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Chinas Corporate Reform and Its Economic Effects

PARK Bun-Soon

ChInas EConomIC GRowth and statE-ownEd EntERpRIsEs

The Chinese economy was a planned economy from 1949 to 1978 wherein state-owned enterprises (SOEs) played a central role. Materials and capital were distributed and supplied to enterprises through the state or state banks. Management was appointed by the Communist Party, and the government not only controlled and distributed the output of these companies, but also covered any losses. From this perspective, the state itself served as a large

enterprise. SOEs lacked independence in decision-making and incentives, with their employees enjoying the same benefits as public servants. Under this backdrop, the productivity and efficiency of these companies remained low, and the Chinese economy fell behind. When its market opened up in 1978, China kicked off economic development by attracting foreign direct investment and promoting exports. Since then, China has achieved rapid economic growth. After 1990, Chinas annual economic growth averaged 12.3% during 1991-1995, 8.6% in 1996-2000, 9.6% in 2001-2005, and 11.2% in 2006-2008. Chinas GDP shot up to US$4.402 trillion in 2008, equivalent to 30.9% of that of the US and 89% of Japans. Although lagging behind the US in terms of the volume of goods imports, China outpaced the

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PARK Bun-Soon

|Table 1

Economic Indicators of Major Economies (2008)

China US 304 14,265 1,300 2,100 -673 -4.7 78 Euro area 494 13,633 5,320 5,574 -91 -0.7 520 Japan 128 4,924 776 756 157 3.2 1,031

Population (Unit: 1 million People) Nominal GDP (Unit: billion US$) Goods Exports (Unit: billion US$) Goods Imports (Unit: billion US$) Current Account (Unit: billion US$, %) Foreign Reserves (Unit: billion US$)

1,320 4,402 1,429 1,132 440 10.5 1,946

Note: The goods exports and imports and foreign reserves of the euro area is a sum of the EU countries Source: Statistical authorities of each country, EIU and IMF

US and Japan in exports, with its foreign reserves nearing US$2 trillion. Chinas nominal GDP accounted for a mere 1.7% of the world total in 1990, much lower than Japans 9.0%. In 2008, however, China accounted for 7.3%, similar to Japans 8.1%. In light of purchasing power parity, Chinas GDP accounted for 11.4% of the world total, far higher than Japans 6.4%. This represents a remarkable expansion from 1990 when the GDPs of China and Japan stood at 3.6% and 9.0%, respectively.

The rapid economic growth of China can be attributed to its outward-oriented growth strategy, with growth concentrated in the industrial sector, which includes manufacturing, electricity, gas, waterworks, and mining. According to the data compiled by the Chinese statistical authority, the number of Chinese industrial companies that have an annual production of over 5 million yuan stood at 337,000 as of 2007. The industry employed 78.75 million people, with its combined production and assets estimated at 40.5 trillion yuan and 35.3 trillion yuan, respec-

Chinas Corporate Reform and Its Economic Effects

|Table 2

Chinas Industrial Sector in 2007

Number of Firms Total Mining 336,768 15,831 313,046 7,891 2,910 33,596 300,262 Production 405,177 23,298 353,631 28,248 140,858 121,699 142,620 Asset 353,037 28,568 265,503 58,967 138,731 118,284 96,022 Profits 27,155 5,444 19,622 2,089 11,412 8,215 7,529

(Unit: 100 million yuan) Employment (10,000 people) 7,875 705 6,856 314 1,823 2,580 3,472

By Industry

Manufacturing Waterworks, Electric and Gas Large Firms

By Corporate Size

MediumSized Firms Small Firms

Source: China Statistical Yearbook (2007)

