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Mitchell, Arthur "Privatization and Reform of the Financial Sector in China" [2004] ADBLPRes 4 (9 June 2004)

Privatization and Reform of the Financial Sector in China

Arthur M. Mitchell
Kamal Ahmad*

9 June 2004

There is little doubt that the reform movement in the People’s Republic of China (China) is attempting to transform the economy by eliminating or reducing the undue influence of politics on the bureaucracy and the bureaucracy, in turn, on the economy. This process is deemed imperative in order to further sustain and enhance economic growth by expanding production, producing higher quality goods and improving financial performance. Most state-owned enterprises (SOEs), which even today, comprise a large part of China’s industrial capacity, cannot achieve these goals. It will be difficult for China to maintain the growth of its economy at current levels if it is not able to enhance the productivity of its enterprises or provide sufficient financing to fund that growth. Accordingly, the restructuring of its industrial capacity and reform of its financial system are mutually dependent upon each other. China hopes to address this problem through privatization of SOEs, deregulation and reform of the financial system. This article will examine some of the issues that the reformers face as they approach the monumental task of simultaneously dealing with a mountain of moribund SOEs and a financial sector that is mired in bad debts. It will conclude by raising questions suggested by the discussion.

While privatizations vary from country to country, there are certain key lessons learned that are certainly applicable everywhere:

  1. The goals of the privatization should be clear and the policies adopted should follow from those goals.
  2. The initial focus should be on reform of the regulatory framework --- prior to privatization.
  3. Steps must be taken to ensure political and social support for the program.
  4. The process should be transparent and competitive.
  5. The government needs to build its institutional capacity to support privatization.
  6. Certain core institutions (such as the “rule of law”) must be strengthened in order to encourage the development of capital markets and properly reform the financial system.
Experience1 shows that success or failure depends upon how these issues are addressed.

Ideologues on both extremes of the political spectrum either argue that privatization2 is inherently bad --- principally because it allows private parties to gain control of precious national assets, or inherently good --- principally because it allows the private sector to put underutilized assets to work in the most efficient manner. We believe that privatization can be either good or bad for a country based how it is done and how the transformed entities are governed, both internally as well as externally. Technically speaking, there is both a right and a wrong way to privatize, given local conditions. Post-1992 Russia is the most notable example of how privatization of SOEs can lead to oligarchy and monopoly. On the other hand, there are many examples in other countries that demonstrate how the process can be managed to establish a framework that deals with the legitimate interests of all stakeholders.3

Privatization has been tremendously popular, as evidenced by the fact that about 75,000 medium and large-sized firms have been privatized around the world, along with hundreds of thousands of small business units, generating proceeds in excess of $735 billion.4

China was the first among socialist countries to adopt privatization, beginning with agriculture in 1978. An important feature of the country’s economic agenda has been the restructuring of SOEs. Already the SOE share in China’s gross domestic product has come down from 77.6% at the beginning of the economic reform period to now less than 30%.5 Still, no country in the world today has as many SOEs as China does: there are 170,000 SOEs with assets totaling 6.9 trillion yuan.6 Privatization of SOEs in China so far has also been partial at the firm level. There is not a single listed former SOE that has been fully privatized. In fact, the value of government-held shares in listed companies was about $1.19 trillion at the end of the year 2000, reflecting roughly 17% of the country’s GDP.7

The State Asset Management Commission has announced that out of this enormous pool of SOEs, only 196 large SOEs will be retained while the remainder will be transferred to local governments to either sell or restructure.8

The Privatization Imperative

The imperative for privatization stems from inefficiency, poor management and low productivity generally associated with SOEs that are, consequently, reflected in poor quality of goods and services and mounting losses and rising debts. This is because state ownership creates the wrong incentives. SOEs are controlled by bureaucrats who have no rights to the cash flow generated by the business. Too often, those bureaucrats have socially harmful objectives, such as political favoritism and corruption. Privatization can lead to better alignment of corporate decision-making and allocation of cash flows, through managerial and technological innovations. On the other hand, the stigma that has dogged privatization relates to its social consequences. It is associated with rising unemployment and social dislocation. Where transactions lack transparency, they also signal corruption and illicit private gain in the name of public interest. Privatization of monopolies without the appropriate regulatory restrictions may create unfair profit opportunities and overall welfare losses.

