Development of the Private Sector: Constraints and Some Policy Implications

Notwithstanding the rapid progress of the private sector over the past two decades or more, it appears that there are still quite a number of constraints to the further development of the sector.

4.1 Lack of a "Level Playing Field"

Unlike existing SOEs and privatized former SOEs (in particular old SOEs under local government control), newly developed private enterprises have serious disadvantages in receiving bank loans and getting approval from authorities, since they do not have close connections with local authorities. (See Section 1.6)

First, government procurement and bidding is generally only open to government departments and SOEs. Private enterprises are excluded.

In investment policy, private enterprises do not enjoy the same preferential tax treatment as SOEs and foreign-invested enterprises. For example, foreign-invested enterprises enjoy a treatment called "Er Mian San Jian" which is a special program for foreign-invested manufacturing companies with expected operation times of at least 10 years. This program is not available for private enterprises. Under this treatment, beginning from the first year when the company registers a profit, it is taxexempted for two years, and from the third to fifth year, the tax is halved (Income Tax Law for Foreign Funded Enterprises of the People's Republic of China). This policy benefits foreign investors, and is clearly intended to attract foreign investment. Private enterprises have to pay not only a 33% income tax but also a 20% individual adjustment tax, since in many cases the owners of private enterprises are also the operator or manager of the company. In such case, they have to pay both the individual tax and the enterprise tax.

At the end of 2001, the Statistics Bureau of Wuhan City, Hubei Province surveyed 50 private enterprises. Of the respondents, 62% felt the tax policy was unfair, and 28% said that overall a competitive environment did not exist. In Dongguan City, Guangdong Province, 80 industries were surveyed, of which 62 were open to foreign-funded enterprises, but only 42 to private enterprises. This indicates that there is some discrimination against private enterprises in 20 industries.

Also in terms of financial and industrial services, private enterprises are not given equal treatment. It is well known that financial support is an important factor for private enterprise development. At present, private enterprises face many financial difficulties. Firstly, they have relatively fewer financial channels and credit records. Due to the financial constraints, it is usually very difficult for them to bid on projects requiring large financial resources. Their financial resources for investment come mainly from the enterprises themselves. Looking at the classification of the resources for private investment in 2001, 2.3% came from national budget, 1.9% from foreign countries and self-financing accounted for 82%. This indicates that, the rapid development of private enterprises can be mostly attributable to their own financial accumulation capability on one hand, but it also means that the financing channels of private enterprises are relatively narrow and that financial support from the banking sector is far from sufficient.

According to a survey of 357 private enterprises in Shangdong Province in 2002, it is clear that the demand for loans of private enterprises is not satisfied, since only 62% of private enterprises reported success in getting bank loans. This is 8.1% lower than the average, and 10.4% lower than SOEs. Of private enterprises, 33.2% felt it was difficult to get loans from banks.

The issue is, why? Unlike in many other developing countries, the PRC's problem is not necessarily a shortage of financial resources, but how to mobilize the huge amount of unused savings. It may be that banks believe the cost effectiveness of providing loans to private enterprises is low and that the risk is still high vis-¨¤-vis SOEs. CEIN, on March 3, 2004, quoted comments from private entrepreneurs (2,004 NPC representatives) that there was a close relationship between the difficulty of accessing bank loans and the development stage of private enterprise, as medium-sized private enterprise face the most difficulty, because their demand for financial resources is increasing rapidly, while their status is not as stable as that of large private enterprises. They also said that banks usually require collateral, but that this is very difficult for private enterprise to provide, since they are very risk-sensitive and do not have many assets.

In short, a level playing field currently has not yet been achieved for private enterprises vis-a-vis SOEs and foreign-invested enterprises. Ensuring a sound and fair market environment for private enterprises is a critical issue.

4.2 Excessive Red Tape

One of the biggest obstacles to the establishment of new private enterprises is receiving approval from local authorities. The administrative approval procedures, including registration and rectification, are generally cumbersome and incur excessive transaction costs for private enterprises. Looking at the investment project for Guangzhou Citong Bridge as an example, we find that to get approval for building the bridge, 55 documents had to be endorsed (2003 [44]). In fact, many administration approval procedures are not based on laws and regulations, and the central government has given repeated instructions that they be terminated. Recently, the State Council cancelled more than 800 administration approval documents, but no one knows how many remain. Since every procedure requires some fees, and thus can provide administration departments or officials with considerable economic interests, many excessive administration approval procedures remain. Accordingly, the barriers to entry for individuals and private enterprises are still very high. This high threshold has long been rich soil for corruption and at the same time creates various costs relating to corruption, which are shared by private enterprises.

