Governance Practices in Chinese SOEs: Content of Change - Corporate Governance and Business Ethics

In the planned economy before 1978, state ownership was considered the solelegal form of enterprises. This concept provided justification for state planners to mobilize human and financial resources and allowed them to assess production and distribution demands. The state did not only own the property rights of, but operated the SOE's through its officials who were executing the managerial powers. This model served as an organizer of economic resources and activities as well as a tool binding the state, SOE's, and employees to each other (Shipani and Liu 2002). That is to say, SOE's were operating on the state’s coffers as the sole financial input, while employees were living on salaries earned at the SOE's. Therefore, SOE's had some social security functions other than just production units. A job at a certain SOE was once called an “iron rice bowl” that symbolized a secured life with salary, housing, medical treatment, and pension offered by the SOE.

Having learned a bitter lesson from abolishing the development of the national economy during the ten year long Cultural Revolution and seen the economic success in the developed countries, the central government intended to increase productivity and raise living standards in 1978 by reforming its economic model systematically into a more competitive one. On the Third Plenum of the Eleventh Chinese Communist Party Congress at the end of 1978, the Party out set to shift its focus from class struggles to economic development (CPC 1978). Following this ideological turning, the Chinese reform era began.

Depending on the central government’s major policies for reforming SOE's and their management, we identify three governance stages of Chinese SOE's since 1978: (1) the incentive stage from 1978 to 1983, (2) the contracting model from 1984 to 1992 and (3) the corporatization model since 1993. As summarized in Figure, governance practices at the three stages differ in their features with regard to the goal of relevant policies and the roles of the state as well as SOE's and their executives (managers) as participants.

The Incentive Stage (1978–1983)

The experiment of SOE reform had started even shortly before the Third Plenum of the Eleventh Chinese Communist Party Congress was held. In autumn 1978, six SOE's in the Sichuan Province were selected by the local government to be the first ones to undertake an experiment along the lines of “expanding enterprise autonomy and introducing profit retention” (Qian 1999). In 1979, the number of experimenting SOE's in Sichuan was increased to about 100. The selected SOE's were given more autonomy in a way that they could produce and sell goods to the external free market and retain some profits in case they had fulfilled the plan quotas. They were also authorized to promote some middle-level managers, who still had to be approved by the government.

In summer 1979, the central government issued Some Provisions on Enlarging Industrial SOE's’ Autonomy (CPC 2008) and other four documents to extend the SOE reform experiments to other provinces. By 1980, more than half of Chinese SOE's (in terms of output value) were involved in the experiments and obtained some limited autonomy in production planning, material purchasing, employment, sales, and use of retained profits. These incentives had an active effect on SOE's’ performance of that time. Compared with 1978, the delivered profits of all SOE's to the state grew in 1979 by 10.1%. The government deficit of 1 billion RMB in 1978 was replaced by a surplus of 13.5 billion RMB in 1979. The income from SOE's rose by 7.5% as against the previous year (Wang 2006).

However, these practices were de facto no change of the dominating planned system, but a cautious testing of a profit-orientation of the SOE's.

Planned production quotas still took priority on SOE's’ task lists. Only those who were able to complete their production plans and to mobilize surplus human and financial resources could enjoy the profit retention. Although the state shared some decision-making rights with SOE's, it remained pervasive in SOE's’ operations. It owned all the enterprises on behalf of the Chinese people and delegated officials to manage SOE's’ operations. At the same time, it assessed production and distribution demands, formed production schemes for SOE's, and monitored the realization of these schemes. Apart from material resources, the state furthermore supplied funds to finance SOE's’ operations. In fact, the state provided all SOE's with the input resources and distributed their output according to its plans. In this context, SOE's were rather “production units” or factories, as they were often called in Chinese, t hand real business enterprises with an orientation to increase returns and profits for their investors via active management. SOE's were not regarded as independent legal persons. Unsurprisingly, the term legal person never existed in the central-planning period. In nature, the governance practices in SOE's had not changed much in comparison with those in the planned system.