We believe that the following issues need to be carefully considered during the next phase of the privatization process to ensure that it delivers to the nation the greatest benefit and avoids some of its more deleterious effects.

  1. The goals for privatization must be clear. Privatization can be an instrument for pursuing various objectives -- it can be a device to attract new capital, technologies and management and spur added competition; it can be used to generate proceeds that supplement state revenues; or it can be a way to transfer valuable state assets to private parties in order to minimize the drain on state budgets. Unless the objectives are clear from the outset and policies and strategies are set accordingly, the privatization process may be captured by private interests and that can de-legitimize the case for privatization.

    As an early step in this direction, the government will need to establish the principles that will govern what assets and services will remain within the state’s control and management and what may be subject to privatization. Different countries have defined different roles for the state in the economy. Some have taken the position that other than some clearly defined strategic interest areas of the state, economic activities should be carried out by the private sector, with or without foreign capital and involvement.9 Others have taken a more flexible and opportunistic approach where the state has retained the management of even those enterprises with no obvious links to any strategic interests, especially if the enterprises have been profitable. Some may also take the view that the government’s economic interest in an enterprise is best served by the taxing opportunity provided by highly profitable firms.

    The strategy for privatization must derive from the goals set. For instance, there is evidence suggesting that in the typical mix of different stakeholders in a Chinese privatization scheme, participation of institutional investors may be an important determinant in enhancing corporate governance and performance.10 To the extent there may also be policy objectives that relate to a broader public ownership of privatized SOEs, the case for a dispersed ownership structure has to be reconciled with the case for an ownership structure that is more concentrated in institutional investors.

    It is important to recognize that government will always have a critical role to play in providing for its citizens through policy making, regulation and financing of various productive activities. This is distinct from the actual production of goods and services, which are more easily privatized, through public offerings of stock11, trade sales to a small groups of strategic investors, management buy-outs, auctions, asset sales, joint-ventures of various sorts (especially project finance) and contracting out with service providers.

  2. Getting the regulatory framework right. The regulatory framework governing the firms that are privatized should be set out prior to privatization taking effect. The regulatory framework should nurture competition and promote good corporate governance and encourage investments. The government’s role as owner must be separated from its role as regulator. In cases where industries have benefited from state monopoly, competition can be introduced through various ways and means. The firm itself could be reorganized by either vertically separating its stages of production or horizontally into competing producers. Deregulation of the industry itself may be important in encouraging new entrants and thereby furthering competition.

    However, experience suggests that commercially driven restructuring of the firm should be delayed until the privatization process is complete. There are at least two reasons for delaying such restructuring of the firm – First, while an SOE may be in need of modernization and cost-cutting, these decisions are best made by the new owners in a way that fits their particular strategy and outlook. Second, pre-privatization restructuring can be costly – in many cases it has turned out to be more expensive than the actual proceeds yielded by the privatization of the firm concerned.

    In regulating privatized firms, the government must also be willing to give up control. If the new owners are subject to unduly detailed and extensive government rules that pertain to their operations, privatization is unlikely to yield the intended results. Privatized enterprises must be able to adhere to the principles and practices of private enterprise with respect to allocation of capital and pricing of its goods or services.

    It is important to emphasize that sequencing of reforms leading to privatization does matter. A recent study has demonstrated that investors are willing to pay substantially more for firms in countries where regulatory reform took place prior to privatization.12

    China has already made a great deal of progress in reforming the basic financial architecture by establishing regulatory commissions13 for the banking, securities and insurance industries and establishing a Code of Corporate Governance for listed companies but further work needs to be done to address the quality of the core institutions that are the necessary preconditions for successful reform, including the rule of law, creditor rights, shareholder rights, accounting standards, foreign bank presence and the elimination of state ownership of the banking sector.14 The establishment of the rule of law is imperative because it will determine what the “rules of the game” are, especially with respect to property rights and the enforcement of contracts. Creditors and shareholders need to know what their rights are under various distress scenarios so that they will be willing to part with their money in the first place. Clear accounting standards are necessary so that all stakeholders know whether the enterprise is succeeding or failing. Foreign banks and other institutions provide innovative technologies and business techniques. Finally, new non-governmental owners of financial institutions must be found in order to provide the incentives for the needed changes in operations and the managerial mindset. The reformers in China recognize the importance of these core institutions.

