China in Transition

Who Owns China's State-owned Enterprises - Toward establishment of effective corporate governance

Chi Hung KWAN
Consulting Fellow, RIETI

Recently, a string of "good news" has been coming out of China, such as the buoyant performance of major state-owned enterprises (SOEs) and their rise in international status. Responses within China, both from the media and the general public, however, have been cold. Criticism has been mounting over the predatory behavior of those belonging to major SOEs; huge profits these enterprises have made by abusing their monopoly position are being split among insiders, such as managers and employees, without being returned to the true owner - the people of China. When a major controversy arose over the reform of SOEs two years ago, the possibility of privatization leading to the loss of national assets was the contentious point and those against privatization prevailed from start to finish. This time around, the primary focus is on the lack of corporate governance in SOEs as symbolized by the fact that national assets are being eroded even without privatization. In order to solve this problem, China must quickly move to establish a competitive and fair market and to undertake further SOE reform primarily by means of privatization.

Chinese SOEs growing enormous in size

According to the "Financial statistics of central government-controlled SOEs for fiscal 2005" (in Chinese) released in July by the State-owned Assets Supervision and Administration Commission (SASAC), 169 SOEs under the central government's jurisdiction earned a total of 627.65 billion yuan in profits in 2005, up 27.9% from the previous year. The favorable result, however, is attributable to only a handful of these companies; 12 big earners with 10 billion yuan or more in profits accounted for 78.8% of the total (figure 1). In particular, three major oil companies - China National Petroleum Corporation (CNPC), China Petrochemical Corporation (Sinopec), and China National Offshore Oil Corporation (CNOOC) - and Shenhua Group Corporation Limited, a coal company, demonstrated outstanding performance, benefiting from rising energy prices. As shown in statistics provided by the SASAC and the National Bureau of Statistics of China, major SOEs are continuing to perform strongly in 2006.

Meanwhile, the U.S. magazine Fortune, in its latest list of the world's top 500 companies (in terms of revenues in 2005) published in July, included 19 Chinese enterprises (excluding those in Hong Kong and Taiwan), all of which are state-owned (table 1). China Railway Engineering Corporation, Shanghai Automotive Industry Corporation, China Railway Construction Corporation, and China State Construction Engineering Corporation made it onto the list for the first time, respectively ranked 441st, 475th, 485th and 486th. Meanwhile, significant strides were made by China's three highest-ranked companies: China Petrochemical Corporation (Sinopec) from 31st last year to 23rd this year, State Grid Corporation from 40th to 32nd, and China National Petroleum Corporation (CNPC) from 46th to 39th; as well as by four major state-owned banks: the Industrial and Commercial Bank of China from 229th to 199th, the Bank of China from 399th to 255th, China Construction Bank from 315th to 277th, and the Agricultural Bank of China from 397th to 377th.

Figure 1: Top 12 central government-controlled SOEs in profits (2005)

Table 1: Chinese enterprises ranked among Fortune Global 500 companies (2006)

State ownership and monopoly privilege as the generator of enormous windfall profits

Each of these giant enterprises belongs to a sector with high entry barriers. It is thus widely recognized that their strong performance is more attributable to their monopoly position and preferential treatment by the government rather than being an outcome of the efforts and capabilities of their staffs.

Firstly, having a dominant position in the market, these enterprises can control prices. In the era of the planned economy, SOEs were unable to set their own production levels and prices or to allocate profits. With the marketization of the economy, however, they were given the discretion to independently set production levels and prices to maximize profits. This, along with soaring resource prices, has been helping improve the performance of some SOEs.

Second, SOEs have access to low-cost resources. For instance, natural resource tax rates applicable to mining of mineral resources are extremely low compared to those in other countries.

Third, the government has too easily been providing financial subsidies to SOEs. For instance, Sinopec, despite generating huge profits in 2005, received a 10 billion yuan state subsidy because of the sharp rise in the prices of crude oil, a raw material for its products; a move that has provoked fierce criticism from the public. Also, it must not be forgotten that public funds to the tune of several trillion yuan have been injected into state-owned banks to help them dispose of nonperforming loans; a majority of their borrowers are SOEs.

