During the early 1980s, there was little market awareness in China's state sector. Asking how much it cost to transport timber 1,400km from Heilongjiang to Beijing, a US forestry official was told that since the state provides all the railway transport, no cost at all would be incurred.
Traditionally the Chinese government has provided all financing, owned all assets, and appointed all managers to its enterprises. Management were given no responsibility for loss or profit, just for production and the social welfare of the employees and their families.
Desire for control
The end of state monopolies and pricing controls has led to a need for more market orientation among China's state-owned enterprises (SOEs). This change has been accelerated by the arrival of intense foreign competition in the domestic market, especially over the past five years.
The Chinese economy has grown strongly in recent years but if the rate falls sharply in reaction to regional financial problems, and there is a fall-off in export growth and foreign investment, then reforming state enterprises and absorbing millions of redundant workers will be very difficult. However, the key to GDP growth in China is the domestic market and the need for massive capital investment, and these will be largely unaffected by external problems.
The ability to find employment for laid off workers is a fundamental requirement of SOE reform. This would necessitate an annual growth rate of around eight per cent ?if this is not achieved, the pace of reform would have to slow down.
The recent SOE reform package, discussed at the 15th Party Congress last year, is an endorsement and continuation of an on-going process of past 20 years, which has included:
contract responsibility reforms of the 1980s, started in Sichuan
joint stock companies launched in the mid-1980s
Shunde experience of 'privatisations' in the late 1980s
listing of large SOEs on stock exchange in the 1990s
experimental reform of 100 SOEs in 1994
1997/98 mergers to improve SOE competitiveness.
While a lot of progress has been made, the common negative theme of these reforms is the failure to separate government and management control.
This desire for control reflects the importance of the sector to the government: SOEs officially accounted for 34 per cent of industrial output in 1995 and 41 per cent of GDP in 1996, although the proportions are falling. The state sectoremploys more than 112 million people ?some 10 per cent of whom are probably severely under-employed.
The 'private' sector, which includes foreign-funded businesses, is growing fastest and it will continue to take over staff and output from the state sector.
There is no fixed timeframe for enter-prise reform and policies will inevitably shift with economic realities. The process may slow down and protection-ism may increase in some sectors if reforms prove difficult to achieve.
China now has around 300,000 state-owned enterprises, of which about 118,000 are industrial. There are an estimated 68,000 which are deemed to be 'significant' in size. Of these, 52,000 of the smaller ones will be reformed by sale, merger and acquisition, and leasing. The remaining 16,000 large and medium-sized enterprises will be reformed in two ways.
First, of the top 1,000 such companies, 512 profitable ones have been chosen for strengthening. All aim to make profits, and to save key industries from being overrun by foreign competition in the short term. Second, unprofitable and loss-making companies (about one-third), will try to reduce debts using mergers and bankruptcies. Some 2,000 went this way in 1997.
Shedding excess capacity
The purpose of the reform is to strength-en the core of strategic domestic industries. The initial list of 512 companies encompasses 26 sectors with around one-third of the total coming from the engineering, chemical, metallurgical and light industries. Some of the weaker and more heavily protected sectors have fewer companies in the first wave of reform: textiles, one of the worst per-forming industries overall, accounts for just seven per cent; pharmaceuticals, already restricted to foreign investment and trade, accounts for less than three per cent; the automobile sector, still restricted to investment, makes up for around two per cent.
Within these chosen industries there will be a wave of mergers and acquisitions that will seek to create competitive national and multinational groups. Some will make it onto the Fortune 500 list in the next few years and may cause some multinationals to take note of new competitors.
This may appear a long-term concern, but Shanghai Enterprise, an SOE listed in Hong Kong, has already accomplished this by acquiring 28 per cent of a South African consumer electronics business.
Experimentation dates back to 1994
but China has so tar gained little merger experience. Those ministries which are being rationalised to become more like holding companies are planning to consolidate their core businesses to create asset-rich conglomerates. For example, the State Petrochemical Bureau will create. 55 large corporate groups. The auto-mobile sector will create three or four large groups and the pharmaceuticals sector will aim to have the 5(1 top companies accounting for 60 per cent of sales by the year 2000.
Recent mergers have included:
China Eastern United Petrochemical (with assets of US$6.53bn)
Qilu Petrochemical (US$2.12bn)
China Road and Bridge Construction Group (US.$93m).
Planned mergers include Bao and Shanghai Steel (US$12.7bn), but they all face practical difficulties. In the case of Qilu, which merged with Zhibo Chemical Fiber and Zhibo Petrochemical, the local government requested merger approval in June 1995 from Shandong provincial government and China Petrochemical Corp. The Zhibo businesses were very poor and closed down in March 1997. Qilu did not want to merge but in August 1997 was forced to do so. To lighten the burden on Qilu, the Zhibo companies had their outstanding debt interest written off ?however, 5,000 new staff had reportedly been signed up to the Zhibo companies before the merger, probably with the knowledge of local officials.
