price. When net assets are negative, the debt may be reduced by the amount it would take to make total assets and debts more or less equal. The debt that has been deducted could be financed or compensated from part of the sale of land-use rights (see chapter 4), or by using the returns from state assets managed by the state asset management agency. Another method is to exempt the gaizhi firm from income tax until the zero net asset value is reached. The main priority of the local government for the sale of state assets is to use the proceeds to redeploy workers (see chapter 4), but in many cases the SOE’s net assets are negative. Three governmentsponsored funds exist to facilitate and reduce the costs of gaizhi: state asset exit funds, SOE bankruptcy provisional funds, and funds to assist retailers to prepare for enterprise reform. State asset exit funds provide a loan to the gaizhi firm to allow it to meet the costs of redeploying its workers. The loan must be repaid within five years. The funds are managed by authorized state asset management agencies or by finance departments of local governments. The funding comes from income earned from transferring ownership rights and selling or leasing state assets. The bankruptcy provisional funds are operated by the finance departments of local governments. They aim to meet the funding gap caused by delays in redeploying workers and disposing of assets during bankruptcy. Funds are normally for one year and are required to be repaid after the assets are eventually sold. The funds to reform retailing enterprises can be used to cover part of a firm’s negative net assets, to pay part of the cost of redeploying workers that cannot be met through selling the firm’s assets, or to compensate for any shortfall from selling and auctioning the firm’s assets. The funds come from the sale or auction of the net assets of state retailing enterprises, from the transfer of state shareholdings in retailing industries, from lease of the remaining part of state assets and dividends from state shareholdings in retailing industries, and from public finances. Not all regions have the ability to set up these funds. Wealthier provinces such as Guangdong have been better able to handle the costs of gaizhi, although local officials are still concerned about their ability to bear the costs, especially the costs of redeploying workers. Those regions where average incomes are low and the number of SOEs is high lack adequate government funding to support gaizhi programs, many 66

THE GAIZHI PROCESS

of which have stalled.12 Local governments have come under increased pressure to reform their SOEs as gaizhi programs have increased in coverage and extent, but some have demanded greater central government support for poorer regions or those with a higher concentration of SOEs. Social security contributions by the national government tripled between 1999 and 2002, while the overall level of government expenditures increased 1.9 times. Social security, however, still accounts for 4.1 percent of central government expenditures. At the same time, the level of local government subsidies by the national government has been flat at about 30 percent of total government expenditures (CEIC). A particular thorny issue is the problem of guarantees (collateral) that SOEs have extended to other SOEs. Gaizhi firms have been required to put aside, in a special account, a share of net assets equivalent to the amount required to cover their exposure. The account is supervised by the state asset management agencies. If a trigger event occurs, the gaizhi firm-guarantor can use the assets in this fund to perform under the guarantee arrangement. If the actual losses are larger than the amount the gaizhi firm has reserved to cover the losses, it is responsible for paying the difference. If no losses occur, or losses are smaller than the reserved amount, or the firm is able to recover some losses from acquiring assets from the bankrupt firm, the surplus will go to the original owner of the assets. During the interviews, a number of chief executive officers (CEOs) indicated that loan guarantees made by pre-gaizhi SOEs are a potential source of dispute between various stakeholders in gaizhi, because of fears that such commitments could add to enterprise debts. In employing these different methods for selling or transferring state assets, one of the state’s main concerns is to prevent the further loss of state assets while addressing issues such as the redeployment of workers. It is important, therefore, that the process of dealing with assets, particularly asset valuation and the policy of discounting the price of assets, is transparent and fair. Asset Valuation When carrying out gaizhi, firms must go through the procedures of asset valuation, the demarcation of ownership rights, and the verifica12. See chapter 1 for data on per capita incomes and other statistics across different sample cities.

67


tion of assets. Valuation is just a starting point, however. While it forms the basis for the sale or transfer of assets, discounts are often given by local governments to compensate the buyer for assuming more social obligations or to speed up the gaizhi process. Valuation is not an academic exercise; it is subject to the same interests as the gaizhi process. Valuation has to be perceived as fair if it is to be accepted by all the parties concerned. It is safe to assume that insiders (managers and employees) have informational advantages with respect to other players regarding the “true” value of the assets. Outsiders, including the government, can level out the playing field by using comparisons with other similar companies, and by relying on competition (that is, through auctions) to extract informational rents from insiders. Given the importance of procedural features, independent valuation professionals have become indispensable in the valuation process. China’s asset valuation industry has developed since the late 1980s; now more than 90 percent of its businesses deal with state assets. The industry is regulated by the 1991 State Council’s Regulation on the Management of State Asset Valuation. The Ministry of Finance is the principal administrative body responsible for the industry, but the ministries of Construction and of State Land and Resources exercise control over the licenses for conducting asset valuations, especially property and land valuations. The valuation industry is relatively young and struggling to overcome a number of problems. Local valuation firms often started life as specialist accountancy departments of central government ministries or regional administrations. There are layers of administration overseeing the industry but no uniform system of qualifications. The industry is fragmented because valuers specialize in particular areas, such as assets, property, land, mining rights, or vehicles. Chinese valuers are always under threat of having their licenses withdrawn if they undervalue state assets. In other common situations, their local license has been granted by a government authority that is also connected to the state assets being valued. As a result, a proportion of agencies do not act professionally and are influenced by local governments or gaizhi firms who make requests for a favorable valuation. Rules for professional ethics and conduct are evolving. There are several standard methods for valuing business assets: historical cost and realized incomes; replacement cost and business income; current cash equivalents and realizable income; and discounted 68

THE GAIZHI PROCESS

cash flows and economic income (Sterling 1971). Several structural features of the Chinese economy make the task of valuation difficult and restrict the applicability of some of the standard methods and techniques. For example, a major characteristic of the Chinese market is the high volatility and significant regional variation that leaves interpretation of older information almost meaningless. From inflation rates of over 25 percent in 1994, we have seen deflation in the late 1990s and early 2000s, and the recent reemergence of inflation. Low volume of transactions within certain sectors or regions, rapidly changing tariffs, unique local taxes, lack of transparency for sales, and an in-built tendency to control centralized information also make useful interpretation of available information difficult at best. As a consequence, using market comparables outside of the main cities and industrial areas is of little value, and the state authorities have been reluctant to accept the transaction approach as a basis for valuation of state-owned assets. The high degree of volatility in prices and markets also affects the accuracy of the income approach, which is based on a future cash flow model. As a result the income approach, where the value of an asset is linked to the benefits of future ownership, has not gained wide acceptance within the valuation community in China. In many cases it is not “sanctioned” by Chinese valuation firms and authorities, particularly when it might mean the recognition of redundancy or other permanent diminution in value of a state asset. Additional problems include the fact that expected rates of return can vary significantly between different analysts, and it is very difficult to get accurate historical accounts for most Chinese businesses. Consequently, this method is almost always rejected by local valuation firms and the authorities. The approach that is perhaps best understood and most widely applied in China is the cost approach. Information on costs is readily available, there are published standard price books for most types of machinery, and Chinese valuation firms apply standard depreciation periods for different types of machinery on a straight-line basis. As with any standard formula there is little application of the effect of individual circumstances, and economic obsolescence is rarely considered in the depreciation rates adopted. Imported equipment also presents a problem to local valuers, since they rarely bear in mind the regional pricing mechanisms of multinationals, differing exchange rates, and contrary inflation rates. 69


BOX 3.3 PROBLEMS AND MEASURES TO IMPROVE ASSET VALUATIONS 1. There is insufficient information to enable a fair valuation: (a) Accounting standards and the presentation of information need to improve. (b) Training is needed on the preparation of valuations and business plans. (c) A memorandum should be prepared showing the strengths and weaknesses of businesses. (d) Accurate costs and prices should be used. (e) A database should be created of past privatization prices to assist with future comparisons. 2. Valuations are uncertain: (a) Valuations will be higher if the political and economic environment improves, as investors will have more confidence and there will be fewer risk factors. (b) There is a need for policies that develop the profit orientation of companies, provide technical and business education, improve the tax system, assist with export promotion, and develop human resources. (c) Complementary channels of finance should be set up to fund the initial purchase and further development of companies. International financing should be enhanced through private institutions and international organizations. 3. There is no set methodology for valuations: (a) There needs to be a system for establishing a price using an “open book” methodology. Valuation agencies should be independent and objective.

In addition, as in Eastern Europe, China’s underdeveloped and distorted capital markets provide insufficient and unreliable information to allow sophisticated methods of asset valuation, such as priceearning methods, to be used (OECD 1993). Furthermore, intangible assets such as brand names, trademarks, and patents have been inadequately valued. Box 3.3 provides some suggestions and recommendations for improving asset valuations, based on the experience of Eastern European countries. Thus asset valuation in China takes place in a dynamic and complex environment. Some aspects of this environment—such as the fastgrowing economy, the underdeveloped capital markets, and the young 70

THE GAIZHI PROCESS

(b) Valuations need to take into account other elements than price, such as: • The percentage of control sold: If a minority shareholding is sold, consideration should be given to small investors and PER (price-earnings), DCF (discounted cash flow), or DCD (discounted dividends) methods used, as appropriate. In the case of majority shareholding, the conditions of market entry, and the synergy that the potential buyer will obtain, should be considered. • The methods of privatization will affect the valuation, as prices vary in cases of public offerings and auctions. (c) To avoid over- and undervaluation, in certain cases initial prices can be fixed and adjusted by pre-established formulae. Another system is that the purchaser is authorized to buy a certain percentage, with an option to acquire the remaining or a further percentage after a certain period at a fixed price or at the valuation at that date. The process of establishing a price should be objective but also take into account the positions of both sellers and buyers. SOURCE: OECD 1993, pp. 100–1.

and immature accounting profession—tend to increase uncertainty and therefore make it more difficult to agree on a “fair” price. Other factors, including some of the administrative rules governing asset valuation in China, may lead to serious overvaluation of state assets. For example, Chinese valuation firms work on a set fee scale that is based on the values reported; a higher value therefore generates higher fees. Furthermore, a valuer faces the risk of his license being withdrawn if it is determined that he has undervalued state assets. As a result, foreign companies often complain about serious overvaluation of assets in favor of the domestic partner, which is usually an SOE (Oxford Analytica 2002). Finally, there are powerful groups that benefit from 71


undervaluation of state assets. Anecdotal evidence suggests that asset appraisals often undervalued the assets to make them cheaper to buy. Although rules exist for registering and verifying the valuation outcomes, many cities had no effective mechanism of supervision over the valuation of assets. Media reports of cases of erosion of state assets have attracted a lot of public attention (see box 3.4). Irregularities have been associated with situations involving potential conflicts of interest, such as SOE managers choosing valuers, the practice of giving discounts to appraised value, and insider privatization, particularly MBOs. Given the potential conflicts of interest surrounding the valuation process, it is important to look at how the decision to select a valuer is made. The choice of a valuer can be made by either the government or the firm. The 11-city survey found that in the first round of gaizhi un-

BOX 3.4 FRAUDULENT CASES OF PRIVATIZATION State media have disclosed a number of fraudulent cases of privatization: • People’s Daily: Two SOEs in Shanxi province were taken over by a private firm at a cost of RMB230 million. The sale was later invalidated after the intervention of the provincial government, and the two SOEs were subsequently sold at auction to another private firm at a price of RMB64 million, around one-quarter the original price. One official was reportedly arrested for corruption. • CCTV: An SOE manager in Wuhan was fired by a district government when he requested a local court to void a privatization contract with a private firm and rejected the government’s instruction to withdraw the request. The district government had “helped” a local private company to acquire the land of the manager’s SOE at a unit price of RMB690,000, when other pieces of land nearby had been sold at a cost of RMB200,000. The unit price was determined by dividing the total estimated cost of labor settlement by the area of the land. The announced intention of the district government was to hide revenue from creditor banks. • The chairman of Jiahua Company, a Chongqing-based firm and the first case of a medium-size SOE privatization, was detained in April 2004 for possible theft of state assets during the privatization process seven years earlier. The success of this privatization had been widely publicized at the time.

72

THE GAIZHI PROCESS

TABLE 3.5 CHOICE OF VALUER BY FORM OF GAIZHI (percentage in parentheses)

Listed on the stock market Internal restructuring Employee shareholding Sale Lease Joint venture with foreign company Other Total

Government and firm Unreported

Only government

Only firm

12 (40)

11 (37)

7 (23)

0 (0)

30 (24)

35 (28)

28 (23)

30 (25)

28 (27)

31 (30)

21 (21)

23 (22)

11 (22) 9 (16) 0 (0)

11 (22) 14 (25) 1 (50)

11 (22) 7 (13) 0 (0)

16 (34) 26 (46) 1 (50)

1 (8) 91 (24)

2 (17) 105 (28)

6 (50) 80 (21)

3 (25) 99 (26)


dertaken by the sample firms, 38 percent of valuers were chosen by gaizhi firms, 33 percent by local governments, and the remaining 29 percent jointly by local governments and firms13 (see table 3.5). When the form of gaizhi does not involve formal change in ownership— for instance, in the case of internal restructuring and leases—the decision was more likely to be made by firms. As figure 3.5 shows, there is significant regional variation in the choice of valuation firm. It is common for buyers to receive state assets at a discounted price.14 Government regulations in Harbin, for example, allow the government to offer a discount when selling state assets. Buyers who purchase the whole business and make a one-off payment could receive a 30 percent discount. Those making a one-off payment covering 60 percent of the total assets could receive a 10 percent discount. After 60 percent of the value of assets, a half-percentage point discount can be given

13. Unreported cases are excluded from the calculations. 14. Li and Rozelle (2003), in their study on rural privatization in China, find that close to 23 percent of surveyed firms paid a price higher than the appraised value.

73


FIGURE 3.5 Choice of Valuation Firm in Eleven Sample Cities Chengdu Fushun Guiyang Harbin Hengyang Huangshi Lanzhou Tangshan Weifang Xining Zhenjiang 0

20

40

60

80

100

Percent Government

Firm

Both


for every percentage point increase in payment. The first payment should not be below 30 percent of the decided price, and payments should be made in installments, with guarantees given before the assets are transferred. Discounts can also be provided when the operators responsible for the transfer of state assets are authorized to do so by the state asset management agencies or government administrative departments to which the firm belongs. These agencies or departments are allowed to set the sale price above or below the valuation. Any discount is normally no more than 10 percent below the valuation. Discounts greater than 10 percent need the approval of the state asset management agency. It appears that government discounts on the net assets of gaizhi SOEs result in the loss of state assets, but local governments have to weigh these losses against other objectives, such as the need to meet their quotas for gaizhi or to maintain employment in the locality. Figure 3.6 presents data on the discounts given to gaizhi firms by local governments. 74

THE GAIZHI PROCESS

FIGURE 3.6 GAIZHI Cases with Price Rebates in Eleven Sample Cities Huangshi Harbin Guiyang Xining Tangshan Chengdu Lanzhou Fushun Hengyang Weifang Zhenjiang 0

5

10

15

20 Percent

25

30

35

40


The percentage of gaizhi cases that involved a discount on the firm’s assets ranged from 0 percent in Huangshi to 37 percent in Zhenjiang. Local governments often took into consideration the buyer’s ability to upgrade technology and provide employment. Figure 3.7 suggests that governments also favored SMEs. Table 3.6 reports the distribution of discounts across gaizhi firms. Most firms surveyed (ranging from 74 percent of those firms that underwent restructuring to 48 percent of listed companies) did not want to report whether they had received a discount in gaizhi. Firms that were sold were more likely to receive a discount. Regressing the discount rate on forms of gaizhi and firm size shows that open sales are likely to receive a higher discount rate and larger firms a lower discount rate (Li 2004). Smaller firms tend to receive discounts more often and in relatively larger amounts than do other firms. As shown in table 3.6, employee shareholding (MBOs) also shows a high propensity to benefit from discounts. Media reporting of irregularities in the process of MBOs has attracted considerable public 75


FIGURE 3.7 Discounts Provided to GAIZHI by Firm Size (percent of firms) Above RMB 2,000 million 17%

RMBt

0.35 −0.147 −0.124 −0.001 0.000 −0.23

0.02 0.04 0.037 0.00001 0.000 0.04

0.000 0.000 0.001 0.000 0.035 0.00

NOTE: Variables are averages over the time period. R2 is 0.2. SOURCE: Authors’ calculation.

governments in terms of lower privatization prices and/or the retaining of land-use rights. Nevertheless, layoffs have become a common practice. The average discharge rate5 in the sample is about 35 percent for the period between 1995 and 2001. Both gaizhi and non-gaizhi firms have shed labor. In fact, we estimate that the discharge rate for non-gaizhi firms is about 4 percent higher than that for gaizhi firms when controlling for asset size, firm obligations in arrears, and pre-gaizhi profitability. There are differences in the discharge rate by types of ownership. Using wholly state-owned enterprises as a control group, and controlling for asset size, overdue obligations, and pre-gaizhi profitability, we find that state-controlled firms6 have a discharge rate that is 14.7 points lower—and privately controlled firms have a discharge rate 12.4 points lower—than the discharge rate for wholly stateowned firms (see table 4.2). We also find that firms with higher overdue payments have a higher discharge rate, while larger firms and firms with a higher level of pre-gaizhi profitability have a lower discharge rate. All coefficients are statistically significant at the conventional 5 percent level.

5. Defined as the ratio of xiagang and laid-off employees over working, xiagang, and laid-off employees. 6. These are firms with diversified ownership, but still with majority (more than 50 percent) state control.

96


These are interesting and important findings, in our view, as they go against the conventional wisdom that restructuring and privatization are necessarily associated with more job losses. In the case of China, the opposite holds: over the sample period, when controlling for size and profitability, non-gaizhi firms and purely state-owned firms suffered larger job losses. To explore this relationship further, we look at the time pattern of the discharge rate relative to the year of gaizhi. We estimate the discharge rates for the years before, during, and after gaizhi using regression analysis and controlling for size, profitability, and type of gaizhi. The results are presented in figure 4.3. They show a clear stylized pattern: the discharge rate begins to grow four years before restructuring, reaches a climax in the first year after gaizhi, and then gradually begins to decline. Firms that went through a more radical form of gaizhi discharged (xiagang and layoffs) more workers in the year when gaizhi happened (see figure 4.4). The leasing firms discharged almost half of the total number of employees, and the firms that were sold out discharged more than half of the employees. Publicly listed firms have almost no layoffs, but we need to keep in mind that these firms typically undergo

FIGURE 4.3 Rate of Employee Discharge Four Years before and Five Years after Year of GAIZHI 0.20 0.16 0.12 0.08 0.04 0 Four

Three

Two

One

Gaizhi year

One

Two

Three

Four

Five

Sources: Survey data; authors’ estimates.

97


FIGURE 4.4 Rate of Employee Discharge by Type of GAIZHI in the Year of GAIZHI Public offering Internal restructuring Employee shareholding Sale Lease Other 0

10

20

30 Percent

40

50

60


significant restructuring in what has come to be known in China as “packaging for listing” (Tenev, Zhang, and Brefort 2002). Similarly, firms controlled by outsiders discharged more workers than firms controlled by insiders. The discharge rate in outsidercontrolled firms was 37 percent, but the figure was 32 percent in insidercontrolled firms. Inside an SOE there is often a set of implicit contracts that provide protection to all the employees in terms of job security and other tangible benefits. The more radical gaizhi is, the easier it is for the firm to fire workers, because radical gaizhi measures introduce into the firm outsiders who are not bound by these implicit contracts (Shleifer and Summers 1988). Beyond the first year of gaizhi, however, gaizhi firms have done better than non-gaizhi firms in the sample. Figures 4.5 and 4.6 show the time trends of the cumulative percentages of xiagang and laidoffs for the two types of firms. The contrast in terms of xiagang is dramatic. In 1995 the xiagang rate was under 10 percent of the total number of employees in both types of firms, with the non-gaizhi firms being slightly higher; but by 2001 the accumulated xiagang 98


FIGURE 4.5 Percentage of Accumulated XIAGANG in GAIZHI and Non-GAIZHI Firms, 1995–2001 Percent 80 60

Non-gaizhi firms

40 20

Gaizhi firms

0 1995

1996

1997

1998

1999

2000

2001

Note: The number of accumulated xiagang workers was calculated under the assumption that their average stay in the reemployment service centers was three years (reflecting the difficulty of gaining employment and the provision of a subsidy over the period that acts as a disincentive to seek employment). Source: Survey data.

FIGURE 4.6 Percentage of Accumulated Layoffs in GAIZHI and Non-GAIZHI Firms, 1995–2001 Percent 6 5 4 Gaizhi firms

3 2

Non-gaizhi firms

1 0 1995

1996

1997

1998

1999

2000

2001


99


rate had reached 70 percent in non-gaizhi firms, whereas it was 30 percent in gaizhi firms. The contrast in terms of layoffs, however, is less dramatic. In fact, gaizhi firms have maintained a faster pace than non-gaizhi firms in accumulating laid-off workers. This shows that gaizhi firms are more inclined than non-gaizhi firms to terminate the employment contract if they want to shake off their excessive employment. The finding that privatization had led to significantly fewer layoffs and xiagang workers after the first year of gaizhi is an encouraging one. Statistics for employment growth show similar results. Over the years, the size of the on-duty workforce has been shrinking in all the sample firms, and the reduction was accelerated in more recent years (see figure 4.7). Fully state-controlled SOEs had the highest rate of reduction in on-duty workers: an average annual reduction of 7.3 percent. The negative growth of on-duty workers in privately controlled firms was somewhat lower, at an annual rate of 5.7 percent. Firms with private shares but still controlled by the state had the lowest rate of negative employment growth, at an annual average of 3.1 percent. There was a convergence in more recent years, however. In 2001 the reduction rate was about 8 percent for all three types of firms. In short, we do not find that privatization is associated with larger job losses relative to the alternatives. When compared by the type of gaizhi, the reduction of the workforce has been the most radical in firms sold out and incorporated. On

FIGURE 4.7 Growth of the Workforce in the Sample Firms, 1996–2001 Percent 2 0 –2 –4 –6 –8 –10 Fully state-owned –12 1996 1997 Source: Survey data.

100

State controlled

Privately controlled 1998

1999

2000

2001


average, the number of on-duty workers decreased by an annual rate of 7.7 percent and 7.4 percent in those two types of firms, respectively (see figure 4.8). Again, unlike what happened in the first year of gaizhi, the reduction of the labor force in the subsequent years was not negatively related to the extent of privatization and restructuring. An observation to reinforce this conclusion is that outsider-controlled firms maintained a lower rate of reduction than insider-controlled firms. The average reduction in outsider-controlled firms was 3.6 percent, but the figure was 7 percent in insider-controlled firms. Regression analysis using the fixed-effect panel method, and controlling for asset size and overdue payments, confirms the above findings. We find that gaizhi firms had a workforce growth rate 1.78 percentage points higher than non-gaizhi firms, and that a state-controlled firm had a growth rate 1.84 percentage points higher than fully state-owned firms. Privately controlled firms also had a higher growth rate than fully stateowned firms, but the gap is statistically insignificant. The relative good performance of state-controlled firms may be related to self-selection; that is, the state may deliberately maintain control in firms with better growth potential. The fixed-effect estimation places a control for the selection

FIGURE 4.8 Average Growth of On-Duty Workforce by Type of GAIZHI in the Sample Firms, 1996–2001 Public offering Internal restructuring Employee shareholding Sale Lease Other –10

–8

–6

–4

–2

0

Percent Source: Survey data.

101


problem, however. An alternative explanation is that the state-controlled firms may continue to get help from the government, yet at the same time share in the benefits provided by the introduction of private shares. In addition to changes in the overall size of the labor force, restructuring can have an impact on the structure of the workforce. We look at the ratio of full-time to casual workers relative to the year of gaizhi. The ratios of full-time to casual workers are estimated using regression analysis, and the results are shown in figure 4.9. There is a clear trend toward a higher share of casual, most likely migrant, workers. This trend seems to predate the gaizhi process. Gaizhi seems to reverse the trend temporarily, but the process accelerates following the second year after restructuring. Firms that are privately controlled tend to have the lowest ratio of full-time to casual workers. A concern that is frequently raised regarding China’s industrial restructuring and privatization is that women may be more likely than men to lose their jobs in the process. We do not find evidence in our sample of a systematic bias against women. Anecdotal evidence suggests that female migrant workers are often the preferred type of worker by employers in China, as they are seen as a docile and hard-working labor force (Marquand 2004).

FIGURE 4.9 Ratio of Full-Time Workers to Casual Workers Four Years before and Five Years after Year of GAIZHI Percent 70 60 50 40 30 20 10 0 Four

Three

Two


102

One

Gaizhi year

One

Two

Three

Four

Five


In summary, our analysis suggests that gaizhi and privatized firms discharged more workers in the year when restructuring took place, but that over the sample period they shed less labor than non-gaizhi and wholly state-owned firms. This is an important finding, as gaizhi and ownership diversification have often been viewed in China as causing massive unemployment. The results obtained here show that within a relatively short period of time, restructured firms have a better labor performance than unrestructured firms. Gaizhi and Obligations of Firms to Workers During the central planning era, workers and staff were permanently employed by SOEs until they retired and received a pension from the enterprise. In the mid-1980s it was decided that new recruits would no longer have a job for life and would be hired under a term contract. In practice the situation changed very little, as most contracts were automatically renewed. In the mid-1990s a large number of SOE workers were laid off when enterprises went through gaizhi. Jobs in the new privatized enterprises were no longer as secure. For this reason, many argue that workers deserve to be compensated for the loss of job security and lifetime benefits. Some cities have compensated all SOE workers when their job contracts were terminated during gaizhi, regardless of whether they were to be made redundant or employed by the new owners. The ability of local governments to provide compensation under this system depends on whether the SOEs and the government are in a strong financial position. In Harbin, Chengdu, and Hengyang, a share of the SOE’s assets is used to compensate workers before the firm is sold. Only those workers made redundant, however, receive cash. Those workers who continue to work in the privatized enterprise are usually required to use their compensation to buy shares in the enterprise. The enterprise becomes a shareholding cooperative, although the management commonly holds the largest amount of shares. In other cases, funds are left in the firms to enable them to pay compensation in the future. In both cases it is possible that workers who stay with the firm may not receive the compensation directly. It has become more common for the funds to be looked after by enterprises, rather than to be given directly to workers. In some cases of gaizhi in Tangshan, the new owners received a discount on the price of the SOE assets on the basis that only 10 per103


cent of the workers would be made redundant and need compensation. This has reduced the government’s costs in gaizhi, especially in situations where SOEs have zero or negative net assets. It has also, however, made gaizhi more difficult in firms where there is serious overemployment. Whether the level of discount is acceptable to the new owners, who will have to bear the cost of any additional compensation, will depend on the attractiveness of other elements of the sales package. The municipal government in Guiyang has adopted a policy of formally discharging all workers during gaizhi, which is followed by a (re)hiring process. This policy has reduced the pressure on buyers, but, given that the private sector is underdeveloped and there are only limited job opportunities, there has been greater resistance from workers. In terms of the settlement of the redundant workers, non-gaizhi enterprises in the sample appear to have more generous social security provisions than gaizhi firms, but to be slower in paying workers’ wages. Table 4.3 shows overdue wages and other overdue payments, such as pensions or supplemental pension payments, xiagang allowances, and medical reimbursements, as a percentage of total wages in 2001. Gaizhi enterprises had a significantly lower proportion of overdue wages than non-gaizhi firms, possibly because of a combination of overdue wages being settled during the gaizhi process and because of an improvement in the financial situation of firms following gaizhi. The share of other overdue payments was higher in gaizhi than in nongaizhi enterprises, however. In non-gaizhi firms the amount of overdue wages amounted to 23.3 percent of the payroll in 2001, and the amount of overdue social security and other payments amounted to 21 percent of the payroll in the same year. Gaizhi firms have done much better in

TABLE 4.3 OVERDUE WAGES AND OTHER OVERDUE PAYMENTS AS A PERCENTAGE OF PAYROLL, 2001

Non-Gaizhi Gaizhi Total

Overdue wages

Other overdue payments

23.3 5.7 12.7

21.0 26.3 24.2

NOTE: The category “other overdue payments” includes overdue pensions, xiagang allowances, and medical reimbursements. SOURCE: Survey data.

