Neil Gregory and Stoyan Tenev
Cover by Benjamin Hurd
Neil Gregory and Stoyan Tenev are Head of Strategy (South Asia) and Principal Economist (East Asia), respectively, at the International Finance Corporation (IFC), the private-sector arm of the World Bank Group. This article is adapted from the recently published IFC study, China's Emerging Private Enterprises (2000), available online at http://www.ifc.org/.
Where they came from, where they are going
Because of the way the domestic private sector emerged from the shadows, it is organized in a very informal way. Many enterprises possess only the vaguest of property rights, ownership structures, corporate governance mechanisms, financial records, and rights to market access.
The policy environment to date has heavily favored SOEs, whether in providing access to markets or to finance. Markets closed to private enterprise include banking, telecommunications, wholesale distribution, metals, audio products, primary real estate development, and taxi services.
China's economy has undergone a dramatic transformation during the last decade. Most prominent in this process have been the restructuring of state-owned enterprises (SOEs) and the surge in foreign direct investment. But an equally important change has been the emergence of a vibrant domestic private sector. As a result, China has shifted from heavy reliance on state-owned and collective enterprise to a mixed structure in which private enterprise also plays a strong role. By 1998 the domestic private sector had grown to about 27 percent of GDP, making it second only to the state enterprise sector (see Figure 1). A constitutional amendment in 1999 formally recognized this shift, thereby allowing the domestic private sector to emerge from the shadows and play a prominent role in China's future development.
To help understand this new and important segment of the Chinese economy, the International Finance Corporation (IFC) and China's State Economic and Trade Commission conducted a study of the status of the domestic private sector, and the issues and constraints facing it. As part of this study, consultants surveyed over 600 companies, and interviewed over 300 CEOs, in Beijing; Chengdu, Sichuan Province; Shunde, Guangdong Province; and Wenzhou, Zhejiang Province. The study showed how private enterprises have been shaped by the difficult circumstances under which they evolved. While many have achieved spectacular growth rates in spite of the constraints, they now face important challenges in adapting to a more open economic environment.
Keep it under your hat
Private business was gradually abolished following the 1949 Communist revolution, so that by the 1950s it had all but disappeared. It was first revived after the Cultural Revolution as a way to respond quickly to the mounting pressures of unemployment and economic stagnation. It was allowed on the fringes of the economy and was initially regarded as a supplement to the state and collective sectors. Private enterprise first took hold in the rural sector, as an outgrowth of the virtual privatization of agriculture, and in small-scale individual enterprises in the urban sector.
During the 1980s, larger private enterprises grew out of these rural and individual enterprises, and out of collectives (enterprises with common ownership by the employees, under state supervision) and SOEs. Some were sole proprietorships (getihu) that grew and took on more employees. By 1988, when private firms were first officially recognized, China had 500,000 getihu that could be called private firms (siying qiye). Some larger private enterprises emerged from the leasing of state or collective enterprises to individuals. The private entrepreneur paid the collective a fixed rent a nd operated the firm as if it were his own-and in many cases accumulated considerable assets. These enabled him to reduce the share of collective ownership and gradually transform the enterprise into a solely owned firm.
Many large private firms disguised their true identities by maintaining the formal status of a collective or SOE, a process known as "wearing the red hat." Collective status allowed a degree of local government involvement in the enterprise. This could be helpful in obtaining access to land, bank loans, government contracts, and tax breaks. On the other hand, wearing the red hat meant that enterprises could not operate on a fully commercial basis, but had to cooperate, to some degree, with the local government's wishes.
The change in political sentiment following the events of 1989 caused a temporary setback to the growth of private enterprise, but Deng Xiaoping's famous "Southern Tour" in September 1992, during which he called for continuation of the reform effort, opened the way for renewed growth. During the 1990s, government encouraged the privatization of smaller, nonstrategic SOEs and allowed collectives to transform into private enterprises. As a result, the number of registered private firms (excluding sole proprietorships) rose from 108,000 in 1991 to 960,000 in 1997. In March 1998, the government issued a directive requiring all the red hat firms to "take off the hat," or show their private ownership, by November 1998. In effect, government was playing catch-up with the reality of how these enterprises were operating. However, because of the advantages of maintaining connections to local government, many privately run enterprises have maintained their collective status.
