Asian Development Bank Law and Policy Resources
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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:
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.
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.
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.
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.
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: