Under New Ownership

Under New Ownership Shahid Yusuf DECRG World Bank December 2005

Enterprises and Growth Enterprise sector responsible for much of China’s remarkable growth But cost of growth is high • Investment equals 45 percent of GDP, the highest sustained rate of investment for any country in recent history. • Most growth is from input of capital and labor. Share of total factor productivity increase is one quarter of overall growth. In industrial countries, share is one-half or more.

Enterprises and Growth (cont’d) • Cost of growth related to inefficiency and low profitability of many enterprises, especially SOEs. • Enterprise problems imperil banking sector • NPLs of banks amount to 9 percent of GDP, not including those taken over by asset management companies. • Enterprise inefficiencies also reflected in high consumption of energy and raw material, and associated environmental damage. • Enterprise efficiency and competitiveness good for growth and for overall welfare.

Attributes of Successful Firms • Quality of management and strategy focused on competitiveness to assure longer term growth. • Organizational capability, especially adaptability and resilience in the face of shocks. • Flexible internal labor market to maximize gains from training and efficient use of workforce.

Attributes of Successful Firms (cont’d) • Culture of innovativeness and openness to ideas. • Emphasis on core strengths and effective use of subcontracting and outsourcing. • Skills and readiness to operate internationally, to market abroad and manage a multicultural workforce.

Do Chinese Firms Have these Attributes? • Some do. Mainly private firms and joint ventures. Also a few SOEs (e.g., CIMC). • Majority of SOEs do not. • SOEs constrained by national/subnatoinal objectives, management skills, high degree of vertical integration, diversifed activities, labor market rigidities, lack of innovativeness, and localized or domestic market orientations.

Why Do SOEs Matter? • Share of state sector in industrial output shrinking: now close to one-fifth. • But, one-half of industrial value added is in the state sector. • State sector holds two-thirds of net fixed assets. • Absorbs nearly two-thirds of bank loans. • Growth in total factor productivity is less than one-fifth of collectively or privately-owned enterprises. SOEs still strongly influence the performance of China’s economy

Fifteen Years of Enterprise Reform1980-95 Enterprise reform dates back to early 1980s. Has been through several stages: • Negotiated profit retentions; • Simplified administrative controls; • Selling of above plan output; • Flexibility in hiring workers or contract; • Management contracting. Productivity gains from giving enterprises more autonomy disappointingly small.

Is Privatization the Key • Western countries adopted privatization in mid-1980s after other policies to reform public enterprises proved unsuccessful. Many transition economies followed from the early 1990s. • By end 2002, privatizations had generated $1.1 trillion for government, one-third in developing and transition economies.

Is Privatization the Key (cont’d) • On balance, privatization has helped raise profitability, labor productivity, growth of sales and sales per employee. • Manufacturing firms have performed better than others. Also banks. • One decade’s experience shows that fast reformers among transition economies, after initial difficulties, did better than slow reformers.

Why Privatization Works • Change in objectives: clearer focus on profitability and growth. • Market-based incentives reinforced by private ownership, displace administrative incentives. • New management, stronger governance mechanisms and stronger minority shareholder rights.

Why Privatization Works (cont’d) • Competitive pressures from product market and financial markets. • Greater flexibility in restructuring operations and hiring/firing workers.

Pitfalls of Privatization • Continuing significant government share and influence on decision-making a handicap • Many companies initially go through a period of losses after privatization. • External recruitment of management and BOD that exercises effective oversight important, or else governance remains weak. • Ability to shed excess workers and sideline businesses and rationalize production vital for success.

China’s Strategy Since 1996 • Privatization, divestiture and closure of small SOEs. • Start at corporatizing MLSOEs. Creation of Limited Liability Companies (LLCs) and Limited Liability Shareholding Companies (LLSCs). • FDI in MLSOEs.

Research Objective: Comparing Impact of Ownership on Performance • Main objective of the empirical exercise is: • Did reformed enterprises perform better? • If so, what were the main contributing factors? • Factors associated with better performance were: • Ownership, competition, hard budget constraint, role of managers (appointment, turnover, incentives, autonomy), and corporate governance (shareholder meetings and board of governors).

Data Description • The data is based on survey conducted by China National Bureau of Statistics, Enterprise Survey Organization. • Information collected from 736 firms for the period 1996-2001. Sample of enterprises drawn from five cities (Beijing, Chongqing, Guangzhou, Shanghai, Wuhan); and from 7 subsectors, electronic components, electric equipment, consumer products, vehicle and vehicle parts, garment, general machinery, and textile. • Of these firms, 140 were never reformed, 266 reformed, 330 were never SOEs.

Estimation Strategies • Used Cobb-Douglass production function (as most researchers of this topic do), along with city, industry, and year dummies. • Also used panel regression to take full advantage of the both cross-section and time-series dimension of the data.

Findings • Ownership • Firms with 100% state ownership perform the worst in all specification • Joint venture firms are the best performers, followed by LLSCs and LLCs. • Competition • Paradoxically, firms in more competitive markets seem to perform less well than those faced with less competition.

Findings (cont’d) • Corporate governance • Having a board of governors is performance-enhancing. • Having a shareholder meeting also tends to improve performance, if and only if one-share-one-vote is instituted. • Manager • Firms with managers appointed by the government perform less well. • Changing of managers did not have any effect.

Findings (cont’d) • Hard Budget • A priori, one would expect a hard budget constraint to have a positive effect on performance, but such an effect not apparent from the tests

Concluding Observations • Study shows that if the objective is to raise the performance of firms, then ownership reform is desirable. • Such reform should include at least the following: • Managers should not be appointed (or approved) by the government • The shareholder meetings needs to align the financial stake and the voting rights (one-share-one-vote) • There should not be any restrictions on the ownership (i.e. foreign ownership)

Concluding Observations (cont’d) • Full privatization better than partial privatization with continuing substantial government ownership or control rights. • Successful privatization can be assisted by several complementary factors • An effective national social safety net, and scope for flexibility managing enterprise workforce • Adequate supply of experienced managers

Concluding Observations (cont’d) • Legal and audit institutions to sustain corporate governance, rules, minority shareholder rights, and bankruptcy laws • Well functioning financial markets to discipline managers

Thank You

Under New Ownership