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terms of overdue wages, reducing it to 5.7 percent of the payroll, but have been equally poor in paying social security, medical insurance, and other payments, as the total amount of these arrears was 26.3 percent of the payroll. Local governments have emphasized settling the overdue wages and other payments, and have often made this a condition in the privatization package. There are three major methods of settling overdue wages and other payments (see table 4.4). The first method is for the government to give the firm cash with which to pay its workers. The percentage of overdue payments settled by this method was low in the sample, only 1.6 percent. The second method is for the government to give the new owners discounts on the privatization price, usually taken on firm assets. This was quite common in the sample. A total of 22.6 percent of the overdue payments were settled in this way. The third method is for the firm to take on the task and to digest the overdue payments itself. A total of 66.6 percent of the overdue payments were settled in this manner. Table 4.4 breaks up the figures by city. Chengdu relied heavily on government subsidies to repay the overdue payments. Cash from the

TABLE 4.4 DISTRIBUTION OF METHODS OF SETTLING OVERDUE PAYMENTS IN THE ELEVEN SAMPLE CITIES, 2001 (percent)

Cash paid by government

Discount on assets

Borne by firm

Other

20.0 0.0 0.0 0.0 0.0 4.6 0.0 0.1 0.0 0.0 0.0 1.6

40.0 0.0 32.9 18.2 14.3 5.3 40.0 29.5 38.4 0.0 23.1 22.6

30.0 100.0 53.9 81.8 76.2 74.3 36.0 60.5 54.6 100.0 76.9 66.6

10.0 0.0 13.3 0.0 9.5 15.8 24.0 10.0 7.1 2.0 0.0 9.2

Chengdu Fushun Guiyang Harbin Hengyang Huangshi Lanzhou Tangshan Weifang Xining Zhenjiang Total SOURCE: Survey data.

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government digested 20 percent of all the overdue payments. Other cities seldom provided cash to repay overdue payments. (Huangshi had a figure of 4.6 percent and Tangshan 0.1 percent.) With the exception of Fushun, Huangshi, and Xining, discounts on assets were commonly used by all other cities, especially in Chengdu and Lanzhou. In contrast, the burden was 100-percent shouldered by the firm in Fushun and Xining. The gaizhi firms used different methods for deploying redundant employees. Most redundant workers (38 percent) found another job by themselves (see table 4.5). This is similar to the findings by Giles, Park, and Cai (2003), who report, based on data from the China Labor Urban Survey conducted in five Chinese cities in 2001, that 34.8 percent of individuals experiencing job separation were employed again within 12 months. A large share (26 percent) were classified as xiagang, most likely by enterprises that continued to be owned by the state after gaizhi. Far fewer redundant workers were reemployed in a

TABLE 4.5 DISTRIBUTION OF METHODS OF REDEPLOYING REDUNDANT WORKERS IN THE ELEVEN SAMPLE CITIES, 2001 (percent)

City Chengdu Fushun Guiyang Harbin Hengyang Huangshi Lanzhou Tangshan Weifang Xining Zhenjiang Total

Find new jobs

Enter reemployment center

Assigned to a separate entity in the firm

Hired by other firms, as arranged by the government

Other

71.6 19.0 29.0 26.2 36.6 40.5 40.7 35.3 4.4 65.6 45.1 37.5

26.5 67.0 14.1 50.6 15.7 24.9 23.3 37.4 37.5 20.4 4.5 25.9

1.9 0.0 7.5 11.8 21.8 21.6 10.0 1.9 12.2 8.0 9.8 11.6

0.0 6.3 10.2 2.1 1.0 1.0 0.3 0.0 0.0 0.0 9.7 3.0

0.0 7.8 39.2 9.3 28.7 14.7 25.7 25.5 43.9 6.0 31.1 22.9


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separate entity set up by the enterprise or by the government (12 percent and 3 percent, respectively). Methods varied from city to city. In Weifang only 4 percent of redundant workers had to find another job on their own, and 37 percent were classified as xiagang. In Huangshi and Hengyang, both in central China, a large proportion of workers were assigned to a separate entity set up by the companies. In Zhenjiang and Guiyang, around 10 percent of redundant workers were reemployed in entities set up by the local government. Reemployment is always the best solution for redundant workers and the state, because it lowers the cost of gaizhi. This is why governments give tax holidays and deductions to former SOE employees who start a business, or to new enterprises whose xiagang workers account for 60 percent or more of their workforce. Government departments and banks also help these firms with registration and access to bank loans. In some cases the government assists redundant workers in finding other work, but this practice accounts for only a small proportion of employee redeployment. When SOEs are sold, local governments can use part of the assets to compensate xiagang or discharged employees, or they can reduce the price of the assets (including land) to compensate the new owners for taking responsibility for employees who will have to be compensated if they are fired in the future. Many enterprises are sold at zero value, and in some cases the government pays extra subsidies to cover the redeployment of the employees. (See chapter 3 for details.) In Tangshan city, buyers of SOEs must agree to take responsibility for all employees and retired workers.7 The government compensates buyers for the future cost of redeploying workers by reducing the price of the assets on the basis that 10 percent of employees will be made redundant. The new owners frequently reported that the compensation was inadequate, as the cost of redeploying workers was much higher. There were also complaints from employees that state assets such as land were being sold off too cheaply.8 7. Workers and staff members retired from SOEs are covered by the new pension system. Pension payments are low, however; perhaps lower than the common pension rate in SOEs. Enterprises still have to pay the difference between the actual and common pension rate. 8. During the field study we found only a few cases in different cities of new owners complaining about the overvaluation of state assets.

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In Harbin the municipal government allows enterprises going through gaizhi to sell part of their assets to compensate employees who are being discharged. Land-use rights can be transferred if funds are inadequate. In Nan An district, Chongqing city, similar to the practice in Guiyang, the employment contracts of all SOE employees are terminated. Compensation is given before the enterprises are sold or declared bankrupt, regardless of whether workers will be reemployed by the new owners of the enterprises. This has made gaizhi much easier and eased the dissensions that occur after gaizhi. A large percentage of the district’s SOEs have completed gaizhi. The proportion of enterprises that have done so is much smaller in the other districts, which adopted a municipal government policy of redeploying employees after the enterprise went bankrupt. In these districts, state assets are used to pay off debt, leaving little for employee redeployment. If governments wish to compensate the employees before gaizhi, they need the consent of the creditor banks. Usually there also needs to be a large positive net value of state assets to cover the costs of employee redeployment. In Nan An district, land values are high and the sale of land-use rights has financed redeployment. In what is a typical practice for China, Guiyang has a policy that gaizhi plans have to pass a vote of the employee conference or employee representative committee. Employees in this city must agree with the decision to terminate their contract, and they should receive a lump-sum payment of two months’ wages for every year of service. Despite these relatively generous conditions, which were not common elsewhere, the gaizhi process in Guiyang was not easy. The private sector in the city was underdeveloped, and the prospects of finding new jobs quickly were poor. As shown in chapter 2, the development of the private sector in the local economy helps provide employment opportunities for redundant state workers and is a crucial factor for progress in gaizhi. Gaizhi and Changes in Compensation Schemes Approximately two-thirds of gaizhi firms have changed their worker remuneration schemes. Figure 4.10 shows the income shares that employees of gaizhi and non-gaizhi firms received in 2002 from fixed wages and salaries, piece-rate wages, bonuses, dividends, and other sources of income. Employees in both gaizhi and non-gaizhi firms 108


FIGURE 4.10 Employee Remuneration by Type in GAIZHI and Non-GAIZHI Firms, 2002 Percent 70 Gaizhi firms Non-gaizhi firms All firms

60 50 40 30 20 10 0

Fixed wage

Wage by piece

Bonus

Dividends

Other


earned most of their income from fixed wages, but the share was lower for those in gaizhi firms (at 46 percent of total income) than for those in non-gaizhi firms (at 68 percent). In contrast, gaizhi firms relied more on piece-rate wages to motivate their employees. They also gave slightly more in bonuses to their employees. Although non-gaizhi firms were not able to give shares to their employees, in gaizhi firms the practice was not that common— dividends made up only 1.7 percent of employee income. Gaizhi firms preferred performance-based incentives over rewarding employees through dividends. This can be seen as a rational choice on the part of the management, because the shares were dispersed throughout the firm, and dividends would not have been a particularly effective tool. There are examples, however, where the practice of “incentivizing” employees has been abused, resulting in assets stripping of SOEs.9 This chapter has shown that gaizhi firms have managed a smaller reduction in their workforce than non-gaizhi firms. It is of interest to 9. It was recently reported in the Chinese media that the whole management of a Beijing SOE was jailed after they collectively decided to give away RMB24 million to their employees as bonuses through various forms, including insurance policies.

109


know whether they have also improved the welfare of the workers left in the firm. Overall, gaizhi firms have maintained a higher growth rate in wage payments than non-gaizhi firms. Over the period 1995–2001, the average wage in gaizhi firms increased by an annual growth rate of 8.1 percent, whereas it was 5.3 percent in non-gaizhi firms. Figure 4.11 presents the time trend of the differences between the two groups of firms. With the exception of 2000, gaizhi firms maintained a higher growth rate every year than non-gaizhi firms. Econometric analysis of wage growth, controlling for asset size and profitability, confirms the main findings. Gaizhi firms maintained a growth rate that was 3 percentage points higher than that of non-gaizhi firms. While privately controlled firms were not statistically different from the fully stateowned firms, state-controlled firms achieved a growth rate 2.9 percentage points higher. Within the gaizhi firms, those having adopted more radical forms of gaizhi had achieved a higher growth rate for their average wages. Firms that were sold had a wage growth rate of 10.7 percent in the period 1995–2001, those with internal restructuring had 6.5 percent, and those going public achieved only 5.4 percent, almost half of that achieved in the firms sold to private owners (see figure 4.12). Consistent with this

FIGURE 4.11 Rate of Wage Growth in GAIZHI and Non-GAIZHI Firms, 1996–2001 Percent 14 Gaizhi Non-gaizhi

12 10 8 6 4 2 0

1996

1997


110

1998

1999

2000

2001


FIGURE 4.12 Average Wage Growth in Different Forms of GAIZHI, 1995–2001 Public offering Internal restructuring Employee shareholding Sale Lease Other –4

–2

0

2

4 Percent

6

8

10

12


divergence, firms controlled by outside shares registered a growth rate of 8.2 percent, as compared with 5.1 percent achieved by firms controlled by inside shares. Conclusion This chapter discussed some of the main issues concerning the impact of gaizhi on labor. A somewhat surprising result offered by this chapter is that gaizhi and privatized firms have maintained a lower rate of employment reduction and a higher rate of wage growth than nongaizhi and fully state-owned firms, respectively. Consistent with the conventional belief, gaizhi firms discharged more workers in the year when gaizhi was implemented than non-gaizhi firms, but they were able to afford to retain more workers in the subsequent years. Therefore, gaizhi and privatization in the long run create a win-win result for both employment and wage growth. Local governments face a dilemma in deciding who should bear the responsibility for state employees. Some governments do not have 111


the resources to compensate all SOE employees and so offer discounts on state assets to potential buyers of state firms. In places where the municipal governments have taken little responsibility for state employees, it is likely that the process of gaizhi will meet resistance. A strong policy implication is that governments need to encourage the rapid development of the private economy to lessen the overall burden of gaizhi.

112

5

Impact of Gaizhi on Corporate Governance Market reforms have resulted in a significant degree of insider control, as SOE managers have gradually acquired considerable discretion over the use of state assets. Expanding managerial autonomy was a necessary complement to market reforms, as managers needed the flexibility to respond to market signals. It has exacerbated agency problems, however, by enlarging the discrepancy between control and the ownership structure. The agency costs of this increased autonomy have manifested themselves in various incentives for managers to maintain or acquire private benefits of control through on-the-job consumption and other rents related to investment and expansion. Although much of the reform initiatives with respect to SOEs can be understood as continuous efforts to alleviate these agency costs (see Tenev, Zhang, and Brefort 2002, 20–24), the main issue that gaizhi—and privatization in particular—still has to solve is how to control the agency costs of managerial autonomy; in other words, how to improve the incentive structure and strengthen the accountability of managers. There are two main approaches to resolving agency costs: (1) through monitoring, and (2) by aligning managerial incentives with those of the owners, including by making managers owners. Gaizhi includes both approaches. Gaizhi repartitions rights and obligations regarding production and the distribution of its results among input owners. As such, it affects incentives and how the firm is governed. New owners are often introduced with different incentives and capacity to monitor managers. New institutions are established for the exercise of corporate control. Changes occur in the allocation of decision-making powers among various stakeholders, which affects the discretion that managers have to make decisions. Managers and employees become owners. This chapter examines the impact of gaizhi on corporate governance. Its focus is on the effectiveness of gaizhi in providing solutions 113


to the problem of agency costs of managerial autonomy. It asks several questions. What changes in ownership are occurring as a result of gaizhi? What is the relationship between ownership and actual control at the enterprise level? How does gaizhi affect the allocation of decisionmaking powers within the firm? In particular, has gaizhi had any impact on the role of the enterprise party committee? Are the new institutions for corporate control functioning? How does gaizhi modify the relationship between the firm and the state? Changes in Ownership Structure In theory, all Chinese SOEs are owned by the central government, which manages the state’s assets on behalf of the citizens. In reality, SOEs are under the control of different levels of government. In the mid-1990s, in response to falling SOE profits, higher-level governments started to transfer SOEs to lower-level governments in order to avoid the growing fiscal burdens (Yao and Yang 2003). The 11-city survey covered only SOEs owned by municipal and county/district governments.1Therefore, there was little variation in share distribution among the various levels of government. Gaizhi, in its more radical forms, brings new types of owners. There has been a steady decline in government shares in privatizing firms (see figure 5.1). Government shares as a percentage of total shares declined from 20 percent in 1995 to just above 10 percent in 2001, and the shares of other SOEs declined from nearly 50 percent to less than 30 percent. Therefore, both direct and indirect (through SOEs) state ownership has declined. What is surprising is the dominant form of indirect state ownership in the mid-1990s. This indicates that by the mid-1990s SOEs were playing a key role in spawning and restructuring other SOEs. Qian and Stiglitz (1994) and Qian (1995) describe one mechanism for such a role: a process of organizational transformation consisting of several rounds of joint ventures established by SOEs and their subsidiaries with other government and SOE partners. The process of organizational transformation results in several degrees of separation from the initial supervising authority, and therefore in an expanded managerial autonomy. In addition to increasing their independence from government, SOE managers were also motivated by a desire to 1. The analysis in this section focuses only on those firms with some ownership changes—thereafter called privatizing firms.

114


FIGURE 5.1 Shares of Ownership in GAIZHI Firms Held by Government and State-Owned Enterprises, 1995–2001 Percent 80

Government Other SOEs State total

60 40 20 0

1995

1996

1997

1998

1999

2000

2001


shift bad debts and overemployment burdens on to parent companies, and to undertake new business opportunities without losing existing connections to and benefits from the state. Often the state itself was playing the role of matchmaker between profitable and struggling SOEs. According to some estimates,2 about 50 percent of the mergers and acquisitions involving SOEs were “marriages” arranged by the government. Profitable SOEs have been less keen to take over unprofitable state firms in recent years. The process of M&As has become more market-based in recent years. We are seeing some strong SOEs participating in industry consolidation across provincial boundaries. Many of these strong SOEs are listed companies that are funding some of their acquisitions through primary and secondary stock offerings. A number of A-share companies have been acquiring nonlisted companies. Tsingtao Brewery acquired 2 factories in 1997, 5 in 1998, and 15 in 1999, all near bankruptcy. Shanghai Jinling, a company that produces and distributes electronic and communications products, has adopted the growth strategy of acquiring troubled SOEs in the sector and revitalizing them with improved incentive schemes for management. Some listed mining companies—for example, Yanzhou Coal Mining— have also acquired, or are planning to acquire, existing mines. 2. Private communications with officials from various government agencies.

115


With the emergence of nonstate players in the economy, the abovedescribed process of transformation has become a process of hybridization involving the combination of state and nonstate investments in new ventures. This hybridization can lead to very rapid changes in ownership patterns. Suppose that a parent SOE has a majority control in two SOEs with mixed ownership. Privatization of the parent automatically transforms the two SOEs into private companies. Thus, as outside SOE investors privatize themselves over time, the process of privatization accelerates. The increase in private shares has been strong in recent years. Among the various types of private owners, insiders have been the most active. Figure 5.2 shows the trends in private shares owned by various insiders within privatizing firms. In 1995 insiders held 5 percent of the total shares in privatizing firms, and most were owned by employees. Since then, the shares owned by middle and top management have increased rapidly. Of the 32 percent of total shares held by individuals in 2001, top management held 13 percent, just under the total employee shares of 18 percent. In a more limited study on gaizhi, Tenev, Zhang, and Brefort (2002, 34) find a similar percentage of senior management ownership. They find that in the transformed enterprises in Jianhua, Zhejiang province, natural persons held 76 percent of the shares, of which senior managers accounted for 20–30 percent.

FIGURE 5.2 Percentage of Shares Held by Managers and Employees in GAIZHI Firms, 1995–2001 Percent 35 30 25 20

Middle management Top management Employees Insider total

15 10 5 0

1995

1996


116

1997

1998

1999

2000

2001


Sixty percent of the managers in gaizhi firms held shares in the firm. This percentage is higher than was found by Tenev and Zhang (2002). Privately controlled firms were more likely than governmentcontrolled firms to give shares to the manager (82 percent, compared with 59 percent). On average, the manager owned 20 percent of the shares in 169 firms with valid answers. There were wide geographic disparities, however (see figure 5.3). Generally, managers in the southern cities owned more shares than those in the northern and western cities. Share ownership was particularly low in Xining, Lanzhou, Harbin, Fushun, and Guiyang. Chengdu granted managers the highest percentage of shares, on average 31.7 percent of the firm’s total. Domestic private firms have increased their ownership of shares in privatizing firms from 11 percent in 1995 to around 16 percent in 2001 (see figure 5.4), a much smaller rise than in the percentage of shares owned by insiders. Foreign investment as a percentage of total equity has declined. Foreign companies held 10 percent of total shares in privatized companies in 1995, but only 3.2 percent in 2001. The decline in foreign FIGURE 5.3 Percentage of Shares Owned by Managers in GAIZHI Firms, by City, 2002 Chengdu Huangshi Hengyang Tangshan Zhenjiang Weifang Xining Harbin Lanzhou Guiyang Fushun 0

5

10

15 20 Percent

25

30

35


117


FIGURE 5.4 Percentage of Shares of GAIZHI Firms Owned by Foreign Companies and Domestic Private Companies, 1995–2001 Percent 20 15

Foreign companies Domestic private companies

10 5 0

1995

1996

1997

1998

1999

2000

2001


ownership amid the rapid growth of FDI to China can be explained in part by the growing preference of foreign investors for wholly foreignowned enterprises as opposed to equity joint ventures. As figure 5.5 indicates, there is a very pronounced trend toward 100 percent foreign ownership at the expense of joint ventures. For instance, equity joint ventures accounted for 53 percent of all cumulative FDI by year 2002. In that year, however, equity joint ventures accounted for 30 percent of all projects involving foreign investment. The percentage shares for wholly foreign-owned enterprises were 34 and 65 percent, respectively. Another reason for the low and declining trend of foreign ownership is the negligent share of M&As in Chinese FDI. According to statistics of the United Nations Conference on Trade and Development, cross-nation M&A in China is less than $2 billion a year, accounting for only 5 percent of the country’s total FDI. Globally, M&As have been the key driver of global FDI flows since the late 1980s, accounting for about 80 percent of FDI.3 It is the government’s policy to encourage FDI in the restructuring of SOEs. By selling state assets to foreign companies or inviting foreign equity participation, SOEs can establish a modern enterprise sys3. See “Ten Major Trends in China’s Utilization of Foreign Investment,” Business Alert China, 6, June 1, 2003, http://www.tdctrade.com/alert/cba-e0306h.htm.

118


FIGURE 5.5 Types of Foreign Direct Investment in 2002 and Cumulative to 2002 (percent) Percent Year 2002 Cumulative to 2002

60 40 20 0

Equity joint venture

Contractual joint venture

Wholly owned foreign enterprise

Note: There is also a very small number of FDI projects that are classified as joint exploitation. They were omitted from the calculations. Source: Ministry of Commerce, PRC.

tem, improve corporate governance, achieve sustainable development, and increase their competitiveness. In November 2002 the government issued the Provisional Regulations on the Use of Foreign Capital for Restructuring State-Owned Enterprises. Along with the Circular on Issues Concerning the Transfer of State-Owned Shares and Legal Person Shares of Listed Companies to Foreign Investors, promulgated on November 1 by the SETC, the MOF, and the CSRC, it forms part of China’s policy on the use of foreign capital for restructuring SOEs. The enactment of this new legislation will further improve the legal environment for M&As of mainland enterprises by foreign businesses. As a result of China’s efforts to improve laws and regulations related to crossnation M&As, such approaches as equity injection, buy-out, share swapping, and cross-shareholding will become important modes of investing in China by multinational companies. The trend is expected to be more prevalent, as more SOEs are undergoing asset reorganization and being put up for sale. Foreign investors will be able to select their target enterprises and to acquire controlling stakes through these M&A approaches. 119


Overall, the percentage of shares held by domestic and foreign private companies has declined, while the percentage of shares held by individual insiders has risen dramatically. The decline in corporate shareholding has caused a decline in share concentration in the privatized firms. Figure 5.6 shows the shares of the three largest shareholders in the period 1995–2001. The share of the largest shareholder declined by about 20 percentage points from a high of 80 percent, whereas the share of the second- and third-largest shareholders remained in the range of 15–20 percent. The largest shareholder maintained a controlling position, with share ownership close to 60 percent in 2001. The ownership concentration of privatizing firms is quite high and seems to be higher than the ownership concentration of listed companies. In the case of listed companies, Tenev and Zhang (2002, 78–79) find, for example, that the average shareholding of the largest shareholder is 47 percent. Thus we observe a tendency toward ownership deconcentration among privatizing firms, as a result of reduced state shares and increasing individual shares, held mainly by insiders. At the same time, observers (Tenev and Zhang 2002) have noticed the tendency of company managers and outside investors to concentrate ownership at the expense of employees’ shares. Box 5.1 presents a case in which

FIGURE 5.6 Percentage of Shares Owned in GAIZHI Firms by Three Largest Shareholders, 1995–2001 Percent 90

60

30

0

1995

1996

1997

Largest shareholder Source: Survey data.

120

1998

1999

2000

2001

Second and third largest shareholders


BOX 5.1 A STALEMATE IN CHENGDU The first privatized SOE in Chengdu was a company that produced construction materials. In 1996 the company was sold to the employees and one outside private investor. The private investor bought 51 percent of the shares. There was no clear rule regarding the distribution of shares among employees, so the remaining 49 percent was grouped into a block share owned by all the employees. Responding to a call from the municipal government to relocate industry away from the downtown and surrounding areas, the company moved to a suburban industrial park and converted some old factory buildings, which were let out to tenants. The location was suitable and the company began to make money. The presence of the block of employee shares was a potential threat to the private owner, who tried to further privatize the block shares on the basis of the original values approved by the municipal government in 1996. Because the company’s value had increased, the employees wanted more for their shares and the plan failed. The private owner and the management persuaded the employee representatives to agree that the company could buy back the shares at the original price. Many employees felt cheated and drove away the management. They demanded rents from the tenant businesses, but many businesses refused to pay. By 2002 the occupation had been ongoing for two years, and the municipal government had been unable to mediate between the management and the employees. In addition, the management demanded that the squatting employees pay back more than RMB10 million in losses caused by their occupation, a demand that the employees firmly rejected.

the attempt by an outside investor to buy the employees’ shares led to conflict that has paralyzed the firm. There is no clear trend with respect to outside shares. Ownership and Control Gaizhi typically involves the establishment of new governance structures. The shareholder conference, the board of directors, and the board of supervisors are introduced as new institutions for the exercise of ownership rights. Some wholly state-owned firms may also 121


establish the new forms of governance if they decide to incorporate themselves. One-third of sample firms reported having a shareholder representative conference. About 60 percent of gaizhi firms had set up a conference. Forty-four percent of the firms reported having a board of directors. This figure was higher than the percentage of firms that had a shareholder conference, because some SOEs—such as incorporated SOEs—have boards of directors but not shareholder conferences. On average, the board had been set up for four years. Seventy-eight percent of gaizhi firms have established boards of directors. Privately controlled firms were more likely than government-controlled firms to have established a board: 92 percent compared with 88 percent. Among the wholly government-controlled firms, only 21 percent had a board of directors. Most of the firms (75 percent) elected the directors through a shareholder conference. Firms used different methods: 39 percent set the number of board seats in proportion to the number of shareholders; 36 percent set them in proportion to the number of shares held. A few firms gave the right to choose board members to either the board of directors or the management (see figure 5.7). There was no significant difference between privatizing and fully state-owned firms in this regard. Unlike in the shareholder conference, where the systems of one share-one vote and one person–one vote were similarly popular, the board of directors tended to rely on the latter system. Sixty-eight percent of the firms adopted the one person–one vote principle in decisionmaking by the board. Only 12 percent of the firms adopted the one share–one vote system. A total of 21 percent of privately controlled firms had instituted a one share–one vote system at their boards, while less than 9 percent of state-controlled firms had done so. In the sample, about half of the firms with a board had decided that the manager or the Party secretary would be board chairman (see figure 5.8). This is consistent with the study by Tenev and Zhang (2002). In 30 percent of firms the chairman was from the largest shareholder. There was no significant difference between privatizing and fully state-controlled firms. Managers were in strong positions. Not only was the firm’s manager often the board chairman, but, on average, the top management took 53 percent of the seats on the board and the middle management took another 17 percent (see table 5.1). 122


FIGURE 5.7 Method of Electing Board Members in China, 2002 Other 18% By shareholder conference in proportion to number of shareholders 39%

By board of directors 4% By management 3%

By shareholder conference in proportion to shares held 36% SOURCE: Survey data.