    There are also a number of other reforms that can help facilitate privatization and bolster competition among firms. To the extent pensions are tied to individual firms, they provide a strong disincentive to employees to support privatization that may change the terms of the pension benefits. It also serves as an effective barrier to the movement of employees from one firm to another, makes employment unnecessarily sticky, and may inhibit prospects for career advancement. A pension scheme that is portable with the employee can help relieve such structural impediments to privatization.

  3. Ensuring political and social support for privatization. Historically speaking, support for privatization in Europe and the United States has waned when the private sector lacked accountability and social commitment. In the immediate aftermath of World War II, the private sector was accused of the very things that are associated with state managed enterprises today – corruption, collusion, inability to attract capital and lack of innovation. It is not hard to imagine that the pendulum can swing the other way again unless the privatization process is properly managed to mitigate some of its negative consequences for certain stakeholders.

    For example, workers may fear job losses or future job security. Government bureaucrats who manage SOEs may fear loss of privileges. Even consumers, if they are rural or living in other marginalized areas, may fear that a privately-owned company may no longer seek to service such marginal customers. A successful privatization strategy must take into account each of these constituencies and develop a response that helps mitigate their concerns. For instance, workers who otherwise might fear job losses may be more willing to support privatization if they have the opportunity to buy shares and there are feasible financing mechanisms in place to enable them to exercise such options. In some cases, worker and other employee opposition to privatization has been mitigated by extending preferences to retrenched employees to set up small business that then rendered services to their former employer.

    As China’s SOEs have been responsible for much of the welfare of its workers, new arrangements will have to be made to provide schools, health care and adequate pensions. It can be expected that new pools of capital for further investment will be generated as new mutual funds and other private investment vehicles continue to emerge but, in the meantime, it is imperative to expand the social safety net to ensure against dislocations that will inevitably result from privatization of the SOEs.

  4. The method of privatization must be transparent and competitive. Whatever method is chosen for privatizing, transfer of the firm to private hands should be open and competitive. Information about the transaction and the process should also be shared with key constituents such as workers. Often the lack of information and lack of involvement in the process stirs unwarranted fears and opposition to privatization schemes. All things being equal, the state for obvious reasons will have the greatest interest in privatizing enterprises that are least profitable. However, loss-making enterprises do not often attract new investors. In such situations, franchise schemes may provide effective solutions.
  5. Enhancing government capacity for institutional development. While in some ways privatization is intended to relieve government of pressures of and resources required for managing organizations, in other ways it increases the need for government competence. To successfully execute a privatization program, governments must be able to analyze complex policy and strategic issues, introduce new laws, weigh different privatization options and negotiate and complete deals. Skills in financial restructuring, valuation and regulatory systems are essential. In the absence of such capacity in government, privatization efforts will always face a higher risk of failure or mismanagement.
  6. Enhancing Domestic Capital Markets. As China relies disproportionately on banks for the provision of financial services, it is vulnerable to financial and macroeconomic instability. This problem is further compounded by the weakness of the domestic capital market. In the long run, the privatization process will be facilitated by the growth of a robust debt and equity market within China. It will help broaden the access to the capital markets to medium sized enterprises. To the extent the listing process demands a higher level of corporate good governance and accountability, it will serve as a powerful incentive for firms entering the public market as for all aspiring entrants to adopt better practices. It will also lessen the concentration of risk in the banking sector.

    Regulatory restrictions that excessively limit the investment choices of insurance companies also retard the growth of capital markets and deserve reconsideration. Capital markets also cannot easily grow in the shadow of a protected banking sector. China has already taken important steps to ensure the commercial viability of its banking sector but more action is clearly needed.

Privatization & Development

As a development finance institution, ADB is particularly concerned about successful means of privatization. SOEs not only lock up significant fractions of state assets in under-productive schemes, they often consume large subsidies from the state year after year, draining state treasuries of resources that could be invested more productively. To the extent that SOEs draw capital from the banking system, often under government guarantees, and are then unable to service and repay the borrowed funds, they pose mortal threats to the financial system. A significant fraction of the non-performing loans in the Chinese banking system today are owed by SOEs, crowding out opportunities for private sector borrowings and investment.

