Industry and Economic Reform

2.1 Second chance for PRC venture capital firms

The history of venture capital (VC) firms in the PRC ( “fengxian shiye”) is short and undistinguished. In the early 1980’s many VC firms were established following Deng Xiaoping’s slogan, “science and technology constitute the main engine for production.” The VC firms generally grew out of university research institutions, but failed more often than not because of financial constraints. VC firms are still not an active part of the PRC economy. University graduates prefer to forgo the financial and personal risks of starting a business and instead seek stable employment in the government sector, with state owned enterprises, or with foreign companies. Even in areas where private enterprise is very active, like Jiangsu ( ) and Guangdong () provinces, only 2–3 percent of students have plans to start their own firms.

Because the PRC government fully appreciates the critical role that VC firms can play as a market economy reaches a certain stage of development, there is renewed support for VC development. The Ministry of Labor plans to initiate training programs that will assist students and laid-off workers in starting independent firms. Shanghai Municipality announced that financial support would be provided for start-up plans, and provisional regulations for VC firm management are soon to be approved. The provisions include the creation of investment funds and the development of a second board on the stock exchange. Rising unemployment is intensifying the competition for good jobs among university graduates (3 million per year) who are no longer a guaranteed elite. Government assistance for start-up VC firms is expected to mitigate such pressure as well.

Since PRC corporate finance relies heavily on bank loans, the main bottleneck for VC firms is how to access financial backing. In order to mobilize household savings and promote higher risk investment, further development of the PRC capital market will be required. And unless PRC authorities can fully monitor the efficient use of resources for VC financing, their development may create another opportunity for corruption.

Still, there’s reason to have an optimistic long-term view of VC development in the PRC. It took Japan over two decades to turn its VC firms into profitable entities, and the US has a similar long history in this regard. Of course, one difference is how the PRC’s unique pursuit to achieve a “socialist market economy” will nurture VC development. Defining the proper role of government in encouraging VC firms, whether it is through minimal intervention or heavy-handed guidance, becomes more complex than is the case in capitalist market- oriented countries. (21 June 2005)

2.2 Transportation sector in the PRC

Since the PRC’s entry into the WTO in 2001, the transportation sector has gradually opened up to foreign investors. 2005 marked the first year of fully open logistics, road freight transportation, maintenance, and repair markets in the country. Foreign investors can now run both joint ownership enterprises and wholly foreign-owned freight transport enterprises.

Trucking accounts for roughly 75% of the freight transport markets, and that percentage has been growing. Such an increase poses a number of challenges for PRC authorities already trying to impose tighter regulations to improve transportation “safety” and encourage “energy savings.” As market demand for direct, on-time delivery has increased, so has the need for PRC officials to secure safer transportation practices. However, sector experts note that the logistics market currently faces over-competition, and freight companies tend to overload freight trucks illegally in order to reduce costs. Such practices amount to a form of tax evasion, and result in road destruction and serious environmental degradation.

Although foreign companies account for 60% of the export freight market, their share of domestic freight is minimal. The domestic freight market remains dominated by highly competitive domestic companies, which would suggest that entry of foreign companies into the sector would not significantly affect the market. However, the growing PRC economy continues to attract foreign firms to the potentially huge PRC freight logistics market. Foreign firms generally target “high value-add” transportation such as the delivery of frozen commodities requiring refrigeration or delivery of high-end, IT related goods that must be transported without vibration. In addition, foreign companies try to introduce sophisticated logistics networks, find niche markets, and coexist with PRC companies.

Like other sectors, such as banking, opening the transportation sector to foreign competition is a generally positive step that will likely accelerate the modernization and restructuring of domestic companies in that sector. To promote this outcome, PRC authorities need to consider the pros and cons of the range of transportation modalities in order to ensure that policies are efficient and conducive to environmental protection. One consideration might be to expand the use of rail transport for ordinary freight. Experts in this sector point out a continued prejudice against using rail to transport goods other than grains and raw materials such as coal. And because train tables are not fully available to citizens, there is a broad perception that rail transport is neither efficient nor convenient. Another constraint is that the government has maintained full control of the railway system until recently. In July 2005, the Ministry of Railway announced measures to promote private capital investment in railway construction and management. This is an encouraging sign. (21 December 2005)

2.3 The real issue behind postal restructuring in the PRC

The discussion around postal restructuring in the PRC is heating up among concerned parties such as China Post, the China Banking Regulatory Commission, the State Council, and also foreign investors who as of December 2005 can operate fully owned logistics and express delivery companies in the country. The discussion is fueled by reports that the State Council has decided in principle to split the current China Post into three organizations. Though details of this scheme have yet to be announced, the possible restructuring would have the State Postal Bureau concentrate on regulating postal business, have the China Post Group Corporation run various postal services, and engage the Postal Depository Bank in the deposit and loan business of postal savings. With more than RMB 1 trillion in deposits this would make the Postal Depository Bank the fifth-largest commercial bank in the PRC.

