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Is Bigger Better?

Though conglomerates may help rationalize China's structurally fragmented economy, bureaucracy severely hinders their formation

Shawn Shieh

A centerpiece of China's state-owned-enterprise (SOE) reform strategy has come to be known colloquially as "managing the large and letting go of the small" (zhua da fang xiao). This slogan refers to the government's decision to concentrate state support on China's larger and more successful SOEs while taking measures to loosen state control and ownership over smaller ones.

A second look at an old idea

In the early days of the reform era, supporters once again began to argue that enterprise groups would help rationalize the economy. But the lack of a coherent industrial policy, as well as the same bureaucratic obstacles that had frustrated Liu during the 1960s, slowed the formation of enterprise groups until the early 1990s.

Two major policy decisions in 1993 marked the turning point in China's policies toward conglomerates. First was the Central Committee's Decision on Certain Questions in Establishing a Socialist Market Economy Structure, which made the "modern enterprise system" the crux of enterprise reform and called for the formation of large enterprise groups that would transcend regional and sectoral divisions. Second was the Company Law, approved in 1993 and formally implemented in July 1994.

The Company Law, along with other laws and regulations that have been passed since 1993, is effectively the legal foundation for the modern enterprise system, and thus a key part of the conglomerate strategy. The modern enterprise system seeks to weaken bureaucratic ownership by making companies legal corporate entities with their own clearly defined property rights. By clarifying the property rights of enterprises and turning them into legal corporate entities responsible for their own profits and losses, the Company Law blunts political interference from bureaucratic superiors, making it easier for enterprises to base mergers on economic considerations. Parent companies would be able to exercise greater control over their subsidiaries within the group.

Following these initial moves, the central government selected 100 enterprises and 56 enterprise groups in 1994 as experiments in establishing a modern enterprise system. These entities were given greater autonomy in drafting economic plans, financing their operations, and engaging in foreign trade.

Two years after the adoption of the zhua da fang xiao policy in the Ninth Five-Year Plan (Ninth FYP, 1996-2000), in spring 1997 the State Council expanded the number of enterprise groups from 56 to 120. By the time Jiang Zemin made his pronouncements at the Fifteenth Party Congress in September 1997, he was only reaffirming a policy that had already been decided on at the highest levels--and implemented on an experimental basis over the pre vious two years (see The CBR, July-August 1998, p.8).

China's concerted effort at fashioning an industrial policy during the 1990s appears to have been motivated by several considerations. These include the government's belief that China can replicate the successes of Japan and Korea in using industrial policy to form large conglomerates, and the need for PRC firms to compete effectively with huge foreign multinational firms operating in China. The Ninth FYP, as a result, calls for developing economies of scale in the following pillar industries: automotives, construction, electronics, machinery, petrochemicals, and steel.

The PRC government also regards conglomerates as a vehicle for absorbing China's growing numbers of loss-making enterprises and unemployed workers. Mergers and acquisitions are, in this regard, seen as much-preferred alternatives to bankruptcy. Enterprise groups such as the Qingdao Haixin Group, Shandong Province's biggest state-owned electronics conglomerate, have received media attention because their growth is driven in large part by the acquisition of enterprises in the red. According to a 1997 Xinhua News Agency report, over the period 1994-97, mergers with profitable large groups saved some 2,000 loss-making enterprises.

Forward momentum in pillar industries

Similarly, the central government announced plans in 1995 to pool more than RMB100 billion ($12 billion) to support eight key auto conglomerates, in line with the automotive industrial policy formulated a year earlier. These eight auto manufacturers are Shanghai-Volkswagen Automotive Co. Ltd., First Automobile Works (Group) Corp., Wuhan's Shenlong Automotive Co. Ltd., Beijing Jeep Corp., Tianjin Automotive Industry Group Corp., Guangzhou Peugeot Automobile Corp. Ltd., Chang An Automobile Co. Ltd., and Guizhou Aviation Industry Corp.

China's provinces and municipalities have also jumped on the conglomerate bandwagon, spawning initiatives at the ministerial, provincial, and local levels. In recent years, even the Ministry of Agriculture and local governments have promoted enterprise groups at the township level. In the spring of 1995, the municipa l government of Shanghai took an early lead by adopting measures to encourage the growth of conglomerates. Not surprisingly, areas that have been more aggressive in promoting this strategy tend to be coastal provinces and cities--in particular Shanghai Municipality and Hebei, Jiangsu, Liaoning, and Shandong provinces--where large-scale state-owned industry is more developed and where international competition has been more keenly felt.