The Contracting Stage (1984–1992)

Dual-Track System

It was not until 1984, as the government issued On Regulations of Further Expanding Autonomy of SOE's and officially permitted a market track alongside with the planned track for industrial goods, that the SOE reform in China got a new push. Under the dual-track system, which was officially activated in early 1985 for all economic agents, SOE's were to sell industrial goods up to an appointed quota quantity to the state at a planned price, while any surplus products were allowed to be sold at the market and priced freely. Consequently, any kind of good was priced twofold with a planned price and an unregulated one. Chinese SOE's were now for the first time linked with the market. Due to decreasing market prices mainly caused by tight monetary policy in 1990, the price difference between the planned and the market track became insignificant. By the mid-1990s, most provinces had undertaken liberalization in prices and the planned-price track had almost ended for most industrial goods.

Three-Governance-stages-of-Chinese-SOEs-Since-1978

Three-Governance-stages-of-Chinese-SOEs-Since-1978

Contracting for SOE's

More importantly in this phase, the central government launched the Contract Responsibility System at the beginning of 1987, trying to separate the state from the management of SOE's and to encourage the latter to expand production and earn profits. Under this system, the director of a SOE signed a contract, which governed the relationship between the SOE and its factory director, with the local government for a period of time of at least three years, so that he or she would be fully responsible for the SOE’s operation and gained consequently more control rights over the enterprise’s operation than before. The focus of such a contract rested mainly with the profit sharing between the government and the SOE: The SOE as an entity should contribute a fixed proportion or a minimum amount of profit to the government, while the total income of managers and employees were dependent on the operational performance – the rest of the profit after tax. The contract responsibility system had a political advantage because the government, managers, and workers could all derive a benefit, if the SOE performed well. Hence, the incentive effect was high for all these parties. By 1989, almost all SOE's were subject to a responsibility contract. In 1992, this practice was promoted through the issue of Regulations on Transforming the Management Mechanism of State-Owned Industrial Enterprises that granted SOE managers more control rights in areas of foreign trade, investment, employment, wages, etc.

Roles of the State

At this contracting stage, the state began to loosen its control over SOE's and cut its roles in the SOE's’ governance from owner, manager, planner, supervisor, and finance provider down to three: owner, supervisor, and finance provider. The “State owned Industrial Enterprises Law of China” (SOE's law) prescribed that the local organization of the Chinese Communist Party should guarantee and supervise the implementation of the Party’s and the state’s guiding principles and policies, so that the SOE's’ supervision by the state became actually localized. This was particularly important with regard to the state’s new financial policies referring to SOE's.

The new financial policies, which intended to strengthen constraints for SOE's, stepwise introduced a tax system to replace the former way of profit retention. As mentioned, in the incentive stage SOE's had gained full freedom in using their retained profits. However, the proportion or sum of retained profits remained dependent on the quota and therefore arbitrary. Addressing this problem, the State Council approved in 1983 On Methods of Promoting SOE Taxation instead of Profit Retention, according to which large- and medium-sized SOE's should be taxed by 55% upon their incomes, while small-sized SOE's were subject to a progressive tax rate from 7% to 55%. In the light of differences in industries, the second step tax reform was carried out after the Provisional Regulations of the People’s Republic of China on Enterprises Income Tax had been issued in late 1984. New tax items, such as tax on industrial products, sales tax, value added tax, city planning tax, real estate tax, and resource tax, were introduced. As a result, the state made an advance in governing SOE's, for it tried to replace an arbitrary administrative control (setting the retained profits) with clear law provisions (tax rates).

In addition, the way SOE's obtained financing changed along with the fiscal reform of banks. As early as in 1970, local governments were made responsible for material allocation and fixed investment. With the fiscal decentralization in 1980, provincial governments could not only share their budgetary income revenue, but had the authority to determine the structure of their expenditures including the financing of SOE's. In 1983, the state strengthened the financial constraints for SOE's by introducing bank loans instead of appropriations for SOE's’ circulating capital. Now, alongside the contractual system in force, local governments gained great influence over credit decisions of the regional branches of the central bank and state specialized banks for SOE's and even had the authority to determine whether loan should be paid back by the relevant SOE's.

