CHINA'S EMERGING PRIVATE ENTERPRISES PROSPECTS FOR THE NEW CENTURY 21120 September 2000 .-- -t--' e R r nb i _ h a t I n a In te r nati o nalI Fi n an ce Co rp or a ti on 2 00 0 CHINA'S EMERGING PRIVATE ENTERPRISES PROSPECTS FOR THE NEW CENTURY I n tern atIo n alI F Ina n ce C orp or a t Ion 2 00 0 Copyright i 2000 International Finance Corporation 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433 U.S.A. Telephone: 202-473-7711 www.ifc.org All rights reserved Manufactured in the United States of America First printing September 2000 The International Finance Corporation (IFC), an affiliate of the World Bank, promotes the economic development of its member countries through investment in the private sector. It is the world's largest multilateral organization providing financial assistance directly in the form of loans and equity to private enterprises in developing countries. This volume is a product of the staff of the International Finance Corporation. The conclusions and the judgments contained herein should not be attributed to, and do not necessarily reflect the views of, IFC or its Board of Directors, or the World Bank or its Executive Directors, or the countries they represent. IFC and the World Bank do not guarantee the accuracy of the data included in this publication and accept no responsibility whatsoever for any consequence of their use. Some sources cited in this volume may be informal documents that are not readily available. The material in this publication is copyrighted. Please contact the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A., for permission to reprint or reproduce portions of this work. For additional copies of this work, please contact Corporate Relations, IFC, 2121 Pennsylvania Ave., N.W., Washington, D.C. 20433. Visit our Website at www.IFC.org. Principal authors: Neil Gregory, Stoyan Tenev, and Dileep Wagle. Library of Congress Cataloging in Publication data applied for ISBN 0-8213-4849-3 O Preface v Executive Summary vii 1. Introduction I 2. Evolution and Status of the Domestic Private Sector 7 3. Informal Status of Domestic Private Enterprises 20 4.Toward a Rules-based Environment 35 5. Financing Domestic Private Enterprises 45 6.An Agenda for the Future 60 Notes 75 References 77 CHINA'S EMERGING PRIVATE ENTERPRISES iii One of the important outcomes of market-oriented reforms in China over the past 20 years or so is the emergence of a significant private sector. Initially allowed only on the fringes of the economy, it now accounts for about a third of gross domestic product and is officially recognized as an important component of the economy. This recognition reflects the new internal and external realities facing China today. Internally, one of the main challenges is the reform of the state-owned enterprises (SOEs) and the related reform of the financial sector. Restructuring SOEs and recapitalizing the banks are likely to be expensive, both because of short-term employment losses and fiscal costs. The private sector has emerged as an important source of income and employment growth, which can mitigate the social costs of reforms. In addition, China is trying to address the growing regional disparities in growth and incomes. Private sector development in the interior of China could be one way to narrow the gap betweeni the interior and the coast. Externally, China is becoming increasinglv exposed to the opportunities and challenges of globalization. The prospect of membership in the World Trade Organization highlights the need for major and rapid adjustments in virtually all sectors of the economy. New private businesses are likely to be the main agents of this rapid change. These developments make this a good moment to take stock of the evolution of the domestic private sector thus far and to identify constraints and opportunities for its future contribution to China's development. This study is one of the first systematic attempts to do so. It is based on extensive surveys and interviews carried out in four locations: Beijing, Chengdu, Shunde, and Wenzhou. These were supplemented by additional discussions held by the authors with entrepreneurs, industry associations, govemment officials, and others in these locations, as well as in Chongqing and Shanghai. The report focuses on three main themes: the structure of private enterprises, the enabling environment for their development, and access to financing. For each of these areas, the report presents an analysis of constraints on private sector development and outlines an agenda for entrepreneurs, the government, and the financial sector for addressing these constraints. The principal authors are Neil Gregory, Stoyan Tenev, and Dileep Wagle. Extensive guidance and support were provided by Davin Mackenzie and Jianguo Cui from IFC's Beijing office. The State Economic and Trade Commission (SETC) supported and facilitated the study for its successful implementation. Wei Dong (director general, Small and Medium Enterprise Department), Tian Chuan (deputy director, Small and Medium Enterprise Department), Wang Xu (International Department), and other SETC staff provided valuable guidance and support throughout, and the fieldwork was supported by the Economic and Trade Commissions in each locality. A range of other government and non-government institutions at the central level and in the four localities also contributed information and perspectives. This partnership was supported by the government of Australia, which financed the costs of the study through the IFC Australia-China Trust Fund. Donnelle Wheeler gave encouragement and support to our work at all stages. The study draws heavily on a technical report by the Asia-Pacific School of Economics and Management (APSEM), Australian National University, which carried out the fieldwork for the study with the assistance of the China Center for Economic Research (CCER), Peking University. Ligang Song (APSEM) and YangYao (CCER) were the principal authors of the technical report, under the direction of Ross Garnaut (director, APSEM). The fieldwork team also included Xiaolu Wang (APSEM) and graduate students from CCER. CHINA'S EMERGING PRIVATE ENTERPRISES v Additional inputs were provided by Gao Shi-Ji and Xu Gang on sources of equity capital under the supervision of Gary Fine (World Bank) and on the legal framework by Stephen Harder (Clifford Chance). A draft of the study was presented and discussed at a conference in Beijing in April 2000. Additional presentations and comments were made byYingyi Qian (University of Maryland), Wu Jinglian (State Council Research and Development Center), and Nicholas Lardy (Brookings Institution), which together with the discussions at the conference enriched the final study Ed Steinfeld (Massachusetts Institute of Technology) commented extensively on the technical report. The study also benefited from comments and insights from other IFC and World Bank staff, including Jean-Francois Arvis, Joseph Battat, Joan Bayard, Ravi Bugga, Amanda Carlier, Simeon Djankov, Xiaofeng Hua, Albert Keidel, Klaus Lorch, and Guy Pfeffermann. Finally, the study depended upon the insights and perspectives of the private entrepreneurs themselves. We are extremely grateful to the hundreds of entrepreneurs who talked at length with interviewers during the fieldwork and to the hundreds more firms that returned survey questionnaires. The study reflects IFC's and the World Bank's increasing emphasis on improving the business environment as one of the main conditions for sustained growth and poverty reduction. It also reflects the evolution of lFC's strategy in China. The size and the breadth of IFC's program in China are in many ways a function of the development of the private sector in this transition economy. When the private sector was mostly small scale and informal, and the industrial and financial sectors were dominated by SOEs and joint ventures with foreign private investors, IFC's China program consisted largely of industrial projects sponsored by foreign investors. IFC had an important role to play as a provider of long-term project financing, which was not otherwise available for private projects. While this activity and this role will continue, the emergence of the domestic private sector has given us new opportunities to broaden our program to include support for local financial institutions, indigenous industrial and infrastructure enterprises, and small and medium enterprises. We hope this study will provide all those with an interest in the development of the domestic private sector in China with new insights into its status and new ideas for ways to support and participate in its future growth. Javed Hamid Director East Asia and Pacific Department International Finance Corporation September 2000 vi PREFACE I : VN : [l IV, A A Ai China's economy has grown rapidly over the past decade. China has adopted a unique approach to market- At the same time, it has undergone a fundamental oriented reforms, with extensive local and sectoral change, from complete reliance on state-owned and experimentation and a "dual-track" reform process. collective enterprise to a mixed economy where This has influenced the way in which the domestic private enterprise also plays a strong role. By 1998 the private sector has developed since its reemergence in private sector had grown to about 33 percent of gross the late 1970s. Private enterprise first took hold domestic product, making it second to the state in the rural sector as an outgrowth of the restructur- enterprise sector in economic importance. A consti- ing of the rural economy. During the I 980s, tutional amendment in 1999 formally recognized this larger private enterprises grew out of these shift, thereby laying the foundation for the private rural and individual enterprises, and out of collectives sector to emerge from the shadows and play a promi- and state-owned enterprises, although they were not nent role in China's future development. officially recognized until 1988. In the 1990s, gov- ernment policy placed increasing emphasis on build- To date, analysis of China's private sector has concen- ing a market economy and shifted toward a rules- trated on the dramatic surge in foreign direct invest- based framework, which paved the way for rapid ment and has paid little attention to the growth of growth of private enterprises. This was given further domestic private enterprise. This study represents a impetus by policy changes that encouraged owner- first attempt to understand the domestic private sector: ship reform of smaller, nonstrategic state-owned where it has come from, its current status, and its enterprises and that allowed collectives to transform future prospects. But as Marx said, the point is not just into private enterprises. In many cases, such transfers to understand the world, but to change it. So the study were merely catching up with the reality of how these focuses as much on prescription as on description. It enterprises were operating. addresses the question, what needs to be done for domestic private enterprise to flourish? This question Owing to this pattern of development, the domestic is directed at the three main players in the story: the private sector exhibits a high degree of informality. private entrepreneurs themselves, the financial institu- Many enterprises possess only the vaguest of property tions that finance them, and the government, which rights, ownership structures, corporate governance controls the policy and regulatory environment. mechanisms, financial records, and rights to market access. They are often part of complex groups of To arrive at an answer, it is necessary to go beyond the companies, spanning many different activities. This rather limited statistics on the private sector and talk gives entrepreneurs great flexibility to respond to an directly to entrepreneurs, policymakers, and finan- uncertain world composed of unclear and rapidly ciers. This study is based on extensive surveys and changing government policies, taxes, and regulations. interviews in four locations: Beijing, Chengdu, However, it hampers their ability to raise capital, to Shunde, and Wenzhou. These cities were chosen not reward managers and employees, and to operate effi- as typical examples of the Chinese experience, but as ciently. As a result, even large, mature businesses instances of relatively advanced private sector develop- have many of the strengths and weaknesses more ment in different circumstances (capital city, inland often associated with small start-ups. The challenge province, coastal province, Pearl River delta). They for entrepreneurs now is to put their businesses on a therefore illustrate the constraints and opportunities firmer footing as the policy and regulatory framework the private sector is experiencing in its early stages. becomes more stable and accommodating. CHINA'S EMERGING PRIVATE ENTERPRISES vii Up to now, the policy environment has been heavily move beyond the start-up, high-growth phase. As with biased in favor of state-owned enterprises, whether in other issues, the solution involves a combination of providing access to markets or to finance. Now that the straightforward regulatory changes (such as allowing government recognizes the private sector as a pillar of private firms greater access to equity markets) and the economy alongside the state sector, it faces a large more fundamental reform (such as building a com- agenda of reform if it is to level the playing field between mercial banking system that allocates credit on the the public and private sectors. A high priority will be to basis of commercial decisions rather than government shift from a discretionary, particularistic way of regulat- direction). However, access to finance will not improve ing and taxing the private sector toward a rules-based until private enterprises formalize and their financial system. Much of this will be a straightforward matter of position, corporate governance, and beneficial owner- making the registration of private enterprises simple, ship become more transparent. cheap, and automatic. But the future growth of private enterprise also depends on progress in more fundamen- China's impending accession to the WTO provides tal reforms, such as strengthening property rights and new impetus for moving toward a rules-based, nondis- ensuring the judicial system enforces them. criminatory policy environment. This not only will expose the domestic private sector to new competition Critically, business cannot grow without access to from abroad but will also introduce new financial insti- finance. The domestic private sector is particularly tutions to serve the needs of private business. Hence poorly served: a very small portion of bank credit goes the environment for domestic private enterprise will to private firms, and only 1 percent of listings on the continue to evolve rapidly. The challenge for the gov- Shanghai and Shenzhen exchanges are private. As a ernment and for entrepreneurs alike is to put the result, private firms rely very heavily on self-financing domestic private sector on solid ground, so that it will for their growth. This will not be sustainable once they be ready to seize the new opportunities that will arise. viii EXECUTIVE SUMMARY _|P"i IS:mre sol Zs a 9ML In 1999 China passed a constitutional amendment figure 1.4) and SOE employment is declining. As a giving formal recognition to the country's emerging result, the domestic private sector is becoming a major private sector.' This step, along with the buildup of engine of growth for the economy as a whole. foreign direct investment (FDI) and the reform of state-owned enterprises (SOEs), is setting China's A strong domestic private sector takes on additional economy on a course of major structural change. In a significance as China prepares for accession to the sense, the amendment was propelled by the sector World Trade Organization (WTO). This will involve itself, which in the past decade has experienced phasing out the preferential treatment given to foreign dynamic growth-in number of enterprises, employ- private enterprises to attract FDI and opening up ment, and output (see figures 1.1, 1.2, and 1.3). domestic markets to foreign enterprises (see box 1.1). The creation of a level playing field between domestic Already more than half of economic activity in China and foreign enterprises opens new opportunities for is in the private sector-nearly two-thirds, if agricul- the domestic private sector, but also poses the chal- tural and collective enterprises are counted, too (see lenge of new competition in domestic markets. During chapter 2). While the state-owned sector and foreign the preparatory period, it is critical for domestic private direct investment have stagnated, domestic private enterprises to improve their ability to compete under enterprises continue to grow rapidly. Between 1991 the new framework. and 1997 the output of domestic private firms grew on average 71 percent a year (figure 1.3) and employment Because of the sector's growing significance for China's 41 percent on average (figure 1.2). Though much of future development, this is a good time to take a first this growth represents a transfer of activity from the look at its evolution thus far and to identify state-owned enterprises and collective sector, many constraints and opportunities for its future contribu- individual enterprises are achieving double-digit tion to economic growth. With that purpose in mind, growth each year. Importantly, this growth has this study offers business owners, managers, and policy- occurred at the same time that FDI has slowed (see makers assistance in identifying an agenda of action Thousands of firms Millions of employees 1,200 15 1,000 1 800o 10 600 400 -5 200- 0 0 1991 1992 1993 1994 1995 1996 1997 1991 1992 1993 1994 1995 1996 1997 Source: Table 2. 1. Source.: Table 2. 1. CHINA'S EMERGING PRIVATE ENTERPRISES 1 Chengdu, Shunde, and Wenzhou (for a summary of the size of the domestic private sector in each location, see figure 1.5). Beijing provides an opportunity to observe how private enterprises emerge and develop in the Billions of RMB national capital and political center. Beijing has also 2,500 - witnessed rapid development of high-tech industries in its non-state sector in recent years. Chengdu is the 2,000 - capital of Sichuan Province and has maintained a good record of private sector development, presenting a case 1,500 - study of private enterprises in inland areas. Shunde is ooo0 ; *a county-level city in the Pearl River Delta in 1,000; Guangdong Province and has experienced rapid soo _ growth in its private sector following a comprehensive enterprise ownership reform program in the early 0 1 1 1 990s. Wenzhou, on the coast of Zhejiang Province, is 1991 1992 193 1the first city in modern China in which private enter- prises have flourished. These locations are described in Source: Table 2.1. further detail in the next section. Although these locations do not provide a representative sample of private enterprises across the whole of China, that caportunihel reduce thoseconstraintsandenhance they are cities in which such businesses have become an important part of the local economy. Hence their expe- rience reveals much about the constraints and opportu- This study was supported and facilitated by the State nrie vea enterprses fae insChintatday Economic and Trade Commission (SETC) and draws on fieldwork in China in the summer of 1999, along with discussions at a conference in Beijing in April Description 2000. It also draws on IFC's and the World Bank of the Fieldwork Locations Group's global experience in promoting private sector development. Private enterprise has flourished in each of the field- work locations. As mentioned earlier, the four cities The fieldwork focused on four cities with distinct were chosen for their distinctive approach to private approaches to private sector development: Beijing, sector development. Billions of current US dollars 50 - 40 - 30 - 20 - 10 - 0 1988 1989 1990 1991 1992 1993 1 1995 1 1997 1998 Source: World Bank. 2 INTRODUCTION Box 1.1. China's Accession to the WTO 120n) or 30Number of firms (thousands) 100 - Output (billions of RMB) 80- 60 40 20 0 Beijing Chengdu Shunde Wenzhou Source: Bureau of Industry and Commerce Management. capital of RMB228,000 [US$27,500]) to 61,113 B gprivate firms (siyingJqiye) in 1998 (average size of Beijing, including its suburbs, has apopuregistered capital is RMB621,000 [US$75,000]). Recently, the municipal government issued a document calling for a speeding up of private sector development. Concrete policies promoting such development are under consideration. Chengdu Chengdu is the provincial capital of Sichuan and has a population of 9.9 million. Its GDP in 1998 was RMBIIO billion (US$13.29 billion), or RMB11,103 (US$1,341) per capita, and its industrial output was RMB121.9 billion (US$14.72 billion). The private sector in Bijin ha exprieced api devlopsector in Chengdu has become a significant contrib- utor to the city's economy. In the first half of 1998, its industrial output was RMB14.1 billion (US$1.7 bil- - - -- ~~~~~lion), or 30.8 percent of the city's total output, and its GDP was RMB10.7 billion (US$1.3 billion), or 22.3 percent of the city's total. In the period Beijing January-November 1998, the private sector con- Beijing, including its suburbs, has a population of tributed RMB607 million (US$73 million) of tax, or 12.4 million. In 1998 its gross domestic product was 10.3 percent of the city's total. In some counties, the RMB201 billion (US$24 billion), or RMB18,423 private sector dominates the local economy. In Xinjin (US$2,225) per capita. Industrial output was County, for example, the private sector (private firms RMB171.5 billion (US$20.7 billion). Although and getihu) contributed 90 percent of the total tax Beijing has more private firms than the other cities, revenue in 1998. they appear to be fairly small because their output and sales volume are the smallest. Even so, the private Since 1992 the number of large private firms in sector in Beijing has experienced rapid development. Chengdu (firms with registered capital of more than Its numbers increased from 1,428 registered private RMB5 million [US$604,000]) has climbed to 260. firms in 1992 (each firm on average had registered One of these, the Hope Group, is the largest private CHINA'S EMERGING PRIVATE ENTERPRISES 3 Industry Beijing Ch0ndu Shud ;Wenzhou Overail Chemicals 12 19 20 8 8 Electronics 19 10 18 35 35 and apparatus Foods and cigarettes 11 18 8 4 4 Garments and 31 18 28 14 14 other light products Machinery 7 11 8 29 29 Metal and nonmetal 9 14 10 10 10 manufacturing Primary Industries 3 5 6 0 0 Others 8 5 2 0 Source: Bureau of Industry and Commerce Management firm in China, with an annual sales volume of more Some large firms have emerged since the early stage of than RMB5 billion (US$600 million). Of the first 20 development, and now the city has 72 such firms, private firms to obtain the right of direct export in each with an annual sales volume of more than China, 5 were in Chengdu. In addition, some large RMB 100 million (US$12 million). In particular, it has private firms began to buy large SOEs, playing an become the nation's largest industrial base for home increasingly significant role in the state sector reform. electronics, producing every kind of home electronic The industrial distribution is quite balanced, as product except televisions. Several nationally shown in table 1.1. renowned firms have also emerged, notably Kelong (a major national refrigerator producer), MD (the Shunde world's largest electric fan producer and a major Shunde is a county-level city with a population of only national producer of air conditioners), Grand (the 1.4 million and a gross domestic product of RMB26 nation's largest microwave producer), Wanjiele (gas billion (US$3 billion), or RMB24,769 (US$2,991) per heater manufacturer), and Kangbao (the nation's largest capita. Industrial output is about RMB60.5 billion kitchen sterilizer producer). Together with Zhongshan, (US$7.3 billion). Situated on the west bank of the Pearl Nanhai, and Dongguan, Shunde is regarded as one of River estuary, the city lies outside the enterprise the four "small tigers" in Guangdong Province. zones on the east bank, which have attracted massive foreign investment, especially from Hong Kong. Wenzhou Shunde's private sector began to take shape largely as a Wenzhou is a prefecture-level city governing several result of its ownership reform program, which started in counties and county-level cities and has a population of 1992. Currently, there are almost no purely state- about 7.2 million. Its GDP in 1998 was RMB72 billion owned firms in Shunde. Its private sector ranks second (US$9 billion), or RMB9,986 (US$1,206) per capita. among the four cities in terms of sales. Before its own- Wenzhou has a long history of private sector develop- ership reform program, Shunde was renowned for its ment. In 1984 it became one of 14 coastal cities township-village enterprises (TVEs). Its leading indus- opened to foreign trade, and a national economic tries were small home appliances such as electric fans, development zone was established there. It has a his- rice cookers, and water heaters. tory of pioneering new forms of enterprise. The size of 4 INTRODUCTION its private sector is the largest among the four cities in or chief accountants. A total of 2,400 such question- terms of the number of firms and sales volume. Its naires were posted to randomly selected firms in industries have formed several nationally renowned Beijing, Wenzhou, Shunde, and Chengdu. The number geographical clusters, such as electronic parts in collected amounted to 628, which represents a Hongqiao, low-voltage electrical products in Liushi, response rate of 26.2 percent. Because of inaccurate and buttons in Qiaotou. In addition, the garment indus- addresses, the response rate from actual recipients was try is a pillar of the local economy. Overall, the sample somewhat higher. enterprises are heavily concentrated in machinery and electronics (table 1.1). Sampling Strategy We adopted a stratified random sampling strategy, Fieldwork Methodology choosing firms from a database constructed and maintained by the Bureau of Industry and Commerce In view of the size of the Chinese economy, it is not Management in each city. This excludes privately possible with limited resources to undertake a controlled collectives and TVEs.2 Very small firms, comprehensive representative survey. Moreover, there those with no more than eight employees (known as is a trade-off between timeliness and thoroughness. geti gongshang hu, or getihu), were also excluded Therefore, in order to take a snapshot of the status of from the sampling because of the difficulty of obtain- the private sector and draw policy conclusions, we ing accurate information on them. Later, a few joint adopted a rapid assessment approach in the field- ventures and firms engaged in commerce and services work. That is to say, we analyzed specific locations were also surveyed. and segments of the private sector that could yield usable information and analytical insights within a The ratio of rural versus urban firms sampled in each limited time frame. This is therefore a preliminary locality was kept roughly the same as the ratio of rural analysis, which could provide further valuable infor- versus urban firms in that locality. This was achieved by mation if extended to cover more locations and other the random selection of firms within rural-urban strata segments of the private sector. in each locality. The share of each type of ownership examined-sole proprietorship, partnership, limited The fieldwork consisted of structured interviews of liability company, and so on-were kept roughly the government officials, banking officials, business same as their respective share in the population. associations, and chief executive officers (CEOs) of Finally, a number of newly emerging high-tech enter- 338 domestic private enterprises. This was supple- prises were included in the sample to ensure represen- mented by a mail-out survey of some 628 domestic tation of this group. Firms were selected randomly private enterprises. within each stratum. CEO Interviews The sampling strategy was difficult to apply, however, Guided by a questionnaire containing both structured because in many cases local government agencies did and open-ended questions, interviewers met with CEOs not have the required data, and many firms under the in a subset of 338 of the surveyed firms. CEOs filled in control of private domestic entrepreneurs were not the structured questions during interviews, and inter- registered as such and so could not be identified. Thus viewers posed the open-ended questions. These latter the enterprises covered in the survey do not represent a questions elicited CEOs' opinions on the most important true cross-section of the domestic private sector. and pressing issues private enterprise is facing and the Rather, they are concentrated in the part of the private changes that are needed to improve the business and pol- sector that it is easiest to identify and contact. These icy environments in which private enterprise operates. tend to be among the larger, more mature private enterprises. Although they certainly offer insight into Mail-out Questionnaires domestic private enterprises, they do not necessarily The questionnaire mailed to firms contained structured reflect all the dimensions of the domestic private sec- questions on factual aspects of a firm's operation and tor. More extensive survey work would be required to development. These questions were to be answered by understand the full range of private sector activity in persons designated by CEOs, such as deputy managers China today. The distribution of sample enterprises CHINA'S EMERGING PRIVATE ENTERPRISES 5 by industry as a whole and in each city sample is institutions, and business associations. The official shown in table 1.1. institutions consisted of the Central Bank, tax/regula- tory agencies, and policy agencies. The financial insti- Other Interviews tutions included commercial banks and rural credit To gain a wider perspective on private enterprises, we unions. In some locations, we also interviewed people also interviewed officials of official institutions, financial at business associations. 6 INTRODUCTION EVOLUTION AND STATUS OF THE DOMESTIC PiolY'131M11103:_ C hina's market-oriented reforms of recent external trade and payments (through the sharing of years have produced impressive results. foreign exchange between central and local govern- Perhaps the most important is the emer- ments, trade contracting, and foreign exchange trading gence of a significant private sector. This centers), and labor markets (through the contract chapter looks at the evolution and current status of system for new hires in the state sector). In a sense, the domestic private sector in the context of China's the same dual-track approach was adopted with overall approach to reform. respect to private sector development because transfer of ownership did not enter political debate until well Reform Approach into the second decade of market reforms. When the reforms began, the prevailing view was that activities One notable feature of China's approach to reform is in the private sector complemented those of the state its emphasis on gradual experimentation at the local sector. They were tolerated and even encouraged in and sectoral level (Gelb et al. 1993; Harold 1992). areas where large-scale state enterprises did not exist, Thus China took its first steps toward reform without such as services, light industry, and agriculture. a well-defined strategy or a clear blueprint. From the outset, Chinese leaders did not envision the private This dual-track approach is perhaps the most important sector as the driving force of economic growth. Rather, aspect of Chinese reforms since it was, at the time, an private business was revived in the period after the innovative solution to the political constraints on the Cultural Revolution as a quick way to respond to the direction and speed of reform. One such constraint mounting pressures of unemployment and economic was the emphasis on "consensus-making," meaning it stagnation. It was an experiment in itself and for most was imperative to "leave no one worse off than before" of the reform period has evolved through cycles of (Shirk 1993, pp. 130, 137, 334). As economic analysis unpublicized experimentation, followed by general "in has shown, the dual-track approach in China has been principle" approval, then by ratification and specific both efficiency-enhancing and Pareto-improving, that regulations, only after the reform in question has is, with no one made worse off (Laffont and Qian become well established. Oftentimes, new regulations 1999; Lau, Qian, and Roland 1997). It has allowed have been accompanied by "rectification" campaigns, economic agents participating in the market track to which have set the private sector back in its devclop- benefit from liberalization while protecting the vested ment. As the term "gradual" suggests, reforms are interests of state-owned enterprises and bureaucrats in implemented over time. Several years may elapse from different industries and sectors. Although the reforms the beginning of a reform experiment in one of the were controversial, the experimental dual-track way of Chinese provinces until it is endorsed from the center introducing them enabled reformers to bypass the formal or is imitated by other provinces. ideological debate usually required for public legislative sanction of reforms and also to use the successful results Another reform characteristic in China has been the of the reform as ammunition in the debate. use of partial reforms within sectors, also known as the dual-track approach. The first such tactic was two-tier Several features of China's social and political environ- pricing, introduced in rural areas in 1979 along with ment have contributed to this unique transition to the household responsibility system. Later it was market. One is decentralization. Since 1958, the applied to other sectors: industry (through the contract Chinese economy has been organized around a geo- management responsibility system), the national budg- graphical principle known as regional organization. By et (through the fiscal contract responsibility system), contrast, organization in the former Soviet Union was CHINA'S EMERGING PRIVATE ENTERPRISES 7 much more centralized, along sectoral lines (Qian creating the self-reinforcing character of Chinese 1999). A regional system has the important advantage reforms. There were not many rents for bureaucrats to of flexibility: it can experiment with reforms locally collect in poor rural areas where the household respon- because regional entities are self-contained and differ- sibility system was first introduced. The success of ent ingredients of reforms can be tested and matched reforms in agriculture brought needed savings, which without disrupting the organization as a whole. then had to be channeled into the industrial sectors in rural areas, where they fueled the big boom of the non- Added to this possibility for local experimentation were state industrial sector, that is, the TVEs. Local govern- powerful incentives to promote local economic devel- ments and new entrepreneurs alike shared in the opment. They were in the form of a fiscal contracting benefits of growth in this sector. The development of system known by the nickname "eating from separate the non-state sector in turn created pressure, but at the kitchens," which replaced the previous system of same time offered solutions, for the reform of the state "unified revenue collection and unified spending." sector. This generated a self-reinforcing virtuous cycle The new system encouraged and rewarded local govern- of reforms with growth, and the private sector ended ments for promoting economic development of their up playing a key role in the process. local economies. The nature of local experimentation, however, was heavily influenced by the existing Major Turning Points political structure. in Private Sector Development The fact that China adopted a new policy course with- out political liberalization and under the same political The cycles of experimentation discussed in the pre- structure practically ruled out experiments that would ceding section make it possible to distinguish three create losers on a large scale within the bureaucracy. phases in the development of the private sector: the Consequently, the experiments had to be of the dual- first from 1978 to 1983, the second from 1984 to track type, so as to preserve the vested interests of the 1992, and the third from 1993 to the present. bureaucracy and a level of political stability. Despite the lack of political liberalization, China has been able Phase 1: 1978-83 to transform its bureaucratic system substantially This phase is marked by the official revival of private with a mandatory retirement program for the revolu- business. However, the private sector was limited to tionary veterans, a drive for administrative and fiscal individual businesses (getihu), which developed first in decentralization, and the decision to allow bureau- a regulatory vacuum. These businesses had a strong crats to quit the bureaucracy and join businesses (Li experimental flavor. Regulations came later in the 1998). As a result, the bureaucracy tends to function process and were followed by a short "rectification" cam- as a "helping hand" for economic development, is inti- paign. The sector was intended to play a marginal, stop- mately involved in promoting private economic activity, gap role and to act as a "supplement" to the state and supporting some firms and inhibiting others, pursuing collective sectors, "filling the gaps" they left in the econ- industrial policy, and often having close economic and omy, particularly in the distribution of consumer goods family ties to entrepreneurs (Frye and Shleifer 1997; and services and in employment. Official attention Walder 1995). Under such incentives, central and local focused on the urban private sector, although perhaps governments have the capacity to act like Olsonian deeper changes were taking place in the rural areas. encompassing organizations, exercising self-restraint and not expropriating efficiency gains through ratchet- The Third Plenum of the Chinese Communist Party's ing (Olson 1992). The township and village enterprises, 11th Central Committee in December 1978 is said to in which local governments have direct ownership mark the beginning of market-oriented reforms in and management stakes, were one incarnation of this China. Although the plenum itself made no specific long-term interest in promoting local development (Jin announcements concerning private business, it signi- and Qian 1998). fied the official adoption of economic modernization and growth as the paramount concern of the The political constraints may have also accounted for Communist Party. It emphasized economic develop- the choice of agriculture as the starting locus of the ment and individualistic incentives, which gave impetus changes, a decision that played an important role in to the revival of private business. 