Chapter

9 State Enterprise Reforms

Author(s):
Wanda Tseng, and Markus Rodlauer
Published Date:
February 2003
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Author(s)
Paul Heytens

Reform of state-owned enterprises (SOEs) has been among the most difficult and gradual of China’s structural reforms. The financial performance of SOEs has been weak for much of the reform period, and the losses they have incurred have required heavy subsidization by the state. Early in the reform era this was effected through direct budgetary allocations, but thereafter it took the form of loans from the state commercial banks (SCBs), creating increasingly large contingent liabilities.

By the early 1990s it had become clear that fundamental restructuring of the SOEs—and, by extension, of the state-owned banks (see Chapter 10)—could no longer be delayed. Despite a broadening and acceleration of the process, the pace of reform remained conditioned by concerns over social stability and public support for reforms, as layoffs from SOEs added to regional income disparities and strained an inadequate social safety net. Some progress has nevertheless been made in hardening budget constraints, and enterprise profitability has improved following Premier Zhu Rongji’s pledge in 1998 to revitalize medium-size and large SOEs. Although part of this improvement reflected one-time changes (such as the conversion of a sizable portion of nonperforming loans into equity), there have also been durable efficiency gains through layoffs, a reduced social welfare burden, and efforts to shed excess capacity in key sectors.

This progress notwithstanding, deep-rooted problems remain. Available balance sheet data suggest that some one-third of China’s predominantly state-owned companies are unable to generate sufficient earnings to cover interest payments, and aggregate data indicate that SOEs are less efficient and display considerably weaker financial profiles than enterprises under other forms of ownership (see Chapter 11). Moreover, enterprise management and operational efficiency have remained weak, outside governance remains limited, excess labor is still high, and exit channels for poorly performing SOEs remain limited.

The Reform Agenda

The overarching goal of China’s reform process is to create a market economy with “socialist characteristics.” In principle, this has meant an economy in which substantial public ownership of industry is retained, but where enterprises of all ownership types seek to maximize profits in response to market forces. As in other transition economies, the creation of a market economy in China has been seen less as an end in itself than as a necessary means to achieve growth and development in a manner consistent with the country’s social and political objectives.

By the early 1990s the move toward a market economy was already well advanced. Most product prices, and to a lesser extent wages, were free to vary with market conditions. Competition was strong in many, if not all, industrial sectors. Overall, the economic behavior of enterprises had become more responsive to market forces as a result of increased competition in most consumer goods sectors, the rapid growth of the nonstate sector, and management reforms carried out in the SOEs in the 1980s. These reforms generally involved delegating greater authority to the enterprises and allowing them to retain a larger share of the profits they generated. However, some of the more difficult reform tasks remained to be accomplished, including the following: transforming the SOEs into modern commercial entities; restructuring and reorganizing the strategic or “pillar” economic sectors to achieve economies of scale in production; developing the financial, legal, and other institutions necessary for the functioning of a market economy; and completing the opening of the domestic economy to international markets.

The 1993 Reform Agenda

The basic parameters of China’s current SOE reform program were set out during the Third Plenary Session of the 14th Communist Party Congress in November 1993. Although enterprise reforms had been undertaken during earlier periods, the approach and pilot policies adopted in 1993 were much broader and more sweeping than anything implemented previously. The central elements were

  • The introduction of corporate governance, including incorporation under a new company law, the clear separation of ownership from management, and granting enterprises a list of “autonomous rights”1

  • Removal of social welfare functions, such as hospitals, schools, and pension and unemployment liabilities, from enterprise balance sheets, as well as steps to reduce excess labor

  • Reduction of accumulated enterprise debts

  • Provision of new financing for technical updating, improvement, and expansion

  • Organizational and ownership restructuring through sales, mergers, leasing, contracting, joint-stock participation, and, if necessary, liquidation and bankruptcy.

The guiding principle in applying these reforms was to “seize the large and release the small.” The end result envisaged by the architects of these reforms was an economy in which larger enterprises in key economic sectors remained under state control, with the rest under other forms of ownership. Both state and nonstate enterprises were to have independent management and operate according to market principles, although it was expected that some sectors would benefit from natural oligopolies or barriers to nonstate entry. With few exceptions, the state sector was expected to be profitable and to attract resources on a competitive basis, with minimal recourse to budgetary subsidies.

The emphasis on large enterprises and key sectors constituted a substantial shift in SOE reform strategy. In contrast to earlier reform initiatives, which were aimed at improving the performance of the entire SOE sector, the current strategy has emphasized downsizing the overall scope of state activity while concentrating state resources and efforts on those areas that could feasibly stay under central control. For example, state ownership would be retained in sectors where there was a perceived social need for state management (such as natural monopolies), or where state intervention could exploit economies of scale (as in coal mining and steel), or where resource allocation represented a national development priority (as in electric power generation and telecommunications services).

For the first time, smaller enterprises as a group were explicitly encouraged to leave the state-owned fold. Responsibility for this process was essentially handed over to local governments. Small enterprises could be restructured in any way local governments saw fit, but no central financing or subsidies were to be provided in the process. This approach was based on the assessment that smaller enterprises accounted for a disproportionately large share of losses and indebtedness, which were best dealt with by moving them out of the hands of the state.

Pilot Programs

The State Council subsequently adopted a number of diverse pilot programs to carry out these reforms. The following are the most prominent:

  • Adoption of modern enterprise systems. This comprehensive initiative initially involved 100 medium-size and large enterprises in 50 cities. The primary aim was to convert the enterprises into incorporated entities with modern corporate governance structures, clarified ownership rights, and strengthened management functions. This program also adopted many of the measures of the “pilot cities” project outlined just below.

  • Enterprise restructuring and recapitalization in pilot cities. This program, managed by municipal governments in 111 (originally 18) cities and involving enterprises chosen by them, included specific measures to lower debt-to-assets ratios as well as a general framework for enterprise restructuring. The former included central and local tax credits and exemptions as well as accelerated annual depreciation deductions, all to be used for enterprise recapitalization. Restructuring measures included special procedures for mergers and bankruptcies of SOEs as well as divestiture of hospitals, schools, and other “nonproductive” social assets.