Roles of SOE's

At this stage, the Chinese government set up big enterprise groups which should link SOE's vertically and horizontally. This policy aimed at promoting a more rational production structure, technological development, and intra-group cross-financing as well as creating large conglomerates. Accordingly, a new level in the governance structure between the state/government and a number of SOE's came into existence. As stated in a Party’s document from 1984, SOE's themselves were to be transformed into legal entities whose management should enjoy full management authority and full responsibilities for their own profits and losses. With the SOE's Law that was adopted in 1988, a legal person status was granted to SOE's by law.

The factory director acted now as the legal representative and exercised leadership in the operation of the enterprise. For the first time in Chinese SOE history, the factory director occupied the central position in the enterprise operation. According to the SOE's Law, the director should be selected through a “competitive process”. Although no details were issued on how to fulfill this requirement, it provided incentives to select a higher qualified director for the enterprise. Besides, some measures were introduced to facilitate SOE's’ management. For example, SOE's were allowed, through the employees’ congress and other forms; to practice “democratic management”, while employees might take part in the management and its supervision. The SOE's Law also required the establishment of a management committee or a similar consulting body to assist the director with decision-making on important issues.

The Corporatization Stage (since 1993)

Unsuccessful Contracting

Despite the major reform efforts made for the state sector since 1978, it still proved to be uncompetitive in contrast to the private sector that expanded impressively in the first 15 years of China’s reform and opening-up policies. There was steady increase in SOE losses since the managements obtained more decision-making power (Sachs and Woo 1997). Even though no SOE had ever been closed down, the state sector was no longer the main strength of the national economy by the end of 1993. The share of the state sector in the industrial output descended from 78% in 1978 to 43% in 1993 (Qian 1999). Even its share in total non-farm employment was down from 60% to about 30% in the same time period (ibid).

The contracting system did not help SOE's to expand and function well due to some deficiencies in its design. As far as profit retention is concerned, it was difficult to fix a reasonable minimum profit for the SOE's to pay to the state. The responsibility system was itself experimental, which means there was no readymade standard for setting the minimum proportion or sum of profits. In addition, the contracting system said nothing about what to do when SOE's could not make a desired profit or suffered a loss. Nonetheless, the profit paid to the state was obligatory. With regard to the entire reform policies, the state leadership had not planned to establish a rule-based market through their first reform attempts. For this reason, the contracting system rather aimed at stimulating improving efforts from inside SOE's than to generate incentives and to enhance constraints through outside forces like more competitive environment and stricter legislation. Besides, neither the ownership nor the property rights issues were included in the contracting system. Logically, the state would undertake all the losses of its SOE's in the end to avoid SOE's’ bankruptcy, which actually reduced the incentives for SOE's’ efforts to make more profits. As a result, some incentives for the SOE's per se were either short-term or got reduced in view of the state’s soft budget constraints. To solve these problems, SOE reform entered a new corporatization phase compatible with the establishment of a market economy by the government.

SOE Corporatization and Restructuring

In 1993, the Third Plenum of the Fourteenth Party Congress adopted the “Decision on Issues Concerning the Establishment of a Socialist Market Economic Structure”. The Decision formulated clear goals in the areas of the reform strategy (coherent package and appropriate sequencing of reforms), a rule-based system (unified foreign exchange rate and tax rates and accounting rules for all enterprises regardless of ownership), market-supporting institutions (formal fiscal federalism, centralized monetary system, social safety net), and property rights and ownership (transforming SOE's), respectively (Ian 1999).

Unlike at the incentive and contracting stages, which centered on the extension of SOE's’ autonomy and profit sharing, the Decision addressed SOE reforms in terms of property and ownership rights in several ways. First, it intended to transform SOE's into modern enterprises with “clear property rights, clarified rights and responsibilities, separation of enterprises from the government, and scientific management” (CPC 1993) Second, the Decision implied the privatization of small SOE's: With regard to small SOE's, the management of some can be contracted out or leased; others can be shifted to the partnership system in the form of stock sharing or sold to collectives and individuals. (ibid)

Third, the Decision supported the development of a financial market, advocating “standardizing issuances and listings of shares, and gradually enlarging the scale” (ibid.). Through this policy, the Chinese stock market was combined with SOE reforms.