One possible rationale behind the restructuring is to separate the supervisory and enterprise functions that are currently held by China Post. Delineating these postal functions would introduce a measure of fair competition into the logistics market for international express companies. A second rationale is that by establishing an independent depository bank that engages in small loan operations, the restructuring stands to mobilize huge amounts of postal savings. Currently, not all of the RMB 800 billion that is deposited in the People’s Bank is mobilized. If such a bank is created it will naturally fall under the supervision of the China Banking Regulatory Commission, and in the process China Post will lose its most profitable business.

In Japan postal restructuring has met with strong resistance from vested groups such as “specially designated postal offices,” the postal labors union, and lawmakers supported by those groups. While the absence of such groups in the PRC should make some aspects of the restructuring process easier than in Japan, the China Post itself represents a powerful vested interest group. According to China Economic News, postal savings contributes almost 40 percent of the total PRC postal system revenue even though postal savings has fewer employees than do other postal services. China Post’s resistance to losing its most profitable business could slow down any restructuring efforts. Much like the forces driving postal restructuring in Japan, the PRC also faces considerable external pressure to restructure its postal business. This pressure intensified once the PRC committed to an open postal business market upon joining the WTO.

Domestic bureaucratic struggles aside, the real issue for the PRC is how best to mobilize these valuable, under-utilized financial resources. Even though significant postal deposits come from rural areas through the wide rural postal network, these resources are flowing to urban areas. Finding a way to redirect these financial resources to rural areas is an important consideration for developing these areas. In this sense, the postal restructuring discussion may well be an extension of the policy debate aimed at addressing regional imbalances in the Mainland. (26 December 2005)

2.4 Foreign-invested companies in the PRC: Joint partnerships or wholly foreign-owned?

The PRC has three types of foreign-invested companies ( “sanzi qiye”): Sino-foreign joint partnerships, joint cooperation companies, and wholly foreign-owned companies. In the past, joint partnerships accounted for roughly half of these, while the share of wholly foreign-owned companies was around 30 percent. The number has grown since the late 1990’s, and through to the PRC’s entry into the WTO in 2001, such that by 2003 the number of foreign owned companies had increased to 65.5 percent. Now, the number of joint- cooperation companies has become negligible.

Japanese companies are no exception. The proportion of joint partnerships compared to wholly Japanese-owned companies was 60:40 in the past, but since 2000 the proportion has changed to 30:70. Companies 100 percent owned by Japanese capital have gradually become mainstream in the PRC. This is partly because PRC officials have softened their attitude toward total foreign ownership (see Note page 14) since entering the WTO. Local PRC governments have also come to welcome these companies. An example of this is that foreign companies were previously required to sell all of their products outside the PRC whereas now they are merely “encouraged” to do so. This has led many multinationals to pursue sole proprietorship to avoid management conflicts with PRC-based partners. And now, multinationals exhibit a higher degree of confidence in the PRC market since its WTO entry.

What are the pros and cons of each type of foreign-invested company? The organization and management of joint partnerships is regulated by the Joint Partnership and Company Management Act, which offers little latitude for foreign capital. While no such regulations constrain wholly foreign-invested companies, PRC authorities have adopted stringent approval policies for setting up wholly foreign-owned companies. Though even with capital constraints, joint partnership companies benefit from their PRC partners’ connections to government institutions, and also from access to domestic partners’ sales networks. This joint-ownership arrangement should be a valuable advantage in doing business in the notoriously difficult PRC market. To overcome this advantage, foreign companies trying to move to wholly foreign-owned status either try to purchase domestic partners’ shares and convert the joint partnership into a total foreign arrangement, or a foreign company might just acquire an existing state-owned enterprise.

PRC authorities seem to accept this trend as inevitable particularly as multinational companies become increasingly borderless, and as the PRC itself pursues more open economic policies. Since prior joint partnership arrangements have not necessarily resulted in technology transfers, the most important issue may be how PRC officials can use this trend to encourage domestic companies to develop technologies that will enhance their own international competitiveness. Additionally, the PRC needs to identify sectors that may be vulnerable internationally and establish a detailed timetable for allowing wholly foreign-owned companies into those sectors. Certainly the PRC should not engage in protectionism, but it must foster economic conditions that will avoid adverse effects on the domestic economy. (4 January 2006)

2.5 SME policy in the PRC: Lessons from other countries

The overall picture of small and medium-sized enterprise (SME) policy in the PRC can be observed through the Act on the Promotion of SMEs. This Act came into effect in 2003 and exists as the only SME-specific statute that includes such policy measures as financial support for start-up businesses, technological innovation, and market expansion. The Act also states that the government will provide various information and training services for SMEs. However, since the Act is both brief and ambiguous, and contains no specific provisions for implementation, it falls short of a comprehensive SME policy for the country.

Globally, there are two general approaches to SME policy. The first approach reflects the typical SME policy in the United States where SMEs are viewed as market participants and US policy makers try to ensure a fair and competitive market environment conducive to SME development. While the role of policy-lending financial institutions is limited and SME financing is mainly supported by the government guarantee of commercial loans, support for start-up businesses is at the core of SME policy. Contrary to this principle, there are individual cases where US authorities try to protect internationally uncompetitive industries and enterprises.

