public disclosure authorized china's emerging private...

CHINA'S EMERGINGPRIVATE ENTERPRISESPROSPECTS FOR THE NEW CENTURY

21120September 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

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CHINA'S EMERGINGPRIVATE ENTERPRISESPROSPECTS 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 2000International Finance Corporation2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433U.S.A.Telephone: 202-473-7711www.ifc.org

All rights reservedManufactured in the United States of AmericaFirst printing September 2000

The International Finance Corporation (IFC), an affiliate of the World Bank, promotes the economic development of its member countries throughinvestment in the private sector. It is the world's largest multilateral organization providing financial assistance directly in the form of loans and equityto 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 beattributed 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 countriesthey represent. IFC and the World Bank do not guarantee the accuracy of the data included in this publication and accept no responsibility whatsoeverfor 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 ourWebsite 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 emergenceof a significant private sector. Initially allowed only on the fringes of the economy, it now accounts for about a thirdof gross domestic product and is officially recognized as an important component of the economy. This recognitionreflects 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 reformof the financial sector. Restructuring SOEs and recapitalizing the banks are likely to be expensive, both becauseof short-term employment losses and fiscal costs. The private sector has emerged as an important source of incomeand employment growth, which can mitigate the social costs of reforms. In addition, China is trying to address thegrowing regional disparities in growth and incomes. Private sector development in the interior of China could beone way to narrow the gap betweeni the interior and the coast. Externally, China is becoming increasinglv exposedto the opportunities and challenges of globalization. The prospect of membership in the World Trade Organizationhighlights the need for major and rapid adjustments in virtually all sectors of the economy. New private businessesare 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 thusfar 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 outin four locations: Beijing, Chengdu, Shunde, and Wenzhou. These were supplemented by additional discussions heldby the authors with entrepreneurs, industry associations, govemment officials, and others in these locations, as wellas in Chongqing and Shanghai. The report focuses on three main themes: the structure of private enterprises, theenabling environment for their development, and access to financing. For each of these areas, the report presentsan 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 wereprovided 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 successfulimplementation. Wei Dong (director general, Small and Medium Enterprise Department), Tian Chuan (deputydirector, Small and Medium Enterprise Department), Wang Xu (International Department), and other SETCstaff provided valuable guidance and support throughout, and the fieldwork was supported by the Economic andTrade Commissions in each locality. A range of other government and non-government institutions at the centrallevel and in the four localities also contributed information and perspectives. This partnership was supported bythe government of Australia, which financed the costs of the study through the IFC Australia-China TrustFund. 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 ChinaCenter for Economic Research (CCER), Peking University. Ligang Song (APSEM) and YangYao (CCER) were theprincipal authors of the technical report, under the direction of Ross Garnaut (director, APSEM). The fieldworkteam 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 ofGary 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 andcomments were made byYingyi Qian (University of Maryland), Wu Jinglian (State Council Research and DevelopmentCenter), and Nicholas Lardy (Brookings Institution), which together with the discussions at the conference enrichedthe 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-FrancoisArvis, Joseph Battat, Joan Bayard, Ravi Bugga, Amanda Carlier, Simeon Djankov, Xiaofeng Hua, Albert Keidel, KlausLorch, and Guy Pfeffermann.

Finally, the study depended upon the insights and perspectives of the private entrepreneurs themselves. We areextremely grateful to the hundreds of entrepreneurs who talked at length with interviewers during the fieldworkand 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 oneof the main conditions for sustained growth and poverty reduction. It also reflects the evolution of lFC's strategyin China. The size and the breadth of IFC's program in China are in many ways a function of the development ofthe private sector in this transition economy. When the private sector was mostly small scale and informal, andthe 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 importantrole 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 newopportunities to broaden our program to include support for local financial institutions, indigenous industrial andinfrastructure 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 inChina with new insights into its status and new ideas for ways to support and participate in its future growth.

Javed Hamid

DirectorEast Asia and Pacific DepartmentInternational Finance CorporationSeptember 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 sectoralchange, 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 domesticprivate enterprise also plays a strong role. By 1998 the private sector has developed since its reemergence inprivate sector had grown to about 33 percent of gross the late 1970s. Private enterprise first took holddomestic 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 theseshift, thereby laying the foundation for the private rural and individual enterprises, and out of collectivessector to emerge from the shadows and play a promi- and state-owned enterprises, although they were notnent 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 rapidment and has paid little attention to the growth of growth of private enterprises. This was given furtherdomestic 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-ownedwhere it has come from, its current status, and its enterprises and that allowed collectives to transformfuture prospects. But as Marx said, the point is not just into private enterprises. In many cases, such transfersto understand the world, but to change it. So the study were merely catching up with the reality of how thesefocuses as much on prescription as on description. It enterprises were operating.addresses the question, what needs to be done fordomestic private enterprise to flourish? This question Owing to this pattern of development, the domesticis 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 propertytions that finance them, and the government, which rights, ownership structures, corporate governancecontrols the policy and regulatory environment. mechanisms, financial records, and rights to market

access. They are often part of complex groups ofTo arrive at an answer, it is necessary to go beyond the companies, spanning many different activities. Thisrather limited statistics on the private sector and talk gives entrepreneurs great flexibility to respond to andirectly to entrepreneurs, policymakers, and finan- uncertain world composed of unclear and rapidlyciers. 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, toShunde, 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 businessesinstances of relatively advanced private sector develop- have many of the strengths and weaknesses morement in different circumstances (capital city, inland often associated with small start-ups. The challengeprovince, coastal province, Pearl River delta). They for entrepreneurs now is to put their businesses on atherefore illustrate the constraints and opportunities firmer footing as the policy and regulatory frameworkthe 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 withbiased in favor of state-owned enterprises, whether in other issues, the solution involves a combination ofproviding access to markets or to finance. Now that the straightforward regulatory changes (such as allowinggovernment recognizes the private sector as a pillar of private firms greater access to equity markets) andthe 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 thethe public and private sectors. A high priority will be to basis of commercial decisions rather than governmentshift from a discretionary, particularistic way of regulat- direction). However, access to finance will not improveing and taxing the private sector toward a rules-based until private enterprises formalize and their financialsystem. 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 privateenterprise also depends on progress in more fundamen- China's impending accession to the WTO providestal 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 competitionCritically, 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. Hencepoorly served: a very small portion of bank credit goes the environment for domestic private enterprise willto 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 theresult, private firms rely very heavily on self-financing domestic private sector on solid ground, so that it willfor 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 01991 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 thesize of the domestic private sector in each location, seefigure 1.5). Beijing provides an opportunity to observehow 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 industriesin 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 case1,500 - study of private enterprises in inland areas. Shunde is

ooo0 ; *a county-level city in the Pearl River Delta in1,000; Guangdong Province and has experienced rapid

soo _ growth in its private sector following a comprehensiveenterprise ownership reform program in the early

0 1 1 1 990s. Wenzhou, on the coast of Zhejiang Province, is1991 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 representativesample of private enterprises across the whole of China,

that caportunihel reduce thoseconstraintsandenhance they are cities in which such businesses have become animportant 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 insChintatdayEconomic and Trade Commission (SETC) and drawson fieldwork in China in the summer of 1999, alongwith discussions at a conference in Beijing in April Description2000. It also draws on IFC's and the World Bank of the Fieldwork LocationsGroup's global experience in promoting privatesector development. Private enterprise has flourished in each of the field-

work locations. As mentioned earlier, the four citiesThe fieldwork focused on four cities with distinct were chosen for their distinctive approach to privateapproaches 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 1998Source: 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 61,113B 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 adocument calling for a speeding up of private sectordevelopment. Concrete policies promoting suchdevelopment are under consideration.

ChengduChengdu is the provincial capital of Sichuan and has apopulation of 9.9 million. Its GDP in 1998 wasRMBIIO billion (US$13.29 billion), or RMB11,103(US$1,341) per capita, and its industrial output wasRMB121.9 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, itsindustrial output was RMB14.1 billion (US$1.7 bil-

- - -- ~~~~~lion), or 30.8 percent of the city's total output, and itsGDP was RMB10.7 billion (US$1.3 billion), or22.3 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, or12.4 million. In 1998 its gross domestic product was 10.3 percent of the city's total. In some counties, theRMB201 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 firmsRMB171.5 billion (US$20.7 billion). Although and getihu) contributed 90 percent of the total taxBeijing has more private firms than the other cities, revenue in 1998.they appear to be fairly small because their outputand sales volume are the smallest. Even so, the private Since 1992 the number of large private firms insector in Beijing has experienced rapid development. Chengdu (firms with registered capital of more thanIts 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


Industry Beijing Ch0ndu Shud ;Wenzhou Overail

Chemicals 12 19 20 8 8

Electronics 19 10 18 35 35and apparatus

Foods and cigarettes 11 18 8 4 4

Garments and 31 18 28 14 14other light products

Machinery 7 11 8 29 29

Metal and nonmetal 9 14 10 10 10manufacturing

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 ofthan 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 thanChina, 5 were in Chengdu. In addition, some large RMB 100 million (US$12 million). In particular, it hasprivate firms began to buy large SOEs, playing an become the nation's largest industrial base for homeincreasingly significant role in the state sector reform. electronics, producing every kind of home electronicThe industrial distribution is quite balanced, as product except televisions. Several nationallyshown in table 1.1. renowned firms have also emerged, notably Kelong

(a major national refrigerator producer), MD (theShunde world's largest electric fan producer and a majorShunde is a county-level city with a population of only national producer of air conditioners), Grand (the1.4 million and a gross domestic product of RMB26 nation's largest microwave producer), Wanjiele (gasbillion (US$3 billion), or RMB24,769 (US$2,991) per heater manufacturer), and Kangbao (the nation's largestcapita. 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 ofRiver estuary, the city lies outside the enterprise the four "small tigers" in Guangdong Province.zones on the east bank, which have attracted massiveforeign investment, especially from Hong Kong. WenzhouShunde's private sector began to take shape largely as a Wenzhou is a prefecture-level city governing severalresult of its ownership reform program, which started in counties and county-level cities and has a population of1992. Currently, there are almost no purely state- about 7.2 million. Its GDP in 1998 was RMB72 billionowned 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 citiestownship-village enterprises (TVEs). Its leading indus- opened to foreign trade, and a national economictries 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 inindustries have formed several nationally renowned Beijing, Wenzhou, Shunde, and Chengdu. The numbergeographical clusters, such as electronic parts in collected amounted to 628, which represents aHongqiao, low-voltage electrical products in Liushi, response rate of 26.2 percent. Because of inaccurateand buttons in Qiaotou. In addition, the garment indus- addresses, the response rate from actual recipients wastry is a pillar of the local economy. Overall, the sample somewhat higher.enterprises are heavily concentrated in machinery andelectronics (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 CommerceIn view of the size of the Chinese economy, it is not Management in each city. This excludes privatelypossible 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 asis a trade-off between timeliness and thoroughness. geti gongshang hu, or getihu), were also excludedTherefore, 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 jointadopted a rapid assessment approach in the field- ventures and firms engaged in commerce and serviceswork. That is to say, we analyzed specific locations were also surveyed.and segments of the private sector that could yieldusable information and analytical insights within a The ratio of rural versus urban firms sampled in eachlimited time frame. This is therefore a preliminary locality was kept roughly the same as the ratio of ruralanalysis, which could provide further valuable infor- versus urban firms in that locality. This was achieved bymation if extended to cover more locations and other the random selection of firms within rural-urban stratasegments of the private sector. in each locality. The share of each type of ownership

examined-sole proprietorship, partnership, limitedThe fieldwork consisted of structured interviews of liability company, and so on-were kept roughly thegovernment 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 randomlyprivate 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 didand open-ended questions, interviewers met with CEOs not have the required data, and many firms under thein a subset of 338 of the surveyed firms. CEOs filled in control of private domestic entrepreneurs were notthe structured questions during interviews, and inter- registered as such and so could not be identified. Thusviewers posed the open-ended questions. These latter the enterprises covered in the survey do not represent aquestions 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 privatechanges that are needed to improve the business and pol- sector that it is easiest to identify and contact. Theseicy environments in which private enterprise operates. tend to be among the larger, more mature private

enterprises. Although they certainly offer insight intoMail-out Questionnaires domestic private enterprises, they do not necessarilyThe 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 todevelopment. These questions were to be answered by understand the full range of private sector activity inpersons designated by CEOs, such as deputy managers China today. The distribution of sample enterprises


by industry as a whole and in each city sample is institutions, and business associations. The officialshown 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 creditTo gain a wider perspective on private enterprises, we unions. In some locations, we also interviewed peoplealso interviewed officials of official institutions, financial at business associations.