  • Revitalization of key enterprises. The State Council selected 1,000 of the largest centrally administered SOEs, which were considered to form the core of the national economy. Of these, about 520 (the precise number has varied slightly over time) were chosen for central support, including the provision of new financing through “principal bank” agreements and the raising of equity capital. In addition, these enterprises were to receive broader operational autonomy, including autonomy with respect to financing modalities (such as issuance of corporate bonds) and direct foreign trading rights.

  • Formation of large enterprise groups. One hundred and twenty (originally 57) key production enterprises were given the right to form large holding structures, which were meant to help achieve economies of scale in a number of industries and play an instrumental role in the restructuring and corporatization of related enterprises. Other measures included privileges similar to those introduced in the pilot cities and the programs for the 1,000 core enterprises, with the addition of autonomy in trade, financing, and investment decisions and direct administration by the State Council.

In addition to these centrally directed programs, provincial governments were encouraged to develop their own pilot schemes and policies for strengthening larger SOEs under their ownership and control. Most of these initiatives have proceeded along the lines of their central counterparts. For example, provinces and municipalities identified nearly 2,600 additional enterprises to undergo “modern enterprise system” reforms and have formed thousands of regional and local enterprise groups.

Subsequent Modifications

The approach to SOE reform adopted following the 14th Party Congress was not all-encompassing. Like reforms in other areas, the process was an evolving set of pilot schemes with varying emphases and generally lacked an overarching vision of the future of the state sector or its role in the economy (following an old Chinese adage, the authorities were “crossing the river by feeling the stones”). This reflected in part the fact that the reform measures had generally arisen as a compromise between those who advocated a strong majority role for state ownership—but with reduced subsidies and greater incentives for efficiency—and those seeking to reduce the role of the state to a bare minimum. In addition, the reform strategy focused primarily on individual enterprises or enterprise groups, with policies and preferences determined according to size and scale, rather than the specific economic conditions in individual production sectors. There were no industry-specific reform blueprints.

By early 1997 the terms of the debate over the role of the state in the economy had begun to shift more decisively in favor of greater liberalization and nonstate participation. President Jiang Zemin, during the 15th Party Congress in September 1997, provided substantial clarification of the desired economic role of the state and the long-term goals of SOE reform. Most important, he clarified that the introduction of market mechanisms (such as stock markets and institutions of corporate governance such as shareholders’ meetings) were consistent with a socialist market economy, and that the state did not have to dominate every sector or have majority ownership in every enterprise in order to maintain broad control of the economy. These clarifications opened the door for a further broadening of the scope of enterprise reform.

There was also a growing recognition, partly as a lesson from the Asian crisis, that the ongoing reforms were not deep enough or proceeding quickly enough to stem the declining performance of the SOEs, particularly the rising losses and resulting nonperforming loans in the banking system. SOE reforms were accelerated significantly following the ascension of Zhu Rongji to Premier in March 1998, who immediately embarked on a three-year program to revitalize China’s medium-size and large SOEs. This was to be achieved by widening implementation of the pilot reform initiatives to a national scale and combining them with efforts to reorganize, upgrade, and improve enterprise management and governance, to change the way enterprises operate, and to carry out a strategic reorganization of key sectors. The social consequences of accelerated reforms were to be dealt with through complementary efforts to establish and secure adequate financing for a broad social safety net, including reemployment programs. The link between SOE problems and sector-specific conditions was also explicitly recognized, prompting the launch of industry-wide restructuring programs aimed at eliminating excess capacity and redundant labor, the main underlying causes of chronic losses.

The Progress of Reforms

The complexity and multidimensional character of China’s SOE reforms make it very difficult to define clear indicators of progress or success. Enterprise reform in China has also been shaped by a number of special characteristics that need to be taken into account in drawing conclusions about the process. A key factor is the explicit policy choice to retain significant state ownership and control of industry. Another important characteristic is the perceived need by the Chinese authorities to proceed in a manner that minimizes social disruption and preserves public support for reforms.

Along with the achievement of Premier Zhu’s three-year revitalization objective (see Box 9.1), important steps have been taken in virtually every reform area. However, progress has been uneven: considerable success has been achieved in small enterprise reform and labor downsizing; on the other hand, a number of critical governance issues in the larger enterprises are only now beginning to be addressed. Looking ahead, stronger reform and revitalization efforts in the larger SOEs have been identified as top priorities for economic policy in the 10th Five-Year Plan (2001–05). In assessing the progress that has been made, it is useful to break the reform process down into its main components: economic restructuring, reform of enterprise management and corporate governance, and ownership reform.

Box 9.1.Premier Zhu’s SOE Revitalization Objective

During the March 1998 annual session of the National People’s Congress, Premier Zhu Rongji announced an ambitious three-year program to revitalize medium-size and large SOEs. The program was aimed specifically at achieving the “two majorities,” that is, to transform the majority of money-losing medium-size and large SOEs into profitable enterprises, and to have the majority of “core” SOEs adopt the modern enterprise system. The first objective was directed at the 6,599 medium-size and large SOEs (out of a total population of about 16,800) that were continuing to suffer losses at the end of 1997, whereas the second aimed primarily at the 100 central-level and 2,700 provincial-level pilot enterprises and the 520 “key” large SOEs.

At the opening of the March 2001 annual session, the premier announced that his revitalization objective had been “realized on the whole,” citing the following indicators:

  • Overall SOE performance had improved dramatically. Industrial SOEs had achieved profits of Y 239.2 billion in 2000, the highest level ever and 2.9 times their level of 1997.

  • Most of the industrial sectors that had been recording large losses were now making profits. Of the 14 “key” industrial sectors targeted, 12 had become profitable by 2000, and the other two, the coal and defense industries, had reduced their losses considerably.