4.3 High Barriers to Entry

Private enterprises have gradually begun to enter such sectors as aviation, ports, education, culture, and civil affairs, which were once monopolized by SOEs. However, there are still high entry barriers for private enterprises, and many industries are still not open to private enterprises. In addition, it appears that the regulations themselves are not necessarily clear.

At present, barriers to entry remain in approximately 30 industries. Private investment are prohibited or partly restricted from entering such industries as electricity, petroleum and chemicals, railways, civil air transportation, finance, telecommunication, travel, labor export, service trade and technology transfers. The threshold for private enterprises is extremely high even in industries that they are allowed to enter. It is natural that there are some restrictions on the establishment of private enterprises. However, the requirements in the PRC are too strict considering its condition as a developing country. For instance, the minimum capital registration for establishing a company undertaking production or operation business is 500,000 RMB. For a company engaged in sales, the minimum requirement is 300,000 RMB. For a company involved in science and technology development or consulting services, it is 100,000 RMB. By comparison, the minimum registration capital for such companies in the U.S. seems to be zero, and in European developed countries it is usually less than 30,000 euros.

The accession to the WTO was likely a great turning point for the PRC economy and its social development. When the PRC committed to the further opening of its market, many scholars and private entrepreneurs from the PRC put forward that it needed to open up its market to the private sector before doing so for foreign investors. Under this pressure, many local governments have now promulgated a series of documents intended to open all industries to the private sector except those prohibited by national public proclamations. However, as usual it may take time to actually enforce these documents. Furthermore, few have clearly listed which areas will be open to private enterprise. The government policy of trying to open up the market to private enterprises thus lags and has not brought real change. In this sense, it is not only foreign companies but Chinese private enterprises as well that complain about the market environment in the PRC.

4.4 Immaturity of the Capital Market

As identified in Chapter 2, it appears that the PRC has changed its policy somewhat and started to accelerate the privatization of existing SOEs. In this connection, we need to look at the sales of SOE shares on the stock market.

Until 1997, the PRC government took a cautious attitude toward the sale of SOE shares. This was during the first two phases of private sector development, when a gradualist approach was adopted (see Chapter 2). However, after 1997 the government started to promote sales of SOE shares. It should be noted that this was directly triggered by the fact that after the Asian Financial Crisis, the government faced the need to stimulate domestic demand by issuing government bonds, rapidly aggravating the national fiscal balance.

In order to cope with this situation, the government tried to sell SOE shares to increase fiscal revenues. In 1999, the Communist Party adopted the "Decision on SOE Reform and Development." Under this plan, it decided to sell shares of SOEs outside of a few critical sectors such as national defense and high-tech industries. Based on this decision, the China Securities Regulatory Commission (CSRC) designated 10 listed SOEs, and put their shares onto the market, though this first attempt ended in failure. The State Council reviewed the method of sale for almost a year and a half, and finally announced the "Provisional Rule on the Financing of the Social Security Fund through Sales of SOE Shares" in June 2001. This provisional rule required SOE to sell shares that equivalent to 10% of total financing when conducting an initial public offering (IPO) or increasing capital.

However, the stock market began to fall sharply and the government faced massive complaints from individual investors. The CSRC declared a suspension of sales of SOE shares in October 2001, and in June 2002 formally terminated sales of SOE shares in accordance with the provisional rule.

Seen from a different angle, the above development seems to paint a very complex picture about the sales of SOE shares. SOE reform led to massive unemployment, and individuals and households who had lost their jobs tried to make money through speculative investment in stocks, since the social safety net was not sufficient. On the other hand the government attempted to sell SOE shares and increase social security funds in order to strengthen the social safety net; however, that behavior itself ironically caused a sharp decline in stock prices, hurting the individuals engaged in stock speculation in an attempt to defend their lives. The pursuit of privatization through the SOE share sales, though originated from a different policy objective, led to another very delicate problem.