8 EVOLUTION OF PRIVATE SECTOR In fact, the individual economy was already develop- Larger private enterprises developed in different ways. ing by that time, in response to economic pressures to Some were getihu that grew and took on more increase employment opportunities and to improve employees. According to a 300-village survey con- living standards. Once the shift in policy was official- ducted by a research branch of the State Council in ly announced at the Third Plenum, local governments 1987, 0.2 percent of the farm households hired more began to formulate procedures for the administration than eight people in 1986. Taking the survey as a of the individual economy. Yet the individual economy representative sample, it was estimated that by the still had an experimental flavor and was confirmed end of 1988, China had 500,000 getihu that could be only by a set of State Council regulations on the called private firms (Zhang and Liu 1995, p. 55). urban, nonagricultural individual economy in July 1981. These regulations defined a new business Some larger private enterprises emerged from the leasing category, geti gongshang hu, or single industrial and of state or collective enterprises to individuals. By 1984 commercial proprietor. The government moved with the share of such firms in the total number of collective caution in developing the getihu. The July 1981 firms had reached 50 percent in some localities (Zhang document capped the number of employees a getihu and Liu 1995, p. 29). The private entrepreneur paid the could hire at eight. In addition, it specified that indi- collective a fixed rent and operated the firm as if it was vidual businesses were only supplements to the state his own and in many cases accumulated considerable and collective economic units, and could develop assets. These enabled him to reduce the share of only within certain limits. collective ownership and gradually transform the enterprise into a solely owned firm. The private enterprise boom began in rural areas. The contract responsibility system evolved into a Yet siying qiye were not officially registered as a category fundamental reform in agriculture because economic until June 1988. Administrative bodies dealt with such management devolved to households. Some house- enterprises in various ways. First, they could be regis- holds then specialized in nonagricultural activities tered as getihu but be given permission to employ more and became "specialized households" (zhuianyehut). than eight people. This practice was more prevalent in Many of these were in fact private nonagricultural urban areas. In rural areas, larger private enterprises businesses. Because they originated within the were able to gain at least partial entry into the collective collective agricultural economy, however, their category by one means or another. Second, firms could private nature could be ignored for the time being obtain a collective license by paying an "administration and obviated the need for guidelines or regulations fee" to a state or collective unit or local government dealing with them as such. organization and thereby receive its stamp on the appli- cation for registration. Such firms were called "red hat In 1983 China introduced a series of central and local firms," meaning that the private owners put on a hat of regulations for the licensing and control of individual collective ownership to evade the government's prohibi- businesses, taxation, product quality and hygiene, and tion of private firms and its ideological harassment. This free markets. These were followed by inspection kind of firm continued to exist even after the regulations drives. "Market rectification" drives became an oppor- on private enterprises were issued in 1988. In Shunde, tunity to attack private business. for example, almost all firms at the village level were red hat firms before the enterprise ownership reform pro- Phase 2:1984-92 gram took place in 1992. The red hat phenomenon This phase is characterized by the rise of the siying remains important even today. Third, in certain cases, qiye (privately run enterprises), to be distinguished distributing shares or profits as bonuses to employees from the smaller getihu (individual enterprises). wvas enough to qualify a private enterprise as a collective. Such enterprises, defined as privately owned enter- prises employing more than eight people, began to In June 1988, the State Council issued the so-called develop as early as 1981, but they did not come Tentative Stipulations on Private Enterprises (TSPE) under regulation until 1988. However, in 1989 the to govern the registration and management of private development of the sector suffered a setback. The firms. This document defined a private firm as "a for- private sector continued to be regarded as a supple- profit organization that is owned by individuals and ment to the public sector. employs more than eight people."' Firms that hired CHINA'S EMERGING PRIVATE ENTERPRISES 9 eight employees or less could still be registered as Once Deng Xiaoping called for further market- getihu.2 The TSPE identified three types of private oriented reforms, attitudes toward private firms firms: those under sole ownership, partnerships, and changed, providing private entrepreneurs with a limited liability companies. Siying qiye, defined as more hospitable social and psychological environ- enterprises with privately owned assets and employ- ment. By the end of 1992, China had 27 million reg- ing more than eight people, were recognized as a sup- istered getihu and 140,000 private firms. But the plement to the socialist, publicly owned economy and most rapid private firm development occurred from enjoyed the protection of the state. By the end of 1992 to 1994, not only with respect to the number of 1989, the total number of registered private firms had private firms and employment but also with respect reached 90,600. to output (table 2.1). The number of registered getihu declined from 23.1 Perhaps the greatest change in official attitude million at the end of 1988 to 19.4 million at the end of toward private ownership came at the Fifteenth Party 1989, and the number of registered private firms Congress held in September 1997, when private declined from 90,600 at the end of 1989 to 88,000 in enterprise was recognized as an important compo- June 1990. Of the firms closed down, a considerable nent of the economy. The forum also stressed the number were transferred into collective firms or had rule of law and its crucial role for a modern market their employees reduced to fewer than eight people. economy to work well. Private ownership and the According to a survey of 286 private firms closed in the rule of law were incorporated into the Chinese period January to April 1991, 22.7 percent of these Constitution in March 1999. firms were transferred to collective ownership and 20.3 percent had their employees cut to under eight (Zhang Patterns and Liu 1995, pp. 50-51). of Private Sector Evolution Phase 3: 1993 to the Present This period has been marked by important changes in For historical and ideological reasons, private businesses China's overall approach to reforms and its official atti- first emerged as individual enterprises in rural areas tude to the role of the private sector. While experi- and in sectors such as trade and services, where there mentation continued, a coherent strategy of transition were a limited number of large state enterprises, and to a market system began to emerge. The strategy distortions from central planning created market envisages a market system based on the rule of law, in opportunities for private entrepreneurs. The scope of which the private sector is an important component. private sector activities then gradually expanded, as their legal and organizational framework, geographic Deng Xiaoping's famous southern tour in September distribution, and presence in various sectors increased. 1992, when he called for a continuing of the reform Comparisons with other transition economies suggest effort, was a defining moment in China's transition that this pattern is by and large consistent with the to market. It was followed by the big ideological normal evolution of private business. For example, one breakthrough at the Fourteenth Party Congress: for of the most important inroads of private activity in the first time, the socialist market economy was other socialist economies occurred through private endorsed as China's goal of reform. And in 1993 the farming and in the service, transport, and construction government designed the first "grand strategy" of industries (Kornai 1990). Once China allowed some transition to a market economy, with an emphasis on room for private activities to emerge, this was enough a rule-based system and on the building of market- to trigger the spontaneous development of the Chinese supporting institutions. This was the turning point for private sector, despite the remaining plethora of China on the road to markets. The new approach restrictions and biases. When the internal dynamics of advocated a coherent package of reforms; it called for this movement ran counter to existing formal restric- creating a level playing field through a rule-based mar- tions, the system was flexible enough to accommodate ket system, as opposed to particularistic contracting; the new realities until formal constraints were relaxed and it addressed the enterprise reform issue in terms and new room was created for the expansion of private of property rights and ownership, thus opening the sector activities. This flexibility, as explained earlier, was door for the transformation (gaizhi) of SOEs. largely due to factors related to decentralization and 10 EVOLUTION OF PRIVATE SECTOR Table 2.1. Private Firm Development since 1991 i~~~~~~r _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ I!uiribor GroEiit4 N u mls Grx-4h I1uGrowth (tflousandfs Oh) (icusns} (% (b1iortS of iWiBa) (N) 1991 107.8 1839.0 93.7 1992 139.6 29.5 2318.4 26.1 116.0 23.8 1993 237.9 70.4 3726.3 60.7 260.1 124.2 1994 432.2 81.7 6483.4 74.0 551.7 112.1 1995 654.5 51.4 9559.7 47.4 1,005.3 82.2 1996 819.3 25.2 11711.3 22.5 1,592.3 58.4 1997 960.7 17.3 13492.6 15.2 1,983.7 24.6 Average 45.9 41 i. 7 la. l Note: 'Private' refers to siying qiye. B In 1995 constant prices. Sources: Yearbook of China Industrial and Commerce Administrative Management, 1992-98; China Statistical Yearbook, 1992-98. bureaucratic incentives and became a key factor in especially in the early phase, because major reforms ensuring the continuity and the cumulative nature of were first tried and proved successful in agriculture. private sector development. Indeed, until 1993 employment in siying qiye was higher in rural areas than in urban areas (figure 2. 1). From Rural to Urban As just mentioned, the rural enterprise played a domi- Self-employment in rural areas continues to exceed nant role in private sector development in China, urban self-employment by a wide margin. Rural areas, Figure 2.1. Self-Employment and Private Employment in Rural and Urban Areas in China, 1990-98 1998 - k ffi Rural self-employment U Rural private employment 1997 1997 _ _ = Urban self-employment 1996 _ Urban private employment 1995 1994 1993 1992 1991 1990 . . I ' ' ' I I I 0 5 10 15 20 25 30 35 40 45 Millions of employees L Source: China Statistical Yearbook, 1999. CHINA'S EMERGING PRIVATE ENTERPRISES 11 Table 2.2. Distribution of Private Firms by Region Yea Firms Employment Rim Employment Firms Ermloyment :thousands1 ~thousan8s0 (thousands) 1991 95.4 1754.5 24.5 453.4 19.7 380.5 1993 159.3 2351.3 44.6 768.9 34.1 600.6 1996 529.2 7232.8 178.6 2741.2 111.4 1737.4 1997 610.1 8235.5 211.1 3189.7 139.5 2067.4 Note: "Private' refers to siying qiye. a Liaoning, Hebei, Beijing, Tianjin, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian, Guangdong. b Heilongjiang, Jilin, Shanxi, Henan, Hubel, Anhui, Jiangxi, Hunan, Hainan. Inner Mongolia, Shaanxi, Ningxia, Gansu, Qinghai, Xinjiang, Tibet, Sichuan, Guizhou, Yunnan, Guangxi. Source: Yearbook of China Industrial and Commerce Administrative Management, 1992-98. being somewhat detached from central bureaucratic ratio of the number of firms in the western, central, control, spawned a private sector whose nature and role and coastal areas was 21:26:100 in 1992 and differed from those of the urban private sector. One 23:34:100 in 1997. In terms of employment, the ratio notable difference can be seen in the ratio of getihu to was 22:26:100 in 1992 and 25:39:100 in 1997. In siying qiye, which is much higher in rural than in urban terms of both numbers of firms and employment, the areas. Historically, the industrial structure of the private central provinces were able to catch up with the coast sector has also differed significantly in rural and urban faster than the western provinces. areas. In the cities, private businesses have clustered in the small-scale retail, service, or food service industries, As figure 2.2 shows, however, the relative shares in urban which have had a disproportionately strong impact on employment are not that different. The coast has the the public perception that private business is interested lowest shares of both SOE and private sector employ- primarily in "nonproductive" activities. At the same time, ment (siying qiye and getihu) but the highest shares of largely hidden from the public eye, more than 75 per- employment in the foreign-invested and collective enter- cent of private businesses developed in rural areas, after prise sector. The central region had the highest share of reforms promoted a surge in the growth of rural enter- domestic private sector employment as of 1998. Within prises. Of these, nearly 40 percent were engaged in the domestic private sector, however, the coast has the manufacturing or processing (Young 1995). highest share of employment in private enterprises with more than eight employees (siying qiye), and the highest From East 2o West ratio of siying qiye to self-employed. The latter closely Because of China's emphasis on decentralization and resembles the urban-rural dimension of the relationship local experimentation with reforms, private sector between siying qiye and getihu. Overall, the share of the development was greatly influenced by local condi- non-state sector in urban employment is highest in the tions, including the attitude of local governments to coastal area and lowest in the western provinces. the role of the market. As a result, the patterns of development differ from region to region. The differ- From ln normality and PariVcularisim ences between coastal and interior provinces are espe- 2io tlh$ RuWe og Law cially pronounced. Some of the unique features of private business in China derive from the fact that the private sector The regional distribution of siying qiye is strikingly dif- developed experimentally, in an environment of politi- ferent across the country, as shown in table 2.2. The cal, legal, and regulatory uncertainty. The typical 12 EVOLUTION OF PRIVATE SECTOR Figure 2.2. Ownership Structure of Urban Employment by Regions in China, 1998 West W Collectives Private sector Central USelf-employed (including getihu) Foreign Coast -, 0 20% 40% 60% 80% 100% Source: China Statistical Yearbook, 1999. sequence of development-unpublicized experimenta- However, unclear property rights have slowed the tion, followed by general "in principle" approval, then growth of many firms, and the hybrid forms of owner- by ratification and specific regulations-implies that ship that resulted created perverse incentives, which for most of the reform period private businesses have become a drain on the resources of enterprises evolved without clearly defined and secure property and the government alike (see chapter 3). The particu- rights. Political uncertainty remained substantial as laristic approach, as opposed to universally applicable long as activities in the sector were viewed as a tempo- rules, forced local officials and enterprise managers to rary solution to some economic problems of the day concentrate on rent-seeking rather than economic and as a supplement to state and collective sectors, returns. It led to collusion between local governments "filling the gaps" the latter left in the economy. and enterprises, with the local governments acting as patrons rather than regulators. Moreover, the process The Chinese experience therefore seems to suggest made private entrepreneurs more susceptible to inter- that a system of well-defined and secure property rights ference from local bureaucrats. The former reliance on is not necessarily a precondition for the emergence and personal connections in the relationship with the gov- initial development of a private sector (McKinnon ernment has been transplanted to the marketplace and 1992). Rather, the growth of private enterprise and mar- now dominates exchanges there. The highly particular- ket institutions over time can create a demand for a istic nature of market transactions makes it difficult to clear definition and enforcement of private property gain reliable information about people, commodities, rights. Small businesses, which constitute the bulk of prices, and distribution channels. the private sector in the initial stage of development, need little in the way of legal protection (Murrell The market has therefore become highly fragmented 1992; Rapaczynski 1996). They are typically owned by and relies on personal relationships for vital information. a single individual or a small group of people who In interprovincial market transactions, this particularism know each other very well; they do not raise capital has created a high degree of local protectionism. Fiscal from the public; and debt capital plays an insignificant decentralization and patronage over local enterprises role in their financing. What they need most is to have encourage local officials to protect local markets for the state eliminate the obstacles that it has been put- their own factories by erecting administrative blockades. ting in their path. Indeed, local governments in China Thus perhaps the biggest challenge for the develop- often interpreted new regulations as a signal allowing ment of the domestic private sector in China today is them to attack and interfere in private sector activities. to establish the rule of law. CHINA'S EMERGING PRIVATE ENTERPRISES 1L3 801F MD= 1F0? Mop©(Gap W C© ( y' new methods of selling the firm or transforming it Because China emphasized de novo private firms into an employee-held company or cooperative. instead of transforming the ownership of existing com- Therefore, gaizhi did not necessarily imply privatiza- panies, the private sector emerged on the fringes of the tion. The policy had a direct impact on the so-called economy and during most of the reform period was red hat firms. In March 1998, the government issued viewed as a supplement to the state sector. China a directive requiring all the red hat firms to "take off delayed ownership reform of SOEs, and, in fact, did the hat" or show their private ownership by not divest any state-owned assets or lay off any state November 1998. workers before 1992. It took the first of these steps on a large scale in 1995. Not all localities were fully prepared for gaizhi. Many firms just changed their name without going through any The rapid development of the private sector and its form of restructuring (see box 2.2 for a description of impressive performance in the 1990s have been a cata- gaizhi in Sichuan Province). This was particularly true for lyst for SOE reform, with major progress occurring in firms introducing ownership in the form of employee the transformation of small SOEs. According to shareholding. These are still regarded as collective firms, some estimates, ownership changes have taken place and local govemments still interfere in their operations. in about 80 percent of firms owned by governments Ownership reform, it has been argued (Yao and Zhi at the county or lower administrative level have been 1999), is not sufficient to improve economic efficiency if restructured. This has put the vast majority of firms the role of the govemment does not change. Shunde pro- and workforce in the private sector and thus has totally vides an example of combining transfer of ownership changed China's economic makeup. with government reform. In the course of its program, the Shunde government undertook a radical reform by Ownership reform programs were initiated at the local cutting one-third of its employees and 40 percent of its level in part because the large amount of debt accu- functional units. This reform has served as a signal to mulated in the state sector was a drain on local budg- the private sector that the government has a credible ets, especially in the smaller cities. That was certainly commitment to curbing rent-seeking behavior as well as the case in Shunde when it started its program in 1992 microlevel interference. To a large extent, the smooth and took the radical step of selling off almost all its and successful transformation in the city should be state and collective firms (box 2.1). attributed to government reform. In 1995, the central government formulated a policy Contributions of the Private called zhuada fangxiao, meaning "keep the large ones and let the smaller ones go." It decided to keep under Sector to the National Economy its ownership 500 to 1,000 large state firms and to reform the smaller SOEs through a package of policy The private sector is the most dynamic component of measures including reorganizations, mergers, acquisi- the domestic economy. Between 1991 and 1997, the tions, leasing, and sales. In 1997 the 500 largest state number of siying qiye grew at an average annual rate of firms had 37 percent of all assets held by state indus- 46 percent, employment in siying qiye grew at 41 per- trial firms, and contributed 46 percent of tax cent, and output grew at 71 percent (table 2.1). revenues collected from all state firms and 63 percent During the period 1990-97, new jobs created in the of total profit in the state sector. By contrast, smaller private sector accounted for 38 percent of all new for- firms owned by local governments were performing mal employment, or 56 percent of new formal employ- poorly: in 1995, 72 percent of the firms owned by ment in urban areas. In recent years, new employment local governments were in the red, compared with in the private sector has exceeded the combined total only 24 percent of the centrally owned firms. for state, collective, and township and village enter- prises (Rawski 1999). This explosive development is From the "let the smaller ones go" policy came the in sharp contrast to the stagnation of the SOE and col- word gaizhi, meaning "changing the ownership struc- lective sectors (figure 2.3). The private sector has, ture." Starting in 1994, gaizhi began to spread therefore, become an important source of job creation, throughout the country. Gaizhi consisted of contract- absorbing a significant number of workers laid off from ing and leasing, two methods used before, as well as the SOE sector. 14 EVOLUTION OF PRIVATE SECTOR Box 2.1. Shunde's Ownership Reform Program When Shunde began its ownership reform program in 1992, it tried to maintain collective ownership and adopted employee shareholding as the main form of ownership. However, it encountered several problems with this strategy. First, employees could not be counted on to purchase shares, either because they did not have enough money or because they did not have enough faith in the factory's future. Second, the manager in an employee-held firm still played the role of an agent, and the firm continued to experience the monitoring problem faced by state and collective firms. Third, free-riding was a major concern because irrespective of performance an employee could still receive dividends from shares. Fourth, uniform shareholding did not help establish authority in a firm. As a result, Shunde shifted to other forms of ownership change after this initial experience. These forms included listing in the stock market, management leasing, and management buyout (MBO). Because China had a very restrictive policy regarding listing on its two stock markets in Shanghai and Shenzhen (usually in the form of quotas to each province), only two Shunde firms, MD and Kelong, have been listed in the stock market in Shenzhen. To get around government restrictions, some firms were sold or partly sold to a listed firm in another city. This form of ownership change is called "borrowing the shell for the egg." Management leasing was used for firms that had a large amount of net assets or firms whose man- agement did not have enough funds to buy it. In such cases, management purchased the equipment and leased the land and buildings from the local government. MBO was the most important and most interesting form of transformation. Many firms that were initially restructured as employee shareholding were transformed by MBO through the concentration of shares in the hands of management. This has been encouraged by the Shunde government. Before it was sold to management, a firm's assets and debts were valued by an outside accounting firm, usually from Guangzhou, the provincial capital. To protect workers' employment, no more than 5 percent of the workforce could be fired in three years. Competitive bidding was allowed, but the incum- bent had priority if it had the same qualifications as its competitors. As a result, the firm was usually purchased by the original management. To handle problems emerging in the transitional period such as debt issues or ownership transfers, the government usually asked the management to register a new firm that owned the old firm together with the government. For a firm with positive net assets, the top management was asked to pay for the price of the net assets and shoulder the firm's debts. The payment could be made within five years. For some firms that had a large amount of net assets, the local government retained a large proportion of the shares. For a firm with a net debt, the local government that previously owned the firm would take over the net debt. The management had to purchase 15 percent of the firm's gross assets, with the payment being made within five years. CHINA'S EMERGING PRIVATE ENTERPRISES 15 The increasingly important role of the private sector Although the private sector appears to have become is reflected in the rapid increases in its share of the most dynamic portion of the Chinese economy, it employment and output in the national total.' is difficult to measure its size and performance with Between 1985 and 1997, the share in national indus- any confidence, in large part because the classifica- trial output rose from 2 percent to more than 34 tion system for the components of the economy mixes percent (figure 2.4). The employment picture also the concepts of ownership, sectors, and corporate shows impressive growth (figure 2.5). The private organizing methods. This makes it difficult to arrive sector's share was already around 2 percent of the at an accurate view of the country's economic owner- national nonagricultural labor force in 198 1. By 1997, ship structure. Furthermore, it has become difficult its share in industrial employment had reached more to separate out what portion of the increasing than 18 percent of the national total. Between 1989 employment and output of the sector is due to and 1991, the expansion of employment experienced "indigenous growth" within the sector, on the one a major downturn, but since then it has grown rapidly. hand, and to the transformation of enterprises from By 1997, the total number of workers had reached other types of ownership, on the other. The difficulty 67.9 million. of measuring the performance of private firms is fur- ther compounded by the lack of adequate financial im ~~~~~~~~~data on the sector's profits, fixed assets, and working ~~~~~~~~~~~~~~~~~~~~~~I capital. Data on these financial variables published by the National Statistics Bureau do not separately iden- Percent tify subtotals for private firms. The lack of accurate 150 -*%SOF financial data on pretax profits, fixed capital, and work- * Collectives ing capital makes systematic comparisons of the rate of 100 Foeinreturn on private firms' assets with those of other forms * Dometic pivateof ownership, notably state-owned firms and foreign 50 ~ ~ ~ ~~ ~omsi piaeinvested firms, a difficult task. 50 - s 0 To estimate the private sector's share of GDP, we take a sector-based approach, which derives ownership -50 ~~~~~~~~~~~shares in GDP by sectors using plausible assumptions -50 1 191931941919610)Abased on official data. In 1998 the true private sec- 19119 93 199 199 19619719 tor's share of GDP was approximately 33 percent Source: China Statiical Yeabook, 16 EVOLUTION OF PRIVATE SECTOR Figure 2.4. Share of Private Sector in Total ustrial Output in Chnai 1980-97 Percent 35 30- 25- 20- 15- 10- 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Note: Data include getihu and, from 1991 onward, siying qiye. Sources: Yearbook of China Industrial and Commerce Administrative Management, 1992-98; and China Statistical Yearbook, 1982-98. (table 2.3)," which was still smaller than the state of private sector investment in the national total was in sector's share of 37 percent. If agriculture is regarded as the range of 15 to 27 percent. In addition, the sector mostly private, however (inasmuch as it consists mostly took only a negligible portion of the formal bank loans: of individual farmers), the share of the private sector according to official statistics, less than 1 percent of would increase to 51 percent. Adding the GDP contri- working capital loans went to the private sector. The bution of collectives would bring the share of the non- disproportion between performance and resource state sector to 62 percent of GDP in 1998. absorption is a major feature of China's private sector development in the 1990s. From official data, it appears that the private sector has achieved this impressive growth with relatively Private enterprises have in general made more efficient few resources. In the period 1991 to 1997, the share use of capital. Figure 2.6 shows that the average capital- Figure 2.5. Share of Private Sector in Total National Employment in China, 1981-97 Percent 20- 18- 16- 1 4 1 2 1 0 8 0 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Note: Non-farm labor force. Private sector includes getihu and siying qiye. Because new categorization was adopted after 1995, data for 1996 and 1997 are not strictly comparable with those of earlier years. Prior to 1991, only getihu are included. Sources: Yearbook of China Industrial and Commerce Administrative Management, 1992-98; China Statistical Yearbook, 1982-98. CHINA'S EMERGING PRIVATE ENTERPRISES 17 Table 2.3. Composition of China's GDP by Percent, 1998 ~~~~~~~~et1ud agiutue fexudg agltr) aecun Eagrutre (Icuing pvae agicltre State sector 37 State sector 37 State sector 37 State sector 37 State sector 38 Agriculture 18 Agriculture 18 Agriculture 18 Agriculture 18 Non-state 62 sector Collective 23 Collective 1:2 Collective 12 Non-state 45 (official) (true) (true) sector Share holding 3 Share holding 3 Private