  • State enterprises in all provinces, autonomous regions, and municipalities under the central government had also begun making profits in the aggregate. Of the 31 such entities, 12 had turned losses into profits and the other 19 had increased their profits in 2000.

  • Most of the money-losing medium-size and large SOEs at the end of 1997 had been turned around. By the end of 2000, 4,799 of the 6,599 such enterprises had been removed from the list, either by becoming profitable, by merging with stronger enterprises, or by entering bankruptcy.

  • Most core SOEs had also adopted the modern enterprise system. The vast majority of the targeted enterprises noted above had been incorporated under the company law and had adopted other aspects of the modern enterprise system by the end of 2000.

However, the improvement in SOEs’ financial performance may not be as strong as the headline figures suggest. In particular, a sizable portion (estimated at some 75 percent) of the increase in profits in 2000 reflected outside factors, including higher oil prices and lower interest payments resulting from debt-equity swaps and other measures. In addition, more than a third of all industrial SOEs were still recording losses at the end of 2000, and the aggregate losses of ailing enterprises fell by a less impressive 27 percent in 2000.

Economic Restructuring

As enterprise restructuring gained momentum, it soon became constrained by the limited financial resources available to pay the costs. Principal among these has been the scarcity of fiscal resources, which are necessary to separate social welfare functions from enterprises, write off or restructure bank debts, and provide support for unemployed workers. Enterprise restructuring has therefore been reasonably well advanced in the wealthier coastal provinces, but much less so in the old industrial and mining areas of the less-affluent northeastern and interior provinces. A weak legal and institutional framework, in particular the lack of modern bankruptcy institutions, has also slowed the pace of enterprise restructuring. The World Bank recently identified a number of deficiencies in the current regime, including the lack of clear rules, like those in Chapter 11 of the U.S. bankruptcy code, for resolution of company bankruptcies, and insufficient protection of creditor rights.2

Mergers and Bankruptcy

The number of bankruptcies has increased but remains relatively small, and bankruptcy proceedings have yet to be applied widely to medium-size and large enterprises. The State Economic and Trade Commission (SETC) estimates that by mid-2001 only 2,300 enterprises, with assets totaling Y 290 billion (less than 4 percent of total assets of all medium-size and large SOEs), had exited the market since the special merger and bankruptcy procedures established under the pilot cities program were applied on a national scale in 1998. These figures are small in relation to the continued weak overall performance of SOEs and the large number of potential candidates for bankruptcy or other forms of fundamental restructuring. For example, nearly 45 percent of the 47,500 industrial SOEs continued to record some form of loss in early 2001.

In light of the financial and legal obstacles involved, formal bankruptcy has often not been the most practical alternative available to creditors and local governments. Many cash-strapped local governments have instead found it easier to idle production, send workers home on minimal monthly living wages (often paid for through continued bank lending), and keep accumulating interest arrears. The pilot cities program provided a special central government charge-off fund for banks, which has been applied both to formal bankruptcies and to the write-down of overdue interest in merger cases, to help defray the costs of enterprise restructuring. However, the funds utilized under this mechanism have been quite meager—rising from Y 30 billion in 1997 to just over Y 80 billion in 2000—relative to the size of the remaining problem.3

The use of bankruptcy procedures has nevertheless become more widespread and socially acceptable in recent years. The World Bank has estimated the number of bankruptcies since the mid-1990s at about 20,000 nationwide, half of which have involved SOEs. Considerable experience has been gained and capacity built up in the courts and local administrations as a result of the widening application of bankruptcy procedures, which has also helped to create greater public understanding and acceptance of the process.

Exit of Surplus Labor

Labor redundancies are high in the SOEs. Official estimates by the Ministry of Labor and Social Security based on 1994–95 data suggest that the number of unneeded employees in the SOEs at that time was over 20 million, or more than one-fourth of the SOE workforce. Other estimates, taking account of subsequent increases in production capacity and competition as well as the need to close money-losing enterprises, have placed the number of labor redundancies at 30 million to 35 million at the end of 1997, or well over one-third of the 77-millionstrong SOE workforce at that time.

Recent years have witnessed a significant acceleration in the number of layoffs. SOEs laid off a total of 16 million workers from 1998 through 2000,4 thus eliminating roughly half of the estimated redundancies. Despite official concerns about the rising number of layoffs and the potential for social unrest, the declining financial performance of many SOEs and the increasing reluctance of banks to lend to them left local governments with no alternative but to allow workers to be laid off. Increased layoffs were also facilitated by stepped-up efforts to strengthen the social safety net for unemployed workers (Box 9.2). The proportion of redundant workers nevertheless remains high, at about one-third of the SOE labor force of 47 million as of the end of 2000.5

Reducing Indebtedness

Leverage among industrial SOEs has declined in recent years—liabilities-to-equity ratios among SOEs have fallen from about 200 percent in the mid-1990s to about 150 percent—but nevertheless remains high. The authorities have used a variety of channels to reduce SOE indebtedness. As noted above, debts have been written off in the context of the merger and bankruptcy program, as well as through a number of other special programs. For example, old policy loans from the SCBs that had been transferred to the policy banks were converted to state equity shares in some SOEs. Nearly Y 38 billion of such debts were converted under this program in 1997, with another Y 50 billion targeted for conversion in 1998. Increased equity issuance on foreign and domestic stock markets has also helped to reduce SOE debt.6

In a more recent initiative, debts of about Y 310 billion from some 580 SOEs are in the process of being swapped for equity under the asset management company (AMC) initiative begun in mid-1999 (see Chapter 10), in order to reduce the debt burdens of large SOEs that have shown the potential to be financially viable. To qualify for debt-equity swaps, enterprises must be approved by the SETC and be considered to have marketable products, advanced technology, and good management expertise. The AMCs will assume ownership stakes equivalent to the amount of equity they have in the enterprises. However, there are concerns that the AMCs have not been provided with sufficient powers to restructure SOE operations (for example, to reduce leverage ratios), thus limiting their capacity to improve enterprise performance.