tively. Manufacturing companies accounted for 313,000 or 93.0% of the total number of companies, and also accounted for roughly 35.4 trillion yuan or 87.3% of total production, 72.3% of total assets and 87.1% of total employment. By corporate size, large companies accounted for 0.9% of the total number of companies, 34.8% of production, 39.3% of assets and 23.1% of employment, indicating that large companies are relatively capital-intensive, while small companies are labor-intensive. Although it is difficult to say that the technology, productivity and corporate structure of Chinese companies are at a world-class level, their sales and assets are certainly on a global scale. This is particularly so for Chinas flagship companies that dominate domestic markets in telecommunications, petroleum, oil refining, steel and airlines. From a sales perspective, Petrochina has grown into one of the global leaders with sales of 835 billion yuan (more than US$128 billion) in 2007, likewise China Telecom with US$22.4 billion and Baosteel with US$20.1 billion. Moreover, five of the worlds top ten companies in terms of market capitalization were Chinese companies at the end of 2007, including Petrochina (No. 1) and China Mobile (No.
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4), although this partly reflected a massive stock market boom in China up to that point. Chinese manufacturing companies also achieved unrivaled growth in terms of production scale. Shanghai Automobile Group, for example, sold 1.69 million units in 2007, although it did not have its own brand. Although still lagging behind in quality compared to their Japanese and Korean rivals, Chinas electronics companies such as TCL and Haier are rapidly catching up on the back of strong price competitiveness.

ChInas CoRpoRatE REfoRm

Chinas corporate reform took place hand-inhand with, and laid down the foundations for, its economic growth. This corporate reform took place on two levels. First, corporatization and privatization were carried out to improve the governance structure of state companies. Second, financial reform was implemented to promote corporate restructuring. The key intent behind the attempt to improve the governance structure of the state companies was to clarify corporate ownership. To reform the cor-

PARK Bun-Soon

Corporate reform took place on two levels. First, corporatization and privatization were carried out to improve the governance structure of state companies. Second, financial reform was implemented to promote corporate restructuring

porate sector, the Chinese government expanded the range of autonomy for the state companies from 1979 onwards, among others, giving entrepreneurs more leeway in the decision-making process and introducing a performancebased contract system. Under the performancebased contract system, the management signed contracts with the state concerning the level of performance in categories of sales, profits and investment. If the management outperformed, they were allowed to share the profits. This approach of gradual reform is credited with raising the productivity of state-owned enterprises during the 1980s. However, it had its limits in terms of reforming the sector, as on one hand successful management was able to share the profits from their performance, but on the other failed entrepreneurs did not have to take any responsibility for their failures. The government introduced the management leasing and responsibility system for small SOEs in the mid-1980s. Under this system, an entrepreneur leases an SOE from the state in return for paying a certain portion of profits to the state. The State Council established regulations on this leasing system in May 1988 which led mainly to the privatization of township-and villagelevel enterprises (TVEs). Corporatization served as another means for privatization. Initially, corporatization took the form of exchanging of stock between SOEs, but private ownership of stocks was later allowed. Shenyang Motors Corporation1 issued stocks to the public in August 1988 and became the first company to be incorporated among Chinas large enterprises. Since the Nanshun Speech by Deng Xiaoping, corporatization has been actively used as a tool to promote privatization. The Company Law took effect in July 1994, acknowledging the public limited company as the modern corpo-

1 Garnaut Ross et al. (2005), Chinas Ownership Transformation: Process, Outcomes, Prospects, IFC, World Bank, p. 2

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Chinas Corporate Reform and Its Economic Effects

rate system. Corporatization may be seen as the stage prior to complete privatization, what allows a reduction of state intervention and improvement of corporate governance structure. It also decentralizes managerial authority from the state toward national agencies and other SOEs, enabling enterprises to be checked and balanced by shareholders. From an economic perspective, corporatization also enables enterprises to expand the scope and methods of fund-raising, enabling them to not rely solely on subsidies from the government and state banks. At the 4th Plenary Session of the 15th Central Committee of the Communist Party held in 1999, China approved the stock ownership system, enabling itself to own the stakes of SOEs that are incorporated. The state also decided to turn most of the mid-and large-sized SOEs, excluding those specializing in strategic industries, into corporations mainly through asset sales and IPOs. The State Council established the Stateowned Assets Supervision and Administration Commission (SASAC) in 2003. On behalf of the state, the SASAC was set up to perform the role of an investor, to supervise and manage stateowned assets and to implement the reform and restructuring of state enterprises. Under the guideline of the central government, the SASAC is also responsible for the appointment and dismissal of top executives at SOEs, performance evaluation and the provision of rewards. In its move towards privatization, the state had a specific interest in the development of large companies and the creation of business conglomerates. At the 5th Plenary Session of the 14th Central Committee of the Communist Party in 1995, China adopted the Zhuada Fangxiao policy which means keep the large and let the small go. This policy aimed for the full privatization of small companies, which comprise the majority, and the transformation of mid- and large-sized SOEs (via structural re16 |