Many problems remain
This experience shows that government, not managers, controls the process of merging SOEs, so state interests rather than business interests are at the heart of the matter. However, mergers will allow companies to start shedding excess capacity and workers, and to begin separating production and marketing from social responsibilities.
These policies will help reduce over-capacity and waste but will not directly assist in improving quality, technology and marketing in the industry. The same story is likely to be seen in other industries, and the competitive environment may be slow to change as the processrelies on the willingness of managers to take tough decisions.
These newly debt-free and rationalised companies may represent an opportunity for foreign investors who want to focus on added value, without the hassle of had debts, poor asset allocation or over-staffing. However, especially with larger companies, equity interests may not be translated directly into management control. For listed companies, shareholder representation may be equally poor ?an important consideration when about 12 per cent of state assets have reportedly 'disappeared' from these companies in the past.
There are many practical problems which must be overcome to make the reforms work at an operational level. Major problems identified by the State Development and Planning Commission include: strategic and operational issues often being ignored; large economic scale which is mistakenly assumed to produce economies of scale; too much diversification; not enough thought given to operational efficiency; and poor co-ordination within mergedr groups.
One of the biggest planned mergers is between Bao Steel and Shanghai Steel.
The merger has been suggested twice before but fallen through on both occasions. Vested interests are worried about losing power and security for worker 'communities'. Bao wants the merger for strategic reasons and to be competitive. The company does not want to leave opportunities for foreign groups such as Krupp to buy more factories. It favours focusing on those complementary parts of Shanghai Steel's business, not those which overlap.
Shanghai leads the way
Shanghai' Metallurgical Stock Control Company, formerly the Metallurgical Bureau, is the parent company of Shanghai Steel. It sent the government a different proposal ?for a complete merger of all their businesses. The proposals still cannot be agreed, and the moral may be: the larger the company, the more local and central government will interfere.
Because of regional differences in development, the industries selected for the first phase of reform will be subjected to regional variation in treatment. Of the 512 pilot companies already identified for reform, the majority are in traditionally strong commercial locations where most of the best companies are found. Some 23 per cent are in Shanghai, Jiangsu and Guangdong, and a total of 50 per cent are in just seven eastern and southern provinces and municipalities. Of the inland and western areas, Sichuan leads with just five per cent.
The geographical distribution is in line with the overriding policy of making kev industries competitive in advance of opening the domestic market to more foreign brands and goods. The effect of this focus is to reform first those areas with the greatest amount of foreign competition, and it will have animpact on the competitive environment as well as investment potential.
Shanghai is the nucleus of the pioneering reform, containing almost 10 per cent of the target 512 companies. The Shanghai Commerce Commission has split industry into four categories:
Efficient large and medium-sized enterprises, and commercial and retail ventures dealing in key commodities. These companies will be reformed into shareholding companies, with the state having a controlling stake.
The second category will include medium-sized and small companies with net assets under US$1.2m. These will be shareholding companies, with the state taking a minority stake.
Small enterprises with annual sales under US$250,000 will be privatised, with workers and managers invited to buy and run the businesses.
About 3,000 small loss-making companies will be sold at auction to the highest bidder.
An investment opportunity?
In Shanghai, 83 SOEs with US$1.2bn of debts were declared bankrupt between 1994 and 1997, with US$512m in debts being written off by banks. In 1997 alone, 27 SOEs in Shanghai went bankrupt and 45 were taken over.
Shanghai is in better shape than the rest of the country. Official figures show bad debt levels of around nine per cent compared with a national average of 20 per cent. If the reforms work in Shanghai, they will be extended elsewhere, with important strategic implications.
The reform process will happen slowly, as the size of the investment will be massive and many jobs will be lost. The slower the rate of GDP growth, theslower the process will be, and it may be some time before investment opportunities really open up in the next phase of SOE reform.
The reform strategy is based on a strong core of domestic state-controlled industry. This means that relatively weak industries will continue to receive protection of the type recently seen in pharmaceuticals (with profit restrictions), and brewing (with market share limits for foreign brands).
The creation of large cross-regional groups will end the parochial nature of state enterprises, and more of these large groups will develop nationwide production and sales strategies to take advantage of their changed structures. As a result, competition in some areas looks likely to intensify.
The key to success in a reformed SOE will be true separation of management and government control. Unless this can be achieved, these emerging companies and conglomerates could be saddled with poor assets or forced into mergers with bad businesses.
In the first phase of reform, as the best companies first have to consolidate and realise their value, investment opportunities will be limited. However, there is already considerable investment interest in the state sector, from both financial and industrial investors. Government expectations are that US$10bn-15bn a year in foreign investment will come into the reforming state sector.