The following index describes the relationship between the composition of the board and the share structure of the firm (Xu, Zhu, and Lin 2002): I =

1 N

∑i (rsi

− rbi )

2

rsi is the ratio of shares held by the ith party, rbi is the ratio of board seats held by the ith party, and N is the number of parties. Seven parties are considered: the government, top management, middle management, workers, outside SOEs, outside private firms and foreign firms, and others. There were 207 firms that provided valid data. A low index number indicates a better match between the composition of the board and the share structure of the firm. The average for privatizing firms was 0.127, and the average for fully state-owned firms was 0.155. The difference was significant at the 5 percent level. The index also differed according to the dominance of government shares. It was 0.129 for 123


FIGURE 5.8 Method of Choosing a Board Chairman in China, 2002 Other 15%

By manager or party secretary 49% By the largest shareholder 30%

By the government 6% SOURCE: Survey data.

firms with a dominant government share, and only 0.096 for privately controlled firms.4 In addition, parties in outsider-controlled firms were slightly better represented than insider-controlled firms, with indices of 0.121 and 0.138, respectively. There were considerable differences among the cities. Harbin and Lanzhou had the highest degree of discrepancy between ownership and control structures, with indices of 0.172 and 0.167, respectively. Guiyang and Fushun were the next highest, with indices of 0.140 and 0.132, respectively. Huangshi, Zhenjiang, Tangshan, and Hengyang were in the middle, with indices in the range of 0.128 to 0.121. Weifang, Chengdu, and Xining had the best match between ownership and control structures, with indices of 0.119, 0.113, and 0.109, respectively. 4. In terms of benchmark, an index of 0 indicates a perfect match between ownership and control structures; a firm with a representative ownership structure, but where the largest shareholder controls all the board seats, will have an index of 0.133.

124


TABLE 5.1 ALLOCATION OF OWNERSHIP AND CONTROL OF GAIZHI FIRMS, 2002 (percent)

Government SOE Private firms Workers Top management Middle management Others

Shareholding

Board Seats

12 28 17 18 14 4 7

3 9 6 7 53 17 5

SOURCES: Survey data; authors’ calculations.

Table 5.1 shows that gaizhi firms and firms with greater private control had a better match between shareholding power and representation on the board of directors. Boards of directors are becoming more representative in Chinese firms. Gaizhi has been a catalyst in this process. The variations among the cities largely matched their progress in gaizhi. Have the new organs of corporate governance—the shareholder conference and the board of directors—begun to play a meaningful role in gaizhi firms? Figures 5.9 and 5.10 report data on the percentage of gaizhi firms that find the role of shareholder conferences and boards of directors, respectively, to be important or very important. A substantial number of gaizhi firms regarded the shareholder conference as important, especially in decisions on investment and profit distribution (see figure 5.9). Even then, though, the percentage of gaizhi firms that regarded the shareholder conference as important was only around 30 percent. The decision to call a shareholder conference was mostly made by the board of directors. Fifty-nine percent of firms said that it was a collective decision of a number of directors, while only 14 percent of firms said that a certain minimum number of shareholders could call a conference. A total of 13 percent of firms allowed the managers to call a shareholder conference, and 2 percent allowed the labor union to do so. These practices are not fully consistent with the principles of corporate governance found in developed market economies. The right of the managers to call a conference might be because, in many firms, management 125


FIGURE 5.9 Percentage of GAIZHI Firms That Find the Role of Shareholder Conferences Important or Very Important in Six Management Areas, 2002 Employment Wages Investment Managerial appointment Disposal of profits Production and marketing 0

5

10

15 20 Percent

25

30

35


comprises the board of directors. Unions are likely to have greater power in employee shareholding firms. The role of the shareholder conference was outweighed by that of the board of directors in every aspect of decision-making. Boards of directors were particularly important in decisions on investment and profit distribution, the two areas in which the shareholder conference had been the most involved (see figure 5.10). Most importantly, the board of directors was the most influential body for managerial appointment in the gaizhi firms. It did not have a heavy presence in production and marketing decisions, and only a medium input in employment and wage determination decisions. Managers were more visible in these decisions. The board of directors was the most influential governance body relative to all, including old and new structures, in the gaizhi firms. Currently in China, companies have two boards: a board of supervisors and a board of directors. There is confusion as to the respective roles of the two boards. For example, according to CSRC regulations and in practice, the audit function is run by the board of directors. At the same time, the Company Law gives the board of supervisors the 126


FIGURE 5.10 Percentage of GAIZHI Firms That Find the Role of Boards of Directors Important or Very Important in Six Management Areas, 2002 Employment Wages Investment Managerial appointment Disposal of profits Production and marketing 0

10

20

30

40 Percent

50

60

70

80


right to inspect the company’s financial situation. Furthermore, it is not clear who the board of supervisors is representing and to whom it is accountable. The Company Law specifies that the board of supervisors is composed of representatives of the company’s staff and workers, and of the shareholders, but it does not specify to whom the board of supervisors is accountable. The CSRC’s Code of Corporate Governance makes the board of supervisors accountable to all the shareholders. Therefore, the existing structure creates confusion as to the exact responsibilities and accountability of the two boards. This tends to diminish the role of the board of directors. Gaizhi and Traditional Stakeholders In China, new market institutions have been introduced without first dismantling the old practices. The coexistence of new and old institutions has been a distinctive feature of China’s process of institutional transformation. This is particularly pronounced in the area of corporate governance, where old traditional structures such as labor unions 127


and Party committees exist side by side with new institutions such as boards of directors and shareholder meetings. Gaizhi and the Influence of Stakeholders. Although gaizhi may not affect the absolute power of managers, it may have an impact on their relative influence vis-à-vis other stakeholders such as the government, the labor unions, and the Party committee. How does gaizhi affect the allocation of decision-making powers among these governance bodies? This section reviews the importance of the government, the Party, and the labor union in key decisions about employment, wages, investment, managerial appointments, the distribution of profits, and production and marketing. Privatization transfers ownership from the government to private hands, but it does not necessarily prevent the government from interfering in firm decisions. Figure 5.11 shows that the government was regarded as more influential in non-gaizhi firms than in gaizhi firms. The government is perceived to be most influential with respect to managerial appointment by both gaizhi and non-gaizhi firms. The gov-

FIGURE 5.11 Percentage of Firms That Find the Role of Government Very Important or Decisive in Six Management Areas, 2002 Employment Wages Investment Managerial appointment Disposal of profits

Gaizhi firms Non-gaizhi firms All firms

Production and marketing 0 Source: Survey data.

128

10

20

30

40 Percent

50

60

70

80


ernment also had an important role in the firm’s investment decisions, and played a significant part in decisions about employment and wage rates. In both gaizhi and non-gaizhi firms the government did not interfere unduly with the firm’s production and marketing decisions. This shows that the government has generally retreated from the daily operations of the firm. The biggest difference between gaizhi and nongaizhi firms is in the direct influence of the government over managerial appointment. We see a significant decline in this influence in gaizhi firms. This is perhaps the most significant impact of gaizhi on the power structure within the firm. The labor union was quite active in decision-making in non-gaizhi firms, especially on employment and wage decisions (see figure 5.12). In gaizhi firms the role of the union had declined, but it maintained considerable influence over employment and wage determination. This reflects the high degree of employee ownership in many gaizhi firms. Nonetheless, the diminished role of the union in gaizhi firms indicates that there has been a move toward the dominant international practice of involvement only in wage and employment issues.

FIGURE 5.12 Percentage of Firms That Find the Role of Labor Unions Very Important or Decisive in Six Management Areas, 2002 Employment Wages Investment Managerial appointment Disposal of profits

Gaizhi firms Non-gaizhi firms All firms

Production and marketing 0

5

10

15 20 Percent

25

30

35


129


Gaizhi and the Role of the Party. Of particular interest is the question of the role of the Communist Party, particularly in managerial appointments. Influential observers (Qian 2000; Qian and Wu 2003) have argued that reform of large SOEs has been a failure in China mainly because of the continued role of the Communist Party in the appointment of managers. Observers (Qian 2000; Chan and Wong 2003) have noted the dual impact of the Party on firm performance and incentives. On one hand, the Communist Party’s firm control over executive appointments is believed to have several negative consequences. First, the influence of Party committees on personnel appointments leads to skewed management incentives. Managers tend to spend considerable effort presenting the right political image and nurturing good relations with superiors in the Party hierarchy. Second, the system of internal checks and balances envisaged by the Company Law cannot develop. In particular, the board of directors cannot perform one of its key functions: to freely select, monitor, and fire the executive managers of the company. Third, the monopolization of executive appointments by the Party apparatus sets back the development of the managerial market. Managers can be transferred (promoted or demoted) to other SOEs suddenly and based on political criteria, without taking into account the interests of the company and its shareholders. The end result is that Party management curtails the effective monitoring of managerial behavior, distorts management incentives, and creates a tendency toward insider control. On the other hand, observers have argued that the Communist Party can help alleviate agency costs. Chan and Wong (2003), for example, find that the decision-making power of the local Party committee is positive for controlling the agency costs of the largest shareholder, and negative in terms of its impact on firm performance, for controlling the managers’ agency problems. On net, they find that the existing level of Party control is excessive and that reducing the decisionmaking power of local Party committees tends to improve the performance of China’s listed firms. The general perception is that Party committees are very influential. For instance, Freedom House, a nonprofit organization founded in the 1940s by Eleanor Roosevelt, states in its annual report on political freedoms, “All government offices, public schools, and state firms still have party committees that handle budgets, political education, and

130


FIGURE 5.13 Percentage of GAIZHI and Non-GAIZHI Firms That Find the Role of the Communist Party Very Important or Decisive in Six Management Areas, 2002 Employment Wages Investment Gaizhi firms Non-gaizhi firms All firms

Managerial appointment Disposal of profits Production and marketing 0

5

10

15 20 Percent

25

30

35


personnel decisions.”5 All Chinese SOEs contain branches of the Chinese Communist Party. Gaizhi firms have maintained this arrangement, and many private firms have also established Party branches.6 The key indicator of the relative importance of the Communist Party in making decisions is the percentage of firms that regarded the Party as “very important” or “decisive.” In the sample the Party branch was found to be more active in the non-gaizhi firms relative to the gaizhi firms in terms of all firm decisions, except in appointing the manager (see figure 5.13). The Party, however, is not perceived to have an important 5. Freedom House, 2003, http://freedomhouse.org/research/freeworld/2003/ countryratings/china.htm. 6. According to Chinese media, only 14 percent of the private firms have established Party branches (People’s Daily 2001). With the implementation of the “new theory of the three represents” the percentage has probably increased. According to The Economist (2002), only 17 percent of private firms employed Party members in 1999 and just 3 percent had any kind of Party organization. Only 35 percent of the foreignfunded enterprises employed Party members that year, and a mere 17 percent had Party cells.

131


or decisive direct influence on managerial appointments in either gaizhi or non-gaizhi firms. Only in 18 percent of gaizhi and 13 percent of nongaizhi firms does the branch of the Communist Party play an important role in managerial appointment. In non-gaizhi firms, managerial appointment is the type of decision where the role of the Communist Party is the least important. Therefore, while the gaizhi process does not diminish Party control over managerial appointment, Party control is already low prior to the transformation process. In fact, gaizhi firms report a greater role of the Party in managerial appointment than do nongaizhi firms. The situation is different, however, in outsider-controlled gaizhi firms. In those firms the role of the Party in managerial appointment is lower than in gaizhi firms (see Figure 5.14). This can be interpreted as evidence that the Party acts as a countervailing force to managerial power in the case of insider-controlled firms. The Overlap between New and Traditional Institutions. An important issue in gaizhi firms is how to divide the firm’s functions between the new institutions representing the shareholders and the traditional orFIGURE 5.14 Percentage of GAIZHI and Non-GAIZHI Firms That Find the Role of the Communist Party in Insider- and Outsider-Controlled Firms Very Important or Decisive in Six Management Areas, 2002 Employment Wages Investment Managerial appointment Disposal of profits Insider-controlled Outsider-controlled

Production and marketing 0 Source: Survey data.

132

5

10

15 Percent

20

25

30


ganizations of social control, such as the workers’ congress, the Party committee, and the trade unions. The standard approach has been to combine the leadership or functions of various institutions. The usual practice is to combine shareholders’ and workers’ congress meetings, and to have the same person serve as chair of the board of directors and secretary of the Party committee. Many enterprises hold joint meetings of various representative bodies. This overlap provides a sense of continuity, a sort of translation between the old institutional language and conceptual framework and the new ones. It therefore facilitates adaptation to the new rules. At the same time, the coexistence of the old and new institutions is creating confusion about the division of labor and the procedures to be followed in performing various functions. For example, the combination of shareholders’ conference and workers’ congress is creating confusion about the voting process, especially in employee-owned firms. Both the one person–one vote and the one share–one vote systems of majority decision-making are common in shareholders’ conferences. More than 80 percent of the firms that have established shareholders’ conferences have adopted one of these systems. Forty-one percent of gaizhi firms with shareholders’ conferences voted on the basis of one share-one vote, and 42 percent followed a system of one person-one vote. As mentioned above, some firms were allowing labor unions to call a shareholders’ conference. The overlap between the old and the new corporate bodies is providing a channel for political influence on corporate governance. Under the so-called Concurrent System, top enterprise leaders have tended to act both as Party secretaries and as chairs of the board of directors. In our sample, almost half of the chairmen of the board are also Party secretaries. As a result, the role of Party secretary is often fused with that of the chairman of the board of directors. To achieve the objectives of the Corporate Law and improve corporate governance in China, the practices of the Concurrent System should be discouraged and the new bodies of corporate governance permitted to function independently. Gaizhi, Managerial Autonomy, and Managerial Incentives How is gaizhi affecting managerial autonomy with respect to key decisions about employment, wages, investment, managerial appointments, the distribution of profits, and production and marketing? Figure 5.15 133


FIGURE 5.15 Percentage of GAIZHI and Non-GAIZHI Firms That Find the Role of the Manager Very Important or Decisive in Six Management Areas, 2002 Employment Wages Investment Gaizhi firms Non-gaizhi firms All firms

Managerial appointment Disposal of profits Production and marketing 0

20

40

60

80

100

Percent Source: Survey data.

shows the percentage of firms that regarded the manager as important or decisive in the issues under consideration. The manager played the most important role in decisions related to employment and the daily operation of the firm. The manager also had a significant role in decisions on investment, but a lesser role in decisions on profit distribution. Only a small proportion of the firms believed that the manager was very important in determining his or her own appointment. There was no significant difference between gaizhi and non-gaizhi firms with respect to managerial influence. Management has acquired significant discretion and power in non-gaizhi firms. Gaizhi does not seem to affect the influence of management, though it seems to have somewhat limited the manager’s power over financial decisions—in particular, with respect to the allocation of profits. How is managerial influence and control exercised? One channel is through control over the collective bodies of corporate governance such as the board of directors. In our sample, in many firms, the power of managers who were also board members is considerable. Sixty-one percent of managers were also the chairman of the board. The figure 134


was high in gaizhi firms and privately controlled firms (69 percent), but low in firms that were controlled by outside investors (32.3 percent). China has a relatively high degree of separation between chief executive officer and chairman of the board in its listed companies. According to the Tenev and Zhang (2002) study, in about three-quarters of the listed companies the CEO and chairman are separate people. Debates continue in China, however, as to whether the positions of CEO and chairman should be combined or separated. It is important to note that, despite the relatively high degree of separation between CEO and chairman, power is frequently concentrated in Chinese companies in the legal representative, the so-called key person, who used to represent the state and is the chairman of the board. As a practice of company regulations in China, every enterprise must appoint a legal representative. By definition, the legal representative represents the enterprise in question in every matter, large and small. He or she can then delegate such powers to another person unless such powers may not be delegated under the law or the articles of association. This can lead to situations where the chairman takes on roles and functions that should belong to the CEO. For improved corporate governance, this practice will have to change in favor of an allocation of powers that is in line with the respective roles of the CEO and the chairman of the board. In the aftermath of recent corporate governance scandals, there is an emerging consensus globally about the need to split the chairmanship of the board from the chief executive position in a company. It has become clear that if a CEO of a company is also the chairman, the board agenda is set by the management and all the information available to the board is filtered by the management. It is therefore more difficult for the board to obtain the information that allows for independent judgment of the company. Also, the two positions are full-time jobs that require different skills and experience. In the United Kingdom, in more than 90 percent of companies the chairman of the board and the CEO of the company are separate people. In the United States the debate is ongoing, but an influential commission chaired by Treasury Secretary John Snow has recommended splitting the CEO–chairman job. Given the concentration of power in management, what mechanisms exist to align the incentives of managers with those of owners and the interests of the companies? As discussed above, managers are becoming significant owners themselves. Ownership is just one compo135


nent, however, of the overall compensation and incentive structure of Chinese managers. The shape and form of incentives are important for eliciting good performance from managers. Overall, 24 percent of sample firms linked the manager’s performance to the amount of shares held, and 25.2 percent linked it to the level of wages. Gaizhi firms were more likely to provide bonuses to their managers than non-gaizhi firms: 39 percent of gaizhi firms, as compared with 14 percent of non-gaizhi firms. Accordingly, 43 percent of privately controlled firms gave bonuses to their managers, whereas the percentage was 39 percent among government-controlled firms and only 17 percent among fully government-owned firms. In addition, outsider-controlled firms were more likely than insider-controlled firms to offer such incentives (41 percent, compared with 21 percent). Together with Guiyang, Lanzhou paid the lowest share of bonuses at only 23 percent of the manager’s total income (see figure 5.16). Managers in the other cities relied heavily on

FIGURE 5.16 Percentage of Bonuses in Managers’ Total Income in Ten Sample Cities, 2002 Weifang Chengdu Tangshan Xining Hengyang Huangshi Harbin Zhenjiang Lanzhou Guiyang 0

10


136

20

30

40 Percent

50

60

70

80


such incentives. In Weifang, bonuses made up more than 70 percent of total wages on average, with only a small portion of the manager’s income coming from a fixed salary. The firms in the survey were much more willing to provide bonuses to their managers than were the publicly listed firms covered in Tenev and Zhang’s study, which found that bonuses made up only 24 percent of managers’ incomes on average (Tenev and Zhang 2002, 92). Whether this is a contrast between publicly listed firms and unlisted firms is unknown and remains a topic for further research. There is lively debate in China about the reform of the compensation system of company managers. The growing disparities between the level of remuneration of top managers in some large SOEs and ordinary workers’ wages are also attracting considerable attention.7 The current compensation systems of company managers in China suffer from serious weaknesses. First, significant discrepancies exist between the salary levels in different types of companies, indicating an underdeveloped managerial market. Second, the implicit benchmarking of management salaries to the compensation levels in the civil service tends to persist. Finally, there are some legal and regulatory barriers to the introduction of modern compensation mechanisms. For example, the Company Law does not provide any basis for issuing share options; companies cannot reserve unissued shares and grant vested rights to acquire such shares in the future. Some companies, however, are able to structure innovative contracts that link management’s compensation with the firm’s performance (see box 5.2). In this area, China, as a latecomer, can benefit from the extensive debates and analysis done post-Enron regarding management compensation and stock options and create a framework for compensation policies that allows for better links of compensation to performance. It is essential, however, that actual compensation policies are set by the board of directors and not by management or government agencies.

7. According to media reports, the average annual salary of senior managers of SOEs under central SASAC was RMB350,000 in 2003, or 13.5 times that of all employees, which stood at an average of RMB24,000. Central SASAC Party Secretary Li Yizhong was reported as saying that any gap exceeding 12 times is not acceptable.

137


BOX 5.2 THE MANAGEMENT INCENTIVE SCHEME OF TCL GROUP The successful IPO of TCL Group, a Guangdong-based SOE group specializing in the manufacture of TV sets and electronics, attracted media attention when its senior managers turned themselves into millionaires overnight. Each of the top four managers owns shares in the newly listed group that were worth over RMB100 million at the time of the IPO. The group’s chairman, Li Dongsheng, has a stake of 9.1 percent in the company, which is worth RMB616 million. TCL management’s innovation was to acquire ownership stakes in their company not by MBOs or other forms of privatization, but by means of a contract with the municipal government of Huizhou, which represents the state in the company. The contract enabled management to claim bonuses for themselves when the value of the ownership stake of the state appreciated, and to convert those bonuses into shares in the company. Before the IPO, the management held 25 percent of the company, with another 17 percent held by employees.

Gaizhi and Changes in the Relative Influence of Stakeholders Gaizhi thus leads to significant changes in the relative influence of traditional stakeholders. Table 5.2 summarizes these changes by comparing gaizhi and non-gaizhi firms. It shows the rank of influence of each stakeholder in each area of decision-making in the gaizhi firms, together with the change in rank relative to the non-gaizhi firms. The roles of the government and the Party in all aspects of firm decisions were considerably weakened after gaizhi. It is important to note, however, that the government retains significant influence in managerial appointments within gaizhi firms. While the decision-making power of the labor union diminished in most firm decisions, the union actually increased its role in employment and wage decisions. Overall, gaizhi seems to be neutral with respect to the decision-making powers of management. We do see, however, changes in some decisions. There is a somewhat reduced role for management in investment and profit distribution decisions. The results on the relative influence of the board of directors and the shareholders’ conference are encouraging. It seems that these new bodies are becoming functional. The board of directors was the most influential body in exactly the areas where its power is expected to 138


be the highest: managerial appointment, large investments, and distribution of profits. There is a significant increase in the relevance of the shareholders’ meetings in gaizhi relative to non-gaizhi firms (see figure 5.17). It is important to note, however, that the power of the board of directors is a derived power. The board of directors is an arena where various stakeholders are represented and are struggling for control. As indicated in table 5.1, managers have the strongest type of control over the board of directors, where they are significantly over-represented and control more than half of all seats. Thus we have a situation in the gaizhi firms whereby the board of directors is influential in managerial appointment, but managers control the board. The government is also influential in managerial appointment but is not represented on the board. Thus when we take into account the indirect influence through the board of directors, it seems that gaizhi has further strengthened the power of enterprise managers. In the next section we consider which players and institutions are emerging to control the agency costs of managerial autonomy. The Role of Outside Investors in Corporate Governance Survey results suggest that the presence of strong outside investors is associated with a reduced role for traditional stakeholders. For instance, the government, the Party, and the labor union had less significant roles in outsider-controlled firms than in insider-controlled firms. The most significant difference in influence was in the role of the Party (see figure 5.14). Many outsider-controlled firms were owned by private firms and businesspeople who were not attached to the old structures. The labor union still had an important role, however, in wage determination in these firms: 29.4 percent of insider-controlled firms and 28.8 percent of outsider-controlled firms regarded the union as important in wage determination. At the same time, firms controlled by outside investors were more likely to rely on the new institutions of corporate governance. The shareholder conference was more important in outsider-controlled firms than in insider-controlled firms. In decisions related to investment, 22 percent of outsider-controlled firms believed that the shareholder conference was important; in decisions related to profit distribution, 28 percent of outsider-controlled firms believed it to be important. The percentages for 139


TABLE 5.2 INFLUENCE ON DECISION-MAKING OF VARIOUS STAKEHOLDERS IN GAIZHI VERSUS NON-GAIZHI FIRMS, 2002 Government

Management

Labor

NonNonNonGaizhi gaizhi Change a Gaizhi gaizhi Change a Gaizhi gaizhi Change a

Decision Employment Wages Investment Managerial appointments Distribution of profits Production and marketing Average (net change)

5 4 4 2

3 2 2 1

−2 −2 −2 −1

1 1 2 3

1 1 1 5

0 0 −1 2

3 3 5 6

4 4 3 3

1 1 −2 −3

5

4

−1

2

1

−1

4

3

−1

6

4

−2

1

1

0

4

2

−2

4.3

(−10)

1.7

(0)

4.2

(−6)

Note: The highest rank is 1, and the lowest rank is 6. a. Gaizhi relative to non-gaizhi firms.

FIGURE 5.17 Changes in the Relative Influence of Various Stakeholders in GAIZHI versus Non-GAIZHI Firms, 2002 Government Management Labor Party BOD Sh. Conf. –20

–15

–10 –5 0 5 10 15 Cumulative changes in influence ranking

Sources: Survey data; authors’ calculations.