The case of the Stone Group, one of China's largest information technology companies, illustrates how China's collectives shifted to private ownership. Originally established in 1984 by scientists from a state-owned computer factory, the Stone Group began as a collective under the authority of Sijiqing Township in Haidian District in Beijing. In 1992, the government gave Stone permission to corporatize SET, one of its subsidiaries, and list it on the Hong Kong Stock Exchange. SET then became the private holding company that controlled the other Stone subsidiaries. Through a process of stock option allocation, by 1994 the staff of Stone had gradually acquired equity in SET. In 1999, with IFC assistance, the employees bought out the 51 percent of the equity still held by the collective, completing its transformation to a wholly private enterprise.
Business is booming
The private sector is now the most dynamic component of the domestic economy. Between 1985 and 1997, its share of national industrial output rose from 2 percent to more than 34 percent (see Figure 2). The IFC estimates that the domestic private sector (excluding agriculture) accounted for 27 percent of GDP in 1998, compared to 6 percent for foreign private enterprises. In total, the private sector share of GDP (33 percent) was nearly as large as the SOE share of GDP (37 percent). The direction of change is clear: in recent years, new employment in the private sector has exceeded the combined total for state, collective, and township-and-village enterprises. This explosive development is in sharp contrast to the decline of the SOEs and collectives. The private sector has become an important source of job creation, absorbing a significant number of workers laid off from SOEs (see Figure 3).
Because of the way the domestic private sector emerged from the shadows, it is organized in a very informal way. Many enterprises possess only the vaguest of property rights, ownership structures, corporate governance mechanisms, financial records, and rights to market access. They are often part of complex groups of companies, spanning many different activities. For example, one Beijing group founded in 1983 began in construction, which led on to real estate ownership and management. It then diversified into manufacturing refrigeration equipment though a joint venture with a Japanese company. Later, it established manufacturing facilities for pharmaceuticals and health products, which are now its main lines of business.
This informality gives entrepreneurs great flex ibility to respond to an uncertain business environment composed of unclear and rapidly changing government policies, taxes, and regulations. However, it hampers their ability to raise capital, reward managers and employees, and operate efficiently. As a result, even large, mature businesses have many of the strengths and weaknesses more often associated with small startups.
Companies typically go through a "life cycle" of formation, growth, and maturity. Starting as a sole proprietorship, family business, or startup, they gradually expand their ownership as closely held corporations. Eventually, the largest become publicly traded to tap wider sources of capital. Their legal structure, financial structure, corporate governance, and market relationships all change during the life cycle. For example, startups and sole proprietorships provide minimal financial disclosure, while public corporations provide extensive financial information. Similarly, startups generally lack formal governance structures, while more mature companies have formal systems by which owners hold managers accountable for their performance and protect investor interests.
However, firms in China's private sector have a limited ability to evolve beyond the first, informal stages of life, and tend to become stuck in a framework of legal, financial, and governance structures that they have outgrown in terms of the size and complexity of their business. Thus the informality of the private sector is particularly problematic for larger, more mature enterprises. It is becoming an even more serious constraint now that the private sector is beginning to play a larger role in the Chinese economy. Private enterprises need to expand beyond the scale of a small family business. They must be able to gain access to external capital, hire skilled managers, and engage in partnerships with other enterprises. To do these things, enterprises need to display greater transparency and structure in their financial management and corporate governance.
Growing up...fast
The policy environment to date has heavily favored SOEs, whether in providing access to markets or to finance. Markets closed to private enterprise include banking, telecommunications, wholesale distribution, metals, audio products, primary real estate development, and taxi services. Until 1998, few private enterprises were allowed to export directly; the rest had to work through state-owned trading companies. Bank loans have been freely available to SOEs, but virtually impossible for private enterprises to obtain. Similarly, access to the government-determined quota for stock-exchange listings has been heavily biased toward state-owned enterprises.
Since the government recognized the private sector as a pillar of the economy alongside the state sector in 1997, it has faced the difficult reform agenda of leveling the playing field between the public and private secto rs. One of the high priorities of this agenda will be to shift from a discretionary, particularistic way of regulating and taxing the private sector toward a rules-based system. For instance, government needs to make the registration of private enterprises simple, cheap, and automatic. But the future growth of private enterprise also depends on progress in more fundamental reforms, such as strengthening property rights and ensuring that the judicial system enforces them.