sector 33 Foreign share 6 Foreign share 6 Domestic 13 Domestic 27 private sector private sector a Official collective includes "red hat" firms as well as gaizhi firms that are actually private firms. Domestic private enterprises consist of formafly registered private firms and getihu. b Domestic private enterprises.now include shareholding firms and those firms under collective titles but truly private, assuming they accounted for about half of the official collective firms. In some areas and sectors, the proportion of this type in the total collective is more than half. Private sector consists of foreign firms and domestic private enterprises. Non-state sector excluding agriculture consists of true collective and private sector as defined in c. 0 In non-state sector including agriculture, state-owned share accounts for about 1 percentage point, which has been added to the state sector Source: Calculated according to a sector-based approach, which derives ownership shares in GDP based on their shares in each of the following sectors: agriculture, industry construction, transportation, post and telecommunication, wholesale and retail trade, and others. Various assumptions on the relative shares of each ownership type in each sector have been made from relevant data. All the original data are from Statistical Yearbook of China, 1998 (SSB)3 China Statistical Abstract, 1999 (SSB). The shares of all these sectors in GOP are provided by State Statistical Bureau (1999, p. 13). Figure 2.6. Capital-Output Ratio, 1996 to-output ratio for private and individual enterprises is only about half of that of SOEs, which suggests Ratio that investment in the private sector is more efficient 2.0 I than in the state sector.5 1.5 The latest statistics released by the State Bureau of Industry and Commerce Management (BICM) show 1.0 that by June 1999 the total number of siying qiye in I China had reached 1.3 million, employed 17.8 million 0.5 0: ;Q. : 0 t0;. ; 00. g workers, and had registered capital of RMB817.7 bil- lion (US$98.8 billion).6 All three indicators increased 0.0 Non-state Co_llective_ -Lby about 25 percent over 1998. SOE Non-state Collertive Private Foreign The numbers and growth rates of private enterprises Note: Capital-output ratio is calculated by dividing gross industrial v output by total assets. vary across sectors of the economy By the first half Source: China Statistical Yearbook, 1997, 424-25. | of 1999, there were 30,000 private firms (siying qiye) 18 EVOLUTION OF PRIVATE SECTOR in primary industry (mainly agriculture), which Cultural Revolution as a quick way to respond to the represented an increase of 20 percent from the end mounting pressures of unemployment and economic of 1998. There were 530,000 firms in secondary stagnation. It was first allowed on the fringes of the industry (manufacturing), up about 5 percent from economy and was initially regarded as a supplement to half a year earlier. The majority of private firms are in the state and collective sectors. Private entrepreneurs tertiary industry (services); their number had did not yet enjoy a clear identity, their property rights reached 722,000 by June 1999, and they accounted lacked protection, and they had to function in an envi- for about 56 percent of the total number of private ronment of significant legal and political uncertainties. firms in China. Faced with a plethora of restrictions and biases, they had to establish close links with the local bureaucracy In terms of employment and output, however, industry and operate under a high degree of informality. is still the largest sector, occupying more than half of Because of China's marked decentralization and strong the employment and output in the private sector in bureaucratic incentives to promote local development, 1997. Trading is the second largest sector, accounting however, the system was flexible enough and reason- for more than 30 percent of employment and output. ably responsive to demands for legislative measures to From 1992 to 1997, the shares of industrial employ- allow the cumulative development of the domestic ment and output declined by about 10 percentage private sector. Thus decentralization, experimenta- points. During the same period, the shares of employ- tion, and informality have served the evolution of the ment and output at trading companies increased by 15 private sector well in the past. But this evolution and 7 percentage points, respectively The shares of constantly brings new problems, some of which other sectors did not post such significant changes. require new approaches. Areas of strength in the past are now turning into liabilities for the dynamic growth of the private sector. Today the private sector accounts (Conclusion for about one-third of China's GDP and is officially rec- ognized as an important component of the economy. The emergence of a dynamic private sector was the Perhaps the biggest challenge for its continued devel- most important result of the reform process in China. opment is to establish the rule of law and address the Private business was revived in the period after the related problem of informality. CHINA'S EMERGING PRIVATE ENTERPRISES 19 a 0 mAlk M I MaU F or most of the period from the establishment * Red hat firms (including TVEs). Many firms were of the Peoples' Republic in 1949 until the registered as having collective ownership when they Constitutional Amendment of 1999, private were actually privately owned. This was more com- enterprise lacked legitimacy in the eyes of the mon in the countryside. As explained in chapter 2, state. This led to a "withering away" of the private sector such a firm was said to be wearing a "red hat," which in the 1950s. Although private enterprises began to enabled it to evade the prohibition of private firms reemerge in the late 1970s, they remained under a veil of and ideological harassment by the government. informality, which had important consequences for the Collective or TVE status brings with it a degree of way in which the private sector has developed since then. local government involvement in the enterprise. This can be helpful in securing access to land, assets, Companies typically go through a "life cycle" of for- finance, and markets. Local governments also often mation, growth, and maturity. Their legal structure, subsidize collectives and TX/Es, through tax breaks, financial structure, corporate governance, and market favorable contracts, or loans on preferential terms. relationships all change during the life cycle. However, On the other hand, government involvement inter- firms in China's private sector have a limited ability to feres with truly commercial management and can evolve beyond the first, informal stages of life and tend lead these firms to operate more like SOEs. Red hat to become "stuck" in a framework of legal, financial, firms continued to exist even after private ownership governance, and market structures that they have out- forms were created in 1988, owing to the continuing grown in terms of the size and complexity of their advantages of government involvement. Although business. Thus the informality of the private sector is an estimate of these firms is not available, the particularly problematic for larger, more mature enter- prevalence of this practice can be illustrated in prises. It is becoming an even more serious constraint Shunde, where we found that almost all the firms at now that the private sector is beginning to play a larger the village level were red hat firms before 1992. role in the Chinese economy. Furthermore, most of these have since been trans- formed into private enterprises with the encourage- Establishment ment of the municipal government, partly because of its concern about the budgetary cost of supporting At first, only sole proprietorships employing up to eight them. The red hat phenomenon remains important people could be registered as geti gongshang hu. In in all the cities covered by the survey. 1988 larger private enterprises were permitted to regis- ter, either as sole proprietorships, partnerships, or lim- * Rented collectives. Many collective firms were ited liability corporations. Even then, their status as rented out for private operation. According to one private enterprises kept them at a disadvantage com- estimate, in 1984 such firms made up 19 percent of pared with SOEs and collectives, owing to the heavy all collectives in Hebei, 30 percent in Tianjin, 40 restrictions on their freedom to operate (see chapter 4) percent in Liaoning, and 50 percent in Ningxia and limited access to finance (see chapter 5). (Zhang and Liu 1995). A private entrepreneur would pay the collective a fixed rent and operate the firm as As a result, many private enterprises registered in though it was his own. Many such entrepreneurs other ways that gave them the freedom to run a larger accumulated considerable capital assets, thereby enterprise, with fewer regulatory restrictions and reducing the share of the collective assets. Hence greater access to finance. The following were the most the operation was gradually transformed into a solely popular alternatives: privately owned firm. 20 INFORMAL STATUS * Foreign investors. Since foreign private enterprises In some cities such as Shunde, a spouse is permitted were permitted to operate as joint ventures with local to act as a partner, so a firm can obtain corporate sta- collectives or SOEs and obtained significant tax tus without necessarily having the sole owner's family advantages, many domestic entrepreneurs invested lose control of the firm. In other cities, such as Beijing, through offshore companies so as to qualify as foreign a spouse is not permitted as a partner. In this case, investors. Hong Kong has been an important source some firms just give a nominal partner a nominal share, of foreign direct investment in China, and it is widely but both parties agrce between themselves that the believed that a significant proportion of this has been share is not real. This discrepancy between personal "roundtripping" by domestic entrepreneurs. agreement and legal protection has already brought cases in which the second owner has sued the first In addition, many getihu grew beyond the formal limits owner to get his share out of the company. Such dis- on their size (see chapter 2). Private firms also attached putes can obviously be devastating for the firm. themselves to existing state-owned and collective firms in various ways to obtain representation, solve procure- The mismatch between the formal structure of the ment problems, and obtain access to markets and firms and the reality on the ground has important financial services. Many coinvested with state and consequences for their operation. While it confers collective firms to overcome entry barriers in particular on the enterprise the rights and privileges of the form sectors, thus creating a variety of mixed-ownership adopted (say, a collective or a foreign joint venture), forms. Some covered themselves in a cloak of ambiguity, it also weakens the structure, especially as the firm referring to themselves in terms associated with public grows in size. enterprises, such as "business department" and "service department," to suggest a public status. The success of China's rural industrialization led many Another practice designed to create ambiguity was to people to argue that the combination of private entre- give local government cadres enterprise shares, paid preneurship and collective ownership helped attain positions as advisers, and positions as board members. that success. It was seen as a second-best response to China's imperfect market and policy environments. The firms we surveyed were all registered as private State subsidies and allocations of land, assets, and enterprises and therefore did not include red hat credit contributed substantially to the initial financing firms. Of these, 40 percent were sole proprietor- of many private enterprises. ships, 30 percent partnerships, and 29 percent limited liability companies. Sole proprietorship has the dis- Although this may be one way to address China's advantage of taking unlimited liability, but it has the market and policy failures, the fact remains that many advantage of not being liable to establish a standard private entrepreneurs put on a red hat just to evade corporate account and put it under the state's super- the ideological bias and government regulations. In vision. This provides certain attractions, including many cases, local governments suffered fiscal losses scope for tax evasion. Many of the sole-ownership rather than benefited from the presence of a red hat firms surveyed were large (the average of net fixed firm. At the same time, the private firm suffered from capital stock of these firms was RMB15 million political interference in its operations. [US$1.8 million]). In Shunde, for example, the most important reason for The current law prohibits a firm with a single owner the local government to transfer collectives to private from registering as a limited liability company Where ownership was to get rid of the burden of red hat and firms do want the protection of limited liability, sole other government-owned firms. A red hat firm made an proprietors may form partnerships with sleeping part- entrepreneur's incentive asymmetric. If the firm made ners, such as a family member, who have no effective a profit, it was his. If it incurred a loss, the government control or role in the enterprise while formally owning had to shoulder the burden. As a result, village and a share of it. Although the law does not set a minimum township governments accumulated a considerable share for the second owner, in implementation the amount of debt. Government officials in Shunde called share is set at between 5 and 20 percent in the four this "bleeding" and the transformation program the cities covered in the first phase of our survey. "project for stopping the bleeding." CHINA'S EMERGING PRIVATE ENTERPRISES 21 Corporate Governance _ A key characteristic of the informality of the private sector is its opaque organization (for types of corporate governance, see box 3. 1). That is to say, because of their artificial status, firms operate quite differently from what their formal status would suggest. Many collective - l - firms, for example, are effectively under the control of * a - an individual proprietor; some foreign companies are l effectively owned by domestic companies. Managers appear to make most of the important deci- sions in the firm: in those surveyed, managers did so in 69 percent of the cases, the board of directors in 23 percent, and others in 8 percent. This is typical of early- stage companies or family businesses in which owners and managers are the same people. Similarly, most of @ the CEOs interviewed were themselves owners. This structure becomes problematic as companies a . grow beyond the span of control of the owner-manager. - i aa Once he or she needs to delegate to managerial staff, - formal corporate governance structures are required to tackle the principal-agent problem of ensuring that staff act in the interests of the owners. In the absence of formal structures, owners often hire family mem- bers, trading off trust for competence. The compe- tence of managerial staff then becomes a constraint on 09 enterprise performance. As might be expected, larger a a - enterprises that have taken the legal form of corpora- a - tions make greater use of boards of directors to take - , important decisions. Legally barred from maturing into publicly traded com- panies, large private firms have had to adopt alternative approaches to corporate governance. Some have tried to mimic the structure of state-owned enterprises, with - both a board of directors and a supervisory board rep- 88 resenting shareholder interests. These boards tend to include political appointees and may lack business or _a. sectoral expertise. This situation has contributed to the poor performance of some large enterprises, which lack effective managerial control and take excessive account of political considerations in their decisionmaking. A large problem for family businesses everywhere is how to manage a smooth transition once the original would help increase the survival rate of enterprises. owner-manager is no longer able or no longer wishes Many private enterprises in China are still relatively to run the business. Because businesses often fail at young, however, so this has not yet emerged as a major this point, any means of overcoming this problem constraint, but it is likely to do so over time. 22 INFORMAL STATUS Management Capacity Background information culled from our surveys indi- cates that top managers' in the sample firms have a Except in the smallest firms, owners are not able to reasonably high education: 35 percent have gone to provide all the management skills themselves. junior high school, 25 percent have gone to senior high provideg l the surveyedfirmanaement skills themsel school, and 28 percent have been to college.2 However, Among the surveyed firms, many owners ave hir educational attainment may not be a good indicator of maagr to brn.nadtoa mngra n te business skills. According to the CASS/NAIC study specific skills. This leads to principal-agent prob- g lems, which firms address either by hiring family just mentioned, only 40 percent of entrepreneurs les hc im drs ihrb iigfml could read a balance sheet. Among the smallest firms, members (whose interests are expected to be closely the read at b y Amanager ismconentfraea aligned~~~ wit ths.fteonr)o ygvn h the education attained by managers is concentrated at maalgne whaose of the owner) og. the junior high school level (34 percent), while it jumps to the college level for the larger firms: in firms of 100 to 500 employees, nearly 50 percent of the According to a 1999 study of 1,900 medium and managers have a college diploma. large enterprises by the China Academy of Social Sciences (CASS) and the National Association of When broken down by location, 45 percent of the Industry and Commerce (NAIC), 48 percent of the managers in Shunde and 34 percent in Beijing have a relatives of the entrepreneur were employed in man- junior high school education, while 28 percent in agement of the enterprise, including 51 percent of Beijing are college graduates. In the four cities as a the spouses and 20 percent of the adult children. whole, more than 40 percent of the managers are col- Another study by the All China Federation of lege graduates. In Beijing and Chengdu, 5 percent of Industry and Commerce (ACFIC) found that 98 per- the managers have a Ph.D. degree, while there are cent of private enterprises were family-managed. almost none with this degree in the other cities. This One such enterprise is a medium-size firm in makes sense because those two cities have many top Wenzhou with a turnover of RMB300 million universities, while the others have none.3 The propor- (US$36 million) per year, which makes analytical tion of managers with a foreign education is highest in devices for the chemical industry. The father is the Wenzhou at 2.3 percent. chairman of the board, the mother is the office man- ager, the eldest daughter is the general manager, the Overall, 75 percent of CEOs had management experi- son is the vice-general manager, the second daughter ence before they had taken their current job. Their is the financial manager, the second son-in-law is the past sectoral experience breaks down as follows: 74 sales manager, the sister-in-law is in charge of gener- percent worked in the industrial sector, 43 percent in al affairs in the office, and the nephew is the pur- private firms, 33 percent in state-owned firms, and 13 chasing manager. percent in collective firms. Thus both the private and the state sectors train and foster entrepreneurs. With Even if employees are given the option of buying the the further reform of SOEs, more entrepreneurs can firm's shares, the problem is not fully resolved because be expected to emerge from the state sector. However, the shares are not transferable unless listed in a stock the figures show that the private sector itself is becom- market. They thus have reduced value for the employ- ing a significant source of human capital accumulation. ees and must be cashed out for an employee who wants to leave the firm. Moreover, the lack of financial At the same time, private firms have difficulty transparency and clear asset ownership makes it diffi- obtaining and retaining skilled workers. For one cult to value the shares or to realize their value when thing, state firms are able to offer greater job security the manager leaves the firm. For owners of large firms, and social benefits (including residence rights, hous- public listing of their shares would help to make the ing, and health and education benefits). Thus many allocation of shares or share options to managers more college graduates do not want to work in a Chinese effective. In fact, a major reason for Stone Group, one private firm even if it pays a higher wage than a state of the largest high-tech firms in China (see box 3.2), to firm. This situation is more prevalent in Beijing and go public was to solve its internal incentive problem. Chengdu, where the first choices of university The software industry is knowledge-intensive, and the graduates are foreign companies, joint ventures, and incentive problem is more acute here. government institutions. CHINA'S EMERGING PRIVATE ENTERPRISES 23 Again reflecting the economic uncertainties they face, Labor Relations private firms tend to recruit managers in an informal way, with an eye on reducing their risks. For example, Employees in a typical private firm can be divided into one surveyed firm pays a master'S graduate only two groups: local people and outside university gradu- RMB3,000 (US$360) per month in the tryout period, ates, on one hand, and rural migrants on the other. The whereas a low-level office mnanager can get more than first group generally occupy better positions in the firm RMB8,000 (US$970) per month. The tryout period and enjoy better wages and benefits. For example, may help the firm identify qualified people, but it also many cities require firms to purchase retirement and discourages highly talented people. Offers of such a health insurance for urban residents. Firms need the wage and uncertain career prospects make it almost expertise of outside graduates, so they tend to treat impossible to get qualified people. them as locals. Because rural migrants have a high 24 INFORMAL STATUS turnover rate and have accrued few skills that cannot Beginning last year, the firm began to hire unem- be acquired quickly by readily available new workers, ployed local workers. Because they had already lost firms do see much sense in purchasing retirement or jobs once, these local workers valued the work oppor- health insurance for them. tunity and worked hard. Apart from being more disci- plined, their previous working experience also reduced In the private workforce, then, a clear distinction the cost of training for the owner. is made between the locals (and outside graduates) and the rural migrants. The latter group not only Financial Disclosure have less favorable jobs and lower wages but also poorer accommodations. Rural workers usually live To preserve their chosen formal status, firms often in firm-provided dormitories within the factory, often need to keep their financial structure opaque. Most 8 to 12 people in one small room. In contrast, local do not maintain transparent, audited financial people live in their own houses, and outside college records. Even where audited accounts are required, graduates enjoy much better housing provided by the they may misrepresent the true financial position of firm (two persons in a room, the firm buys commer- the firm. Restrictions on registration under different cial apartments for employees with higher positions, categories of incorporation give firms an incentive to and so on). underreport and misreport financial flows, numbers of employees, stocks of assets, and the like. This is Only 27 percent of the surveyed firms responded to a exacerbated by the burdens of the tax system, which question about worker unions. Of these, 60 percent also encourages underrecording. had a unionized workforce. This may overstate the prevalence of unions, however, because those firms Enterprises are commonly said to keep three sets of that did not provide an answer to the question might books: one for the government, one for the banks, and not have any. All the same, unions appear to play a one for themselves.' This means it is difficult for out- significant role in representing the interests of the siders to ascertain who owns the assets, who controls workers: among the chief executive officers inter- the firm, and how management decisions are made. viewed, 41 percent reported using unions to help This lack of clarity in corporate governance has allowed resolve workplace disputes, whereas only 11 percent companies to respond with agility to shifting regulatory relied on direct negotiation.4 In addition, the courts and policy constraints. and the government played an important role: 21 percent used courts in labor disputes; 25 percent Only 37 percent of the sample firms provided share- turned to the government. holders an annual report certified by an outside accounting agency (and only 1.2 percent of the firms Note, too, that a few firms consciously used unions used an international accounting firm; see box 3.3). and Communist party organizations to strengthen their Since the law requires only corporations to provide management. This is particularly significant in Beijing. such a report and 70 percent of the sample firms are Although conforming to the law or public relations may not incorporated, this constitutes legal compliance. be one aim of setting up a party organization, Furthermore, since many firms are closely held by the employees may also see it as beneficial in that it allows owner, there is little immediate reason to publish employees who are party members to justify working audited financial statements. Unless audited financial for a "capitalist" firm.5 statements are disclosed, however, it is difficult to demonstrate creditworthiness, and thus to enter con- As the reform of state-owned enterprises has deep- tracts and attract investment. ened, many urban workers have lost their jobs. These unemployed workers are willing to lower their asking When asked why they did not produce audited finan- wages and benefits in order to find new jobs. As a cial statements, 25 percent of the firms that did not result, they have become competitive in the labor mar- said they never considered it, 41 percent thought it ket. Consider the case of a Beijing garment company was not required, 14 percent said it was too expensive, that in the past hired rural migrants. These rural work- and 5 percent thought the report was of no use. Again, ers had a high turnover rate and went on strike twice. this is typical of less mature, smaller enterprises. CHINA'S EMERGING PRIVATE ENTERPRISES 25 Box 3.3. Toward International Accounting Standards in China In the early 1980s, the government inaugurated changes to the Chinese accounting profession, which are continuing. The first Chinese certified public accountant firm was formed in 1981, at which time international accounting firms received permission to open representative offices in China. The Chinese accounting system continued into the 1990s. Early in the decade, an accounting system was developed and implemented for Sino-foreign joint ventures, marking the country's first step away from the fund accounting concept. To enable Chinese enterprises to attract foreign investment or list stocks on overseas markets, the Ministry of Finance in January 1992 issued a separate set of accounting regulations for selected joint stock companies that conform more closely to international accounting and disclosure practices than the general Chinese standards. In 1994 the Company Law took effect, providing a regulatory framework on which new accounting and auditing standards could be based. In the last five years, the Ministry of Finance has issued or revised three sets of accounting regulations applicable to all enterprises in China, including joint-stock limited companies and foreign-invested enterprises. These regulations are prescriptive in nature, however, setting out specific accounting treatments for different types of enterprises in different industries and therefore are still rigid compared with international accounting standards (IAS). The Accounting Law was revised in October 1999 to tighten the requirements for transparent accounting and unbiased auditing, and to introduce new penalties for misleading accounting practices. In addition to passing new accounting laws and regulations, China joined the International Accounting Standards Committee in July 1997. The joint-stock limited company is perhaps the only type of enterprise in China that typically uses accounting standards approximating international accounting standards. However, there remain important distinctions between IAS and Chinese accounting standards in the areas of method and choice of accounting policies, the treatment of provisions for accounts receivables and contingencies, income taxes, and asset valuation. To understand the financial position of domestic private firms, it is important to look at the handling of related-party transactions, which can include loans, loan guarantees, and raw material purchases. In June 1997 the Ministry of Finance released the Accounting Standard for Business Enterprises: Disclosure of Related Party Relationships and Transactions. Based on IAS, the standard requires listed companies, and encouraged unlisted firms, to disclose related-party relationships and transactions. Nonetheless, it is still difficult to gain a thorough understanding of significant related-party transactions and the processes and internal controls over such transactions. This is particularly problematic because of the triangular debt situation that has resulted from companies' obtaining loan guarantees from third parties to cover their debt obligations. Until recently, the fact that companies were not required to disclose such information in their financial statements made it difficult for financial institutions and investors to assess the risk of investing debt or capital in a company. Under the Ministry of Finance's June 1997 pronouncement, however, companies are now required to disclose information about loan guarantees obtained through third parties. 26 INFORMAL STATUS Subsidiaries hotel to generate steady cash flow to support the and Conglomerates volatile real estate business. , [:i~~~~ Principal-agent problems. If a firm has weak cr An important feature of China's domestic private sec- . . ,> porate governance, its shareholders may have little tor is the prevalence of conglomerates consisting of contr governthe, m ana ers oh n rse. Tis related and unrelated businesses. Private businesses g r. have mv itidrtnontallows managers to reinvest profits in the business, have moved in this direction owing to four factors: rte hnrtr hmt h hrhles hr rather than return them to the shareholders. Where * Economic and regulatory risk. With economic profit opportunities are limited in the existing busi- ,. l. . I . ~~~~~~~ness, managers may have the freedom to invest in conditions, government policies, and regulations nela nesses. changing rapidly and unpredictably, businesses are exposed to different risks in each sector in which Sinc thee riks ae no comletey ;f Opaqueness. Diversification also serves to increase they operate. S . a r the opaqueness of the enterprise, which may help to correlated, firms can reduce risk by diversifying disguise the true ownership or tax liabilities. their operations among different sectors. The more unrelated they are, the lower the risk covariance. Among the firms in the survey, 28 percent had one sub- Hence the observed pattern of diversification into sidiary, 22 percent had two, 27 percent had three unrelated businesses. This seems to be more preva- to five, and 24 percent had more than five. In addition, 5 lent in locations such as Chengdlu where th...............e cli- ... lent iloaosscaChnuwhpercent had subsidiaries outside China. Furthermore, 33 mate for private enterprise has been less certain. By firms reported that they belonged to enterprise conglom- contrast, where private enterprise has a more stable contrast, where private enterprise has a more stable erates; 38 percent of the firms also said there was no spe- policy framework, as in Wenzhou, private enterprises cific industrial connections between themselves and are typically concentrated into narrow market niches. their subsidiaries. The average size of the conglomerates To cite one example, an entrepreneur in Chongqing in 1998 was 1,127 employees, with a sales volume of started with a small foundry producing parts for RMB150 million (US$18 million) and a profit of local engineering companies. A chance meeting at a RMB20 million (US$2.4 million). This would make the trade fair with an American company selling horse- riding equipment led to a contract to manufacture bridles and stirrups for export to the United States. ... TIs beam th main lin of buins. Usin the One Beijing group ran the gamut from construction to pharmaceuticals. Founded in 1983, this firm's first cash flow from this business, the entrepreneur is sponsoring the development of a resort complex out- side Chongqing. Most recently, he has acquired a-__ contract to construct and operate a toll road. Figure 3.1. Prevalence of Vertical and Horizontal Integration in Surveyed Firms 29 Market failure. Where labor and financial mar- kets do not work well, existing enterprises find it * Vertical integration ' ~~~~~~~~~~~~Percentage of firms advantageous to enter new businesses, because 70 * Horizontal integration they can obtain capital and management skills from within the existing business. This leads them 60 - into unrelated businesses as opportunities arise. 50 - This pattern can be seen in a number of other 40 - Asian countries. Keiretsu in Japan and chaebol in 30 - Korea, for instance, make it possible to share cap- ital and human resources across unrelated sectors. 