6 INTRODUCTION

EVOLUTION AND STATUS OFTHE DOMESTIC PiolY'131M11103:_

C hina's market-oriented reforms of recent external trade and payments (through the sharing ofyears have produced impressive results. foreign exchange between central and local govern-Perhaps the most important is the emer- ments, trade contracting, and foreign exchange tradinggence 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 withoverall approach to reform. respect to private sector development because transfer

of ownership did not enter political debate until wellReform Approach into the second decade of market reforms. When the

reforms began, the prevailing view was that activitiesOne notable feature of China's approach to reform is in the private sector complemented those of the stateits emphasis on gradual experimentation at the local sector. They were tolerated and even encouraged inand 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 theoutset, Chinese leaders did not envision the private This dual-track approach is perhaps the most importantsector as the driving force of economic growth. Rather, aspect of Chinese reforms since it was, at the time, anprivate business was revived in the period after the innovative solution to the political constraints on theCultural Revolution as a quick way to respond to the direction and speed of reform. One such constraintmounting pressures of unemployment and economic was the emphasis on "consensus-making," meaning itstagnation. 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 analysisunpublicized experimentation, followed by general "in has shown, the dual-track approach in China has beenprinciple" approval, then by ratification and specific both efficiency-enhancing and Pareto-improving, thatregulations, only after the reform in question has is, with no one made worse off (Laffont and Qianbecome well established. Oftentimes, new regulations 1999; Lau, Qian, and Roland 1997). It has allowedhave been accompanied by "rectification" campaigns, economic agents participating in the market track towhich have set the private sector back in its devclop- benefit from liberalization while protecting the vestedment. As the term "gradual" suggests, reforms are interests of state-owned enterprises and bureaucrats inimplemented over time. Several years may elapse from different industries and sectors. Although the reformsthe beginning of a reform experiment in one of the were controversial, the experimental dual-track way ofChinese provinces until it is endorsed from the center introducing them enabled reformers to bypass the formalor is imitated by other provinces. ideological debate usually required for public legislative

sanction of reforms and also to use the successful resultsAnother reform characteristic in China has been the of the reform as ammunition in the debate.use of partial reforms within sectors, also known as thedual-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 tothe household responsibility system. Later it was market. One is decentralization. Since 1958, theapplied 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. Byet (through the fiscal contract responsibility system), contrast, organization in the former Soviet Union was


much more centralized, along sectoral lines (Qian creating the self-reinforcing character of Chinese1999). A regional system has the important advantage reforms. There were not many rents for bureaucrats toof 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 ofent ingredients of reforms can be tested and matched reforms in agriculture brought needed savings, whichwithout 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 theopment. They were in the form of a fiscal contracting benefits of growth in this sector. The development ofsystem known by the nickname "eating from separate the non-state sector in turn created pressure, but at thekitchens," 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 cycleThe new system encouraged and rewarded local govern- of reforms with growth, and the private sector endedments 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 Pointspolitical structure. in Private Sector DevelopmentThe 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 threecreate losers on a large scale within the bureaucracy. phases in the development of the private sector: theConsequently, the experiments had to be of the dual- first from 1978 to 1983, the second from 1984 totrack 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. Despitethe lack of political liberalization, China has been able Phase 1: 1978-83to transform its bureaucratic system substantially This phase is marked by the official revival of privatewith a mandatory retirement program for the revolu- business. However, the private sector was limited totionary veterans, a drive for administrative and fiscal individual businesses (getihu), which developed first indecentralization, and the decision to allow bureau- a regulatory vacuum. These businesses had a strongcrats to quit the bureaucracy and join businesses (Li experimental flavor. Regulations came later in the1998). 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 andsupporting 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 goodsfamily ties to entrepreneurs (Frye and Shleifer 1997; and services and in employment. Official attentionWalder 1995). Under such incentives, central and local focused on the urban private sector, although perhapsgovernments have the capacity to act like Olsonian deeper changes were taking place in the rural areas.encompassing organizations, exercising self-restraintand not expropriating efficiency gains through ratchet- The Third Plenum of the Chinese Communist Party'sing (Olson 1992). The township and village enterprises, 11th Central Committee in December 1978 is said toin which local governments have direct ownership mark the beginning of market-oriented reforms inand management stakes, were one incarnation of this China. Although the plenum itself made no specificlong-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 theThe 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 impetuschanges, 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 moreincrease 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 inly announced at the Third Plenum, local governments 1987, 0.2 percent of the farm households hired morebegan to formulate procedures for the administration than eight people in 1986. Taking the survey as aof the individual economy. Yet the individual economy representative sample, it was estimated that by thestill had an experimental flavor and was confirmed end of 1988, China had 500,000 getihu that could beonly by a set of State Council regulations on the called private firms (Zhang and Liu 1995, p. 55).urban, nonagricultural individual economy in July1981. These regulations defined a new business Some larger private enterprises emerged from the leasingcategory, geti gongshang hu, or single industrial and of state or collective enterprises to individuals. By 1984commercial proprietor. The government moved with the share of such firms in the total number of collectivecaution in developing the getihu. The July 1981 firms had reached 50 percent in some localities (Zhangdocument capped the number of employees a getihu and Liu 1995, p. 29). The private entrepreneur paid thecould hire at eight. In addition, it specified that indi- collective a fixed rent and operated the firm as if it wasvidual businesses were only supplements to the state his own and in many cases accumulated considerableand collective economic units, and could develop assets. These enabled him to reduce the share ofonly 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 categoryfundamental reform in agriculture because economic until June 1988. Administrative bodies dealt with suchmanagement 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 moreand became "specialized households" (zhuianyehut). than eight people. This practice was more prevalent inMany of these were in fact private nonagricultural urban areas. In rural areas, larger private enterprisesbusinesses. Because they originated within the were able to gain at least partial entry into the collectivecollective agricultural economy, however, their category by one means or another. Second, firms couldprivate nature could be ignored for the time being obtain a collective license by paying an "administrationand obviated the need for guidelines or regulations fee" to a state or collective unit or local governmentdealing with them as such. organization and thereby receive its stamp on the appli-

cation for registration. Such firms were called "red hatIn 1983 China introduced a series of central and local firms," meaning that the private owners put on a hat ofregulations 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. Thisfree markets. These were followed by inspection kind of firm continued to exist even after the regulationsdrives. "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 phenomenonThis 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 employeesfrom 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-calleddevelop 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 privatedevelopment 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 andment to the public sector. employs more than eight people."' Firms that hired


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 firmsfirms: those under sole ownership, partnerships, and changed, providing private entrepreneurs with alimited liability companies. Siying qiye, defined as more hospitable social and psychological environ-enterprises with privately owned assets and employment. 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 theplement to the socialist, publicly owned economy and most rapid private firm development occurred fromenjoyed the protection of the state. By the end of 1992 to 1994, not only with respect to the number of1989, the total number of registered private firms had private firms and employment but also with respectreached 90,600. to output (table 2.1).

The number of registered getihu declined from 23.1 Perhaps the greatest change in official attitudemillion at the end of 1988 to 19.4 million at the end of toward private ownership came at the Fifteenth Party1989, and the number of registered private firms Congress held in September 1997, when privatedeclined 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 thenumber were transferred into collective firms or had rule of law and its crucial role for a modern markettheir employees reduced to fewer than eight people. economy to work well. Private ownership and theAccording to a survey of 286 private firms closed in the rule of law were incorporated into the Chineseperiod January to April 1991, 22.7 percent of these Constitution in March 1999.firms were transferred to collective ownership and 20.3percent had their employees cut to under eight (Zhang Patternsand Liu 1995, pp. 50-51). of Private Sector Evolution

Phase 3: 1993 to the PresentThis period has been marked by important changes in For historical and ideological reasons, private businessesChina's overall approach to reforms and its official atti- first emerged as individual enterprises in rural areastude to the role of the private sector. While experi- and in sectors such as trade and services, where therementation continued, a coherent strategy of transition were a limited number of large state enterprises, andto a market system began to emerge. The strategy distortions from central planning created marketenvisages a market system based on the rule of law, in opportunities for private entrepreneurs. The scope ofwhich the private sector is an important component. private sector activities then gradually expanded, as

their legal and organizational framework, geographicDeng 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 suggesteffort, was a defining moment in China's transition that this pattern is by and large consistent with theto market. It was followed by the big ideological normal evolution of private business. For example, onebreakthrough at the Fourteenth Party Congress: for of the most important inroads of private activity inthe first time, the socialist market economy was other socialist economies occurred through privateendorsed as China's goal of reform. And in 1993 the farming and in the service, transport, and constructiongovernment designed the first "grand strategy" of industries (Kornai 1990). Once China allowed sometransition to a market economy, with an emphasis on room for private activities to emerge, this was enougha rule-based system and on the building of market- to trigger the spontaneous development of the Chinesesupporting institutions. This was the turning point for private sector, despite the remaining plethora ofChina on the road to markets. The new approach restrictions and biases. When the internal dynamics ofadvocated 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 accommodateket system, as opposed to particularistic contracting; the new realities until formal constraints were relaxedand it addressed the enterprise reform issue in terms and new room was created for the expansion of privateof property rights and ownership, thus opening the sector activities. This flexibility, as explained earlier, wasdoor for the transformation (gaizhi) of SOEs. largely due to factors related to decentralization and


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 reformsensuring 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 UrbanAs just mentioned, the rural enterprise played a domi- Self-employment in rural areas continues to exceednant 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-employmentU Rural private employment

19971997 _ _ = 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.


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 anddiffered from those of the urban private sector. One 23:34:100 in 1997. In terms of employment, the rationotable difference can be seen in the ratio of getihu to was 22:26:100 in 1992 and 25:39:100 in 1997. Insiying qiye, which is much higher in rural than in urban terms of both numbers of firms and employment, theareas. Historically, the industrial structure of the private central provinces were able to catch up with the coastsector has also differed significantly in rural and urban faster than the western provinces.areas. In the cities, private businesses have clustered inthe small-scale retail, service, or food service industries, As figure 2.2 shows, however, the relative shares in urbanwhich have had a disproportionately strong impact on employment are not that different. The coast has thethe 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 oflargely 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 ofreforms promoted a surge in the growth of rural enter- domestic private sector employment as of 1998. Withinprises. Of these, nearly 40 percent were engaged in the domestic private sector, however, the coast has themanufacturing or processing (Young 1995). highest share of employment in private enterprises with

more than eight employees (siying qiye), and the highestFrom East 2o West ratio of siying qiye to self-employed. The latter closelyBecause of China's emphasis on decentralization and resembles the urban-rural dimension of the relationshiplocal experimentation with reforms, private sector between siying qiye and getihu. Overall, the share of thedevelopment was greatly influenced by local condi- non-state sector in urban employment is highest in thetions, 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 ofdevelopment differ from region to region. The differ- From ln normality and PariVcularisimences between coastal and interior provinces are espe- 2io tlh$ RuWe og Lawcially pronounced. Some of the unique features of private business in

China derive from the fact that the private sectorThe 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


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 thetion, 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, whichfor most of the reform period private businesses have become a drain on the resources of enterprisesevolved 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 applicablelong as activities in the sector were viewed as a tempo- rules, forced local officials and enterprise managers torary solution to some economic problems of the day concentrate on rent-seeking rather than economicand 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 processThe 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 onis 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 and1992). 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 toclear 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 fragmented1992; 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 particularismknow each other very well; they do not raise capital has created a high degree of local protectionism. Fiscalfrom the public; and debt capital plays an insignificant decentralization and patronage over local enterprisesrole in their financing. What they need most is to have encourage local officials to protect local markets forthe 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 isthem 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 itBecause 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-calledeconomy and during most of the reform period was red hat firms. In March 1998, the government issuedviewed as a supplement to the state sector. China a directive requiring all the red hat firms to "take offdelayed ownership reform of SOEs, and, in fact, did the hat" or show their private ownership bynot divest any state-owned assets or lay off any state November 1998.workers before 1992. It took the first of these steps ona large scale in 1995. Not all localities were fully prepared for gaizhi. Many

firms just changed their name without going through anyThe rapid development of the private sector and its form of restructuring (see box 2.2 for a description ofimpressive performance in the 1990s have been a cata- gaizhi in Sichuan Province). This was particularly true forlyst for SOE reform, with major progress occurring in firms introducing ownership in the form of employeethe 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 Zhiat the county or lower administrative level have been 1999), is not sufficient to improve economic efficiency ifrestructured. 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 ownershipchanged China's economic makeup. with government reform. In the course of its program,

the Shunde government undertook a radical reform byOwnership reform programs were initiated at the local cutting one-third of its employees and 40 percent of itslevel in part because the large amount of debt accu- functional units. This reform has served as a signal tomulated in the state sector was a drain on local budg- the private sector that the government has a credibleets, especially in the smaller cities. That was certainly commitment to curbing rent-seeking behavior as well asthe case in Shunde when it started its program in 1992 microlevel interference. To a large extent, the smoothand took the radical step of selling off almost all its and successful transformation in the city should bestate and collective firms (box 2.1). attributed to government reform.