The second approach can be understood by studying the Japanese experience with SME policy following World War II through to the 1970’s. Compared to large enterprises, SMEs were perceived to be disadvantaged in technical skills, human resource and financing capability, which led to SME policies that protected them from market forces. Accordingly, SME policy in Japan became one of the “industrial policies” for many years and was characterized by the “industrial restructuring programs” of the mid-60’s that aimed to adjust lag-behind SMEs to the new industrial structure. At that time various “market-distorted” measures such as preferential tax treatments, favorable government subsidies, and favorable loans by policy-lending financial institutions specializing on SME financing were also introduced. During this period the policy agenda was not necessarily to support start-up business and venture capital.

Following the 1980’s, the Japanese government began recognizing SMEs as market participants and contributors to the national economy with diversified skills and innovations. SME policy has gradually shifted from a protectionist approach to a more market- oriented approach. Measures now aim to promote a fair and competitive market and support SME innovation to enhance competitiveness. Since the mid-1990’s support for SME start-up businesses and venture capital projects has strengthened.

The PRC’s current SME policy could be characterized as a mixture of both approaches. In one sense, there does not seem to be a clear vision about the role government should play in SME promotion. This may partly reflect the transitional nature of the PRC’s “socialist market economy,” but it might also be a response to the changing global economic picture. Unlike Japan during the initial phase of SME promotion from the 1950’s to the 1970’s, the surrounding world economy has become incomparably borderless. This means that SMEs in the PRC not only face competition from large, domestic state- owned enterprises, but also from foreign enterprises and multinationals.

The most salient reason for PRC authorities to promote SMEs is the need to absorb a redundant labor force, particularly in the rural areas. In this regard, PRC authorities must first identify a basic vision for SME policy, and then proactively move on implementing specific measures. Meanwhile the government could take certain protectionist measures, and also may draw on recent progress in developing financial markets with the credit-scoring loan model, relationship banking, and the development of asset-based lending (see Note below). All of these measures could address the financial difficulties that face SMEs in the PRC. (13 March 2006)

2.6 System transformation in the PRC

For more than 25 years the PRC has transformed itself from a centrally planned economy to a more market oriented economy. Over this time the role of state-owned enterprises (SOEs) has diminished while private enterprises have emerged to play a more critical role. Until now, there has not been a detailed study that examines this transformation (“gaizhi” or ) along with the new ownership diversification to determine the impact these changes have made on governance, labor, and firm performance. The book “China Ownership Transformation: Process, Outcomes and Prospects” recently released by the IFC attempts to fill this gap by presenting valuable data from a survey of around 700 Chinese enterprises in 11 cities.

The survey tries to identify the factors that contribute to the gaizhi process, and reveals that improving enterprise efficiency is not necessarily the primary factor motivating governments to initiate privatization. Rather, it concludes that regional factors such as the overall progress of market liberalization and private sector development, can deeply affect the gaizhi process. The survey also points out that restructuring and privatization are not always associated with unemployment, but in many cases can contribute to increasing job opportunities. This one important policy implication suggests that policy makers should view the impact of gaizhi from a medium and long-term perspective. PRC authorities seem to realize this since they continue to promote private sector development as a means of absorbing redundant labor forces that are created by SOE reforms.

The most important message from this survey is that while increased ownership diversity has greatly improved the efficiency of PRC enterprises, it has not always impacted income distribution in a positive way. Equity in income distribution continues to be an issue, and the progress of the transformation in ownership places pressure on authorities to create and enforce a more equitable market environment. It is important to remember that market mechanisms help firms perform more efficiently and achieve the Pareto optimal resource allocation; however, these mechanisms are silent with regard to income distribution. The creation of a sound regulatory framework is essential to ensure fairness, and it is important to note that many private enterprises still do not have the access to financing that SOEs do. Such a framework will not solve the current problem of a widening income gap.

In response, PRC officials have put forward the idea of a “harmonious society” and are trying to shift the policy focus more towards this problem. This shift of stance may require additional social policies and government interventions in the market. How these measures will fit with the progress of economic restructuring, in particular the development of the private sector, remains to be seen. Currently the debate in PRC academic circles, between the traditionally dominant “new liberalism school” and the newly growing “new leftist school,” reflects a measure of progress on this matter.

Another important issue worth examining is the impact that ownership diversification and private sector development have on the overall PRC political and social system. In fact, some Chinese people are worried that privatization and the diminishing power of SOEs will challenge the PRC system of one party rule. In other words, what is the role of the State under market socialism? In some senses it appears that economic imperatives overshadow this issue and therefore, it is not given the consideration it merits. However, sooner or later, the PRC will need to confront this issue. If PRC authorities delay political reform and push aside economic imperatives by maintaining control over the economy through SOE ownership, corruption and myopic behavior on the part of both enterprises and the government may emerge. The challenge is going to be how gradually the PRC authorities can adjust the political and social systems while responding to more immediate pressures for economic development.

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