Overview Ownership change Industrial finance Governance in state-owned sector Privatization and hybrid ownership Conclusions

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2 Overview Ownership change Industrial finance Governance in state-owned sector Privatization and hybrid ownership Conclusions

3 State-owned industry core of command economy government control pervasive and political objectives clear Entry of new firms and competitive pressures key to institutional change initially driven by emergence of TVEs, and later foreign-invested firms Competition drove down SOE profits, causing changes in financial position 1980s - experiment in incentive mechanisms, mid-1990s onwards, focus on corporatization, governance, and privatization

4 (i) First Period of Transition: 1978 Chinese industry made up of many publicly owned organizations: SOEs, urban collectives, rural TVEs Small firms virtually non-existent, and no multi-plant corporations SOEs/urban work units (danwei), responsible for welfare, health, and worker indoctrination Managers had little flexibility and low rewards no accountability/no risk

5 Ownership Change Ownership Composition of Output (%) SOEs Collectives (TVEs) (9) (28) Private and household 0 19 Foreign-Invested 0 12 (Foreign nationals) (7) (Hong Kong/Taiwan) (5) Source: Naughton (1995)

6 Over period, industrial economy became less state-run, but still dominated by publicly-owned firms, especially TVEs State, collective and private firms (including foreign-owned) each accounted for about 1/3 of industrial output by 1996 Domestic private firms evolved, but propertyrights protection was minimal, and there was continued discrimination against them Gradualist transition produced growth and ownership diversification, while state role still critical

7 (i) 1996 to Present: 1994 adoption of Company Law, uniform legal framework covering differing ownership forms Allowed corporatization of SOEs conversion of SOEs into corporations that could sell shares Boundaries between ownership forms began to blur after mid-1990s Impact of adoption of Company Law still being worked out

8 Gradual reorganization of SOEs was overshadowed initially by significant downsizing of state sector lay-offs 40% of SOE workforce September 1997, 15 th Communist Party Congress adopted policy of grasping the large and letting the small go Involved reorganizing largest firms through restructuring and refinancing, while maintaining state control e.g., energy, natural resources Local governments effectively given more authority to restructure their firms especially via privatization/removal of loss-making firms

9 Ownership Change Ownership Composition of Industrial Output* (%) SOEs and state-controlled corporations Joint-stock corporations Foreign-invested enterprises Collective enterprises Source: Naughton (2007) * Above-scale industry firms with annual output value > 5 million RMB ($600,000) Note: Lines 1 and 2 overlap due to some joint-stock corporations remaining statecontrolled, e.g., oil companies such as Petrochina and Sinopec are joint-stock corporations with shares sold on Shanghai Stock Exchange

10 June 2003, group of large scale firms controlled by central government transferred to State Asset Supervision and Administration Commission (SASAC) Responsible for exercising government s rights of ownership over large, highly-capitalized firms in state sector Petroleum and refining, metallurgy, electricity, military industry, and telecommunications Share of state controlled firms in output has declined more gradually than their share of employment partly due to demand driving up prices, and hence value of output

11 Finance not an issue under central planning SOEs in protected markets with high margins, profits transferred to state budget and then reinvested in heavy industrialization SOE profits 14% of GDP in 1978, driven virtually to 0% by 1996 through competition SOE downsizing, layoffs, ending of jobsecurity achieved some success, state sector profits rising to 4% of GDP Cycle of state-based finance broken

12 Percent of GDP Figure 1 State Industrial Enterprise Profit 16% 14% 12% 10% 8% 6% 4% 2% 0% Source: Naughton (2010)

13 SOEs forced to get finance from banking system, with broader implications for Chinese economy Bank financing eased transition, and was consistent with macroeconomic position of falling government/rising household savings However, also contributed to subsequent problems in banking system with nonperforming loans (NPLs) Shift to bank lending in line with basic principle: repayment of loans with interest should have focused SOEs on profitability and risk of investments

14 SOEs in fact got credit without much concern for ability to pay - increased indebtedness Debt-equity ratios rose up to 1994, where equity (the state s interest in the firm) is valued as total assets minus the value of debt Since 1994, SOE debt levels have declined/stabilized improvement in both their financial health, and write-off of NPLs Banks tightened lending standards, and highlyindebted firms failed, forcing bank write-offs of unpaid debt

15 Industrial Finance Debt-Equity Ratios (%) China, state-owned industry Comparison-economies, average Korea 347 Japan 230 Germany 151 United States 103 Source: Naughton (2007)