Foreign investors have two basic investment choices: listed or unlisted ?but mainly unlisted ?investments. Of the 512 pilot companies, 120 were listed by the end of 1997 but just one was in Hong Kong and two on the B-Share markets in Shanghai and Shenzhen. The remaining 117 were listed on the A-share markets, which are restricted to Chinese investors. As a result, it is hard to access the core of the state sector through the markets at this stage ?although there remain plenty of Red-chip opportunities (Hong Kong-incorporated mainland Chinese companies, such as Citic Pacific) and severaI state offshoots. In the next three years, 80 per cent of the pilot companies may float on the markets, providing greater access to them.
Large and medium-sized companies are at the core of enterprise reform and are often protected from foreign competition and investment. According to the State Commission for Economic Restructuring, foreign investors will be granted no more than 30 per cent stakes in these ventures ?and management input may be even more limited in certain sectors:
Unlisted 'large' companies (those with assets exceeding Yn100m) may be attractive if restructured to free up performing assets, and they can pro-vide useful infrastructure and central government support. The downside is that foreign investors will be minority shareholders with little management control.
'Medium-sized' companies (between Yn5m and Yn100m in assets) may be more flexible for local markets, r but while debts may be written off, it will be harder to find, and effectively separate, useful assets.
'Small' companies (under Yn5m) will often be available after bankruptcy but finding value among them may be like searching for a needle in a haystack.
Protecting the investment
Reforming Chinese companies have varying interest in foreign investment, and structures can differ. A few examples serve to illustrate typical issues.
A classic example of investing in SOEs is that of Zhongce, or China Strategic. The Hong Kong-based company invested US$300m in 100 state enter-prises, taking 51 per cent controlling stakes. It has been successful in trans-forming the enterprises with new management and technology, and has become a show-piece investment case-study. However, the company has also had its critics, and has been accused or profiteering from state assets. As a result, more care is now taken over state asset sales and companies can take very different approaches to investment and management issues.
Jinan Ship Group in Shanghai will be one of four large shipbuilding groups. To raise capital, the company chose to go public rather than look for foreign investment, and listings are likely to increase dramatically in coming years.
Since 1992, Shanghai Tire & Rubber has talked to various suitors, including Michelin and Goodyear. The foreign companies wanted a 51 per cent controlling share, but failed to get control. In 1996 .Bridgestone came to the table and reached a 50-50 compromise on the US$12m venture, which may now go ahead. The case illustrates the fact that not all SOEs are willing to lose joint venture control.
Krupp's US$1.4bn venture with Shanghai No.3 Steel Works gave it a 60 per cent controlling share ?and kept the venture completely independent from the rest of the Chinese parent group.
At the other end of the scale, Changzhou Diesel's negotiations with Japanese and Korean companies failed over surplus workers and welfare for retired workers. These restructuring issues can be a major hurdle, but are not the only ones to consider.
By whatever means a specific company is identified, homework still needs to be done to protect the investment — whether purely financial, or operational. Often the information provided during the initial introduction will be very basic, showing raw projections of production, sales and rates of return, as well as the capital, land and other inputs required from both par-ties. These figures are generally internal assumptions rather than the result of independent research, and should be carefully scrutinised, along with the company's trading history.
A need for understanding
Stated assets and debts should also be clarified, as ownership issues are still complex and open to interpretation. Some debts may be carried off the balance sheet, while some payments on account may never materialise.
While SOEs often suffer from a lack of management independence, they can benefit from state support at local and national levels. However, where management is in conflict with local government over aspects of enterprise reform, political problems may arise.
Many reforming companies will come to the table having already restructured but if not, layoffs could account for some 30 per cent of the workforce. It has been suggested that a payoff of Yn15,000-20,000 per person would be suitable compensation, so the entry cost is high.
As in any business the people are vital and the need for mutual understanding with partners on a personal and professional footing is important. Negotiations should be conducted with sensitivity if good working relationships are to survive the process.
Investing in China has always been difficult. The dilemma for most investors remains whether to invest under difficult conditions to stay ahead of competitors, or to wait for perfect conditions and to battle in a more competitive environment.
Transparency, regulation, iron rice-bowl mentalities, skill deficiencies, transportation, marketing and consumer demand issues still exist inside and out-side the state-owned sector. The new environment will help separate management from state administration, but it will not happen overnight. Government will still drive these businesses in the medium term. In larger companies, and in key industries, this control will remain firm as a matter of policy.
Competition for capital
Nevertheless, there will be opportunities for investors in the state sector, not least because of the increasing competition for capital. There may also be opportunities to gain limited access to previously restricted sectors.
Generally the opportunity for investment in SOEs is not yet ripe. The process of consolidating major enterprises will take time to complete and many investment proposals in the short term will relate to small, bankrupt operations. As with other policies, the experiment will be re-evaluated based on experience, and all parties have an opportunity to watch progress being made and to contribute to future developments through consultation, if not participation.
China Concept Consulting provides industry information, market strategy and public affairs services though offices in Beijing, Guangzhou, Hong Kong, Shanghai and London. For further details, please contact Jeremy Gordon in London, tel: (44) 171 253 4590, or James King in Beijing, tel: (86) 10 6518 2518.
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