In 1995, the central government formulated a policy Contributions of the Privatecalled zhuada fangxiao, meaning "keep the large onesand let the smaller ones go." It decided to keep under Sector to the National Economyits ownership 500 to 1,000 large state firms and toreform the smaller SOEs through a package of policy The private sector is the most dynamic component ofmeasures including reorganizations, mergers, acquisi- the domestic economy. Between 1991 and 1997, thetions, leasing, and sales. In 1997 the 500 largest state number of siying qiye grew at an average annual rate offirms 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 theof 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 employmentlocal governments were in the red, compared with in the private sector has exceeded the combined totalonly 24 percent of the centrally owned firms. for state, collective, and township and village enter-

prises (Rawski 1999). This explosive development isFrom 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 froming and leasing, two methods used before, as well as the SOE sector.


Box 2.1. Shunde's Ownership Reform Program

When Shunde began its ownership reform program in 1992, it tried to maintain collective ownershipand adopted employee shareholding as the main form of ownership. However, it encountered severalproblems with this strategy. First, employees could not be counted on to purchase shares, eitherbecause they did not have enough money or because they did not have enough faith in the factory'sfuture. Second, the manager in an employee-held firm still played the role of an agent, and the firmcontinued to experience the monitoring problem faced by state and collective firms. Third, free-ridingwas a major concern because irrespective of performance an employee could still receive dividendsfrom 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. Theseforms 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 andShenzhen (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 firmswere sold or partly sold to a listed firm in another city. This form of ownership change is called "borrowingthe 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 equipmentand leased the land and buildings from the local government.

MBO was the most important and most interesting form of transformation. Many firms that were initiallyrestructured as employee shareholding were transformed by MBO through the concentration of sharesin 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 accountingfirm, usually from Guangzhou, the provincial capital. To protect workers' employment, no more than 5percent 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 usuallypurchased by the original management. To handle problems emerging in the transitional period suchas debt issues or ownership transfers, the government usually asked the management to register anew 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 netassets and shoulder the firm's debts. The payment could be made within five years. For some firmsthat 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 netdebt. The management had to purchase 15 percent of the firm's gross assets, with the payment beingmade within five years.


The increasingly important role of the private sector Although the private sector appears to have becomeis 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 withBetween 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 mixespercent (figure 2.4). The employment picture also the concepts of ownership, sectors, and corporateshows impressive growth (figure 2.5). The private organizing methods. This makes it difficult to arrivesector'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 difficultits share in industrial employment had reached more to separate out what portion of the increasingthan 18 percent of the national total. Between 1989 employment and output of the sector is due toand 1991, the expansion of employment experienced "indigenous growth" within the sector, on the onea major downturn, but since then it has grown rapidly. hand, and to the transformation of enterprises fromBy 1997, the total number of workers had reached other types of ownership, on the other. The difficulty67.9 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 bythe National Statistics Bureau do not separately iden-

Percent tify subtotals for private firms. The lack of accurate150 -*%SOF financial data on pretax profits, fixed capital, and work-

* Collectives ing capital makes systematic comparisons of the rate of100 Foeinreturn on private firms' assets with those of other forms

* Dometic pivateof ownership, notably state-owned firms and foreign50 ~ ~ ~ ~~ ~omsi piaeinvested firms, a difficult task.

50 -s

0 To estimate the private sector's share of GDP, we takea 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 percentSource: China Statiical Yeabook,


Figure 2.4. Share of Private Sector in Total ustrial Output in Chnai 1980-97

Percent

35

30-

25-

20-

15-

10-

01980 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

01981 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.


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 62sector

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 27private 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 formaflyregistered private firms and getihu.

b Domestic private enterprises.now include shareholding firms and those firms under collective titles but truly private, assuming they accounted forabout 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 followingsectors: agriculture, industry construction, transportation, post and telecommunication, wholesale and retail trade, and others. Various assumptions onthe relative shares of each ownership type in each sector have been made from relevant data. All the original data are from Statistical Yearbook ofChina, 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 suggestsRatio that investment in the private sector is more efficient2.0 I than in the state sector.5

1.5 The latest statistics released by the State Bureau ofIndustry 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 million0.5 0: ;Q. : 0 t0;. ; 00. g workers, and had registered capital of RMB817.7 bil-

lion (US$98.8 billion).6 All three indicators increased0.0 Non-state Co_llective_ -Lby about 25 percent over 1998.

SOE Non-state Collertive Private Foreign

The numbers and growth rates of private enterprisesNote: Capital-output ratio is calculated by dividing gross industrial voutput by total assets. vary across sectors of the economy By the first halfSource: China Statistical Yearbook, 1997, 424-25. | of 1999, there were 30,000 private firms (siying qiye)


in primary industry (mainly agriculture), which Cultural Revolution as a quick way to respond to therepresented an increase of 20 percent from the end mounting pressures of unemployment and economicof 1998. There were 530,000 firms in secondary stagnation. It was first allowed on the fringes of theindustry (manufacturing), up about 5 percent from economy and was initially regarded as a supplement tohalf a year earlier. The majority of private firms are in the state and collective sectors. Private entrepreneurstertiary industry (services); their number had did not yet enjoy a clear identity, their property rightsreached 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 bureaucracyIn 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 strongthe 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 toFrom 1992 to 1997, the shares of industrial employ- allow the cumulative development of the domesticment 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 thement and output at trading companies increased by 15 private sector well in the past. But this evolutionand 7 percentage points, respectively The shares of constantly brings new problems, some of whichother sectors did not post such significant changes. require new approaches. Areas of strength in the past

are now turning into liabilities for the dynamic growthof 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 thePrivate business was revived in the period after the related problem of informality.


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 ofits 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 permittedwere 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 familyadvantages, 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 thebelieved 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 firstIn 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 firmsin various ways to obtain representation, solve procure- The mismatch between the formal structure of thement problems, and obtain access to markets and firms and the reality on the ground has importantfinancial services. Many coinvested with state and consequences for their operation. While it conferscollective firms to overcome entry barriers in particular on the enterprise the rights and privileges of the formsectors, 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 firmreferring 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 manyAnother 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 attainpositions 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, andenterprises and therefore did not include red hat credit contributed substantially to the initial financingfirms. Of these, 40 percent were sole proprietor- of many private enterprises.ships, 30 percent partnerships, and 29 percent limitedliability companies. Sole proprietorship has the dis- Although this may be one way to address China'sadvantage of taking unlimited liability, but it has the market and policy failures, the fact remains that manyadvantage of not being liable to establish a standard private entrepreneurs put on a red hat just to evadecorporate account and put it under the state's super- the ideological bias and government regulations. Invision. This provides certain attractions, including many cases, local governments suffered fiscal lossesscope for tax evasion. Many of the sole-ownership rather than benefited from the presence of a red hatfirms surveyed were large (the average of net fixed firm. At the same time, the private firm suffered fromcapital stock of these firms was RMB15 million political interference in its operations.[US$1.8 million]).

In Shunde, for example, the most important reason forThe current law prohibits a firm with a single owner the local government to transfer collectives to privatefrom registering as a limited liability company Where ownership was to get rid of the burden of red hat andfirms do want the protection of limited liability, sole other government-owned firms. A red hat firm made anproprietors may form partnerships with sleeping part- entrepreneur's incentive asymmetric. If the firm madeners, such as a family member, who have no effective a profit, it was his. If it incurred a loss, the governmentcontrol or role in the enterprise while formally owning had to shoulder the burden. As a result, village anda share of it. Although the law does not set a minimum township governments accumulated a considerableshare for the second owner, in implementation the amount of debt. Government officials in Shunde calledshare is set at between 5 and 20 percent in the four this "bleeding" and the transformation program thecities covered in the first phase of our survey. "project for stopping the bleeding."


Corporate Governance _

A key characteristic of the informality of the privatesector is its opaque organization (for types of corporategovernance, see box 3. 1). That is to say, because of theirartificial status, firms operate quite differently fromwhat 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 leffectively owned by domestic companies.

Managers appear to make most of the important deci-sions in the firm: in those surveyed, managers did so in69 percent of the cases, the board of directors in 23percent, and others in 8 percent. This is typical of early-stage companies or family businesses in which ownersand 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 totackle the principal-agent problem of ensuring thatstaff act in the interests of the owners. In the absenceof 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 alternativeapproaches to corporate governance. Some have triedto 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 thepoor performance of some large enterprises, which lack effective managerial control and take excessive accountof political considerations in their decisionmaking.

A large problem for family businesses everywhere ishow 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 relativelyto run the business. Because businesses often fail at young, however, so this has not yet emerged as a majorthis 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 toprovide all the management skills themselves. junior high school, 25 percent have gone to senior highprovideg 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 studyspecific skills. This leads to principal-agent prob- glems, which firms address either by hiring family just mentioned, only 40 percent of entrepreneursles 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 atmaalgne whaose of the owner) og. the junior high school level (34 percent), while it

jumps to the college level for the larger firms: in firmsof 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 SocialSciences (CASS) and the National Association of When broken down by location, 45 percent of theIndustry and Commerce (NAIC), 48 percent of the managers in Shunde and 34 percent in Beijing have arelatives of the entrepreneur were employed in man- junior high school education, while 28 percent inagement of the enterprise, including 51 percent of Beijing are college graduates. In the four cities as athe 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 ofIndustry and Commerce (ACFIC) found that 98 per- the managers have a Ph.D. degree, while there arecent of private enterprises were family-managed. almost none with this degree in the other cities. ThisOne such enterprise is a medium-size firm in makes sense because those two cities have many topWenzhou 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 indevices 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. Theiris the financial manager, the second son-in-law is the past sectoral experience breaks down as follows: 74sales manager, the sister-in-law is in charge of gener- percent worked in the industrial sector, 43 percent inal affairs in the office, and the nephew is the pur- private firms, 33 percent in state-owned firms, and 13chasing manager. percent in collective firms. Thus both the private and

the state sectors train and foster entrepreneurs. WithEven if employees are given the option of buying the the further reform of SOEs, more entrepreneurs canfirm'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 employing a significant source of human capital accumulation.ees and must be cashed out for an employee whowants to leave the firm. Moreover, the lack of financial At the same time, private firms have difficultytransparency and clear asset ownership makes it diffi- obtaining and retaining skilled workers. For onecult to value the shares or to realize their value when thing, state firms are able to offer greater job securitythe 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 manyallocation of shares or share options to managers more college graduates do not want to work in a Chineseeffective. In fact, a major reason for Stone Group, one private firm even if it pays a higher wage than a stateof the largest high-tech firms in China (see box 3.2), to firm. This situation is more prevalent in Beijing andgo public was to solve its internal incentive problem. Chengdu, where the first choices of universityThe software industry is knowledge-intensive, and the graduates are foreign companies, joint ventures, andincentive problem is more acute here. government institutions.


Again reflecting the economic uncertainties they face, Labor Relationsprivate firms tend to recruit managers in an informalway, with an eye on reducing their risks. For example, Employees in a typical private firm can be divided intoone 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. Thewhereas a low-level office mnanager can get more than first group generally occupy better positions in the firmRMB8,000 (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 anddiscourages highly talented people. Offers of such a health insurance for urban residents. Firms need thewage and uncertain career prospects make it almost expertise of outside graduates, so they tend to treatimpossible 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 lostfirms 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 reducedIn 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 Disclosurehave less favorable jobs and lower wages but alsopoorer accommodations. Rural workers usually live To preserve their chosen formal status, firms oftenin firm-provided dormitories within the factory, often need to keep their financial structure opaque. Most8 to 12 people in one small room. In contrast, local do not maintain transparent, audited financialpeople 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 offirm (two persons in a room, the firm buys commer- the firm. Restrictions on registration under differentcial apartments for employees with higher positions, categories of incorporation give firms an incentive toand so on). underreport and misreport financial flows, numbers

of employees, stocks of assets, and the like. This isOnly 27 percent of the surveyed firms responded to a exacerbated by the burdens of the tax system, whichquestion about worker unions. Of these, 60 percent also encourages underrecording.had a unionized workforce. This may overstate theprevalence of unions, however, because those firms Enterprises are commonly said to keep three sets ofthat did not provide an answer to the question might books: one for the government, one for the banks, andnot 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 controlsworkers: 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 allowedresolve workplace disputes, whereas only 11 percent companies to respond with agility to shifting regulatoryrelied on direct negotiation.4 In addition, the courts and policy constraints.and the government played an important role: 21percent 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 firmsNote, 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 providemanagement. This is particularly significant in Beijing. such a report and 70 percent of the sample firms areAlthough 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 theemployees may also see it as beneficial in that it allows owner, there is little immediate reason to publishemployees who are party members to justify working audited financial statements. Unless audited financialfor 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. Theseunemployed 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 notresult, they have become competitive in the labor mar- said they never considered it, 41 percent thought itket. 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.