16 Financial position of SOEs improved due to lower interest-rate burden as NPLs were written-off, and failure of many firms Large, centrally-controlled firms regained profitability due to their protected status Debt-equity ratios still high, with new finance still coming through banks as opposed to capital markets A challenge to reform of corporate governance in China is regulation of competing claims of banks vs. equity holders

17 Transforming socialist enterprises into profitoriented firms, required: change of organizational form, objective function, and economic signals; plus hard budget constraint Term soft budget constraint coined by Janos Kornai (1979/80) where a loss-making firm continues to get financing Without hard budget constraints, managers free to pursue other goals (investment hunger ) without concern for profitability SOEs had soft budget constraints until late- 1990s, while TVEs faced harder budget constraints

18 Governance in State-Owned Sector Industrial Enterprise Transition: Elements of Analysis Organizational Form Managerial Objective Pure Plan Transition A: Hierarchical bureaucracy Meet plan; interests of danwei Incentivized bureaucratic element Profits by contract; interests of danwei Transition B: 1996-current Reorganized into corporations Profit with qualifications Price System Planned Dual-track Market prices with intervention Budget Constraints Soft Soft Hard with qualifications Pure Market Multiform Profit; discounted present value of future profit stream Market prices with regulation Hard Source: Claessens, Stijn, Djankov, and Lang (1998)

19 (i) Transition A: organizational form changed slightly reformers reluctant to disrupt danwei; experimented with incentives tied to profitability Had to be accompanied by dual-track pricing increasing share of transactions in markets Internal organization of SOEs unchanged, and coordinated with various bureaucratic agencies, e.g., local governments; non-uniform treatment of firms meant no level playing field Managers exercised residual control over assets a need to restructure property rights and corporate governance to hold them accountable

20 (i) Transition B: Mid-1990s, new program of enterprise reform focused on corporatization, and harder budget constraints Number of SOEs dropped from 120,000 (mid- 1990s) to 31,750 (2004) more competitive markets and tighter credit Enabled by other reforms: VAT and profit taxes (1994); banking reforms (1995); social security (1995); housing privatization Result could peel away non-core functions from urban danwei

21 In principle, corporatization with stateappointed board of directors should align interests of managers with owners: - firms have greater autonomy within welldefined legal framework, managers being accountable to board not bureaucrats - shareholder voting reduces agenda to one of distributable profits - also encourages specialized government oversight with interest in profitability

22 Have objectives been achieved? - implementation of Company Law slow SOEs still exist 23,000 at end of 2003, and not all firms with functioning boards - problems with oversight agency SASAC: conflict between appointment power and nomenklatura role of Party; does not directly collect earnings - SASAC has increased focus on profitability and maximization of asset value through focus on restructuring - inconsistency between SASAC efforts to increase shareholder value and its arguments for maintaining state ownership where there is market failure

23 How is oversight of managers exercised? In theory, two methods: (i) market-based through stock-market (Anglo- American) (ii) control-based through banks/founding families (Continental/Japanese keiretsu) Chinese state-ownership has characteristics of method (ii), however, banks are have little role in oversight this is fragmented among state holding companies, SASAC, government and Party bodies

24 Method (i) does not exist either - while firms are listed on Chinese stock markets, weak disciplinary role Chinese state-firm managers therefore have a high degree of independence, although autonomy is not absolute have to negotiate with controlling shareholders However, risks of insider coalitions gaining control of firms without external oversight/constraint Communist Party does serve as a mechanism of corporate governance albeit with costs

25 As with TVEs, insider privatization dominant Two key policies in 1990s: - transitional ownership form of joint-stock cooperatives, where shares sold to workers/managers at concessionary prices, then converted to joint-stock corporation, workers being able to sell shares - technology firms allowed to distribute equity to managers involved in start-up (seeking a Silicon Valley-type effect)

26 Allowed acceleration of restructuring of industry via insider privatization and managerial buyouts (MBOs) although state often retained passive minority interest Prominence of MBOs has been controversial critics claim managers have used firms assets to get credit which was used to finance purchase of firms SASAC has attempted to place some limits/transparency on privatization

27 China has produced only a few firms that approach international best practice in governance Overall command structure has been eroded, but privatization has been slow, and still plagued by problems that afflicted speedy process in Russia and Eastern Europe Creation of more broadly based system of private ownership not achieved negatively affects efforts to achieve a harmonious society