20 - In addition, to balance their overall operations, 10 entrepreneurs may deliberately match a business 0 experiencing uneven cash flow with another having Sole Partnership Company even cash flow. In one case, a real estate develop- er in Beijing operates a department store and a Source: Survey CHINA'S EMERGING PRIVATE ENTERPRISES 27 * Vertical integration Percentage of firms U Horizontal integration *60 50 40 30 20 - 10 0 Primary Foods and Garments Chemicals Manufacturing Machinery Electronics Others industries cigarettes etc. Ohr Source: Survey line of business was the construction of computer as GE, with strong enough management structures to rooms. Since the early 1990s, it has used the profits perform well across a wide range of industries. from this business to expand into other businesses and is now active in more than a dozen industries. Where there was an industrial connection, firms in our First, it plowed profits from construction into real sample were fairly evenly balanced between vertical estate ownership and management, such as office (within the supply chain) and horizontal (cross-chain) blocks in Beijing. Second, its contacts with a integration (figure 3.1). Japanese manufacturer of refrigeration equipment led it to enter refrigeration manufacturing. Later, it Another feature of conglomerates in China is that the established manufacturing facilities for pharmaceuti- different activities tend to be organized as separate cals and health products, which are now its main line legal entities, rather than formal subsidiary companies of business. or divisions of the parent company. This serves to obscure financial and control relationships between This pattern of conglomeration among unrelated companies, which depend more on family relations companies has been a rational response to the eco- than legal control. This also makes it more difficult for nomic environment facing private enterprises. companies to be taken over, as the parent company However, it confers weaknesses on the companies, does not formally control its subsidiaries. On the other which will become exposed as capital and labor mar- hand, financial separation allows the managers of each kets improve and economic uncertainty declines. activity to be rewarded according to the performance This has been the experience of keiretsu in Japan and of their company, and legal separation makes chaebol in Korea, whose performance has deteriorated unbundling of activities easier. following economic liberalization. Managers of highly diversified groups face an enormous challenge, Supplier and Customer because they are required to understand many differ- ent businesses in different markets. Many are tempted Relationships to run such companies in their interests rather than shareholder interests, because the use of intercompany Conglomeration can also be a way to reduce transac- transactions rather than the market obscures the eco- tion risk, through vertical integration. In our sample, nomic performance of each constituent enterprise. 37 percent of the firms had subsidiaries they There are only a few conglomerates in the world, such described as vertically integrated (figure 3.2). It 28 INFORMAL STATUS seems that the firms with longer years in operation 4, tend to be more vertically integrated, although the level varies across industries. For example, foods and cigarettes and primary industries have a high level of vertical integration. To address the problems arising Materials in market transactions, some firms invite their cus- tomers and suppliers to invest in the firm. In the Capital sample, 24 firms had suppliers as shareholders, 39 had Technology customers, and 8 had financial institutions. Sales Such integration practices may be a response to another 0 10 20 30 40 50 feature of informality: operating in an informal envi- ronment, private enterprises have difficulty forming Percent relationships with third parties such as banks (dis- Source: Survey cussed below) or suppliers and customers. Thus many private enterprises are reluctant to advance trade credit to other private enterprises (for example, by filling an These figures provide considerable insight into the role order in advance of payment) because they cannot of networks in a private firm's market operations. assess the creditworthiness of the other enterprise or Private entrepreneurs seldom ask family members to easily sue for the recovery of losses. This constrains the be a business partner, but quite a few of them do busi- growth of business. As one entrepreneur told the ness with friends, and a lot of them do business with researchers: "No one ever went bankrupt by turning people introduced by friends or family members. down an order, but many have gone bankrupt by Therefore, networks help make up for the informational accepting orders that were never paid for." deficiencies of informality. Overseas Chinese are impor- tant members of networks, especially in the areas of This puts a premium on stable, long-term trading marketing and technology acquisition (figure 3.3). relationships, as reflected in the survey results: 84 However, private firms also rely heavily on the "faceless" percent of the companies in the CEO survey had market to find customers and suppliers. stable suppliers, and 85 percent had stable customers. When asked about buyers, 26 percent of the firms Some sample firms also establish business relations indicated they buy mainly from government agencies, through industrial associations. Because most such asso- 46 percent from state-owned firms, 50 percent from ciations are dominated by state firms, private firms that private firms, and 42 percent from foreign companies. produce intermediate products used by state firms find it In the case of main suppliers, 45 percent of firms are particularly helpful to join these associations. According supplied by SOEs, 58 percent by private firms, and 39 to interviews with CEOs, entrepreneurs form different percent by foreign firms. interactive circles by firm size: owners of smaller firms had one circle, larger firms another circle. Smaller firms Because of its informality, the relationship also relies were at a disadvantage, however. Through association greatly on trust, especially where payment for sales is contacts, they hoped to find opportunities for subcon- concerned. Among the firms in the survey, 21 percent tracting from the larger firms, whereas the larger firms reported that their customers were introduced by already had enough small firms coming to their factories friends or family members, 19 percent said their part- to ask for subcontracting work. ners were friends, and 3 percent said that their partners were family members. In other words, about 43 percent In view of the current economic slowdown and wide- had some prior direct or indirect connection. As for sup- spread enterprise arrears, firms are becoming more cau- pliers, 24 percent said they were introduced by friends tious about selecting their customers.7 Because firms and family members and 10 percent said the partners operate under conditions of tight liquidity, losing one were their friends. That is to say, about 34 percent had payment may bankrupt them. Many of the surveyed some connection. In addition, 30 percent of CEOs said firms had reduced their business volumes in order to family and friends were important in material supply, avoid deferred or dead payments. A common sentiment and 46 percent said they were important in sales. was, "If you do not have a deal, you are not going to die CHINA'S EMERGING PRIVATE ENTERPRISES 29 Percent 60 - 50- 40- 30 - 20- 10 0 Lack of Regulatory distribution Foreign Domestic Weak market barriers channels competition competition demand Source: Survey immediately; but if you have done a deal without pay- relation to existing capacity was a constraint to market ment, you are going to die quickly." To get the informa- entry. Similarly, the tax breaks, subsidies, and prefer- tion on the payment ability of a customer, a private firm ential access to resources and markets available to joint relies on contacts with firms that have done business ventures make it very difficult for private enterprises to with that customer. Only if the customer has a good compete and remain viable. Of the firms surveyed, 12 record of payment will the firm do a deal with it. percent cited foreign competition as a barrier to entry. In addition, SOEs and collectives have been able to Market Entry and Competition exploit their political patronage to obtain contracts, access to land and resources, credit, and other sources Because until recently private enterprise lacked of competitive advantage not available to private enter- recognition, many areas of economic activity were prises. As a result, private entrepreneurs have tended reserved for state-owned and collective firms. Hence to put on the red hat to obtain market advantages (see private firms were excluded from many domestic box 3.4) or to seek niches where SOE competition is a markets and, until recently, were excluded from limited threat, such as new products (software) or rap- direct exporting. Even now, only a limited list of pri- idly changing markets (fashions, toys) where SOEs vate firms have direct export rights, and a number of find it difficult to compete. This has severely limited sectors continue to be reserved for SOEs (see chap- their range of markets. Hence the survey found little ter 4). Of the firms surveyed, 18 percent cited legal head-to-head competition between registered private restrictions and 15 percent cited the lack of distribu- enterprises and SOEs. Only 12 percent of the CEOs tion channels as barriers to entering new markets interviewed thought state firms were their competitors; (figure 3.4). 81 percent saw other domestic private firms as their main competitors. Formal exclusion is not the only means of keeping pri- vate enterprises out of the markets dominated by state- Competition among private firms themselves is high owned enterprises and foreign joint ventures. Another because their numbers are increasing in all categories, is the fact that SOEs, TVEs, and collectives have pref- whether newly restructured SOEs, gaizhi firms, or red erential access to bank credit. As a result, they are able hat firms. The competition is especially keen in the sev- to invest without full market discipline, which in turn eral industries where private firms tend to be concen- allows overexpansion and excess capacity to develop in trated. In rural areas, for instance, many small private many sectors. Not surprisingly, 48 percent of the enter- firms are producing similar low-grade products and prises surveyed reported that "weak market demand" in competing with each other and with other TVEs. 30 INFORMAL STATUS Many of the private firms surveyed also formed clusters - -a * a * - - a * a a.in terms of both location and industry. Such clusters tend to deepen industrial specialization, increase economies of scale, enhance efficiency, and widen the 8 *.. - * ** *** - - * scope for development of private enterprises. Local gov- ernments' policy of developing hi-tech areas, as in Beijing and Chengdu, fosters the formation of industrial clusters. Such clusters can be highly competitive or, as in some industries in Wenzhou, can engage in practices that reduce competition (see box 3.5). According to the CEOs interviewed, entrepreneurs see the lack of access to market information as a key inter- nal constraint. One of the biggest differences between a planned and a market economy is that the latter rc 8 - ~~~~~~~ognizes the need to respond to market conditions and consumer preferences. Chinese enterprises lack these 8 e 8 8 8 8 8 8 ~~~~~skills, and the private ones are anxious to acquire them. Financing -. * 8 8 8 8 - 8 88 - - ~As chapter 5 points out, the financial system has until - 8 - - 88 8 * * * ~~~recently been entirely under the direct control of the state. As a result, private enterprises have been bound 8 - 8 8 8 8 - - 8 8 8 ~by government policies toward them: before private enterprises were formally recognized, they found it very difficult to obtain credit without a red hat. Even as restrictions on private enterprise were eased, the government continued to direct credit toward SOEs, 8 8 8 8 8 8 ~~~~~~~~crowding out private enterprises. Similarly, access to public equity markets has been closely controlled by 8 8 0 80 ~~~~~~the Securities Commission, which has given prefer- ence to SOEs. - 8 8 - 8 ~~Aside from the particular constraints of the Chinese financial markets, the informal nature of China's pri- 8 888" * * a - ~~~~~vate enterprises makes it difficult for them to attract 8 8 * 8 8 - ~~~~~~~~external financing, particularly bank loans. Private 88 - ~~~~~~~borrowers lack clear title to assets, and few have transparent financial statements with which to assess 8 88 8 88 8 - 8 ~~~~~repayment ability. In the past, some got around this barrier by wearing a red hat, which gave them prefer- ential access to credit from state banks. However, recent reforms of the banking system are phasing out the preferential treatment of state-owned and collective enterprises. At the same time, the prospect of entry into the banking sector by private banks (including, under 8 8 8 * 8 -, ~~~~the VWTO agyreement, foreign banks) increases the 0 - ~~~~~~~~~~~~pressure on banks to abide by market disciplines. CHINA'S EMERGING PRIVATE ENTERPRISES 3 1 ~0 *0. - - 0 O . 00 - - - !0 - I~ 0 0_ 0 ~ S~ 0 Informality also makes it difficult to attract equity Hence equity investors tend to be limited to close investment. For unlisted, private equity, investors are family and associates of the firm, who can directly deterred by the lack of clear asset title and lack of clear supervise their investments and who hold some kind of corporate governance. This leaves them with little leverage over the enterprise managers. Again, this is means of safeguarding their investmnent and little typical of small, early-stage enterprises, hut in China prospect of exiting the investment. Exit is made more even large, mature private enterprises are stuck at difficult by stock exchange listing rules that give pref- this stage of financial development. Among the firms erence to state-owned enterprises. Even by wearing surveyed, more than 90 percent relied on self-financing the red hat, few private enterprises have been able to for their initial capital. obtain permission to list. Without a transparent financial track record, clear asset ownership, and Most firms continue to rely heavily on investments by clear corporate governance, private firms have little their owners and on internal cash generation as they hope of gaining such permission. grow. This is sustainable only under conditions of rapid 32 INFORMAL STATUS growth. Since many private enterprises have experi- between the private sector and the government by enced explosive growth, finance has not always been informing the former of government policies and reg- an obstacle. However, these conditions are unlikely to ulations and by informing the latter of the sugges- persist. As companies adjust to more normal rates of tions of the private sector. growth, the need for external finance will become more pressing (see chapter 5). The chamber assists the private sector in several ways. For example, it recommends good firms to banks with Government Relations a view to reducing the efficiency losses associated with information asymmetry. It works with the government A final consequence of the private sector's informal- to grant technical titles to technicians in the private ity has been an awkward relationship with govern- sector, recommends promising firms for funds issued ment. Up to now, private enterprises have spent by the national "Star Plan" and "Torch Plan," and helps much time, effort, and resources either hiding their private firms obtain passports and visas to facilitate the activities from government scrutiny or negotiating conduct of business abroad.8 It also operates three cen- spccial treatment. Furthermore, they have had little ters offering consulting services in firm management, influence over the policies and regulations that legal affairs, and public relations. affect them. SOEs and collectives have sponsoring ministries that represent their interests at the provin- Townships in Shunde that in the past did not have an cial and national level, for example, by ensuring that ACFIC office have organized their own chambers of credit is available from the banking system. Not hav- commerce. Though officially affiliated with the city ing such state support, private enterprises operate at ACFIC office and granted substantial government a disadvantage in coping with the regulatory frame- support, most chambers are established and run by work and with the financial system. the private entrepreneurs themselves. Private entre- preneurs in the township told interviewers they see China has long maintained national industrial associa- the chamber as a place to interact and are quite tions. These associations have played a significant role pleased with the facilities and services it provides. Its in helping firms exchange technical information and main drawback is the restrictions on entry, which obtain technology-related consultations as well as set exclude smaller firms from joining. national technical standards. However, these are dom- inated by SOEs. Another official organization for private entrepreneurs is the Association of Private Firms. It does not have a At the national level, ACFIC, China's official cham- national headquarters and is organized by the local ber of commerce, has an extensive organizational net- BICM. All private firms are eventually forced to join work that covers all the government jurisdictions at or this association, according to the firms surveyed, above the county level. It was first created in the because the BICM collects a membership fee when- 1950s as a part of the CCP's united fronts to accom- ever a private firm is registered. The fee is also included modate private firm owners. During the Cultural in the annual firm examination. Although in some Revolution, its activities were suspended. After it started localities the president of the association is a private up again in the late 1970s, it gradually shifted its weight entrepreneur, more often the president is a deputy from old private owners to new entrepreneurs and director general of BICM. Most private entrepreneurs gained in popularity in many localities. interviewed regarded the association as merely a way of collecting fees from them. Some local offices of the All China Federation of Industry and Commerce play a significant role in organizing private entrepreneurs. Its office in The Cost of Informality Sichuan Province is also called the Sichuan Chamber of Commerce, a name with significant In one sense, informality has been the private sector's overtones: it softens the political color of ACFIC. great strength during a period of uncertainty and rapid The new Chamber of Commerce provides a wide change. It has allowed private enterprises to respond ranges of services to its members and acts as a bridge flexibly to changing policies and regulations and to new CHINA'S EMERGING PRIVATE ENTERPRISES 33 Figure 3.5. Key Internal Constraints Cited by Surveyed Firms 1 Percent 50 40 20 ": 0' Managerial Skilled Access to Market Access to Domestic capacity labor technology information finance competition Source: Survey market opportunities, while diversifying risk and avoid- assurance of a stable policy environment for private ing excessive taxation, regulation, and competition. enterprises, which should encourage formalization. However, informality creates serious obstacles to the further growth and development of the sector, leaving As the economic environment becomes more stable, pri- large, mature companies stuck with structures more vate enterprise gains legitimacy, state support for SOEs suited to small, young companies. It also makes com- and collectives declines, and capital and labor markets panies opaque and unfocused, endows them with improve, the balance of advantage will shift away from limited management capacity, and prevents them from informality. Increasingly, domestic Chinese firms will attracting the finance and skills they need to grow. As find themselves in open competition with foreign private figure 3.5 shows, the owners of the sample companies enterprises. This will provide a strong incentive to adapt recognize these constraints, which together make it to international best practice in business organization. very hard for these companies to engage in beneficial partnerships with customers and suppliers or to work Formalization has its costs, of course. Companies constructively with the government to improve the may find that they have to pay more tax and spend policy and regulatory environment. more resources on compliance with government reg- ulations, audit and financial disclosure, and gover- Many larger private enterprises also recognize that they nance. They will become more exposed to policy need to formalize their structures and allow them to changes and to developments in the markets they adapt as the firms grow and mature. This process has choose to focus on. International experience sug- already begun, with the transformation of many TVEs gests that for all but the smallest firms, these costs and collectives into private enterprises, the transfer of are more than outweighed by the efficiency benefits SOEs to private ownership, and the emergence of of formalization. The policy and regulatory changes many stock-holding companies from getihu. At the required to reduce the barriers and disincentives to policy level, the recognition of the private sector in the formalization and to help firms make the transition recent Constitutional Amendment provides greater are laid out in chapter 6. 34 INFORMAL STATUS TOWARD A RULES-BASED :VS LI: IanelN"AA,I :V I A key challenge for the development of the China demonstrated its commitment to the rule of law private sector today is to combine the con- by including the principle of "governing the country tinuing process of economic liberalization, according to law" in the constitution. The which reduces the scope for government Constitutional Amendment of 1999 upgrading the sta- intervention in private sector activities, with institution tus of the private sector from a supplement to public building, which would gradually establish the rule of ownership to an important component of the socialist law as the basis for government-business relationships. market economy and guaranteeing legal protection of As the experience of the transition economies during private property rights is an important step toward cre- the past decade has shown, the transformation of an ating a protected private sphere in China. Significant economic structure from state-dominated to private progress has also been made in unifying certain areas sector is a complex task. A great deal can be achieved of economic law and in scparating regulators from the in the short run through the use of consistent policies, regulated. However, much more needs to be done. combining liberalization of markets, trade, and new Some areas of the law still treat different forms of business entry, but in the long run, an efficient market enterprise differently. Private firms are often discrimi- response can be obtained only through such steps as the nated against on the basis of unclear and uncertain implementation of clearly defined property rights and the rules, and government interference in private econom- establishment of key supporting institutions. ic activities is still widespread. The rule of law, it is generally agreed, includes (1) gen- A frequently emerging theme from the survey is that eral, abstract rules that are prospective, never retro- local governments and administrative officials tend spective in their effect; (2) rules that are known and to overexpand their duties and focus on rent-seeking certain; (3) rules that are equal in the sense that they activities. This is reflected in part in the ill-defined should not discriminate on the basis of irrelevant roles of government departments, coupled with func- distinctions; and (4) a separation between regulators tions that are becoming increasingly obsolete and and the regulated. The rule of law therefore presup- out of tune with a market system. The functions of poses a protected private sphere whose economic many departments also overlap. In addition, rent- aspects are defined mainly in terms of property and seeking behavior is evident in areas of administra- contract rights. tion, as well as institutions, not subject to market discipline. Reforms are needed to clarify and rede- While this protection can never be absolute, it at least fine the functions of government departments at dif- incorporates the principles of "no expropriation with- ferent administrative levels according to the require- out just compensation" and of independent judicial ments of a market economy, and to prevent improper review of government actions. The argument against and unnecessary interference at different levels in interference does not mean that the government enterprise operation. should not get involved in economic matters. On the contrary, there is a whole range of government activi- The survey found that law enforcement and adminis- ties that are not only compatible with the rule of law, trative performance were better in some locations but also necessary for its existence. The rule of law than others. Shunde emerged as a role model in applied to the business environment guarantees trans- many respects, having undertaken reforms to bring parency, predictability, uniformity, and the protection about a radical downsizing and transformation of the of private property rights, which are necessary condi- role of the government in 1993, some six years ahead tions for the efficient functioning of markets. of other parts of China. At that time, the number of CHINA'S EMERGING PRIVATE ENTERPRISES 35 government departments in Shunde was reduced sector is not necessarily inconsistent with the rule of from 49 to 29, and the number of employees from law, it often creates conditions that may lead to devia- 1,400 to less than 900. Equally important, this was tions from this principle. For instance, large losses in the accompanied by a change in the role of government, state sector may trigger government support in the form which shifted from being a player in the economy of subsidies or soft loans. In China, this has led to over- to being an arbitrator and service provider. This capacity in many industries and a huge stock of nonper- has allowed it to pursue an agenda of openness forming loans in the financial system. As a result, private and integrity in administration and to introduce a firms are often discriminated against in their access to strong element of predictability and regularity into markets and financing. the business environment. China is making progress on SOE reforms, but its Without the rule of law, it is impossible to protect commitment to the private sector may not be easy to private property and contract rights. Ironically, the assess. Progress in the reform of state-owned enter- real need for such protection stems from the prises and creation of clear property rights has been progress the government has already made in extri- clearly uneven. SOEs no longer dominate all sectors of cating itself from markets: that is to say, legal norms the economy, but neither have they withered away. The and procedures are needed to substitute for direct government's policy goals with regard to private sector government control over economic decisions. As development have often been less than transparent, summed up by the World Bank (1997, p. 36), but there has clearly been a growing emphasis on mar- "Economic reforms have made legal rules matter." ket orientation in the allocation of resources. This is reflected in China's exceptionally high overall (total Establishing such a rule of law may take a while. It factor) productivity growth since the mid-1980s. calls for a legal infrastructure that can implement the evolving legal framework, establish good gover- In one sense, the Chinese industrial economy seems to nance, and foster a legislative system that works be operating in a vast grey area, somewhere between plan equitably and speedily. Even if laws were not the and market, while also in the grip of "extraordinarily rapid problem, adequate-meaning speedy and equi- transformation and flux" (Steinfeld 2000, chap. 3). table-enforcement would be. Indeed, this may be From this perspective, the organizational environment the most significant challenge that China's legal sys- appears to have reshuffled opportunities and con- tem will face in the foreseeable future. straints, reshaping incentives and the ways in which autonomy is exercised. In this new dynamic, SOE Private property rights, including intellectual property reform in China may not manifest itself in conventional rights, also need to be defined, legislated more clearly, privatization measures, which involve a complete sepa- and protected more effectively. Because legal redress ration of state-owned firm from the government, but against violators remains difficult to secure, busi- instead may take a middle path of market-oriented nesses that are highly vulnerable to piracy (such as incentives imposed on managers through both a hard- software companies) remain at a primitive stage of ening of the firms' budget constraints and a significant development in China. This chapter looks at issues expansion of management's autonomy To this extent, related to the application of the rule of law in the government commitment to the market, and to private areas of overall commitment to the private sector, the sector activity, may in fact be stronger than is apparent openness of markets, commercial legislation, the from progress in the transfer of property rights. financial system, and taxation. Although China has made progress in the divestiture of Commitment state enterprises, it will not reap the full benefits from SOE reform unless it limits the incentives and oppor- to the Private Sector tunities for interference in the operation of these com- panies. Of course the state has a legitimate interest in A government's commitment to the private sector is ensuring proper valuation and documentation before usually reflected in its willingness to support divesti- state assets move into private hands, as reflected in ture of SOEs and in the consistency and long-term legislation on appraisal and verification of state assets sustainability of its policies. Although a large SOE and capital contribution. These regulations play a 36 A RULES-BASED ENVIRONMENT useful role in confirming to various investors or part- ners the value of the capital contributions of other _ - _ partners or investors and in reassuring potential investors that the state has no remaining interest in the assets. However, the vague language in the Company i Law apparently giving the state the authority ain tain special rights over assets formerly under state con trol creates uncertainty as to whether property rights in transformed companies are fully protected. Openness of Markets While parts of the economy now function quite com- petitively, many markets remain restricted in certain on Granting Self- respects. Though the government has allowed private firms to exist for more than io years, it still keeps them from entering many areas of business where the state 1 1 B sector continues to maintain monopolies. The govern- ment stipulates that private firms are to be excluded from 15 types of industries (see box 4.1). The group t mos n i ms h r can be divided into three main categories: (1) indus- tries using very scarce resources; (2) industries consid- ered vital to the national economy; and (3) industries 0*0 -0 whose products entail certain public hazards. Since there are no general criteria with which to determine whether a business belongs to any of the three cate- 0 M i a gories, officials have room to use their personal judg-ENTERPR0SES 37 ment in applying these guidelines. Numerous other laws prohibit and restrict the entry of private enterprises into certain industries. According to press reports, certain lists exist that set out extensive industry-related restrictions for the establishment of pri- vate enterprises. Private capital is reportedly not permit- ted in some 30 industries plus 17 products belonging to other industries, including banking, railways, freeways, telecommunications, and wholesale networks for a large number of goods. Another list is said to "restrict" private companies. In 1998, the government began to grant capital in certain industries. This list contains more than direct export licenses to selected private firms. Privately 20 industries, including automobile manufacturing and owned production enterprises and research organiza- chemical fibers. We are not aware that the lists have ever tions may obtain limited foreign trade rights according been made publicly available, to the Interim Provisions on Granting Self- Import/Export Rights to Privately Owned Enterprises Private firms also face restrictions on direct access to and Science and Research Institutes effective January foreign trade. Prior to 1998, private firms were not 1, 1999. By the end of 1999, about 150 private firms allowed to export directly, although this right had been had been allotted these licenses. granted to many SOEs for several years. Having an export license enables a firm to hold foreign currencies To obtain such rights, a firm must meet certain condi- and bypass trading companies, which in turn not only tions: most notably, it must have registered capital, as acquire the value added of the exports but in many well as net assets of more than RMB8.5 million (US$1 cases also hold the tax return belonging to the export million). Moreover, its annual sales must exceed CHINA'S EMERGING PRIVATE ENTERPRISES 37 RMB50 million (US$6 million) and the export value production of certain products.' These restrictions must exceed RMBl million (US$120,000) continu- greatly reduce new entries in these industries, how- ously in the previous two years. It is obvious that newly ever, and therefore limit the opportunities for private established private companies cannot meet these enterprises to play a role in the restructuring process. requirements. Furthermore, there is still no statutory rule that explicitly permits pure trading companies to To complicate matters, localities are able to impose become established through private investment and to additional restrictions and licensing requirements on engage in the import and export of goods produced by specific industries at their discretion, which cause fur- others or to act as a foreign trade agent, as the existing ther fragmentation of the domestic market and a prolif- state-owned import and export companies are at present eration of entry restrictions. Increasing restrictions have permitted to do. serious negative consequences for the development of private enterprises. Those already established face even These forms of discrimination have aroused consider- greater uncertainty about their future opportunities for able attention in the past year because under the growth and expansion, particularly to other provinces. conditions China has negotiated to enter the World State-owned and collective enterprises face disincentives Trade Organization, some sectors (such as telecommu- for changing or clarifying ownership rights. A company nications and financial services) that are still closed to that distributes medicines in Shunde, for example, will private Chinese investors will be open to foreign not be able to do business in Guangzhou, a place with investors. According to the related agreement concluded much higher demand. A collective firm in Shunde that between China and the United States on China's produced containers before it was transformed will be accession to the WTO, the government will grant free unable to continue this operation because private firms trade rights to all Chinese enterprises-within three are not licensed to produce this kind of product. years after the WTO accession. Of the firms surveyed, 28 percent stated that various Other types of entry barriers arise from tight market con- forms of market barriers hamper their business ditions in certain industries. The soft budget constraints operations. Regional differences in these barriers of state-owned and collective enterprises and local appear to be fairly small. The main barriers cited by protectionism are a particular concern because they the majority of respondents consisted of licenses, create severe overcapacity problems for a large number general policy restrictions, and local protection. of sectors. To address the problem, the government has undertaken industrial adjustment by prohibiting The effects of entry barriers may differ for firms of dif- investment in certain industries, reducing the number ferent sizes, as seen from table 4. 