Ch 13. Industry:
Ownership and
Governance (Control)
Contents

1. Ownership change
 1.1 The first period (1979-1995)
 1.2 The second period (1996-present)


2. Industrial Finance
3. Transforming Corporate Governance
 3.1 Creating Corporate governance: Transition A
 3.2 Creating Corporate governance: Transition B




(1) Corporatization and Company Law (公司法 회사법)
(2) Chinese System in Practice
(3) Typology of Corporate governance systems
4. Privatization and Hybrid Ownership
Introduction

An ‘industrial revolution’ has arisen since 1978.
Every aspect of technological and institutional
foundation of China’s industry has changed.
 15% real growth per year in industrial production.



Whole new industries have been created.



Industrial output of 2005 reached 20 times that of 1978.
Enormous structural change has occurred.
China emerged as the “world factory”.
This chapter deals with institutional changes
behind this dramatic transformation.


Key to the market transition from planned economy
State-owned industry (the core of the planned
economy) has gone through enormous changes.
Introduction (cont’d)

The important factor for the initial institutional
change was the entry of new firms.
Created intense market competition, which disciplined
firms to be more efficient.
 Led to substantial change in ownership composition.


Corporate governance (of SOEs) has gone
through major changes.

Began with partial & incremental reform in incentive
system (without change in ownership).

More autonomy & more incentives (“放權讓利”) .
 Fundamental reform (in both corporate ownership
and governance) implemented after mid-1990s.


Corporatizing large SOEs, combined with related
improvement in governance system.
Privatization of (medium and small) SOEs, combined
with downsizing & restructuring of overall SOE sector.
1. Ownership Change: Diverse
Industrial Base.

During early stage of reform (upto 1993),
privatization of SOEs played little role.
 Instead, diverse ownership base emerged through
active entry of diverse new non-state firms.


More diverse ownership structure has
developed gradually.



In 1980s, TVEs were most important entrants, followed
by entries of private firms, and FIEs.
Some SOEs privatized since late 1990s.
However, large SOEs play important role in Chinese
economy even today.
Concepts of corporate ownership and
governance & their relations

See Box 13.1 (p. 299)
1.1 Ownership Change in the First
Period of Transition

China’s industry was composed of a few types
of publicly-owned (公有) enterprises by 1978.
 The traditional SOE (國有企業) was dominant one.



Behave like government bureaucracy.
Little accountability & risk, just fulfilling plan targets.
Substantial welfare burden for its members as ‘workunit 單位’.
 The collective enterprise(集體企業) play minor role.


Nominally owned by the workers of the enterprise (urban
collectives) or by community (rural collectives;
commune and brigade enterprises).
Actually controlled by local government.
1.1 Ownership Change in the First Period
of Transition (cont’d)

The ownership composition of industry has
changed during this period (Table 13-1).
 Many new non-state enterprises (particularly
TVEs) entered market.

TVEs expanded their share based on more rapid
growth.


Unburdened by obligations of SOE & other reasons (Ch12)
Overall collective enterprises (TVEs) reached their
maximum share in 1996 with 36% (28%)..
 From the early 1990s, FIEs entered and grew fast,
particularly in several manufacturing sectors.
 Also, revival and rapid growth of small-scale
private enterprises.
 Consequently, SOEs’ share (in total industrial
output) had shrank substantially.
1.1 Ownership Change in the First Period
of Transition (cont’d)

Limitation of the early ownership change revealed by
rather high share of the collective enterprise.


Collective enterprise- a kind of public enterprise.
Authority’s ‘benign neglect’ of private enterprise
limited to ‘small’ ones until mid-1990s.



Property right protection was weak in this early period.
Some private business registered as collective (假集体 眞私营).
A tripod structure appeared by mid-1990s, with state,
collective, private (including foreign) producing
about one-third of industrial output.


See table 13.1 (p. 300)
A large role of state maintained, albeit impressive
ownership diversification & growth of market.

Reflect ‘gradualist transition approach’.
1.2 Ownership Change from 1996 Thru
the Present

A new wave of industrial reforms began in mid1990s, with adoption of Company Law (公司法,
회사법) in 1994.




