1. Overview

2001 is the year that most observers expect China to enter the World Trade Organization. The event is important for China and for the WTO itself, given the magnitude of China’s trade volumes and the uniqueness of China’s trade practices. Not the least to be impacted by the new environment are China’s State-owned enterprises (SOE). Once the hope of China’s wobbling economy at the end of the long civil war in 1949, when the People’s Republic was established, by the time China opened its doors to the outside, State-owned enterprises had become synonymous with inefficiency and stagnation.

When Deng took control of the Party leadership at the end of the 1970s, he made reform of the State-owned sector a priority for the post-Mao era. A set of cautious and sometimes explicitly experimental policy and structural changes were implemented over the years, but progress has been slow, solutions uncertain. In the most recent three years, as China prepares to enter the WTO, the expectation of fierce competition in a more open economy has increased the perceived urgency and stakes of SOE reform.

More than a decade ago, a steep and steady decline of productivity in the State sector as a percentage of total productivity became a documented reality of China’s economy. That seemingly irreversible trend gave reason to believe the State-owned sector might shrink into irrelevance. From the top, China’s leaders adopted a number of strategies and practices to undo the inefficient and faltering enterprises that the previous centrally planned economy had engendered.

China’s leaders continued to maintain their commitment to the concept of a Socialist-Market Economy, and they maintained and even strengthened State control of key sectors of the economy. During the first two decades of this process, China experienced astonishing growth in its industrial economy. New wealth has been created, China’s infrastructure has leapt forward, and living standards of many citizens have been vastly improved. Still, the process of reforming the State sector is unfinished, and it has followed the Deng principle of ‘crossing the river by feeling the stones.’

In the last two years, the State Council has made increasingly dramatic changes in the organization and regulation of the economy, in sector after sector, generally pursuing a policy of "corporatization" of major enterprises. This has been a bold effort to restructure the governance of large enterprises, to depoliticize their governance and separate regulatory process from strategic and commercial processes, without privatizing them, without removing the State from a major position of direct ownership.

As we enter 2001, the process of enterprise reform is running closely parallel to the process of entering the WTO. Various sectors are emerging with their own unique reform characteristics. Some like energy and telecommunications remain largely domestic, whereas some like automotive and consumer goods have become extensively internationalised through joint-ventures. Some like non-ferrous metals are being consolidated into very large corporate entities. Others like ferrous metals and pharmaceuticals are increasingly fragmented and competitive. In some sectors, national governance is being used as keys to reform, in others, provincial and municipal governance. Across the board, regulating entities are being separated from their companies, and sources of capital are increasingly internationalized.

2. A look back

The role of the state in the economy is an ancient debate in China, extending back to China’s unification 23 centuries ago. Contending factions at court argued over the issue of whether the government should own the means of producing essential commodities--salt and iron at that time-- and manage the pricing and distribution of goods among the land, or whether they was best left to markets. With the establishment of PRC and the commitment to a Soviet-styled socialist industrial model, China did not put the long-standing debate to rest. The new government took firm control of major productive assets and consolidated their management directly under powerful ministries. Still, radical experiments in basic production continued, like the effort to push iron production down to the village or even family level during the Great Leap Forward.

After his return to power, Deng set the course for the early direction of industrial reform. The first stage, in the early 1980s, was deconsolidation, returning governance authority to local managers and political leaders, through what was called the responsibility contract system. Under this system, contracts were made for performance goals. Otherwise operational and financial decisions devolved to the local level. This change triggered the wholesale conversion of State-assets to local control, stimulation of the growth of new enterprises at the township and village level, and a burgeoning of special development zones, investment regulations, and tax arrangements, designed to draw foreign direct investment into competing locales. From the 1980s, state statistics began reflecting three types of ownership, State-owned, Collectively-owned, and Other, with individually owned added as a fourth type in the mid 1990s.

When SOEs are compared to Collectives, the data makes clear that for nearly two decades, the decline in relative contribution from the State sector continued, and basic problems of performance and efficiency remained unsolved. From 1980 to 1996, SOEs grew in number from 83,000 to nearly 114,000, an anemic 36%, but Collectives grew from 293,000 to nearly 1.6 million, a growth of 542%. Real output for the SOE group increased 329% from 1980 to 1996, an annualized growth rate of 7.7%, against Collectives, whose output grew a whopping 2,246%, an annualized rate of 21.5%. SOE growth of 7.7% growth is a very respectable figure, but it was starkly overshadowed by spectacular growth in other forms of ownership.

Productivity is only one measure of the gap. Profits, growth, and employment measures confirm the decreasing importance of the SOE sector in China’s overall economic development, which continued to the end of the decade. And Collectives themselves, really localized versions of SOEs, proved to be an imperfect model, when faced by other forms of more individualized ownership, and experienced accelerating decline throughout the 1990s. By 1998, the once nascent individual enterprise and newly popular enterprise limited by shares had surpassed the Collectives in total employment.