These policy announcements, combined with mounting competition from international firms, have led to a noticeable trend toward larger, more ambitious mergers nationwide. In 1995, a number of large enterprise groups in the auto industry were either established or enlarged in response to both the government's industrial policy and the growing demand in international markets for passenger sedans (see The CBR, November-December 1997, p.8). China's largest existing auto group, the Changchun-based First Automobile Works, annexed Changchun's light motor vehicle plant. Other new groups included Hubei's Dongfeng Motor Corp., Beijing Automotive Industry Group Corp., Shanghai Automotive Industry Group Corp. (which includes Shanghai-Volkswagen), and Nanjing's Yuejin Automobile Group Corp. Yuejin, built around the Nanjing Automotive General Co., includes more than 200 enterprises in Jiangsu and seeks to produce more 500,000 vehicles worth RMB60 billion ($7.2 billion) by the end of the century.

A num ber of important mergers have also taken place in the chemical and petrochemical industries in the last few years. In 1996, the Shanghai municipal government merged the assets of the Shanghai Chemical Industrial (Group) Corp. with those of the Shanghai Pharmaceutical Administration and its subordinate enterprises to form the Huayi (Group) Corp., which is projected to achieve sales revenue of RMB100 billion ($12.1 billion) by 2000. Huayi includes among its members a number of large enterprise groups, including Shanghai Pharmaceutical (Group) Corp., Shanghai Tianyuan (Group) Corp., Shanghai Tire and Rubber (Group) Corp., and Shanghai Pacific Chemical Industrial (Group) Co. Ltd.

In 1997 and 1998, mergers in this sector were even more impressive. Qilu Petrochemical Corp. purchased two chemical plants in Shandong; Shandong's Haihua Group absorbed 17 enterprises to expand its oceanic chemical product line; and China National Petrochemical Corp. (Sinopec) purchased a controlling share of Beijing Yanshan Petrochemical (Yanhua) Group. Yanshan Petrochemical itself had previously merged with the nation's largest producer of high-grade lubricants, Tianjin Hangu Petrochemical. Shanghai Petrochemical Co. Ltd. acquired the Shanghai Jinyang and the Zhejiang acrylic fiber plants in 1996 and 1997, respectively. The most ambitious case to date, though, has been the 1997 merger of four of the nation's largest chemical and petrochemical comp anies in the Nanjing area--Yizheng Chemical Fiber Group, Yangzi Petrochemical, Jinling Petrochemical Corp., and Nanjing Chemical--to form China's largest chemical enterprise group, Donglian Group.

In the engineering machinery industry, consolidation has gone beyond the establishment of conglomerates to the formation of strategic alliances among conglomerates. Four of the nation's largest enterprise groups in this sector--Shanghai Dongfeng Machinery Group, Xuzhou Construction Machinery Group (see below), Anhui Forklift Group, and Qinghai Engineering Group--formed such an alliance in May 1997. The alliance's purpose is to concentrate investment on the development of a united, registered-brand product to compete with overseas firms. SETC and the former Ministry of Machine-Building Industry (now a state bureau under SETC) are providing additional support for product and technology development.

The emergence of such conglomerates over the past few years indicates that China's attempt at formulating and implementing an industrial policy is having an impact on China's industrial structure, even if that impact has been more visible in the northeastern and eastern parts of the country than in the interior. Nevertheless, until last year, a coordinated central-government effort to provide support for overseas marketing and investment by these conglomerates had been lacking. Last summer, the Ministry of Foreign Trade and Economi c Cooperation announced it would support outstanding enterprises--especially those among the 120 enterprise groups selected by the central government for priority support--in launching projects in Africa and Latin America to produce machinery, electronics, and clothing.

Bureaucracy rears its head

Perhaps the most formidable obstacle is domestic--the government bureaucracy that manages and oversees the country's SOEs. Many SOEs are controlled by provincial, city, and even county governments, as a result of past policies that transferred control of these operations to the provinces and allowed provincial and local governments to invest in and establish their own enterprises. As a result, state enterprises within the same industry are not always under the control of a single ministry. Moreover, ministerial, provincial, and local authorities have developed a strong sense of ownership over enterprises they supervise and are often reluctant to allow mergers with other enterprises, particularly those under the jurisdiction of another region or ministry. Recent government restructuring has not changed this basic ownership structure, though it has streamlined and weakened the bureaucracy's control over an enterprise's operation.