China also made a concerted effort to cultivate its own business conglomerates. By benchmarking the industrial policies of Korea and Japan and their highly efficient and competitive business groups, China aimed at creating National Champion companies that could compare favorably with their rivals in Korea and Japan

PARK Bun-Soon

form) into public limited companies, with the state only playing the role of shareholder. China also formulated a blueprint aimed at advancing three to five Chinese SOEs into the worlds top 500 rankings by 2000. To this end, the state selected six SOEs, including Baosteel, Haier and Changhong, as enterprises to receive support. China also made a concerted effort to cultivate its own business conglomerates. By benchmarking the industrial policies of Japan and Korea and their highly efficient and competitive business groups, China aimed at creating National Champion companies that could compare favorably with their rivals in Korea and Japan. This brought about a vertical integration throughout major industries, which had also occurred in Japan and Korea. Mergers proved to be an effective way of fostering these business groups. In 1997 alone, as many as 3,000 firms were merged, and 15.5 billion yuan worth of national assets were re-distributed. It was during this period that large-scale business groups were created through mergers in the areas of petrochemicals, steel and air transportation. China ultimately pursued the listing of SOEs.
|Table 3

Even before its full-fledged drive towards turning SOEs into corporations, China set up a stock exchange market in Shanghai in December 1990 and in Shenzhen in July 1991. Stateowned companies became privatized at a rapid pace through the stock market; the number of listed companies rose to 53 in 1992 from 14 in 1991. China applied a planned distributionbased quota system for stock issuance until March 2001. After determining the list of companies to go public and the scale of IPO stocks, the state allocated quotas to each ministry and provincial government. Although this had the adverse effect of influencing relations between enterprises and the administrative ministry on the selection of the IPO firms, the number of the companies which issued A- and B-type stocks in China increased to 1,088 in 2000. The overseas listing (H stocks) of Chinese firms has increased sharply since 2000. The number of Chinese firms which issued H stocks remained low at 52 until 2000 but saw a three-fold jump to 143 in 2006. Particularly since 2002, the number of companies that issued H stocks increased sharply, indicating the trend of attracting capital from overseas markets. In practice, the Chinese

Number of Chinas Listed Stocks

A,B within China 2000 2001 2002 2003 2004 2005 2006 2007 1,088 1,160 1,224 1,287 1,377 1,381 1,434 1,550 B within China 114 112 111 111 110 109 109 109 H in Overseas 52 60 75 93 111 122 143 148

Source: China CSRC

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Chinas Corporate Reform and Its Economic Effects

firms showed great interest in listing themselves on Hong Kong and New York stock markets from the 2000s. This move was also welcomed by the international financial community. Despite the fact that the state allowed SOEs to go public, it still remained reluctant to transfer ownership totally to private hands. It divided the stocks into tradable and non-tradable types and restricted the trading of some stocks, aiming at using the privatization of SOEs through IPOs as a fund raising window for these companies rather than as a means to protect the investors. However, the existence of non-tradable stocks that account for two-thirds of total stocks served as a factor that distorted the capital markets. Since the size of tradable stocks was smaller than those of non-tradable ones, the owners of tradable stocks had no option but to have more interest in profit-making than participating in management, causing the stock market to become a veritable casino. Financial reform took place in lockstep with corporate reform. For a long time, state banks extended loans to SOEs under the guidance of the government, and when SOE performance deteriorated, a huge amount of bad loans were left in the banks. Indeed, the percentage of bad loans in the portfolios of the four major state banks exceeded 40% until the early 2000s, emerging as one of the biggest economic problems facing China. To reform the financial structure, the Chinese government issued special bonds in August 1998, aimed at enabling state banks to improve their capital adequacy ratios. The government also set up an asset management company (AMC) at each of the four major banks, as a way to dispose of the bad loans. The AMCs of the four major banks took over the bad loans and conducted a series of debt-to-equity swaps with roughly 580 companies that accounted for about 40% of stateowned assets and sales.
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Despite the fact that the state allowed SOEs to go public, it still remained reluctant to transfer the ownership totally to private hands. It divided the stocks into tradable and non-tradable types and restricted the trading of some stocks
After normalizing the financial structure of state banks through the disposal of bad loans and the injection of public funds, China started attracting foreign capital in order to enlarge the capital of the banks. An increasing number of foreign financial institutions and institutional investors developed interest in the Chinese banks, in light of Chinas rapid economic growth since its entry into the World Trade Organization, low interest rates prevailing in the international markets centering on the US since 2001, and the completed restructuring of the Chinese financial industry. Until early 2006, they invested US$3.78 billion in the Industrial and Commercial Bank of China, US$5.095 billion in the Bank of China and US$3.97 billion in the China Construction Bank. Most of these investors were international financial institutions. International investors made a huge investment in Chinese banks amid expectations for possible IPOs of these banks. China Construction Bank (ranked No. 3 among Chinese banks) raised US$8 billion through IPOs in October