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 ofFinance'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 crAn important feature of China's domestic private sec-

. . ,> porate governance, its shareholders may have littletor is the prevalence of conglomerates consisting of contr governthe, m ana ers oh n rse. Tisrelated 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 hrrather 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 inconditions, government policies, and regulations nela nesses.changing rapidly and unpredictably, businesses areexposed to different risks in each sector in which

Sinc thee riks ae no comletey ;f Opaqueness. Diversification also serves to increasethey operate. S . a r the opaqueness of the enterprise, which may help tocorrelated, firms can reduce risk by diversifying disguise the true ownership or tax liabilities.their operations among different sectors. The moreunrelated 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 threeunrelated businesses. This seems to be more preva- to five, and 24 percent had more than five. In addition, 5lent in locations such as Chengdlu where th...............e cli- ...lent iloaosscaChnuwhpercent had subsidiaries outside China. Furthermore, 33mate for private enterprise has been less certain. By firms reported that they belonged to enterprise conglom-contrast, where private enterprise has a more stablecontrast, 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 andare typically concentrated into narrow market niches. their subsidiaries. The average size of the conglomeratesTo cite one example, an entrepreneur in Chongqing in 1998 was 1,127 employees, with a sales volume ofstarted with a small foundry producing parts for RMB150 million (US$18 million) and a profit oflocal engineering companies. A chance meeting at a RMB20 million (US$2.4 million). This would make thetrade fair with an American company selling horse-riding equipment led to a contract to manufacturebridles 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 firstcash flow from this business, the entrepreneur issponsoring 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 Firms29 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 integrationthey can obtain capital and management skillsfrom 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, 10entrepreneurs may deliberately match a business 0experiencing uneven cash flow with another having Sole Partnership Companyeven cash flow. In one case, a real estate develop-er in Beijing operates a department store and a Source: Survey


* Vertical integration

Percentage of firms U Horizontal integration

*60

50

40

30

20 -

10

0

Primary Foods and Garments Chemicals Manufacturing Machinery Electronics Othersindustries cigarettes etc. Ohr

Source: Survey

line of business was the construction of computer as GE, with strong enough management structures torooms. Since the early 1990s, it has used the profits perform well across a wide range of industries.from this business to expand into other businessesand is now active in more than a dozen industries. Where there was an industrial connection, firms in ourFirst, it plowed profits from construction into real sample were fairly evenly balanced between verticalestate 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 equipmentled it to enter refrigeration manufacturing. Later, it Another feature of conglomerates in China is that theestablished manufacturing facilities for pharmaceuti- different activities tend to be organized as separatecals and health products, which are now its main line legal entities, rather than formal subsidiary companiesof business. or divisions of the parent company. This serves to

obscure financial and control relationships betweenThis pattern of conglomeration among unrelated companies, which depend more on family relationscompanies has been a rational response to the eco- than legal control. This also makes it more difficult fornomic environment facing private enterprises. companies to be taken over, as the parent companyHowever, it confers weaknesses on the companies, does not formally control its subsidiaries. On the otherwhich will become exposed as capital and labor mar- hand, financial separation allows the managers of eachkets improve and economic uncertainty declines. activity to be rewarded according to the performanceThis has been the experience of keiretsu in Japan and of their company, and legal separation makeschaebol in Korea, whose performance has deteriorated unbundling of activities easier.following economic liberalization. Managers of highlydiversified groups face an enormous challenge, Supplier and Customerbecause they are required to understand many differ-ent businesses in different markets. Many are tempted Relationshipsto run such companies in their interests rather thanshareholder 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 theyThere 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 andcigarettes and primary industries have a high level ofvertical 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 another0 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 manyprivate enterprises are reluctant to advance trade creditto other private enterprises (for example, by filling an These figures provide considerable insight into the roleorder 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 toeasily 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 withresearchers: "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 informationalaccepting orders that were never paid for." deficiencies of informality. Overseas Chinese are impor-

tant members of networks, especially in the areas ofThis 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 relationsindicated 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 thatprivate firms, and 42 percent from foreign companies. produce intermediate products used by state firms find itIn the case of main suppliers, 45 percent of firms are particularly helpful to join these associations. Accordingsupplied by SOEs, 58 percent by private firms, and 39 to interviews with CEOs, entrepreneurs form differentpercent by foreign firms. interactive circles by firm size: owners of smaller firms

had one circle, larger firms another circle. Smaller firmsBecause of its informality, the relationship also relies were at a disadvantage, however. Through associationgreatly 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 firmsreported that their customers were introduced by already had enough small firms coming to their factoriesfriends or family members, 19 percent said their part- to ask for subcontracting work.ners were friends, and 3 percent said that their partnerswere 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 firmsand family members and 10 percent said the partners operate under conditions of tight liquidity, losing onewere their friends. That is to say, about 34 percent had payment may bankrupt them. Many of the surveyedsome connection. In addition, 30 percent of CEOs said firms had reduced their business volumes in order tofamily and friends were important in material supply, avoid deferred or dead payments. A common sentimentand 46 percent said they were important in sales. was, "If you do not have a deal, you are not going to die


Percent

60 -

50-

40-

30 -

20-

10

0Lack of

Regulatory distribution Foreign Domestic Weak marketbarriers 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 theirmain 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, increaseeconomies 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 industrialclusters. Such clusters can be highly competitive or, asin some industries in Wenzhou, can engage in practicesthat reduce competition (see box 3.5).

According to the CEOs interviewed, entrepreneurs seethe lack of access to market information as a key inter-nal constraint. One of the biggest differences betweena planned and a market economy is that the latter rc

8 - ~~~~~~~ognizes the need to respond to market conditions andconsumer 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 thestate. As a result, private enterprises have been bound

8 - 8 8 8 8 - - 8 8 8 ~by government policies toward them: before privateenterprises were formally recognized, they found itvery difficult to obtain credit without a red hat. Even

as restrictions on private enterprise were eased, thegovernment continued to direct credit toward SOEs,

8 8 8 8 8 8 ~~~~~~~~crowding out private enterprises. Similarly, access topublic 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 havetransparent financial statements with which to assess

8 88 8 88 8 - 8 ~~~~~repayment ability. In the past, some got around thisbarrier 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 outthe preferential treatment of state-owned and collectiveenterprises. At the same time, the prospect of entry intothe 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 closeinvestment. For unlisted, private equity, investors are family and associates of the firm, who can directlydeterred by the lack of clear asset title and lack of clear supervise their investments and who hold some kind ofcorporate governance. This leaves them with little leverage over the enterprise managers. Again, this ismeans of safeguarding their investmnent and little typical of small, early-stage enterprises, hut in Chinaprospect of exiting the investment. Exit is made more even large, mature private enterprises are stuck atdifficult by stock exchange listing rules that give pref- this stage of financial development. Among the firmserence to state-owned enterprises. Even by wearing surveyed, more than 90 percent relied on self-financingthe red hat, few private enterprises have been able to for their initial capital.obtain permission to list. Without a transparentfinancial track record, clear asset ownership, and Most firms continue to rely heavily on investments byclear corporate governance, private firms have little their owners and on internal cash generation as theyhope 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 byenced 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 becomemore 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 withinformation 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 issuedment. Up to now, private enterprises have spent by the national "Star Plan" and "Torch Plan," and helpsmuch 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 sponsoringministries 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 ofcredit is available from the banking system. Not hav- commerce. Though officially affiliated with the citying 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 bywork and with the financial system. the private entrepreneurs themselves. Private entre-

preneurs in the township told interviewers they seeChina has long maintained national industrial associa- the chamber as a place to interact and are quitetions. These associations have played a significant role pleased with the facilities and services it provides. Itsin helping firms exchange technical information and main drawback is the restrictions on entry, whichobtain 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 aAt 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 joinwork 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 ofcollecting fees from them.

Some local offices of the All China Federation ofIndustry and Commerce play a significant role inorganizing private entrepreneurs. Its office in The Cost of InformalitySichuan Province is also called the SichuanChamber of Commerce, a name with significant In one sense, informality has been the private sector'sovertones: it softens the political color of ACFIC. great strength during a period of uncertainty and rapidThe new Chamber of Commerce provides a wide change. It has allowed private enterprises to respondranges of services to its members and acts as a bridge flexibly to changing policies and regulations and to new


Figure 3.5. Key Internal Constraints Cited by Surveyed Firms 1Percent

50

40

20": 0' Managerial Skilled Access to Market Access to Domesticcapacity labor technology information finance competition

Source: Survey

market opportunities, while diversifying risk and avoid- assurance of a stable policy environment for privateing excessive taxation, regulation, and competition. enterprises, which should encourage formalization.However, informality creates serious obstacles to thefurther 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 SOEssuited to small, young companies. It also makes com- and collectives declines, and capital and labor marketspanies opaque and unfocused, endows them with improve, the balance of advantage will shift away fromlimited 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 privatefigure 3.5 shows, the owners of the sample companies enterprises. This will provide a strong incentive to adaptrecognize these constraints, which together make it to international best practice in business organization.very hard for these companies to engage in beneficialpartnerships with customers and suppliers or to work Formalization has its costs, of course. Companiesconstructively with the government to improve the may find that they have to pay more tax and spendpolicy 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 theyadapt 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 costsand 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 changesmany stock-holding companies from getihu. At the required to reduce the barriers and disincentives topolicy level, the recognition of the private sector in the formalization and to help firms make the transitionrecent 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 lawprivate sector today is to combine the con- by including the principle of "governing the countrytinuing process of economic liberalization, according to law" in the constitution. Thewhich 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 publicbuilding, which would gradually establish the rule of ownership to an important component of the socialistlaw as the basis for government-business relationships. market economy and guaranteeing legal protection ofAs 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. Significanteconomic structure from state-dominated to private progress has also been made in unifying certain areassector is a complex task. A great deal can be achieved of economic law and in scparating regulators from thein 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 ofbusiness 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 uncertainimplementation 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 thateral, abstract rules that are prospective, never retro- local governments and administrative officials tendspective in their effect; (2) rules that are known and to overexpand their duties and focus on rent-seekingcertain; (3) rules that are equal in the sense that they activities. This is reflected in part in the ill-definedshould 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 andand the regulated. The rule of law therefore presup- out of tune with a market system. The functions ofposes 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 improperreview of government actions. The argument against and unnecessary interference at different levels ininterference does not mean that the government enterprise operation.should not get involved in economic matters. On thecontrary, 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 locationsbut also necessary for its existence. The rule of law than others. Shunde emerged as a role model inapplied to the business environment guarantees trans- many respects, having undertaken reforms to bringparency, predictability, uniformity, and the protection about a radical downsizing and transformation of theof private property rights, which are necessary condi- role of the government in 1993, some six years aheadtions for the efficient functioning of markets. of other parts of China. At that time, the number of


government departments in Shunde was reduced sector is not necessarily inconsistent with the rule offrom 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 theaccompanied by a change in the role of government, state sector may trigger government support in the formwhich 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, privateand integrity in administration and to introduce a firms are often discriminated against in their access tostrong element of predictability and regularity into markets and financing.the business environment.

China is making progress on SOE reforms, but itsWithout the rule of law, it is impossible to protect commitment to the private sector may not be easy toprivate 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 beenprogress the government has already made in extri- clearly uneven. SOEs no longer dominate all sectors ofcating itself from markets: that is to say, legal norms the economy, but neither have they withered away. Theand procedures are needed to substitute for direct government's policy goals with regard to private sectorgovernment 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 (totalEstablishing such a rule of law may take a while. It factor) productivity growth since the mid-1980s.calls for a legal infrastructure that can implementthe evolving legal framework, establish good gover- In one sense, the Chinese industrial economy seems tonance, and foster a legislative system that works be operating in a vast grey area, somewhere between planequitably and speedily. Even if laws were not the and market, while also in the grip of "extraordinarily rapidproblem, 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 environmentthe 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 conventionalrights, 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, butagainst violators remains difficult to secure, busi- instead may take a middle path of market-orientednesses 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 significantdevelopment 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 privateareas of overall commitment to the private sector, the sector activity, may in fact be stronger than is apparentopenness 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 fromSOE 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 beforeusually 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 assetssustainability 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 potentialinvestors that the state has no remaining interest in theassets. However, the vague language in the Company iLaw apparently giving the state the authority aintain special rights over assets formerly under state con trol creates uncertainty as to whether property rights intransformed companies are fully protected.

Openness of MarketsWhile parts of the economy now function quite com-petitively, many markets remain restricted in certain on Granting Self-respects. Though the government has allowed privatefirms to exist for more than io years, it still keeps themfrom entering many areas of business where the state 1 1 Bsector continues to maintain monopolies. The govern-ment stipulates that private firms are to be excludedfrom 15 types of industries (see box 4.1). The group t mos n i ms h rcan 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. Sincethere are no general criteria with which to determinewhether a business belongs to any of the three cate- 0 M i agories, officials have room to use their personal judg-ENTERPR0SES 37ment in applying these guidelines.