The Ninth FYP calls for accelerating the formation of enterprise groups that are inter-regional and inter-sec toral in nature. This will ensure, however, that China's bureaucratic structure will remain a major obstacle to PRC industrial policy in the years to come. For enterprises seeking to form conglomerates with firms from other regions, support from local governments that administer those firms will be crucial. As the president of the successful Qingdao Haixin Group noted, an important factor in the group's success was "vigorous support from the Qingdao city government [as well as from] the government departments of places where other involved enterprises were based.... For example, Guiyang city government and Qingzhou city government actively supported Haixin's mergers and purchases" of enterprises in those two cities.

To get around just such problems of local-government resistance, the many new, large enterprise groups tend to be made up of companies concentrated in the same geographical region. Yet even geographic proximity is no guarantee. Plans to merge Shanghai Petrochemical and Shanghai's Huayi Group in 1997, for instance, fell through because of bureaucratic rivalries: Shanghai Petrochemical was under MCI in Beijing, while Huayi was under the jurisdiction of the Shanghai municipal government, which has cultivated Huayi as one of its flagship conglomerates.

The formation of the Donglian Group is instructive because it illustrates the high-level support that is often essential to overcoming these bureaucratic road b locks. The four enterprises making up Donglian were under three different bureaucratic jurisdictions: Sinopec, the China Textile Council, and the Jiangsu provincial government. A merger agreement reportedly required the intervention of a leader above the ministerial level, in this case Wu Bangguo, who as vice premier outranks both the ministries and the provincial government.

A second, related barrier is the slow pace of establishing the modern enterprise system in China's state sector. Many Chinese policymakers and scholars view the modern enterprise system as an important prerequisite to the growth of successful conglomerates. The problem is that a large majority of the enterprises that have incorporated in the last few years have done so as wholly state-owned companies, rather than limited-liability or shareholding-liability companies. Unlike limited-liability or shareholding-liability companies, wholly state-owned companies do not have to hold shareholder's meetings, and most powers vested in shareholders are exercised by the board of directors.

Indeed, a number of recently established enterprise groups have resulted from mergers undertaken by the government, in which administrative departments and corporations have been combined as a part of the ongoing effort to streamline China's vast bureaucracy. As one 1997 World Bank study points out, these wholly state-owned companies and enterprise groups do not differ sig nificantly from traditional SOEs because their investors are still state organs, with no other shareholders to assume limited liability over the enterprise's assets. The governance structure of many of these "modern corporations" still allows the enterprises' administrative superiors to exert substantial influence over major management decisions. According to a 1998 New York Times article, the president of North China Pharmaceutical Group, a conglomerate that began experimenting with the modern enterprise system in 1994, admitted as much when he stated, "We say that the board of directors makes the main decisions, but it's really the Hebei Party Committee."

A third barrier arises from the dual role that conglomerates are being asked to take on now that China's state-owned economy has gone further into debt. Though Chinese authorities see the conglomerates as the vanguard of China's state-owned sector, authorities also see them as capable of rescuing loss-making enterprises and absorbing workers. There have been a number of reports that government authorities have pressured successful conglomerates to acquire loss-making enterprises--raising concerns that conglomerates are, in some cases, being formed on the basis of political considerations rather than economic ones. Moreover, the demise of many small and medium-sized local enterprises raises unemployment considerations that will certainly slow the pace of mergers and acq uisitions over the coming years, especially if China's economic growth fails to rebound significantly.

Concerns on the international front

There have also been concerns that PRC industrial policy is misguided, as large conglomerates in South Korea have been exposed as contributors to that country's economic crisis. The intimate ties between the Chinese government and its conglomerates only adds weight to these concerns. Although Chinese policymakers are confident that they will be able to learn from South Korea's mistakes, there have been no significant changes in China's industrial policy regarding conglomerates since the Asian crisis hit.

A streamlined corporate sector

Yet as many Chinese policymakers, economists, and entrepreneurs recognize, conglomerates have a long way to go before they become political and economic successes. Bureaucratic obstacles will slow the transformation of SOEs into independent corporate entities, and necessitate the intervention of high-level, central-government officials and politicians to broker mergers and acquisitions. Even after conglomerates are formed, the unanswered question remains of whether they will be able to compete with foreign firms in a more liberal, post-WTO environment while fending off government pressure to absorb China's growing army of deficit enterprises and unemployed.

Shawn Shieh is an assistant professor of Political Science at Marist College in Poughkeepsie, New York.