Zhu Rongji was widely recognized as China’s economic czar when Deng Xiaoping re-stimulated reform initiatives in 1992. Zhu and his advisors shifted much of the authority for overseeing reform from the its locus in the State Planning Commission to the State Economic and Trade Commission. He continued to seek solutions to the acute problems of the State sector and the mounting losses of large enterprises. The losses had deleterious effects on the government and the economy. SOEs were requiring large direct infusions of capital from the State, which compromised reform of the banking sector. Officials voiced fears of social instability as a result of unemployment in the wake of downsizing or outright failures of large SOE employers.

State banks were restructured into regional branches to protect them from provincial level pressures, and by the end of the decade vast amounts of non-performing loans were moved into asset management companies, as debt for equity swaps. Special care was taken to quell social turbulence in SOE dependent regions like the industrialized northeast. Promises were made and then made again that the problems of the State-owned sector would be solved, and the maturation of China’s socialist-market economic model was on track.

3. Facing fierce competition

For at least three years now, China’s official media has been filled with warnings for managers of every sector that WTO would bring fierce competition to China, which would threaten the existence of many SOEs. This comes after a half decade of several reorganization efforts prescribed by state planners and continued protection from market pressures. Few SOEs have really had to face the prospect of bankruptcy, although many faced difficulties meeting their internal and external obligations.

Nonetheless, the official press reported in 2000 that the strategic reorganization of the State sector had achieved initial results, primarily through the consolidation of major industries into large industrial groups. The press counted 10 major industrial groups in military related enterprises, including nuclear, aviation, aerospace, and weapons. Three large groups were formed in non-ferrous metals, four in information services, and similar consolidations were achieved in textiles, coal, and other industries.

Both the policy and ideological focus became the creation of very large enterprises, like Chaebols, as the way of fending off the fierce competition of the post WTO era. In some key respects, consistently applying this policy would represent a reversal of Deng’s effort to decentralize control of enterprises to local governments, with the resultant fragmentation of enterprise management and emergence of internal, domestic competition. The reconsolidation happened in the oil and gas sector, the non-ferrous metals sector, and transportation, among other industries.

The success of the consolidation policy was proclaimed in a reported 8.9% growth in 1999 of the value add of SOEs and large non-SOEs with sales exceeding 5 million yuan. By the third quarter of 2000, the State reported that losses of enterprises owned completely or in the majority by the State had been cut by nearly 13% over the previous year. Chinese leaders began to talk of SOEs and large non-SOEs entering the list of the global Fortune 500, and in several capital-intensive industries, survival against fierce competition has become linked to making bigness work.

The interest in bigness notwithstanding, in actuality, there is considerable variety in the implementation of the SOE reform agenda around a core set of consistent practices being enforced at the highest levels of government. Because SOE reform has been a focus of research inside and outside China for two decades now, there is a helpful body of information about the paths taken for most major industry sectors. Looking at some key sectors individually helps to isolate the common themes as well as the variety of strategies now unfolding.

Throughout most of the 1990s, the leadership has downsized the government bureaucracy to reduce the sheer cost of government and reduce the sheer weight of government on productive enterprises. At the heart of this exercise has been the policy to separate the regulators from the regulated. Dramatic examples include telecommunications, commercial aviation, automotive, and media. In these sectors, regulating bureaucracies have been trimmed sharply, and a concerted effort has been made to establish a regulatory function independent of major business operations. This trend has also contributed to squeezing down the channels for the infamous post-budgetary subsidies that had fostered and hid massive losses in SOEs. Enterprise managers have been under increasing pressure to improve fiscal discipline.

Another core trend has been to transfer more of the substantial social burden historically carried by the SOEs to public funded entities. Progress here differs widely from location to location. Close corollary trends include increasing freedom of SOEs to manage their labor forces according to commercial needs, to reduce the influence of national and local political forces on business decisions, and motivate the major banks to lend in a more commercially responsible, less politically determined fashion. This in turn has raised questions of financing the public social security funds, and in early 2001, the Ministry of Finance announced its intent to collect 10% of IPO proceeds for this purpose.

In contrast to these uniform core practices, there as a variety of actual reform practices deriving from several influences, different histories of production and ownership, management practices, geographies, and extent of foreign involvement. Ownership and formal property rights have been subjects of intense interest to economists studying China, who tend to puzzle over China’s inexplicable combination of fuzzy property rights and sustained economic growth. Management practices have been the focus of practicing consultants in China, many of whom have seen new opportunities to work in SOEs as they contemplate IPOs overseas.