Numerous other laws prohibit and restrict the entry ofprivate enterprises into certain industries. According topress reports, certain lists exist that set out extensiveindustry-related restrictions for the establishment of pri-vate enterprises. Private capital is reportedly not permit-ted in some 30 industries plus 17 products belonging toother industries, including banking, railways, freeways,telecommunications, and wholesale networks for a largenumber of goods. Another list is said to "restrict" private companies. In 1998, the government began to grantcapital in certain industries. This list contains more than direct export licenses to selected private firms. Privately20 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 accordingbeen made publicly available, to the Interim Provisions on Granting Self-

Import/Export Rights to Privately Owned EnterprisesPrivate firms also face restrictions on direct access to and Science and Research Institutes effective Januaryforeign trade. Prior to 1998, private firms were not 1, 1999. By the end of 1999, about 150 private firmsallowed to export directly, although this right had been had been allotted these licenses.granted to many SOEs for several years. Having anexport 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, asacquire the value added of the exports but in many well as net assets of more than RMB8.5 million (US$1cases also hold the tax return belonging to the export million). Moreover, its annual sales must exceed


RMB50 million (US$6 million) and the export value production of certain products.' These restrictionsmust 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 privateestablished private companies cannot meet these enterprises to play a role in the restructuring process.requirements. Furthermore, there is still no statutoryrule that explicitly permits pure trading companies to To complicate matters, localities are able to imposebecome established through private investment and to additional restrictions and licensing requirements onengage 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 havepermitted to do. serious negative consequences for the development of

private enterprises. Those already established face evenThese forms of discrimination have aroused consider- greater uncertainty about their future opportunities forable 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 disincentivesTrade Organization, some sectors (such as telecommu- for changing or clarifying ownership rights. A companynications and financial services) that are still closed to that distributes medicines in Shunde, for example, willprivate Chinese investors will be open to foreign not be able to do business in Guangzhou, a place withinvestors. According to the related agreement concluded much higher demand. A collective firm in Shunde thatbetween China and the United States on China's produced containers before it was transformed will beaccession to the WTO, the government will grant free unable to continue this operation because private firmstrade 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 variousOther types of entry barriers arise from tight market con- forms of market barriers hamper their businessditions in certain industries. The soft budget constraints operations. Regional differences in these barriersof state-owned and collective enterprises and local appear to be fairly small. The main barriers cited byprotectionism 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 governmenthas 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 ofof enterprises in certain industries, and ordering the all sizes had complaints about government licensingelimination 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 dustryI~ ~ 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 categoryiSource: Survey


because larger firms were more likely than smaller registering with the local labor bureau, and so on, atfirms 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 theaddition, 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 51firms surveyed found it particularly difficult to gain in terms of start-up delay, and 43 in terms of start-upaccess 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 15and lowest in Shunde. days for a WIOE and 30 days for a partnership if the

basic conditions are met. In practice, however, there isCommercial 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 routinedirect 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 requirementcompany, 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, bymust be confirmed as paid up before a business license implication, narrowly) defined, and such businessis issued. scope is subject to the substantive review and approval

of government authorities. SAIC or its local branchOne 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 entrepreneursIndividual Owned Enterprises (WIOE Law), whereby to adapt flexibly to market. This obviously forces themhe 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 scopeliability for his business debts. This liability could even of business. (Perhaps the most liberal government incontinue for a number of years after his company was this regard may be that of the State of Delaware, in theliquidated 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 touation applies when two or more entrepreneurs form a state that it is "engaged in any lawful activity.")partnership and register themselves under thePartnership Law of 1997. Furthermore, the application for registration must

specify a fixed site and "necessary conditions" forRegistration requirements are not only expensive but production. This requires an entrepreneur to organizealso time-consuming, with many ad hoc requirements key elements of his business before registering it. Itand 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 andsteps could be between three and six months, because perhaps of business partners.they could involve registering with the administrativebureau of industry/commerce in the relevant locality, The predictability of government policies and the degreeobtaining registration certification from the State of consistency in enforcing laws and regulations have aAdministration of Industry and Commerce (SAIC), major impact on the environment for private sector


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 issueda directive calling on all restaurants with a floor area ofless than 30 square meters to close down because itfelt 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 beenmade. It also sets clear procedures and time limits forreview. 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. Privatefirms 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 rightsremains vague or ineffective. Large firms fear unfair

competition from smaller firms that may be able topirate 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


well in China. One problem is that different types of

enterprises are subject to different legal treatment. For and Their Protectionexample, the bankruptcy of SOEs falls under a specialBankruptcy 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 ofoften difficult to interpret and apply existing bankruptcy 17 private investors (only two remain). Becauseregulations. Another complication is that enterprises in - of sharp competition, the company's profit marginthe form of "natural persons," which include all firms is low. But the general manager believes that YZXwith eight or fewer employees, do not come under any is doing well. In his view, a major problem forbankruptcy regime. The notion of personal bankruptcy small firms, particularly private ones, is the riskstill runs counter to ideology and raises widespread that accompanies research and development.concerns about sociopolitical stability.

The current legal system does not provideBankruptcy also raises problems regarding the priority mh prect to s'ptents nd brandsof 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 onlyworkers. However, SETC Circular No. 492 of 1996 an 8-10 percent chance of success. Even if ithad made even land mortgage rights subordinate to becomes successful, its products will be soonworker claims under the so-called Capital Structure be copied by other companies. In fact, two newOptimization Program. A new bankruptcy law under products developed by YZX were copied byfinal review may allow more bankruptcies to be others, with minor changes. The company spentdeclared in the future. This highlights a key chal- one and a half years and RMB200,000lenge of enterprise reform in China, which is to cre- (US$24,000) on a legal suit against one of theate market-oriented corporate governance systems that violators. But the final judgment allowed bothare independent of government influence. This can be companies, the inventor and the company thatdone 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" bycapacity 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 mayneed to adopt different legal forms. However, Chinese die if you didn't develop new products, and youregulations do not adequately allow for such a trans- - were hoping to die if you did: the money youformation. It seems that a WIOE or a partnership can spent was simply for others."transform into another legal category of business onlyby liquidating its current business and establishing anew entity. Limited liability companies face similarproblems. Under Chinese law, they can only transforminto companies limited by shares. The present system, the big four state-owned banks-Agricultural Bank ofwhich calls for liquidation of one legal entity and the China, Bank of China, Industrial and Commercialestablishment of another, wastes both time and Bank of China, and China Construction Bank-eachmoney. It can also have an adverse impact on the con- with an extensive network of branches nationwide andtinuation of normal business operations during the together accounting for more than 60 percent of thecourse of transformation. country's financial sector's assets.2 There are a large

number of nonbanking financial institutions. HoweverThe Financial System they hold less than 4 percent of the total assets in the

financial system. Although steady progress has beenChina'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 laggedyears ago under central planning. It is dominated by behind developments in the real sector.


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 inlending, 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. Thegovernment 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 muchequity 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 aspart 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 Lawand 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. Initiallyallowed 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.


Capital markets. The government closed the 20-odd tax burdens: as many as 89 percent of firms with 5 1-100city-level "informal" stock exchanges whose emergence employees were dissatisfied with the burden of fees, inhad been tolerated earlier. In December 1998, the comparison with 67-78 percent for all other sizes.Securities Law, China's first comprehensive nationallaw on securities matters, was promulgated. However, The tension between decentralized income rights andit failed to unify China's rigidly segmented securities centralized tax legislation has created an uneven playingmarkets. 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 collectedshares, allowing for a greater presence of institutional in an arbitrary fashion. Firms surveyed complained, forinvestors on the Chinese stock market. In March 2000, instance, that technical standards inspectors (inthe government announced that the quota system on Chengdu) exaggerated technical defects so as to boostlistings 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 localgovernments in China was embodied in a revenue con- Conclusiontracting system whereby provinces handed over a fixedamount of taxes to the central government and retained Building a rules-based framework for private sectorthe rest. In 1994 China introduced a new system requir- development is a long and complex task, as manying the central government and each local government developing countries have found. Yet it is an essentialto collect their own specific taxes. Under this system, step toward ensuring that barriers to entry, an unevenprovincial governments may collect 25 percent of the playing field, and all the other obstacles private sectorsvalue-added tax, sales tax, personal income tax, corporate face are removed as efficiently as possible. Throughincome tax (of non-SOEs), agricultural tax, property tax, competition, well-functioning markets provide the bestand other smaller taxes. As a consequence, tension now opportunity for the optimal allocation of scarceexists between China's unitary state and decentralized resources. Furthermore, markets need rules to providefinancial 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 providethe right to determine their own taxes as a means of adequate recourse for the resolution of disputes. Asincreasing their revenues, but they are allowed to collect most governments have found, they themselves play anew fees. The end result is a proliferation of fees that definite role in this structure-one that has changedcan be introduced as govemment directives without from that of a player to that of an facilitator, ensuringobtaining 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 yearsin the private sector has been fairly uneven. Because of in large part because of a high degree of competitivethe 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 to217 firms in the survey that reported data for 1998, foster prosperity. At the same time, as this reportlarge differences were observed between corporate shows, the transition from plan to market has beenincome taxes due and actually paid, especially among uneven. State enterprises continue to dominate manyfirms of different size. Smaller firms paid higher taxes key sectors, and a number of barriers to entry intothan 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 whichwhen it came to the schedule of fees: smaller firms a rules-based structure has developed to fortify thefaced average rates of 4.8 percent, in comparison with business environment. This has given rise to variousthe 1.9 percent faced by the largest. This was reflected in distortions, which make it all the more difficult forthe degree of the firms' reported unhappiness with their the private sector to acquire formal status. Instead,


enterprises are forced to adopt time-consuming strate- needs of a market economy. Yet much more needs togies to cope with the problems and pressures arising be done. As the responses from the enterprise surveyfrom an opaque regulatory and legal structure. have shown, many distortions exist: in the implemen-

tation of existing laws, in the uneven playing fieldAs China continues with economic reform to reduce the between state and private enterprises, in the poorstate'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 institutionsvide the institutional and policy frameworks markets needed to protect the interests of investors and torequire to function efficiently. Legal norms and proce- guarantee good governance.dures will therefore have to substitute for direct controlover economic decisions, not only to encourage compet- China needs to continue with its market-orienteditive behavior and allocate scarce resources efficiently reforms-especially those aimed at improvingbut also to generate investible surpluses. commercial legal processes, the supervision of the

banking system, and the functioning of officialChina has in fact made a great deal of progress in the regulations-if it is to realize the true potential of itsdevelopment of legal norms corresponding to the private sector.


FINANCING DOMESTICUa:IIY TT E E N T E 1 11:IMW

firm goes through a financial growth F . Icycle in which its financial needs andoptions change as the business grows,establishes a track record, and becomes Financing needs/

level of riskless informationally opaque. Start-ups and younger Growth

firms tend to rely on insider finance, trade credit, Iand 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 equityand debt markets (figure 5.1).' The financial growth Development

cycle model implies that a private sector populatedby firms at different stages of development needs adiversified financial system to support its continued Early stagegrowth. This chapter considers the main sources of Seed capitalfinancing for private firms and some of the key fac- Familytors affecting a private firm's access to financing, 0 Time

Idea Business Business Industrialparticularly bank lending. development creation development production

Access to Bank Lending SME Largecompany +

Data on total lending by ownership are hard to comeby in China, but the People's Bank of China (PBoC) Access to Private Equitydoes publish figures on working capital lending byownership. 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. Attions are classified as working capital loans.2 present, there are no regulatory guidelines defining theAlthough 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-bethe private sector (including individual firms) has fund promoters, generally local governments interestedgrown substantially over the past decade (figure 5.2), in developing their high-technology sectors, often setat 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 capitalunderreports 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 billionnevertheless suggests that the share of lending to the (US$300 million) has been invested at home andprivate sector is low, particularly when compared abroad. Insurance companies and pension funds are notwith 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


Figure 5.2. SIiort-term Loans t rivt ntepies,1991-98 : X0 000j0:

Percent Percent

0.9 50

| 0.8 _ 3 100.7 4

U) 0.6 W

I 0 0.0 ' ' : , , O I300.5 25 19

I 0.4.20

0.30.2 ~~~~~~~~~~~~~~~~~~~~~150.2 ~~~~~~~~~~~~~~~~~~~~~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 togain 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 BusinessShenzhen 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 ExchangeDongfang 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 Buildingmaterials

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 Informationtechnology

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 CRtYBeijing 96.1 0.3 2 1.6Shunde 87.1 6.5 6.4 0Chengdu 91.5 2.8 2.1 3.6Wenzhou 97.3 1.1 0.1 1.5

By Yas of operation< 3 years 92.4 2.7 2.2 2.73-5 years 92.1 3.5 0 4.45-10 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 consideraccess to financing a moderate or major constraint. Sources of FinancingAbout 40 percent consider it a major constraint, the for Sample Firmssecond highest after weak market demand. To theextent that the state of market demand reflects invest- The firms in our survey started their businesses relyingment opportunities, this result implies that practically almost exclusively on self-financing (table 5.3). Moreany sample firm with some investment opportunities than 90 percent of the initial capital came from theperceives 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, whereAccess to financing correlates with firm size and the share of self-financing in start-up capital exceedslegal 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 amajor 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 tothan 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 ofcent of sole proprietorships and 28 percent of corpora- financing start-ups, revealed by the survey, is alsotions in the sample mention access to financing as a markedly different from recent findings on sources ofmajor 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


Table 5.4. Financing for Private Businesses: Results from Srn eysV. in Transition Economies

Russinot"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 79savigs In start-up (0%)

Bank loans at start-up (%) 66 9 n.a. 22 5

Received at least 75 43 68 47 67one 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 minornot take the lion's share: for infant SMEs (from birth role, except in Shunde, where bank loans were moreto two years of age), the upper bound of the share of evident. By contrast, SME start-ups in the Unitedinsider financing has been about 54 percent (see States receive on average about 30 percent of their initialBerger and Udell 1998). funding from financial institutions, 16 percent of

which comes from commercial banks. Start-up firmsThe firms in our sample indicated that initial capital in transition economies, too, appear to have betterwas available from various other sources as well, access to bank loans (table 5.4). About two-thirds ofincluding 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 aConstraint 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


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 marketsmercial loans within the first six months after regis- played an insignificant role.tration (Webster and Taussig 1999).

