We are the champions
Mar 18th 2004
From The Economist print edition

World Bank publishes Management of China's State-Owned Enterprises Portfolio: Lessons from International Experience, by William Mako and Chulin Zhang. See also China National Petroleum Corporation, the State-Owned Assets Supervision and Administration Commission and CNOOC.

China's state-owned enterprises want to make their mark on the world stage. They will struggle

DALIAN, the port city of Liaoning province in China's north-east, is home to the country's biggest, most modern shipyard. In the cavernous dry dock, a modern crane lifts massive steel sections for final assembly of a gigantic oil tanker ordered by Iran. The din is deafening as workers hammer and weld the parts together.

Ten minutes' drive away there is noise of another kind: children laughing as they play basketball during a break from lessons. Their school, a shabby concrete building with bitterly cold classrooms, looks out of place amongst Dalian's grand Russian- and Japanese-inspired architecture, and wholly unconnected to the gleaming shipyard. Yet both are part of the same state-owned enterprise, Dalian New Shipbuilding Heavy Industries.

“Theoretically, it would be better to get rid of the school,” says Sun Zhenlie, the company's vice-president. “In reality, it is not that easy.” Yet the school is only one of the group's non-shipbuilding activities. Along with routine overmanning, it helps to explain why productivity at Dalian New Shipbuilding, despite cheap labour, the latest equipment and subsidised loans, is just one-seventh to one-tenth that of its Japanese and South Korean rivals.

Several hundred miles further north, the contradictions are even sharper. Daqing, in Heilongjiang province, is at the centre of China's largest oil field. More than 50,000 “nodding donkeys” dot the city centre and the surrounding desolate plain. The production facilities are owned by PetroChina, an arm of China National Petroleum Corporation so thoroughly restructured that it is listed on the New York Stock Exchange. Warren Buffett, America's smartest investor, owns a stake.

Yet through its ties to CNPC, PetroChina in effect still pays for the main hotel and some restaurants in Daqing, as well as for the housing, heating and even wages of thousands of laid-off workers. To divert attention from Daqing's troubles, local officials drag visitors to a museum commemorating “Iron Man” Wang, an oil worker who in the 1960s helped to cap a blazing wellhead by jumping into a vat of badly mixed concrete. He survived the feat, but his famous slogan, “I will get the oil, even if it takes 20 years off my life”, proved prophetic: he died in 1970, aged only 47.

The contrast between old and new in the state sector is at its starkest in China's north-eastern “rustbelt”, where state-owned enterprises (SOEs) generate 70% of GDP. But it exists throughout the country, and shows how much further SOE reform has to go.

It is no exaggeration to say that China's economic future depends on such reform. In 2002, the state controlled half of industrial output, and SOEs still account for 35% of urban employment, despite having halved their workforce in the past 12 years. Virtually all of China's heavy industry and much of its technology is in state hands. Half of all bank loans go to SOEs. This crowds out the private sector, China's growth engine, and threatens the entire financial system, because most of those loans will never be repaid.

This is not to deny that progress has been made. When state corporations were set up in the 1960s, they were simply arms of government bureaucracies, which told them what to make, took all their revenues and covered all their costs. Factories were, in effect, “little societies”, responsible for everything from education and medical care to housing and recreation. That they made huge losses did not matter.

Don't let go

It was only in March 1998, when Zhu Rongji became prime minister, that reform of the sick state sector moved to the top of the political agenda. He enunciated the doctrine of zhuada fangxiao (“grasp the big, let go the small”), which remains the guiding principle of SOE restructuring. It means that the government wants to keep control of the biggest and most important companies, but will let the smaller ones fend for themselves.

The following five years saw a wave of incorporations and stockmarket listings of SOEs, big and small, as the central government and the provinces sold minority stakes. Urged on by the centre, local officials organised auctions of state assets, most of which were sold at rock-bottom prices to managers and party bosses. Eventually the government had to call a halt.

Meanwhile, restructuring, mergers and closures reduced the number of SOEs from 262,000 in 1997 to 174,000 in 2001. Lay-offs reached such a scale that they triggered serious unrest. In early 2002, thousands of oil workers gathered in Iron Man Square in Daqing to protest against unfair severance packages. The government quietly rounded up and imprisoned the ringleaders, but in March 2003 it also set up a new agency to oversee the SOEs' management: the State-Owned Assets Supervision and Administration Commission (SASAC).

Since SASAC started life, its chairman, Li Rongrong, has announced nothing but good news. In the 11 months to November 2003, China's top 500 SOEs reported revenues of 4.07 trillion yuan ($492 billion), up 25% on a year earlier, and profits of 334 billion yuan, up 33%. Only 87 of the 500 were still making losses.