It provided a framework for corporatization of SOEs, with an
option for hybrid ownership & eventual privatization.
Intend to create uniform legal framework for diverse
ownership firms, for level playing field (fair competition).
Distinct boundary between ownerships became blurred.
The effects of the Law were only gradual.


Gradual reorganization of existing SOEs in line with the Law.
Overshadowed by the massive downsizing of the SOE
sector in the late 1990s.

Closure (including M&A) of thousands of SOEs and urban
collectives, massive lay-offs of workforce, etc.
1.2 Ownership Change from 1996 Thru
the Present (cont’d)

The “grasp the large, letting the small go” (抓大
放小) policy affected changing ownership
composition.

Different approaches toward SOE restructuring, based on
the size and affiliations.




Central gov’t control large profitable firms in “strategically
important sectors”, with little impetus for privatization.


SOEs controlled by either central gov’t or local gov’t.
Central: energy, natural resources, industries with scale
economy (high entry barrier)- large with high, stable profits.
Local: industries exposed more to competitive pressuremuch less profitable small-medium SOEs.
Reorganized into larger ‘enterprise group’s.
Local gov’ts given much authority to restructure their firms.


Allowed to privatize or close down some.
Restructuring progress fast at local level since late 1990s.
1.2 Ownership Change from 1996 Thru
the Present (cont’d): not from the book

Gradual progresses in the legal status of
private firms & protection of private property.


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

The private enterprise (私營企業, with over 7
employees) not legitimate initially, but soon implicitly
accepted. <cf: household business (個體戶)
Private sector legitimatized in 1988, recognized as
“supplement for the (core) public sector”.
Private sector recognized as “major component of
economy” (1999 constitutional amendment).
Protection of legitimate private property right declared
(2004 constitutional amendment).
Property law (物權法) of 2007 declared the equal
protection for private property with public property.
1.2 Ownership Change from 1996 Thru
the Present (cont’d)

Complex forces reshaped the ownership
composition of industry, after the mid-1990s.


Competition, restructuring, privatization, etc.
Method of industrial data classification changed,
reflecting the complex reality.

Data collected only for “above scale” firms (5million RMB).


Ownership categories no longer mutually exclusive.


Smaller firms dropped out of the statistical system.
‘SOEs & state-controlled corporations’ overlap with ‘jointstock corporations’ in Table 13-2 (p.303).
The share of output by state-controlled firms decreased.


From 50% to 38% of above-scale industrial output (roughly
29% of total industrial output).
The share of collective firms dropped sharply, while FIE’s
share continue to increase (at moderate pace).
1.2 Ownership Change from 1996 Thru
the Present (cont’d)

Firms controlled by the central gov’t are
important subcategory of state-controlled
firms.
 State Asset Supervision and Admin. Commission,
(SASAC 國有資産監督管理委員會) founded in 2003,
to exercise the owner’s role for central gov’t.

Provincial and municipal SASAC set up in 2004, 2005.
 Largest and most highly capitalized firms (less
than 200 firms) are included in this category.
 Five important sectors under the central SASAC:


Petroleum and refining, metallurgy, electricity,
telecommunication, and military industry.
Account for two thirds of the total workers and threequarters of asset value, under SASAC’s control.
1.2 Ownership Change from 1996 Thru
the Present (cont’d)

Trends in the small-scale industry not clear.
 Small firms (with output value less than 5million RMB)
accounted for 42% of total industrial output in 1999.

Too high to be reliable?
 There has been conflicting pressure since then.


Privatization and liberalization expanded the space for
small private firms.
More intense market competition made the small,
undercapitalized, low-technology firms weaker.

TVEs’ development slowed down since 1997 (Ch 12).
 According to census of 2004,


5.3 million household business (個體戶) and 947,000
private enterprises (私營企業) engage in industrial
production, employing 59 million.
Their industrial sales only 23% of total industrial sales.

Considerable decline from 1999? Or 1999 figure inflated?
2. Industrial Finance

Industrial finance was not an issue before reform.


SOE profits decreased, as entry of new firms took
away much of excess profits of SOEs. (Fig. 13-1).


SOEs had high margin, with profits transferred to the state
budget, which granted back to firms for investments (統收
統支).
SOE profits (to GDP) 14% in 1978 down to 0 in 1996-98.
This created pressure (to gov’t) for industrial reform.


