Restructuring Restructuring: State-Owned Enterprise Reform in the PRC (Part 1)

[Fair warning: this is a post concerning Chinese law, and not about our experiences living in China. It is one of a series of posts concerning the modernization of State-Owned Enterprises in China. They are based upon a paper I wrote for a class in Economic Law that I recently completed in the Peking University LL.M. Program. I welcome any comments or questions.]

The privatization of state-owned property should aim to efficiently allocate ownership rights and maximize revenue in privatization transactions. Yet like many other eastern European and Asian nations making the transition to market-based capitalism, China has seen its efforts to modernize state-owned property fall victim to political economies. To be sure, China's regulation of state-owned property has focused upon the assignment of property rights, the reduction of transaction costs, and the facilitation of dispositions in state-owned assets and entities. Even so, non-economic considerations suffused in the so-called"diversification" of state property have produced a decidedly mixed record with respect to financial performance.

One must keep in mind, however, that the label "privatization" only describes one aspect of China's policy towards state-owned property. Under a current policy referred to as the "Modern Enterprise System," China maintains a two-pronged strategy known as "Control the Big and the Release the Small." Controlling the Big entails the consolidation of control over industries and businesses considered critical to China's ongoing development and global economic power, while Releasing the Small entails divesting smaller businesses in non-critical sectors through a variety of disposition methods. In other words, while one fist tightens to ensure politically-suffused economic results, the other lets slip organizations and property considered more suitable to private management.

The seeds of the Modern Economic System were planted during the Third Plenum of the 11th Party Congress on December 22, 1978, which marked the return of Deng Xiaoping, the end of the Cultural Revolution, and the beginning of China's efforts to "diversify" state-owned property. At that time, so-called "administrative appendages" of the State produced goods according to Soviet-style central plans, provided cradle-to-grave social welfare benefits to the laobaixing, and operated with the knowledge that poor performance could be mitigated by State re-capitalization in the event of financial difficulties. But in 1978, agricultural units began to raise funds via financial instruments that resembled fixed-income securities, and the State Council affirmed the nascent practice through a notice that allowed for the open sale of equity in production units. Six years later, the Chinese government still oversaw an estimated 1 million work units, but they were then only responsible for 74% of the domestic market value. Recognizing the dangers of social unrest among laid-off workers and the potential for massive resistance from entrenched managers, many of them Communist Party officials, China's leaders had nonetheless opted to continue reforms by reducing China's industrial bureaucracy through layoffs and restructuring. And once the central government committed firmly to reorganizing state-owned property, the ensuing diversification of China's industrial system occurred in several waves.

Between 1978 and 1984, China instituted the "Transfer Rights Down and Surrender Part of Profits" policy, which transformed state-administered work units and property with expanded managerial autonomy, liberalized pricing and production policies, and the creation of an incentive contracting system driven by the State plan known as the Contract Management Responsibility System. In 1984, after the Communist Party of China (CPC) issued the Decision on Restructuring the Economic System, a series of rules and regulations transformed the administrative appendages from government-operated collectives into State-owned Enterprises (SOEs) with separate legal personality, created large holding conglomerates and asset management organizations, distinguished management functions from ownership functions, and allowed for foreign investment. The Modern Enterprise System crystallized in 1993 and gave additional managerial authority to SOEs, allowed for increased competition within the market, reduced price controls, and saw the institution of modern laws and institutions emphasizing corporate governance and a market-based economy. As alluded to above, a more recent round of changes driven by the Control the Big and Release the Small policy has consolidated and restructured SOEs through corporate transactions and securities offerings, and placed non-financial SOEs and State-owned Assets (SOAs) under the supervision of the State-Owned Assets Supervision and Administration Commission (SASAC), a newly-formed "special organ" of China's State Council. The Ministry of Finance, by contrast, oversees China's approximately 1.2 trillion yuan worth of state-owned financial assets (SFAs), 80% of which is invested in Industrial and Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China, the PRC's big four state-owned banks. In 2006, SASAC reported that China had nearly 120,000 SOEs that possessed more than $ 1.3 trillion dollars in assets.

China has employed a combination of divestment, displacement, and delegation strategies to Release the Small. Divestment by sale occurs in transactions with one of four kinds of buyers: private actors can acquire an SOE in its entirety as a going concern in a privately-negotiated transaction; the public can buy an entire firm or a portion of it via the listing of shares on a foreign or domestic stock exchange; or, managers and employees can buy an SOE in a direct transaction with the government, often at a below-market price. Divestment by liquidation occurs when the government liquidates poorly-performing enterprises and sells off their assets. Displacement by default occurs when private entities out-compete an SOE in the market and assume its place, while displacement by withdrawal happens when the central or local government simply decides to shutter an SOE without proceeding with a liquidation. Delegation, the final means of diversification, is carried out when the State contracts SOE supervision and control to outside parties under either a management contract or a franchise model. Put together, divestment, displacement, and delegation have reduced the number of SOEs by 85% over the past thirty years, and produced more than $86 billion USD in proceeds between 2000 and 2006.

To Control the Big, China has likewise relied upon divestment, in the form of limited consolidations and public offerings intended to raise capital while maintaining government control. Such maneuvers reflect a nine-year old decision issued by the CPC Central Committee which stated that:

[P]eace and development are still the themes of the times, but hegemony and power politics have also appeared in a new form....To enhance China's economic strength, defense capability and national cohesive force, we must constantly promote the development and growth of the State-owned economy.

In keeping with this ideal, China has steadfastly adhered to the principle that state ownership of some form must continue, albeit with better management and better financial controls. Indeed, "the stated goal of the securities markets has been to promote greater operating efficiencies in SOEs still controlled absolutely by the state." For this reason, domestic and off-shore SOE security offerings rarely float more than 25% of total capital, and the remaining equity remains held by the government in a form that resembles preferred stock.

In the next five years, the PRC will further consolidate ownership of SOEs in "important sectors and key areas that are crucial to national security and the national economy[,]" while continuing to divest SOEs in non-crucial sectors. Wang Zhongming, director of SASAC's Economic Research Center, recently referenced plans to reduce the number of centrally-managed SOEs from 159 to between 30 and 50, and to reduce the number of SOEs overseen by local governments to less than 1,000. While such comparatively small numbers might suggest a relatively simple task, the number 159 in fact refers to massive holding companies and conglomerates which themselves own subsidiaries numbering well into the thousands, as portrayed below.
To appreciate the scale of the Modern Enterprise System, one need only note that in 2007 the SOEs listed on China's stock exchanges amounted to approximately 35%of total market capitalization, produced 18% of GDP, and yielded $140 billion in profit. One should also note that profits from the 150 national-level SOEs grew 223 percent between 2002 and 2007, and that four of the ten most valuable companies in the world are China's SOEs.