Reducing the Social Welfare Burden

Efforts to divest SOEs of their traditional social welfare burdens are aimed at making these enterprises more competitive with nonstate enterprises, which do not carry such heavy burdens, and to improve labor mobility by delinking access to the social safety net from employment with an enterprise. These efforts have two main components: the transfer of “nonproductive” social services units, primarily in housing, medical services, and education, away from SOEs, and the disposal of (generally unfunded) pension and unemployment liabilities.

Box 9.2.The Social Safety Net for Laid-Off SOE Workers

Because layoffs of SOE workers were a new phenomenon when enterprise reforms were broadened in the mid-1990s, the social security system was partial and incomplete. A three-phase system was introduced to improve the social safety net for unemployed SOE workers (or xiagang1) to deal with the surge in layoffs:

  • Income support and reemployment of xiagang. Reemployment centers were set up to aid the transition to new jobs. Laid-off workers became eligible for income support based on prevailing wages in their locality. The program was financed by local governments, local unemployment insurance funds, and the SOEs. The central government also increased transfers to the regions hardest hit by layoffs to help them meet their required contributions to the reemployment centers.

  • Unemployment insurance. Xiagang who remain unable to find employment after three years have to sever their relation with their reemployment center and join the pool of registered unemployed; this implies, among other things, the loss of nonwage benefits provided by their former employer. Such workers are then eligible for unemployment insurance (which provides lower payments than the reemployment centers) for a period of two years. The unemployment insurance system is also financed by local governments, worker contributions, and enterprises. Because the funds are pooled locally, in some high-unemployment areas beneficiaries receive partial payments or none at all because of a lack of funds.

  • Minimum income program. After eligibility for unemployment insurance expires, workers can collect a minimum living stipend under a program introduced in 1994 as part of a broad poverty alleviation initiative. These programs are locally financed, and in some cities stipends are very low or not paid at all because of local fiscal constraints.

Although the coverage of this social safety net has been far from complete, it has facilitated an acceleration of labor downsizing in the SOEs in recent years. By the end of 2000, some 21 million xiagang had entered the reemployment centers, and about 95 percent were reported to have received formal income support payments. Of these, 13 million have been reemployed elsewhere in the economy, and another 3.3 million have been moved to the general unemployment insurance scheme.

Beginning in 2001, no more reemployment centers are to be established in the pilot areas for national social security reform (currently only in Liaoning province), and newly laid off SOE workers will enter the general unemployment insurance scheme directly. Those workers currently in reemployment centers will remain there until their three years have elapsed, or until they are reemployed.

1Xiagang retain formal links to their state employers until reemployed and are not included among the registered unemployed.

Progress to date in transferring these social assets off of SOE balance sheets is difficult to judge, given the lack of comprehensive time-series data available on such assets. The SETC reports that the transfer process has been very uneven: enterprises in many wealthier coastal provinces and cities have disposed of virtually all of their social welfare units, but in other areas (particularly in company towns in the SOE-laden interior and northeastern provinces) progress has been considerably slower. The National Bureau of Statistics estimates that SOEs’ overheads came down only slightly from 9 percent of operating costs in the mid-1990s and remain about twice those of the collectives and foreign-funded enterprises, an indication that the social welfare burden is still very heavy. The authorities estimate that the divestiture process could take another 5–10 years to complete, given the financing constraints.

Central and local governments have also been actively reforming pension, medical, and unemployment insurance systems. The main emphasis has been on switching from unfunded (and poorly defined) benefits to partially or fully funded schemes, based on contributions from enterprises and employees as well as from various levels of government. Policies pertaining to unemployment insurance have already been discussed in Box 9.2. The authorities are also moving ahead with reforms of the medical insurance and pension systems. They intend to replace the current pay-as-you-go pension system with a three-tier model along the lines recommended by the World Bank,7 and they initiated a pilot project in Liaoning province in 2001. They also began at about the same time to require that 10 percent of the proceeds of all new share offerings by SOEs be used to fund the pension system.8 However, parametric changes (such as raising the retirement age or lowering the replacement ratio, or both) will also be necessary to make the new pension scheme viable, in view of the size of the implicit pension debt (estimated by the World Bank at nearly 100 percent of GDP).

Reducing Excess Capacity

Excess capacity and production for inventory have long been identified as major contributors to SOE losses. Massive investment in excess productive capacity (“duplicated construction”) during the early years of the reform period resulted in very low levels of capacity utilization by the mid-1990s. Although reliable time-series data for capacity utilization are not available (the last comprehensive data were compiled by the National Bureau of Statistics in 1995; see Table 9.1), anecdotal evidence suggests that additional capacity continued to come on line at least until late 1997, worsening an already very difficult market oversupply situation.

Table 9.1.Capacity Utilization by Industry, 19951
Level of UtilizationIndustries
FullNatural gas, industrial timber, plywood, rubber, distilled spirits
90 percent or abovePaper pulp, crude oil, crude iron, fiberboard, electric fans
80–90 percentDyes and chemicals (acids, ammonia, alcohols, sodas, etc.), plate glass, railway locomotives and passenger carriages, magnetic tape, refined steel, cigarettes, paper, cement, coal, sawn timber, ceramic and glass products
70–80 percentCopper, ferroalloys, plastics, large-scale integrated circuits, chemical fertilizers, radios, sewing machines, clocks
60–70 percentBeer, railway freight cars, tractors, mining equipment, vacuum cleaners, steel products, cleansing agents
50–60 percentRefrigerators, medicine, telephones, vegetable oil, tires, bicycles, motorcycles, cameras
40–50 percentVideo recorders, washing machines, automobiles, color televisions, engines, machine tools, paint
25–40 percentAluminum products, air conditioners, copy machines, pesticides, microwave ovens
Less than 25 percentElectric power generators, mini-and microcomputers, film
Source: National Bureau of Statistics.