140

20

25


Party Gaizhi

Board of directors

NonGaizhi Changea

Gaizhi

Shareholders’ conference

NonGaizhi

Changea

Gaizhi

NonGaizhi

Changea

4 6 6 3

2 3 4 2

−2 −3 −2 −1

2 2 1 1

5 5 5 4

3 3 4 3

6 5 3 3

6 6 0 0

0 1 3 3

6

2

−4

1

5

4

3

0

3

5

2

−3

2

5

3

3

0

3

5.0

(−15)

1.5

(20)

3.8

(13)

insider-controlled firms were 14 percent and 13 percent, respectively. Firms controlled by outside investors were also more likely to adopt a share-based voting system than were firms controlled by insiders (50 percent versus 42 percent). Controlling outside investors are also more likely to restrict managerial powers, particularly in areas such as financial management, and to provide high-powered incentives to managers. See box 5.3 for an example of the role that some outside private investors have played in the corporate governance of acquired state firms. While outsider- and insider-controlled firms showed no significant differences in the other aspects of decision-making, outsider-controlled firms were more cautious than insider-controlled firms in granting the manager decision-making power over investment and profit distribution. Of the insider-controlled firms, 38 percent believed that the manager was decisive in investment decisions and 37 percent said the same for profit distribution decisions. The figures for outsider-controlled firms were 21 percent and 16 percent, respectively. Firms that were controlled by outside investors had relatively new managers. In those firms, 53 percent of managers had previously been employees, but the share was 70 percent for other firms. The managers had been in their posts for an average of 4.3 years, which was a shorter 141


BOX 5.3 THE SUCCESSFUL EXPERIENCE OF NEW HOPE GROUP IN REFORMING SOES The New Hope Group was founded in the early 1980s by four brothers of the Liu family. The group is mainly engaged in animal feed, food processing, banking, real estate, chemicals, and dairy businesses. Mr. Liu Yonghao, one of the brothers, is a high-profile entrepreneur whose leadership has propelled this family-owned business to one of the most prominent success stories in Chinese private enterprise. While initially New Hope Group grew organically by reinvesting accumulated earnings, recently acquisitions of SOEs have become the main pillar of its growth strategy. In 2000 New Hope, jointly with the International Finance Corporation, the private-sector arm of the World Bank Group, invested in Chengdu Huarong Chemicals, a bankrupt SOE in the chemical sector. Although the newly acquired state-owned company was bankrupt, it had advantages over developing a plant from scratch, due to existing facilities and experienced employees. After three years the company increased sales from less than $10 million to more than $30 million, and has been successful in maintaining employment of about 500 regular employees. The New Hope Group is also rapidly becoming one of the most prominent players in China’s emerging dairy industry. Encouraged by the success in acquiring Chengdu Huarong, and enticed by the prospects of the dairy industry in China, the group moved into the sector with the acquisition of a state-owned dairy plant in Sichuan province in October 2001. Subsequently, New Hope acquired 12 state-owned dairy plants in southwestern, eastern, northern, and northeast provinces. Most of the acquired companies are leaders with solid brands and loyal followings in their local markets. New Hope plans to double its production capacity by 2008. The New Hope Group brings capital, committed management, and strict financial control to its investee companies. Investments in target companies are made through a holding company that is listed on the domestic stock exchange. Since the holding company needs to present consolidated financial statements, the acquired companies are subject to the discipline of the stock market. They need to provide frequent, detailed financial results to the parent company and receive frequent inspection visits from headquarters. Strict control is also evidenced by the fact that it is the policy of the group for the financial officers in acquired companies to be (continues)

142


BOX 5.3 (CONTINUED) appointed by the board of directors, and not by the general manager as is typically the practice in China. The general manager and the chairman of the board are different persons in the acquired companies. SOURCE: Survey data.

period than the 5.8-year average for other firms. Since the entry of outside investors is a relatively new phenomenon, the shorter tenure of their managers suggests that these investors changed the management when they became involved with the firm. Furthermore, outsider-controlled firms were more likely to separate the positions of CEO and chairman of the board. While managers were also the chairman of the board in 61 percent of the gaizhi firms, the figure was 32 percent in firms that were controlled by outside investors. At the same time, outsider-controlled firms were more likely than insider-controlled firms to offer incentives to managers: 41 percent compared with 21 percent. Conclusion The above analysis shows that the government has retreated from the privatizing firms by reducing its shares in those firms to less than 10 percent. The shares of employees and outside investors have increased rapidly. The influence of the Communist Party over the firms has also declined, but the role of the labor union in collective wage bargaining has been more clearly defined and enhanced. Gaizhi has improved incentives for managers, because firms are more likely to provide them with shares and bonuses. Shareholder representation on the board of directors has improved, and power sharing among the shareholders’ conference, the board of directors, and the management has begun to occur. The dominance of the managers appeared to be the main weakness in the corporate governance of gaizhi firms. There was a high degree of overlap between the managers and the board of directors. The dominant 143


BOX 5.4 THE TEMPTATIONS FACING MANAGERS Mr. K is the young, energetic manager of a company in one of the survey cities. When the company was privatized, K was a deputy manager. The then manager made a promise to the government that the company’s performance would improve within three years. After two years the target did not look achievable and Mr. K proposed that the company go through gaizhi. The municipal government approved the plan, and the company’s net assets were sold to the employees at a discount. The shares were sold according to tenure in the company regardless of seniority. The company quickly took off after gaizhi. The previous manager was promoted to a post in the municipal government, and K became the manager. Under K’s leadership the company expanded and received new investment from a Shenzhen investor. At the time of interview the company had RMB200 million in cash in the bank. K admitted that he was too cautious to expand the company further and that a new manager was needed. Some financial intermediaries approached K and offered to finance a management buy-out. It would have been easy for K to profit from an MBO. He declined, however, because this “would have been unfair to the ordinary employees.”

role of managers, who are over-represented on the board of directors, opens up the risk that the management will manipulate the board of directors in a way that infringes the interests of owners and ordinary employees. This danger is greater in those employee shareholding companies where the manager enjoys considerable discretionary power. In most of these firms the management initiated and dominated gaizhi. After gaizhi the previous management and the old power structure were maintained. In many cases, it was only the manager’s conscience that limited his or her private gains (box 5.4). Survey results indicate that outside investors in controlling positions are more likely to use and rely on the new mechanisms of corporate control, to provide effective checks and balances on managerial discretion, and to offer high-powered incentives to senior managers.

144

6

Impact of Gaizhi on Firm Behavior and Performance The merits of gaizhi should ultimately be judged on how well the restructured firms perform. While improving the performance of enterprises was not the only goal of gaizhi, it would have been a failed experiment if efficiency had not improved. This chapter compares the performance of gaizhi and non-gaizhi firms. Within gaizhi firms, special focus is given to assessing the impact of different forms of gaizhi and, particularly, of different forms of ownership change. We are interested in the impacts of three aspects of ownership change: private shares versus state shares, outsider shares versus insider shares, and different forms of gaizhi. The chapter looks at both changes in behavior and changes in outcomes. In terms of behavioral changes, the chapter focuses on the internal restructuring of firms; for instance, whether departments were reorganized, managers replaced, changes made to employee remuneration, or new products introduced, and whether gaizhi has hardened the budget constraints of firms. In terms of changes in performance, we use indicators that have been frequently studied in the literature (Megginson and Netter 2001; Djankov and Murrell 2002), such as pre-tax profit rate over assets, cost per unit revenue, and labor productivity. Gaizhi, Internal Restructuring, and Financial Discipline Has gaizhi led to changes in the internal structures of firms? Have firms changed their management and organizational structures, bought new technologies and equipment, or introduced new products? These are some of the questions that we asked enterprise managers. The most common changes were departmental restructuring, a reduction in the number of managers, and the establishment or reorganization of the board of directors (see figure 6.1). At the government’s request, many firms had set up offices with roles corresponding 145


FIGURE 6.1 Methods of Restructuring in GAIZHI Firms, 2002 Restructure departments Reduce management personnel Establish or reorganize the board of directors Purchase new equipment or introduce new technology Develop new products Change wage remuneration Recruit new manager Establish new factories or branches Other 0

20

40

60

80

100

Percent SOURCE: Survey data.

to those of government agencies. For example, some firms had set up a statistical office to work with the bureau of statistics, an environmental office to work with the bureau of environmental protection, or a family planning office to work with the family planning commission. These organizational changes were not in general associated with an increase in management personnel. In fact, more than 80 percent of gaizhi firms have reported a reduction of their management personnel. On average, 36 percent of managers were made redundant. This number is very similar to the overall labor redundancies (see chapter 4), suggesting that managers and ordinary workers have equally shared the pain of layoffs. More than two-thirds of the gaizhi firms had recruited new general managers. Gaizhi firms have been investing more than non-gaizhi firms. More than 70 percent of the gaizhi firms bought new equipment, intro146


FIGURE 6.2 Spending on Fixed Investment by GAIZHI and Non-GAIZHI Firms, 1995–2001 RMB mn 20 Gaizhi firm Non-gaizhi firm 15 10 5 0

1995

1996

1997

1998

1999

2000

2001


duced new technology, or developed new products. Figures 6.2 and 6.3 show average absolute amounts of Renminbi spent on fixed investment and research and development (R&D) by gaizhi and non-gaizhi firms. The gap increased over the late 1990s. In 1995 non-gaizhi firms spent on average 80 percent of what gaizhi firms spent on fixed investment, but by 2001 the fixed investment of non-gaizhi firms was only 29 percent that of gaizhi firms. In 1995 non-gaizhi firms spent 17 percent of what gaizhi firms spent on R&D. The gap narrowed in the mid-1990s, but had returned to the 1995 level by 2001. Gaizhi changes the relationship between firms and the government. Has this affected the hardness of firms’ budget constraints? The four major areas where the soft budget constraint problem1 is most likely to arise are bank loans, interest payments, taxes, and social security. Overdue Loans. Both gaizhi and non-gaizhi firms carry a large stock of overdue loans, although gaizhi firms had less than half the stock of non-gaizhi firms (see figure 6.4). The average stock of overdue loans in 1. In a soft budget constraint (what Kornai [1980] calls the “pure” case) the following apply (1) firms make their own prices; (2) firms influence tax rules and obtain exemptions and postponements, and taxes are not strictly collected; and (3) subsidies and soft credits are given to firms.

147


FIGURE 6.3 Spending on R&D by GAIZHI and Non-GAIZHI Firms, 1995–2001 RMB mn 6 Gaizhi firm 5 Non-gaizhi firm 4 3 2 1 0

1995

1996

1997

1998

1999

2000

2001


FIGURE 6.4 Average Value of Overdue Loans Held by GAIZHI and Non-GAIZHI Firms, 1995–2001 RMB mn 20 Gaizhi firm Non-gaizhi firm 15 10 5 0

1995

1996


148

1997

1998

1999

2000

2001


FIGURE 6.5 Percentage of GAIZHI and Non-GAIZHI Firms with New Overdue Loans, 1996–2001 Percent 30 Non-gaizhi firms 20 10 0 1996

Gaizhi firms

1997

1998

1999

2000

2001


non-gaizhi firms rose steadily to reach RMB18 million by 2001. Gaizhi will become more difficult for these firms if their financial burdens continue to grow. An example is the Hengdong Ceramic Factory, which borrowed RMB14.4 million from the Industrial and Commercial Bank for investment in 1995. The factory performed poorly and the loan became overdue in 1997. In 2001, four years and several managers later, the overdue amount, including interest, had risen to RMB15.9 million. New overdue loans are a better indicator of financial discipline than the stock of past overdue loans. Figure 6.5 shows that in most years a lower share of gaizhi firms than non-gaizhi firms had problems with new overdue loans. The difference between the two types of firms was 10 percentage points in 1996 and 17 percentage points in 1997. In the late 1990s the gap narrowed considerably, and by 2001 gaizhi firms had slightly greater problems with overdue loans. The convergence between gaizhi and non-gaizhi firms, however, hides significant differences within gaizhi firms. Figure 6.6 shows data on new overdue loans by different forms of gaizhi. Firms that underwent public offering and employee shareholding had a lower level of overdue loans than other gaizhi firms. Less than 10 percent of these firms had newly created overdue loans, and most of the time these loans were negligible. In firms that were sold or leased out, the amount of new overdue loans fluctuated over the period but converged to the level of the public offering and employee shareholding firms in 2000 and 2001. 149


FIGURE 6.6 Percentage of Firms with New Overdue Loans by Different Types of GAIZHI, 1996–2001 Percent 40 Open sales 30 20



Leasing Public offering

10 0 1996

1997

1998

1999

2000

2001


In contrast, one-quarter of the firms that opted for internal restructuring had new overdue loans. The performance of these firms is largely responsible for the observed convergence in the percentage of firms with new overdue loans between gaizhi and non-gaizhi firms. Internal restructuring is the least drastic form of gaizhi, and the enterprises that have gone through internal restructuring differ least from the traditional SOEs. While they had been reorganized to comply with the Company Law and may have restructured their internal management, they were still fully government-owned. In addition to overdue loans, it may be instructive to look more closely at overdue interest rates. Interviews with banks and enterprises revealed that the banks were often prepared to extend the term of the loan but insisted that the interest be paid. They were especially keen to enforce this rule on gaizhi firms. Maintaining a steady stream of interest payments is an indicator to higher-level authorities that the loan is still active, regardless of whether it was overdue. Figure 6.7 shows the new overdue interest payments in gaizhi and non-gaizhi firms from 1996 to 2001. Gaizhi firms have performed consistently better than non-gaizhi firms, although the gap has narrowed, as in the case of new overdue loans. Across most types of gaizhi firms the share of firms with overdue interest payments increased over the 1990s to converge on an average of around 25 percent in 2001 (see figure 6.8). No firm listed on the stock market had any overdue interest payments. Such firms are generally of 150


FIGURE 6.7 Percentage of GAIZHI and Non-GAIZHI Firms with New Overdue Interest Payments, 1996–2001 Percent 40 30

Non-gaizhi firms

20 Gaizhi firms

10 0 1996

1997

1998

1999

2000

2001


FIGURE 6.8 Percentage of Firms with New Overdue Interest Payments by Type of GAIZHI, 1996–2001 Percent 40 Open sales 30


Leasing


20 10 0 1996

1997

1998

1999

2000

2001

Note: The public offering firms did not have any new overdue interest. Source: Survey data.

a better quality, as they typically undergo a significant amount of restructuring prior to listing. They are, in addition, subject to monitoring by the stock market and need to retain a sound financial reputation in order to maintain their share price and continue to raise funds. The ability of these firms to obtain finance from the stock market means they 151


FIGURE 6.9 Percentage of GAIZHI and Non-GAIZHI Firms with New Overdue Taxes, 1996–2001 Percent 50 Non-gaizhi firms

40 30

Gaizhi firms

20 10 0 1996

1997

1998

1999

2000

2001


are less dependent on bank loans. Firms that had undergone internal restructuring were the most likely to have overdue interest payments. In general, the increasing trend of gaizhi firms’ defaulting on interest payments is of concern. Overdue Taxes. The trends in overdue taxes matched those of overdue interest payments (see figure 6.9). The percentage of non-gaizhi firms with new overdue taxes was very high at above 40 percent in most years. The percentage of gaizhi firms with new overdue taxes was less than half that of non-gaizhi firms in most years, but the gap narrowed quickly. A total of 24 percent of gaizhi firms had new overdue taxes in 1996, compared with 40 percent of non-gaizhi firms. However, the share of gaizhi firms with overdue taxes increased considerably between 1996 and 2001. The average size of new overdue taxes of gaizhi firms steadily increased over the period, but it was still much smaller than that of non-gaizhi firms. The percentage of new overdue taxes held by all types of gaizhi firms had converged to between 20 percent and 40 percent by 2001 (see figure 6.10). It is surprising to find that a high percentage of publicly listed firms were in arrears on their tax payments. Given the nature of the listing process in the past (Tenev and Zhang 2002), most publicly listed firms have a particularly close relationship with the government, and their overall financial situation is relatively strong. It is interesting, therefore, to find that their performance in terms of overdue tax pay152


FIGURE 6.10 Percentage of Firms with New Overdue Tax Payments by Type of GAIZHI, 1996–2001 Percent 60

Employee shareholding Public offering

40 Leasing 20 Internal restructuring

Open sales 0 1996

1997

1998

1999

2000

2001


ments, although improving in the last two years of observations, is among the worst. Overdue Social Security Payments. The percentage of firms with new overdue social security payments was high throughout the period, regardless of whether or not the firm had undertaken gaizhi (see figure 6.11). There was no clear indication as to which type of firm performed better in each year. Within gaizhi firms, there was some convergence in the share of firms with overdue payments across all types of gaizhi, but publicly listed firms became the major contributor to the arrears problem (see figure 6.12). Overdue social security payments in publicly listed firms were nil until 1998, but from that year this group of firms had a relatively high arrears rate and the highest average size of overdue social security payments. The rate decreased to about onethird in 2000 and 2001, but the average size of social security payments owed by publicly listed firms continued to climb and reached RMB900,000 in 2001. Internally restructured and employee-owned enterprises show a different pattern of behavior regarding overdue social security payments. These enterprises started with very high arrears rates in 1996, but rates declined over the next five years. While the average size of the amount owed remained considerable in restructured firms, employee 153


FIGURE 6.11 Percentage of GAIZHI and Non-GAIZHI Firms with New Overdue Social Security Payments, 1996–2001 Percent 60 Gaizhi firms

40

Non-gaizhi firms

20 0 1996

1997

1998

1999

2000

2001


FIGURE 6.12 Percentage of Various Types of GAIZHI Firms with New Overdue Social Security Payments, 1995–2001 Percent 100 80

Internal restructuring Open sales

60 40 20

Leasing

Public offering 0 1995 1996

Employee shareholding 1997

1998

1999

2000

2001


shareholding firms fared somewhat better. They had a lower rate of arrears than other firms, and the average size of the overdue debt was the smallest of all types of firms in most years. The sudden increase in arrears in publicly listed firms in 1998 may be related to the introduction of China’s social security system in that year. The new system requires firms to pay 20 percent of their payroll 154


into funds that are pooled together at the city level, and then at the provincial level, and ultimately at the national level. The pooling of funds may have created a moral hazard problem for larger and betterperforming firms, inducing them to default on their payments. Their strong bargaining power, partly due to the fact that they make large tax contributions to local governments, may have permitted them to behave in such a fashion. The better performance of the employee-shareholding firms as far as social security payments are concerned might have something to do with their ownership structure. Since these firms are owned by their employees, workers may have a greater incentive to ensure that social security payments are made on time, because their retirement depends on it. The above analysis suggests that the financial discipline of gaizhi firms, while somewhat better relative to non-gaizhi firms, has been deteriorating in recent years. Gaizhi firms have a better record than nongaizhi firms in paying bank loans and interest—and, to some extent, taxes—but they show equally poor discipline as far as social security payments are concerned. The aggregate statistics hide significant differences within gaizhi firms. In terms of access to bank loans, fully privatized firms appear to face a harder budget constraint than firms that have undergone only internal restructuring. And as for overdue tax and social security payments, publicly listed firms seemed to have a surprisingly bad record. We use multivariate analysis to gain a better understanding of the factors influencing firms’ soft budget constraints. Three indicators of soft budget constraints are examined in the regression analysis: overdue bank payments combining principal and interest, overdue taxes,2 and overdue social security payments. We use two sets of indicators of gaizhi. In the first set, all firms are divided into three groups according to their controlling shares: fully state-owned, state-controlled, and privately controlled. Fully state-owned enterprises are the control group. In the second set, firms are again divided into three groups, this time by forms of gaizhi: nongaizhi firms, internally restructured firms, and firms that have introduced some private ownership. The fully state-owned enterprises are again the control group. We control for asset size, firms’ social burdens, per capita municipal government revenues, firms’ performance, and time trends. 2. Not reported because there are no statistically significant coefficients.

155


The results are summarized in table 6.1. Privately controlled firms show a better financial discipline than state-owned firms with respect to bank payments. Their overdue loans as a percentage of assets are on average 5.2 points lower than the corresponding number for nongaizhi firms. With respect to social security payments, however, the various types of firms do not differ in a statistically significant way from each other. In terms of the form of privatization, privatizing firms show better results than non-gaizhi and internally restructured firms with respect to bank loans, but a worse performance with respect to social security payments. The results also show that in cities with higher per capita government revenues, firms tended to have higher overdue loans. This result suggests that firms in a city with a stronger financial position are more likely to default on their bank payments. At the same time, a stronger fiscal position of the local government is associated with better firm discipline with respect to social security payments. Various hypotheses can be advanced to “explain” these results. Perhaps firms are more likely to default on bank payments if they believe that a fiscally strong local government is in a better position to offer a bail-out. In terms of social security payments, firms may be reluctant to entrust their social security to municipalities with weak finances. Recent reports by the central government have warned against the accumulation of risks in the fiscal position of local governments, including as a result of appropriation of social security funds (see box 6.1). Or the same latent variable may be behind stronger municipal finances and more disciplined social security payments—that is, better enforcement of tax and social security payments by the local government. Further research is needed to shed light on these interesting results. The level of worker redundancy is positively associated with overdue bank loans, but the results are not significant. Worker redundancy is, however, positively and significantly associated with overdue social security payments. This suggests that keeping redundant workers on the payroll and making social security contributions are viewed as substitutes by firms and governments. A 1 percent increase in redundancy leads to a 1.1 percent increase in social security arrears as a percentage of total assets. As expected, better-performing firms are less likely to default on their tax and social security payments. These results are largely consistent with the descriptive statistics. We find, therefore, evidence suggesting that privatization has a positive and significant effect on bank discipline. The soft budget constraint 156


TABLE 6.1 FACTORS INFLUENCING FINANCIAL DISCIPLINE OF FIRMS Dependent variable

Independent variables State-controlled vs. wholly state-owned Privately controlled vs. wholly state-owned Internal restructuring vs. non-gaizhi Some private ownership vs. non-gaizhi Firm’s social burdensa Firm’s asset size Firm’s performanceb Local government’s fiscal strengthc Time trendd

Overdue bank payments as percentage of firm assets

Overdue social security payments as percentage of firm assets

Not statistically significant Negative, statistically significant Not statistically significant Negative, statistically significant at 10% level Not statistically significant Not statistically significant Negative, statistically significant Positive, statistically significant Declining since 1997

Not statistically significant Not statistically significant Not statistically significant Positive, statistically significant at 10% level Positive, statistically significant Not statistically significant Negative, statistically significant Negative, statistically significant No clear pattern

NOTE: Method of estimation: weighted least squares. a. “Social burdens” is the proportion of official retirees plus internal retirees plus xiagang workers in the total number of employees; official retirees are counted as a social burden because, in many cases, firms are still responsible for directly paying their retirement wages despite the fact that China has established a new pension system that in most cases maintains a centralized system up to the provincial level. b. Firm’s performance is measured in terms of return on capital averaged over the previous three years. c. Local government’s fiscal strength is measured by per capita fiscal revenues at the municipal level. d. Time trend is captured by year dummies. SOURCE: Author’s estimates.

problem is severe, however, in cases of tax and social security payments. The descriptive analysis shows that roughly one-third of firms were in arrears on those two payments, regardless of the controlling shares or the form of gaizhi. Therefore, we find that firms are more likely to evade payments to local governments than to commercial banks. 157


BOX 6.1 FISCAL POSITIONS OF LOCAL GOVERNMENTS IN CHINA The Development Research Center at the State Council (DRC) released two reports in 2004 warning of the potential risks associated with local government debts. The reports found that the forms of debts incurred by local governments are “so many” and their debt burdens are “so heavy” that it “goes beyond normal people’s imagination.” The study team failed to obtain precise data from local governments, but it estimated that the total amount of local government debts could be on the scale of RMB1 trillion or more. In their estimation, primary items include: • bank loans borrowed by various “development companies” created by local governments to bypass the budget law • appropriation of social security funds • wage arrears • SOE losses to be written off (primarily grain trading companies) • payables to construction firms for infrastructure projects • debts incurred by township governments The DRC team recommends the legalization of local government bonds to cope with the challenge.

Gaizhi and Firm Performance We look at three indicators of firm performance: profitability, unit cost, and labor productivity. Profitability is defined as the return on assets— that is, the percentage of the pretax profit over the total book value of assets. Unit cost is the percentage of the material and operational cost over the revenue. It does not include wage payroll. Labor costs are partly reflected by labor productivity. In the same way as the definition by Frydman and others (1999) does, our definition of the unit cost also serves the purpose of accounting for a firm’s passive restructuring measures centered on cost reduction. The third indicator, labor productivity, is defined as the real revenue contributed by an on-duty worker. A salient feature of the Chinese SOEs is their worker redundancy. A considerable portion of the workforce is not active, although it is attached to a particular firm. Hence, we use the number of on-duty workers as an indicator of firm performance. Labor productivity captures the fea158


tures of both passive adjustments and positive expansion by the firm. It may reflect more of the expansionary side in the Chinese context, however, because of the rigidities in the labor market. Figures 6.13 to 6.15 show the time trend of the three performance indicators by various dimensions of the gaizhi process. Figure 6.13 compares gaizhi and non-gaizhi firms. Gaizhi firms outperform non-gaizhi firms on all three indicators. We observe, however, the declining trend in the profitability of gaizhi firms over the sample period. Both gaizhi and non-gaizhi firms show a trend of improving labor productivity. Figure 6.14 compares the performance of sample firms by ownership characteristics. As before, we look at wholly state-owned, state-controlled, and privately controlled firms. State-controlled firms tend to be the best performers in the sample, followed by privately controlled and wholly state-owned firms. Finally, figure 6.15 compares the performance of firms based on whether they are controlled by insiders or outsiders. We distinguish between state-owned firms that are controlled by insiders (managers and employees), privately owned firms that are controlled by insiders (employee shareholdings), and outsider-controlled firms, where outsiders could be either private firms or other SOEs. Here the picture is more mixed. Outsider-controlled firms dominate most of the time. Insider state-controlled firms tend to be the worst performers. A notable feature in figures 6.13 to 6.15 is the higher volatility in the performance of private firms compared with wholly state-owned and state-controlled firms. The higher volatility of the private sector relative to other segments of the economy has been a notable feature of the transition process in China. For example, the volatility of the UBS Warburg China Private Enterprise Index is on average 1.5 times higher than the volatility of the Hang Seng Index3 (see table 6.2). Several factors may account for the higher volatility in the performance of private enterprises. Particularly for the de novo private firms, the higher volatility may be simply a restatement of the fact that private firms are subject to exit discipline and are younger and smaller than other firms. But it also reflects the fact that other sectors of the economy, and particularly the state-owned sector, react more slowly, if at all, to business opportunities and exit pressure. The performance volatility of the private sector is in this sense higher than it would have been were market principles to apply equally to all sectors of the economy. The tendency for private-sector performance to be more volatile is more pronounced 3. The volatility of non-SOE A-shares has also been very high (see Chan 2002).

159


FIGURE 6.13 Comparison of GAIZHI and Non-GAIZHI Firms on Three Performance Dimensions, 1995–2001 a. Profitability Percent 8 6 4

Gaizhi firms

2 0

Non-gaizhi firms

–2 –4 1995

1996

1997

1998

1999

2000

2001

1999

2000

2001

2000

2001

b. Unit cost Percent 66 64

Non-gaizhi firms

62 60 58

Gaizhi firms

56 54 1995

1996

1997

1998

c. Labor productivity RMB 1,000 80 Gaizhi firms

60

Non-gaizhi firms

40 20 1995

1996

1997

1998

1999

Source: Calculated and plotted using the survey data.