China’s privatization policy so far has been a deliberate, step-by-step approach that has systematically attempted to learn by doing on a small scale first before escalating the process. It has yielded excellent results so far. Now as it climbs to the threshold of escalating this process, a number of questions are worth considering:

  1. Is the rule of law sufficiently embedded in the Chinese politico-economic system to promote the development of a healthy market economy?
  2. Are creditor rights sufficiently protected in order to induce credit-driven lenders to make loans?
  3. Are corporate governance rules sufficiently developed to provide adequate protection to minority shareholders and are they being effectively implemented?
  4. Can proper accounting and auditing standards be implemented?
  5. Will foreign financial institutions be allowed to have more than a minimal impact on the financial system?
  6. Under what circumstances would the Chinese authorities permit the free transfer of all shares in SOEs?
  7. What further can be done to encourage entrepreneurship?
  8. Is the social safety net sufficiently strong to withstand the pressures that could be created by massive privatizations?
  9. Do the financial sector regulatory agencies have sufficient political independence, financial autonomy, legal immunity and investigatory powers to create the right regulatory framework?
  10. Should accelerated privatization of the banking sector precede further privatization of the industrial SOEs?
The questions that could be asked may be unlimited but answers to the foregoing would be a good starting point.


* Arthur M. Mitchell is General Counsel of the Asian Development Bank (ADB). Kamal Ahmad is Counsel in the Office of the General Counsel of the ADB. The views expressed are those of the authors and do not necessarily reflect those of the Asian Development Bank.
1 For a more comprehensive list of global lessons learned, see “Special Evaluation Study on the Privatization of Public Sector Enterprises: Lessons for Developing Member Countries”, Asian Development Bank, December 2001, Manila.
2 Privatization has been simply defined as any transaction “that reduces either a government’s ownership in or control over a public enterprise or results in the liquidation or sale of its assets.” (The World Bank, (1994), World Bank Assistance to Privatization in Developing Countries. (Washington, D.C.))
3 Peter Drucker, the management guru, introduced the notion of privatization as early as 1969. However, privatization really took off with the elections of Margaret Thatcher as Prime Minister of Britain in 1979. Beginning that year, Britain privatized a series of state-owned enterprises such as British Petroleum (1979), British Aerospace (1981), British Telecom (1984) and British Airports Authority (1987), among others. Water and electric utilities were also turned into private hands. In 1988 the British government also mandated compulsory tendering of local government services. Except for Cuba and the Democratic People’s Republic of Korea, virtually every country has since followed the privatization path in some measure.
4 Privatization International. (London: Issue No. 123, December, 1998), p. 4.
5 Qian Sun and Wilson H.S. Tong, “China share issue privatization: the extent of its success” in Journal of Financial Economics, 70 (2003), pp.183-222.
6 Allen T. Cheng, “The privatization of state firms to shift into top gear” in South China Morning Post, May 23, 2004, p. 6.
7 Qian Sun and Wilson H.S. Tong, Ibid, p. 185.
8 Allen T. Cheng, Ibid.
9 This approach is traced back to V.I. Lenin’s New Economic Policy. The State, Lenin said, would control the “commanding heights” i.e. the most important elements of the economy. It was also adopted by the British Labor Party during the interwar years, by Jawaharlal Nehru and the Congress Party in India and many others. See Daniel Yergin and Joseph Stanislaw, The Commanding Heights: The Battle for the World Economy (New York: Touchstone, 2002).
10 Xiaonian Xu and Yan Wang, “Ownership Structure, Corporate Governance, and Firms’ Performance: The Case of Chinese Stock Companies” (Washington, D.C.: The World Bank, mimeo, May 1997).
11 The Chinese government has announced its intention to do an initial public offering (IPO) of a portion of the shares it owns in the Bank of China as part of the effort to reform the banking sector. Asian Wall Street Journal. 31 May 2004.
12 Scott Wallsten. 2002. “Does Sequencing Matter? Regulation and Privatization in Telecommunications Reforms”, (Washington, D.C.: The World Bank).
13 The China Securities Regulatory Commission (CSRC) was established in 1992, the China Insurance Regulatory Commission (CIRC) was established in 1998 and the China Banking Regulatory Commission (CBRC) was established in 2003. The budget for each of these regulatory agencies is provided by the government and all policies and major decisions require the endorsement of the State Council.
14 Generally, see Policy Proposals for Sequencing the PRC’s Domestic and External Financial Liberalization, Asian Development Bank Institute, 2002, at p. 5.

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