1. Whereas firms of of enterprises in certain industries, and ordering the all sizes had complaints about government licensing elimination of certain types of enterprises, produc- and policy restrictions, concerns about local protec- tion facilities, and technological processes for the tion increased in relation to the size of firms, perhaps Table41TyeofEtyBrirbyim Sie (peretag ffrswt e nwr tumber of pofly N oet d dustry I~ ~ Ep~e I4ee fs ~ rcIn Pra; tlo Monpl MWaret S!z 51 22.6 29.0 6.5 29.0 12.9 6 S100 750.0 12.5 12.5 25.0 0.0 101-50 37.5 37.5 18.8 0.0 6.3 >500 80.0 0.0 20.0 0.0 0.0 *Percentage of firms providing an answer in the total number of firms in a size categoryi Source: Survey 38 A RULES-BASED ENVIRONMENT because larger firms were more likely than smaller registering with the local labor bureau, and so on, at firms to sell their products outside their own the cost of another RMB5,000 (US$600). In addition, provinces. Conversely, since larger firms enjoyed larger it would be necessary to obtain permits for hiring labor, markets, they were less concerned about industrial for environmental protection, and for factory set-up, monopoly and market size than were smaller firms. In which would add a further discretionary element to the addition, many firms complained about the lack of process. Not surprisingly, out of a sample of 75 coun- access to relevant business information. CEOs of tries (including developed nations), China ranked 51 firms surveyed found it particularly difficult to gain in terms of start-up delay, and 43 in terms of start-up access to information on financial sources, investment cost as a ratio of GDP (Djankov et al. 2000). opportunities, markets, and technologies. This dissatis- faction was greatest among those located in Beijing In principle, local registration must occur within 15 and lowest in Shunde. days for a WIOE and 30 days for a partnership if the basic conditions are met. In practice, however, there is Commercial Legislation no fixed time limit for official review of an application for the establishment of a limited liability company. The regulation governing commercial enterprises has a This greatly undermines the effectiveness of the routine direct impact on general market access. For example, treatment of such applications and exposes entrepre- registered capital requirements for a private limited neurs to the possibility of official coercion. company in China are among the highest in the world: minimum amounts for a limited liability joint stock An additional constraint arises from the requirement company, for instance, amount to RMB300,000 that entrepreneurs must define precisely their "scope (US$36,000) in retail trade, and RMB500,000 of business" in the registration document. The busi- (US$60,000) in wholesale trade or manufacturing, and ness scope of the enterprise must be clearly (and, by must be confirmed as paid up before a business license implication, narrowly) defined, and such business is issued. scope is subject to the substantive review and approval of government authorities. SAIC or its local branch One way for an entrepreneur to avoid these barriers officials must approve any subsequent changes to busi- would be to register himself under the Law for Wholly ness scope, which makes it difficult for entrepreneurs Individual Owned Enterprises (WIOE Law), whereby to adapt flexibly to market. This obviously forces them he would face no minimum capital requirement. to inform government officials of their business plans, However, this could entail a high degree of risk. Under which could have negative implications for confiden- the WIOE law, the entrepreneur is not allowed to raise tiality and competition. By contrast, developed coun- capital from other individuals, and he bears unlimited tries do not unduly constrain an entrepreneur's scope liability for his business debts. This liability could even of business. (Perhaps the most liberal government in continue for a number of years after his company was this regard may be that of the State of Delaware, in the liquidated and thus could seriously affect his ability to United States, whose Article 102 of company registra- raise funds to start a new venture. Almost the same sit- tion procedures says it is sufficient for the enterprise to uation applies when two or more entrepreneurs form a state that it is "engaged in any lawful activity.") partnership and register themselves under the Partnership Law of 1997. Furthermore, the application for registration must specify a fixed site and "necessary conditions" for Registration requirements are not only expensive but production. This requires an entrepreneur to organize also time-consuming, with many ad hoc requirements key elements of his business before registering it. It and additional costs. According to a recent study also exposes an entrepreneur to the possibility of gov- (Djankov et al. 2000), the time frame for some of these ernment interference in the selection of a site and steps could be between three and six months, because perhaps of business partners. they could involve registering with the administrative bureau of industry/commerce in the relevant locality, The predictability of government policies and the degree obtaining registration certification from the State of consistency in enforcing laws and regulations have a Administration of Industry and Commerce (SAIC), major impact on the environment for private sector CHINA'S EMERGING PRIVATE ENTERPRISES 39 private firms complained heavily about the govern- ment's frequent policy changes. The government's abil- ity to suddenly and compulsorily acquire land was par- ticularly destabilizing for many private firms, and in extreme cases could destroy a promising business (see box 4.2). Recently, the Bureau of Public Health issued a directive calling on all restaurants with a floor area of less than 30 square meters to close down because it felt that small restaurants did not meet hygiene stan- -, 3- *E -5 dards. If strictly enforced, this directive would put more -;i IYM - 5 E - 1 than 3,000 small restaurants in the city out of business. * 3 -; 'E1 E 51ili -9 - A similar directive from the Bureau of Publications 9Si -1 5 l 0O | S *li;5 aimed at all bookstores with a floor area of less than 50 - * ilgli * ei il3 -square meters would, if strictly implemented, force the - e il * o E - a - small bookstores in Beijing to close. ffll *, * _ - * -. * - * * In an important recent development, China adopted the Administrative Review Law in October 1999. The new law gives citizens and private entrepreneurs the _- -l! -_ *right to appeal an administrative decision if they believe that officials have acted outside their authority or refused to act when a proper application has been made. It also sets clear procedures and time limits for review. In contrast to court proceedings, which require a substantial fee before litigation can begin, * - 5; 0ll 9 the administrative review imposes no fee on the applicant. In an environment where numerous per- = -_ * * e * e * * s -mits and licenses are still essential, this is a very - .l a * * - a * * a important potential right. It would be helpful to monitor this law in practice. Commercial legislation has yet another area of weak- ness: it lacks an effective competition policy. Private firms are still reluctant to enter sectors dominated by state enterprises because they do not believe that con- ditions for fair competition exist in such markets. * _ 5 5 0 S Legislation protecting intellectual property rights remains vague or ineffective. Large firms fear unfair competition from smaller firms that may be able to pirate new technologies from them. Competition of this development. The enforcement of laws governing com- nature, unregulated by an effective legal infrastructure mercial enterprise and their administrative perform- is, many say, a cause of inefficiency and market ance varies greatly across cities and regions. The firms disorder (box 4.3). surveyed reported that major laws, regulations, or poli- cies changed only 0.36 times in Shunde during the Entrepreneurs in a rapidly changing economic environ- past three years, but as many as 6.2 times in Beijing. ment need clear guidelines not only on establishment, This variation may also reflect different levels of famil- growth, and enforceable commercial arrangements, but iarity with new laws and regulations. The seemingly also on reorganizing or closing down a business. This higher stability in Shunde was accompanied by a process of "creative destruction" is an essential part of greater degree of trust in the court system in the res- the optimal use of a nation's entreprencurial talent. In olution of disputes. In Beijing, on the other hand, this respect, the bankruptcy laws have not worked very 40 A RULES-BASED ENVIRONMENT well in China. One problem is that different types of enterprises are subject to different legal treatment. For and Their Protection example, the bankruptcy of SOEs falls under a special Bankruptcy Law, while other types of enterprises (including SOEs) are covered by Chapter 19 of YZX, a building material producer in Wenzhou, China's Code of Civil Procedures. As a result, it is established his operation in 1993 with the help of often difficult to interpret and apply existing bankruptcy 17 private investors (only two remain). Because regulations. Another complication is that enterprises in - of sharp competition, the company's profit margin the form of "natural persons," which include all firms is low. But the general manager believes that YZX with eight or fewer employees, do not come under any is doing well. In his view, a major problem for bankruptcy regime. The notion of personal bankruptcy small firms, particularly private ones, is the risk still runs counter to ideology and raises widespread that accompanies research and development. concerns about sociopolitical stability. The current legal system does not provide Bankruptcy also raises problems regarding the priority mh prect to s'ptents nd brands of claims. According to the Bankruptcy Law, the liqui- dation proceeds are to go to secured creditors ahead of firm trying to develop a new product has only workers. However, SETC Circular No. 492 of 1996 an 8-10 percent chance of success. Even if it had made even land mortgage rights subordinate to becomes successful, its products will be soon worker claims under the so-called Capital Structure be copied by other companies. In fact, two new Optimization Program. A new bankruptcy law under products developed by YZX were copied by final review may allow more bankruptcies to be others, with minor changes. The company spent declared in the future. This highlights a key chal- one and a half years and RMB200,000 lenge of enterprise reform in China, which is to cre- (US$24,000) on a legal suit against one of the ate market-oriented corporate governance systems that violators. But the final judgment allowed both are independent of government influence. This can be companies, the inventor and the company that done only'if entrepreneurs are empowered to under- copied, to produce the same product. A techni- take the market-driven consolidations, shakeouts, and cian of the company was also "hunted up" by capacity reductions that may be necessary to meet the another company, which was interested in gain- tests of competitive efficiency ing access to the know-how of his company. The manager concluded: "You were waiting to Over the course of their growth cycle, enterprises may need to adopt different legal forms. However, Chinese die if you didn't develop new products, and you regulations do not adequately allow for such a trans- - were hoping to die if you did: the money you formation. It seems that a WIOE or a partnership can spent was simply for others." transform into another legal category of business only by liquidating its current business and establishing a new entity. Limited liability companies face similar problems. Under Chinese law, they can only transform into companies limited by shares. The present system, the big four state-owned banks-Agricultural Bank of which calls for liquidation of one legal entity and the China, Bank of China, Industrial and Commercial establishment of another, wastes both time and Bank of China, and China Construction Bank-each money. It can also have an adverse impact on the con- with an extensive network of branches nationwide and tinuation of normal business operations during the together accounting for more than 60 percent of the course of transformation. country's financial sector's assets.2 There are a large number of nonbanking financial institutions. However The Financial System they hold less than 4 percent of the total assets in the financial system. Although steady progress has been China's financial system today is markedly different achieved in transforming China's financial sector, finan- from the mono-banking system that prevailed about 15 cial reform and deregulation have generally lagged years ago under central planning. It is dominated by behind developments in the real sector. CHINA'S EMERGING PRIVATE ENTERPRISES 41 The institutional structure of the financial sector in other banks). The quota system tended to create an China has remained quite weak, especially in terms of uneven playing field in access to bank loans. Its elimi- risk management and credit analysis functions, as can nation is a significant step toward the establishment of be seen in the quality of the banks' portfolios. Despite the rule of law in the financial sector. efforts aimed at establishing commercial criteria in lending, China's banks continue to act as an extension Bad assets. A major source of vulnerability of the of the treasury, one of their main tasks being to chan- Chinese domestic banking system is the high level of nel savings to designated state-owned enterprises nonperforming loans that occur mainly in SOE lend- rather than to the most creditworthy customers. At the ing: according to official estimates, 25 percent of same time, banks are expected to turn in more profits China's state-owned bank loans are nonperforming, to offset shortfalls in the central budget. and 5-6 percent are considered unrecoverable. The government has implemented several major measures Subject to conflicting constraints of this sort, to strengthen the balance sheets of state-owned banks, Chinese banks are still administered in the manner of including (1) injecting additional capital to strengthen state agencies, and as such have little incentive to their capital adequacy (US$32 billion was injected in improve efficiency. This is becoming an urgent prob- 1998), (2) increasing loan loss provisioning and short- lem in view of the fact that WTO concessions portend ening the period for nonaccrual of interest on delin- increased competition. They envisage that foreign quent loans, (3) setting up asset management compa- banks would be able to conduct local currency busi- nies to take over their bad loans, and (4) increasing the ness with Chinese enterprises two years following write-off of their unrecoverable debts. A risk-based accession, and local currency business with Chinese loan classification system was announced in early individuals five years after accession. 1998, dividing loans into five categories, as recom- mended by the Bank for International Settlements. Outside of the banking sector, China's capital mar- This represents a significant step in unifying Chinese kets have been subject to many of the same kinds of banking practices with international standards. constraints and controls, with quotas. on how much equity and securitized debt can be issued in a year. Interest rates. Controls on interest rates tend to dis- The relatively small role of capital markets, it seems, criminate against small enterprises in their access to "was not a product of market forces but of adminis- financing. China has partially liberalized interest rates trative decree" (World Bank 1997, chap. 3). In addi- by allowing banks to set deposit and lending rates with- tion, government oversight of the capital market is in a wider band. Recently, it announced plans to liberal- weak. The capital market is still at a very early stage ize its domestic interest rate regime within three years. of development, however, and has been little used as part of China's macroeconomic program. Even if this Provincial network of the central bank. The central market were to grow at more than twice the rate of bank has been restructured to improve its independ- projected (real) GDP growth, by 2020 the value of ence, authority, and professionalism. In order to break stocks and bonds in relation to China's economy the links between local government and central bank would only approach that in India's capital market in branches, regional offices have been formed by com- 1997 (World Bank 1997, p. 34). Since 1993, the bining provincial branches. This measure is expected to Chinese financial system has undergone considerable significantly reduce the scope of government interfer- regulatory reform, reflected in more than 25 new laws ence in bank lending. and regulations, including the Central Banking Law and the Commercial Banking Law (both passed in Foreign banks. In recent years, China has eased its 1995). The following are some of the more important control on foreign banks slightly, but not enough to reform initiatives: make a substantial difference to the industry. Initially allowed to operate in Shanghai and Shenzhen, foreign Credit quota system. In 1998 the authorities banks can now expand in Guangdong, Guangxi, replaced the credit quota system (for both working Hunan, Zhejiang, and Jiangsu. The ceiling on their capital and fixed asset loans) applicable to the four domestic lending was raised from 35 to 50 percent of state-owned banks with the indicative quota and a foreign exchange liabilities, and foreign banks have system of assetAiability management (as applied to been allowed greater access to the interbank market. 42 A RULES-BASED ENVIRONMENT Capital markets. The government closed the 20-odd tax burdens: as many as 89 percent of firms with 5 1-100 city-level "informal" stock exchanges whose emergence employees were dissatisfied with the burden of fees, in had been tolerated earlier. In December 1998, the comparison with 67-78 percent for all other sizes. Securities Law, China's first comprehensive national law on securities matters, was promulgated. However, The tension between decentralized income rights and it failed to unify China's rigidly segmented securities centralized tax legislation has created an uneven playing markets. New rules open the door for both domestic field for private firms, especially smaller firms. To com- and foreign insurance companies to purchase A plicate matters, taxes and fees are sometimes collected shares, allowing for a greater presence of institutional in an arbitrary fashion. Firms surveyed complained, for investors on the Chinese stock market. In March 2000, instance, that technical standards inspectors (in the government announced that the quota system on Chengdu) exaggerated technical defects so as to boost listings would be abolished in favor of a system in fees levied, or (in Wenzhou) that the environmental pro- which underwriters would determine the timing and tection office levied arbitrary fines for equipment noise. pricing of new issues. There appears to be an urgent need to improve the con- sistency and effectiveness of tax laws, to avoid generat- Tax System ing negative incentives that could further constrain the competitive efficiency of the private sector. Prior to 1994, the relationship between central and local governments in China was embodied in a revenue con- Conclusion tracting system whereby provinces handed over a fixed amount of taxes to the central government and retained Building a rules-based framework for private sector the rest. In 1994 China introduced a new system requir- development is a long and complex task, as many ing the central government and each local government developing countries have found. Yet it is an essential to collect their own specific taxes. Under this system, step toward ensuring that barriers to entry, an uneven provincial governments may collect 25 percent of the playing field, and all the other obstacles private sectors value-added tax, sales tax, personal income tax, corporate face are removed as efficiently as possible. Through income tax (of non-SOEs), agricultural tax, property tax, competition, well-functioning markets provide the best and other smaller taxes. As a consequence, tension now opportunity for the optimal allocation of scarce exists between China's unitary state and decentralized resources. Furthermore, markets need rules to provide financial system. By law, only the central government equal access and advantage to all participants, to pro- can set taxation policies. Local governments do not have tect the rights of third-party investors, and to provide the right to determine their own taxes as a means of adequate recourse for the resolution of disputes. As increasing their revenues, but they are allowed to collect most governments have found, they themselves play a new fees. The end result is a proliferation of fees that definite role in this structure-one that has changed can be introduced as govemment directives without from that of a player to that of an facilitator, ensuring obtaining legislative approval. that structures are in place that allow markets to work. Most important, the incidence of these taxes and fees China's economy has performed so well in recent years in the private sector has been fairly uneven. Because of in large part because of a high degree of competitive the opaqueness of firms' financial positions (see chap- pressure. This pressure has come from different actors, ter 3), taxes are negotiated rather than levied. For the including provinces and local governments trying to 217 firms in the survey that reported data for 1998, foster prosperity. At the same time, as this report large differences were observed between corporate shows, the transition from plan to market has been income taxes due and actually paid, especially among uneven. State enterprises continue to dominate many firms of different size. Smaller firms paid higher taxes key sectors, and a number of barriers to entry into than larger firms, which enjoyed many more tax breaks. various markets still exist, despite economic reforms. The size of a firm had an even more unequal impact A serious weakness has been the slow pace at which when it came to the schedule of fees: smaller firms a rules-based structure has developed to fortify the faced average rates of 4.8 percent, in comparison with business environment. This has given rise to various the 1.9 percent faced by the largest. This was reflected in distortions, which make it all the more difficult for the degree of the firms' reported unhappiness with their the private sector to acquire formal status. Instead, CHINA'S EMERGING PRIVATE ENTERPRISES 43 enterprises are forced to adopt time-consuming strate- needs of a market economy. Yet much more needs to gies to cope with the problems and pressures arising be done. As the responses from the enterprise survey from an opaque regulatory and legal structure. have shown, many distortions exist: in the implemen- tation of existing laws, in the uneven playing field As China continues with economic reform to reduce the between state and private enterprises, in the poor state's direct intervention in markets, the government enforcement of contracts or the arbitration of dis- must be prepared to adopt a new role: it will need to pro- putes, and in the lack of the key oversight institutions vide the institutional and policy frameworks markets needed to protect the interests of investors and to require to function efficiently. Legal norms and proce- guarantee good governance. dures will therefore have to substitute for direct control over economic decisions, not only to encourage compet- China needs to continue with its market-oriented itive behavior and allocate scarce resources efficiently reforms-especially those aimed at improving but also to generate investible surpluses. commercial legal processes, the supervision of the banking system, and the functioning of official China has in fact made a great deal of progress in the regulations-if it is to realize the true potential of its development of legal norms corresponding to the private sector. 44 A RULES-BASED ENVIRONMENT FINANCING DOMESTIC Ua:IIY TT E E N T E 111:IMW firm goes through a financial growth F . I cycle in which its financial needs and options change as the business grows, establishes a track record, and becomes Financing needs/ level of risk less informationally opaque. Start-ups and younger Growth firms tend to rely on insider finance, trade credit, I and family and friends. As the firm grows, it gains i 9 High risk access to intermediated finance on the equity side / (venture capital) and on the debt side (banks, Going public finance companies). Eventually, if the firm continues nkfinance to exist and grow, it may gain access to public equity and debt markets (figure 5.1).' The financial growth Development cycle model implies that a private sector populated by firms at different stages of development needs a diversified financial system to support its continued Early stage growth. This chapter considers the main sources of Seed capital financing for private firms and some of the key fac- Family tors affecting a private firm's access to financing, 0 Time Idea Business Business Industrial particularly bank lending. development creation development production Access to Bank Lending SME Largecompany + Data on total lending by ownership are hard to come by in China, but the People's Bank of China (PBoC) Access to Private Equity does publish figures on working capital lending by ownership. According to this time series, fully three- China lacks a developed organized private equity mar- quarters of all loans from Chinese financial institu- ket to provide long-term capital to private SMEs. At tions are classified as working capital loans.2 present, there are no regulatory guidelines defining the Although the share of working capital loans from legal/organizational structures available for the estab- banks and other financial institutions outstanding to lishment of private equity funds. As a result, would-be the private sector (including individual firms) has fund promoters, generally local governments interested grown substantially over the past decade (figure 5.2), in developing their high-technology sectors, often set at the end of 1998 it was still less than 1 percent of up limited liability corporations as investment vehicles. total lending. Although this time series certainly China has approximately 92 such venture capital underreports the private sector's share in bank lending investment corporations, with RMB10 billion (US$1.2 (owing to classification and consistency problems), it billion) in funds, of which about RMB25 billion nevertheless suggests that the share of lending to the (US$300 million) has been invested at home and private sector is low, particularly when compared abroad. Insurance companies and pension funds are not with the sector's contribution to employment and permitted to invest in nonlisted securities. Increasingly, GDP (see chapter 2). large SOEs are among the most active domestic legal CHINA'S EMERGING PRIVATE ENTERPRISES 45 Figure 5.2. SIiort-term Loans t rivt ntepies,1991-98 : X0 000j0: Percent Percent 0.9 50 | 0.8 _ 3 10 0.7 4 U) 0.6 W I 0 0.0 ' ' : , , O I30 0.5 25 19 I 0.4. 20 0.3 0.2 ~~~~~~~~~~~~~~~~~~~~~15 0.2 ~~~~~~~~~~~~~~~~~~~~~10 0.1 5 0.0 p0 1991 1992 1993 1994 1995 1996 1997 1998 I 1. Private enterprise loans as a share of all loans from all banks (left axis). i 2. Private enterprise loans from state banks as a share of private enterprise loans from all banks (right axis). I 3. Private enterprise loans as a share of all loans from state banks (left axis), Source: Almanac of China's Finance and Banking, 1999. investors in non-state firms. Some of these, especially Until recently, China also had several regional stock listed companies, have stepped in to provide venture markets for small and medium-size firms. These capital, primarily for hi-tech growth companies.3 markets were recognized and managed by local Securities firms, asset exchanges, and trust and governments, and many of them ran quite well and investment companies currently play a limited role in helped local firms finance their growth. During its facilitating private equity financing to private enterprises. reform of financial markets, however, the central government closed these regional markets. Non-state Access to Public Equity Markets firms unable to list their own shares are now trying to gain access to the market through the purchase of a To date, China's stock market has served primarily to controlling (often relative rather than absolute) interest finance SOEs and to enable them to take the first halt- in an SOE (table 5.2). ing steps at diversifying their ownership. As a result, pri- vate firms have had limited access to the stock market. In March 2000, the Chinese Securities Regulatory Although no explicit rules in the Securities Law or in Commission announced that the quota system on list- administrative regulations prevent non-state firms from ings would be abolished and underwriters would now seeking public listing, the quota system and size determine the timing and pricing of new issues. This requirements limit the number of private firms that welcome news suggests private firms will have greater make it to the stock market, either through initial public opportunity to acquire long-term funding through the offering (IPO) or by buying into listed companies. Of equity market. During the current transitional period, the 976 companies listed on the Shanghai and however, many SOEs previously approved for listing Shenzhen stock exchanges, only 11 are non-state firms under the quota system have yet to come to market. (table 5. 1). In 1998 and 1999, a total of only four non- This is creating a bottleneck in offerings and preventing state-firm IPOs took place. non-state firms from coming to market. 46 FINANCING PRIVATE ENTERPRISES T-able 56.1-. Non-State Firms Listed via IPO Firm {viouzands o e~ass) D-t'OU n fiatn Business Shenzhen Exchange Wanxiang Qianchao 21,758 1994 Auto parts Shisi Xinfa 6,798 1996 Conglomerate Hena Sida 8,875 1996 Electronics, Instruments Lasha Pijiu 6,600 1997 Alcohol New Hope 14,002 1998 Agriculture Shanghai Exchange Dongfang Group 35,479 1994 Conglomerate Xinfu Industry 31,280 1996 Clothing Xinchao Industry 14,336 1996 Textile Jiahe Gufeng 12,750 1997 Agriculture Fuxin Industry 15,070 1998 Biomedicine Haixin Keji 19,800 1999 Computer Source: Gao arnd Xu 2000. Table 5.2. Non-State Firms Buying Listed Companies Seller ~~~~~~~~~%W60 4." o nO 8t-yer s Huali Gaoke Stone Group 2,300 13.4 1995 Machinery Hi-tech iXiang Huoju Xinjiang Delong 3,000 13.5 1997 Industry Real estate Yinghe Dongli Yinghe Gaoke 2,058 29.0 1998 Auto parts computer iTiange Group Fubei Zhengchang 3,000 20.9 1998 Clothing Hi-tech, agribusiness IJinlu Group Sichuan Santong 3,568 12.2 1998 Chemical Building materials Liao Wuzi Shengyang Yingji 4,663 35.9 1998 Trade Tourism, Real estate Shen Jingxin Guangdong Yi'an 1,923 26.1 1999 Real estate Information technology Source: Gao and Xu 2000. CHINA'S EMERGING PRlVATE ENTERPRISES 47 Table 5.3. Sources of Financing for Sample Firms, 1byi a _ D >anS Institn Other A#l 90.5 4 2.6 2.9 By CRtY Beijing 96.1 0.3 2 1.6 Shunde 87.1 6.5 6.4 0 Chengdu 91.5 2.8 2.1 3.6 Wenzhou 97.3 1.1 0.1 1.5 By Yas of operation < 3 years 92.4 2.7 2.2 2.7 3-5 years 92.1 3.5 0 4.4 5-10 years 89 6.3 1.5 3.2 > 10 years 83.1 5.7 9.9 1.3 Source: Survey Access to Financing sectoral characteristics and different degrees of infor- among Sample Firms mational opaqueness, all of which affect access to financing as well. About 80 percent of the firms we surveyed consider access to financing a moderate or major constraint. Sources of Financing About 40 percent consider it a major constraint, the for Sample Firms second highest after weak market demand. To the extent that the state of market demand reflects invest- The firms in our survey started their businesses relying ment opportunities, this result implies that practically almost exclusively on self-financing (table 5.3). More any sample firm with some investment opportunities than 90 percent of the initial capital came from the perceives access to financing as a major constraint to principal owners, the start-up teams, and their fami- its development. lies. 'Ihe reliance on personal savings is especially pro- nounced for the cities of Beijing and Wenzhou, where Access to financing correlates with firm size and the share of self-financing in start-up capital exceeds legal form of organization (figures 5.3 and 5.4). 