160


FIGURE 6.14 Comparison of Private and State-Controlled Firms on Three Performance Dimensions, 1995–2001 a. Profitability Percent 7 State controlled

5 3

Privately controlled

1 –1

Fully state owned –3 1995

1996

1997

1998

1999

2000

2001

b. Unit cost Percent 70 65

Fully state owned

60 55

State controlled Privately controlled

50 1995

1996

1997

1998

1999

2000

2001

2000

2001

c. Labor productivity RMB 1,000 120 State controlled 100 80 60 40 20

Privately controlled Fully state owned

0 1995

1996

1997

1998

1999


161


FIGURE 6.15 Comparison of Outsider- and Insider-Controlled Firms on Three Performance Dimensions, 1995–2001 a. Profitability Percent 7

Insider privately controlled

5

Outsider controlled

3 1 –1 Insider state controlled –3 1995

1996

1997

1998

1999

2000

2001

b. Unit cost Percent 70 Insider state controlled 60 Outsider controlled

50 Insider privately controlled 40 30 1995

1996

1997

1998

1999

2000

2001

c. Labor productivity RMB 1,000 100 80

Outsider controlled

60 40 20

Insider state controlled Insider privately controlled

0 1995

1996

1997

1998

1999


162

2000

2001


TABLE 6.2 PRICE VOLATILITY OF VARIOUS CATEGORIES OF COMPANIES AFFILIATED WITH CHINA AND LISTED ON THE HONG KONG EXCHANGE, MAY 2002 Index Hang Seng Index China-affiliated companies China Enterprise Index (SOEs) China Mainland Index (Red Chips) China Private Enterprise Index

30-day volatility

50-day volatility

100-day volatility

16.7 22.5 14.3 19.0

18.1 24.6 19.5 21.2

20.4 29.5 19.2 25.8

22.8

28.4

38.3

SOURCE: Bloomberg.

in sectors where the degree of competition between private and state companies is relatively high (Chan 2002). The higher volatility of performance of private firms implies that lending to these companies is viewed by commercial banks as being more risky. On the other hand, because private businesses are less politically protected, the banks have a freer hand to act if problems arise. Chinese banks tend to be risk averse, however; as a result, private enterprises still account for a disproportionately small share of credit flows in China. In the current regime of monetary tightening, private and smaller companies seem to be disproportionately affected (see box 6.2). Privatized firms in the sample raised concerns that gaizhi may have a negative impact on their access to financing. Figures 6.13 to 6.15 present indicative results only. To isolate the effect of gaizhi, we need to control for other factors and address the endogeneity issues—that is, that the timing and method of gaizhi may be influenced by firm performance. In particular, there may be a selection bias in privatization and gaizhi, in the sense that better-performing firms are selected to conduct gaizhi or to be privatized first. In the following sections we present and discuss some of the results of the regression analysis of the factors affecting firm performance where we control for other variables and for the selection bias. For a detailed exposition of the methodology, see Song and Yao (2004). The Effect of Private Ownership. The results in table 6.3 focus on the effects of private ownership introduced during gaizhi on firm perfor163


BOX 6.2 EFFECTS ON THE PRIVATE SECTOR OF MONETARY TIGHTENING MEASURES A private entrepreneur, a chicken farmer in Shanxi province, was imprisoned for “illegal fundraising” after supplying cheap eggs to his customers in return for extra money. The case turned out to be controversial, as local public opinion tended to believe that the government had punished an honest and creative entrepreneur. Proposals were made at sessions of the National People’s Congress to amend the law. With tightened macroeconomic policies, some private enterprises have turned to sources of funds with high interest rates. The real financing cost can be as high as 45 percent, according to some media reports. Some credit guarantee companies have set up direct lending businesses.

mance. Wholly state-owned enterprises are the control group. We find that state-controlled and privately controlled firms have a clear advantage over wholly state-owned firms with respect to profitability. The results concerning the impact of private ownership on unit costs and labor productivity are mixed and inconclusive. Ownership diversification has a significant economic impact on firm profitability. We estimate that a privately controlled firm will have a return on assets that is from 1.2 to 1.7 percent higher than a fully state-owned firm. In the case of state-controlled firms, their advantage over fully state-owned firms is estimated at between 1 and 2.7 percent. The finding that privatization only has a significant positive impact on profitability, but has a weak or insignificant impact on unit cost and labor productivity, is consistent with the finding of Frydman and others (1999) on three Eastern European countries. It may reflect the interplay of limitations on cost cutting in terms of technological and business environment constraints,4 and a focus on expansion rather than on defensive cost-cutting restructuring. It also suggests that firms with diversified ownership tend to make more economic use of their capital stock than does an old-style SOE. Chinese SOEs are characterized by a

4. See chapter 4 on labor policy.

164


TABLE 6.3 ANALYSIS OF THE EFFECT OF PRIVATE OWNERSHIP ON FIRM PERFORMANCE Dependent variable Independent variables

Profitability

State-controlled vs. wholly state-owneda Privately controlled vs. wholly state-owneda Firm’s social burdensb

Positive, statistically significant Positive, statistically significant

Arrearsc

Not statistically significant

Negative, statistically significant Firm’s size Negative, statistically significant Debt-equity ratio Not statistically significant

Unit cost

Labor productivity

Negative, not statistically significant Not statistically significant

Positive, not statistically significant Negative, not statistically significant

Negative, not statistically significant Positive, not statistically significant Positive, not statistically significant Not statistically significant

Negative, not statistically significant Not statistically significant Positive, not statistically significant Not statistically significant

NOTE: Dummy variables are used to indicate privately controlled and statecontrolled firms. All control variables are three-year time averages. Sectoral and regional dummies were also included in various model specifications. We control for selection bias through lagged performance variables and the fixed-effect panel methods. Only coefficient signs that are consistent in both estimations are reported. Only results that are statistically significant in both methods are reported as statistically significant. For details, see Song and Yao (2004). a. Wholly state-owned firms are the control group. b. “Social burdens” is the proportion of official retirees plus internal retirees plus xiagang workers in the total number of employees; official retirees are counted as a social burden because, in many cases, firms are still responsible for directly paying their retirement wages, despite the fact that China has established a new pension system that in most cases maintains a centralized system up to the provincial level. c. “Arrears” includes overdue payments related to bank loans, taxes, and social security. SOURCE: Song and Yao (2004).

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much higher capital intensity than private firms, indicating certain levels of inefficiency (Lin and Tan 1999). The above results concerning the impact of private and state ownership on firm performance have been corroborated by research on the performance of Chinese listed companies. Sun, Tong, and Tong (2002), for example, find that neither too much nor too little government ownership is beneficial to a firm’s efficiency, and show that the relationship between government ownership and firm performance follows an inverted U-shaped pattern. They show that government ownership (whether in the form of state shares or legal person shares) has a positive and significant impact on firm performance. Among the benefits of government ownership they include the signaling effect when a government shows its commitment to the firm by retaining a relatively high portion of the firm’s equity; the monitoring role that the government plays for the benefit of all shareholders; and the supporting policies that the government formulates to favor the firms it owns or partially owns. According to Sun, Tong, and Tong (2002), the findings suggest that when a state-owned enterprise goes private, it may be beneficial to build in a stage when a certain degree of government ownership is maintained, rather than going too quickly from a state-owned status to complete privatization. They do not differentiate, however, between state shares and legal person shares, and combine both in the category of government ownership for the purpose of their analysis. The Effect of Outsiders. Table 6.4 shows the results of the impact of insider and outsider shareholdings on firm performance. The most important result is that outside shareholding has a stronger positive impact on firm performance than insider shareholding. The effect of outside shares is particularly pronounced with respect to profitability and labor productivity. According to our estimates, the return on assets of a fully outsider-owned firm would be about 2 percentage points higher than that of a fully government-owned firm. Respectively, a worker in a fully outsider-owned firm would on average contribute RMB6,200 per year more than their counterpart in a fully state-owned firm.5 Both effects are economically and statistically significant.

5. The average labor productivity in the sample was in the range of RMB46,000 to RMB62,000 for different years.

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TABLE 6.4 ANALYSIS OF THE EFFECT OF OUTSIDE OWNERSHIP ON FIRM PERFORMANCE Dependent variable Independent variables Insider private shares, including: • Management shares • Employee shares Outsider shares, including: • Outside state shares • Outside private shares Firm’s social burdensa Firm’s size Debt-equity ratio Arrearsb

Profitability

Unit cost

Positive, not statistically significant Not statistically significant


Positive, not statistically significant Positive, statistically significant Positive, statistically significant Positive, not statistically significant Negative, statistically significant Negative, statistically significant Not statistically significant


Not statistically significant

Not statistically significant Negative, not statistically significant Negative, not statistically significant Positive, not statistically significant Positive, not statistically significant Not statistically significant

Labor productivity Negative, not statistically significant Negative, statistically significant Positive, not statistically significant Positive, statistically significant Positive, statistically significant Not statistically significant Negative, not statistically significant Not statistically significant Positive, not statistically significant Not statistically significant

NOTE: All control variables are three-year time averages. Sectoral and regional dummies were also included in various model specifications. We control for selection bias through lagged performance variables and the fixed-effect panel methods. Only coefficient signs that are consistent in both estimations are reported. Only results that are statistically significant in both methods are reported as statistically significant. For details, see Song and Yao (2004). a. “Social burdens” is the proportion of official retirees plus internal retirees plus xiagang workers in the total number of employees; official retirees are counted as a social burden because, in many cases, firms are still responsible for directly paying their retirement wages, despite the fact that China has established a new pension system that in most cases maintains a centralized system up to the provincial level. b. Arrears includes overdue payments related to bank loans, taxes, and social security. SOURCE: Authors’ estimates.

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When insider shares are broken up into management and employee shares, we find that a higher share of employee ownership tends to have a negative effect on unit cost and a positive effect on productivity. The results are not statistically significant, however. Management shares have a negative and significant impact on labor productivity. Both outside private and outside state shares contribute to the positive effect of outsider shares on profitability, but the latter make a more significant contribution than the former. Outside state shareholding shows a positive and statistically significant association with profitability and labor productivity. Larger outside private shareholdings tend to reduce unit costs, but the effect is not statistically significant under all model specifications. Thus, while more outside state shares help a firm improve its profitability and labor productivity, more outside private shares help it to reduce costs. This finding seems to suggest that a firm is more likely to adopt expansionary measures to improve its efficiency if it has more outside state shares, and is more likely to adopt defensive measures to reduce costs if it has more outside private shares. In the Chinese setting, SOEs may have a bias in favor of an expansionary strategy because they have easier access to bank loans and other sources of finance, and face a weaker financial discipline than private firms. The finding that outside state ownership has an important positive impact on firm performance has several important implications. First, it suggests that outside ownership matters, irrespective of whether it is a private or state outside ownership. Second, it implies that not all types of state ownership are created equal. Outside state ownership is different from direct state ownership in which the control is typically in the hands of insiders. Third, it implies that in the Chinese context, outside state ownership may bring some advantages to firms relative to outside private ownership. One such advantage is the superior ability of the state sector to obtain external financing and government support. For example, SOEs account for 37.5 percent of industrial production in 2003 (CEIC), but they have absorbed 58.6 percent of new lending in that year (Goldman Sachs 2004). In addition, the Chinese stock market is overly dominated by state-controlled firms. Often, the private sector relies on the funds leaked from the state sector to get finance (Lu and Yao 2003). Consequently, an outside SOE is in a better position to bring more finance to the recipient SOE than is an outside private firm. 168


Outside state ownership shows a much more pronounced dominance over inside state ownership, however, than over private outside ownership. A more pertinent question, then, is, What are the advantages of outside versus inside state ownership? Most likely the answer has to deal with the power of outsiders to shake the implicit contracts within the firm that entrench managers and employees. As a general rule, outsiders find it easier to introduce changes that affect labor and managerial practices. An outside SOE may not be able to establish work discipline with respect to its own employees, but its status as an outsider may give it more leverage to do so with the employees in the new firm.6 Research on other transition economies has confirmed the power of outside shareholdings to improve efficiency, although only in the case of outside private ownership. For example, Djankov and Murrell (2002) find that outside block shares are more helpful than scattered private shares, because block shares make it easier to establish better corporate governance. Our finding that employee shares do not have a tangible positive impact on efficiency is largely consistent with the literature on transition economies. Our similar finding about the impact of management shares, however, differs from some early findings by Groves and others (1994, 1995), Gordon and Li (1995), and Li (1997). These studies have shown that contractual incentives (such as performance-based bonus schemes) in the early reform period did help the Chinese SOEs to improve efficiency. It seems reasonable to believe that ownership incentives should play at least the same role as contractual incentives, because the manager gets more autonomy when he owns part of the firm. A possible explanation for the observed inconsistency is that we do not control for managerial autonomy. In the literature (for example, the above-quoted studies on China, while more comprehensive discussion can be found in Djankov and Murrell 2002), management autonomy is found to be as important as managerial incentives in achieving firm efficiency. Privatization may not automatically give the manager autonomy, so control for management autonomy is needed

6. One such example is the giant Luoyang Tractor Factory. It has a serious problem in its headquarters in Luoyang, Henan province, but it runs a successful joint venture (through a subsidiary registered in Great Britain) with another SOE in Zhenjiang, Jiangsu province. Indeed, one of the purposes of many failing SOEs seeking a joint venture relationship with another SOE is to find an opportunity to get rid of the excessive workforce.

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in our regressions to obtain an accurate assessment of management incentives. We do not have a complete series of data on management autonomy, however, so we cannot perform this test in the panel framework.7 We also look at the impact of various forms of gaizhi on firm performance. The only result that is statistically significant under all specifications is the negative and relatively strong association of internal restructuring and firm profitability. Gaizhi and Time Trends in Performance In this section, we examine some of the time dimensions of the relationship between various forms of gaizhi and firm performance. Are the effects of gaizhi concentrated in the first years after restructuring, or are they spread pretty much evenly post-restructuring? Do we see a diminishing impact of gaizhi as new and different cohorts of SOEs enter the process? Time patterns in the relationship between gaizhi and firm performance may arise for a variety of reasons. For example, Frydman and others (1999) point out two kinds of selection bias that may distort the estimation of the effects of privatization. Insiders may underreport the firm’s performance (or deliberately perform poorly) before privatization in order to get a better deal in privatization (or because of a shortened time horizon), so the better postprivatization performance may be artificial. In this case, one would expect to see stronger effects early on postprivatization. The positive effects of privatization/gaizhi may diminish or become stronger over the years, depending also on the forms of privatization/ gaizhi and other firm-specific characteristics. For example, privatization in the form of employee shareholdings may have a significant effect on firm performance in the earlier years of privatization because of enhanced incentives, but this effect may quickly diminish in the later years because the shortcomings of employee shareholding overtake the positive effects of enhanced incentives. On the other hand, the effects of privatization/gaizhi may also be enhanced over the years because it takes time for restructuring to take effect. 7. We have data on the distribution of decision rights in the firm for 2002, the year when the survey was conducted, that allow us to perform some form of the test based on cross-sectional comparison in future research.

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In addition, later privatized /gaizhi-ed firms may not perform as well as early privatized /gaizhi-ed firms. This may be because it is simply easier to restructure firms that are in relatively good shape. Difficult cases naturally take longer to go through the process. Furthermore, local governments typically want to start with success stories in order to build political capital. Self-selection also plays a role; insiders with superior knowledge about the “true” characteristics of firms that are to be privatized may push selectively for the better firms to be privatized sooner rather than later. In all these situations, better-quality firms will be privatized first—or, as the saying goes in China, “The prettier daughters are married off first.” It is also possible to rationalize why poorly performing firms may be privatized firms. For instance, local governments in a “market for lemons” type of situation may try to divest themselves of the poor-quality firms first. If this “prettier daughters” effect were strong, the privatization/ gazhi effect would be overestimated for the early privatized /gaizhi-ed firms. Conversely, the effect of the later privatized /gaizhi-ed firms would be overestimated if “the prettier daughters” were married off late (Guo and Yao 2003). It is therefore more or less an empirical question as to what is the time profile of the relationship between gaizhi and firm performance. In this section we test for the time distribution of the impact of gaizhi on performance and for the “prettier daughters” effect. The test is performed for only three aspects of the gaizhi process: gaizhi versus non-gaizhi firms, private versus state shares, and outsider versus insider shares. To analyze the time patterns, it is important to determine the time of privatization/gaizhi in order to see whether the interactions of the time elapsed before and after privatization /gaizhi with the three aspects of the gaizhi process have a significant impact on performance. If the positive impact of gaizhi were concentrated in early years, we would expect to see a weaker impact as the number of years after gaizhi increases. We would therefore expect the coefficient of the interaction term between the gaizhi variable and the number of years after gaizhi to have the opposite sign to the coefficient of the gaizhi variable. If it were the case that the “prettier daughters were married off first,” this would imply that the coefficient of the interaction term between years before gaizhi8 and the gaizhi variable would have to be 8. The variable assumes a value of f-1995 for t ≥ f, and a value of zero for t < f, where f is the year of gaizhi.

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negative, as the smaller the number of years before gaizhi, the stronger the positive impact on performance. The results are summarized in table 6.5. In regard to the early impact of gaizhi, only outsider shares show a consistent effect across all three performance indicators. Only the impact on unit costs is statistically significant, however. Private shareholding shows an early impact on unit costs and labor productivity, but only the impact on unit costs is statistically significant at the 10 percent level. The results seem to suggest, therefore, that outside ownership has somewhat quicker delivery than other forms of gaizhi as far as positive impact on performance is concerned. The “prettier daughters” effect turns out to have mixed results. We find some evidence for such an effect in terms of profitability, but not in terms of unit costs and labor productivity. More profitable firms tended to go through the gaizhi process first. On the other hand, latecomers tended to have lower unit costs and higher productivity. These contrasting trends could be explained by different adjustment strategies employed by early, as opposed to late, gaizhi firms. It is possible that early gaizhi firms had relied more on an expansionary strategy to increase their profitability, but enjoyed less flexibility than the latecomers in terms of adjusting their employment and cost structures. Comparisons between firms that were privatized /gaizhi-ed firms in 1996–98 and those that were privatized/gaizhi-ed in 1999–2001 show that, in their post-privatization /gaizhi years, the first group of firms reached an average investment rate of 13.3 percent but reduced their onduty workforce by an average rate of only 2.7 percent per annum; in contrast, the latter group obtained an investment rate of only 8.6 percent but reduced their on-duty workforce by an annual rate of 8.0 percent. The Impact of Other Factors on Performance The results presented in tables 6.3 and 6.4 show that size and social burdens tend to be negatively associated with performance. The negative impacts of worker redundancy on profitability are to be expected, as more redundant workers increase the firm’s wage, social security, and healthcare burdens. It is not immediately clear what the reasons behind the positive effects of worker redundancy on unit cost and the negative effects on labor productivity might be. One explanation is that firms with excess labor substitute labor for other inputs. This will account for the negative effect of redundancy on labor productivity as 172

TABLE 6.5 ROLE OF TIMING ON GAIZHI PERFORMANCE Early gaizhi effect

Gaizhi vs. non-gaizhi Private vs. state Outsider vs. insider

Profitability

Unit costs

No, not statistically significant No, not statistically significant Yes, not statistically significant

Yes, not statistically significant Yes, significant at 10% level Yes, statistically significant

“Prettier daughters” effect Labor productivity Yes, not statistically insignificant Yes, not statistically significant Yes, not statistically significant

Profitability

Unit costs

Labor productivity

Yes, statistically significant at 10% level Yes, statistically significant

No, statistically significant at 10% level No, statistically significant

Yes, not statistically insignificant No, statistically significant

Yes, not statistically significant

No, statistically significant

No, statistically significant

NOTE: “Prettier daughters” effect implies that better-quality firms are the first to undergo gaizhi. SOURCE: Authors’ estimates.

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well. That is, firms with redundant labor try to minimize the number of xiagang workers. Any worker whose marginal product will be higher than the difference between the minimum wage and the xiagang allowance will be on the factory floor rather than at home. Firms with more xiagang workers are more likely to have reached this limit. In the process, they will also have exhausted opportunities to substitute labor for other inputs. The same process may account for the negative impact of size on performance. As firms are forced to keep workers on the books, firm size may be another indicator for worker redundancy. Conclusion Privatization has brought considerable efficiency gains to the Chinese enterprise sector. It has a significantly positive impact on firm profitability, although a weak or no significant impact on unit cost and labor productivity. We find that outside ownership, irrespective of whether private or state, has a strong and significant impact on performance. This impact tends to be concentrated in the early years of reforms. The finding that outside state ownership has a strong positive impact on firm performance has important implications for our understanding of state ownership. The conventional belief is that state-owned enterprises fail because public ownership provides an inadequate incentive structure within the firm. China’s experience shows that SOEs with a relatively high degree of autonomy to participate in the market process may have difficulty in putting reforms into effect in their own enterprises but can be effective agents of change in other state enterprises. From the perspective of the ultimate owner—the state—this can be viewed as an illustration of the efficacy of using agents to monitor other agents (Varian 1989).

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7

Toward a Fairer and More Efficient Gaizhi Process Gaizhi has brought about efficiency-enhancing changes in China’s state enterprise sector. While the process is far from over, it is already delivering results in terms of preserving employment and improving financial performance. The potentially harmful social impact associated with a restructuring on such a massive scale has so far been muted, due to the combined effect of a rapidly evolving social safety net, the dynamic growth of the private sector, and a robust macroeconomic performance. Although very important, the efficiency aspects of the gaizhi process most likely will not determine the future of enterprise reform in China. Fairness and distribution issues1 related to gaizhi have been attracting most public attention recently. The concern of the government and the general public has been that gaizhi has been accompanied by erosion of state assets, corruption, and “inglorious” enrichment by private individuals. An ongoing public debate in China puts the main issues surrounding the future of privatization in the country into sharp relief. The Public Debate about Privatization in China An unprecedented public debate on the ongoing privatization policy is taking place in the Chinese media.2 Two views on the future of privatization policy have chrystalized in the course of the discussion. One view, which is close to the official stance on privatization, calls for “sticking to the current direction of SOE reform and pushing forward ownership 1. We do not imply that efficiency and equity are necessarily contradictory to each other. On the contrary, more often than not they tend to coincide. For instance, an open and competitive process of sale of state assets is more likely than a nontransparent one to maximize privatization proceeds and identify the best owner.

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transformation in a regulated way.”2 The other view expressed during the debate can be summarized as follows: (1) the ongoing privatization, especially MBOs, has resulted in the loss of a large number of state assets to the benefit of a small number of private enterpreneurs and SOE managers; (2) SOEs can be run as efficiently as private firms so long as the government hires professional managers and imposes fiduciary duties on them; and (3) the current direction of SOE reform must be changed and privatization (“property rights reform”) stopped. Both views reflect concerns about corruption, nontransparency, unemployment, and inequality associated with the gaizhi process, but they differ in their prescriptions. What are some of the implications of the analysis and the findings presented in this study for the concerns expressed in the debate? One concern is that the ongoing privatization, especially MBOs, has resulted in the loss of a large amount of state assets to the benefit of a small number of private individuals and SOE managers. It is clear that gaizhi has been a messy process often associated with asset stripping. It is difficult—perhaps impossible—to quantify the extent of this type of abuse. The best this study can do is to offer some circumstantial and anecdotal evidence, which of course needs to be interpreted very carefully. The analysis helps, however, to put the debate in a certain perspective. The main source of loss of state assets has been loss-making in inefficient state firms. In fact, one motivation for gaizhi, as discussed in chapter 2, has been to stop the bleeding of state firms. Has the cure been worse than the disease? Based on the empirical analysis presented in this study, the answer should be “no.” Economic crimes take place on a significant scale in state firms that are not going through gaizhi or before they embarked on a process of restructuring. All the major state banks in China, for instance, have been plagued by major embezzlement scandals. In fact, some of these scandals have been unearthed as part of the appraisal process in preparation for restructuring. The rise of economic crime in China is, to some extent, an unwelcome byproduct of market liberalization. As dis2. This view is perhaps best reflected in an article published in the People’s Daily in September 2004 in the name of SASAC’s research department and in a recent speech delivered at Tsinghua University by Shao Ning, deputy director of SASAC (The Economic Observer 2004).

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cussed in chapter 2, market liberalization tends to exacerbate the agency costs of managerial autonomy under traditional state ownership. It therefore changes the cost-benefit balance of various forms of ownership relative to central planning and provides incentives for privatization. The government transfers ownership to the manager or outside owners to better align control and ownership and, in this way, reduce the incentives to commit economic crimes. Asset stripping during gaizhi can take place in a number of ways, few of which are directly linked with privatization. One commonly used channel in China is through the choice of the valuation firm. As reported in chapter 3, we don’t find systematic differences between MBOs and sales and the other forms of gaizhi, although one can argue that the conflict of interest in the case of MBOs, in particular, is more severe. Another channel is the practice of giving discounts to appraised value to buyers of state assets. Since MBOs and sales are the main forms of gaizhi involving transfer of ownership, it is no surprise that these forms show a bias in favor of discounts (see chapter 3, table 3.6). It is important to note that sales to private firms and individuals account for a small percentage of gaizhi: 10 percent of the gaizhi cases in our sample. Both these channels are relatively easy to control, so that conflicts of interest and, consequently, abuses are minimized. But perhaps the main channel for asset stripping has been debt evasion through policy bankruptcy or various forms of internal restructuring. This channel is perhaps more difficult to control, as it often involves tensions between powerful local incentives and national interests. This last point is also a reminder that every irregularity associated with gaizhi has at least two sides, one of which is typically a government agency. In summary, one can argue that the irregularities often associated with privatization are not intrinsic attributes of the MBOs or privatization process, but involve other factors as well. The second point is that SOEs can be run as efficiently as private firms, so long as the government hires professional managers and imposes fiduciary duties on them. We will briefly discuss two issues that have a direct bearing on this argument: (1) the attributes of heterogeneous ownership structures; and (2) the relationship between ownership structure and regulation. Debates on ownership change—like the one unfolding currently in China—typically treat private and state ownership as homogeneous and monolithic concepts. In fact, the so-called private and state ownership can

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take diverse forms, to the point where it is difficult to tell the difference. For example, shareholders in a corporation can include diversified minority individual shareholders, conglomerates with significant stakes but with a dominant related party interest, institutional investors of various stripes, employees of the firm, private commercial banks, and so on. Each one of these shareholders faces different incentives, including incentives to exercise ownership rights, and their interests may be in conflict. The same applies to state ownership. An SOE can be “owned” by a government ministry, by a local government at the level of the province, municipality, or county, by another SOE, by government-owned banks, pension funds, or asset management companies, or by combinations thereof. Again, these stakeholders may face different incentives, including incentives to exercise their ownership rights, and their interests may be in conflict with each other (see box 7.1). Heterogeneous and indirect3 ownership structures, including hybrid structures combining various types of private and state owners, are rather typical in modern economies. In China the hybrid firm, and not the purely private or the purely state-owned firm, has become the representative business entity. This type of heterogeneity is not trivial; it matters. Diverse ownership structures exhibit common features that tend to transcend differences based on whether the state or individuals as ultimate owners have the majority stake.4 First, multiple owners with conflicting incentives and interests may provide mutual checks and balances, allowing a common principal (the state, for example) to use agents to monitor each other. Second, diversity, with the implied conflicts of interest between various types of owners, invites regulation. In the case of conflicts between various owners, whose rights should prevail? In heterogeneous ownership structures, one type of ownership interest is often particularly weak in the sense of being more vulnerable to abuse by managers and controlling shareholders. Typically, most vulnerable are diversified individual shareholders who abdicate their ownership functions and be-

3. Indirect in the sense that the direct owners are themselves agents and the ultimate owners can be removed several degrees of separation from the managers. 4. An often-heard criticism of state ownership is based on the assertion that the state as owner introduces noneconomic objectives in the firm. This assertion looks increasingly unconvincing in the light of the global corporate social responsibility movement. Societal demands find their way into firms irrespective of the type of ownership.