PARK Bun-Soon

|Figure 1

Change in Weight of SOEs in Chinese Economy

Number of Companies Employment Total Output Total Assets

80 70 60 50 40 30 20 10 0











Source: Chinese Statistics Yearbook (2008)

2005 and turned itself into a gigantic bank with assets of US$70 billion. The Bank of China raised US$9.7 billion through the IPO of a 10.5% stake at the Hong Kong stock exchange in May 2006. The Industrial and Commercial Bank of China also raised US$19 billion through IPOs at the Hong Kong and Shanghai stock markets in October 2006. The processes undergone by these Chinese banks show that the Chinese governments attempts to transform the Chinese banking and financial markets have been successful.
|Table 4

fRuIts of thE REfoRm

The reform of state-owned enterprises occurred contemporaneously with the rapid growth of the Chinese economy and contributed to raising the overall competitiveness of the Chinese economy. This reform brought about a drastic change in Chinas corporate structure, with the weight of SOEs in the Chinese economy declining. Within the industrial sector, the share of SOEs in the total number of companies stood at 6.1% in 2007, a sharp decline from 39.2% in 1998,
(Unit: %)

Performance of Industrial Sector

Employment per Firm (1 person) Output per Firm (10,000 yuan) 4,103 5,260 6,101 7,296 9,256 10,484 12,031 Output/ Asset Ratio 62.2 67.9 75.8 93.7 102.8 108.7 114.8 Debt-toEquity Ratio 63.7 60.8 58.7 58.0 57.8 57.5 57.5 Debt Ratio 175.8 155.1 142.2 137.9 137.0 135.1 135.2

Profit/ Output Ratio 2.2 5.1 5.2 5.9 5.9 6.2 6.7

1998 2000 2002 2004 2005 2006 2007

375 341 304 240 254 244 234

Source: Chinese Statistics Yearbook (2008)

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Chinas Corporate Reform and Its Economic Effects

|Figure 2

Trend in Profitability of Listed Companies

(Unit: %)

12 10 8 6 4 2 0 1999 Source: SERI 2000 2001 2002 2003 2004 2005 2006 2007 9.6 8.8 7.9 Operating Profit/Sales 4.7 9.0

Net Profit/Sales 6.0 6.0 4.7 5.8 4.4 4.0 4.2 2.9 5.6

7.5 5.4 3.9 6.3

with its share in total employment plunging to 22.1% in 2007 from 56.1% in 1998. In contrast, total assets of SOEs registered a relatively mild decline to 44.8% in 2007 from 68.8% in 1998, indicating that SOEs still play a major role in the industrial sector. In terms of total output, SOEs saw their share fall to 29.5% in 2007 from 49.6% in 1998, indicating that SOE reform has not yet been completed with high shares of output. Second, corporate efficiency has been improved substantially. For the Chinese industrial sector, employment per firm registered a sharp decline, while the efficiency of assets improved. The output/asset ratio nearly doubled to 114.8% in 2007 from 62.2% in 1998. The debt-to-equity ratio declined to 135.2% in 2007 from 175.8% in 1998. Corporate profitability, as represented by the profit/output ratio, improved sharply to 6.7% in 2007 from 2.2% in 1998. SOEs achieved great improvement in their asset efficiency and profitability through employment adjustment and structural reform. An analysis of the profitability of Chinese listed companies from 1999 to 2007 shows that they