95 percent. This finding is consistent with the finan- About 30 percent of larger private firms (having more cial growth cycle pattern. than 500 employees) consider access to financing a major constraint to their development, whereas Comparisons with other similar surveys (table 5.4), about 40 percent of the smaller firms (having less however, indicate that Chinese entrepreneurs have to than 51 employees) think so. rely to a greater extent on personal savings and insider financing for start-up capital than do their counter- In the case of organizational structure, about 49 per- parts in transition economies. The Chinese pattern of cent of sole proprietorships and 28 percent of corpora- financing start-ups, revealed by the survey, is also tions in the sample mention access to financing as a markedly different from recent findings on sources of major constraint to their development. Form of own- financing for U.S. small firms (86 percent of U.S. ership, while clearly related to size, may also reflect sample firms have fewer than 10 employees). Even 48 FINANCING PRIVATE ENTERPRISES Table 5.4. Financing for Private Businesses: Results from Srn eysV. in Transition Economies Russi not"wbHGO l4ungary Polartd (St. Peters trv) f,'> . Year study conducted 1992 1991 1991 1992 1999 Sample size 121 106 93 99 95 (number of firms) Average firm size 42 44 32 74 200 (number of employees) Reliance on personal 54 85 n.a. 66 79 savigs In start-up (0%) Bank loans at start-up (%) 66 9 n.a. 22 5 Received at least 75 43 68 47 67 one bank loan (%) Source: Webster 1993a, b; Webster and Swanson 1993; Webster and Taussig 1999. among the youngest U.S. firms, insider finance does institutions. But these sources played only a minor not take the lion's share: for infant SMEs (from birth role, except in Shunde, where bank loans were more to two years of age), the upper bound of the share of evident. By contrast, SME start-ups in the United insider financing has been about 54 percent (see States receive on average about 30 percent of their initial Berger and Udell 1998). funding from financial institutions, 16 percent of which comes from commercial banks. Start-up firms The firms in our sample indicated that initial capital in transition economies, too, appear to have better was available from various other sources as well, access to bank loans (table 5.4). About two-thirds of including bank loans and other financial or nonfinancial start-ups in the Czech Republic appear to receive Figure 5.3. Access to Financing as a Figure S.4. Access to Financing as a Constraint in Surveyed Firms, by Size Constraitit in Surveyed Firms, by Type !S0 I ~~~~~30 I~~~~~~~~~~3 0 0 <51 51-100 101-500 >500 Sole Partnership l Source: Survey Firm size (number of employees) Sproprietorship ownership frm j Source: Survey.1 1 Source: Survey. P CHINA'S EMERGING PRIVATE ENTERPRISES 49 Table 5.5. Sources of Finance in Surveyed Firms, 1995 and 1998 (percent) |~~~~~an ,t >¢ mJ4% on tkt=X cx a wn ch otat, by year ' 1995 1 1 12.2 10.4 12.6 30.2 21.9 10.7 j 1998 1.3 0.3 9.7 8.3 9 26.2 35.8 9.4 Beijing 0.6 0 3 5.3 11.1 23.1 45.6 11.3 Shunde 0 0 15.9 14.1 7.8 19.6 28.8 13.8 i Chengdu 5 2.1 17.2 8.3 6.2 30.4 28.6 2.2 Wenzhou 2.3 0 17.6 1.7 6.5 43 28 0.9 FIm size (198 < 51 1.1 0.6 3.4 6.3 10.4 22.4 45 10.8 51-100 0.3 0 7.8 11.3 6.1 32.9 31.7 9.9 101-500 2.8 0 16 10.5 7.7 35.2 21.8 6 > 500 2.3 0.4 25 9.7 4.2 30.2 23.6 4.6 Source: Authors' calculations based on answers to survey questions. bank loans, and even in Vietnam, 5 percent use com- including public equity, and public debt markets mercial loans within the first six months after regis- played an insignificant role. tration (Webster and Taussig 1999). Comparisons with transition and developed economies In our sample, the percentage of self-financing in ini- suggest a relatively high reliance on internal sources of tial capital tends to decrease with the age of the firm financing. For example, a recent World Bank survey on (table 5.3). This may reflect the fact that gaizhi firms, the business environment finds that internal funds or being already established, need less initial capital, or retained earnings account on average for 60 percent of rapid development and a longer history of private sec- investment funding in transition economies. However, tor activities have produced more personal wealth. It the share of internal funding is significantly lower in may also be that entry conditions for private firms are advanced reform nations such as Estonia (33 percent), changing. In the early years of China's reforms, an Poland (34 percent), and Lithuania (37 percent). In association with various state institutions yielded valu- the United States, even start-ups and very small firms able "intangibles" in the form of market access, repre- have about 50 percent of their financing in the form of sentation, and protection. outside debt (Berger and Udell, 1998). In the case of additional (post-start-up) investments At the same time, the relative importance of sources for expansions, the sample firms continued to depend of financing in our sample vary significantly across overwhelmingly on internal sources (table 5.5). localities (table 5.5). Bank loans appear to be impor- Retained earnings and principal owner financing tant for private firms in Shunde, Chengdu, and accounted for at least 52 percent of financing in 1995 Wenzhou in 1998, but insignificant for those in and 62 percent in 1998. Among external sources, infor- Beijing. Among the sample firms, those in Beijing had mal channels, credit unions, and domestic commercial the highest dependence on internal sources of financing. banks were about equally represented. Outside equity, Credit unions were quite important sources in 50 FINANCING PRIVATE ENTERPRISES Shunde. Informal channels for financing played an Figure 5.5. Sources of Finance in Surveyed 1 important role in all the cities surveyed, especially in Firms, by Firm Size Beijing. These differences are statistically significant after controlling for firm characteristics such as size, I legal form, and age and hence suggest that local con- , * Financi institutions'debt ditions play an important role in determining a private 70 firm's access to various sources of financing. ' r The relative importance of these different sources of 50 financing appears to depend directly on firm size (fig- 40 ure 5.5). Internal sources tend to become less impor- 0 30 - tant as firms grow larger. External sources for the 20 smallest firms are mainly informal channels, but their '210 share also tends to decrease as firms grow bigger. The 0 share of commercial bank loans, on the other hand, <51 51-100 101-500 >500 increases with firm size and becomes the dominant S Size Source: Survey.S source of external financing for larger firms. Hence, loans from commercial banks tend to substitute for informal financing as private firms grow bigger. statistics on loan applications by the sample firms, Commercial banks become the second most important one-third of these firms applied at least once for loans source of funds for the largest firms, after retained earn- in the past five years, and the success rate was 84 per- ings. This seems to indicate that banks provide more cent. However, a low percentage of firms ever made an support for larger and relatively successful private firms. application, which indicates self-selection in deciding These findings are in line with the financial growth whether to apply for a loan. As table 5.4 reveals, corre- cycle theory outlined earlier (see figure 5. 1). sponding numbers from other transition economies are significantly higher. There are major differences across Although the survey did not collect specific informa- the sample cities in China, however. Firms in Beijing tion on working capital finance and the related issue of had the lowest application rate and those in WVenzhou enterprise arrears, interviews with CEOs revealed that the highest. Firms in Wenzhou also had the highest arrears were common among the sample firms. In cer- success rate. tain cases, particularly among younger firms, arrears problems had a serious impact on firm performance. Effective demand for bank loans, as reflected in loan Large firms were more prone to defer their payments applications, tends to increase with firm size. Only 17 and were in a stronger position to request cash pay- percent of firms with no more than 50 employees ever ments from small firms in thcir trading relationships. made a loan application, as opposed to 83 percent of firms with more than 500 employees (table 5.6). Larger Abetted by poor law enforcement, which makes the firms also had a higher success rate in their loan appli- practice possible, interenterprise arrears are used prima- cations. This size-related pattern of distribution shows rily to alleviate liquidity problems. Many private firms that larger firms have significant advantages over use such arrears as a substitute for bank loans. Some smaller firms in getting a bank loan. have also learned to handle the risk created by weak law enforcement and to price the business risk associated Information Problems with arrears in negotiations with their customers. Information problems, which are generic to financial Demand for Bank Loans markets, are especially severe for private firms in China. Most of these firms are smaller and younger On average, Chinese banks tend to play a smaller role than their state-owned counterparts and are a higher in the financing of private firms, not only for start-up risk in the eyes of banks. Furthermore, firm size bears capital but also for subsequent investments, This is a clear relationship to profitability. In 1998 about especially the case among smaller firms. According to three-quarters of firms with fewer than 51 employees CHINA'S EMERGING PRIVATE ENTERPRISES 51 Table 5.6. Applications for Bank Loans unit's leader is legally responsible for the truthfulness by Surveyed Firms and completeness of accounting materials. In addition, audited units must provide real material and docu- | lgS t: ments for certified public accountants and should APll never ask accounts offices to produce unreal auditing ct y reports. These documents are supposed to support the Beijing 14 88 processes described in chapter 3, which are creating Shunde 52 90 incentives for private enterprises to formalize. As one i Chengdu 51 71 1l of the main users of financial information, banks have | Wenzhou 70 96 i an important role to play in ensuring compliance with these provisions. rm sZ0 Recently, the PBoC announced mandatory registration < c51 0.17 76 tI requirements with the central bank's national credit 51 -100 0.46 78 i database for corporate borrowers. In effect, corporate 101 - 500 0.63 87 borrowers will be "licensed" to borrow through the > 500 0.83 88 issuance of a "borrower's card." The requirements will make the central database more comprehensive and Source: Survey. prevent companies with poor records from getting loans or using the same collateral for multiple loans. The licenses will be renewed on an annual basis, except for borrowers having payment problems or fail- reported they were profitable, but the figure rose to 93 percent for firms with more than 500 workers. Having ing to meet certain requirements; they will be barred dperen fi with dor than 500 workers. Hmin from borrowing. China is also constructing a credit developmedt, Xinan ufiriendl politcal andelonomi database for personal borrowers that should help with envlronment,hprive firm havne asesdeliber- credit card, leasing, and housing finance. While poten- ately made themselves more opaque and are especially til borrowers and financial institutions welcome the cautious about revealing information to outsiders. The initiative, its success will ultimately depend on the resulting lack of clear ownership and management central bank's capacity to discourage free-riding behavior structures imposes obvious constraints on borrowing on behalf of participating lenders. (see chapter 3). To add to the problem, banks are unable and lack the incentive to collect and process T C relevant information (for their perspective on these ransaC1ion osts problems, see box 5.1). and Risk Factors At present, the interactions between financial institu- Small and opaque private firms have difficulty obtain- tions and private firms do not encourage the use of ing external financing not only because they represent transparent financial and accounting systems. Taxes high risk and high unit transaction costs, but also and other potential liabilities, as mentioned earlier, are because state policy is somewhat biased against lending an additional concern. By avoiding formal accounting to private enterprises. When a public borrower fails to systems or keeping several sets of books, firms can amortize a loan, the state will almost certainly step in so make auditing difficult or impossible (see chapter 3). that the bank will not have to absorb the entire loss on its own balance sheet (Lardy 1998).4 But when a private Banks are naturally reluctant to accept financial state- borrower fails, banks appear to have no recourse but to ments that cannot be trusted. This is a multidimen- absorb the loss from their own provisions and profits. sional problem that involves the government, market Until the asymmetry in risks associated with different forces, and cultural factors. The revised Accounting types of ownership is eliminated, banks feel they must Law stipulates that every business unit is obliged to be careful about lending to private sector firms. have account books and to keep true and complete records in the books. Every unit must have only one Banks therefore need added incentives to lend to pri- account book (or one set) that reflects its business vate enterprises. One such incentive could be the operations and property situation. Under this law, the expectation of higher returns, except that most banks 52 FINANCING PRIVATE ENTERPRISES in China are owned by the state and face limited com- regime but indicate interest rates need to be liberalized petition, with the result that the profit incentive is further to encourage more lending to private SMEs. weak. Furthermore, the financial sector reforms Further relaxation is expected in preparation for WTO focused on reducing the pace of accumulation of non- entry. For the time being, banks and credit unions are performing loans in the system are making banks more using "creative" ways to circumvent interest rate con- averse to risk. Their policies concentrate on avoiding trols. According to the firms surveyed, state banks loss and show little interest in sharing the rewards of charge an average interest rate of 7.9 percent and cred- riskier but higher net present value projects. Indeed, it unions 11.5 percent. These rates, with transaction the central bank requires all banks to implement a pol- costs factored in, are comparable to the informal mar- icy called "responsibility to individuals," which makes ket rate (the difference is not statistically significant). each credit officer personally responsible for loans. At the same time, most of the mechanisms used to cir- Such a "zero-risk policy" leaves bank employees with cumvent restrictions on interest rates entail additional limited incentive to initiate lending. Adding to their transaction costs, tend to discriminate against smaller reluctance are the controls on interest rates and firms, and are too blunt to reflect differences in the restrictions on the use of transaction and monitoring risk profile of projects. fees, although the government has been gradually relaxing some of these restrictions. Interest rates on Collateral and Guarantees loans to SMEs are allowed to fluctuate within 30 per- cent of the prescribed interest rates, and rural credit One standard mechanism used to alleviate generic cooperatives are allowed to charge interest rates up to information problems associated with debt markets is 50 percent higher than the basic interest rate. Banks collateral and guarantees. This is especially the case are taking advantage of this more flexible interest rate for informationally opaque firms, where it is generally Box 5.1. Lending to Private Firms: Wenzhou Branches of Agricultural Bank of China Wenzhou was an experimental zone for interest rate reform. In the late 1 980s interest rates on loans to private firms were allowed to float. After 1998, the practice was abandoned in favor of a uniform approach to state-owned and private enterprises. Today, about 70 percent of outstanding loans made by the Wenzhou branches of the Agricultural Bank of China are to private firms. The bank has deemed the performance of the portfolio to be satisfactory, with only about 10 percent consisting of problem loans to private firms, which is significantly lower than the national average. According to bank officials, small and medium enterprises in the private sector have difficulties in obtaining external finance mainly because of the following problems: * Uncertainty about the protection of private property rights. Despite important constitutional changes in recent years, there is a long way to go from official proclamations to real results on the ground. * The quality and accounting practices of management in private firms continue to be unsatisfactory. Some firms were found to have three different account books for different purposes, and lowered credit grades at the bank. * Accounting and auditing services are usually rubber stamps. The integrity of the profession is often under question. These problems increase the perception of risk and persuade lenders to remain conservative in their dealings with the private sector. CHINA'S EMERGING PRIVATE ENTERPRISES 53 easier to assess the value of particular assets than guaranteed bank loans, one of which involved a foreign future cash flows. In the United States, 92 percent of trade company as the guarantor. The preferred forms of all small business debt from financial institutions is collateral obviously depend on the existence of func- secured (Berger and Udell 1998). This implies that the tioning markets in the underlying assets and on differ- vast majority of virtually all types of financial institu- ences in the enforceability of creditor rights. tion loans and leases to small businesses-including loans drawn under lines of credit-are backed by col- Although land use rights are commonly used as collat- lateral. In addition, almost 52 percent of financial eral, many private firms do not have their own land or institution debt is guaranteed, usually by the owners of buildings to use in this way. In the absence of a devel- the firm. On bank lines of credit to small business, oped housing market, the houses and apartments are accounts receivable or inventory (or both) appear to be typically low in value, compared with the amount of pledged twice as often as all other types of collateral loan needed. In rural areas, most owners have property combined. In addition, small firms that pledge rights to the house but not to the land, the latter accounts receivable or inventory tend to be younger being owned by the village. In such cases, banks are and have shorter relationships with their lenders, reluctant to accept the house as collateral. An increas- which suggests that this type of collateral is especially ing number of private firms, however, are acquiring important for more opaque firms (Federal Reserve land use rights for terms ranging from 50 to 70 years. Board 1998). The ability to buy land use rights and afford collateral is one of the significant factors behind the size-related According to the sample firms, the inability to meet distribution of loan applications presented in table 5.6. collateral or third-party guarantee requirements is the most frequent reason for not being able to obtain a The use of collateral also entails significant costs, bank loan. Until recently, guarantees were commonly which arise in acquiring the credentials needed to provided by local governments and by other firms. establish the value of a firm's assets. An appropriate However, such guarantees contributed in large part to government branch of land or real estate management the soft-budget constraints in both public and private usually delegates asset appraisal to a commercial real firms, especially in semi-urban and rural areas. estate appraisal firm. After appraisal, firms have to reg- Because the central bank discourages both govern- ister the assets with the government branches in ment and firm-to-firm guarantees, providing collateral charge. Table 5.7 shows the kinds of fees a firm could has become the only way for most firms to obtain a incur in the process. These fees usually amount to a bank loan. Yet many firms do not have the capacity to percentage of the total value of the assets. In addition, provide adequate collateral. About two-thirds of the firms must renew their asset registration on a yearly sample firms regarded collateral as a moderate or basis and pay an annual registration fee in full or in major obstacle to their ability to get bank loans. The part. In many cases, however, the fee is based on the problem is particularly severe for private firms in the value of the property. This gives the appraisal firm an services and hi-tech sectors, where working capital incentive to inflate the value of the property and cre- and intangible assets constitute a large portion of a ates a potential risk to the bank. Repeated and arbitrary firm's capital. fees have greatly reduced the incentive of firms to Banks accept various forms of collateral: land, build- apply for a loan. ings, houses, apartments, cashable saving instruments Bank Procedures and (savings certificates, government bonds), equipment, and sales contracts provided by credible buyers (buyer- Relationship Lending guaranteed bank loans). In practice, however, real estate assets appear to be the most common collateral, Chinese banks often complain about the poor quality of and in some cases the only kind accepted. Equipment projects seeking financing. What they perceive as a is frequently rejected as collateral because of its speci- "bankable" project, however, depends in part on the ficity. In contrast to U.S. and other developed financial procedures they use to screen projects. These proce- markets, China's system makes only limited use of dures, both formal and informal, rely on collateral (and accounts receivable or inventory as collateral. The personal) relationships in evaluating a project and make firms surveyed reported only a few cases of buyer- little effort to determine project intrinsics. Furthermore, 54 FINANCING PRIVATE ENTERPRISES the procedures are inflexible and tailored, partly for his- through greater bank lending to enterprises. Local torical reasons, to the "typical" state-owned enterprise.; bureaucrats, for instance, are finding it more difficult to According to the firms surveyed, applying for a loan is a intervene on behalf of private entrepreneurs in the very bureaucratic and costly process. About 70 percent credit decisions of banks, although anecdotal evidence said that paperwork was a moderate or major obstacle to suggests that local governments are finding new ways to their application for a formal loan. To be able to use their preserve some role in the allocation of financial resources assets as collateral, firms have to do paperwork not only through the banking system.6 Second, the consolidation with the bank but also with the office of notary public, of urban and rural credit cooperatives and of investment the asset evaluation agency, and other related govern- and trust companies is allowing decisionmaking in those ment agencies. Collateral requirements, the cost of the financial institutions to become more centralized and is application process, and relationship banking tend to endangering the "relationship capital" of some private make it especially hard for smaller firms to gain access firms, especially the smaller ones. to financing (see figure 5.6). Other Forms of Financing To alleviate information problems, many potential borrowers establish a relationship with a bank. About 70 The current environment in China still draws private percent of the sample firms indicated that not having a firms to seek financing from providers other than good relationship with a bank was a moderate or serious banks. Of the firms surveyed, most used the informal constraint to their ability to get a bank loan. Establishing market. The stock market and the overseas market and maintaining such a relationship can be costly, espe- played an insignificant role. cially for smaller and newer firms (box 5.2 and 5.3). The Mnlornmae Markel The nature of the relationship between banks and private About half of the sample firms have at some point in entrepreneurs is likely to change, however, in the wake of their history resorted to the informal market to finance recent financial sector reforms. First, some initiatives, their activities. Lending in the informal market has such as the elimination of the credit quota system and several distinct characteristics. First, it usually takes the reorganization of the provincial network of the place among friends or family members. Friends and Central Bank, may break, or at least weaken, the links family members form a closely knit network, and repu- between local government and state-owned banks. Even tation is very important. These factors greatly reduce so, tensions remain between the government's effort to information asymmetry. Indeed, reputation and rela- reform the banks and its desire to stimulate the economy tionship often substitute for the use of collateral. Figure 5.6. Constraints on Accessing Bank Loans among Surveyed Firms, by Firm Size % averring major constraint 40 35 [ Collateral requirements 30 _ Bank paperwork Relationship with banks 25 20 > 10 <51 51-100 101-500 >500 Size of employment Source: Survey CHINA'S EMERGING PRIVATE ENTERPRISES 55 l 0 -. - . - - 000 .- Sa 6 - 0s -0 Second, informal lending is usually of a short-term Third, informal lending has more flexible terms than nature. The primary reason is that individuals face formal lending. Private firms often need money to tight liquidity constraints, hut high interest rates are an complete a production cycle, which can he as short as important factor, too. The short maturities also reduce several days for firms in specific industries. Whereas the risk of default. Thus it is not uncommon for firms formal loans are usually issued for at least six months to buy materials for an order through an informal loan or a year and do not allow a grace period, the term of and then pay it back after the order is settled. an informal loan can vary from several days to a year 56 FINANCING PRIVATE ENTERPRISES and typically do permit grace periods. In fact, the rigidity of formal bank lending is an important deter- and Registration rent to private firms. a . Finally, applying for an informal loan does not require In early 1999, a major state bank organized a much time. A private owner can get a loan from friends m v on fees collected on its or family members in one day. Survey respondents -' iL''Athe process of collateral appraisal and stressed not only the conveniences of informal lending registration. Table 5.7 presents 17 kinds of fees but also the fact that the interest rates charged by a firm may incur in one of China's autonomous formal and informal lenders are much the same, which regions in the process of having its assets means there is no disadvantage to using the informal appraised and registered. A firm may need to market in this aspect. pay up to six or seven of these fees. For exam- 4 ple, a firm that has to use its land as collateral However, the informal financial market encounters needs to pay items 4, 5, 6, 7, 8, and 16. These i serious problems when its scope extends beyond f 1 ~~~~~fees add up to between 0.9 percent and 1.4 friends and family members. The most prominent are default and cheating, which are difficult to con- trol because the parties cannot turn to the law for and conflicting standards may be issued by dif- protection, especially in the absence of written con- ferent government branches at different levels tracts, which is typically the case. Only 14 percent of for the same item. In the case of the land the firms surveyed wanted to use informal borrowing appraisal fee, the standard rate issued in 1999 in the future, yet 49 percent had used it in the past. by the region's Bureau of Prices was set at 0.12-0.16 percent, even though the region's Not long ago, some semiformal financial institutions Bureau of Land Management, the government i such as credit associations organized by county and branch that collects the fee, had set the rate at v township governments emerged in rural areas. They 0.32 percent in 1998. Meanwhile, city L used an q attracted savings by offering high interest rates and outdated standard of 0.16-0.32 percent issued making loans to local firms. Many of them ran into by the region's Bureau of Prices in 1998. serious problems, however, often because of the involvement of local governments. A large portion of the lending went to local TVEs and contributed to the soft-budget problem of these entities. said, is to improve the incentives for managers and employees, primarily through stock options. This is To avert a crisis, the central government decided to shut particularly the case in hi-tech firms, where human down all credit associations. Almost all are now closed, capital plays a critical role in operations. with their debts in the hands of local govemments. Wenzhou is one place where they still seem to be oper- Overseas Financing ating. Wenzhou has a long history of informal financial Though overseas financing remains limited, its role markets and had private banks in the 1980s. Its credit appears to be increasing. Of the sample firms, 23 per- associations were under less govemment influence, and cent wanted to form joint ventures with foreign firms in they issued loans to private firms with hard budget con- order to get capital in the future, and 11 percent said straints. Their good record of management explains in they were willing to borrow from foreign banks. large part why they still exist and shows that semiformal Currently, Hong Kong plays a significant role in provid- financial institutions are viable in such conditions. ing capital to mainland firms. One such firm, MD in Shunde, was first listed in the Hong Kong stock market The Stock Market as H-type (Hong Kong) shares and then in Shenzhen as The stock market has played a very small role in A-type (Shenzhen) shares. It also borrowed foreign financing the development of the 628 sample firms. Of money through its subsidiary in Hong Kong when the this group, only three are listed. However, 15 percent anti-inflationary measures were at their peak in 1995. of the firms planned to finance their business through Some fast-growing firms in Shunde also said they were the stock market. A strong motivation for listing, they considering listing in Hong Kong as H-type shares. CHINA'S EMERGING PRIVATE ENTERPRISES 57 Table 5.7. Fees for Collateral Appraisal and Registration in G Autonomous Region 1. Building appraisal (1) Real estate State Planning Commission 0.03-0.4 appraiser and Ministry of Construction: (1t995) (2) Bureau of Regional Bureau of Prices: 0.2 I3Building Management (1999) (3) Municipal Building Y city Bureau of Prices: 0.01-0.4 In Y city Company (1 999) (4) Municipal Real Regional Bureau of Prices: 0.06-0.2 In L city Estate Appraisal (1996) Center (5) Municipal Building 0.1-2 In Q city Appraisal Center 2. Building collateral Bureau of Building Regional Bureau of Prices: 0.3-0.8 registration Management (1997) 3. Building collateral Building company Regional Bureau of Prices: 0.3-0.8 certification (1997) 4. Land appraisal (1) Bureau of Land Regional Bureau of Prices: 0.12-0.16 Management (1999) (2) Bureau of Land Regional Bureau of Land 0.32 Management Management: (1998) (3) L city Real Estate Regional Bureau of Prices: 0.16-32 Appraisal Center (1995) 5. Land collateral (1) Bureau of Land Regional Bureau of Prices: 0.16 At least RMB 300 registration Management (1998) (2) Bureau of Land Regional Bureau of Land 0.03-0.3 Management Management: (1998) 6. Land collateral Bureau of Land F county Bureau of Land 2 Returned after insurance Management Management: (1998) loan repaid 7. Land transaction Bureau of Land Regional Bureau of Prices: 0.25-5 registration Management (1998) 8. Land collateral L city Bureau of Land Regional Bureau of Prices: 0.15 In L city certification Management (1995) 9. Equipment L city Asset Appraisal State Bureau of State 0.4 In L city appraisal Institute Asset Management and State Bureau of Prices document 10. Equipment Local BICM National BICM and Ministry 0.1 collateral registration of Finance: (1999) Local BICM L county Bureau of Prices: 0.05-0.2 In L county (1998) 1 1. Equipment Local BICM L county Bureau of Prices: 0.1 In L county collateral certification (1998) 12. Property appraisal Bureau of Building Regional Bureau of Prices: 0.4 Management (1997) 13. Property Bureau of Building Regional Bureau of Prices: 0.1 registration Management (1997) 14. Building Local BICM Regional Bureau of Prices: 0.2 transaction (1997) registration 15. Building P County Real Estate 0.32-0.8 In P county transaction Transaction Center certification 16. Contract Local BICM Regional Bureau of Prices and 0.1 Maximum certification Bureau of Finance: (1994) RMB 3,000 17. Collateral property Y City Insurance 0.43 InY city insurance Company 58 FINANCING PRIVATE ENTERPRISES Overseas financing is not used that much, largely access to financing, which is especially problematic because of China's restrictions on foreign banks in its for smaller firms. Private firms in the sample tend to territory. Only recently have foreign banks been allowed rely predominantly on internal sources of financing, to issue renminbi-denominated loans. In addition, to both for start-up capital and for subsequent invest- getting a loan denominated in a foreign currency, a ments. Compared with their counterparts in other domestic private company has to obtain government transition economies, Chinese private firms appear approval and be included in the country's foreign reserve to depend to a larger extent on internal sources of management plan. It is very difficult for even an SOE to finance and have more limited access to bank loans. obtain such approval, let alone a private firm. This poor access to bank loans is in part the result of policy-induced biases against lending to private Conclusion firms; inherent information and risk problems related to the size, age, and informality of private companies; Many factors have contributed to the financial posi- and inadequate capacity, procedures, and incentives tion of the firms surveyed, a primary one being difficult on the part of banks. CHINA'S EMERGING PRIVATE ENTERPRISES 59 T he preceding chapters have described the An Agenda for Entrepreneurs emergence of China's domestic private sector, the evolution of the policy and regulatory Now that the government has begun to rationalize the framework, the availability of financing, and forms of registration available to private enterprises, the resultant structure of private enterprises. Though businesses need to take on more appropriate forms. partial and preliminary, this analysis points to a number These forms will depend on the size of the enterprise of changes that could help improve government policy, and the stage in its life cycle. enterprise management, and the operations of finan- cial institutions and markets. The smallest enterprises will require less change- the prevalent model of owner-managed, closely held Together, they could help unleash the full potential of family enterprises will continue to suit them. For the domestic private sector to contribute to China's larger companies, the greatest scope for building the economic development. This concluding chapter draws business, expanding the management team, and out these implications from the preceding chapters and obtaining external financing lies in establishing a presents an agenda for the future for entrepreneurs, the limited-liability shareholding company. International government, and the financial sector. experience shows that sole proprietorships, collec- tives, and partnerships generally do not function effi- As indicated earlier, China has already taken a num- ciently beyond a fairly small size. Even in activities ber of important steps to support the growth of the that accommodate large partnerships, such as law domestic private sector. These range from the and accounting, the international trend is toward Constitutional Amendment recognizing the role of limited liability (for example, along the lines of the the private sector to the World Trade Organization