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BOX 7.1 THE HETEROGENEITY OF STATE OWNERSHIP IN CHINA China is not unique in having companies with mixed ownership. Countries as diverse as Brazil and Vietnam have also pursued such diversification of ownership. But China is probably unique in terms of the diversity of state ownership forms. It is often not clear how closely associated with the state various shareholders are. In many companies the provincial government may be the controlling shareholder; in addition, there could be a large number of SOEs with small stakes of between 1 and 5 percent of the company. A nontrivial question is how to treat such SOEs: as minority shareholders, or as part of the controlling shareholder? This question arises, for example, in the context of the December 2004 rules introduced by the CSRC giving minority shareholders the ability to influence the decisions of listed companies on (1) the issuance of new shares, (2) the issuance of convertible corporate bonds, (3) asset restructuring, and (4) overseas listing of a subsidiary firm of the listed company. Anecdotal evidence suggests that SOEs as minority shareholders can, and typically do, have different interests from the state and SOEs in controlling positions. Their interests can be more aligned with the interests of other minority investors, including other private minority investors, than with the government as a controlling shareholder. In a recent case from the Supreme People’s Court (SPC), the highlevel administrative body that acted as the domestic party to a joint venture transferred the shares belonging to the Chinese party to one of its subsidiaries by means of its administrative power. Its argument was that since the transfer involved state assets and both parties were state-owned, the ownership of the shares did not change. The court invalidated the argument and ruled that the joint venture partner should have the priority to purchase the shares of the domestic partner (Xu 2004).

come absentee owners.5 It is absentee ownership that drives regulatory activism, which steps in to fill the ownership vacuum. It is the presence of absentee ownership in heterogeneous and otherwise very diverse ownership structures internationally that acts as the common denominator that induces the more-or-less homogeneous regulatory response, which we observe in ongoing global corporate governance reforms. 5. Employees, some types of institutional investors, and the state can all be absentee and passive owners.

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Thus highly diverse ownership structures tend to invite a homogeneous regulatory response in terms of corporate governance regimes. The presence of homogeneous regulations does not guarantee homogeneous enforcement, however. A regulator can be captured by narrow private, as well as by narrow state, interests.6 Nevertheless, one can argue that heterogeneous ownership structures in which the powers of various interest groups are more or less balanced would enhance the independence and enforcement capacity of the regulator.7 One can argue that in heterogeneous and diverse ownership structures the differences between dominant state and dominant private ownership tend to be less relevant, and that in such ownership structures regulation tends to assume greater importance relative to ownership. Our analysis in the preceding chapters lends empirical support to this thesis. We found that heterogeneous ownership structures show similar properties in terms both of their use of the new corporate governance mechanisms and of economic performance. We found that outside investors, whether state or private, tend to energize enterprises. We also found, however, that these new heterogeneous ownership structures put new demands on the regulatory capacity of the state. What are the implications of this discussion for the future course of China’s ownership transformation? If we follow the logic of our arguments, they do not imply a halt of China’s ownership reforms. What they do imply is the need for regulations and stronger regulatory capacity. They also imply the need for a competitive environment in which ownership structures evolve so that different interests provide checks and balances on each other and prevent too much concentration of economic and political power. A critical aspect of such a competitive environment is the ability of outside investors to infuse capital and energy into enterprises. Given the limited role that private outside investors have played in the ownership reform process so far, the implication is that China needs more—not less— outside private ownership at this stage. In the remainder of the chap6. See Hu Angang on the subject of administrative monopoly and the issue of rent seeking by governments and SOEs in China (Hu and Yong 2003). 7. An example is the Chinese companies listed on the domestic stock exchanges. Although in general listed companies in China are dominated by state shareholders, some of these companies have hundreds of thousands of small shareholders. The expectations and the concerns of these investors influence the regulator and in many ways contribute to its resolve to improve the corporate governance of listed companies.

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ter we will focus on these two aspects: (1) building a regulatory framework and capacity; and (2) reducing the transaction costs for outside investors. Regulating Gaizhi Gaizhi has so far been largely a bottom-up, spontaneous development. The decentralized, largely unregulated approach has infused tremendous innovation and dynamics into the process. It has also been associated with practices that have raised public concern about the fairness and transparency of the process. This phase of the ownership transformation process is coming to an end. SASAC has recently put out a flurry of regulations dealing with the transformation of SOEs.8 These regulations were partly in response to “observed irregularities” resulting in the loss of state assets. Their goal is to achieve “standard and orderly” transformation. The regulations clarify the methods that can be used to reform SOEs, such as reorganizations, mergers, leasing contract operations, joint ventures, transfer of state assets, and the joint-stock and jointstock cooperative systems. They specify the process to be followed, including the preparation of restructuring plans, the appointment of auditors and appraisers, the determining of the price of state assets, the methods of payment, and the need to protect the interests of creditors and employees. Special attention is given to the aspects of the gaizhi process that are critical with respect to the protection of state assets, such as asset valuation and discounts on the transfer prices. The regulations specify that the state property rights of nonlisted enterprises must be transferred on the property rights exchange without regard to the region, industry, investment, or affiliation of the enterprise. In addition, the transfer must be made publicly and competitively by such means as auctioning, public bidding, agreed transfer, or other means that are stipulated in state laws and regulations. 8. For example, Notice of the General Office of the State Council Forwarding Opinions of the State-Owned Assets Supervision and Administration Commission of the State Council on Standardizing the Transformation of State-Owned Enterprises, General Office of the State Council of the People’s Republic of China, November 30, 2003; and Measures for the Appraisal and Administration of StateOwned Assets (issued under the State Council Order No. 91), Decree of the StateOwned Assets Supervision and Administration Commission of the State Council and the Ministry of Finance No. 3.

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Importantly, where the state-owned assets and equity transaction price is lower than 90 percent of the results of an asset valuation, approval must be obtained before the transaction can proceed. The procedures also detail the information required to be disclosed by the assignor, the qualifications required of the assignee, the main contents of the assignment contract, and the approval procedure. A notable feature of these regulations is that they establish stricter standards and a higher level of scrutiny when state assets are transferred to nonstate entities. For example, according to the regulations, an enterprise should not be entrusted to develop a plan for restructuring when assets are being transferred to managers and employees of the same enterprise. If the enterprise is to be transformed into a nonstate one, a terminating audit of its legal representative must be carried out. While the appointment of a qualified asset-appraising firm can normally be done by the SOE, it is the organization that directly holds the state property rights in the enterprise that should decide which asset appraiser to appoint if the enterprise transfers its state property rights to nonstate investors. The regulations explicitly instruct that the base price of state property rights to be transferred to nonstate investors, and the price of the shares in existing state-owned assets offered to nonstate investors, should be set by the organization that approved the SOE’s transformation and transfer of its state property rights. The new regulations stress the need to protect the rights of both creditors and workers. The protection of workers’ rights is given higher specificity, however, than the protection of creditor rights. Workers are given de facto veto power by specifying that the transformation may not take place until after the plan for resettling workers is adopted at the workers’ conference. The regulations require that an enterprise going through gaizhi must obtain the consent of its creditors, and that SOEs must be strictly prevented from making use of transformation to evade monetary liabilities. The new regulations devote special attention to MBOs. They address conflict of interest issues by prohibiting the managers who are buying the state-owned assets of their own firms from participating in key decisions of the property transfer, such as those concerning financial auditing, the terminating audit, asset and capital verification, assets evaluation, and the setting of the base prices of property. The opinions prohibit practices such as managers purchasing state assets with enterprise funds, borrowing money from their own company or other state-controlled companies, or using their enterprise’s assets to provide 182


a guarantee, mortgage, hypothecation, or discount for their financing. Importantly, according to the opinions, managers responsible for the poor performance of their company’s operation cannot buy their stateowned assets. An important recent policy development is that the government has ruled out the MBO of large state enterprises (see box 7.2). This reaction seems to be influenced by the concerns about erosion of state assets in MBOs. It probably also reflects concerns about concentration of economic power in private hands that could subvert regulatory capacity. These measures are sensible responses to the most common conflict of interest situations that have been arising during gaizhi. They

BOX 7.2 HAIER’S MBO PLANS PROMPT A BACKLASH FROM THE GOVERNMENT A plan by Haier, China’s leading whitegoods maker, to give its managers greater control of the company has sparked a backlash from the government. The government has announced as a general policy that MBOs of large enterprises will not be permitted. The reaction triggered an intense debate among policy-makers about the course of ownership reform in China. Haier is a more complicated case, as the company used to be a collective enterprise. Furthermore, its chairman, Zhang Ruimin, is one of China’s most well known entrepreneurs. The Qingdao branch of SASAC declared in 2003 that Haier and two other whitegoods companies based in the city—Hisense and Shuangxing—were owned by the state. Haier’s restructuring hinges on a backdoor listing in Hong Kong, which has been approved by shareholders, including the injection into the listed vehicle of some of the Chinese parent company’s most valuable assets. The listing is considered essential for Haier’s ambitious expansion plans, as the company will be able to use its Hong Kong–traded shares to buy overseas assets. Some observers interpret the government’s reaction as interference with corporate autonomy and shareholders’ rights, as well as in contradiction with the government’s announcement that the state will retain control only over strategically important sectors. Others tend to view the government’s response as a legitimate exercise of ownership functions by the main owner. SOURCE: Financial Times, December 15, 2004.

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will certainly contribute toward standardizing the transformation process and making it more transparent. At the same time the measures discriminate against nonstate outside investors. The implicit assumption behind the new regulations is that the transfer of state assets to nonstate-controlled entities is prone to more severe conflicts of interest and should therefore be subject to more scrutiny and bureaucratic supervision. One can argue that erosion of state assets can occur also in state-controlled enterprises with diversified ownership. In addition, it has become increasingly difficult in China to distinguish between various types of ownership. The hybrid enterprise combining various types of ownership has become the representative Chinese enterprise at this stage of China’s institutional transformation. Under such conditions it would be very difficult for the state to enforce these regulations. A simpler and fairer solution would be to universalize the proposed measures to all types of gaizhi irrespective of the ownership type of the investor. In addition to developing new regulations, the government has stepped up enforcement. Since August 2004, SASAC has issued three circulars on the reform of SOEs and transfer of property rights. Among other things, these documents require local governments to carry out a thorough inspection of all cases of reform and transfer since January 2004. The inspection should cover whether the property right transfer cases have been listed on the property right trade market, whether the operations are in accordance with official standards, whether the process is fair and transparent, whether the legal rights of employees have been effectively protected, and whether illegal operations have been corrected in a timely manner. SASAC also handed out a specific notice requesting governmental agencies to compile more detailed statistics on the sales of state-owned property rights, so as to effectively monitor the status of state-owned assets. The central government’s strategy for SOE reform deals with other areas that are particularly prone to conflicts of interest and, consequently, erosion of state assets. At the national working conference of central SASAC in February 2004, the strategy for SOE reform was communicated to local officials. Several new key directions were announced. Parent companies of SOE groups are encouraged to prepare for IPOs wherever possible. The idea is to avoid a split of the group into a listed subsidiary and a nonlisted “shell,” as has been common in the past. In this way the parent company’s ownership structure will also be diversified and will subject the parent company 184


to additional scrutiny. “Policy-oriented” bankruptcy, which has generated a lot of abuse related to evasion of debt payments, will be phased out within four years. In addition, managers of large SOEs will be subject to additional control mechanisms: boards of directors will be created in all large central SOEs within three years, and, starting in 2004, a new regime of performance evaluation for managers of central large SOEs will be implemented. Importantly, the new strategic directions specify that private firms are encouraged to participate in SOE restructuring. Strengthening Enforcement Regulations are hollow if they go unenforced. The dramatic increase in gaizhi regulations will need to be accompanied by a strengthening of the government’s enforcement capacity. In particular, the capacity of the central government needs to be strengthened. Many of the situations that are subject to regulatory control involve conflicts of interest between the center and the localities. Yet the national agencies typically rely on local agencies for enforcement. As mentioned above, central SASAC requires local governments to undertake inspections and to collect statistics on gaizhi. The large discrepancy between central government expenditures and central government revenues suggests that this implementation of national objectives through the local governments extends over most functions of the government (see figure 7.1). At present, only about 3 percent of China’s expenditures on government administration, and only about 1 percent of the government’s expenditures on social relief and welfare, take place at the central level (Ahmad, Singh, and Fortuna 2004). With the growth of uniform national regulations, China will need to establish a regulatory capacity at the local level that is independent of local governments. According to the vice chairman of SASAC, Li Yizhong, the establishment of local SASAC offices is the most important and efficient way to prevent the loss of state assets, as it would “materialize the responsibility of the maintenance and appreciation of state assets” (Caijing 2003). The plan was to finish the establishment of local SASACs in 2004. Enforcement, and particularly fair enforcement, is expensive. With the rapid growth of regulations, China cannot avoid the growth of government expenditures for enforcing regulations. But the growth in regulation costs can be reduced by adopting a new approach to 185


FIGURE 7.1 Central Government’s Share of Total Government Revenues and Expenditures, 1978–2003 Percent 60 50 40 30 20 10 0

Share of central government in total government expenditures

Share of central government in total government revenues 1980

1985

1990

1995

2000

Sources: CEIC; authors’ calculations.

regulation that utilizes and channels the energy of self-interest of the affected parties.9 In the gaizhi process, there are stakeholders whose interests in particular situations can be aligned with the interests of the state as an owner to prevent dissipation of state assets. By adding its weight to such parties, the state can become more effective in enforcement and in protecting its interests. It is not sufficiently recognized in China that the interests of creditors are often aligned with those of the owner (in this case, the state) in the gaizhi process. For creditors, net worth is a cushion above their debt claims. Hence, creditors, and particularly unsecured creditors, have an interest in carefully monitoring and reacting to any erosion of this cushion. Modern finance theory, as well as empirical evidence, suggest that financial intermediaries such as commercial banks, insurance companies, and finance companies monitor and control their borrowers on behalf of other investors.10 In this role they perform a public service. 9. See Tenev, Zhang, and Brefort (2002, 132) for a short account of the approach taken by the U.S. Securities and Exchange Commission in the early days of its existence. 10. Rajan and Winton (1995).

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Creditors are among the least utilized monitoring mechanisms in China’s gaizhi process. They need to become an integral part of the restructuring process. Banks, for instance, can assume a more important role in several ways. One vehicle is through the use of covenants in loan agreements. The standard credit contracts used in China include few covenants that permit real involvement. On such matters as major financial or asset restructuring, ownership changes, or changes in business lines, at best they usually require “information” rather than consultation, let alone approval. The new regulations on gaizhi require “consent” by creditors. Banks should add specificity to this general provision through covenants in loan agreements that specify the process of bank approval for various restructuring plans of the borrower. Another vehicle is the ability of banks to initiate and carry through restructuring of their borrowers. It has been difficult for Chinese banks to initiate restructuring or even to write off bad debts. Any write-off has to follow stringent requirements from the Ministry of Finance. More recently, as part of the government effort to improve the asset quality of the banks, the People’s Bank of China and MOF have issued new decrees to allow banks to increase write-offs with more flexible requirements. Finally, the bankruptcy framework needs to be improved to strengthen and clarify creditor rights. Currently there is no comprehensive bankruptcy regime in China. The bankruptcy of SOEs follows a separate framework. The bankruptcy rules governing SOEs do not contemplate reorganization by agreement or decree, either inside or outside the bankruptcy proceedings. Most significantly, these rules are drafted with a view to protecting workers’ rights11 and providing for the extensive participation of local courts, and of regional and local political authorities. A Bankruptcy Law is under preparation in China. The draft Bankruptcy Law covers private enterprises, and therefore makes a step toward a comprehensive bankruptcy framework. According to the draft, however, SOE bankruptcies would remain subject to State Council regulations. Similar to unsecured creditors, employees have a strong interest in monitoring the net worth of the company. Employees have a compar11. Policy-makers in China are concerned that strengthening creditor rights may be at the expense of labor. While there are situations where the interests of workers and creditors are in conflict, it should be noted that there is no inherent contradiction between creditors and labor. In fact, their interests tend to coincide. Workers can be viewed as unsecured creditors who have an interest in monitoring the financial situation of the company.

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ative advantage in terms of access to privileged information and can therefore play an important role in identifying and reporting irregularities in the gaizhi process. The role of employees can be enhanced by appropriate legislation protecting whistleblowers. China is probably the only country in the world where the Constitution itself contains a provision guaranteeing protection to whistleblowers. Article 41 of the Constitution confers the right on citizens to make “complaints and charges against, or exposures of, violation of the law or dereliction of duty by any state organ or functionary,” while prohibiting “fabrication or distortion of fact for purpose of libel or false incrimination.” Besides empowering every citizen to blow the whistle on authorities, the Constitution says: “No one may suppress such complaints, charges and exposures, or retaliate against the citizens making them.” Despite the constitutional provision, the rights of whistleblowers are far from being adequately protected in China. Their constitutional rights are not further developed and elaborated upon in a special legislative Act. Furthermore, article 41 talks about the relationship between whistleblowers and the state but does not cover the labor relationship in state and nonstate companies. The development of such legislation will be an important part of strengthening workers’ rights. The ability of the government to mobilize the energy of independent public monitoring is proportionate to the amount of information available to the public. Disclosure of information by corporates and the government is of key importance. While China has made significant progress in the area of corporate disclosure (Tenev, Zhang, and Brefort 2002), the movement toward an open government has been slower. The Chinese State Council is working on a draft of China’s first freedom of information legislation. However, some localities are coming out with local legislation. In January 2004, Shanghai adopted China’s first provincial-level open information legislation (Horsley 2004). Earlier, in 2003, Guangzhou, spurred by the SARS episode, issued the first Municipal Open Government Information Provisions. Rigorous enforcement of rules and regulations begins with selfdiscipline by the regulator. One cannot expect a strong regulatory capacity to develop in China if the government does not play by the rules. A particularly sensitive issue is that of managerial appointment in reformed enterprises with significant state ownership, where practices exist that are incompatible with the new corporate governance regime for gaizhi enterprises. 188


It is still a widespread practice in China for the government and the Party directly to appoint managers in gaizhi enterprises after bypassing the institutions of corporate governance, particularly established procedures by boards of directors. Arbitrary and unpredictable (from the point of view of shareholders) transfers of enterprise managers from and to the government are a common occurrence (see box 7.3). The implicit, or even explicit, benchmarking of enterprise managers to grades and levels in the civil service persists. If such practices continue, the new institutions of corporate governance will not be able to develop as functioning organs of corporate control. Some influential observers see the control by the Communist Party over the appointment of SOE managers as one of the main outstanding problems of SOE reforms in China (Qian and Wu 2003). According to them, no meaningful corporate governance can evolve while the Party continues to have a role in the managerial appointments of large SOEs. They expect corporate governance reform to be the most difficult part of SOE reforms because of the political position of the CCP, and recommend that the issue of the Party’s role be addressed before the goal of “separation of government and enterprise” can be achieved. A more pragmatic approach, in our view, would be to address the role of the Party in managerial appointments through the corporate governance framework. An owner in an enterprise has the right to solicit recommendations for candidates for the board of directors. The government, as an owner, can solicit and get recommendations from the Party as to who can be nominated as a board member or chairman. Private investors with the right to nominate board members can do the same—they can solicit third parties, including the Communist Party, for candidates. This is not critical. What is critically important is to go through the proper governance procedures for nominating and selecting candidates for senior managerial positions. The focus on process will provide a safeguard so that the relationship between the Communist Party and the Chinese government does not interfere with the governance practices set by companies’ shareholders. To date, the government, as the largest shareholder in many enterprises, has generally not adhered to good governance standards. It has allowed the role of the Party to interfere with sound corporate governance standards, since the government has allowed human resources decisions to be made and sometimes implemented prior to the board meetings where a government-nominated candidate should be vetted and confirmed. 189


BOX 7.3 LACK OF DEMARCATION BETWEEN GOVERNMENT OFFICIALS AND BUSINESSMEN IN CHINA In March 2004 the Chinese Communist Party’s Central Commission for Discipline Inspection and the Organization Department of the CCP Central Committee jointly issued instructions requiring all local governments and ministries to make thorough examinations on the issue of Party or government leaders concurrently taking jobs in companies. The instructions were triggered by a report of Xinhua News Agency, which disclosed that many officials in Wuhu city, Anhui province were concurrently taking jobs in SOEs. The Wuhu city local government reacted without delay, with government officials immediately resigning from their positions in the SOEs. The Provisional Rules of State Public Servants, promulgated in 1993, expressly prohibit public servants from engaging in business activities. However, the rules prohibit them from engaging in business activities only as individuals. They still leave open the possibility of “official” employment or concurrent engagement in SOEs. The practice of concurrent positions is due partly to the historical practice of assigning administrative rank to enterprises and linking managerial positions with civil service grades. Some large SOEs established in the early years of New China held a higher status than local governments. For example, Daqing city came into being after the establishment of Daqing Oil Administration. This has resulted in the general managers of some state-owned companies being concurrently the most senior leaders of local Party committees and local governments, or standing members of local Party committees and decision-makers in local government. This is not uncommon. In fact, many state-owned companies set up by governments are led by one or more government-appointed officials who may work fulltime or part-time for the companies. That the practice of assigning administrative rank to enterprises and linking managerial positions with civil service grades persists is apparent by the transfers between large SOEs and government agencies. Li Yizhong, former general manager of China Petrochemical Corporation and president of Sinopec, has been appointed Party secretary and vice chairman of the newly established State Asset Supervisory Commission. Wei Liucheng, former general manager of China Off-shore Petroleum is governor of Hainan province. Thus there is still no clear demarcation between senior managers of state-owned companies and government officials. SOURCE: Li Nan (2004).

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The reality on the ground is that, given majority government control, it is likely that government/Party–supported candidates would be elected in any case. Nevertheless, it is important for the government to take candidates to the board per the articles of association and not just accept the recommendation from the Party as a fait accompli. As outside shareholders’ shares in enterprises increase, it will be even more imperative to ensure that the government/Party–recommended candidates come to the boards for appointments, since there will be more likelihood that a block of nongovernment shareholders could object to such a candidate. With the establishment of SASAC, the policy for reforming the personnel system in state-owned companies and for establishing a modern corporate management system has gained momentum. The central government has announced its strategy to withdraw from direct economic activities and to function mainly as a regulator of the macroeconomy and provider of public goods. According to the modern corporate system in state-owned companies, the state should act as a stockholder who supervises the companies, instead of taking part in their day-to-day management. The transfer between senior managers and government officials tends to result in managers who give priority to political objectives. This practice inhibits the development of the managerial profession and a managerial market in China as well as undermines minority shareholders’ rights as laid out in good corporate governance practices. Reducing Transaction Costs for Outside Investors The Chinese government has recognized the importance of outside investors in the restructuring of SOEs. A number of policy initiatives and regulatory measures reflect the drive to create a regime that facilitates the participation of outside investors in the ownership transformation process. For example, the Shanghai government launched its new round of reforms of state assets management in March 2004 with the aim of reorganizing the sectoral state holding companies set up some years ago. The central objective is to create multiple shareholders in virtually every SOE, even with state-owned shareholders. The intention reflects the accumulated wisdom that heterogeneous ownership provides not only checks and balances, and hence facilitates monitoring, but also energizes SOEs. A host of new regulations aimed at developing a market for corporate control have come into force in China. In September 2002 the 191


CSRC promulgated the Measures to Administer the Takeover of Listed Companies (the “Takeover Rules”) and the Rules for Management of Disclosure Requirements for Changes for Controlling Shareholders of Listed Companies (the “Disclosure Requirements”). The Takeover Rules and Disclosure Requirements are modeled on similar takeover regimes applicable in other jurisdictions. They are comprehensive and apply to a broad range of possible transactions and situations, many of which are currently only theoretical in China—for example, hostile takeovers. The Takeover Rules and Disclosure Requirements are likely to have an impact on the reform of SOEs, as more than 90 percent of all listed companies are state-owned. Chinese companies listed on the domestic stock exchanges have two main classes of shares: nontradable or legal person shares, and tradable shares.12 The new regulations will apply to both, as shares of SOEs traded on the market typically make up no more than 25–40 percent of a company’s outstanding shares and the takeover threshold in the Takeover Rules is 30 percent. According to the rules, if the acquisition agreement will result in the investor’s holding 30 percent or more of the target company’s outstanding shares, an offer must be made to acquire all the outstanding shares of the company. The Takeover Rules set different price floors for the two classes of shares. For nontraded shares, the price should be no less than the higher of (1) the highest price paid by the purchaser for other nontraded shares of the target company during the last six months, and (2) the most recently audited net asset value per share of the target company. The price offered for traded shares must be no less than the higher of (1) the highest price paid by the purchaser for such shares in the previous six months, and (2) 90 percent of the arithmetic mean of publicly quoted sales of the stock over the previous 30 days. A series of regulations were promulgated in China in 2002 and 2003 to enhance the role of foreign investors in the reform of SOEs. In November 2002 the China Securities Regulatory Commission and the People’s Bank of China jointly issued the Provisional Rules on the Management of Investment in Domestic Securities by Qualified Foreign Institutional Investors (the “QFII Rules”). The QFII Rules make it possible for the first time for foreign institutional investors that

12. See Tenev, Zhang, and Brefort (2002) for a description of the Chinese stock market.

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satisfy certain criteria to acquire A-shares as well as B-shares. There are significant restrictions on the size and liquidity of these investments, however. Individual institutional investors may now acquire in the market up to 10 percent of total outstanding shares (traded and nontraded), and qualified foreign institutional investors may acquire, in the aggregate, up to 20 percent. Foreign institutional investors acquiring such shares have restrictions on their access to foreign currency from the proceeds of any sale of those shares for a period of one to three years (depending on the type of investor). Because of these restrictions, the QFII Rules alone offer only limited possibilities for M&A activity in China. Until recently, nontraded legal person shares, which are typically controlling shares, could be transferred between the state and Chinese “legal persons” but were off-limits to foreign buyers. Those rules changed in 2003 when the CSRC, the MOF, and the SETC jointly issued a Notice on Relevant Issues Concerning the Transfer to Foreign Investors of Listed Company State-Owned Shares and Legal Person Shares (the “State-Owned Shares Notice”), effective January 1, 2003. The notice contemplates the direct sale to foreign investors of both state-owned and legal person shares, and offers the potential for foreign investors to acquire, for the first time, sole or shared control of China’s publicly listed SOEs. At about the same time, regulations for the acquisition of, and other investments in, nonlisted SOEs were announced: the Tentative Provisions on the Use of Foreign Investment to Restructure State-Owned Enterprises (the “SOE Restructuring Provisions”), which the former SETC, the MOF, the State Administration for Industry and Commerce (SAIC), and the State Administration of Foreign Exchange (SAFE) jointly promulgated in November 2002. The tentative provisions appear to give the workers an effective veto over such restructuring transactions and, at a minimum, ensure that employee costs and terms will be a central feature of any privatization investment. The Interim Provisions on the Acquisition of Domestic Enterprises by Foreign Investors came about in April 2003. Many pre-existing rules and procedures for foreign investments in nonlisted Chinese domestic enterprises were consolidated and clarified through the M&A Rules that were promulgated in April 2004. Finally, the options and vehicles for restructuring of foreigninvested enterprises (FIEs) themselves were significantly expanded in China by allowing two structures in which one FIE may hold an ownership interest in another: the holding company and the limited liability company. 193


Partly as a result of these regulations, foreign acquisitions of local Chinese companies surged in the first half of 2004. Following three years during which foreign acquisitions ran at about $5 billion per year (10 percent of FDI), acquisitions nearly tripled in the first half of 2004 to $7.3 billion and have likely reached 15–20 percent of FDI for 2004. Acquisitions of local companies are fast becoming a third wave of FDI in China, following the prevalence of joint ventures in the 1980s and early 1990s and the surge of wholly foreign-owned enterprises during the past 10 years (Woodard and Wang 2004). Even with this significant increase, however, M&As still account for a relatively small proportion of Chinese FDI. Globally, M&As account for more than 50 percent of FDI. Despite the issuance of regulations, M&As involving foreign investors are proceeding more slowly than might have been expected. The reason: an increasingly transparent legal system is needed for M&As to reduce risks and transaction costs. The regulations are a step forward, but not enough to tip the balance. Impediments exist on both the demand and supply side of the process. Investors have difficulty finding independent and reliable financial information about the companies. Publicly available records on many aspects of a Chinese company’s business, such as legal title to land-use rights, the existence of pending litigation, and priority security interests over assets, are often either unavailable or unreliable. Corporate accounting is also frequently lax, especially by foreign standards. And Chinese companies, particularly SOEs, are accustomed to a culture of secrecy and may not be forthcoming in disclosing their records.13 As

13. Sometimes, even majority control does not guarantee access by the “controlling” foreign party to a company’s records. In a recent case that went to the Supreme Court, the foreign party took a 51 percent stake with the right to appoint the president of the board of directors of the joint venture and five members of the board. The domestic party held 49 percent of the company, with the right to recommend the general manager of the joint venture and four members of the board. During operations, however, the foreign party complained that even though it was the controlling party it could not check various original certificates and financial accounts, and it was deprived of management rights. Further, it stated that the general manager of the joint venture also acted as the general manager of the domestic party, which is not in compliance with the law. This case illustrates the importance of drafting corporate charters and joint venture contracts in which the division of powers between the board of directors and the general manager is clearly specified.

