China's Silent Revolution

IFC Asia economist and China expert, Stoyan Tenev discusses SOE restructuring in China.

State owned enterprise (SOE) reform has been going on for 20 years. What's different about the latest round?

Tenev: There's a huge privatization programme underway. Local government can no longer carry the burden of loss-making SOEs and attendant social costs. So they're being sold off in large numbers.

One difference with previous attempts is the sheer scale - some 80% of all SOEs have been touched in some way by corporatization (that is to say, running the company according to the discipline of the Company Law), of which half have been privatized. You can now say that the traditional 100% state owned enterprise is about to become extinct. In a recent study we compare available national data with a sample of our own. The national survey undertaken in 2002 showed that 86% of firms had gone through restructuring. It also showed that the number of state owned enterprises had declined by 41%. This implies that 48% of the restructured firms have been privatized.

In our sample of close to 700 enterprises, the number of SOEs (more than 50% state ownership) decreased by 50% in the period 1995-2002.

Another important difference is that SOEs are beginning to take the restructuring initiative themselves. Previously, it was more as a result of top down pressure from the government.

What kinds of processes are we talking about?

Sales to insiders and other companies. Also companies being allowed to go bankrupt leasing SOE assets to outside parties - essentially, any method, which enables good assets to be separated from bad assets. The bad assets are left with the bankrupt vehicle.

The idea is similar to joint ventures - putting the good assets into a joint venture with a foreign partner and leaving the bad assets with the parent.

What sort of players are driving the process?

A mixture of MBOs, outside SOEs, private investors. There's also some foreign participation as well. Here are the trends: In 1995, 5% of shares were held by insiders, that is employees or managers. That figure jumped to 33% in 2002.

In 1995, 10% of shares were held by foreigners. That figure was down to 2% by 2002. Outsider shareholder ownership was around 11% to 12% in 1995 and rose to an anaemic16% in 2002.

What is the role of land, an increasingly valuable commodity in China?

Land is often the most valuable an SOE has and several methods are available with it. Majority state-owned enterprises can keep the land they were originally granted. That's a useful subsidy, although the downside is that the land can't be monetized through a sale or a mortgage.

If the company is not majority state-owned, the enterprise has to pay for the right to use the land. The advantage is the land can be mortgaged or contributed to a joint venture as capital.

Land use rights are often sold to the buyers at a discounted rate to compensate for keeping the original workforce. Sometimes the local government converts its ownership of the land used by the factory or company into equity into the company.

Local governments are quite careful about maximising the value of their land holdings, for example by steering urban development in a certain way. Land is very valuable and working out how to monetize its value is key to the process since government needs cash to pay for laid of workers.

How are valuation issues worked out?

The valuation of assets is worked out according to a formula. An independent valuation company is also called in and is usually paid for by the enterprise undergoing restructuring. Valuations need to be verified by the local asset management agency.

If the net asset value is negative, the operating assets and a portion of the debt may be separated from the rest and put into a new legal entity. Contingent liabilities such as loan guarantees can be a contentious issue. SOEs that have extended such guarantees have been required to set aside a share of the privatisation proceeds in a special account.

Can we talk about genuine privatization?

What you can see is a diversification of ownership, rather than outright privatization. Private players have played a role, but interestingly other SOEs have been quite active. As other SOEs undergo ownership changes themselves, the pace of privatization increases. Foreign players have played a very small role, perhaps because the transaction costs are so high.

What's the Chinese view on the ideology of privatization?

The Chinese approach is extremely pragmatic. Ownership per se is not that important. Local governments are more interested in aspects such as tax revenue and employment. And they find the way to deliver that is to have more private ownership.

Have the entities seen major improvements in their performance metrics?

It depends on the metrics you look at. Profitability and hard budget constraints have gone up, but labour productivity has remained low. That's probably related to new owners not being able to lay-off as many of the old workforce as they want, for social reasons. They tend to compensate for that by not respecting the social security payments they should be making.

What concerns you most about the current reform process?

One big concern is that the largest proportion of transactions are being initiated by 'insiders'. The problem here is that it's far more difficult for insiders to carry out root and branch reform than outsiders, such as commercially driven, highly successful private groups like New Hope or SOEs in the commodities sector such as consumer appliance maker Haier (although admittedly this is a former township and village enterprise, rather than a pure SOE). Many of these companies are growing through consolidation.

The strength of insiders exacerbates the 'agency problem'. In contrast, when outsiders step in they tend to accelerate the development of corporate governance mechanisms by actually using them to limit the power of managers.

Unchecked managers are clearly not a good thing for enterprises.

Indeed. Interestingly, the communist party is not necessarily a major influence, although given the dual role of chairman of the board and party secretary it's difficult to make out which role is supporting which.

However, the power of managers is something that has always existed because the state shareholder is very passive. It's not encouraging if no new shareholders come in to force managers to work on behalf of the company rather than themselves.

Aligning the managers with ownership could also be described as a genuine form of privatization. Just like a private company, they only have to answer to themselves. What's your view?

Insider ownership will also eventually align ownership and control, but the process tends to be a long one and in the meantime, managers in control may have perverse incentives such as reducing the value of the company so that it can be bought cheaply by themselves. There's plenty of anecdotal evidence for this in China. Also, most of the SOEs are over-leveraged and what they need is more equity. So insiders with growth opportunities, but no cash will have to give control to outsiders anyhow if they want to take advantage of these growth opportunities.

Is what is happening nevertheless positive for the Chinese economy?

Certainly. Market forces are becoming more apparent. In time, as these companies issue new shares to raise capital, the proportion of government ownership will be gradually diluted.

In any case, the gradual and un-ideological nature of the process means that it's far less corrupt and spontaneous than the privatization process that occurred in Russia and some other former communist countries.