have achieved a sharp improvement in both net profit-to-sales ratio and operating profit-to-sales ratio since 2005. The net profit-to-sales ratio fell to 2.9% in 2005 from 8.8% in 1999 and then recovered to 6.3% in 2007. The operating profitto-sales ratio also rose to 7.5% in 2007 from 4.0% in 2005. These figures indicate that the restructuring of the corporate and financial sector has been completed to some extent. The strengthening of the competitiveness of Chinese firms has also been mirrored in the stock market. Although the direction of the stock market does not always reflect the level of corporate competitiveness, the Chinese stock market has enjoyed a boom since Chinese banks attracted foreign capital through restructuring and global liquidity became abundant in 2005. Third, the scale of Chinas large companies is increasing rapidly. Five Chinese companies ranked in the worlds top 500 companies in 1998. This figure rose to 19 in 2006 and 26 in 2008, higher than Koreas 15 and Indias 72. The size of Chinese firms has been increasing sharply, especially since 2006. With ample capital, large companies have been spearheading Chinas

2 Fortune announced that 29 out of the worlds top 500 firms are Chinese companies. However, three out of the 29 Chinese firms are pure

Hong Kong companies

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PARK Bun-Soon

After more than 30 years of serving as the main driver of Chinas rapid economic growth by undergoing a string of self-reforms, Chinese companies now face a new challenge of how to strengthen their competitiveness further to fit their expanded scale
drive for internationalization. Chinese companies are now emerging as global companies and a number of these companies are building their own brands in the global marketplace. Chinese stock market has been no exception. The Shanghai Composite Index, which once surpassed the level of 6,000, fell below 2,000 at one stage. Moreover, despite the overall improvement in efficiency, productivity and soundness on the part of Chinese companies, some large companies still have a long way to go. Chinas large companies, and even some of its global companies, still remain a mix between state- and privately-owned companies. Moreover, they often occupy a monopolistic position in the nations key markets despite having gone private, leaving many reforms still to be done. After more than 30 years of serving as the main driver of Chinas rapid economic growth by undergoing a string of self-reforms, Chinese companies now face a new challenge of how to strengthen their competitiveness further to fit their expanded scale.

a nEw ChaLLEnGE
The Chinese economy has achieved rapid growth in the past 30 years amid a drastic change in the economic environment, and Chinese enterprises have been leading the way for this growth by undergoing extensive restructuring. However, the environment in which the Chinese companies are operating is rapidly deteriorating. Indeed, adverse effects of such rapid growth have begun to show. Chinas production costs have risen during this period, while the investment environment has deteriorated. The value of the yuan is on a secular rise. The government has also implemented a number of policy changes, especially for the improvement of labors working conditions that is putting more pressure on both domestic and foreign companies in the coastal regions of China. The external environment is also worsening. Amid a growing crisis in the international financial markets ignited by the US subprime mortgage crisis, the stock markets of major countries have weakened substantially. The

PARK Bun-Soon is the Senior Fellow on Asia Economies at SERI. He is the author of numerous publications on the East Asian Economies. Contact:

July 2009 | SERI Quarterly | 21


012 Chinas Corporate Reform and Its Economic Effects

PARK Bun-Soon

From 1978 onwards, China has pursued a vigorous reform of its corporate sector, ranging from expanding the management autonomy of state-owned enterprises to privatization. Despite significant improvement in the efficiency and competitiveness of Chinese companies, corporate sector reform still remains a work in progress. 022 Inward and Outward Internationalization of Chinese Firms KIM Icksoo Since the mid-1990s, Chinese companies are accumulating strategic assets more through outward internationalization, i.e., outward overseas direct investment and M&A. Internationalization has led to sharp improvement in Chinese firms core competency and global competitiveness, leading to sophistication of Chinese exports and an increase in global market share. 032 Chinese Firms Corporate Strategies in the Economic Downturn WANG Xianyi Chinese firms have adopted a three-pronged strategy in response to the global economic downturn: 1) corporate restructuring, 2) catering to strong domestic demand, and 3) seeking to increase market share in overseas markets including by using their strong finances to invest in new production bases in overseas markets. 040 Assessment of Chinese Companies Competitiveness QUI Gang, XU Liyan, SUN Xiaofei Competitiveness of Chinese firms is assessed from three perspectives: 1) scale and diversity of business activity, 2) profitability and ability to innovate, and 3) degree to which they have moved on from serving domestic markets to global markets.

052 Protecting the Domestic Financial System from Crisis Contagion KIM Sungmin What are the solutions to keeping the financial systems of emerging markets safe from contagion of external crises or minimizing the impact of contagion? This paper addresses these issues from the perspectives of addressing institutional weakness and lack of incentives for risk management.

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