This also reveals another reason for the difficulty of privatization through the sales of SOE shares, i.e. the lack of powerful institutional investors. Currently the PRC stock market relies heavily on individual investors whose market behavior is speculative and shortsighted, and who do not have stable financial resources. As of the end of 2003, total outstanding stocks in Shanghai and Shenzhen amount to about 4.0 trillion RMB. It is widely reported that roughly 60- 70% of these are non-tradable SOE shares. Therefore the outstanding volume of SOE shares can be estimated to be approximately 2.4-2.7 trillion RMB.

Looking at the situation from a different angle, while total household deposits are huge (10 trillion RMB as of the end of 2003), only 6-7% of total assets (about 700 billion RMB) are in the stock market. A more fundamental problem is that the behavioral pattern of households is quite speculative and volatile. The total assets of insurance companies, a major source of institutional investment, are still very low, at about 350 billion RMB as of 2001. Trading volume and market outstanding of B shares, an apparent indicator of inflow of foreign capital, is also small, registering about 110-120 billion RMB as of 2001. However, it should be noted that in February 2001, B shares were open to domestic investors. Since then, although no official data is available yet, it is reported that neither the trading volume or market capitalization in the B share market have grown, and that both regulator and investors take a grim view of the future of this market.⁷

All these facts indicate that there is not sufficient liquidity capacity in the market to absorb the outstanding SOE shares; in particular, the lack of institutional investors is a serious problem. There are a few positive signs. For example, the government has been encouraging insurance companies to invest in the stock market in recent years, the B shares market is developing very rapidly, and other institutional investors such as securities investment funds are growing. In July 2003, the Qualified Foreign Institutional Investor (QFII) scheme was introduced, and now major foreign investors can invest in Chinese stocks in Hong Kong, China,Singapore, New York and other markets. Although it is important to find ways to channel household savings into the stock market, the development of sound and solid institutional investors also seems crucial for ensuring that stable and long-term funds flow into the stock market. In short, the PRC's immature capital market constitutes the bottleneck to the further privatization of SOEs through share sales. Further liberalization and internationalization, including the merger of A shares and B shares and the expansion of QFII, for example, would be logical next steps to consider.

In this connection, it is to be noted that the Report by the Forum of Chinese Capital Market [54] divides the development of China's capital market into three stages: "Foundation laying," "Marketization," and "nternationalization." It seems that the "marketization stage" identified in this report started just before or after the entry into the WTO. This stage is a very important one that links between the preceding and following stages. During this stage, many conflicts and contradictions have to be expected between the planned and market economy. Having said so, the report lists a number of issues to be addressed during this stage, including the building of a secondary market, improvement of corporate governance, and creation of withdrawal rules for listed companies (reflecting the recognition of the poor functioning of the ST and PT which were introduced in 1998⁸). The report predicted that both the "marketization stage" and ensuing "international stage" would last about ten years each.

See Tables 4.1 to 4.4 [PDF 182KB | 1 page]

4.5 Lack of Credibility of the Government Sector

A market economy relies on credit in various ways. In the process of economic reform, both private enterprises and the government sector should abide by the rule of credit. At present however, both have problems in this regard. As stated above, private enterprises have relatively short credit records and because of this, they face difficulty in obtaining loans and other external financing.

For the government sector, credit records also need to be improved in a different sense. In particular the credibility of local governments is one of the major impediments to the further development of the private sector. For example, authorities usually welcome private enterprise participation in infrastructure projects, and promise to provide them with many preferential treatments at the beginning. However, once the private enterprises enters the phase of collecting returns on capital, some government sectors take "shut the door and beat the dog" measures, meaning that once private enterprises invest money in infrastructure projects controlled by the government sector, they cannot easily obtain returns. As a result, private enterprises have become very cautious about investing in infrastructure projects and cooperating with SOEs.

For instance, a private company called the Guojing Corporation Group invested in several projects in a local city. One of the projects was the development of a shopping plaza. In accordance with the contract, it paid 1.5 million RMB in advance, but never received an ownership certificate for the land. In early 2000, the city government claimed that it was taking back the land "according to the law." On another road construction project, a private enterprise was offered the right to place advertisements along the road. After investing 15 million RMB, it was abruptly notified that the contract had been cancelled. Another case involved a natural gas project. In 1997, one private enterprise was nominated as the only company to carry out a natural gas project. It tried its best to make the city one of the leading cities benefiting from the national project to "send gas from west to east." However, the city government later abruptly notified it that a newly established company would take over the natural gas project (2003 [44]).

