A Roadmap For Reform

by Harry Broadman

Most of China's state-owned enterprises are technically inefficient, burdened with "cradle to grave" social service obligations and a rising portion of redundant employees. By the third quarter of 1996 their profits had declined to less than 1 percent of GDP, from the late 1980s figure of 6 percent. In 1996, 50 percent of these enterprises incurred net losses (up from 33 percent in 1994), totaling 1.3 percent of GDP. SOEs' capacity utilization for major industrial products has fallen below 60 percent. Although their financial performance is worse than that of the nonstate sector, SOEs receive more than 75 percent of domestic credit and so crowd out investment in nonstate firms-the engines of China's growth-and undermine an already weak state-dominated banking system; nonperforming loans to SOEs account for 20 percent of bank portfolios.

Attempts have been made to transform state enterprises into shareholding companies (corporatize them), delegate greater autonomy to their managers, and diversify ownership. Government authority has been decentralized-all but 2,000 to 3,000 industrial SOEs have been placed under local government supervision, and a multilayered network of state asset management bureaus, state asset operating companies, and supervisory committees has emerged.

These initiatives, while reflecting a serious commitment to reform, have not been fully implemented. Managers do not have the freedom to make business decisions efficiently. Only 5 percent of SOEs have been corporatized. Although economic and legal reforms have been enacted, the implementation and enforcement of laws and regulations remain weak, and SOE property rights are not clearly defined. Government has not been separated from its enterprises; government agencies serve as both shareholders and administrators. The lines between government administrators and enterprise managers remain blurred. Many SOEs could not survive in a competitive environment.

Moreover, government initiatives have created new, unexpected problems. Local decentralization, for example, has eroded the old system of center-directed oversight, creating a vacuum in corporate governance. Unchecked insider control of many large and medium-size SOEs has resulted in asset stripping (taking SOEs' good assets and leaving debt-ridden shells), decapitalization through wage increases, accumulation of unpaid debt, and tax evasion. In other words, assets are being privatized and liabilities and losses are being socialized.

In their call to establish a modern enterprise system early in the next century, China's authorities have focused on developing clearer property rights within a sound legal framework, streamlining the organizational structure of state asset management and the enterprises themselves, strengthening corporate governance, and implementing financial accounting procedures in line with international standards. The following policy recommendations correspond to these objectives:

New Laws and Regulations

• Clarify rules regulating SOEs' conversion into limited liability companies, the transfer of state property, and the autonomous rights of managers.
• Draft a new, unified Contract Law to legislate property, contracts, and succession. A comprehensive Property Law should define and enforce property rights in all sectors of the economy.
• Accelerate corporatization under the Company Law-in force since 1994-of 1,000 priority SOEs (the largest enterprises that operate in key sectors of the economy) and, in the medium term, of the remaining 14,000 large and medium-size industrial SOEs.
• Enhance creditor rights to move lossmaking SOEs into bankruptcy-the new Insolvency Law should be promulgated as soon as possible.
• Build credible commitment to more fundamental reforms and deliver from within a predetermined time frame. Broad ownership diversification should be carried out in the 1,000 priority SOEs within five to seven years, reducing state ownership to a passive minority stake. Moreover, the enterprises should be controlled by independent, professional investment management corporations-a reformed version of the current State Assets Operating Corporations. The state should eliminate its involvement in SOEs that operate in an inherently competitive industries manner. This would signal the government's commitment to implementing deeper SOE reform and encouraging competition with nonstate enterprises.

Streamlining Organizations

• Simplify the network of state asset management institutions, assessing the costs and benefits of replacing intermediary government agencies with direct representatives of the state on enterprise boards of directors.
• Reorient state asset management institutions to focus more on financial management and less on administrative control of assets. (To improve the management of local public utilities, majority shareholdings could be sold to local development companies or commercially oriented entities. The funds to buy these shares would be raised from public institutional investors and social security funds.)
• Employ independent, professional managers. Compensation and job security of managers must be closely linked to enterprise performance. A robust "manager-market" must also be developed.
• Increase "outside" participation, by appointing nonstate representatives to SOE boards, diversifying SOE ownership through the sale of shares on national and international stock exchanges, and contracting out services (transport, accounting, social services) to the nonstate sector.
• Untie social and commercial functions by transferring enterprises' social responsibilities-housing, health care, and schools-to municipal or regional government or to NGOs.

Corporate Governance Reform

• Increase fiscal and financial discipline. Subsidies should be made transparent and, over time, eliminated. A national institution could restructure the stock of bad enterprise debts after halting their flow. The institution could provide transition financing for uncreditworthy enterprises while isolating them from the banking system. Banks should be prohibited from lending to enterprises that are in arrears for more than 180 days.
• Foster competition. The government should eliminate policy barriers that prevent nonstate firms from entering the market, simplify licensing and registration procedures, reduce import quotas and tariffs, rationalize the foreign direct investment policy regime, and promote competition across regions.
• Grant managerial autonomy. If subsidies are eliminated, competition strengthened, and debt service obligations met, insider control can be held in check.
• Diversify SOE ownership, both on a regional and sectoral basis. The government should ensure that ownership shares are transferable and that investments on behalf of the state are owned, supervised, or managed by independent professionals whose remuneration is linked to investment performance.
• Foster market-oriented mergers and acquisitions, provided that a social safety net is established for redundant workers.

The author is Senior Economist at the World Bank; this article is excerpted from his study "China's Management of Enterprise Assets: The State as Shareholder," 1997, Email: HBroadman@world bank.org.