Downsizing of SOEs and the massive layoffs.
As gov’t funding decreased, bank loan used as alternate
source to fund SOE investment & growth.


Consistent with macro-economic changes, where household
saving increased rapidly with declining gov’t saving.
Banks dominated the industrial finance, with a major change in
the role (& importance) of banking sector.
2. Industrial Finance (cont’d)

Shift to bank finance coincided with the newly
introduced incentive system for SOE manager.


Managers expected to pay more attention to profitability &
risk of investment for the loan repayment <cf: gov’t grant
However, SOEs turned increasing to bank loan w/o
much concern about repayment ability.


Reflect their ‘soft budget constraint’.
Indebtedness increased steadily in reform period, reaching
high debt-equity ratio (211% in 1994, Table 13-4).




High (not highest) level in international standard.
SOE sector fell in serious peril, as profitability & cash flow
decreased.
Banking sector fell in trouble too, as NPL accumulated.
Gov’t forced to introduce bolder industrial & financial
reform. <cf: East Asian financial crisis 1997-98.
2. Industrial Finance (cont’d)

SOE debt levels declined & stabilized over
time.


Based on both industrial- and financial- reforms.



Debt-equity ratio declined to 146% in 2004 (Table 13.4).
Industrial reform: restructuring of firms (including exit of
non-viable firms), rebound in profitability (Fig. 13-1) based
on improved efficiency & reduced interest burden, etc.
Financial reform: tightening lending standards, debt writeoffs & debt restructuring (for exit firms & other NPL) based
on recapitalization (by gov’t and capital market), etc. (Ch 19)
Still, bank-dominating financial system, with
moderately high debt-equity ratio of companies.

Over 80% of the enterprise funds come from banks.
3. Transforming Corporate
Governance in SOE sector

In pre-reform economy, “enterprise” was a part of
state bureaucracy.

Just engaged in production & delivery (sale), according to
state plan.

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


No autonomous strategic planning, marketing, logistics, personnel
management, etc.
Served as multi-functioning social unit (單位 danwei).
The gov’t exercised all the real powers on enterprises.
Low productivity (efficiency) and low profitability.
Transforming the “enterprise” into a profit-oriented
company requires changes in multiple dimensions.



At minimum, need to change its objective, organizational
form, signals to which it responds, etc.
To be subject to “hard budget constraint”.
Refer to Box 13.2 & Table 13.5.
3. Transforming Corporate
Governance in SOE sector (cont’d)


Two different approaches to achieve the
multidimensional transformation.
Price liberalization followed by rapid privatization
was taken by many East European economies.



Set the enterprise free from their bureaucratic supervisors
(sponsors) quickly.
Then, firms would face hard budget constraint, forcing the
new owners to restructure organization & objective function
based on their self-interest.
Chinese approach was nearly the opposite in the
initial stage.


Enterprises still tied to bureaucracy, but incentives given to
the managers tied with the firm’s productivity & profitability.
Simultaneously, “dual-track” market prices created.
3.1 Creating Corporate Governance:
Transition in the first stage (Transition A)

Reformers experimented with various incentive
devices(放權讓利) in initial stage of reform (Fig. 13.2).





Increase the rewards to managers and tie incentives closely
to firm profitability.
Initially, modest bonus and re-investment fund out of the
profits (profit sharing with low retention rate, 1979-83)
Increase the share retained out of the increase in profits
(progressive profit sharing, 1983-86) & the surplus profits
over contracted level (profit contracting, 1986-89).
The marginal retention rate increased, even to 100%.
Increasing portion of the transactions took place in
the market, under “dual track” system.


Necessary condition for the above approaches to work.
“Growing into the market & growing out of the plan,” with
market prices & high powered incentives at the margin.
Diverse Incentive Devices
Creating Corporate Governance:
Transition A (cont’d)


This approach had both benefits and costs.
Benefits: enterprise managers gained more
authority and autonomy.
 The focus on profit gave the managers more leeway
to decide firm strategy.
 Managers got superior decision making power to
the Party officials within the enterprise.

However, managerial appointments still decided by
higher level Party organizations.
 Managers had strong say in the use of the retained
profits.