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a result, it can be difficult to conduct satisfactory due diligence. Under these circumstances, most foreign investors will want comprehensive representations and warranties, indemnities for breach, and security for those indemnities. These arrangements are unfamiliar to many Chinese companies, and obtaining conditions that incorporate them is often a challenge. When investors spend a significant amount in due diligence, they often are scared of what they may find: companies with overdue tax and social security payments, with allocated instead of granted land-use rights, or with no clear boundaries with their parent company or related companies (Meyer and Lu 2005). Practices such as the arbitrary shifting of assets from one company to another by the supervision authority or parent company are widespread.14 In addition, numerous obstacles complicate debt financing for M&A transactions in China. Because the procedures for pledging equity interests or registering security interests in assets are not fully developed, and because enforcement of such interests is difficult at best, banks are often unwilling to loan funds for acquisitions. Further complications exist in the case of acquisitions by foreign investors. FIEs are most often the acquisition vehicle but are subject to maximum leverage ratios that cap their borrowing capacity. Acquisitions of Chinese companies by foreign investors are further restricted by prohibitions and limitations on foreign investments in specified economic sectors, and by uncertain

14. In a recent joint venture case from the Supreme People’s Court (SPC), the high-level administrative body that acted as the domestic party to a joint venture transferred the shares belonging to the Chinese party to one of its subsidiaries by means of its administrative power. The court stated that such an administrative method of changing ownership is not in line with the law, and that the joint venture partner has a priority right to buy the shares. Without a resolution from the other party of the joint venture and the board of directors, and without the requisite approval and registration procedure from the government authority, such a decision did not have a legally binding effect. Furthermore, the SPC invalidated an argument from the Chinese party that the applicability of a regulation (Determination of the Title to and the Handling of a Dispute of Ownership of State-Owned Assets Tentative Provisions, issued in 1993) issued by the State Assets Administration Bureau held in the case. The Chinese party argued that the transfer involved state assets, and hence the ownership of the shares did not change after being transferred under the joint venture laws. The SPC held that the Equity Joint Venture Law and its Im-plementing Regulations are the applicable laws (Xu 2004).

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prospects as to when and under what conditions legal person shares acquired by foreign investors would become tradable.15 Disincentives exist on the supply side as well. Often potential takeover targets enjoy special tax and other advantages and subsidies that a joint venture or a merger may jeopardize. As a rule, domestic partners/ targets and local governments make adjustments so that government support flows to the domestic or local party only. This involves additional transaction costs that may discourage M&As. Under the recent regulations, SOEs that transfer their shares—even controlling shares— to a foreign investor will not qualify as FIEs. This will make them the only companies in China with more than a 25 percent foreign investment that do not so qualify. As a practical matter, this will deprive such investments of potentially preferential tax treatment and may serve as a disincentive to some transactions. An important consideration for outside investors, particularly foreign ones, is antidilution rights. Outside investors often seek the protection of antidilution rights in order to maintain their proportionate interest in target companies. The segmentation of China’s capital markets with the presence of different classes of shares makes this difficult. In the case of foreign investors, they cannot subscribe to new issuances of A-shares, for example, unless they are qualified foreign institutional investors. Although the new regulations have given foreign investors the right to buy existing legal person shares, it is not clear whether they have the right to subscribe to legal person shares newly issued by private placement. In general, the existence of different classes of shares presents a major obstacle to the development of a market for corporate control in China. It acts as an antitakeover device. Different classes of shares create conflicts of interest between different shareholders, particularly between the holders of legal person shares and the holders of tradable shares.16 This complicates the corporate governance of Chinese listed companies. The lack of tradability of legal person shares also inhibits the development of a private equity and venture capital market, as it 15. While there have been some recent examples of governmental approval for conversion of such shares to traded shares, there is no clear policy on this issue, and domestic market pressures will probably dissuade authorities from approving many conversions in the near future. This lack of a clear public exit may inhibit many foreign investors. 16. In general, holders of tradable shares value liquidity and capital gains. Holders of legal person shares prefer dividend payments and value control.

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limits exits for outside investors. After several attempts to find a solution to the problem of the legal person shares overhang, the regulator seems to be moving toward a decentralized approach, basically leaving it to the shareholders to decide. The CSRC regulations of December 2004, which give minority shareholders the right to influence major corporate decisions, seem to have been designed partly with the objective of facilitating the process of case-by-case decisions on the tradability of legal person shares. It remains to be seen how these regulations will work in practice, however. Enhancing the Role of the de Novo Private Sector in China’s Transformation As discussed in previous chapters, the domestic private sector is emerging as a significant player in the gaizhi process.While most private enterprises are small and will continue to rely on organic growth, a growing number of de novo private firms are looking at acquisitions of SOEs to speed up expansion. Large private conglomerates such as Fosun High-Technology Group, New Hope Group, Wanxiang Group, and Orient Group have been aggressively buying stakes in state-owned enterprises. Increasingly, such large private groups have been able to implement their acquisition strategies across provincial boundaries, and some have moved overseas. Smaller private companies all over China are also becoming more active. The Sichuan Sihai Group, for example, with operations in the meat-processing business, has been expanding by acquiring bankrupt state-owned slaughterhouses and other businesses in a number of locations around Sichuan. These private companies have been injecting capital and dynamism in moribund state enterprises, thus helping to preserve jobs.17 While private enterprises are becoming more active in acquiring and restructuring state-owned enterprises, they still account for a small share in all gaizhi cases. The policy of the government is to expand the role of the private sector, both domestic and foreign, in the 17. In box 5.3 in chapter 5 we described the experience of Changdu Huarong, which was formed in 2000 when New Hope Group, one of the largest private groups in China, acquired a former state company. The Sichuan Sihai Group, by purchasing bankrupt state-owned slaughterhouses, has not only preserved jobs in these enterprises but has also provided income opportunities for approximately 300 smallscale pig breeders. (See IFC, 2004, “Scaling Up Private Sector Models for Poverty Reduction: A Report on the Field Visit to Sichuan and Zhejiang Provinces, China.”)

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restructuring and privatization of SOEs. This will require sustained efforts from both the government and the private sector to improve the business environment for private economic activities and move China’s private enterprise toward global best practice. China is making substantial progress in improving official attitudes toward the private sector. The fourth revision of the 1982 Chinese Constitution from March 2004 includes for the first time protection of private property and human rights. Article 13 of the Constitution was revised to state that the lawful private property of citizens should not be violated, and that the state should protect the private property and inheritance rights of citizens in accordance with the law. The articles explicitly recognize the need for compensation in case the state exercises its rights of eminent domain. The provision is a clear signal that the private sector is to gain more official support—for example, in easier access to credit, which has long been a problem for private businesses. The amendment builds on former President Jiang’s “theory of the three represents,” with its emphasis on the representation of the interests of capital, and not only of workers and peasants. It reflects the new reality of China: a rapidly rising middle class that wants protection of its property rights. Importantly, the amendments emphasize that “lawful” (meaning legally obtained) private property will be protected. It therefore can serve as a weapon against corruption and the use of state assets for personal enrichment. The amendments might serve as a tool for private businesses to push for further reforms and protection of their position in society, as Donald Clarke points out (in Subrahmanyan 2004). They are expected to trigger legislative activity in the area of private property rights to, for instance, define the government rights of eminent domain, the rights of people to sue the government for taking, or inadequately compensating private entities for taking private property, and so on. “Lawful” does not mean much in the absence of a well-developed and consistent legal framework for private property. Even with a complete legal framework for private property, uncertainty may continue for private entrepreneurs who have accumulated their wealth in a fuzzy or nonexistent framework for private business. The fact of the matter is that it is perhaps difficult to find a private entrepreneur in China who can be certain that he or she has never violated the law in the past. The Chinese private sector has grown for most of its short history in an inhospitable environment. Private entrepreneurs did not enjoy a clear identity, their property rights lacked pro198


tection, and they had to function in an environment of significant legal and political uncertainties. Faced with a plethora of restrictions and biases, they had to establish close links with the local bureaucracy and operate under a high degree of informality (Gregory, Tenev, and Wagle 2000). It is widely believed in China—as in all transition economies, for that matter—that many successful private entrepreneur can be found guilty of something, ranging from violating rules set up in the central planning context to tax evasion and bribery. Many private entrepreneurs in China cannot explain clearly the origins of their accumulated wealth. The situation creates uncertainty that, if not addressed, may inhibit the healthy growth of the private sector. In China the term “original sin” is used to refer to the lack of clarity in the ownership of property rights on assets acquired in the early days of capital accumulation. The issue of “original sin” has generated a lot of debate in China. The spectrum of opinions on how to deal with the issue is broad, ranging from confiscation of “illegal” property to amnesty. Many societies have faced similar problems. The American experience with the disposal of public lands during its westward expansion may be instructive in this regard (see box 7.4). Some localities in China are beginning to develop their own solutions to this problem. For example, the issue of the “original sin” of private entrepreneurs became a subject of public attention in January 2004 when the Political and Legal Committee of Hebei Party Committee issued a document known as the “30-point document.” There are two key articles of the “30-point document,” according to media reports: • For criminal activities committed by private entrepreneurs in the early years of their business creation, criminal litigation procedure should not be launched if the legal period for prosecution has been passed. • For those criminal activities that are still in the legal period for prosecution, the court should consider in a comprehensive manner factors such as the nature of the crime, its particular actions and consequences, the repentance shown by the entrepreneur, and the current financial condition and future trend of his business, in deciding whether to give him either no punishment, a reduced term of sentence, or probation. This document has been widely taken as a signal that the Communist authorities are offering “pardons” to private entrepreneurs. The inten199


BOX 7.4 DEALING WITH “ORIGINAL SIN” IN AMERICA’S GREAT PRIVATIZATION America’s westward expansion followed a framework developed by Thomas Jefferson in the great land ordinances of 1785 and 1787. It was a process of privatization of communal property. But the actual processes of disposal of land had very little to do with the original plan. The government apparatus was too slow in setting up the system. The young American nation was impatient, and events moved too quickly. Thus, from the survey ordinance of 1785 on, squatters settled large areas of public land in defiance of the law, ahead of the official survey, and without a title. But while they waited for the public sale day, these settlers all over the central and Midwestern states set up local governments in the form of “claims associations,” elected officers with whom to record their land claims and from whom to obtain decisions on conflicts, and then generally abided among themselves by these records and decisions. Often unlawful in origin, settlements nevertheless quickly produced an effective demand for law (Hurst 1956). Except for Massachusetts, state governments tended to deal generously with the squatters, valuing their pioneering labors. The federal government was far less generous, often sending troops to burn villages (Hughes and Cain 1998). The American legal innovation for dealing with the issue was preemption—the right to buy the land a settler had improved upon before it was offered for public sale. In 1830, Congress passed a broad preemption act to be renewed biennially. In 1841 a general preemption act was passed, limiting preemption rights to 160 acres. The principle of preemption would become the key to integration of extralegal property arrangements in American law (De Soto 2000). In the end the land was occupied in form as specified by the original plan. The process was messy and inefficient: buyers had to wait as long as five years after purchase to get a title, and land officers were commonly corrupt. But farms, cities, railroads, and a great civilization were built in the process.

tion of the “30-point document” was to set rules for the courts, the prosecution offices, and the policy force, which are all under the leadership of the Political and Legal Committee, to encourage them to help create a favorable “investment climate” for the private sector. Legal professionals have criticized this document on the basis that the Political and Legal Committee has no power to make law. 200


The official attitude toward the private sector remains positive and improving, but public criticism of the behavior of private businessmen remains. This criticism is based on the perception that the rules of the game do not apply for the rich and successful in China. With the growth of the private sector in China, more and more private enterprises are adopting socially responsible practices. They put a priority on workers’ welfare, engage in charitable activities, and build strong ties with the local communities (see box 7.5). However, occasional scandals involving private entrepreneurs tend to have a disproportionately strong impact on public perceptions about the private sector in China. The collapse in 2004 of D’Long, allegedly China’s largest private company, revealed a tangled structure and a shadowy mode of operations (Murphy 2004b). The episode, together with revelations of a number of scandals involving Chinese private companies, has damaged the reputation of China’s fledgling private sector. The combination of growing disparity of wealth and rising unemployment is potentially an explosive one. Reflecting such social concerns, the new Chinese government has put a renewed emphasis on social justice, and not only on runaway economic progress. The Chinese private sector cannot afford to ignore this public criticism. The ongoing public debate in China should make private businessmen more sensitive to public opinion and more responsive to the needs of the general population. At a poverty reduction conference in Shanghai in May 2004, World Bank President James Wolfensohn bluntly warned that China’s growing income disparity could lead to a political explosion. He urged China’s nouveau riches to build a bridge to “the underclass” for the sake of their own long-term survival (Murphy 2004a). Conclusion As a result of gaizhi, a heterogeneous ownership structure involving multiple owners, often with diverging interests, has emerged in China. This ownership structure is creating demand for regulations while at the same time enhancing the options available to the regulators. The results of gaizhi so far indicate that outside investors, both state-owned and private, have breathed new life into SOEs. While the successes of gaizhi are significant, it is the “irregularities” that have attracted most public attention. The Chinese public has been concerned that private companies and SOE managers are enriching themselves at the expense of the state and the society at large. The Chinese private sector, in 201


BOX 7.5 DELIVERING MORE THAN PROFITS Private companies in China are contributing to sustainable development by building good business practices, a sense of responsibility toward workers, and ties with the local communities. New Hope Dairy, for example, is working in innovative ways with farmers to improve the quality of its raw materials while increasing farmers’ income. It is providing free milk to schools and kindergartens, generating goodwill, increasing awareness about the health and nutritional benefits of milk, and thus enhancing future milk consumption. Shiyin Paper in the Sichuan capital of Chengdu profitably produces environmentally friendly paper cups and bowls. The company is making regular tax payments based on accounts that have been audited by an independent CPA firm. Chint in Wenzhou has donated 60 million Rmb to the public welfare and called on 156 enterprises to form the first Aid-the-Poor Society in China and raised Rmb 300 million for the cause. Ao Kang in Wenzhou is a producer of leather shoes, employing more than 5,000 people. The enterprise has contributed about Rmb 23 million since 1993 for schooling, developing poor areas, and other causes. Private enterprises increasingly emphasize workers’ welfare. Da Haoda in Wenzhou has been focusing on improving the working environment. It has also invested 7 million Rmb to build better facilities in the headquarters of the company, which can hold 780 employees. The company has purchased recreational and sports equipment to enrich the leisure time of the staff, improving their living conditions and increasing cohesion within the enterprise. Chint in Wenzhou spends Rmb 18 million per year to buy all the staff insurance including insurance against injury suffered on the job. The group has set up Chint College in collaboration with Shanghai Technological and Polytechnic College to enhance the quality of the staff. It also dedicated a day to listening to concerns and suggestions from staff. SOURCE: IFC, 2004. “Scaling Up Private Sector Models for Poverty Reduction: A Report on the Field Visit to Sichuan and Zhejiang Provinces, China.”

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Index Page numbers in italics refer to figures. Page numbers followed by an “n” refer to footnotes.

absentee ownership, 179 acquisitions. See mergers and acquisitions agency costs, 113, 130, 176 Agricultural Bank of China, 6n Aid-the-Poor Society, 202 allocated land-use rights, 81–82, 83, 84, 85 AMCs, 6, 48, 79, 80–81 antidilution rights, 196 Ao Kang, 202 appropriation, of land-use rights, 81–82, 83 asset management companies, 6, 48, 79, 80–81 assets. See state assets assets stripping, 109, 176–77 auctioning, of state firms, 5, 65n auditing, 181, 182 Australia, 94, 95 bad debts, writing off, 187 Bank of China, 6n bankruptcies abuse of to avoid debt, 47–48, 54, 56, 65, 80, 177, 185 bankruptcy provisional funds, 66 in first round of gaizhi, 56 as a form of gaizhi, xi, 5, 22–23, 24, 26–28, 46–48, 50, 60 lack of comprehensive regime for, 187

in most recent round of gaizhi, 57, 57, 59 priority given to workers’ claims in, 35 in sample cities, 54, 58 in sample distribution, 51, 51 Bankruptcy Law, 47, 54, 187 banks abuse of bankruptcies, 48 credit for private enterprise, 163 as creditors to the SOE sector, 32, 35–36 debt recovery by, 77, 80 embezzlement scandals, 176 evasion of payment to, 157 monitoring of borrowers, 186 role in restructuring process, 187 socialization of losses through, 37 unwilling to lend funds for acquisitions, 195 See also loans benchmarking, of enterprise managers, 189 benchmarking, of managerial salaries, 137 boards of directors chairman of the board, 122, 124, 133, 134–35 division of powers between manager and, 194n influence of the Party on, 130, 189, 191

217

INDEX

boards of directors (continued) influence on decision-making, 140, 141 management on, xiii, 122, 123, 134–35, 139, 144 method of electing, 122, 123 in new governance structures, 121–27, 138–39 perceived importance of, 127 regulation of, 185 reorganization of, 146 shareholder representation on, xiii boards of supervisors, 121, 126–27 bonds, 158 bonuses, xiii, 108–9, 109, 136, 136–37 brand names, 70 Brefort, Loup, 116 budget constraints, effect of gaizhi on, 147, 155–57 Bureau of National Land Resource Management, 82 Bylaw on Unemployment Insurance, 88 Bylaw on Urban Residents’ Minimal Living Safeguard, 89 Cai, Fang, 106 capital intensity, 166 casual workers, 102, 102 central government assets of, 63n concurrent officials and businessmen, 190 conflict of interest with local governments, 32 decreased decision-making after gaizhi, 138 encourages outside investment, 191 enforcement of regulations, 185 in fiscal decentralization, 41

218

funding of redeployment centers, 92 influence on decision-making, 140, 140 influence on managerial appointments, 128, 128–29, 130, 131–32, 139, 188–89 introduces debt-for-equity swaps, 48 level of subsidies for local governments, 67 regulations on debt liabilities, 81 role in gaizhi, 31–33, 37, 38, 39 share of total government revenues and expenditures, 185, 186 unemployment policy, 89–93 vetoes MBOs of large enterprises, 183 warning on financial position of local governments, 156 central planning, 41 CEOs, 135 chairman of board, 122, 124, 133, 134–35 Chan, Eric, 130 Changsha, 81 charities, 202 Chengdu bonuses for managers, 136 choice of valuation firm, 74 compensation of workers, 103 economic indicators, 16 employee shareholding, 57 interviews in, 18 location, 12, 12 management shareholdings, 117, 117 method of obtaining land-use rights, 83 open sales, 57 ownership and control structures, 124

INDEX

per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 14 population, 13 private sector, 53 privatization stalemate, 121 privatized SOEs, 28 redeployment of redundant workers, 106 as a sample city, 11 settling of overdue payments, 105, 106 state-owned enterprises, 29, 29 types of gaizhi, 58 unemployment, 17 xiagang workers in, 15 Chengdu Huarong Chemicals, 142 China Construction Bank, 6n China Enterprise Index, 163 China Labor Urban Survey, 106 China Mainland Index, 163 China Private Enterprise Index, 159, 163 China Securities Regulatory Commission, 6, 127, 192, 193, 197 Chinese Communist Party 14th Party Congress, 31 15th Party Congress, 31, 36 adopts enterprise reforms, 3n influence on boards of directors, 130, 189, 191 influence on decision-making, 138, 140, 141, 144 influence on managerial appointments, 130, 131–32, 189 orders officials to resign business positions, 190 role in corporate governance, 128, 130–33, 139 Chinese State Council, 188 Chint, 202

Chongqing, 18, 25, 80–81, 108 Cinda, 79 Circular on Issues Concerning the Transfer of State-Owned Shares, 119 Clarke, Donald, 198 Code of Corporate Governance, 127 collateral, 67, 82 collectives, 49, 183 Company Law, 46, 49, 126–27, 130, 137, 150 compensation, 49, 78, 81, 91, 93–94, 103–8 competition, 6 Concurrent System, 133 Constitution of China, 31, 188, 198 cooperatives, 51n corporate accounting, 194 corporate control, 191–92 corporate disclosure, 188, 192 corporate governance bypassing of by government and Party, 189 changes in influence of stakeholders, 138–40, 140 Code of Corporate Governance, 127 coexistence of old and new practices, 127–33 CSRC as regulator, 6 effects of classes of shares on, 196 impact of gaizhi on, 113–44 new governance structures, 121–27, 123–24, 126–27 as a restructuring mechanism, 5 role of outside investors, 139, 141–43 corporatization, 6–7 corruption, 72, 175 cost approach, in valuation, 69–70

219

INDEX

credit contracts, 187 creditors, in the gaizhi process, 35–36, 182, 186–87 credit ratings, 81 criminal activities, 199 cross-shareholding, 119 CSRC, 6, 127, 192, 193, 197 Da Haoda, 202 danvei, 17 Daqing, 190 debt avoidance, 47–48, 54, 56, 65, 80, 177, 185 debt-equity ratio, 61, 165, 167 debt financing, 195 debt-for-equity swaps, xi, 5, 46, 48, 51, 79 debt problems, 3, 35–36, 76–81, 158 decision-making, 122, 133 Decree No. 4, 85n deflation, 69 delistings, xi, 5 Deng Xiaoping, 3, 31 depreciation, 69 Development Research Center, 158 disclosure, 188, 192, 194 Disclosure Requirements, 192 dismissal. See firing employees, cost of dividends, 108–9, 109 Djankov, Simeon, 169 D’Long, 201 Doing Business in 2005 project, 94 Dougherty, Sean, 40 downsizing, 34–35 early retirements, 91, 93 efficiency, of firms, xii, 39–40, 43, 44, 144, 166, 169, 175 efficiency hypothesis, 39–40, 43, 44 embezzlement scandals, 176

220

employees medical bills, 91, 93 monitoring of company net worth by, 186–87 role in gaizhi, 34–35, 37–38, 38, 39 veto over restructuring, 193 See also compensation; employee shareholdings; redundancy employee shareholdings choice of valuer in, 73 compared to management shareholdings, 116, 116–17 decline of popularity of, 54 effect on efficiency, 169 effect on labor productivity, 168 effect on unit cost, 168 in first round of gaizhi, 56 as a form of gaizhi, 22–23, 24, 46, 49, 59, 60, 62 geographic variations in survey, 57 increase in, 144 in lieu of wages or benefits, 65 in most recent round of gaizhi, 57, 59 obtaining land-use rights, 84 overdue interest rates after, 151 overdue loans after, 149, 150 overdue social security payments after, 153–54, 154, 155 overdue taxes after, 153 rate of employee discharge, 98 relation to workforce growth, 101 in sample cities, 53–54, 58 in sample distribution, 50–51, 51, 52 shares as compensation for workers, 103 stalemate in Chengdu, 121 in TCL Group, 138

INDEX

wage growth rates under, 111 employment contract status of SOE workers, 93n, 103 fall in for SOE sector, 89–90 rigidity of, 94–95 statistics for sample cities, 16 See also labor; redeployment; unemployment employment regulation index, 94 enforcement, of regulations, 184, 185–86 enterprise-based social security system, 87 enterprise debts, dealing with, 3, 35–36, 76–81 equity injections, 119 exit funds, 66 farmers, social security for, 87n FDIs, 1, 118–19, 119, 194 female workers, 102 FIEs, 193, 195–96 finance companies, 186 financial crisis hypothesis, 40, 43, 44 financial discipline, 147, 155–56, 157, 168 financial intermediaries, 186 firing employees, cost of, 95 firm performance, xii–xiii, 158–59, 160–62, 163–74 firm size, 61–62, 75, 76, 157, 165, 167, 172, 174 fiscal decentralization hypothesis, 40–41 foreign direct investments, 1, 118–19, 119, 194 foreign-invested enterprises, 193, 195–96 foreign investment, in SOEs, 6, 117–20, 118–19, 193–96

Fosun High-Technology Group, 197 Freedom House, 130 freedom of information, 188 Frydman, Roman, 164, 170 full-time workers, 102, 102 Fushun choice of valuation firm, 74 economic indicators, 16 internal restructuring, 57 interviews in, 18 location, 12, 12 management shareholdings, 117, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 redeployment of redundant workers, 106 response to survey, 18 as a sample city, 11 settling of overdue payments, 105, 106 state-owned enterprises, 29, 29 types of gaizhi, 58 unemployment, 17 xiagang workers, 15 gaizhi changes in influence of stakeholders, 138–40, 140 in the cities, 4–5 coexistence with old practices, 127–33 debt problems, 35–36, 76–81 decentralization in, 11