Data are for enterprises at the township level and above with independent accounting systems.

Source: National Bureau of Statistics.

Data are for enterprises at the township level and above with independent accounting systems.

The high excess capacity prompted the State Council to initiate comprehensive restructuring programs in industries where oversupply and financial losses were most severe. Programs were started in the textile and coal industries in 1998; other industry-specific programs were launched in subsequent years (Box 9.3). Encouraging progress has been made in these programs: as noted in Box 9.1, SOEs in 12 of the 14 industrial sectors targeted for capacity reduction had become profitable in the aggregate by the end of 2000.

Recent surveys by the National Bureau of Statistics and the State Internal Trade Bureau (SITB) under the SETC nevertheless indicate that excess capacity remains very high in a broad range of sectors and product areas. For example, the SITB, in its biannual survey in early 2001, found that nearly 80 percent of 609 nonfood product categories were in excess supply. In addition, capacity utilization among the 5,000 principal industrial enterprises surveyed quarterly by the People’s Bank of China was still only about 75 percent in mid-2001, although it had risen by about 15 percentage points since early 1998, when the capacity reduction programs were initiated and tighter controls imposed on enterprise capital investment.9

Enterprise “Revitalization”

Another element of SOE restructuring has been the direct provision of economic resources and other financial preferences for key enterprises (including the 520 key SOEs and the 120 pilot large enterprise groups). The most important policy in this regard has been the adoption of the principal bank system, aimed at providing a steady flow of bank financing according to prearranged contracts and establishing centralized accounts at the bank to allow for greater monitoring of enterprises’ financial performance. Other such preferences have included priority approval of and lending for investment projects, particularly those aimed at upgrading technological capabilities (the “technological renovation” program), and favorable consideration for stock market listings. The authorities in late 1999 began subsidizing interest payments on bank loans for technological renovation investment from the central budget in an attempt to accelerate the revitalization of key enterprises. A total of 880 projects involving Y 240 billion in investment outlays were initially identified for this subsidized financing.

Box 9.3.Restructuring Programs in Selected Industries

The Chinese authorities have introduced a series of industry-specific restructuring programs targeted mostly at basic industries such as textiles, coal, metallurgy, oil refining, sugar refining, electric power generation, cement, glass, caustic soda, and beer—industries where excess capacity and aggregate losses have been most severe. These programs have generally been aimed at reducing excess capacity and rationalizing the industrial structure through various measures, such as closing down small and inefficient firms, encouraging output restraints, restricting new investment, eliminating outdated equipment and obsolete products, and upgrading production technology. The following summaries of selected restructuring programs provide an indication of the scope of these efforts and their modalities.

Textiles

In April 1998 the State Council launched a three-year pilot program to restructure the chronically unprofitable textile industry. By targeting a reduction in obsolete production capacity by 10 million spindles (one-quarter of the capacity at the time) and laying off 1.2 million workers (one-third of total employment), the authorities aimed at returning the industry to modest profitability by the end of the three-year period. The focus of the program was broadened in 1999 to include mergers of efficient enterprises to achieve economies of scale, and bankruptcies of inefficient and technologically outmoded enterprises. More effective penetration of international markets, technological updating of the production base, and product innovation were also emphasized to arrest the decline in export performance. The program has been successful, and the sector returned to profitability in 1999, ending six consecutive years of losses. Sector performance improved further in 2000: aggregate profitability rose 41 percent, to Y 13.9 billion, and total exports rose 20 percent, to nearly $50 billion.

Coal

China’s coal industry, the world’s largest, had been plagued by excess capacity, bloated inventories, declining prices, and chronic losses for nearly a decade. The oversupply was attributed to the large number of small and technologically outmoded mines, which produced about half of national output. In November 1998 the State Council decided to begin overhauling China’s coal industry by shutting down small mines to reduce total output and stockpiles, and to lay off 400,000 workers from large state-owned mines to reduce their overheads and improve profitability. The restructuring program also included outlays of Y 15 billion to implement 282 technological renovation projects, aimed at improving industry efficiency, and efforts to increase exports. By the end of 2000 more than 47,000 small mines had been shut, reducing annual output by more than 25 percent; coal exports in 2000, at $1.5 billion, were 50 percent above their 1998 level. Although the industry has yet to turn a profit, losses have been reduced significantly, from Y 5 billion to Y 3.3 billion in 2000 alone.

Sugar

The sugar refining industry was targeted for intensified restructuring efforts in early 1999. At that time more than 90 percent of state-owned sugar refiners were losing money, largely because of overcapacity, obsolete refining technologies, and inefficient operations. The program aimed to merge hundreds of small refiners with larger ones to achieve scale economies, upgrade refining technologies of key large producers, and close a number of heavily indebted refineries. In 2000, 140 such refineries were shut, reducing capacity from 10.5 million tons to 8.2 million, and Y 12.6 billion was used from the central debt write-off fund to offset debts owed to commercial banks. Nine saccharine plants have also been closed to increase domestic demand for natural sugar. The sugar industry achieved a modest profit of Y 500 million in 2000, the first in several years; profits were targeted to double to Y 1 billion in 2001.

Other Industry-Level Restructuring

Industry-level restructuring has accelerated significantly in the wake of the November 1999 bilateral agreement with the United States on China’s accession to the World Trade Organization (WTO). The current strategy is to grow “national champions”—firms with sufficient size, financial strength, and technological prowess in key industries to enable them to compete with global players following WTO accession. China is currently striving to cultivate 30–50 such companies and enterprise groups through overseas and domestic stock listings, mergers and acquisitions, enterprise alliances, and industry-wide reorganization. This strategy has been particularly apparent in telecommunications services,10 but is being pursued in a number of other industries ranging from aviation to petroleum.