U.S. model of a limited liability partnership). In agreements opening up more sectors to private enter- high-growth economies, a large proportion of small prises. Membership in the WTO will open domestic enterprises in high-growth industries are incorporated private enterprises to greater competition in the and therefore benefit from limited liability, transparent Chinese market as well as to new opportunities to financial reporting, and corporate governance from compete internationally A principal feature of VVTO an early stage in their life. membership is compliance with a rules-based frame- work for industrial policy. A rules-based framework Cities such as Wenzhou and Shunde have made will also help domestic private enterprises. rapid progress in the transition to shareholding com- panies. The benefits of this can be seen in the rapid At the same time, the sector's striking achievements growth and adaptation of these enterprises (for an are due in part to the efforts of the sector itself, for example of one such firm, see box 6.1). For many pri- until recently private enterprise has functioned under vate enterprises, this transition will prove a challenge. policies and regulations of a constraining nature (see Growing out of getihu, TVEs, or collectives, they may chapter 3). But the environment is now changing, and not have clearly defined assets or ownership struc- enterprises will have an opportunity to build more tures. Their first task should be to establish the appropriate structures as they grow and mature. They assets and liabilities of the enterprise and the identity will need more than that, however, in order to be able of the beneficial owners. The equity needs to be allo- to compete for financing, skilled employees, and mar- cated to individual shareholders. Meeting the legal kets on an open market: they will need to move toward requirements of the new form of enterprise may be global best practice. another challenge, particularly if formalization 60 AGENDA FOR THE FUTURE Box 61 Caigshareholders, one of which is to manage the company Governance In Private Firms a m transparently and in their best interests. Where outside equity is sought, it is especially important to adhere to | ~~the required governance standards. In Wenzhou city, private enterprises have ta oped quickly and dominate the local econo Beyond what is required by law, improvements to cor- Most private firms are owned by an individ porate governance will help the enterprise grow and ; a family and also managed by the owners. adapt to a changing environment. Under a well- However, many firms that have grown larg defined management structure with a framework of changing ownership and internal governan clear accountability and incentives, authority for busi- ness decisions can be delegated more readily. Such TZ, a private firm established in 1990, beci delegation is important for the successful management * E~ 7#- after just nine years of growth, of a large business. It will also ease the problem of l E l million (US$24 million l transfer of ownership from one generation to another. * - *0 * j* 8-'mrd¶f 3,000 employe ad three episodes of internal restructurin Financial Disclosure 1994 it converted from a solely owned sm China's law of incorporation imposes limited financial private firm to a company. disclosure requirements. These may be a step forward for many enterprises but are still much more limited Several senior managers became owners. than international best practice. Improved financial dis- 1997 it changed into a shareholding comp closure allows investors, suppliers, customers, and issuing 50 percent of its shares to 50 midd other business partners to make a fair assessment of the level managers. In 1999 it bought the large financial condition of the enterprise. This reduces the parts of the shares of 1 0 member firms an risk premium that such parties would otherwise charge made itself the shareholding company of for doing business with the enterprise and hence lowers A firms. Thus it was able to integrate these sr l business costs while improving profitability. factories into a large one. Enterprises that hope to attract foreign investment or to trade in intemational markets should aim to follow inter- These changes enabled the company to national financial disclosure standards. As the domestic recruit experienced managers from outsid market opens to intemational competition under the improve its management, to reduce the m WTO agreement, domestic enterprises will compete agement cost, and also to expand its size more and more with firms that have adopted such stan- these two years its total capital expanded dards and so should aim for those standards, too. times, and its sales expanded four times. share of the domestic market and its exp Before firms can adopt such standards, they need appro- increased. Technical innovation in the comp priate internal financial systems and controls to ensure also accelerated. The company now alloc. more accurate, timely financial reports. They will also 1-2 percent of its total revenue to researc have to observe higher standards of external auditing to and development of new products. vouch for the accuracy of those reports. Again, the dis- closure standard will depend on the size of the firm, the dispersion of its ownership, and its maturity. Investors expect large, mature companies to provide more infor- imposes new tax and regulatory requirements. Firms mation than young, closely held, small companies. undergoing these changes will require careful man- agement and professional advice. Subsidiaries and Conglomerates To make corporate governance simpler and more trans- Corporate Governance parent, many enterprises will need to reorganize the New corporate forms imply new formal structures of complex structures of holding companies and affiliated corporate governance. In particular, incorporation as a companies they have built up. The opaqueness inher- joint-stock company creates responsibilities toward ent in such structures may have been beneficial for an CHINA'S EMERGING PRIVATE ENTERPRISES 61 informal enterprise but is a handicap for a formal one. partners. Foreign partners will increasingly view such Firms of this nature find it more difficult to define alliances on strictly commercial terms, rather than as a their assets and liabilities, to report financial perform- required step in complying with investment and compe- ance lucidly, and to assign clear management responsi- tition regulations. Chinese enterprises should do likewise bilities and performance measures. Thus, improving and take stock of the business value of joint ventures. corporate governance will in part involve restructuring related enterprises into a single corporate structure, or Similarly, private firms should rethink their alliances separating companies into wholly separate enterprises. with SOEs as the influence of SOEs on government regulation and markets declines. Again, the driving Such transformations should be driven by business force should the business case for partnership, rather efficiency rather than by the incentives created by a than the advantages in dealing with government regu- distorted regulatory and policy environment. As the lations or gaining market access. government pursues its reform agenda, these incen- tives will change, especially as China integrates into Supplier and Customer Relationships the global economy. The general direction of change As the legal enforcement of contracts improves, busi- will be to reduce the distortionary impact of govern- nesses will have greater opportunity to trade at arm's ment policies and regulations. This will leave enter- length with customers and suppliers. Although this will prises freer to structure their businesses according to increase market efficiency, individual companies will commercial imperatives. benefit only to the degree to which they are prepared to go out and seek new suppliers and customers. As the government becomes less involved in determin- ing market access, reduces the distortionary impact of Market Entry and Competition policies and regulations, and reduces the role of SOEs As government control over market entry declines, in many markets, the risk of focus will decline. As cap- private enterprises will have greater access to most ital and labor markets improve, there will be fewer markets. Their choice of markets should be based on advantages to obtaining capital and labor from within a an assessment of their own competencies and conglomerate, and the inefficiencies of managing resources rather than on external regulations. This across multiple industries will be revealed by competi- implies that companies should devote more attention tion from firms that obtain their capital and managers and resources to building up resources and compe- from the market. tences that provide competitive advantage, because they cannot easily be replicated by others. For example, Competition will also come from foreign companies. they could do this by relying on proprietary To stand up to this competition, China's enterprises technology or designs, either self-developed or licensed, will have to show the same focus and efficiency as for- rather than by using widely available (whether legally or eign companies. The trend among conglomerates through piracy) technologies or designs. worldwide has been to unbundle them into separate firms operating in different markets, and to recombine An important new opportunity for export enterprises them through mergers of firms operating in similar arises from the deregulation of export marketing, which markets. Global best practice is to seek synergy is allowing more private companies to obtain licenses to between businesses, building on a company's core export directly This gives companies greater flexibility competences, resources, and capabilities. Chinese and control over the marketing channel. To benefit enterprises will compete more and more against for- from this, they will need to build up their skills and eign companies at home and abroad. Most of these are capacity in export marketing. In some cases, this may focused in one or a few related markets, or in markets best be done by entering into partnership with foreign that draw on the same core competences and enterprises that know the export markets better. resources. To compete effectively, Chinese companies will need to show the same focus and efficiency. Management Capacity In order to thrive in more open, competitive markets, Furthermore, the WTO-related opening of domestic many private enterprises will need to upgrade the capac- markets to foreign investors and competitors reduces ity and skills of their managers. Improved establishment the incentive to enter into joint ventures with foreign and corporate structures will help, as they allow firms 62 AGENDA FOR THE FUTURE to reward their most important managers with shares formalization and expanded financial markets in or share options. They also provide a framework for three ways. First, they will be able to lengthen the holding managers accountable for performance, maturity of their debt to better match the maturity of through more transparent financial reporting. their assets. Thus a company with long-lived assets (for example, a toll road) would be better off financing There should also be greater emphasis on the hiring of them with longer-term debt than would a company managers with business skills and on staff develop- with short-lived assets (for example, an easily copied ment. The informal approach of hiring managers with technology). Second, firms will be able to reduce limited skills at low pay and allowing them to develop their debt:equity ratio by issuing more equity, either on the job is not the way to attract or retain much-need- privately or through an IPO. And third, they will not ed talent. A better tactic, as most international firms have to rely as much on personal, government, and have demonstrated, is to follow a structured approach other third-party guarantees but instead can use the to management development to attract and retain the assets of the business, clearly defined and transpar- management skills they need. ently reported. The first step is to identify what kinds of training are in Most firms in China rely to some degree on arrears most demand. Our survey reveals that the top three as a source of working capital. This imposes costs on areas of concern are technical training, accounting and their suppliers that are inevitably reflected in higher marketing, and quality control. Among the firms inter- prices and less willingness to expand supply. By viewed, 59 percent needed technical training, 57 per- reducing arrears on payables, companies can cent needed accounting and marketing training, and enhance their reputation as an attractive customer, 46 percent needed quality control training. and thereby negotiate better terms and have a wider choice of suppliers. To do this, companies need to Labor Relations budget for adequate working capital in raising debt As firms come to rely more on specific skills acquired and equity finance for the growth of their business. on the job or skills that are scarce in the market, labor relations will become one means of retaining necessary Government Relations skills. Thus it will be important to establish adequate As the government moves toward a rules-based envi- mechanisms (whether unions or other means) for ronment, businesses can reduce the amount of time voicing employee concerns, resolving grievances, and and resources they devote to lobbying for special addressing other labor issues. treatment. They will need to comply fully with regu- lations and with tax rules. They can then reduce the Financing time they spend on disguising their activity from gov- As companies formalize, they will have more access to ernment. But government relations will remain external sources of finance. Ownership structures with important as the policy and regulatory environment transparent financial reporting will provide a stronger continues to evolve. basis for borrowing from the banking system, whether the loans are based on assets or on cash flow. The nature of the dialogue will change, though: Transparency is also essential for selling equity through instead of emphasizing the treatment of their indi- private placement or initial public offerings. vidual firm, enterprises should focus on lobbying for regulations and policies that benefit the private sec- Transparency will allow private enterprises greater tor as a whole. The best way to handle government choice in their debt-equity ratios. Some fast-growing relations will be to lobby as a group rather than as enterprises rely heavily on equity. This is appropriate in individtial firms high-risk activities, but as markets mature and business growth levels off, companies should consider leveraging An Agenda for the Government their equity with greater amounts of debt finance. The government's reform agenda should concentrate Many other private enterprises depend excessively on the protection of private property rights, openness on short-term bank debt, often backed by personal or of markets, improved commercial legislation, and the government guarantees. They stand to benefit from tax system. CHINA'S EMERGING PRIVATE ENTERPRISES 63 Commitment to the Protection competitive business and investment environment, of Private Property Rights must be more strictly implemented. Although the 1999 Constitutional Amendment guar- anteed protection to private property, such property Under WTO agreements, China would give "national was not placed on exactly the same footing as state treatment" to foreign institutions in a number of sec- property (which was considered "sacred and invio- tors. Establishing national treatment in such sectors lable"). Private property did not receive the same pro- should therefore be a priority. In this context, prefer- tection under criminal procedure law, for instance, so ential policies toward SOEs and foreign investments that if someone were to embezzle money in a private should be gradually phased out and a policy of national business, that would only be considered a crime of treatments adopted to enable domestic private enter- encroachment on the property of others and not, as it prises to compete with SOEs and foreign firms on an would in the case of state property, a crime of corrup- equal footing. tion (which carries a more severe punishment). Thus a great deal more remains to be done. Foreign trading rights should be extended to all quali- fied private enterprises to allow them to participate The government's commitment to the protection of directly and more widely in China's foreign trade. private property rights is often tested in cases of con- flict between public and private interests. In such cir- Commercial Legislation cumstances, the principle of "no expropriation with- The legal infrastructure for commercial enterprises has out just compensation" is compatible with the rule of room for several improvements. law. However, since typically it is difficult to estimate the intangible benefits of public action, and since Minimum registered capital requirements for forming bureaucrats tend to overestimate these benefits, the a limited liability company should be significantly adequate protection of private property rights may reduced (or eliminated, as in many Western countries). require a bias in favor of the private owner, without To the extent that high minimum capital requirements opening the door to abuse. were felt necessary on account of the high perceived risk of making loans to businesses, this might be Openness of Markets addressed by improving disclosure requirements. China's accession to the VWTO will call for further opening up of private investment and trade. The survey The line drawn between a getihu and a private firm findings provide support for several recommendations. should be erased. It merely creates an incentive for a private owner to remain a getihu for the purpose of In most sectors, existing restrictions on private sector minimizing taxes. Furthermore, by continued entry run against the spirit of the rule of law, since they reliance on the TSRIPE to govern getihu registration, are typically based on irrelevant distinctions. It is rarely the system perpetuates an anomaly in China's laws the case that the form of ownership should be part of for business operation. the ascertainable qualifications to perform specific economic activities. Therefore, all sectors in which form The scope for official interference and substantive of ownership in the above sense is an irrelevant distinc- review in the registration of private enterprises must be tion should be open to private investors. Furthermore, it significantly reduced. The new laws (Company, is urgent to unify the treatment of market access across Partnership, and the WIOEs) contain some provi- localities, especially since this would be required under sions-such as the need for excessively specific defini- a WTO membership. Adjustment programs in various tion of business scope and for approval of changes in sectors (see chapter 4) should also be examined for their business scope, site, "necessary conditions for produc- impact on private sector entry. More active involvement tion" and a "lawful enterprise name"-that open the of private enterprises should be encouraged, for exam- possibility for bureaucratic interference in the registra- ple, through mergers and acquisitions. tion and establishment of private enterprises. These provisions need to be significantly relaxed, in line with The Law on Protection against Unfair Competition, international practice, so as to reduce the scope of enacted in December 1993 to create a fair and bureaucratic discretion, or altogether eliminated. 64 AGENDA FOR THE FUTURE Box 6.2. An Anecdote against individually owned enterprises. These individual about the Registration Process investors that looked liquid previously suddenly seemed unable to pay off debts. We were told the story of an entrepreneur who ewaere tol then aesturyfant entreprthenmeur ho - There is also an urgent need to unify Bankruptcy Law wanted to open a restaurant under the name of in China and to restore the normal priority of credi- "Paradise in the Real World." In Chinese, the tors' claims. Bankruptcy regulations are one example name has four characters, but the Bureau of of different treatment of different forms of enterprise Industry and Commerce asked the name to be in the area of law. Bankruptcy Law applies to state- changed to two or three characters. The entre- owned enterprises, and the PRC Civil Procedure Law preneur asked whether "The Paradise" was contains bankruptcy provisions that apply to "an acceptable. The bureau said, "You are on the enterprise with legal status" (see chapter 4). The line earth so you cannot be registered as 'The between the scope of the two laws is not clear, since Paradise."' The entrepreneur responded, "'The many SOEs are also persons. The definition of an Real World' must then be a good name." "No" the SOE is not a trivial question, since stakes in many for- bureau said, "since we are all in the real world, mer SOEs have been sold to non-state enterprises and that name is not appropriate, either." After several the public at large. Furthermore, the two laws differ dinners and bribes, the entrepreneur was able to substantially in areas that affect creditors' rights. convince the bureau that "Paradise in the Real Under the Bankruptcy Law, for example, bankruptcy World" was an acceptable name after all. is not available if an enterprise is "public" or has "important bearing on the national economy and the people's livelihood." In those cases, relevant govern- ment departments "will provide economic assistance or Removing unnecessary entry restrictions for private take other measures to assist in the discharge of liabili- enterprises, as discussed above, would probably ties." The law also gives the bankrupt's department in eliminate the raison d'etre for the requirement to charge two years to fashion a reorganization and there- define a narrow business scope. Box 6.2 provides by delay bankruptcy proceedings. The definition of a anecdotal evidence of how such vague provisions can state-owned enterprise also determines the applicabil- be used by local bureaucrats to obstruct the normal ity of additional regulations (Supplementary Notice on registration process. Issues Concerning the Trial Implementation in Several Cities of State-Owned Enterprise Bankruptcy and The five-year period of unlimited liabilities for wholly Merger and Reemployment of Workers, of March individual-owned enterprises following a liquidation 1 997) giving workers first priority in the distribution of should be eliminated. This period seems excessive, and recovery proceeds. This dual-track approach to bank- such unresolved potential liabilities may act to dis- ruptcy could undermine creditors'rights. courage entrepreneurial activity To force entrepre- neurs to accept personal liability until their business Tax System can reach the minimum size required to form a limited As survey results indicate, small and private firms liability company would appear to discourage start-up experience a number of problems arising from the cur- activity or place entrepreneurs at unreasonable high rent tax system and the government's collection of fees. risk of losing their personal property and that of their The following policy changes and reform measures are families to creditors. recommended to deal with these problems: Furthermore, it would be difficult to enforce this provi- * The government should begin a systematic effort to sion in practice. Up until now, China has not had a fully simplify the system of fees and taxes levied on the pri- developed industry that investigates another person's vate sector. The fact that local governments are not personal property. Anonymous banking, among other allowed to adjust the rate of local taxes or create new things, made such investigations impractical in the taxes to meet their needs has in many cases encour- past. In recent years there have been a number of cases aged them to impose arbitrary and nontransparent in which creditors sought to enforce court judgments fees. As a result, the burden on firms is uneven, both CHINA'S EMERGING PRIVATE ENTERPRISES 65 in terms of size and location. To rationalize and sim- a diversified financial system with the institutions, plify this system, it will be necessary to decentralize instruments, and technologies required to solve differ- some taxation powers and rights to revenue, where ent types of information and risk allocation problems. appropriate, and to make policies more consistent across locations. Improving Private Firms' Access to Bank Lending * The tax system needs to be made more transparent The recommendations here can be summed up as and equitable in its application across firms, and arbi- follows: establish a level playing field in providing trary interpretations of tax laws and regulations access to bank loans, strengthen banks'incentives to should be avoided. Rent-seeking behavior in all forms lend to private enterprises, monitor the impact of by government officials and departments must be consolidation of enterprises on incentives for SME strictly prohibited. The key ingredients of reform here lending, further liberalize interest rates, allow banks are clear rules, capable of simple enforcement, and to charge transaction and monitoring fees, and specialized education and training. One important improve incentives in credit guarantee schemes and step would be to clarify or eliminate vague provisions the management of risks. in various laws (see chapter 4) which provide oppor- tunities for government interference in private eco- Establish a level playing field. Recent financial and nomic activities. SOE reforms have made significant progress in harden- ing budget constraints on SOEs and reducing govern- * The quality of accounting and auditing services ment interference in bank lending. However, strong should be encouraged to improve to meet the increas- forces are still keeping the playing field uneven when it ing needs of private firms, especially small firms. comes to access to bank loans. There is ample evidence The role of the government would be to insist upon that local governments continue to extend explicit or transparent reporting of financial data according to implicit guarantees for bank loans to enterprises with clearly defined standards, to support education and state ownership and find other ways to influence bank training in related fields, and to facilitate the devel- lending in favor of state-owned enterprises. opment and operation of professional firms provid- ing these services. Disincentives regarding lending to private companies can also reflect implicit biases against non-state firms An Agenda in older and new legislation. Chinese legislators have been trying to keep pace with the rapid developments Ifor the Fi nanci| al Sector in the real sector and the changing forms of ownership. Important parts of existing legislation, some of which According to the survey results, one of the most seri- have a direct impact on access to financing, are explic- ous problems for private firms is access to financing. itly or implicitly aimed at SOEs in transformation Existing constraints arise from a complex set of factors. rather than at newly formed companies. Bankruptcy Some originate in lingering policy biases against lend- regulations (see chapter 4) are an example. ing to private enterprises; others relate to internal char- acteristics of the private sector, such as the smaller size Furthermore, bank culture still fails to consider a bad of its enterprises, its informational opaqueness, and loan to a state-owned enterprise to be as serious as a the weaknesses of management and governance. A bad loan to a private enterprise. Expectations, rein- third set of factors has to do with the underdeveloped forced by recent experience with the asset management nature of the financial sector. Although all of these fac- companies, are such that when a public borrower fails tors are taken into account in this section, the empha- to amortize a loan, the state almost certainly will step sis is on issues pertaining to the development of the in so that the bank will not have to absorb the entire financial sector. loss on its own balance sheet. Private borrowers obvi- ously do not benefit from the same kind of expectations. The existing universe of private firms in China has Until this asymmetry in the risks banks face in making reached a point at which different types of financing are loans to firms of different types of ownership is eliminat- needed to coincide with the various stages of develop- ed, banks will consider it rational to discriminate against ment in which the firms find themselves. This calls for lending to private sector firms. 66 AGENDA FOR THE FUTURE Strengthen banks' incentives. An important step here measure is not likely to have a significant impact on would be to strengthen profit incentives through private the borrowing costs of these firms. Most private enter- ownership and competition. At present, the ownership prises that are able to borrow already pay effective structures of the real sectors,do not balance with those of interest rates that are significantly higher than the ones the financial sectors. Private ownership in the financial prescribed by the Central Bank. Entrepreneurs also sector is practically nonexistent. The government should indicate that access to financing is more important allow the entry of new domestic private financial institu- than the costs of funds. tions, especially in view of prospective WTO member- ship, which will open up entry opportunities to foreign Allow banks to charge transaction (and monitoring) financial institutions. To alleviate regulatory concerns, fees. Although this recommendation is related to inter- particularly in the light of recent financial crises, stricter est rate liberalization, it has other important dimen- entry and prudential requirements could be applied to sions. Banks find that lending to private companies, new private financial institutions in the initial period. the bulk of which are smaller and informationally more opaque, carries higher unit transaction costs. Private financial institutions are likely to be more Therefore, if they use uniform procedures that do not independent of political considerations and more differentiate between different types of borrowers, profit oriented. They are not likely to compete directly they are likely to discriminate against small firms. with existing state-owned banks, although increased Transaction fees would, to some extent, unbundle the competition through new entry will have an invigorat- decision to look at a project proposal from a credit ing effect on the state-owned financial sector. New standpoint. They would also encourage banks to banks tend naturally to focus on underserved market consider the proposals of a larger number of smaller and niches, especially younger and smaller firms, which informationally more opaque firms. Banks would then constitute the bulk of the private sector today. They do be encouraged to develop a more service-oriented not tend to discriminate among customers on the basis culture and to play an active role in promoting higher of existing relationships, and in their struggle to estab- transparency and better accounting standards. Banks lish themselves in the market, they are more prone to would then need to adopt new procedures and develop trying innovative ways of doing business. skills in areas such as cash flow analysis, project finance, and risk management. The introduction of such fees The big state-owned banks are likely to dominate the would also be an important aspect of the realignment to domestic financial landscape for the foreseeable future. international practices in banking, which seems Strengthening the profit incentives of these banks would inevitable in the light of prospective WTO membership. therefore have a major impact on improving private firms' access to bank loans. Corporatization, listing, and Improve incentives in credit guarantee schemes and strategic partnering with foreign financial institutions improve the management of risks. In the first half of are some of the ways to reach this objective. 