Unfortunately, these numbers cannot be taken seriously. Outright fraud aside, most SOE managers do not know what their real profits are, and tell their superiors what they want to hear. Most of the jump in official profits is due to a windfall the big oil producers reaped from high world prices, and to lower interest costs as banks have swapped dud loans for equity.

China's 1,287 domestically listed companies, most of which are SOEs, reported an average return on assets of 6.2% for the first nine months of 2003. But again, this improvement is down to a few star performers. Stephen Green at London's Royal Institute of International Affairs says 42% of all listed-company profits come from just 20 companies, including Sinopec, Angang Steel and protected sectors such as utilities. The majority of SOEs are running at break-even or worse (see chart 4).

According to a study by the World Bank's William Mako and Chulin Zhang, published last September, overall profitability of SOEs doubled between 1999 and 2001 but 51% of all state corporations were still losing money. Moreover, average current assets had risen to 319 days-worth of annual sales, suggesting that most of the SOEs' working capital was tied up in uncollectable bills or unsaleable inventory. In other words, most SOEs are illiquid, kept alive only by government money.

What SOEs are for

For China's top leadership, this is beside the point. SOE reform is not about profits, and certainly not about privatisation. The aim is not to reduce the state's control over key sectors of the economy, but to make that control more effective. If a stockmarket listing or the sale of a stake can bring in technology, private-sector expertise and discipline, well and good. But the government intends to remain in control.

Nor is the purpose of SOEs to maximise wealth. They merely need to be efficient and big enough to have a strong international presence. China's desire to become a superpower partly depends on its industrial policy. Having watched the breakneck expansion of foreign multinationals over the past decade, it wants to create its own global stars. SASAC's real mandate is the transformation of a group of 30-50 SOEs into globally competitive “national champions” by 2010.

Some, notably the three big oil companies, Baosteel, Haier (household appliances) and TCL (electronics), seem to be on their way. They have vast assets, healthy profits and listed subsidiaries (see table 5). Increasingly, they are also buying assets overseas. The three oil groups have operations in more than a dozen countries. CNOOC is now Indonesia's largest offshore oil producer, following its $585m takeover in 2002 of Repsol's operations there. In Brazil, Baosteel, China's biggest steelmaker, has negotiated China's biggest ever overseas corporate investment, worth $1.5 billion. With the resources of an ambitious government and a huge, protected domestic market behind them, their progress seems inevitable.

But is it? Only 11 Chinese companies rank in the Fortune 500 list of top global firms by revenue, and only two are in the FT 500, ranked by market value. Not a single Chinese brand makes the top 100 list of Interbrand, a consultancy, and “global” companies such as Haier are still confined to niches overseas. Peter Nolan, a professor at the Judge Institute of Management at Britain's Cambridge University and an expert on Chinese companies, comes to a withering conclusion: “China has not built a truly competitive global firm. Its industrial policy of the past two decades must be judged a failure.” All this despite tariff protection, cheap loans, access to foreign technology through joint ventures and privileged access to the stockmarket.

Avic, the national aerospace group, is a good example. Urged on by Deng, by 1985 it had designed a civil airliner from scratch in less than five years. But only two planes were ever built, and even China's nationalised airlines refused to buy. Nearly 20 years later, Avic is trying again with a small regional jet and plenty of tax breaks, but it has no clear idea of its commercial prospects. In pharmaceuticals, Sanjiu, the local contender, lost to foreign rivals because it concentrated on traditional Chinese medicine rather than developing a proper R&D capability, and diversified into biscuits and beer.

Feet of clay

The reasons for failure are plentiful. Mr Nolan points to inconsistent central policy, provincial protectionism that prevents companies from buying up competitors and an inability to reduce overmanning because of the premium placed on low unemployment and social stability. Xie Qihua, the president of Baosteel, saw her company's profitability drastically reduced in the mid-1990s when the government forced her to absorb four rival loss-making steel producers.

Michigan University's Kenneth Lieberthal and Bain's Geoffrey Lieberthal, a father and son writing in the Harvard Business Review, blame weak management. For SOE bosses, political skills matter more than modern management practices. The companies' middle managers are hierarchically minded and display little initiative. They can carry out specific tasks, but fail to grasp the complex processes required to manage a large-scale business.