Reform of Corporate Governance

The traditional system of state-owned property management has proved problematic from a corporate governance perspective. In particular, it has no clear structure of ownership, with little separation between ownership and management functions. As a result, SOEs have encountered political interference in their decision making. Most major decisions have therefore typically been made in coordination with various government agencies rather than on the basis of market criteria. Thus production decisions have been coordinated with line ministries; capital construction and technical renovation investment have been approved by central and local planning agencies; tax payments and profit transfers have often been negotiated with the Ministry of Finance and the local tax bureaus; and employment decisions have generally been made in consultation with the labor ministry.

The authorities have sought to address these problems through adoption of the “modern enterprise system,” which seeks to clarify and separate ownership and management functions, thus providing greater incentives to improve enterprise efficiency. Broadly speaking, the main elements have involved corporatization according to the 1994 company law and devolution of commercial decision-making authority from government agencies to the enterprises themselves. These elements have been supplemented in recent years by efforts to enhance financial transparency, more closely monitor enterprise performance, and improve the quality of enterprise management.

Incorporation Under the Company Law

Incorporation under the company law has now become fairly widespread among larger SOEs.11 The process generally involves the creation of a board of directors and a board of supervisors. A key aim of the program has also been to clarify the ownership of state shares as well as to introduce outside supervision through incorporation with other investors, such as through the creation of limited-liability partnerships. Survey results suggest that 70–80 percent of medium-size and large SOEs had been incorporated by the end of 2000, including all of the 100 pilot enterprises and 430 of the 520 “key” SOEs selected by the State Council.

Although the two-tier board structure and other features of the modern enterprise system are potentially powerful mechanisms for improving corporate governance, they have not functioned as effectively as envisaged. The supervisory boards in practice tend to have little power and independence to carry out their oversight function because they have largely been chosen by and are subject to the controlling shareholder (the state), and thus they have not effectively represented minority shareholders. Moreover, there has in practice been little accountability of senior management to directors who are genuinely independent. The roles of chairman of the board and general manager have often been combined, and boards have been dominated by directors with managerial responsibilities within the firm.12 The appointment of the general manager and directors to the board has also largely been dominated by the controlling shareholder. As a result, the boards of directors have been neither independent from management nor accountable to minority shareholders (Lin, 2000).

Enterprise Autonomy

A major component of the authorities’ efforts to increase enterprise autonomy has been the functional removal of government from enterprise management and decision making. A major step forward in this regard was the reduction in the number of government ministries from 40 to 29 in August 1998. The primary rationale of the restructuring was to eliminate the last of the remaining industrial branch ministries—which formerly directly managed SOEs under their control, but are now only to guide enterprises indirectly by issuing sector development plans and regulations—and to remove the government from the micromanagement of enterprises. This restructuring left two new economic super-ministries—the Ministry of Information Industry (MII) and the SETC—which took over the management and supervision functions of the old industrial line ministries.

In the wake of the government restructuring, the majority of the former industrial branch ministries were reduced to bureau status and placed under the jurisdiction of the SETC, effectively removing their direct enterprise management functions. To fill the vacuum, a Working Committee for Large Enterprises was created under the Central Party Committee to monitor performance of the large SOEs and, in cooperation with the Ministry of Personnel, to look after managerial and staffing issues. This has been complemented by the Supervisory Commissioner System, a group of former senior government officials who—after receiving specialized training in auditing, accounting, and finance—have been closely supervising the operations of the 520 key large enterprises and assessing their financial performance, compliance with relevant legislation and sectoral development policies, and managerial performance.

Despite the significant reduction in the number of supervisory ministries and personnel, the government still retains considerable influence over the management of enterprises. In particular, the Ministry of Personnel continues to select all senior managers in large SOEs. In addition, the central government has maintained overriding control over all key aspects of strategic industries such as automobiles, energy, steel, and telecommunications. The streamlining of responsibilities for information technologies in the MII highlights the ways in which the government restructuring has strengthened central control over a key sector.

Another form of enterprise autonomy is the granting of economic decision-making powers, as codified in the 14 “enterprise rights” outlined above. Some of these, for example profit retention, price setting, and self-determination of production levels and the product mix, have been introduced almost completely. In addition, foreign trading rights have been granted much more widely in recent years, including to nonstate enterprises, and this has significantly eroded the competitive advantage of the state foreign trade companies. However, the scope for independent action is much more limited in some other areas, such as making investment decisions, choosing enterprise managers, and firing workers.

Enhancing Financial Transparency

In late 1998 the Ministry of Finance introduced new accounting standards based on modern principles, and disclosure requirements and supervision of enterprise performance have been strengthened considerably since then, particularly for listed companies. In particular, the securities law promulgated in late 1998 has set out stringent disclosure standards, which has prompted a sharp rise in the number of listed companies reporting losses.13 Disclosure requirements for listed companies were tightened further, and companies will now have to begin reporting detailed financial data on a quarterly basis and provide a public explanation if their earnings’ forecasts are off by more than 10 percent.

Despite the introduction of more stringent accounting and disclosure standards and stepped-up supervision of SOEs’ financial activities in recent years, fraud remains widespread. For example, the Auditor General’s Office found financial irregularities worth Y 100 billion in the 1,290 SOEs audited during 2000. In addition, several spectacular share price manipulation scandals involving the spread of false financial information were uncovered in 2000. More generally, as described in Chapter 11, significant data problems still complicate the analysis of enterprises’ financial conditions.

Improving Enterprise Management

Considerably more attention has been paid in recent years to improving the quality of SOE managers. To this end, in early 1998 the SETC began a “management training project.” Managers are now required to participate in a comprehensive training program focused on developing competent, technocratic managers capable of leading enterprises in a competitive market economy. The authorities are also experimenting with headhunters and auctions for management professionals in an attempt to lure the best managerial talent into SOE management positions, and since 1998 hiring preference has been given to managers educated after the Cultural Revolution of the late 1960s. Systems have been developed to more closely link compensation and promotion with performance, including experimentation with stock option schemes. The personnel ministry has also drafted new regulations for the supervision of SOE managers with a view to establishing more flexible personnel management practices in line with the modern enterprise system.