1999, the State Economic and Trade Commission issued Establishing Credit Guarantee System Pilot Projects for Monitor the impact of financial sector consolidation Small and Medium-Size Enterprises Guidance Opinion on incentives for SME lending. With consolidation to stimulate bank lending to SMEs. By November 1999, taking place in urban and rural credit cooperatives, rural 70 cities had established credit guarantee agencies with credit funds, and investment and trust company sectors, a total capitalization of RMB4 billion (US$483 million). financial institutions are likely to become larger and These agencies are treated as nonfinancial institutions credit decisions more centralized. Given the important and are outside the regulatory scope of the Central Bank. role these financial institutions play in SME financing, any gains made in terms of financial stability should not International experience suggests that under certain con- have an adverse effect on information and relationship ditions (see box 6.3) such schemes can be successful and capital, which would tend to reduce SMEs' access play a useful transitional role in improving SMEs' to financing. access to bank loans. If properly managed and super- vised, such schemes could help reduce transaction Further liberalize interest rates. Evidence suggests costs for banks, improve current practices of risk pric- that further liberalization of interest rates is needed to ing through more flexible guarantee fees (if those are improve private firms' access to bank loans. Such a allowed to be negotiated between guarantee funds and CHINA'S EMERGING PRIVATE ENTERPRISES 67 borrowers), and alleviate collateral problem faced by assign contractual rights independently of the smaller, mostly private firms. However, credit guarantee assumption of the corresponding obligations and schemes also entail risks, which are potentially high in without the consent of the debtor. China's context. Credit guarantee schemes could be used by local governments as a mechanism for contin- Developing Private Equity Markets uing interference in credit allocation and as a substitute Private equity markets in China, venture capital in par- for policy lending. Also, at present there is little risk ticular, are in an embryonic stage of development. sharing between guarantee agencies and banks, which Indeed, offshore venture capital appears to be a far creates perverse incentives in lending decisions. more important source of capital for start-up compa- Furthermore, the introduction of such guarantee nies in China than domestic venture capital. schemes should not divert attention from the long- Recognizing the importance of private equity markets term issues surrounding the role of collateral in bank for the development of the hi-tech sector, the govern- lending, namely, the need for a system for registering ment has stepped up efforts to stimulate the develop- assets used as collateral, especially movable assets; a ment of these markets. Recently, the Bank of China better system of auctioning machinery and equip- established a RMB1 billion (US$121 million) venture ment, and of creating secondary markets in such fund, and the government has reportedly started work assets in general; and a better system of enforcing on venture capital and investment fund legislation. collateral and promoting the development of project finance and leasing. Establish a legal framework for private equity funds. Private equity funds should be developed Alternatives to Bank Lending within a comprehensive legal framework; transitional Some alternatives to bank lending are leasing and arrangements can speed up the process. At present, factoring. Leasing and factoring are underdeveloped in no regulatory guidelines are available to define the China and play an insignificant role in the financing of legal/organizational structures that can be used to private enterprises. Yet they are useful ways to deal establish private equity funds, known in China as with insufficient collateral and, in the case of leasing, "industrial investment funds." As a result, would-be with the enforcement of collateral. fund promoters, generally local governments interest- ed in developing their high-technology sector, often Leasing. However, the concept of leasing may prove set up limited liability corporations as investment difficult to apply in China: rent arrears have long been vehicles. These corporations issue shares in exchange a problem, China has no leasing law, accounting stan- for investment; funds are then pooled and managed dards are unclear, appropriate tax incentives are not in by a fund manager. The corporation must abide by place, and funding is a perpetual concern. A welcome the limitations of the company law, which does not recent development is the inclusion in the new permit more than 50 percent of capitalization to be Contract Law of a chapter on finance lease contracts. invested in subsidiaries or other legal entities. While This is the first time either national or regional legisla- the 50-percent rule was instituted to prevent siphon- tion has covered the fundamental principles of finance ing of company assets (and is often diluted by a gen- leases. However, the legislation should not be viewed erous appraisal of assets, which effectively raises the as a substitute for a special leasing law, which would 50-percent ceiling), it prevents the corporations from address the issues identified above. investing more than half of their assets in anything other than cash-equivalent securities. Factoring. Liquidity and arrears problems are com- mon among private enterprises in China. Factoring, Certain legal and taxation instruments must also be in under which the factor manages the trade debts of a place before private equity funds can be developed. client company, is a method of improving a company's The most important ones relate to the legal organiza- liquidity by substituting a cash balance for book debt. tion of such funds (whether a joint stock company or Factoring is not fully developed in China. However, contractual), the need for trustees to protect investors provisions in the new Contract Law (effective from the adverse actions of the fund manager, and the October 1, 1999) may stimulate the growth of factor- use of a fund manager and tax treatment to avoid dou- ing and other such international practices in the ble taxation. At present, the rights and obligations of future. The new Contract Law makes it possible to fund investor, fund manager, and custodian are not 68 AGENDA FOR THE FUTURE _rnatio - rnational Practices in Credit Guarantee Schemes for SMEs l i __a * a - ~ ~ ui_ from a review of SME experiences: ila. -, * - M ; the financial sector to provide more credit to i - a a a - a a a ~ credit schemes need to reduce the transaction o * . - a*. V, i reu will forge a cooperative relationship - i a a a. - a. - sirS a high degree of mutual confidence. This will ensure that aa a - - a a... a e|- carry out their respective obligations without delay -IE - a l - a - lu.ha.7. r ruv (leverage in this context means I i a - a a a - - - a -, - e., but not borrowings). Leverage that is too low (two to _- = - a - a a - -. so a - - - Y-~A!I-U~I~r~ that is too high will not provide 4 * a- - -a- a. - a ei13b-wifs to suggest a leverage rate of 5--10, to be reached _ ~~~~~~~~~~~~~~~~44 o - a a - - - ii - 8 ~.consider a 5 percent loan default rate high. They would i_ a - - - . a * a * a . - of the schemes' design need to be reviewed j _, a - - a . - a - a - a . - ~,particularly in the procedure for approving guaran- and the level of the guarantee fund. _ ; I - s a - -- v of the loan. On the other hand, it should still be an Coverage in most successful schemes is 70--75 percent. _r1TAYOM their own independent review. Schemes that -, - - - a a - - - a surogaionrates. ___"Mm collateral they can get: cars, future rev- - - a a a a a ~ The client needs to get the right signal that money is valuable. clearly defined by current Chinese law. As a result, the less as a patron of the companies in which it invests relationships between them are somewhat uncertain, and more as a protector of efficient competitive mar- and the role of a trustee who can represent the fund in kets. As a transitional step, the state could use indirect legal proceedings is ill-defined. The draft trust fund mechanisms to ensure that venture capital flows are law currently before the National People's Congress strong, stable, and accessible to a wide range of com- should provide a significantly clearer definition of the panies, including private ones. The experience of the obligations and rights of the parties. Small Business Investment Corporation (SBIC) pro- gram in the United States exemplifies one transitional Transform the role of the state in venture capital. mechanism to ensure that small companies with The state still plays a ubiquitous role as sponsor, attractive futures but not the high returns demanded of investor, and fund manager. The investment industry private venture capital also have access to pre-listing in general would benefit considerably if the state acted equity capital (see box 6.4). CHINA'S EMERGING PRIVATE ENTERPRISES 69 * * S While venture capital plays an important role in shown, successful initiatives tend to complement financing the growth of small, technology-oriented venture capital rather than substitute for it (see box companies, it also has its limitations. Venture funds 6.5). If carefully implemented, such programs could typically back only a tiny fraction of the technology- play a useful role in promoting the development and oriented businesses begun each year. Furthermore, commercialization of intellectual products and the the structure of venture investments is inappropriate associated protection of intellectual property rights, for many young firms: venture capital groups are an important issue in China today. unwilling to invest in very young firms that require only small infusions. Public programs to provide Broaden the range of issuable equity-related early-stage financing to firms, particularly to high- securities. Investors in venture capital and pre-IPO technology companies, have become commonplace in companies need latitude to structure transactions most many countries. As the Small Business Innovation beneficial to issuing companies and to themselves. Research (SBIR) program in the United States has Risk/return preferences vary, and different securities 70 AGENDA FOR THE FUTURE Box 6.5. The Government as Venture Capitalist: The U.S. SBIR Program Established in July 1982, the Small Business Innovation Research program is designed to address imperfections in the market for the financing of young technology-based firms. Under the program, all federal agencies spending more than US$100 million annually on external research must set aside a fixed percentage (1.25 percent) of these funds for awards to small businesses. When the program was reauthorized in 1992, Congress increased the size of the set-aside. While the 11 federal agencies par- ticipating in the program are responsible for selecting recipients, they must conform to the guidelines stipulated by the act and the U.S. Small Business Administration. Recipients must be independently owned, for-profit firms with fewer than 500 employees and must be at least 51 percent owned by U.S. citizens. Promising proposals are awarded Phase I support (originally no more than $50,000 or less), which is intended to allow firms to conduct research to determine the feasibility of their ideas. Approximately one-half of the Phase I recipients are then selected for the more substantial Phase II grants. Phase II awards of at most US$750,000 (originally US$500,000) are designed to support two years of development work. The funds are transferred to the small firms as a contract or grant. In return for the funding, the company must submit a report on the technology under development. The govern- ment receives no equity in the firm and does not have any ownership claim on the intellectual property that the firms develop with the funds. The program has reportedly had a positive and substantial long-run impact: over a 1 0-year study period, SBIR recipients grew significantly faster than a matched set of firms. The positive effects of SBIR awards were confined to firms based in areas with substantial venture capital activity. This finding sug- gests that public funding did not crowd out private sector investment and was actually complementary to venture capital investment. Source: Lerner (1996). might better fit the needs of the issuing company as shareholding environment and to prevent a control- well. This requires the ability to structure investments ling class from abusing the rights of others. However, using a range of securities, which can be issued by the the failure to acknowledge different classes of company receiving investment. shares, and different rights attaching to such classes, will both stymie efforts to provide sophisticated Permit the issuance of preferred stock. A security financing strategies for investors in Chinese issuers essential to many private equity transactions but not and make it difficult to establish a basis upon which permitted in China is the preferred stock. The cumu- minority holders or investors giving different value lative preferred share satisfies the balance of risk and can be recognized and protected. return acceptable to some investors at a level between that of ordinary common shareholders and that of bank Permit such equity-related securities as options lenders. The lack of provision for such different classes and warrants. Issuers also need to be able to offer of shares seems to deny needed flexibility to the finan- investors quasi-debt securities, which provide current cial arrangements of private enterprises. In limiting income as well as the potential for equity appreciation ownership to a single class of shares, policymakers in the future. Securities of this kind include bonds that originally intended to create a simple and transparent are convertible into shares (currently permitted only for CHINA'S EMERGING PRIVATE ENTERPRISES 71 listed companies), or bonds that carry "warrants," in the two Chinese exchanges.2 Also, they may not meaning the right to purchase a fixed amount of qualify because of poor profitability-though many shares at a predetermined price in the future, and high-technology companies are attractive investments stock options. The PRC Company Law does not pro- despite low profitability in their initial years. vide any basis for the issuance of share options and warrants. In particular, it lacks specific regulations Proposed listing rules for the Second Trading Board regarding authorized but unissued shares or authorized would make considerable progress in this area, as com- capital increases. To the contrary, any single capital panies would not have to demonstrate a history of prof- increase is subject to government approval at the time itability to be listed. Furthermore, their proportion of it is effected. Consequently, it is not possible for a intangible assets could be as high as 70 percent, but company to reserve unissued shares and grant the vested they would be required to disclose their corporate right to acquire such shares in the future. There is like- information every three months. The capital required wise no obvious way to provide debt obligations to to obtain a listing is expected to drop from the main lenders that can be converted by their terms into equity boards' RMB30 million (US$3.6 million) to RMB20 claims against a company. million (US$2.4 million). This is progress, although the need for such a high minimum level of capital can Improving Access to Public Equity still be questioned. A few ways to improve access to public equity would be to broaden and strengthen the range of exit mecha- The establishment in late 1999 of a secondary board in nisms available to investors, relax listing requirements, Hong Kong, known as the "GEM," has provided small simplify share buybacks, strengthen the incentive to non-state firms with a trading venue with less stringent list on the domestic exchanges, and reduce restrictions listing requirements. These include lower income on the sale of founders' shares. requirements, shorter operating histories, and a lower minimum portion of total shares offered at IPO. Several Broaden and strengthen the range of exit mecha- mainland high-tech non-state firms have already been nisms available to investors. Measures that would listed there, and several more are pending. strengthen the securities markets and provide increased access to small firms-such as the expected Simplify share buybacks. An investor must be able to establishment of the Second Trading Board by early sell his shares in the event an IPO is not possible. One 2001-would have a profound effect on pre-listing alternative as part of the investment arrangements investors by signaling that they would be able to sell would to require that a company or its major share- their investments when the time comes.' With the holder buy back the investor's shares at some point in advent of the secondary board and official pronounce- the future. A company buyback would result in the ments of transparency in the listing approval process, cancellation of the shares, and under existing legisla- non-state companies are sure to enjoy more equal tion a company may not repurchase its own shares access to listing. This should water down the except when canceling shares in order to reduce the favoritism historically shown to SOEs on the main company's capital or when merging with another com- boards in Shanghai and Shenzhen. Until then, pany or companies that hold its shares. Otherwise, investors are still likely to see the possible lack of viable cancellation of shares must be subordinated to the exit as their greatest risk, and to eye the possibility of consent of the investor, the other shareholders, and the listing firms in Hong Kong or offshore. company's creditors, either by stipulating the possibility of cancellation in the company's articles of association Relax listing requirements. Listing requirements or through subsequent amendment, which would be could be relaxed, even for new Second Trading Board approved by the stakeholders.3 listing. Although intended to protect investors, listing requirements that are too restrictive may actually con- These rules were instituted to protect the rights of strain private equity investment by raising questions the investor, creditors, and shareholders. In the case about the viability of listing as an exit mechanism if of a company buyback negotiated by the investor, they exclude small but attractive companies. The fact there is no question of any infringement of the that many private firms are too small or have limited investor's rights. Creditors have other means at their operating histories would disqualify them from listing disposal-such as covenants that are intended to 72 AGENDA FOR THE FUTURE prevent management activity detrimental to their markets. Similarly, this restriction can be expected to position-that are far more meaningful than any make listing on the new Second Trading Board less detriment arising from the erosion of capital through attractive than it otherwise could be.5 share cancellation. The means cited above seem suffi- cient to protect existing shareholders. A simple solu- There is a perception in China today that increased tion would be to amend company law to permit share share supply, whether from the sale of founders' shares buybacks from investors unless expressly forbidden by or from the many non-state companies that would list on a company's articles of incorporation (which them- the exchanges if given the chance, would cause an over- selves could be amended by shareholders). supply of shares and bring share prices down. This is unlikely to be the case, given the considerable pent-up Strengthen the incentive to list on the domestic savings that are earning a paltry income in commercial exchanges. It is hoped that the practice of conducting banks; as markets increased in breadth (from new a "rights" offering to existing shareholders, at discounts issues) and depth (from more shares available), they of as much as 40 percent, will be curtailed in favor of would probably become more robust markets and more a broader subscription to new and existing investors stable. Furthermore, there would be fewcr opportunitics alike. This should make offerings more attractive to to manipulate share prices on thinly traded markets. potential issuers while strengthening investor percep- tions regarding the viability of the securities markets as Ultimately, the Chinese securities markets will reach an exit mechanism. a state of development where securities firms con- ducting IPOs on behalf of issuers will determine, on Reduce restrictions on sale of founders' shares. the basis of their reading of investor sentiment Another reason founders and other pre-IPO investors toward share sales by insiders, the appropriate lock- favor offshore listings is the restriction on the sale of up period for founders and other pre-listing founders' shares for a period of three years from the investors.6 Later on, once the company is listed, the date of founding of a firm (which is deemed to include size of share sales by insiders will be regulated by the the conversion of a company to a "company limited by brokers handling the sale, for they will have to shares").4 The reduction of this "lock-up" period for ensure that the downward pressure a large sale founders' shares would make raising capital on the would exert on the shares is mitigated. exchanges a considerably more attractive option for non-state firm owners and managers, whose compa- At present, the general speculative nature of the secu- nies, unlike SOEs, are frequently less than three years rities markets suggests it may be too early to eliminate old at the time of offering. the regulatory requirement and leave the determina- tion of the lock-up period to the discretion of the bro- The purpose of the lock-up period is to prevent specula- kers on a case-by-case basis. Instead, by allowing a tion and possible manipulation by owners of small, often gradual reduction over time in the lock-up period to a unproven companies without the kind of track record span of, say, six months, the regulatory intent of the that would promote a more stable market among more restriction can still be realized, while the disincentive seasoned companies. Nevertheless, the lock-up period to listing from the standpoint of the owner of a non- acts as a regulatory disincentive to listing in the domestic state firm can be reduced. CHINA'S EMERGING PRIVATE ENTERPRISES 73 .0 - Notes to Chapter 1, "Introduction" 1. Throuighout this study, we definie domnestic private sector" as business enterprises under the effective private control of resident Chinese private persons, whatever the legal status of the enterprise orformnal ownership rights. Because data are so limited at present, the survey results cover only a narrow' segment of the private sector; as explained later in this chapter. 2. For obvious reasons, it was not possible to find a database of collectives or TVEs that identified those under private control. Notes to Chapter 2, "Evolution and Status of the Domestic Private Sector" 1. Ten?tative Stipulations on Private Enterprises, Article 2. 2. According to Chinese sources, this seemin?gly arbitrary distinction was based on an? exanmple Marx used in Das Kapital wvith eight people to illustrate the capitalist production process. Marx gives one purely hypothetical example in which the employer has to employ eight people in order to extract enough surplus value to make twice the income of the emnployees, plus the samze again to use as capital (Young 1995, p. 5; Marx, Capital, pp. 291-92). 3. Unless othenvise inclicated, "private sector" refers to getihu and siying qiye. 4. See Table 2.3 for a definition of the true private sector. 5. Several fiactors, suich as systcmaitic differences in reporting and in the degrees of vertical integration, can have distorting effects on these results. The higher capital-to-output ratio in SOEs could be due to t,he concentration of state-owvned enterprises in capital-intensive industries, but disaggregated data suggest otheru7ise. Foocl processing anud textiles are generally less capital-intensive than nuichinery, chemical, automnotive, and electronics industries. In all six of these, SOEs had mnuchl high2er capital-to-output ratios than did non-state enterprises. A 1995 VVorld Bank su7rveyfound that in 37 of 39 industrial sectors, non-state enterprises were more capital-efficient than SOEs. 6. People's Daily, Overseas Edition, October 7, 1999, p. 2. Notes to Chapter 3, "Informal Status of Domestic Private Enterprises" 1. Because "managemnent" mean?t different things to different respondents, we restricted the meaning to t,he top managers or those mnanagers plus nmedium-level maniagers. 2. However, the sample included a heavy concentration of high-tech industry wt,here technical edutcation is particularly valuable, so it may' overstate the average educational attainmnent of managers. 3. Cities like Beijing and Chengdut have also set Up high-tech developmrenit areas or zones with special policy packages in place to attract Chinzese students or scholars overseas to work there. 4. Even amTnotg those who did respond, there m7ay be overreportinig to shout comipliance with governinent policy, thich requires enterprises with more than 25 employees to have trade un?ions. Another survey in 1997found only 3 percent of private enterprises were unionized. 5. Thle Latv of Corporation requires that a corporation have both a Comkinutinist Party organization and a union. 6. This is sucht a pervasive problem? that the 1999 Accounting Law7 explicitly outlasvs this practice (see box 3.3). 7. Issues of enterprise arrears are discussed in detail in clhapter 5. 8. Thte "Star Plan" focuses at? promoting snttall firmis, and the "Torch Plan" ont promoting hig,h-teclt industries. CHINA'S EMERGING PRIVATE ENTERPRISES 75 Notes to Chapter 4, "Toward a Rules-based Environment" I. Catalogue (No. 1) of Projects Prohibitedfor Repeated Industry Investment, effective September 1999, and Catalogue (No. 1) of Outdated Production Facilities, Technological Process and Products to Be Eliminated, effective February 1, 1999. 2. China has 14 national and regional commercial banks, which account for about 5 percent of financial sector assets; 3 policy banks, which account for another 5 percent; 8 relatively small Sino-foreign joint venture banks with I percent; and a large number of urban and rural credit cooperatives, for 11 percent. Notes to Chapter 5, "Financing Domestic Private Enterprises" 1. From data and research on SMEs and largerfirms, this stylized pattern appears to be largely consistent with empirical evidence. This paradigm differs in some important respects, however, from recent findings on SME financing in developed financial markets and in some transition economies. There, youngerfirms have access to bankfinancing, and externalfinancing plays a significant role in afirms life cycle. In the United States, for example, bank debt financing accounts for a surprisingly large share of total financing, even for start- up firms (see Berger and Udell 1998, pp. 9-10). That also appears to be the case in the Czech Republic (Bratkowski, Grosfeld, and Rostowski, 1999; Webster, 1993a, 1993b). Several studies have alsofound that the share of externalfinancing tends to decrease asfirms grow over time (See Berger and Udell 1998). 2. People's Bank of China, China Financial Outlook '99, p. 92. 3. For example, Shanghai First Department Store gave seed money to college students from Qinhua University who were starting a new business in large-screen projected TV In another example, Legend, the biggest PC maker in China, invested in a small software company, Kingsoft Technology, whose software rivals Microsoft Word (see Gao and Xu 2000). 4. The experience of the Asset Management Companies created in 1999 provides supporting evidence. 5. For example, the relationship between state-owned enterprises and banks is typically intermediated by a government "sponsoring" agency. The same is usually expected from a private enterprise as well (see box 5.2). 6. One mechanism consists of "conditionalities" attached to government deposits in commercial banks. Another consists of interventions through the government-sponsored credit guarantee funds. Notes to Chapter 6, "An Agenda for the Future" 1 Trial operations will be carried out on the Shenzhen Stock Exchange, and then trading will begin on the Shanghai Stock Exchange. 2. Size requirements are substantial and will eliminate most small and many medium-size companies: the value of the company before IPO must exceed RMB50 million (US$6 million), of which the value of the "sponsor's" shares must exceed RMB30 million (US$3.6 million). Companies must not only have been profitable in the most recent three-year period but must maintain a sufficient rate of profitability (as measured by the ratio of net income to total assets, which must be greater than the PBoC base lending rate). In addition, the IPO must result in at least 1,000 subscribers. (Other listing requirements, which do not unduly burden small companies in particular, dictate that offerings equal at least 25 percent of preexisting shares, that sponsors must own at least one-third of shares after IPO, and that a maximum debt-to-equity ratio must be met.) 3. The articles of association of a company limited by shares could either define the scenarios that would lead to an automatic cancella- tion of shares or delegate the final decision regarding the cancellation to the general meeting of the company's shareholders. 4. There is no explicit stipulation as to when such a three-year period starts in the case of the conversion of a limited liability company into a company limited by shares. If a limited liability company is to be changed into a company limited by shares, however, it must satisfy the conditions for companies limited by shares set forth in the company law. Promoters (that is, founders) exist as such only from the establishment of the company limited by shares. That seems to indicate that the three-year-period is meant to start from the conversion, that is, from the issuance of the new business license of the converted company limited by shares. The legal situation, however, is not totally clear. 5. Secondary board rules are also expected to have a two-year lock-up provision for management (though the definition of management is not clear) holding more than 5 percent of a companys shares, and six months for "strategic" investors with more than 5 percent. 6. In the United States, for instance, IPO underwriters determine whether to agree to the frequent request by existing shareholders to participate in the IPO by selling some of their own shares alongside the shares to be newly issued by the company. The underwriter must con- sider the reaction of investors to this sale, as it is crucial that such sale is not perceived as a lack offaith by insiders in the companys prospects. Note: US$1 = RMB8.2793. 76 NOTES REFERENCES Berger, Allen, and G. Udell. 1998. "The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle." Journal of Banking and Finance 22 (August), 613-73. Bratkowski, Andrzei, Irena Grosfeld, and Jacek Rostowski. 1999. "Investment and Finance in De Novo Private Firms: Empirical Results from the Czech Republic, Hungary and Poland." Working Paper 236. William Davidson Institute, University of Michigan, Ann Arbor. China, Bureau of Industry and Commerce Management, Ministry of Commerce, Ministry of Grains, National Cooperative of Supply and Sales, Bureau of Materials, and Bureau of Labor, 1981. Directives on Issues of Material Supplies to Urban Individual Businesses, June 22. _____, Bureau of Labor, Bureau of Urban Construction, Ministry of Public Security, and Bureau of Industry and Commerce Management. 1981. Directives on Issues Related to Land Used by Urban Collective and Individual Economy, May 6. ______, Central Committee of CCP. 1980. Directives on Several Issues of the Agricultural Production Responsibility Systemn, September 27. , Central Committee of CCP and the State Council. 1981. Several Directives on How to Use New Channels and New Methods to Solve Urban Employmnent, October 17. __ , State Council. 1981. Policies on Urban Nonagricultural Individual Business, July 7. Djankov, Simeon, Rafael la Porta, Florencio Lopez de Salinas and Andre Shleifer. 2000. "The Regulation of Entry." Department of Economics, Harvard University, Cambridge. Mimeo. Frye, Timothy, and Andrei Shleifer. 1997. "The Invisible Hand and the Grabbing Hand." American Economic Review, AEA Papers and Proceedings 87 (May): 354-58. Cao, Shi-Ji, and Gung Xu. 2000. "Sources of Private Equity Capital for Non-state Firms in China." World Bank, Washington, D.C. Mimeo. Gelb, Alan, Gary Jefferson, and Inderjit Singh. 1993. "Can Communist Economies Transform Incrementally? The Experience of China." National Bureau of Economic Research Macroeconomics Annual. Cambridge, Mass.: MIT Press, 87-133. Harold, Peter. 1992. "China's Reform Experience to Date." Discussion Paper 180. World Bank, Washington, D.C. Jin, Hehui, and Yingyi Qian. 1998. "Public versus Private Ownership of Firms: Evidence from Rural China." Quarterly Journal of Economics 113 (August), 773-809. Kennedy, Scott. 1997. "The Stone Group: State Client or Market Pathbreaker?" China Quarterly (December), 747-77. Kornai, Janos. 1990. "The Affinity between Ownership Forms and Coordination Mechanisms: The Common Experience of Reform in Socialist Countries."Journal of Economic Perspectives 4 (Summer), 131-47. CHINA'S EMERGING PRIVATE ENTERPRISES 77 Laffont, Jean-Jacques, and Yingyi Qian. 1999. "The Dynamics of Reform and Development in China: A Political Economy Perspective." European Economic Review 4 (April), 1105-14. Lardy, Nicholas. 1998. China's Unfinished Economic Revolution. Washington, D.C.: Brookings Institution Press. Lau, Lawrence, Yingyi Qian, and Gerard Roland. 1997. "Reform without Losers: An Interpretation of China's Dual-track Approach to Transition." Discussion Paper 1798. London, Center for Economic Policy Research. Lerner, Josh. 1996. "The Government as Venture Capitalist: The Long-run Impact of the SBIR Program." NBER Working Paper 5753. National Bureau of Economic Research, Cambridge, Mass. Li, David. 1998. "Changing Incentives of the Chinese Bureaucracy." American Economic Review, AEA Papers cnd Proceedings 88 (May), 393-97. Llorens, Juan Luis. 1997. "Loan Guarantee Systems for SMEs in Europe." Financier 4 (February/May). Marx, Karl. 1930. Capital. English translation. London: J.M. Dent & Sons. McKinnon, Ronald. 1992. "Spontaneous Order on the Road Back from Socialism: An Asian Perspective." American Economic Revieu7, Papers and Proceedings 82 (May), 31-36. Murrell, Peter. 1992. "Evolution in Economics and in the Economic Reform of the Centrally Planned Economies." In Emnerging Market Economies in Eastern Europe, edited by Christopher Clague and Gordon Rausser. Cambridge, Mass.: Basil Blackwell. Olson, Mancur. 1992. The Rise and Decline of Nations. New Haven, Conn.: Yale University Press. People's Bank of China, China Financial Outlook '99. Qian, Yingyi. 1999. "The Institutional Foundation of China's Market Transition." Paper presented at the World Bank Annual Bank Conference on Development Economics, April. Qian, Yingyi, Gerard Roland, and Chenggang Xu. 1999. "Why Is China Different from Eastern Europe? Perspectives from Organization Theory." European Economic Review (April), 1085-94. Rapaczynski, Andrzej. 1996. "The Role of the State and the Market in Establishing Property Rights."Journal of Economic Perspectives 10 (Spring), 87-103. Rawski, Thomas G. 1999. "The Political Economy of China's Declining Growth." Paper presented at the 11th Annual International Conference of the Association for Chinese Economic Studies, July. Shirk, Susan. 1993. The Political Logic of Economic Reform in China. Berkeley: University of California Press. Steinfeld, Edward. 2000. Forging Reform in China: the Fate of State-Owned Industry. Cambridge: Cambridge University Press. U.S. Federal Reserve Board. 1998. Financial Services Used bv Small Businesses: Evidence from the 1993 National Survey of Small Business Finances. Washington, D.C.: Federal Reserve. Walder, Andrew. 1995. "China's Transitional Economy: Interpreting Its Significance." China Quarterly 144 (December), 963-79. Webster, Leila. 1993a. "The Emergence of Private Sector Manufacturing in Hungary." Technical Paper 229. World Bank, Washington, D.C. 78 REFERENCES _ . 1993b. "The Emergence of Private Sector Manufacturing in St. Petersburg." Technical Paper 228. World Bank, Washington, D.C. Webster, Leila, and Dan Swanson, 1993. "The Emergence of Private Sector M\anufacturing in the Former Czech and Slovak Republic." Technical Paper 230. World Bank, Washington, D.C. Webster, Leila, and Markus Taussig. 1999. "Vietnam's Undersized Engine: A Survey of 95 Larger Private Manufacturers." MPDF Private Sector Disctssion Papers. World Bank, Washington, D.C. World Bank. 1997. China 2020: Developmzental Changes in the Neitw Centatry. Washington, D.C. World Bank. 2000. "Survey on the Business Environment." Washington, D.C. Mimeo. Yao, Yang, and Zhaohua Zhi. 1999. "The Role of Government and Privatisation." Working Paper Series C 1999022. China Center for Economic Research, Beijing. Young, Susan. 1995. Private Butsiness and Economic Reforrm in Chinza. New York: M. E. Sharpe. Zhang, Houyi, and Wenpu Liu. 1995. Chinas Private Economy and Private Entrepreneuirs. Beijing: Zhishi Press. CHINA'S EMERGING PRIVATE ENTERPRISES 79 DESIGN Patricia Hord.Graphik Design Alexandria, Virginia PRINTING The John D. Lucas Printing Company Baltimore, Maryland COVER PHOTOGRAPHS ib a, e, and f: Dana Downie [ci b, c, and d: Dileep Wagle _ S ~~~~~~~~~~~ ¾ ¾,00 fEf:0 ~7> 'Ž> 0 0 ad0020200000«K >< : 1 :0 ;S:0: 00000:0000:X:000000 ft::: ::: S =~~~~~ MIFC International Finance Corporation 2121 Pennsylvania Avenue, NW Washington, DC 20433