But managers were forced to form coalition with workers,
sharing benefits with workers (bonus, housing, etc).
 Overall, firms became more market (profit)-oriented.
Creating Corporate Governance:
Transition A (cont’d)

Costs:
 Internal organization not changed
 The firm had to coordinate its activity with many
government agencies
 Most of unproductive firms continued to survive
 The “incentivizing” process had the managers tied
more closely to their superiors.
Bureaucratic superiors could reward managers with
substantial money and other benefits.
 Firm’s retained profit was determined by contract,
which is the outcome of negotiation between
managers and bureaucratic superiors.


“Particularistic contract” without “level playing field”.
Creating Corporate Governance :
Transition A (cont’d)

A new set of problems arose

Conflict of interest between manager and owner (state), as
managers exercised more control rights and income rights.

Managers (having superior knowledge of the firm)
have decisive advantage in negotiation process.



“Insider control” (a kind of “agency problem”), such as
diversion of revenue, asset-stripping, manipulation of
management contract, etc.
Oversight by the bureaucracy on the profit remittance, on
contract fulfillment, or on manager’s consumption were
necessary, but insufficient.
Need for more fundamental restructuring of property
rights and corporate governance was recognized.

Create better monitoring system over managers, to make them
accountable for their action in controlling public assets.
3.2 Creating Corporate Governance:
Second Stage (Transition B)

A new program of enterprise reform
launched in 1997, with diverse measures.
 The centerpiece was “corporatization” of SOEs..
 Overall restructuring of SOE sector implemented.


Include bankruptcy or plant closure, M&A, reduction in
workforce, etc.
Total number of industrial SOEs dropped from 120,000
in mid-1990s to 31,750 in 2004.
 Firms squeezed between more competitive
product market and tighter bank loan conditions.

Many firms restructured, laid off workers, or shut down,
 In sum, budget constraints faced by enterprises
were more hardened.
3.2 Creating Corporate Governance:
Transition B (cont’d)

The new wave of enterprise reform was enabled by
an economy-wide package of complementary
institutional reforms.

Tax reform (1994)



Banking reforms:


Banks became more independent & commercialized.
Social security reforms (collapse of the work-unit)


Terminated profit contracting, weakening the link between
SOEs and their bureaucratic superiors.
Lowered overall taxes and more equitable tax
Provide alternative support for laid-off workers and retirees.
Other aspects of the collapse of the work-unit system.



Housing privatization
Schools and clinics gradually spun off.
Non-core functions separated from the SOEs
3.2.1 Corporatization and the Company Law:
Objectives and Principles

Company law improved governance in SOEs.
 In addition to working as a vehicle for ownership
diversification and for legal level play field.
 Traditional SOEs (TSOEs) reorganized into two
kinds of corporations.

Joint-stock company (JSC, 股份有限公司 주식회사) or
limited liability company (LLC, 有限责任公司 유한회사).
 Designed to establish a better system of
oversight to ensure managers pursue the same
interests as the state owner.




The key link is the “board of directors” (董事會, 이사회).
State appoints board members, as major shareholder.
The “board of directors” gives direction, oversees, and
hires and fires top manager(s).
State exercise its ownership rights as major shareholder.
3.2.1 Corporatization and the Company Law:
Objectives and Principles (cont’d)

In principle, these organizational changes
produced three interrelated advantages.
 Autonomy


Greater autonomy based on a clear legal framework
(managers accountable only to the board of directors)
No longer subject to orders from many gov’t agencies.
 Depoliticization and profit maximization

If ownership is diversified, the common denominator of
diverse shareholders will be the profits.
 Encouraging specialized gov’t oversight


The key problem of public ownership, namely the lack of
motivated monitoring, may be resolved (partially).
The corporate form, with clearly specified ownership
rights, encourage designation of attentive monitor.
3.2.2 The Chinese System in Practice

(1) Slow implementation
 Progress in corporatization has been slow.
 There were 23,000 TSOEs producing one third
of state-sector industrial output,
 while 11,000 state-controlled corporations
produced two thirds (2003).
 Effective implementation also slow.
 Majority of corporations reorganized under the
company law don’t have functioning board of
directors.
 Even the listed companies have not met the
requirements of independent directors.
3.2.2 The Chinese System in Practice
(cont’d)


(2) Forming oversight agencies
SASAC formed as representative of the state
owner.
 In principle, SASAC it to exercise all the rights &
responsibilities of ownership.