The differing impact of powerful external forces also helps shape individual sector reform trends, including technological changes, impending WTO driven changes, and global industry trends. The growth of distributed information processing, global data networks, customer relationship management tools, and wired and wireless terminal options for consumers impacts different sectors in markedly distinct ways. China’s WTO commitments go into excruciating detail in some sectors, like telecommunications, some detail in others, like distribution and retail, and say very little about others, like oil and gas.

Sectors in which consolidation has been the general trend include oil and gas and non-ferrous metals. By the mid 1993, China faced a long-term need to import what was projected to be a rapidly increasing amount of oil to feed its refineries and support its rapidly growing demand for gasoline and diesel oil. There had been little development of natural gas, the environmental impact of burning high-sulfur coal was increasingly recognized, traditionally productive oil fields in the northeast were entering steep depletion curves, and off-shore exploration had proven a disappointment. The industry was becoming fragmented, not only among provincial and regional players under the Ministry of Petroleum, but with the emergence of enterprises in other ministries, like geology.

In the second half of the decade, the leadership took dramatic steps to reconsolidate the industry, redefine the role of foreign cooperators, and develop natural gas resources. Almost the entire value chain of the oil and gas industry, from exploration to development to production to refining, transport, and retail sales, was rolled up and divided geographically between the Chinese National Petroleum Corporation (CNPC) in the north, and SinoPec in the south. China National Offshore Oil Corporation (CNOOC) retained the right to continue development of the off-shore resources, and they retained valuable trading rights. The establishment of this powerful duopoly rather sharply reduced potential domestic competition and curtailed the leverage of foreign oil companies in China, but its impact on the overall success of the industry remains uncertain as yet. One goal of the new policy was to open foreign capital markets to the remaining consolidated players, by promoting the potential advantages of their powerful and unique industry positioning. CNPC managed a successful IPO with PetroChina, a listed entity into which significant CNPC assets were injected, but the IPO of CNOOC was withdrawn in the face of tepid investor interest.

China’s aluminum and alumina business likewise had become fragmented. Domestic demand exceeded supply, requiring substantial imports. Yet the domestic industry proved unprofitable, as large fixed assets under the influence of provincial and large municipal governments produced inefficiently and faced a disorderly market with few provisions for arbitrage and stability. The leadership established CHALCO, a new corporate entity into which were injected eight of the largest alumina factories. The CHALCO leadership was tasked to consolidate the operations of these units and bundle them for presentation as a business to international capital markets. Similar consolidations were implemented in other non-ferrous metal sectors, creating a number of large, centralized enterprises facing unprecedented organizational change and process improvement challenges.

The automotive industry offers a different example. China’s domestic industry development was built on light and medium duty trucks. Passenger cars were largely undeveloped. In some years since the founding of the PRC, the total passenger car industry, divided between Shanghai Automotive’s (SAIC) Shanghai passenger car and First Auto’s Red Flag limousine, produced fewer than fifteen passenger vehicles a year.

The industry was opened to foreign investment by the mid 1980s, up to 49% for a limited number of approved vehicle programs. Foreign investors, primarily VW, brought viable passenger car programs to China’s SOEs, and they proved to be the most profitable product the industry ever produced. By the early 1990s, SAIC became the only SOE in the industry with a substantial accumulation of cash, overtaking First Auto and Dong Feng (formerly Second Auto), once the flagships in the SOE lineup. In the course of their Santana product development, SAIC also built the most formidable supply network in the country. As a result, SAIC was able to engage the largest Sino-foreign JV in the industry, the Shanghai-GM Buick JV. Across the country, every other successful passenger car initiative was achieved by a joint venture or cooperation, with European (Shanghai, Dong Feng), Japanese (Tianjin, Guangzhou), or American (Shanghai, Nanchang, Beijing) foreign partners.

Several times the government announced its intention to consolidate the industry into a "Big Three," but little progress was made. Periodically a completely domestic passenger vehicle was announced, like Xian's’ Lucky Star, but none survived. Studies routinely reported that there were 126 vehicle makers in China. But the appearance and availability of foreign partners resurrected a number of marginal domestic operations, and consolidation among significant players has been slow to nil.

Finally, Telecommunications offers an example of a third path, radical deconsolidation. Beginning in 1993, first with Jitong and then Unicom, the long-standing, lucrative and impregnable monopoly over telecommunications operations that had become the major revenue source for the Ministry of Post and Telecommunications (MPT) was under attack. To address multiple banes of poor service levels, sluggish reinvestment, and underutilized infrastructure in other ministries like energy and railroads, the State Council began the process of creating domestic competitors. Eventually this led to merging the MPT with the Ministry of Electronics to form the new Ministry of Information Industries (MII). Soon after, MPT’s major telecommunications operator was de-merged into four, sector-defined operators, fixed line, wireless, paging, and satellite.