Fourth and lastly, SOEs rarely pay dividends to the state, the owner of net profits after taxes, effectively receiving funds from the state at zero cost. This puts SOEs at an advantage over non-SOEs in the cost of capital. Under the regime of the planned economy, SOEs were obliged to hand over all earnings to the state in return for having production costs fully funded from the national budget. However, following the launch of the reform and opening-up policy, China has taken a series of measures to strengthen SOEs: the devolution and interest-transfer initiative to increase management's authority to run its companies and allow them to retain more profits, the tax-for-profit reform to replace the earnings delivery system with tax payments, and the State Council's decision in 1994 concerning the implementation of a fiscal management system under the tax assignment system. Consequently, SOEs have been freed from the obligation of delivering their earnings to the government, that is, as long as they properly pay enterprise and other taxes. Many major SOEs are listed on a stock market and do pay dividends to their state- and non-state-owned shareholders. However, those referred to as state-owned shareholders are, in most cases, a corporate group that is parent to an SOE, not SASAC that should be serving as a shareholder on behalf of the government. Therefore, profits earned by SOEs are not incorporated into the national budget.

Harm resulting from state ownership and monopoly

Despite such enormous profits made by major SOEs, the general public, ultimately the owner of these enterprises, hardly benefits from that.

First, monopolies undermine consumer interests. The enormous profits earned by SOEs are merely the result of the "exploitation" of consumers (households and non-state-owned enterprises) that purchase goods and services from the SOEs. Particularly, an increase in output prices by highly monopolistic SOEs in upstream industries - such as resource companies – leads to an increase in production costs for downstream industries. Indeed, in sharp contrast to the robust earnings of SOEs, which enjoy a monopolistic position in the market, the overall performance of non-SOEs has been deteriorating.

Second, the presence of monopolies hinders the market mechanism and further market opening. Monopoly enterprises are inclined to exert pressure on administrative authorities to maintain high barriers to entry so as to protect their vested interests, making it difficult to introduce the principles of market competition or to further open the market. For instance, an Antimonopoly Law drafting team was formed in 1994 and today, after a 12–year lapse, China has yet to enact the law due to strong resistance from monopoly enterprises.

Third, the presence of monopoly enterprises undermines social equity. In fact, employees of monopoly enterprises in the energy, telecommunications, and transportation sectors are favorably treated with both the average wage of employees and the level of fringe benefits higher relative to the scale of profits earned by these companies. It has been reported that the average wages of employees at the 12 biggest-earning SOEs are three to four times the nationwide average for all SOEs, based on figures provided in the abovementioned 2005 SASAC financial statistics.

Lastly, monopolies, privileged to make easy profits at home, lack the incentive to improve efficiency and thus remain uncompetitive in international markets. Indeed, although China has been acclaimed as the "workshop of the world," the true operators of these factories are foreign companies, and the SOEs listed among the Global 500 are hardly contributing to exports. Profits earned by SOEs are now being retained, in large part, for reinvestment, instead of being delivered to the state. Unfortunately, however, such investment opportunities have not been efficiently utilized to increase their corporate value. The same holds true for overseas investment in the form of mergers and acquisitions by SOEs, cases of which have been increasing rapidly in the recent years.

Fair and competitive market environment as a prerequisite for corporate governance

In order to eliminate these problems, it is imperative to establish effective corporate governance within each SOE, particularly those with a monopolistic status.

In a company with separate ownership and management, governance problems stem from conflicting interests and information asymmetry between the company's management as the agent and the owners as the principal. Corporate managers have their own set of goals different from those of their companies' owners. While profits generated by the company belong to its owners, it is the managers who need to strive to make the company profitable. Thus, without an effective monitoring system, the managers are tempted to pursue their own interests rather than those of the owners. However, corporate managers are better positioned than corporate owners to acquire accurate information on business conditions and this asymmetry of information makes it difficult to properly monitor them.

As argued by Professor Justin Lin Yifu of Peking University, the presence of a fair and competitive market environment is crucial to overcoming the problem of information asymmetry and establishing effective corporate governance. In a fair and competitive market environment, dynamics that drive each company's profits to converge toward an overall (or industry-wide) mean are at work. In such a situation, information about each company - such as business and financial conditions as well as management's competence and efforts - can be obtained by comparing its profit levels with the overall or industry-wide average. Thus, profitability is an effective gauge for analyzing and monitoring corporate management. Based on this, corporate managers can be screened and their reward or punishment is determined in accordance with their respective management performances, whereby conflicts between corporate managers and owners can be resolved.