Monitor managers, appoint board members, establish
procedure appointing manager, etc.
In reality, SASAC’s authority is plagued with several
difficulties.

Conflict with Communist Party over personnel decision.


Key personnel appointment belong to Communist Party.
Authority on revenue dividend is constrained by the
powerful large corporations (a holding company, with
hundreds of subordinate firms).
The Chinese System in Practice
(cont’d)

(3) Oversight based on profit and productivity

SASAC has made a progress in focusing on
profitability of firms.


Consolidation of firms, giving up of non-core activities
However, the state (including SASAC) has multiple
objectives for SOEs.

State ownership to be maintained in strategic sectors:




National security, natural monopoly, important public goods
(services), key natural resources.
In addition, a few key enterprises in “pillar” industries and
high-tech industries should be state-owned.
Some regulatory roles are given to the SASAC, to correct
market failure.
These multiple and inconsistent objectives diverts attention
from the responsibility of maximizing profit (the asset value).
3.2.3 Typology of Corporate
Governance System

Market-based corporate governance system.


Anglo-American model.
Capital market played the key role in corporate governance,
in disciplining managers.




Shareholder’s interest has the highest priority.
Selling (buying) stocks, hostile take-over, etc.
Active managerial labor market, etc.
Control-based (bank-based) system



Continental (Europe) and Japanese model
Banks (as a major creditor) monitor corporate behavior,
using insider information.
Accommodate the interests of wider range of stakeholders
(shareholder, worker, creditor, group companies, etc)

Ownership and control usually not contested (stable).
3.2.3 Typology of Corporate
Governance System (cont’d)

China’s corporate governance is neither controlbased nor market-based.





Have many characteristics of a control-based system, but
important differences.
Banks, although a major provider of capital, has neither
incentives nor capability to enforce its interests on firms.
Gov’t control is fragmented among the holding-company,
SASAC (at several levels), gov’t agencies, the Party, etc.
Capital market play very weak disciplinary role, although it
expanded substantially in size.
Consequently, managers still have extraordinary (not
absolute) autonomy.


Coalition of insiders can gain control of the firm w/o
outside oversight or restraint.
Managerial abuse, like state asset stripping, widespread.

(eg) Related-party transactions
4. Privatization and Hybrid Ownership

Corporatization enables privatization.



Either complete privatization or ownership diversification.
Privatization has been significant since late-1990s.
Two precedents for ultimate privatization.

“Joint stock cooperatives” (股份合作制, 주식합작제）for
small SOEs & collective TVEs.




Compromise bet. joint-stock company & workers cooperative.
Stocks sold to managers and workers, while workers allowed
to sell their shares after a year (a transitional model).
Managers entitled to buy much more shares (eg. 20 times)
than ordinary workers.
Lenovo (“聯想”) model of corporatization.



Successful computer producer originally owned by Chinese
Academy of Science (中國科學院).
The founding managerial team were responsible for success.
When corporatized, founders provided substantial (20%) stake.
4. Privatization and Hybrid Ownership
(cont’d)

Gradual acceleration of privatization,
particularly in small-scale industry.
 Insider privatization, particularly management
buyout (MBO), became widespread practice.


Previous manager of the SOE becomes the owner
(largest shareholder) of the privatized company.
Gov’t maintain minority (passive) stake in many medium
sized companies: hybrid ownership.
 The MBO privatizations- controversial in China.


Use insider information to convert state asset into
personal asset at bargain price, related with corruption
The process of privatization (by local gov’t) irregular and
non-transparent.
5. Conclusion


Enterprise reform is the core in the entire
transition process.
China has shown both success and failure.
 The first period of transformation more
successful.

The overall command structure dismantled w/o
abandoning SOE and w/o economic chaos.
 The second period of transformation has been
less impressive.


Privatization has been delayed too long.
Negative impact (unfairness) of insider privatization.
 Still, several steps to go for creating well-
functioning market economy.