Comparisons with transition and developed economiesIn our sample, the percentage of self-financing in ini- suggest a relatively high reliance on internal sources oftial 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 orbeing already established, need less initial capital, or retained earnings account on average for 60 percent ofrapid 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 inmay 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). Inassociation with various state institutions yielded valu- the United States, even start-ups and very small firmsable "intangibles" in the form of market access, repre- have about 50 percent of their financing in the form ofsentation, 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 sourcesfor expansions, the sample firms continued to depend of financing in our sample vary significantly acrossoverwhelmingly 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, andaccounted for at least 52 percent of financing in 1995 Wenzhou in 1998, but insignificant for those inand 62 percent in 1998. Among external sources, infor- Beijing. Among the sample firms, those in Beijing hadmal 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


Shunde. Informal channels for financing played an Figure 5.5. Sources of Finance in Surveyed 1important role in all the cities surveyed, especially in Firms, by Firm SizeBeijing. These differences are statistically significantafter controlling for firm characteristics such as size, I

legal form, and age and hence suggest that local con- , * Financi institutions'debtditions play an important role in determining a private 70firm's access to various sources of financing. ' r

The relative importance of these different sources of 50financing 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 0share of commercial bank loans, on the other hand, <51 51-100 101-500 >500

increases with firm size and becomes the dominant S SizeSource: Survey.Ssource of external financing for larger firms. Hence,loans from commercial banks tend to substitute forinformal 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 loanssource 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 ansupport for larger and relatively successful private firms. application, which indicates self-selection in decidingThese 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 acrossAlthough the survey did not collect specific informa- the sample cities in China, however. Firms in Beijingtion on working capital finance and the related issue of had the lowest application rate and those in WVenzhouenterprise arrears, interviews with CEOs revealed that the highest. Firms in Wenzhou also had the highestarrears were common among the sample firms. In cer- success rate.tain cases, particularly among younger firms, arrearsproblems had a serious impact on firm performance. Effective demand for bank loans, as reflected in loanLarge firms were more prone to defer their payments applications, tends to increase with firm size. Only 17and were in a stronger position to request cash pay- percent of firms with no more than 50 employees everments 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). LargerAbetted 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 showsrily to alleviate liquidity problems. Many private firms that larger firms have significant advantages overuse 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 lawenforcement and to price the business risk associated Information Problemswith arrears in negotiations with their customers.

Information problems, which are generic to financialDemand for Bank Loans markets, are especially severe for private firms in

China. Most of these firms are smaller and youngerOn average, Chinese banks tend to play a smaller role than their state-owned counterparts and are a higherin the financing of private firms, not only for start-up risk in the eyes of banks. Furthermore, firm size bearscapital but also for subsequent investments, This is a clear relationship to profitability. In 1998 aboutespecially the case among smaller firms. According to three-quarters of firms with fewer than 51 employees


Table 5.6. Applications for Bank Loans unit's leader is legally responsible for the truthfulnessby 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 auditingct y reports. These documents are supposed to support the

Beijing 14 88 processes described in chapter 3, which are creatingShunde 52 90 incentives for private enterprises to formalize. As onei 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 withthese 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 gettingloans 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 93percent for firms with more than 500 workers. Having ing to meet certain requirements; they will be barreddperen 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 withenvlronment,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 thecautious 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 behaviorstructures imposes obvious constraints on borrowing on behalf of participating lenders.(see chapter 3). To add to the problem, banks areunable and lack the incentive to collect and process T Crelevant information (for their perspective on these ransaC1ion ostsproblems, 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 representtransparent financial and accounting systems. Taxes high risk and high unit transaction costs, but alsoand other potential liabilities, as mentioned earlier, are because state policy is somewhat biased against lendingan additional concern. By avoiding formal accounting to private enterprises. When a public borrower fails tosystems or keeping several sets of books, firms can amortize a loan, the state will almost certainly step in somake 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 privateBanks are naturally reluctant to accept financial state- borrower fails, banks appear to have no recourse but toments 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 differentforces, and cultural factors. The revised Accounting types of ownership is eliminated, banks feel they mustLaw stipulates that every business unit is obliged to be careful about lending to private sector firms.have account books and to keep true and completerecords 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 theoperations and property situation. Under this law, the expectation of higher returns, except that most banks


in China are owned by the state and face limited com- regime but indicate interest rates need to be liberalizedpetition, 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 WTOfocused on reducing the pace of accumulation of non- entry. For the time being, banks and credit unions areperforming 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 banksloss 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 transactionthe 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 additionallimited incentive to initiate lending. Adding to their transaction costs, tend to discriminate against smallerreluctance are the controls on interest rates and firms, and are too blunt to reflect differences in therestrictions on the use of transaction and monitoring risk profile of projects.fees, although the government has been graduallyrelaxing some of these restrictions. Interest rates on Collateral and Guaranteesloans to SMEs are allowed to fluctuate within 30 per-cent of the prescribed interest rates, and rural credit One standard mechanism used to alleviate genericcooperatives are allowed to charge interest rates up to information problems associated with debt markets is50 percent higher than the basic interest rate. Banks collateral and guarantees. This is especially the caseare 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 toprivate firms were allowed to float. After 1998, the practice was abandoned in favor of a uniformapproach to state-owned and private enterprises. Today, about 70 percent of outstanding loans madeby the Wenzhou branches of the Agricultural Bank of China are to private firms. The bank has deemedthe performance of the portfolio to be satisfactory, with only about 10 percent consisting of problemloans 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 inobtaining external finance mainly because of the following problems:

* Uncertainty about the protection of private property rights. Despite important constitutional changesin 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 loweredcredit grades at the bank.

* Accounting and auditing services are usually rubber stamps. The integrity of the profession is oftenunder question.

These problems increase the perception of risk and persuade lenders to remain conservative in theirdealings with the private sector.


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-includingloans 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 Lendingguaranteed 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,


the procedures are inflexible and tailored, partly for his- through greater bank lending to enterprises. Localtorical reasons, to the "typical" state-owned enterprise.; bureaucrats, for instance, are finding it more difficult toAccording to the firms surveyed, applying for a loan is a intervene on behalf of private entrepreneurs in thevery bureaucratic and costly process. About 70 percent credit decisions of banks, although anecdotal evidencesaid that paperwork was a moderate or major obstacle to suggests that local governments are finding new ways totheir application for a formal loan. To be able to use their preserve some role in the allocation of financial resourcesassets as collateral, firms have to do paperwork not only through the banking system.6 Second, the consolidationwith the bank but also with the office of notary public, of urban and rural credit cooperatives and of investmentthe asset evaluation agency, and other related govern- and trust companies is allowing decisionmaking in thosement agencies. Collateral requirements, the cost of the financial institutions to become more centralized and isapplication process, and relationship banking tend to endangering the "relationship capital" of some privatemake it especially hard for smaller firms to gain access firms, especially the smaller ones.to financing (see figure 5.6).

Other Forms of FinancingTo alleviate information problems, many potentialborrowers establish a relationship with a bank. About 70 The current environment in China still draws privatepercent of the sample firms indicated that not having a firms to seek financing from providers other thangood relationship with a bank was a moderate or serious banks. Of the firms surveyed, most used the informalconstraint to their ability to get a bank loan. Establishing market. The stock market and the overseas marketand 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 MarkelThe nature of the relationship between banks and private About half of the sample firms have at some point inentrepreneurs is likely to change, however, in the wake of their history resorted to the informal market to financerecent financial sector reforms. First, some initiatives, their activities. Lending in the informal market hassuch as the elimination of the credit quota system and several distinct characteristics. First, it usually takesthe reorganization of the provincial network of the place among friends or family members. Friends andCentral 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 reduceso, 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 banks25

20 >

10

<51 51-100 101-500 >500

Size of employment

Source: Survey


l 0 -. - . - - 000 .- Sa 6 - 0s -0

Second, informal lending is usually of a short-term Third, informal lending has more flexible terms thannature. The primary reason is that individuals face formal lending. Private firms often need money totight liquidity constraints, hut high interest rates are an complete a production cycle, which can he as short asimportant factor, too. The short maturities also reduce several days for firms in specific industries. Whereasthe risk of default. Thus it is not uncommon for firms formal loans are usually issued for at least six monthsto buy materials for an order through an informal loan or a year and do not allow a grace period, the term ofand then pay it back after the order is settled. an informal loan can vary from several days to a year


and typically do permit grace periods. In fact, therigidity of formal bank lending is an important deter- and Registrationrent to private firms. a

.

Finally, applying for an informal loan does not require In early 1999, a major state bank organized amuch time. A private owner can get a loan from friends m v on fees collected on itsor family members in one day. Survey respondents -' iL''Athe process of collateral appraisal andstressed not only the conveniences of informal lending registration. Table 5.7 presents 17 kinds of feesbut also the fact that the interest rates charged by a firm may incur in one of China's autonomousformal and informal lenders are much the same, which regions in the process of having its assetsmeans there is no disadvantage to using the informal appraised and registered. A firm may need tomarket 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 iserious problems when its scope extends beyond f

1 ~~~~~fees add up to between 0.9 percent and 1.4friends and family members. The most prominentare 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 levelstracts, which is typically the case. Only 14 percent of for the same item. In the case of the landthe firms surveyed wanted to use informal borrowing appraisal fee, the standard rate issued in 1999in 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'sNot 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 issuedmaking loans to local firms. Many of them ran into by the region's Bureau of Prices in 1998.serious problems, however, often because of theinvolvement of local governments. A large portion ofthe lending went to local TVEs and contributed to thesoft-budget problem of these entities. said, is to improve the incentives for managers and

employees, primarily through stock options. This isTo avert a crisis, the central government decided to shut particularly the case in hi-tech firms, where humandown 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 Financingating. Wenzhou has a long history of informal financial Though overseas financing remains limited, its rolemarkets 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 inthey issued loans to private firms with hard budget con- order to get capital in the future, and 11 percent saidstraints. 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 marketThe Stock Market as H-type (Hong Kong) shares and then in Shenzhen asThe stock market has played a very small role in A-type (Shenzhen) shares. It also borrowed foreignfinancing the development of the 628 sample firms. Of money through its subsidiary in Hong Kong when thethis 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 werethe stock market. A strong motivation for listing, they considering listing in Hong Kong as H-type shares.