The smallest enterprises will require less change. The prevalent model of owner-managed, closely held family enterprises will continue to suit them. For larger companies, the best opportunities for building the business, expanding the management team, and obtaining external financing lie in converting to limited-liability shareholding companies.
- New corporate forms
New corporate forms imply new formal structures of corporate governance. In particular, incorporation as a joint-stock company imposes responsibilities on the company toward its shareholders. One of these responsibilities is to manage the company transparently and in shareholders' best interests. Where outside equity is sought, it is especially important for companies to adhere to the required governance standards. This requires major changes to the way private business es in China operate.
To make corporate governance simpler and more transparent, many enterprises may need to reorganize their complex structures of holding companies and affiliated companies. The opacity inherent in such structures may have been beneficial for an informal enterprise but is a handicap for a formal one. Firms of this nature find it more difficult to define their assets and liabilities, to report financial performance lucidly, and to assign clear management responsibilities and performance measures. Thus, improving corporate governance will in part involve restructuring related enterprises into a single corporate structure, or separating companies into wholly separate enterprises.
- Finance
Above all, business cannot grow without access to financing. This is a particularly acute problem for China's domestic private sector: only 1 percent of bank credit goes to private firms, and only 1 percent of listings on the Shanghai and Shenzhen exchanges are private. As a result, private firms rely heavily on self-financing for their growth (see Figure 4). But that source will be inadequate once they move beyond the startup, high-growth phase. As with other issues, the solution requires a mix of straightforward regulatory changes (such as allowing private firms greater access to equity markets) and more fundamental reform (such as building a commercial banking system that allocates cred it on the basis of commercial decisions, rather than government direction). However, access to finance will not improve until private enterprises make their financial position, corporate governance, and beneficial ownership more transparent.
China's law of incorporation imposes limited financial disclosure requirements. These may be a step forward for many enterprises but are still much less stringent than international best practices. Enterprises that hope to attract foreign investment or trade in international markets will need to adopt international financial disclosure standards. Before firms can adopt such standards, they need appropriate internal financial systems and controls to ensure more accurate, timely financial reports. They will also have to observe higher standards of external auditing than they do now to vouch for the accuracy of these reports.
Recent financial and SOE reforms have made significant progress in hardening SOEs' budget constraints and reducing government interference in bank lending. However, the playing field is still uneven when it comes to bank lending. Local governments continue to influence bank lending in favor of SOEs by, among other methods, extending explicit or implicit guarantees for bank loans to enterprises with state ownership. As a result, banks impose heavy transaction costs and collateral requirements on private enterprises applying for loans, deterring all but the largest private firms from seeking bank loans (see Figure 5).
Competing under new rules
China's impending accession to the World Trade Organization (WTO) provides new impetus for the government to move toward a rules-based, nondiscriminatory policy environment for private enterprise. This will not only expose the domestic private sector to new competition from abroad, but will also introduce new financial institutions to serve the needs of private business. Hence the environment for domestic businesses will continue to evolve rapidly. The challenge for the government and entrepreneurs alike is to put the domestic private sector on solid ground, so that it will be ready to seize new opportunities as they arise.
Assuming that the government becomes less involved in determining market access and places less emphasis on distortionary policies and regulations and on the role of SOEs in many markets, the risk for private enterprises of focusing on one line of business will decline. In response, capital and labor markets will improve, there will be fewer advantages to obtaining capital and labor from within a conglomerate, and the inefficiencies of managing across multiple industries will be shown up by competition from firms that obtain their capital and managers from the market. To withstand this competition, China's enterprises will have to show the same focus and efficiency as foreign companies.
China's home-grown entrepreneurs have shown impressive flexibility and dynamism in expanding their businesses in the absence of secure legal frameworks, and with very limited access to external finance. Recent policy changes offer businesses a sounder footing and access to new sources of capital. China's ability to compete with foreign firms depends on the ability of these entrepreneurs to grow up quickly and match best practices in the West. Their proven ability to respond quickly to changes in the business environment suggests that many will rise to this challenge, and that the domestic private sector will play an ever more important role in the Chinese economy.
All Rights Reserved.