Ownership Reform

“Releasing” Small SOEs

Ownership reform of small SOEs has been one of the most active components of SOE reform. Small enterprises and the local governments that own them were given broad freedom of choice in choosing channels of ownership change, including outright sale, merger, leasing, contracting, joint-stock participation, and, if necessary, liquidation and bankruptcy proceedings. The primary requirement has been that the fiscal costs of such transactions be minimal, which has generally required that new owners assume responsibility for any debts as well as that redundant labor be redeployed.

Efforts to diversify ownership of small enterprises accelerated significantly in the wake of President Jiang’s speech at the 15th Party Congress in September 1997. Viewing themselves as having received the central government’s blessing to transform their small SOEs, city and provincial officials responded with enthusiasm. Hitherto slowly reforming provinces dramatically picked up the pace of ownership transfer, while provinces that were already quite far down the road of enterprise divestiture extended the process from industrial to nonindustrial, and from smaller to larger, enterprises. Indeed, in early 1998 there was a flood of announcements of small enterprise sales and auctions in various localities; some local authorities even traveled abroad to offer their enterprises for sale.

The SETC estimates that 41,500 of the 63,500 small SOEs in the state’s hands at the end of 1996 had been transformed to other forms of ownership (or been bankrupted), with another 10,000 enterprises leased out to the private sector, by the end of 2000. Of the total transformed, roughly one-third merged in some manner with another enterprise, 20 percent were converted to joint-stock companies, about 10 percent sold outright to private investors, and another 10 percent bankrupted. The authorities will continue to transform the ownership of the enterprises that remain under state control, but no timetable has been set for the completion of this process.

Listing Large SOEs

The stock market has assumed a greater role in China’s enterprise reform process since the 15th Party Congress. Issuance of shares on domestic and foreign stock markets has been the mainstay of efforts both to diversify ownership in large enterprises and to strengthen their balance sheets, and the number of listed firms has increased significantly. Funds raised both on the domestic market and overseas set all-time highs in 2000, at Y 160 billion and $21 billion, respectively. The latter figure included several high-profile share issues by very large SOEs, including China’s two largest petroleum companies and two largest mobile phone service providers. At the end of 2001 there were 1,160 firms listed on the Shanghai and Shenzhen exchanges, with a total market capitalization of Y 4.4 trillion (45.4 percent of GDP), up sharply from about 750 firms and Y 2 trillion (about 25 percent of GDP) at the end of 1997.

Despite the surge in listings and in funds raised, the domestic stock market has done little to improve the financial performance or corporate governance of the companies listed there. The domestic market has functioned primarily as a funding vehicle for poorly performing SOEs since its inception in late 1990. Indeed, as the analysis in Chapter 11 illustrates, China’s domestically listed companies are financially very weak, in part because of a poorly developed regulatory framework for the securities markets and a selection mechanism that until early 2001 placed listing decisions in the hands of local governments. Given the lack of a credible delisting threat, the domestic stock market has largely failed to impose greater discipline on listed companies. Nor have the benefits of listing, in terms of reducing debt-equity ratios, been as significant as they should have been, as many listed companies have had to provide financial assistance to smaller and weaker enterprises in exchange for being allowed to list.

Future Reform Priorities

The remaining agenda for SOE reform is a challenging one, which the authorities expect will take up to a decade to complete.14 In particular, the authorities understand that the realization of Premier Zhu’s three-year revitalization objective is just an interim achievement, and that the underlying operational efficiency of SOEs has not fundamentally improved. During the March 2001 session of the National People’s Congress, the new SETC Minister Li Rongrong summarized the current situation with the SOEs as follows:

The SOEs still encounter a number of in-depth issues and problems in their reform and development, and those problems have not been fundamentally solved. The overall profitability of the SOEs remains weak and the foundations for difficulty relief remain soft. The channels for enterprises to exit from the market are far from operating smoothly, and the operating mechanisms of enterprises have not been fundamentally altered. The management and technical production levels of enterprises are not high enough, and major safety accidents occur every now and then. The remaining tasks to consolidate and enlarge the achievements from the reform and difficulty relief of the SOEs, and to further boost the reform and development of the same, are quite heavy.15

The reform of SOEs will therefore remain at the center of the authorities’ economic policy agenda during the tenth Five-Year Development Plan. In this context the following ongoing reforms have been given priority:

  • The establishment of modern enterprise systems. This will involve deepening the implementation of the shareholding system (with independent boards of directors and supervisors); introducing a more diversified ownership structure (particularly by listing on the stock market and bringing in more strategic investors, including foreigners); further separating government functions from enterprise management; and further improving incentive and internal control mechanisms.

  • The creation of internationally competitive large enterprises and groups. This seeks to build on the progress that has been made in the telecommunications services and petroleum industries in establishing enterprises that will be able to succeed with greater foreign competition following WTO accession.

  • The technological upgrading of the state sector. The technological renovation program, which since late 1999 has included subsidized loans to finance new capital investment for key enterprises, will be continued. State support for the development of high-technology industries (information technology, bioengineering, and new materials) will also be deepened, including through the formation of state-financed venture capital funds.

  • The exit of poorly performing enterprises. Mechanisms will be gradually standardized to facilitate the orderly and prompt exit of weak enterprises from the market. In the meantime, relatively large numbers of enterprises will continue to exit the market through the various ongoing sector-specific restructuring programs (for example, those in steel, sugar, oil refining, and coal).

  • The “revitalization” of small SOEs. With roughly two-thirds of small SOEs already transformed, the emphasis will shift to providing greater support services to those small enterprises that remain in the state sector. This includes broadening access to the credit guarantee schemes and enterprise support centers established by the SETC for small and medium-size enterprises of all ownership types.