In 1993, the “Company Law” was enacted to facilitate the new policies in SOE reform. In 1995, the new SOE reform guidelines were brought into action. After local governments in Shandong, Guangdong, and Sichuan had conducted first experiments, small SOE's were privatized and employees lay off nationwide on a large scale. The central government promoted the restructuring of the state sector with the slogan “grasping the large and letting go the small”. “Small” SOE's had played a very important role in China’s planned economy, for the Chinese state sector was made up dominantly by small- and medium-sized enterprises. In 1993, they still accounted for 95% in number, 57% in employment and 43% in output of the state industrial sector (Cano et al. 1999). By the end of 1996, some 70% of small SOE's had been privatized in several pioneering provinces and about half were privatized in many other provinces. From 1996 to 1997, over 20 million SOE employees were laid off throughout China. Until 2005, another 20 million SOE employees were laid off. After reaching a peak of 112.6 million in 1995, the total state sector employment shrank to 64.3 million in 2006 (NBSC 1996, 2007). Even though no large SOE was privatized, the share of state industry was reduced by almost half through releasing the small- and medium-sized SOE's (Qian andWu 2000).

“Grasping the large” referred to keeping a number of backbone large and medium-sized SOE's, particularly those in some strategic industries such as transportation, telecom, banking, oil, steel, etc. Based on the provisions in the Company Law, “to be grasped” large and medium-sized traditional SOE's were “corporative” instead of following a privatization process, that is, converted into different western type corporate entities predominantly in the form of limited liability companies and joint-stock companies, while the state still maintained its control. The new corporation forms of SOE's vary from their predecessors in their better-defined ownership structure, shareholder rights, and management accountability. With corporate entities officially coming into being in People’s Republic of China, the term “corporate governance” is since then relevant for the governance issues of Chinese firms. Before, there had been no “corporate” governance, but governance issues or practices of SOE's. However, to the government’s disappointment, SOE's’ performance continued to decline in the 1990s (Qian 1999).

The Fourth Plenum of the Fifteenth Party Central Committee in 1999 adopted more aggressive policies for the SOE reform. One of them was the “readjustment of the layout of the state economy” (CPC 1999, section III) in the sense to narrow the state sector. Specifically, the state decided to concentrate its control over four main types of industries-industries related to national security, natural monopolies, and industries providing important public goods and services, pillar industries as well as backbone enterprises in high and new technology industries, while withdrawing from other areas. Committing the government to withdrawing from most industrial and services sectors was a significant and encouraging step forward in transforming the state sector in the economy. Obviously, these types were vaguely defined. That being the case, obstacles to privatization in areas other than the core industries could arise, say, due to local governments’ interest there. Nonetheless, this deficiency might slow down but not prevent the privatization process of small SOE's, compared to its potential speed.

Another policy adopted at the Fourth Plenum of the Fifteenth Party Central Committee was the diversification of ownership structure for those enterprises still under state control. Except for a few enterprises solely funded by the state, all other enterprises should become joint stock companies with multiple owners involving private investors or foreign investors. This policy accelerated listings of SOE's both inland and abroad. China Telecom, China National Petroleum Corporation (CNPC), hina Petrochemical Corporation (SINOPEC), and the Legend Group are some examples. Another new policy concerned the establishment of a corporate governance system. The term “corporate governance” appeared in a Party document for the very first time.

Roles of the State and SOE's

At the current corporatization stage, the state has changed its role from the only owner of SOE's to the shareholder possessing property rights over the state-owned part of a corporative SOE’s assets. The state continually acts as the supervisor of SOE's, but the way it finances them has changed a lot, and it has relegated the job to the capital markets. SOE's have changed into different types of companies and introduced, indispensably according to the Company Law, three corporate governing bodies: shareholders, the board of directors, and the board of supervisors. Some new functions such as the chair of the board of directors and the chief manager in the sense of a Chief Executive Officer (CEO) have been introduced as well. The Chinese corporate governance model has been built up.

Today, registered SOE's accounted for about 5% of all industrial companies and about 15% of the total output value. Large scale SOE's still constitute the backbone of the economy. The state sector continues to place a disproportionably large claim on economic resources, for instance, bank lending.


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