Table 5.7. Fees for Collateral Appraisal and Registration in G Autonomous Region

1. Building appraisal (1) Real estate State Planning Commission 0.03-0.4appraiser and Ministry of Construction:

(1t995)(2) Bureau of Regional Bureau of Prices: 0.2I3Building 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 cityAppraisal Center

2. Building collateral Bureau of Building Regional Bureau of Prices: 0.3-0.8registration Management (1997)

3. Building collateral Building company Regional Bureau of Prices: 0.3-0.8certification (1997)

4. Land appraisal (1) Bureau of Land Regional Bureau of Prices: 0.12-0.16Management (1999)

(2) Bureau of Land Regional Bureau of Land 0.32Management Management: (1998)

(3) L city Real Estate Regional Bureau of Prices: 0.16-32Appraisal Center (1995)

5. Land collateral (1) Bureau of Land Regional Bureau of Prices: 0.16 At least RMB 300registration Management (1998)

(2) Bureau of Land Regional Bureau of Land 0.03-0.3Management Management: (1998)

6. Land collateral Bureau of Land F county Bureau of Land 2 Returned afterinsurance Management Management: (1998) loan repaid

7. Land transaction Bureau of Land Regional Bureau of Prices: 0.25-5registration Management (1998)

8. Land collateral L city Bureau of Land Regional Bureau of Prices: 0.15 In L citycertification Management (1995)

9. Equipment L city Asset Appraisal State Bureau of State 0.4 In L cityappraisal Institute Asset Management and

State Bureau of Pricesdocument

10. Equipment Local BICM National BICM and Ministry 0.1collateral 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 countycollateral certification (1998)

12. Property appraisal Bureau of Building Regional Bureau of Prices: 0.4Management (1997)

13. Property Bureau of Building Regional Bureau of Prices: 0.1registration Management (1997)

14. Building Local BICM Regional Bureau of Prices: 0.2transaction (1997)registration

15. Building P County Real Estate 0.32-0.8 In P county

transaction Transaction Centercertification

16. Contract Local BICM Regional Bureau of Prices and 0.1 Maximumcertification Bureau of Finance: (1994) RMB 3,000

17. Collateral property Y City Insurance 0.43 InY cityinsurance Company


Overseas financing is not used that much, largely access to financing, which is especially problematicbecause of China's restrictions on foreign banks in its for smaller firms. Private firms in the sample tend toterritory. 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 otherdomestic private company has to obtain government transition economies, Chinese private firms appearapproval and be included in the country's foreign reserve to depend to a larger extent on internal sources ofmanagement 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 privateConclusion 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 incentivestion of the firms surveyed, a primary one being difficult on the part of banks.


T he preceding chapters have described the An Agenda for Entrepreneursemergence of China's domestic private sector,

the evolution of the policy and regulatory Now that the government has begun to rationalize theframework, 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 enterpriseof 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 heldTogether, they could help unleash the full potential of family enterprises will continue to suit them. Forthe domestic private sector to contribute to China's larger companies, the greatest scope for building theeconomic development. This concluding chapter draws business, expanding the management team, andout these implications from the preceding chapters and obtaining external financing lies in establishing apresents an agenda for the future for entrepreneurs, the limited-liability shareholding company. Internationalgovernment, 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 activitiesber of important steps to support the growth of the that accommodate large partnerships, such as lawdomestic private sector. These range from the and accounting, the international trend is towardConstitutional Amendment recognizing the role of limited liability (for example, along the lines of thethe private sector to the World Trade Organization U.S. model of a limited liability partnership). Inagreements opening up more sectors to private enter- high-growth economies, a large proportion of smallprises. Membership in the WTO will open domestic enterprises in high-growth industries are incorporatedprivate enterprises to greater competition in the and therefore benefit from limited liability, transparentChinese market as well as to new opportunities to financial reporting, and corporate governance fromcompete 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 madewill also help domestic private enterprises. rapid progress in the transition to shareholding com-

panies. The benefits of this can be seen in the rapidAt the same time, the sector's striking achievements growth and adaptation of these enterprises (for anare 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 maychapter 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 theappropriate structures as they grow and mature. They assets and liabilities of the enterprise and the identitywill 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 legalkets on an open market: they will need to move toward requirements of the new form of enterprise may beglobal best practice. another challenge, particularly if formalization

60 AGENDA FOR THE FUTURE

Box 61 Caigshareholders, one of which is to manage the companyGovernance 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 taoped 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 ofchanging ownership and internal governan clear accountability and incentives, authority for busi-

ness decisions can be delegated more readily. SuchTZ, 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 ofl E l million (US$24 million l transfer of ownership from one generation to another.

* - *0 * j* 8-'mrd¶f 3,000 employead three episodes of internal restructurin Financial Disclosure

1994 it converted from a solely owned sm China's law of incorporation imposes limited financialprivate firm to a company. disclosure requirements. These may be a step forward

for many enterprises but are still much more limitedSeveral senior managers became owners. than international best practice. Improved financial dis-1997 it changed into a shareholding comp closure allows investors, suppliers, customers, andissuing 50 percent of its shares to 50 midd other business partners to make a fair assessment of thelevel managers. In 1999 it bought the large financial condition of the enterprise. This reduces theparts of the shares of 1 0 member firms an risk premium that such parties would otherwise chargemade itself the shareholding company of for doing business with the enterprise and hence lowersA 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 totrade in intemational markets should aim to follow inter-

These changes enabled the company to national financial disclosure standards. As the domesticrecruit experienced managers from outsid market opens to intemational competition under theimprove its management, to reduce the m WTO agreement, domestic enterprises will competeagement 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 ensurealso accelerated. The company now alloc. more accurate, timely financial reports. They will also1-2 percent of its total revenue to researc have to observe higher standards of external auditing toand development of new products. vouch for the accuracy of those reports. Again, the dis-

closure standard will depend on the size of the firm, thedispersion of its ownership, and its maturity. Investorsexpect 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 theNew corporate forms imply new formal structures of complex structures of holding companies and affiliatedcorporate 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


informal enterprise but is a handicap for a formal one. partners. Foreign partners will increasingly view suchFirms of this nature find it more difficult to define alliances on strictly commercial terms, rather than as atheir 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 likewisebilities and performance measures. Thus, improving and take stock of the business value of joint ventures.corporate governance will in part involve restructuringrelated enterprises into a single corporate structure, or Similarly, private firms should rethink their alliancesseparating companies into wholly separate enterprises. with SOEs as the influence of SOEs on government

regulation and markets declines. Again, the drivingSuch transformations should be driven by business force should the business case for partnership, ratherefficiency 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 Relationshipsthe 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'sment policies and regulations. This will leave enter- length with customers and suppliers. Although this willprises freer to structure their businesses according to increase market efficiency, individual companies will

commercial imperatives. benefit only to the degree to which they are preparedto 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 Competitionpolicies 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 mostital and labor markets improve, there will be fewer markets. Their choice of markets should be based onadvantages to obtaining capital and labor from within a an assessment of their own competencies andconglomerate, and the inefficiencies of managing resources rather than on external regulations. Thisacross multiple industries will be revealed by competi- implies that companies should devote more attentiontion 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 proprietaryTo 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 oreign companies. The trend among conglomerates through piracy) technologies or designs.worldwide has been to unbundle them into separatefirms operating in different markets, and to recombine An important new opportunity for export enterprisesthem 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 tobetween businesses, building on a company's core export directly This gives companies greater flexibilitycompetences, resources, and capabilities. Chinese and control over the marketing channel. To benefitenterprises will compete more and more against for- from this, they will need to build up their skills andeign companies at home and abroad. Most of these are capacity in export marketing. In some cases, this mayfocused in one or a few related markets, or in markets best be done by entering into partnership with foreignthat draw on the same core competences and enterprises that know the export markets better.resources. To compete effectively, Chinese companieswill 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 establishmentthe incentive to enter into joint ventures with foreign and corporate structures will help, as they allow firms


to reward their most important managers with shares formalization and expanded financial markets inor share options. They also provide a framework for three ways. First, they will be able to lengthen theholding managers accountable for performance, maturity of their debt to better match the maturity ofthrough more transparent financial reporting. their assets. Thus a company with long-lived assets

(for example, a toll road) would be better off financingThere should also be greater emphasis on the hiring of them with longer-term debt than would a companymanagers with business skills and on staff develop- with short-lived assets (for example, an easily copiedment. The informal approach of hiring managers with technology). Second, firms will be able to reducelimited skills at low pay and allowing them to develop their debt:equity ratio by issuing more equity, eitheron the job is not the way to attract or retain much-need- privately or through an IPO. And third, they will noted talent. A better tactic, as most international firms have to rely as much on personal, government, andhave demonstrated, is to follow a structured approach other third-party guarantees but instead can use theto 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 arrearsmost demand. Our survey reveals that the top three as a source of working capital. This imposes costs onareas of concern are technical training, accounting and their suppliers that are inevitably reflected in highermarketing, and quality control. Among the firms inter- prices and less willingness to expand supply. Byviewed, 59 percent needed technical training, 57 per- reducing arrears on payables, companies cancent 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 toLabor Relations budget for adequate working capital in raising debtAs 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, laborrelations will become one means of retaining necessary Government Relationsskills. 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 timevoicing employee concerns, resolving grievances, and and resources they devote to lobbying for specialaddressing other labor issues. treatment. They will need to comply fully with regu-

lations and with tax rules. They can then reduce theFinancing time they spend on disguising their activity from gov-As companies formalize, they will have more access to ernment. But government relations will remainexternal sources of finance. Ownership structures with important as the policy and regulatory environmenttransparent financial reporting will provide a stronger continues to evolve.basis for borrowing from the banking system, whetherthe 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 governmentchoice in their debt-equity ratios. Some fast-growing relations will be to lobby as a group rather than asenterprises rely heavily on equity. This is appropriate in individtial firmshigh-risk activities, but as markets mature and businessgrowth levels off, companies should consider leveraging An Agenda for the Governmenttheir equity with greater amounts of debt finance.

The government's reform agenda should concentrateMany other private enterprises depend excessively on the protection of private property rights, opennesson short-term bank debt, often backed by personal or of markets, improved commercial legislation, and thegovernment guarantees. They stand to benefit from tax system.


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 "nationalwas 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 sectorslable"). 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 investmentsthat if someone were to embezzle money in a private should be gradually phased out and a policy of nationalbusiness, 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 anwould in the case of state property, a crime of corrup- equal footing.tion (which carries a more severe punishment). Thus agreat deal more remains to be done. Foreign trading rights should be extended to all quali-

fied private enterprises to allow them to participateThe 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 Legislationcumstances, the principle of "no expropriation with- The legal infrastructure for commercial enterprises hasout just compensation" is compatible with the rule of room for several improvements.law. However, since typically it is difficult to estimatethe intangible benefits of public action, and since Minimum registered capital requirements for formingbureaucrats tend to overestimate these benefits, the a limited liability company should be significantlyadequate 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 requirementsopening the door to abuse. were felt necessary on account of the high perceived

risk of making loans to businesses, this might beOpenness of Markets addressed by improving disclosure requirements.China's accession to the VWTO will call for furtheropening up of private investment and trade. The survey The line drawn between a getihu and a private firmfindings provide support for several recommendations. should be erased. It merely creates an incentive for a

private owner to remain a getihu for the purpose ofIn most sectors, existing restrictions on private sector minimizing taxes. Furthermore, by continuedentry 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 lawsthe case that the form of ownership should be part of for business operation.the ascertainable qualifications to perform specificeconomic activities. Therefore, all sectors in which form The scope for official interference and substantiveof ownership in the above sense is an irrelevant distinc- review in the registration of private enterprises must betion 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 insectors (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 theof 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 withThe Law on Protection against Unfair Competition, international practice, so as to reduce the scope ofenacted in December 1993 to create a fair and bureaucratic discretion, or altogether eliminated.


Box 6.2. An Anecdote against individually owned enterprises. These individualabout the Registration Process investors that looked liquid previously suddenly seemed

unable to pay off debts.

We were told the story of an entrepreneur whoewaere tol then aesturyfant entreprthenmeur ho - There is also an urgent need to unify Bankruptcy Lawwanted 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 examplename has four characters, but the Bureau of of different treatment of different forms of enterpriseIndustry 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 Lawpreneur asked whether "The Paradise" was contains bankruptcy provisions that apply to "anacceptable. The bureau said, "You are on the enterprise with legal status" (see chapter 4). The lineearth so you cannot be registered as 'The between the scope of the two laws is not clear, sinceParadise."' The entrepreneur responded, "'The many SOEs are also persons. The definition of anReal 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 andthat name is not appropriate, either." After several the public at large. Furthermore, the two laws differdinners 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, bankruptcyWorld" was an acceptable name after all. is not available if an enterprise is "public" or has

"important bearing on the national economy and thepeople'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 ineliminate 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 aanecdotal 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 onregistration 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 Marchindividual-owned enterprises following a liquidation 1 997) giving workers first priority in the distribution ofshould 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 Systemcan reach the minimum size required to form a limited As survey results indicate, small and private firmsliability 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 arefamilies to creditors. recommended to deal with these problems:

Furthermore, it would be difficult to enforce this provi- * The government should begin a systematic effort tosion 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 notpersonal property. Anonymous banking, among other allowed to adjust the rate of local taxes or create newthings, 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 nontransparentin which creditors sought to enforce court judgments fees. As a result, the burden on firms is uneven, both


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 consistentacross 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 providingtrary interpretations of tax laws and regulations access to bank loans, strengthen banks'incentives toshould be avoided. Rent-seeking behavior in all forms lend to private enterprises, monitor the impact ofby government officials and departments must be consolidation of enterprises on incentives for SMEstrictly prohibited. The key ingredients of reform here lending, further liberalize interest rates, allow banksare clear rules, capable of simple enforcement, and to charge transaction and monitoring fees, andspecialized education and training. One important improve incentives in credit guarantee schemes andstep 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 andnomic 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, strongshould be encouraged to improve to meet the increas- forces are still keeping the playing field uneven when iting needs of private firms, especially small firms. comes to access to bank loans. There is ample evidenceThe role of the government would be to insist upon that local governments continue to extend explicit ortransparent reporting of financial data according to implicit guarantees for bank loans to enterprises withclearly defined standards, to support education and state ownership and find other ways to influence banktraining 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 havebeen 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 transformationExisting constraints arise from a complex set of factors. rather than at newly formed companies. BankruptcySome 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 badof its enterprises, its informational opaqueness, and loan to a state-owned enterprise to be as serious as athe 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 managementnature of the financial sector. Although all of these fac- companies, are such that when a public borrower failstors are taken into account in this section, the empha- to amortize a loan, the state almost certainly will stepsis is on issues pertaining to the development of the in so that the bank will not have to absorb the entirefinancial 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 makingreached 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 developed, banks will consider it rational to discriminate against

ment in which the firms find themselves. This calls for lending to private sector firms.