The authorities also have high hopes for the AMCs and view the start of their operations as an important change in the environment for SOEs. The authorities expect that the AMCs’ efforts at asset resolution will impose additional financial discipline on the SOEs, and that debt-equity swaps will be a catalyst for SOE restructuring. The AMCs have begun work on classifying their SOEs into three groups: companies that are viable following debt restructuring or debt-equity swaps; companies that might be viable with operational and financial restructuring, particularly if strategic (foreign) partners are found; and companies that are not viable and need to be liquidated. They also understand the importance of moving ahead quickly to resolve bad assets, and they have started bringing in foreign investors to participate in the process of disposing of nonperforming loans.

Concluding Observations

The discussion in this chapter suggests that significant progress has been made in a wide range of areas essential to the ultimate success of the SOE reform effort. Durable efficiency gains have been achieved in recent years through layoffs, a reduced social welfare burden, and efforts to shed excess capacity in key sectors. These gains have boosted profits and reduced the scope of losses in the SOE sector. The authorities’ current enterprise reform agenda, if fully and effectively implemented, offers good prospects of continued efficiency gains and improvement in SOE performance in the coming years.

However, the reforms thus far have generally only alleviated the effects of past problems and distortions, and they have been noticeably less successful in improving corporate governance and in imposing external financial discipline on enterprises. The financial weaknesses that are still evident in China’s SOE sector and the large nonperforming loans problem that remains in the banking system highlight the difficulties in achieving a fundamental improvement in enterprise behavior. Although important structures and mechanisms for better governance are being put in place, key constraints on their effective functioning remain. These include

  • Lack of a well-developed credit culture. The development of a credit culture is a fundamental requirement if financial intermediaries are to exercise effective discipline over SOEs. As noted in the next chapter, full commercialization of SCBs’ lending decisions is an essential prerequisite in this regard.

  • Poor transparency of enterprise operations. Limited information and lack of transparency of enterprise operations hamper effective surveillance by financial intermediaries and markets and increase the comparative advantage of enterprise insiders to pursue their own interests.

  • Limited enterprise exit channels. The lack of well-developed exit channels has resulted in poor enterprise behavior going largely unpunished. A new bankruptcy law that adequately protects creditors’ rights, and more decisive efforts to delist poorly performing enterprises from the stock market, would be important steps toward developing an effective “stick” with which to improve enterprise performance and strengthen market discipline.

  • Weak protection of minority shareholders’ rights. Enterprise management is generally not accountable to minority shareholders. Allowing the AMCs effective exercise of their ownership rights and bringing in more outside directors to enterprise boards would be important steps forward in this regard. International experience and the corporate governance literature suggest that the role of boards of directors can be strengthened substantially by appointing sufficient numbers of independent, outside directors.

  • Privatization. Ultimately, effective corporate governance will require outside shareholder control by owners focused on profit maximization. For many enterprises, including the large ones, this will have to involve a more complete break from control by the government, which inevitably tends to have a much broader, including political, objective function.

References

    LinCyril2000“Corporate Governance in China,”paper presented at the OECD/DRC Conference on Corporate Governance of SOEs in China, BeijingJanuary.

    World Bank2000“Bankruptcy of State Enterprises in China—A Case and Agenda for Reforming the Insolvency System” (unpublished; Washington: World Bank).

Fourteen such rights were specified, including the right to decide on production and pricing policies, the right to decide the size and composition of new investment, the right to decide on the hiring and firing of labor, and the right to retain profits and undertake foreign trade.

World Bank (2000). China’s bankruptcy regime is still based on the bankruptcy law promulgated in 1986. A new bankruptcy law that addresses many of these deficiencies was drafted several years ago but has not been promulgated, owing in part to concerns that it could accelerate enterprise closures beyond socially acceptable limits.

The total debt write-off under this program from 1997 to 2000 was just under Y 200 billion, or only 10 percent of the authorities’ estimate of the remaining nonperforming loans in the four SCBs following the Y 1.4 trillion transfer of nonperforming loans to the asset management companies in 1999–2000.

Labor ministry data indicate that about 9 million SOE workers were laid off from 1995 through 1997.

The SOE labor force has also been reduced by means other than layoffs, including through the conversion of small enterprises to other forms of ownership.

As indicated in Chapter 11, liabilities-to-equity ratios among listed companies are about half those of the general SOE population. However, it has been common practice for SOEs to create a subsidiary firm for listing purposes, which receives productive assets by transfer, while leaving outstanding debts, redundant workers, pension obligations, and other obligations with the parent enterprise.

The first tier would be a social pension, the second a mandatory funded system with individual accounts, and the third a supplementary (also funded) tier.

This program was suspended in late 2001 following the sharp decline of share prices, which was attributed in part to the additional supply of shares coming to the market under the program.

The SETC in early 1998 imposed a ban on new capital investment in the steel and chemical industries and announced that it would no longer approve bank loans to SOEs to fund the construction of new plants, except for “selected high technology or promising product renovation projects.”

The apparent strategy involves developing flagship companies in each industry segment by encouraging domestic competition and by large capital infusions through overseas stock listings. Recent restructuring in the telecommunications industry has divided the old monopoly service provider (China Telecom) into separate entities providing Internet, mobile voice and data, fixed line, and paging services, and two service providers (China Mobile and China Unicom) have listed on the stock exchanges in New York and Hong Kong SAR.

Most small SOEs are not large enough to meet the minimum capital requirements for formal incorporation under the company law. As discussed below, the preferred means of transforming the governance of small enterprises has been ownership transfer.

PetroChina, which was listed in 2000 in Hong Kong SAR and New York, became the first Chinese SOE to recruit “outside” members to its board of directors.

For example, about 90 listed companies issued profit warnings in the first half of 1999, shortly after the law was passed, in comparison with only 10 in all of 1998.

The communiqué of the September 1999 Fourth Plenary Session of the 15th Central Committee of the Communist Party, which primarily focused on SOE reform, cast the reform process over a 10-year time frame.

State Council press release transcribing Li’s press conference during the March 2001 National People’s Congress.

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