The key issue is that many local governments do not properly enforce laws and regulations. We witness similar problem not only in relation to private sector development but also in areas such as tax administration. On the other hand, the role of local governments in the process of development of the private sector is expected to grow in the future. The experiences of other developed countries, including Japan, show that as the economy matures, more and more authority tends to be delegated from the central to local governments (decentralization) in order to ensure rational resource allocation and administrative efficiency. This "decentralization" is all the more important in the PRC, which is a vast country with a huge population. When pursuing the further development of the private sector, how the central government ensures that local governments enforce laws and regulations properly is a matter to be considered. For the central government, a first step would be to survey existing laws and regulations or practices and to examine what is happening in local areas by, for example, sending examination teams to each province. Then, it could streamline and introduce laws and regulations encouraging the rectification of malpractices. If necessary, sanctions on corruption and malpractice need to be tightened. As local governments become more accountable, the central government may delegate some authorities to them and pursue decentralization.

4.6 Wide Income Disparities

Wide income disparities are a difficult problem for the PRC. The privatization of SOEs and collective firms is in fact aggravating the income disparities between rich and poor and also among regions. For example, the asset value of SOEs, including stocks, was low or nearly zero, reflecting their poor performance, but after privatization their performance may improve, their stocks may be listed on stock exchanges and their asset value may rise sharply. Private entrepreneurs who enter the Communist Party can easily obtain these capital gains by using their privileged status, and these interests may be easily transmitted to other privileged individuals (through bribery, corruption etc.). On the contrary, many workers lose their jobs due to SOE reform. So that's why some experts thought that ironically with the progress of privatization, many Communist Party members have now become "rich capitalists."

4.7 Lack of Management Skills

Many private entrepreneurs still lack sophisticated management skills. Though there are many success stories, there have also been a number of failures. In many cases, the failure was due to overly ambitious expansion policies, too much spending on public relation activities, the failure of equity investment, or conflicts with the government sector. A survey of 21 cities conducted by the National Industrial and Commerce Association shows that roughly 70% of private entrepreneurs cannot read accounting sheets, do not use IT, and do not read documents. Another survey, reported in the People's Daily on 30 May 2004 [51], shows that even Shanghai need more than ten thousand additional senior enterprise managers. In a survey of more than 1,000 Shanghai-based top commercial leaders, over 90% did not speak a foreign language and 75% did not know how to use a computer. According to the same report, there are many cases where project leaders in innovation projects left the country and that more seriously, most Chinese enterprises do not believe that training senior leaders is important, as they think that they are already in a very high position and that further training is not necessary.

As discussed in Chapter 5 and 6 below, we can generally say that as the size of enterprise becomes larger, more sophisticated ability will be required to manage it. The fundamental problem for the PRC is that while many managers have run large SOEs under the centrally planned economic system, they do not have much experience in managing enterprises under different circumstances, i.e. the market economy. Therefore once the SOEs are privatized, they tend to go into trouble.

In fact, PRC authorities themselves appear to understand this problem. Recently, Sino News on June 2, 2004 reported that the State Asset Management Committee, whose primary responsibility is to promote the privatization of SOEs, launched a plan at its meeting on human resources to recruit a mass of high quality personnel on an international scale, in order to improve the quality of management at SOEs. The head of the Committee was quoted as saying that seven high-ranking managers were recruited for six SOEs in 2003, and that another 23 were slated to be recruited in 2004. He also admitted that currently, most of the managers of SOEs were nominated in the same way as the nomination of party cadres and government officials, and that the selection was limited within a region or the enterprise itself, despite the growing market competition with the rest of the world. The same article reported that official statistics indicate that since 1998, central government-controlled SOEs have lost 30% more human resources than their newly-recruited college students. Those who left the SOEs are 40 years old on average.

4.8 Private sector and SMEs

Most private enterprises are still small and medium-sized enterprises (SMEs). According to the information from the website china.com.cn, on June 3, 2004, the number of SMEs in the PRC surpassed 10 million in 2003, accounting for 99% of the total number of enterprises. They also account for more than 50% of GDP, 60% of total exports and more than 40% of tax revenue. How to encourage and assist SME should be an urgent concern for the government. In particular, as seen in Section 4.1 above, the access of private SMEs to the banking sector is severely restricted.