Technology is another Achilles heel. China runs a deficit on its technology trade with the rest of the world, and 80% of technological imports and exports are controlled by foreign-owned firms in China. The Chinese have made little progress in either basic research or in advanced design in vital industries. In the rest of the world, meanwhile, technological development and a wave of consolidation have produced lots of genuinely global companies. If anything, the gap between these multinationals and their Chinese counterparts has widened, Mr Nolan says. Foreign companies will not readily hand over their technology or management skills to a Chinese partner. And cosseted Chinese companies will have to play by international rules the moment they venture abroad.

Huawei, China's leading telecoms-equipment maker, knows this to its cost. At first sight, it looks every bit the global success. Its marbled headquarters in landscaped grounds is a world away from the chaos of nearby Shenzhen city. Last year $1 billion of its total sales of $3.5 billion was earned outside China. Yet critics argue that Huawei owes much of its success to peculiarly Chinese advantages, such as military connections and lax laws governing the theft of intellectual property. William Xu, the company's executive vice-president, hotly denies it has had government help, claiming it is privately owned and run like a western company. Yet Huawei is finding it harder to compete internationally than at home. In a highly publicised case last year, it was sued by Cisco in a Texas court for infringing its intellectual property, and will have to make amends.

Inspired by the “Iron Man spirit”, China will no doubt continue to build its global champions. But like Mr Wang, they may find that life on the world stage can be nasty, brutish and short.

On the capitalist road
Mar 18th 2004
From The Economist print edition

Private businesses are China's great hope for the future

IF CHINA'S north-east with its hulking state-owned industries is a monument to socialism, Zhejiang province, hugging the coast just south of Shanghai, is its capitalist heartland. Combining an entrepreneurial trading heritage with a meticulous division of labour, Zhejiang's family-controlled businesses are taking global markets by storm. In the city of Wenzhou, 3,000 small firms have clubbed together to concentrate on making cigarette lighters, some specialising in components, some in final assembly. Production is flexible, fast and competitive: in 2002, Wenzhou made 750m lighters, the equivalent of 70% of world demand.

Companies elsewhere in Wenzhou manufacture nothing but pens or low-voltage electrical equipment. Cixi is a base for kitchen-equipment makers, and Datang turns out 8 billion pairs of socks a year from 8,000 factories—one-third of all socks sold worldwide. Other parts of the province make vast quantities of shoes, toys, ties, watch movements and Christmas decorations.

These businesses are creating real wealth. Zhejiang's annual income per person among urban residents of 12,700 yuan (a little over $1,500) in 2002 was the third-highest among China's 31 administrative areas, behind only Shanghai and Beijing. On average, the people of Zhejiang earned nearly twice as much as those in the north-east. The province was also home to 62 of the 400 richest Chinese, a third more even than prosperous Guangdong.

Zhejiang's success comes down to one simple fact: 91% of its 240,000 enterprises, with annual revenues of 700 billion yuan in 2002, are privately owned. They also have access (albeit limited) to funds from local private moneylenders and clarity of ownership, rare in China. The government, both at local and national level, deserves credit for its benign neglect of them.

Zhejiang's home-grown capitalism is exceptional in China, and will probably remain so. It was a fortunate accident of history that the communists decided not to base large state projects in an area close to the island of Taiwan, a potential war zone, says Jonathan Zhang, an investment consultant for the Huangzhou city government. That created a vacuum for Zhejiang's risk-taking traders to thrive in. But everywhere in China, private business is springing up in the cracks between state-owned enterprises as well as in new fields such as service industries.

Guangdong and Jiangsu (also opposite Taiwan) were long ago turned into giant export-processing factories by the investments of ethnic Chinese from Hong Kong and Taiwan; and mainland citizens who have lived abroad are flooding back to set up companies in China's countless business parks and make their fortune. Charles Zhang, the MIT-educated founder of Sohu.com, a Nasdaq-listed Internet portal, who returned home in 1996, is now worth an estimated $270m (see article).

It is hard to say just how big the private sector is. Some state businesses are, in effect, run on private lines by their management. Conversely, many firms labelled private by the official statistics, particularly small township, village enterprises (TVEs) and collectives owned by their employees, are in truth controlled by local governments. Bao Yujun, chairman of the Research Association on the Private Economy, a Beijing-based think-tank, reckons the private sector contributes just over 60% of GDP, counting TVEs and businesses with foreign investors (worth about 15%). Yet the World Bank's Country Assistance Strategy report in January 2003 put the share as low as a third.
ROPI
ROPI

The private sector steams ahead

Whatever its precise size, the private sector has, in the World Bank's words, “emerged as the most dynamic component of the Chinese economy”. Growing at around 20% a year, more than twice as fast as the economy as a whole, it has been responsible for most of the recent job creation and for up to 60% of fixed capital investment. According to an IMF working paper by Ray Brooks and Ran Tao, published last November, agriculture and the SOEs have been shedding workers, but China's private companies created 17.5m jobs in the six years to 2001. Another 75m quasi-private jobs have sprung up in the “shadow economy”, outside the official statistics, in street vending, casual construction work and domestic service.