221

INDEX

gaizhi (continued) efficiency of gaizhi firms, 144, 175 empirical tests for, 42–45 factors affecting choice of form, 59–62 forms of, 22–23, 46–50, 55, 56, 57 gaizhi firms contrasted with nongaizhi firms, 129 geographic variations in survey, 56–57 governance structures, 121–27, 123–24, 126–27 impact on corporate governance, 113–44 impact on efficiency, xii impact on profitability, xii impact on workforce structure, 102, 102–3 in the industrial sector, xi key participants in, 31–38 land-use rights, 81–86 managerial autonomy under, 133–35 meaning of, xi, 1 measurement of, 42 obligations of firms to workers, 103–8 outside investment in, 36–37, 48, 50, 53, 139, 141–44, 180 progress of process of, 25–31 public debate on, 36–37, 175–81 rate of employee discharge, 96–98, 97–99 role of central government, 31–33, 37, 38–39, 128, 128–29 role of employees, 34–35, 37–38, 38–39 role of labor unions, 129, 129 role of local governments, xii, xiv, 32, 33–34, 36, 37, 38–39

222

role of management, xiii, 34, 38–39 role of the Party, 130–33 sample distribution of forms of, 50–54, 51–52 theories on incentives for, 38–45 typical gaizhi proposal, 64 undertaking of by sample cities, 30 workforce growth rate, 101, 101–2 See also bankruptcies; employee shareholdings; firm performance; internal restructuring; labor, impact of gaizhi on; leasing; open sales, of firms; ownership; privatization; public offerings; remuneration of workers; restructuring; state assets; survey, of gaizhi Giles, John, 90, 106 Glaeser, Edward, 39 go-slows, 7 government. See central government; local governments government officials, as businessmen, 190 granted land-use rights, 81–82, 85 Guangdong province, 66 Guangzhou, 188 guarantees, 67 Guiyang bonuses for managers, 136, 136 choice of valuation firm, 74 compensation of redundant workers, 108 discharge and rehiring of labor, 104 economic indicators, 16 interviews in, 18 location, 12, 12 management shareholdings, 117, 117

INDEX

method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 private sector, 53 redeployment of redundant workers, 106, 107 as a sample city, 11 settling of overdue payments, 105 state-owned enterprises, 29, 29 types of gaizhi, 58 Guo, Kai, 41 Haier, 183 Hang Seng Index, 159, 163 Harbin bonuses for managers, 136 choice of valuation firm, 74 compensation of workers, 103, 108 economic indicators, 16 internal restructuring, 56 interviews in, 18 location, 12, 12 management shareholdings, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 privatized SOEs, 28 redeployment of redundant workers, 106

sale of state assets, 73 as a sample city, 11 settling of overdue payments, 105 SMEs in, 79 state-owned enterprises, 29, 29 types of gaizhi, 58 unemployment, 17 xiagang workers, 15 Hengdong Ceramic Factory, 149 Hengyang bonuses for managers, 136 choice of valuation firm, 74 compensation of workers, 103 economic indicators, 16 interviews in, 18 land-use rights, 84 leasing, 57 location, 12, 13 management shareholdings, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 private sector, 53 privatized SOEs, 28 redeployment of redundant workers, 106, 107 as a sample city, 11 settling of overdue payments, 105 state-owned enterprises, 29, 29 types of gaizhi, 58 Hisense, 183 holding companies, 47, 193 Hong Kong, 94 Huangshi bonuses for managers, 136

223

INDEX

Huangshi (continued) choice of valuation firm, 74 economic indicators, 16 employee shareholding, 57 location, 12, 13 management shareholdings, 117 method of obtaining land-use rights, 83 open sales, 57 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 privatized SOEs, 28, 28 redeployment of redundant workers, 106, 107 as a sample city, 11 settling of overdue payments, 105, 106 state-owned enterprises, 29, 29 types of gaizhi, 58 human rights, 31 hybrid firms, 178, 179, 184 illegal fundraising, 164 incentives, 38–45, 109, 113, 135–38, 169–70, 178 income approach, in valuation, 69 incorporation, 2, 46–47, 51, 100, 122 Indonesia, 94, 95 Industrial and Commercial Bank of China, 6n, 79, 149 industrial disputes, 7, 9, 9, 90–91 industrial output, in sample cities, 16 industrial sector, xi inflation, 69 inheritance rights, 198

224

initial public offerings, 6, 47–48, 54, 63–64, 84, 184 insurance companies, 186 intellectual property, 65 intelligentsia, 36, 37 interest rates, overdue, 150–52, 151 Interim Provisions on the Acquisition of Domestic Enterprises by Foreign Investors, 193 internal restructuring budget constraints, 155–57 choice of valuer in, 73 debt avoidance through, 177 decline of, 54 discounted price for assets, 75 in first round of gaizhi, 56 as a form of gaizhi, 22–23, 46–47, 59–60, 62 geographic variations in survey, 56–57 hardening of budget constraints, 155 in most recent round of gaizhi, 57, 59 obtaining land-use rights, 84 overdue interest rates after, 151, 151–52 overdue loans after, 150, 150 overdue social security payments after, 153, 154 overdue taxes after, 153 progress of process of, 25–31 rate of employee discharge, 98 relation to workforce growth, 101 rounds of, 57 in sample cities, 20, 24, 53, 58 in sample distribution, 50–51, 51 in sample firms, 22–23 wage growth rates under, 110, 111

INDEX

International Finance Corporation, 142 interviews, 17–18 investment comparisons between privatized firms, 172 discrimination against outside investors, 184 foreign direct investments, 1, 118–19, 119, 194 gaizhi versus non-gaizhi firms, 146–47, 147 new investment, 23 outside investment in gaizhi process, xiii, 36–37, 48, 50, 53, 139, 141–44, 180 restrictions on size and liquidity, 193 SOEs as outside investors, xiii transaction costs for outside investors, 191–97 IPOs, 6, 47–48, 54, 63–64, 84, 184 Jefferson, Thomas, 200 Jianhua, 116 jobs-for-life, disappearance of, 103 Johnson, Simon, 39 joint ventures choice of valuer in, 73 contrasted with wholly foreignowned ventures, 118, 119 conversion of land-use rights into equity, 83 corporate governance, 194n, 195n as a form of gaizhi, 22–23, 46, 50, 51, 51 motivation for, 169n obtaining land-use rights, 84 organizational transformation through, 114 in sample cities, 54, 58

key persons, 135 Korea, South, 94, 95 labor impact of gaizhi on workforce structure, 102, 102–3 industrial disputes, 7, 9, 9, 90–91 influence on decision-making, 140, 140 productivity of, 158–59, 160–62, 164, 166–68, 172–74 workforce growth rate, 101, 101–2 See also employment; redundancy; unemployment labor unions, xiii, 32, 127–29, 129, 139, 144 land, conversion of into equity, 83, 84 land, privatization of, 200 Land Law (1998), 81 land-use rights, 81–86, 108 land valuation, 85 Lanzhou bonuses for managers, 136, 136 choice of valuation firm, 74 economic indicators, 16 forms of gaizhi in, 57 location, 12, 12 management shareholdings, 117, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita income, 13, 14 population, 13 privatized SOEs, 28, 28 redeployment of redundant workers, 106 response to survey, 18

225

INDEX

Lanzhou (continued) as a sample city, 11 settling of overdue payments, 105, 106 state-owned enterprises, 29, 29 types of gaizhi in, 58 unemployment, 17 xiagang workers, 15 layoffs. See redundancy leasing choice of valuer in, 73 in first round of gaizhi, 56 as a form of gaizhi, 22–23, 46, 50, 60 geographic variations in survey, 57 of land-use rights, 81, 82, 83, 84 in most recent round of gaizhi, 57, 59 obtaining land-use rights, 84 overdue interest rates after, 151 overdue loans after, 150 overdue social security payments after, 154 overdue taxes after, 153 rate of employee discharge, 98 relation to workforce growth, 101 in sample cities, 53, 54, 58 in sample distribution, 51, 51, 52 of SOEs in 1980s, 2 in transfer of state assets, 65, 66 trend towards, 54 wage growth rates under, 111 legal person shares, 192, 193, 196–97 Legal Person Shares of Listed Companies to Foreign Investors, 119 legal representatives, 135 ‘let the small go’ policy, 3–4, 32 Li, Shaomin, 41 Li, Shuhe, 41

226

Li, Yizhong, 185, 190 limited liability companies, 46, 47, 49, 51, 193 liquidations, xi, 5, 25, 28 listings, xi, 5, 73 Liu family, 142 living standards, minimum, 89 loans advantages for state sector, 168 to buy shares, 65 gaizhi versus non-gaizhi firms, 155 nonperforming loans, 6, 48, 77 overdue bank loans, 76–77, 79, 147, 148–51, 149–52, 155–57 restructuring of borrowers, 187 state-owned enterprises as guarantors, 67 local governments abuse of bankruptcies by, 48 assets of, 63n compensation of redundant workers, 94, 111–12 conflict of interest with central government, 32 dealing with enterprise debt in gaizhi, 80–81 encouragement of outside investors by, 36 enforcement of regulations, 185 evasion of payment to, 157 in fiscal decentralization, 41 fiscal strength of, 61, 62 funding of redeployment centers, 92 give priority to overdue wages, 105 national government subsidies for, 67 obligation to support laid-off workers, 34, 60 regulation of unemployment insurance, 89

INDEX

relationship with local SOEs, 33–34 responsibility for SOE losses, 37 risks in financial position of, 156, 158 role in gaizhi, xii, xiv, 38, 39, 66 SOEs owned by, 3, 114 use of proceeds from sale of landuse rights, 85 losses, socialization of, 37 Luoyong Tractor Factory, 169n macroeconomic policy, 164 Malaysia, 94, 95 management on boards of directors, xiii, 122, 123, 134–35, 139, 144 division of powers between board and, xiii, 194n government officials in positions of, 190–91 incentives for, 135–38, 136 influence of government on appointments, 128, 128–29, 130, 131–32, 188–89 influence of Party on appointments, 189 influence on decision-making, 140, 140, 141 influence on use of state assets, 113 managerial autonomy, 113, 133–35, 169, 176 perceived importance of, 134, 134 performance evaluation, 185 recruitment of new management, 146 reduction of in gaizhi firms, 146, 146 redundancies, 146 remuneration of, 137, 139, 144, 146

role in gaizhi, xiii, 34, 37, 38, 39 shareholdings by, 49, 65, 116–17, 116–17, 138, 168 temptations facing, 143 transfer of ownership to, 42 management buy-outs, xiv, 4, 49, 72, 75–76, 78, 176–77, 182–83 managerial market, 130 market liberalization hypothesis, 41–42, 44, 45 market volatility, 69 MBOs, xiv, 4, 49, 72, 75–76, 78, 176–77, 182–83 McGuckin, Robert, 40 medical insurance, 88 mergers and acquisitions administered mergers, 36, 115 in Chinese foreign direct investment, 118, 119 debt financing for, 195 by de novo private firms, xiv development of New Hope Group, 142 effect of QFII Rules on, 193 as a form of gaizhi, 23, 24, 27, 50 government encourages takeovers, 64 nonlisted SOEs, 193 as a proportion of FDI, 194 in sample cities, 54 by SOEs, 115 statistics, 25, 26 Takeover Rules, 192 transaction costs, 196 methodology, 11, 17–18 migrant workers, 102 minimum living safeguard system, 89, 93 Ministry of Construction, 68 Ministry of Finance, 32, 68, 187, 193 Ministry of Labor, 32

227

INDEX

Ministry of State Land and Resources, 68 money tightening, 164 monitoring, for agency costs, 113 monopolies, 6 moral hazard, 155 multivariate analysis, 155–56, 157 Murrell, Peter, 169 National Economic Research Institute, 42 National People’s Congress, 31 net assets per worker, 61, 62 net worth, of companies, 186, 187 new enterprises, 107 New Hope Dairy, 202 New Hope Group, 142, 197 New Zealand, 95 nonperforming loans, 6, 48, 77 nonstate enterprises, 7, 9 nontradable shares, 192, 193 NPLs, 6, 48, 77 open government, 188 open sales, of firms choice of valuer in, 73 discounted price for assets, 75 in first round of gaizhi, 56 as a form of gaizhi, 22–23, 46, 50, 59–60 in most recent round of gaizhi, 57, 59 obtaining land-use rights, 84 overdue interest rates after, 151 overdue loans after, 150 overdue social security payments after, 154 overdue taxes after, 153 rate of employee discharge, 98 relation to job losses, 100 relation to workforce growth, 101 in sample cities, 53, 54, 58

228

in sample distribution, 51, 52, 52 trend towards, 54 wage growth rates under, 110, 111 Orient Group, 197 ‘original sin,’ 199–200 ownership changes in structure of, 114–21, 115–20 composition of GDP by, 10 and control, 121–27 discharge rates by type of, 96 diversification of, 5, 46–50, 164, 178–79 effect of private ownership on firm performance, 163–66 under gaizhi, 37 heterogeneous ownership structures, 177–80, 191, 201 hybridized ownership structures, 116 relation to regulation, 178–80 relation to social demands, 178n transfer of to management, 42 ‘packaging for listing,’ 98 Papua New Guinea, 94, 95 Park, Albert, 90, 106 the Party. See Chinese Communist Party patents, 70 Pay As You Earn (pension system), 88 pensions, 77, 81, 87–88, 93–94, 104, 107n People’s Bank of China, 187, 192 per capita government revenue, 14, 16, 156 performance, of firms, 158–59, 160–62, 163–74 performance, of management, 185 performance-based incentives, 109 performance targets, 2

INDEX

Philippines, 94, 95 piece-rate wages, 108–9, 109 political systems, 39 ‘prettier daughters’ effect, 171, 173 price liberalization, 31 price volatility, 69, 163 private ownership, effect on firm performance, 163–66 private property rights, 198 private sector access to finance, 168, 198 acquisitions by, xiv, 197 budget constraints, 155–57 contribution to sustainable development, 202 dominance of, 11 efficiency of, 166 firm performance, 159, 160–62, 163 growth of, xi managers as board members, 135 official attitudes towards, 198, 201 ‘original sin’ in, 199–200 overdue wages and payments, 104–5 as participant in gaizhi, 52, 53, 61, 62 Party branches in, 131n scandals in, 176, 201 shareholdings in gaizhi firms, 117, 121, 172 socially responsible practices, 201, 202, 203 uncertainty in, 198–99 workforce growth rate, 101 See also hybrid firms private shareholdings, 2 privatization China compared to Eastern Europe, 1 effect on bank discipline, 156–57 financial crisis hypothesis, 40

fiscal decentralization hypothesis, 40–41 fraudulent cases of, 72 government shareholdings, 114 hybridized ownership structures, 116 impact on labor productivity, 164 impact on profitability, 164 impact on unit cost, 164 by local government, 33–34 outside versus inside privatization, xiii–xiv ownership concentration of privatizing firms, 120 ‘prettier daughters’ effect, 171, 173 public debate on, 36–37, 175–81 reclassification of jobs in, 90n relation to job losses, xii, 100, 100–101, 111 in rural areas, 4 selection bias in studies of, 170–71 of SOEs (1996–2001), 25–28, 28 spontaneous emergence of, 38 stalemate in Chengdu, 121 start of, 3 See also gaizhi; investment product development, 146, 147 productivity, of labor, 158–59, 160–62, 164, 166–68, 172–74 productivity gap, 60, 61 profitability, xii, 158–59, 160–62, 164, 166–67, 172–74 property rights, 4, 31, 46, 181, 184, 198 Provisional Regulations on the Use of Foreign Capital for Restructuring State-Owned Enterprises, 119 Provisional Rules of State Public Servants, 190

229

INDEX

Provisional Rules on the Management of Investment in Domestic Services by Qualified Foreign Institutional Investors, 192–93 the public, in the gaizhi process, 36–37 public offerings decline of, 54 in first round of gaizhi, 56 as a form of gaizhi, 20, 22, 24, 46, 50 initial public offerings, 6, 47–48, 54, 63–64, 84, 184 in most recent round of gaizhi, 57, 59 overdue interest rates after, 151 overdue loans after, 149, 150 overdue social security payments after, 154, 155 overdue taxes after, 152–53, 153, 155 rate of employee discharge, 98 relation to workforce growth, 101 in sample cities, 53, 58 wage growth rates under, 110, 111 public servants, in business, 190 QFII Rules, 192–93 Qian, Yingyi, 114 Qionglai, 86n rationalization programs, 6 R&D, 147, 148 real estate developers, 85n Red Chips, 163 redeployment, 17, 35–36, 42–43, 66, 67, 91, 106–8 redundancy compensation for, 93 discharge rates, 96–98, 97–99

230

gaizhi and non-gaizhi firms compared, 96, 99 impact on profitability, 172 industrial disputes due to layoffs, 9 influence of on form of restructuring, 60 mid-1990s, 103 relation to overdue social security payments, 156 relation to privatization, xii, 45, 100, 100, 111 resulting from gaizhi, xi, 5, 37, 47 setting of limits for, 95 settlements for, 104 social obligations on local government, 34, 60 statistics, 7 tax concessions for reemployment services, 91 types of redundant workers, 43, 91–92 See also redeployment; unemployment; xiagang workers regression analysis, 60, 96, 101, 102, 102, 155, 163 regulation, xiv, 178–85, 191–93 Regulation on Appropriated LandUse Rights in SOE Reform, 82 Regulation on the Management of State Asset Valuations, 68 remuneration of managers, 137, 139, 144, 146 remuneration of workers collective wage bargaining, xiii gaizhi and non-gaizhi firms compared, 108–9, 109, 110, 110–11 overdue wages, 76–77, 81, 91, 93, 104–5 salary gap with managers, 137n types of, 108–9, 109

INDEX

wage growth rates, 110–11, 110–11 See also compensation research and development, 147, 148 resource allocation, 41 restructuring effect on labor performance, 103 employees’ resettlement programs, 91 foreign direct investment encouraged in, 118–19 range of mechanisms, 5 social cost, 9, 60, 61, 62, 85, 175 through asset management companies, 6 See also internal restructuring retailing enterprises, funds for reform of, 66 retirements, 42–43, 91, 93, 157, 165 return on assets, 61 Roosevelt, Eleanor, 130 rural household responsibility system, 2 safety net, 89, 93, 175 sample cities, 11–17, 18–19, 30 sample distribution, 18–20, 50–54, 51–52 sample selection, 18 SARS, 188 SASAC, 32–33, 49, 78–79, 91, 181, 184, 185 scandals, 176, 201 selection bias, in privatization studies, 170–71 service sector, 14 SETC, 32, 193 Shanghai, 188, 191 Shanghai Jinling, 115 shareholder conferences, xiii, 121–22, 123, 125–26, 126, 133, 138–39, 140, 141

shareholding cooperatives, 51, 103 shares buy-outs, 119 classes of, 196–97 deferred payment of, 65 holdings by foreign companies, 117–20, 118 holdings by government, 114 holdings by management, 49, 65, 116–17, 116–17, 138, 168 increase in private shares, 116 issue of, 137 relation of board to share structure, 123 share swaps, 119 in SOEs, 191 Takeover Rules, 192 three largest shareholders, 120, 120 See also employee shareholdings; shareholder conferences ‘shell’ companies, 184 Shenyang Jinbei Motors, 2 Shenyang Motor Corporation, 2 Shenzhen Stock Exchange, 3 Shiyin Paper, 202 Shleifer, Andrei, 39 Shuangxing, 183 Shunde, 3, 17, 40 Sichuan Sihai Group, 197 SMEs, 19, 78–79 social burdens, of firms, 43, 157, 165, 167, 172 social cost, of restructuring, xi, 7, 9, 60, 61, 62, 85, 175 social insurance payments, 77 socially responsible practices, 201, 202, 203 social relief system, 89 social security expenditure, 67, 104 social security payments, overdue, 91, 104–5, 153–55, 154, 155–57 social security system, 9, 87–89, 154–55

231

INDEX

SOEs. See state-owned enterprises soft budget constraints, 147, 155–56, 157 spin-offs, 23, 46, 47, 50, 51, 53 stakeholders, changes in influence of, 138–40, 140 State Administration for Industry and Commerce, 193 State Administration of Foreign Exchange, 193 state assets arbitrary shifting of assets, 195 concern of central government over, 37 conflict between central and local government, 32 discounts on price of, 43, 74–76, 75–76, 78, 86, 177, 181 erosion of, 72, 175, 176, 184 exit funds, 66 management influence on use of, 113 negative net assets, 64–65, 66 overvaluation and undervaluation, 71–72 productive and nonproductive, 63 transfer of in gaizhi, 62–67, 179, 181–82, 184 use of to meet obligations to workers, 33–34 valuation of, 63, 65, 67–76, 74–76, 181, 182 State-Owned Assets Supervision and Administration Commission, 32–33, 49, 78–79, 91, 181, 184, 185, 190 state-owned enterprises access to finance, 168 bankruptcy provisional funds, 66 budget constraints, 155–57 in composition of GDP, 10 contract status of workers in, 93n, 103

232

debt problems, 3, 35–36, 76–81 decline in numbers, xi, 25, 26, 27, 28, 89–90 efficiency of, 39–40, 166, 169, 175 extension of guarantees by, 67 firm performance, 158–59, 160–62 foreign investment in, 6, 117–20, 118–19, 193–96 fraudulent privatization of, 72 government officials working in, 190 incorporation of, 2 industrial sector, 8 jobs-for-life disappear, 103 ‘let the small go’ policy, 3–4, 32 level of government ownership of, 42 as limited liability companies, 47 management of reform, 32–33 mergers and acquisitions by, 115 outside versus inside control, xiii–xiv, 168–69 overdue bank loans by, 76–77 overview of reform process, 2–11 owned by local government, 3, 114 Party branches in, 131 privatization of (1996-2001), 25–28, 28 profitability of, 7, 8 share in total industrial assets, 7, 8 SOE Restructuring Provisions, 193 trend in ownership structure (1995–2001), 115 workforce growth rate, 101–2 See also corporate governance; gaizhi; hybrid firms; ownership; regulation; restructuring; survey, of gaizhi

INDEX

Stiglitz, Joseph, 114 stock exchanges, 180n strikes, 7 Sun, Qian, 166 Supreme People’s Court, 80, 179, 195n survey, of gaizhi compared with 1998 survey, 20, 24 firms by economic sector, 21 firms by industrial sector, 21–22 methodology, 11, 17–18 number of firms undertaking gaizhi, 30 sample cities, 11–17 sample distribution, 18–20, 24 structure of study, 24 sustainable development, 202 Takeover Rules, 192 Tangshan bonuses for managers, 136 choice of valuation firm, 74 compensation of workers, 103 economic indicators, 16 interviews in, 18 location, 12, 12 management shareholdings, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 private sector, 53 redeployment of redundant workers, 106, 107 as a sample city, 11

settling of overdue payments, 105, 106 state-owned enterprises in, 29, 29 types of gaizhi, 58 xiagang workers, 15 taxes, 76, 107, 152–53, 152–53, 155–57, 199 TCL Group, 138 technology, new, 146, 147 Tenev, Stoyan, 116, 117, 120, 122, 135, 137 terminations, 100 Thailand, 94, 95 theory of the three represents, 198 30-point document, 199–200 Tian, Guoqiang, 41 time trends, in firm performance, 170–72, 173 Tong, Jing, 166 Tong, Wilson, 166 total government revenues and expenditures, 185, 186 township and village enterprises (TVEs), 2, 4, 36 tradable shares, 192, 196 trademarks, 70 trade unions. See labor unions transaction costs, 191–97, 196 transnational corporations, 7 Tsingtao Brewery, 115 TVEs, 2, 4, 36 UBS Warburg China Private Enterprise Index, 159, 163 unemployment central government policy, 89–93 discharge rates, 96–98, 97–99 jobless contrasted with xiagang workers, 91–92 resulting from gaizhi, 34–35, 42–43, 95–103, 97–100

233

INDEX

unemployment (continued) in sample cities, 15, 16, 17 state security fund for jobless, 92 See also redeployment; redundancy; xiagang workers unemployment insurance, 88–89, 92 unemployment insurance levy, 88 unions, xiii, 32, 127–29, 129, 139, 144 Unirule, 86n unit cost, 158, 160–62, 164, 167, 168, 172, 173 United Nations Conference on Trade and Development, 118 United States, privatization of land, 200 United States Securities and Exchange Commission, 186n urban utility privatization program, 86n valuation. See land valuation; state assets, valuation of valuation firms, choice of, 177 valuation industry, 68 valuers, selection of, 72–73, 74 wages. See remuneration of workers Wanxiang Group, 197 Weifang bonuses for managers, 136 choice of valuation firm, 74 economic indicators, 16 employee shareholding, 57 location, 12, 12 management shareholdings, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15

234

per capita government revenue, 14 per capita income, 13, 14 population, 13 redeployment of redundant workers, 106, 107 response to survey, 18 as a sample city, 11 settling of overdue payments, 105 state-owned enterprises, 29, 29 types of gaizhi, 58 xiagang workers, 15 Wei Liucheng, 190 whistleblowers, 188 Wolfensohn, James, 201 women, 102 Wong, Sonia, 130 workers’ congresses, 133 workers’ rights, 182, 187, 188 workforce. See labor working conditions, 202 work units, 17 write-offs, 35, 47, 187 Wu Bangguo, 3–4 Wuhan Motor Engine Factory, 2 Wuhu, 190 xiagang workers allowances for, 92–93, 104 benefits of status of, 92 characteristics of, 15, 91 impact on firm performance, 174 rate of, 98, 99, 100 redeployment of, 92, 107 in sample cities, 16 as a social burden for firms, 43 Xining bankruptcies in, 57 bonuses for managers, 136 choice of valuation firm, 74 economic indicators, 16 forms of gaizhi in, 57 location, 12, 12

INDEX

management shareholdings, 117, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 14, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 redeployment of redundant workers, 106 response to survey, 18 as a sample city, 11 sample firms, 18 settling of overdue payments, 105, 106 state-owned enterprises in, 29, 29 types of gaizhi in, 58 Yang, Lei, 41 Yanzhou Coal Mining, 115 Yao, Yang, 41 Zhang, Chunlin, 116, 117, 120, 122, 135, 137 Zhang, Juwei, 90

Zhang, Ruimin, 183 Zhang, Weiying, 41 Zhenjiang bonuses for managers, 136 choice of valuation firm, 74 economic indicators, 16 employee shareholding, 57 interviews in, 18 location, 12, 13 management shareholdings, 117 method of obtaining land-use rights, 83 ownership and control structures, 124 per capita GDP growth, 13, 15 per capita government revenue, 14 per capita income, 13, 14 population, 13 redeployment of redundant workers, 106, 107 as a sample city, 11 settling of overdue payments, 105 state-owned enterprises in, 29, 29 types of gaizhi in, 58 zhuada fangxiao, 3 Zhucheng, 3, 4, 12, 12, 17, 40

235

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