Strengthen banks' incentives. An important step here measure is not likely to have a significant impact onwould 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 effectivestructures of the real sectors,do not balance with those of interest rates that are significantly higher than the onesthe financial sectors. Private ownership in the financial prescribed by the Central Bank. Entrepreneurs alsosector is practically nonexistent. The government should indicate that access to financing is more importantallow 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 notindependent 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 crediting effect on the state-owned financial sector. New standpoint. They would also encourage banks tobanks tend naturally to focus on underserved market consider the proposals of a larger number of smaller andniches, especially younger and smaller firms, which informationally more opaque firms. Banks would thenconstitute the bulk of the private sector today. They do be encouraged to develop a more service-orientednot 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. Bankslish themselves in the market, they are more prone to would then need to adopt new procedures and developtrying innovative ways of doing business. skills in areas such as cash flow analysis, project finance,

and risk management. The introduction of such feesThe big state-owned banks are likely to dominate the would also be an important aspect of the realignment todomestic 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 privatefirms' access to bank loans. Corporatization, listing, and Improve incentives in credit guarantee schemes andstrategic partnering with foreign financial institutions improve the management of risks. In the first half ofare some of the ways to reach this objective. 1999, the State Economic and Trade Commission issued

Establishing Credit Guarantee System Pilot Projects forMonitor 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 withcredit 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 institutionscredit 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 andcapital, 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 transactionFurther 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 areimprove private firms' access to bank loans. Such a allowed to be negotiated between guarantee funds and


borrowers), and alleviate collateral problem faced by assign contractual rights independently of thesmaller, mostly private firms. However, credit guarantee assumption of the corresponding obligations andschemes also entail risks, which are potentially high in without the consent of the debtor.China's context. Credit guarantee schemes could beused by local governments as a mechanism for contin- Developing Private Equity Marketsuing 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 farcreates 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 marketsterm 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 Chinabetter system of auctioning machinery and equip- established a RMB1 billion (US$121 million) venturement, and of creating secondary markets in such fund, and the government has reportedly started workassets in general; and a better system of enforcing on venture capital and investment fund legislation.collateral and promoting the development of projectfinance and leasing. Establish a legal framework for private equity

funds. Private equity funds should be developedAlternatives to Bank Lending within a comprehensive legal framework; transitionalSome 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 theChina and play an insignificant role in the financing of legal/organizational structures that can be used toprivate enterprises. Yet they are useful ways to deal establish private equity funds, known in China aswith insufficient collateral and, in the case of leasing, "industrial investment funds." As a result, would-bewith the enforcement of collateral. fund promoters, generally local governments interest-

ed in developing their high-technology sector, oftenLeasing. However, the concept of leasing may prove set up limited liability corporations as investmentdifficult to apply in China: rent arrears have long been vehicles. These corporations issue shares in exchangea problem, China has no leasing law, accounting stan- for investment; funds are then pooled and manageddards are unclear, appropriate tax incentives are not in by a fund manager. The corporation must abide byplace, and funding is a perpetual concern. A welcome the limitations of the company law, which does notrecent development is the inclusion in the new permit more than 50 percent of capitalization to beContract Law of a chapter on finance lease contracts. invested in subsidiaries or other legal entities. WhileThis 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 theas a substitute for a special leasing law, which would 50-percent ceiling), it prevents the corporations fromaddress 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 inunder 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 orFactoring is not fully developed in China. However, contractual), the need for trustees to protect investorsprovisions in the new Contract Law (effective from the adverse actions of the fund manager, and theOctober 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 offuture. The new Contract Law makes it possible to fund investor, fund manager, and custodian are not


_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 Ii 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 wouldi_ 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 anCoverage 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 investsrelationships 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 indirectlegal proceedings is ill-defined. The draft trust fund mechanisms to ensure that venture capital flows arelaw 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 theobligations and rights of the parties. Small Business Investment Corporation (SBIC) pro-

gram in the United States exemplifies one transitionalTransform the role of the state in venture capital. mechanism to ensure that small companies withThe state still plays a ubiquitous role as sponsor, attractive futures but not the high returns demanded ofinvestor, and fund manager. The investment industry private venture capital also have access to pre-listingin general would benefit considerably if the state acted equity capital (see box 6.4).


* * S

While venture capital plays an important role in shown, successful initiatives tend to complementfinancing the growth of small, technology-oriented venture capital rather than substitute for it (see boxcompanies, it also has its limitations. Venture funds 6.5). If carefully implemented, such programs couldtypically back only a tiny fraction of the technology- play a useful role in promoting the development andoriented businesses begun each year. Furthermore, commercialization of intellectual products and thethe 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 requireonly small infusions. Public programs to provide Broaden the range of issuable equity-relatedearly-stage financing to firms, particularly to high- securities. Investors in venture capital and pre-IPOtechnology companies, have become commonplace in companies need latitude to structure transactions mostmany 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


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 addressimperfections in the market for the financing of young technology-based firms. Under the program, allfederal agencies spending more than US$100 million annually on external research must set aside afixed percentage (1.25 percent) of these funds for awards to small businesses. When the program wasreauthorized 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 guidelinesstipulated by the act and the U.S. Small Business Administration. Recipients must be independentlyowned, 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 IIgrants. Phase II awards of at most US$750,000 (originally US$500,000) are designed to support twoyears of development work. The funds are transferred to the small firms as a contract or grant. In returnfor 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 propertythat 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 SBIRawards 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 complementaryto 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 ofcompany receiving investment. shares, and different rights attaching to such classes,

will both stymie efforts to provide sophisticatedPermit the issuance of preferred stock. A security financing strategies for investors in Chinese issuersessential to many private equity transactions but not and make it difficult to establish a basis upon whichpermitted in China is the preferred stock. The cumu- minority holders or investors giving different valuelative preferred share satisfies the balance of risk and can be recognized and protected.return acceptable to some investors at a level betweenthat of ordinary common shareholders and that of bank Permit such equity-related securities as optionslenders. The lack of provision for such different classes and warrants. Issuers also need to be able to offerof shares seems to deny needed flexibility to the finan- investors quasi-debt securities, which provide currentcial arrangements of private enterprises. In limiting income as well as the potential for equity appreciationownership to a single class of shares, policymakers in the future. Securities of this kind include bonds thatoriginally intended to create a simple and transparent are convertible into shares (currently permitted only for


listed companies), or bonds that carry "warrants," in the two Chinese exchanges.2 Also, they may notmeaning the right to purchase a fixed amount of qualify because of poor profitability-though manyshares at a predetermined price in the future, and high-technology companies are attractive investmentsstock options. The PRC Company Law does not pro- despite low profitability in their initial years.vide any basis for the issuance of share options andwarrants. In particular, it lacks specific regulations Proposed listing rules for the Second Trading Boardregarding 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 ofit is effected. Consequently, it is not possible for a intangible assets could be as high as 70 percent, butcompany to reserve unissued shares and grant the vested they would be required to disclose their corporateright to acquire such shares in the future. There is like- information every three months. The capital requiredwise no obvious way to provide debt obligations to to obtain a listing is expected to drop from the mainlenders that can be converted by their terms into equity boards' RMB30 million (US$3.6 million) to RMB20claims against a company. million (US$2.4 million). This is progress, although

the need for such a high minimum level of capital canImproving Access to Public Equity still be questioned.A few ways to improve access to public equity wouldbe to broaden and strengthen the range of exit mecha- The establishment in late 1999 of a secondary board innisms available to investors, relax listing requirements, Hong Kong, known as the "GEM," has provided smallsimplify share buybacks, strengthen the incentive to non-state firms with a trading venue with less stringentlist on the domestic exchanges, and reduce restrictions listing requirements. These include lower incomeon the sale of founders' shares. requirements, shorter operating histories, and a lower

minimum portion of total shares offered at IPO. SeveralBroaden and strengthen the range of exit mecha- mainland high-tech non-state firms have already beennisms available to investors. Measures that would listed there, and several more are pending.strengthen the securities markets and provideincreased access to small firms-such as the expected Simplify share buybacks. An investor must be able toestablishment of the Second Trading Board by early sell his shares in the event an IPO is not possible. One2001-would have a profound effect on pre-listing alternative as part of the investment arrangementsinvestors 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 inadvent of the secondary board and official pronounce- the future. A company buyback would result in thements 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 sharesaccess to listing. This should water down the except when canceling shares in order to reduce thefavoritism 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 theexit as their greatest risk, and to eye the possibility of consent of the investor, the other shareholders, and thelisting firms in Hong Kong or offshore. company's creditors, either by stipulating the possibility

of cancellation in the company's articles of associationRelax listing requirements. Listing requirements or through subsequent amendment, which would becould be relaxed, even for new Second Trading Board approved by the stakeholders.3

listing. Although intended to protect investors, listingrequirements that are too restrictive may actually con- These rules were instituted to protect the rights ofstrain private equity investment by raising questions the investor, creditors, and shareholders. In the caseabout 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 thethat many private firms are too small or have limited investor's rights. Creditors have other means at theiroperating histories would disqualify them from listing disposal-such as covenants that are intended to


prevent management activity detrimental to their markets. Similarly, this restriction can be expected toposition-that are far more meaningful than any make listing on the new Second Trading Board lessdetriment 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 increasedtion would be to amend company law to permit share share supply, whether from the sale of founders' sharesbuybacks from investors unless expressly forbidden by or from the many non-state companies that would list ona 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-upStrengthen the incentive to list on the domestic savings that are earning a paltry income in commercialexchanges. It is hoped that the practice of conducting banks; as markets increased in breadth (from newa "rights" offering to existing shareholders, at discounts issues) and depth (from more shares available), theyof as much as 40 percent, will be curtailed in favor of would probably become more robust markets and morea broader subscription to new and existing investors stable. Furthermore, there would be fewcr opportuniticsalike. 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 reachan exit mechanism. a state of development where securities firms con-

ducting IPOs on behalf of issuers will determine, onReduce restrictions on sale of founders' shares. the basis of their reading of investor sentimentAnother 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-listingfounders' shares for a period of three years from the investors.6 Later on, once the company is listed, thedate of founding of a firm (which is deemed to include size of share sales by insiders will be regulated by thethe conversion of a company to a "company limited by brokers handling the sale, for they will have toshares").4 The reduction of this "lock-up" period for ensure that the downward pressure a large salefounders' shares would make raising capital on the would exert on the shares is mitigated.exchanges a considerably more attractive option fornon-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 eliminateold 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 ation and possible manipulation by owners of small, often gradual reduction over time in the lock-up period to aunproven companies without the kind of track record span of, say, six months, the regulatory intent of thethat would promote a more stable market among more restriction can still be realized, while the disincentiveseasoned 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.


.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 surveyresults 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 Statusof 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 toillustrate the capitalist production process. Marx gives one purely hypothetical example in which the employer has to employ eightpeople in order to extract enough surplus value to make twice the income of the emnployees, plus the samze again to use as capital (Young1995, 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 theseresults. 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. A1995 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 Statusof 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 attractChinzese 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 withmore 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.


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 theFinancial 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: EmpiricalResults 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 Supplyand 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 CommerceManagement. 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 Methodsto 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 ofEconomics, Harvard University, Cambridge. Mimeo.

Frye, Timothy, and Andrei Shleifer. 1997. "The Invisible Hand and the Grabbing Hand." American Economic Review, AEA Papers andProceedings 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 ofChina." 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 ofEconomics 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 Reformin Socialist Countries."Journal of Economic Perspectives 4 (Summer), 131-47.


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 SlovakRepublic." 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." MPDFPrivate 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 forEconomic 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.


DESIGNPatricia Hord.Graphik DesignAlexandria, Virginia

PRINTINGThe John D. Lucas Printing CompanyBaltimore, Maryland

COVER PHOTOGRAPHS iba, e, and f: Dana Downie [cib, 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 =~~~~~

MIFCInternational Finance Corporation2121 Pennsylvania Avenue, NWWashington, DC 20433

public disclosure authorized china's emerging private...

Documents