Most private companies are still tiny: 90% employ fewer than eight people. But the number of larger private enterprises is growing. Some are old-fashioned exporters, taking advantage of a low domestic cost base. Galanz makes one in three microwaves sold the world over, and Pearl River Piano is the globe's second-largest piano maker. Others, such as Legend, the nation's number one PC manufacturer, and collectively owned Haier, the leading white-goods producer, are building respectable domestic brands.

One such group is Wahaha, a maker of soft drinks, named to sound like a laughing baby. Founded in Hangzhou in 1987 by Zong Qinghou, Wahaha began by selling vitamin drinks. In 1991 Mr Zong had to sell a stake to the district government. In 1996 he sold a further slice to France's Danone to bring in new technology and product lines. On paper Danone now has 51% of the company, but Mr Zong runs the company like his own fief, to good effect. The group has 16% of China's bottled-drinks market, and its “Future Cola” is the third-largest domestic cola supplier behind Coke and Pepsi, achieving higher margins than they do thanks to its local knowledge.

Unequal struggle

Despite such successes, China's private sector as a whole does not enjoy a level playing field. One fundamental issue is property rights. China's 1982 constitution caused an explosion of entrepreneurial activity by legitimising the “individual economy” alongside the socialist public one. Amendments in 1988 referred to the “private economy”, and a year later private activity was dubbed an important part of a “socialist market economy”. But only now, in yet another amendment brought in this month, does the constitution declare private property “inviolable”. And even now, public ownership retains preferred status. The constitution still refers to it as “sacred”.

This matters. As private businesses grow, they come into contact with state-sector suppliers, distributors and customers, and often find that their theoretical property rights count for little when it comes to collecting debts or having contracts honoured. Moreover, the government is still inclined to meddle, even taking stakes and muddying ownership. And rules, regulations and bureaucratic fiats abound, many of them conflicting.

From political access to obtaining official licences to matters like unsupervised travel, the discrimination in favour of SOEs is always in evidence. Mr Bao talks fervently of a need to “change the mindset” in China. “Under the planned economy, private businesses cannot enjoy equal treatment,” he says. His think-tank's shabby office on the outskirts of Beijing, complete with a rusting bed and a well-used spittoon, bear testimony to the second-class status of the private sector.

This discrimination is reflected most critically in a lack of access to capital. Bank loans still go overwhelmingly to state corporations, as do stockmarket listings. Indeed, although SOEs represent far worse credit risks than many private companies, loans to them are classified as more secure, forcing private businesses to rely on money raised from friends and family and on retained earnings.

That, however, is not the only reason why most private companies remain small. Nowhere is the Chinese propensity to base business on relationships more obvious than in the family-run firms that make up the bulk of the private sector. The dominance of a single individual gives them clear lines of command and enormous flexibility. But as they grow, they run up against the limits of what one person can manage. In contrast to the West, argues INSEAD's Gordon Redding, in China “a culture that transcends the individual is exceptionally rare”.

Another problem is that most Chinese businesses are broad rather than deep, preferring to diversify rather than concentrating on a core business. This reflects a huge range of money-making opportunities and a lack of individual patience. Kenichi Ohmae, a consultant who used to run McKinsey's operation in Japan, says it took the Japanese 40 years to develop the sophisticated products and the quality control that allowed them to prosper. “I see very few Chinese managers excelling in one area,” he says. “Chinese managers will never spend five or ten years developing a smaller, faster component—it is not in their mentality.” Such short-termism helps to explain why China is struggling to build home-grown brands. The consistency and quality that builds trust with consumers is not part of the Chinese management style.

The development of a vibrant private sector has been China's greatest commercial achievement since opening itself up in 1978. At that time it had barely 130,000 individual businesses. Now it has several million, representing a large part of the economy. They are driving growth, creating jobs and contributing to social stability by absorbing workers from farms and SOEs. But not enough of them are growing into companies that can compete globally, developing proprietary technologies and long-term competitive advantages. Even with a level playing field, that would take decades. And they remain vulnerable. As the World Bank's strategy report notes: “The continued growth of the private sector cannot be taken for granted without continued progress in market reforms to improve the business environment.”

To continue to develop, China's private companies need, above all, rational banks and a well-functioning stockmarket. Yet if the private sector is China's brightest hope, the financial system is its weakest point.