Domestic competition was strengthened with the public offering of shares in the China’s mobile operator on the Hong Kong exchange, the establishment of a third generally licensed network operator (China Netcom), the restructuring of Unicom and its IPO, and the recent licensing of Railways to provide public commercial telecommunications operations. A long-delayed decision to permit operators of China’s extensive television distribution cable networks to offer data services was made in favor of deploying convergent technologies. And IP telephony was licensed to a number of providers, resulting in a sharp reduction of international calling rates.

By the eve of China’s entry into WTO, a powerful monopoly that existed until 1993 had been systematically exposed to a range of powerful domestic competitors for share in one of China’s most explosive and lucrative sectors. Two of the operators have gathered large infusions of capital from international capital markets, and the remaining operators were at one point or another in progress toward their own planned public offering. Wholesale and retail service prices were dramatically reduced, and in some cases exposed to market forces, with a set of dramatic tariff reforms implemented January 1, 2001. Backbone carriage rates were reduced as much as 80%, even as massive new capacity was being installed under the aegis of several network builders.

Standing against this liberalization of domestic competition, recent regulations assert the continued right of the State to own more than half of all Class One telecom businesses, which encompass all of the basic service providers. Foreign majority ownership is prohibited, and foreign minority ownership is phased in gradually, first in three markets, then an additional fourteen, over a period of three years after WTO accession. Departing from the regional and global trend toward privatization, China has committed to a reform path for telecommunications that relies on continued state ownership, strong central planning, and a process of "corporatization."

Over recent years, as official Chinese media has emphasized the threat of fierce competition after WTO, the leadership has increased the rate of rather bold reform steps in a number of key sectors. Several of these are reviewed above. From the perspective of policy, WTO has created a new level of pressure on reform minded leaders, who believe they must achieve effective reform in advance of the forced opening of sectors where the State’s stakes are high. The elements of reform include restructuring to achieve some effective market influence within most sectors or to achieve scales of economy, diversifying sources of capital, especially to include foreign portfolio investment as a complement to foreign direct investment, and broad management and process improvement to enhance efficiency and productivity.

The trade-offs were straightforward in sectors where the leadership chose to surrender a degree of central control, central government monopolies in key markets, price control or guidance, and direct authority over allocation of financial resources. This was achieved by creating new competitors, generally domestic and generally still state-owned, increasingly detached from their regulating parents. The hope is that these new-style State-owned enterprises will survive in a world of market pricing, a world with the discipline that markets can bring, where central planning and administrative fiat could not.

In summary, the leadership chose in some sectors to create competition that was both controlled and controlling. It was controlled in that licensing was still restrictive and political, business scopes were still carefully regulated, and access to capital remained for a time in the hands of Beijing. It was controlling in that its objectives were to bring s strong measure of market discipline to the State-sector. In other sectors, the leadership chose what was perceived to be the relative security of massive, consolidated industry groups, whose survival was assumedly assured by their formidable mass. In all cases, the outcomes are the result of the unprecedented vigor of central planners and the unpredictable impact of market forces. The process of creating a socialist market economy has become clearer, even though the potential success of the effort remains far from clear.

What lagged behind in this flurry of activity was further clarification of basic property rights and basic legal processes in ways that are familiar to non-Chinese, developed economies. This is true even though a number of new localized and share-based ownership structures have been created and have become popular. And what remains the key to success is whether the newly created entities, when big, can use bigness to their advantage rather than suffer its potential disadvantages, and when small and focused, can muster the resources necessary to compete with global giants landing on Chinese soil.

5. Looking forward

No matter which sector we examine, and no matter what question we ask, it is apparent that China’s State-owned industry reform is a work in progress, unfinished business. Studies of China’s economic reform attribute success to many factors, including various economic, social, and geographic preconditions. It is clear that China has had dramatic outcomes from rather limited reforms. It is equally evident that reform has aggravated problems with maldistribution of income, between the urban and rural populations and within the urban populations themselves. It has also mobilized large number of people in a system that has historically maintained stability and sustainability by impeding mobility. It is evident that within any given sector, there are State-owned entities that have been advantaged by reforms and others that have been disadvantaged. Finally, it is also clear that the success of the reform initiatives to date create pressure for continuing reform, and those pressure are no longer confined to the economy.

For foreign investors in China, an understanding of the state of SOE reform is important for understanding major opportunities to participate in the marketplace. No matter what other forces bear on the leadership, the condition and competitiveness of their own assets will be a major determinant of the pace and nature of market liberalization.

For foreign investors, every sector poses the prospects of shifting regulations and inconsistent practices, the threat of serious, even "fierce" competition from newly reformed SOE players, and new opportunities for partnerships and associations with well-established or newly formed State-owned entities. What is certain to remain true is that China will be China, committed primarily to meeting the ongoing challenges of supporting its huge population, the frugal use of its limited resources in food, energy, and materials, and striving to render the best possible value from the massive asset base the State painfully built over the history of the People’s Republic.