SME policies of other countries including Japan may be useful, in areas such as the setting up of financial institutions specializing in SME loans, and the establishment of private associations that provide various kinds of information to SMEs. In his recent paper, Wang Yanzhong (2004 [36]) proposes several measures in this regard. First, the role of special SME credit-service departments at state-owned banks should be fully developed. Second, a more flexible interest rate-floating regime should be adopted for SMEs. Third, specialized financial institutions such as small non state-owned banks, small credit guarantee companies and small leasing companies should be introduced. Fourth, there is a need to learn from the experiences of developed countries in second board markets. Fifth, the loan guarantee system must be improved. Sixth, various SME support bodies such as an SME credit-rating system and comprehensive service system, including legal advice, taxation support system and professional staff training system, must be created.

We believe that in view of the relatively premature stage of development of SMEs in the PRC, the most effective immediate measure would be to establish various institutional infrastructures, in particular, a financial support framework. However, in the medium to long term, it will become more and more important to place emphasis on creating a sound and fair market environment for SMEs. A policy, which aims to directly assist SMEs by distorting the market mechanism, cannot be sustained in the long term. Rather, a policy to address market failures is critical. (See Appendix 2.)

We believe that in view of the relatively premature stage of development of SMEs in the PRC, the most effective immediate measure would be to establish various institutional infrastructures, in particular, a financial support framework. However, in the medium to long term, it will become more and more important to place emphasis on creating a sound and fair market environment for SMEs. A policy, which aims to directly assist SMEs by distorting the market mechanism, cannot be sustained in the long term. Rather, a policy to address market failures is critical. (See Appendix 2.)

4.9 Private Sector and Macro Policy

We identified several factors that constitute a bottleneck to the further development of the private sector in the PRC. Seen from a different angle, it should be noted that the development of the private sector itself now leads to some problems when the government tries to implement adequate macroeconomic policies. South China Morning Post on May 18, 2004 [27] reported that one Hong Kong, China based economist estimates the size of the PRC economy may be twice as large as the official figure. These estimates may be exaggerations, but it is widely believed that official figures underestimate the size of the economy, because many private companies fail to report their income accurately for fear of facing an increased tax burden. This has a serious implication in the context of macroeconomic policy. Because of the lack of accurate information, the government lacks a real picture of the economy. In this case, the government faces the critical challenge of how to formulate and implement adequate macroeconomic policies in order to achieve sound and sustainable economic growth. For example, since 2003, concern over excessive investment and overheating of the PRC economy has increasingly emerged. (See footnote 3) However, since healthy companies in the private sector usually do not go to the commercial banks to seek bank credit and they are not concerned if the People's Bank of China changes interest rates. It is inevitable that government efforts to cool down overheated investment could be thwarted.

One of the most important economic implications of private sector development is that it is absorbing a tremendous amount of excessive labor released from the SOEs. Therefore, the pursuit of private sector development is something that must be done by the PRC government. In this connection, assessing the absorbing capacity of private enterprises and their economic and social implications is an important task for the government. Will their capability be strong enough or most likely not, as we suggested in Chapter 3? If we assume a private sector development that fully absorbs unemployment, the economic and political impact would be huge. It should also be noted that the model in Chapter 5 indicates that the demand for labor will decrease, and unemployment will become more serious, with the progress of SOE reform and marketization. Further developing new products, adjusting the industrial structure and actively promoting the service sector may be good solutions.

Another important implication is that the private sector and SOEs should compete with each other through complementary relations, so that private sector development forces the SOEs to enhance their own competitiveness. In other words, the success of SOE reform will depend on the sound development of the private sector.

It seems that the status of employees in private enterprises is not stable, for instance, since most are temporarily hired or are not covered by social security. So long as people stay in the government sector or SOEs, they are fully protected, but now more and more people are forced to leave and they are suffering from tremendous amount of uncertainty.

Under the economy in transition, people's perception of the private sector is low. Ownership diversification may have developed, but the political and legal system, bureaucracy and economic system have not caught up. However, there have been signs of change in this regard. Although the government still plays a significant role in the reform process, the main driving force behind the transformation of the PRC from a planned economy to a market-oriented economy is a change in perception and desire for better life among the people. Under the Marxist dogma that dominated the planned economy, the desire of people for wealth, consumption goods, freedom and democracy were greatly suppressed. Traditional socialist practice itself opposed the so-called basic principle of "materialism." The reform and opening up policy is constantly liberalizing people's productivity and releasing people's desire for higher living standards.

Box 3: The closed project of Tieben Steel Corporation: a case of the overheating economy and its cost

Box 4: Failures

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