In contrast, in cases where a company has a monopoly, the profitability of the company does not reflect the true state of its business management. Thus, proper monitoring of such a company would require more detailed information and the cost of monitoring would correspondingly increase. In order to establish effective corporate governance, the SOE monopoly must be broken to pave the way for a fair and competitive market environment. In addition to accelerating the process of enacting an Antimonopoly Law, it is imperative to incorporate SOE profits - in the form of dividends - into a national budget and to substantially raise the resource taxes imposed on the mining of oil and other natural resources.

Full-fledged privatization on the horizon

Even a highly-developed capitalist economy is not immune to the possibility of managers encroaching upon owners' interests due to the separation of ownership and management. This problem, however, is particularly serious in Chinese SOEs where, as symbolized by the "absence of owners," the notion of ownership is highly ambiguous. Each of the 1.3 billion Chinese people, as an ultimate owner, is supposed to own one 1.3-billionth of the stake in each of the SOEs. But these people would have neither capability nor incentive to monitor several hundred thousand SOEs nationwide on their own. Even if they were willing to play a monitoring role, it would be physically impossible for them to attend the shareholders' meetings of all each enterprise. Therefore, the Chinese people have no choice but to delegate their rights as a shareholder to the relevant government agency as their proxy. However, the government manages national assets for purposes apart from maximizing profits; such as creating jobs, achieving social stability, and promoting an equitable distribution of income. In addition, government officials, who are responsible for policy planning and implementation, often prioritize their own interests over those of the people or the nation.

Ultimately it comes down to the question of who should supervise supervisors. This question is difficult to solve even in a developed country where well-established democratic systems - such as elections and congress - are in place, and it is even more so in China which maintains the single-party regime, a system extremely difficult to supervise. As such, state ownership is the root cause of management problems and therefore corporate governance would be difficult to be implemented without privatization.

Based on this recognition, the Chinese government, since the mid-1990s, has been promoting privatization of SOEs under the slogans of "grasping the big ones and letting the small ones go" and "strategic realignment of the state-owned economy" (box). Under the zhuada fangxio policy, only small and medium-size SOEs were targeted for privatization. In the strategic realignment of the state-owned economy, however, the government has laid down a policy requiring SOEs, including large ones, to withdraw from all areas in which they compete with privately-owned enterprises, with state ownership maintained only in sectors providing public goods. While the privatization of small- and medium-size SOEs has progressed substantially, for instance, by means of management buyout (MBO), the privatization of larger SOEs has been delayed because of the restriction on the transfer of state-owned shares, which account for the majority of shares issued by listed companies in China. Fortunately, the government has taken a big step toward making state-owned shares "fully transferable" (quan liutong) as part of the securities market reform launched last year and this is expected to pave the way for accelerating the privatization of large SOEs.

July 28, 2006


The government's policy of "strategic realignment of the state-owned economy," adopted at the 15th National Congress of the Communist Party of China (CPC) in September 1997, was a big turning point in China's reform of SOEs. The policy was meant to promote full-fledged privatization of SOEs regardless of their size as the government no longer tries to maintain state ownership in any sector except in some key industries.

Following the policy set forth at the 15th CPC National Congress, the Fourth Plenary Session of the 15th Central Committee of the CPC in September 1999 adopted a "resolution on certain important problems concerning the reform and development of SOEs" to clarify the substance of the realignment policy. According to the resolution, the strategic realignment of the state-owned economy is to be completed by 2010 whereby the state-owned sectors will be divided into those in which SOEs are to stay and those from which they are to withdraw in the course of industrial adjustments. That is, in competitive sectors except for some key industries, state-owned capital is to be curtailed or withdrawn altogether. Specifically, the government has set aside four areas as subject to control by the state-owned economy with all the other industries designated for privatization.

    The four areas in which the government continues to maintain control are:
  1. sectors related to national security, which include defense industries such as arms manufacturing, the minting of money, and industries crucial to the nation's strategic stockpiling system (including food and energy);
  2. sectors subject to natural monopoly and oligopoly, which include postal, telecommunication, electricity, railway, and airline industries;
  3. sectors that provide important public goods and services, which include public utilities - such as water, gas, and public transportation services - in urban areas, the management of infrastructure such as ports, airports, irrigation, and other water-related facilities, and the development of crucial protection forests; and
  4. core enterprises in sectors that constitute the backbone of the economy including oil mining, steel, automobile, and part of the electronics industry that uses the latest technology.

As such, the scope of sectors in which the Chinese government intends to maintain state control is not much different that those in the capitalist economy, except for those in the fourth category, which are retained for industrial-policy considerations.

July 28, 2006