China in Transition

Post-Third Plenum Reform of State-Owned Enterprises: Can corporate governance be improved?

Chi Hung KWAN
Consulting Fellow, RIETI

Since shifting to reform and opening-up policies at the end of the 1970s, China has been building a market economy and part of this effort has been reforming its state-owned enterprises (SOEs). It tried to expand the rights of management and the retention of profits by individual SOEs during the 1980s and to develop a modern corporate system during the early 1990s, but the "absence of owners" made it difficult to address such basic issues as weak corporate governance. Recognizing this problem, in the late 1990s, the government began to promote the privatization of SOEs in the name of strategic restructuring of the state-owned economy and ownership reform. In recent years, however, the reform of SOEs has stagnated, with the market share of SOEs rising at the expense of private enterprises in some sectors.

To make a fresh start with the reform of SOEs, the administration of Xi Jinping has presented reform proposals centering on three areas: the promotion of a mixed ownership economy, the development of a modern corporate system, and the improvement of the supervision and administration of state-owned assets. These proposals appeared in the Decision of the Central Committee of the Communist Party of China on Several Major Issues Concerning the Comprehensive Deepening of Reform (hereafter referred to as the "Decision") which was adopted at the Third Plenary Session of the 18th Central Committee of the Communist Party of China (the "Third Plenum") held in November 2013.

Promotion of a mixed ownership economy

Ownership of China's SOEs has been diversified in recent years with the introduction of non-state-owned capital through the shareholding system and other measures, and a mixed ownership economy is gradually taking shape (Note 1). In the Decision, the Third Plenum positioned the mixed ownership economy as "an important way to materialize the basic economic system of China."

The Decision states: "A mixed ownership economy, with cross-holding by and integration of state-owned, collective, and non-public capital, is an important way to materialize the basic economic system of China. It is conducive to improving the economic functioning of state-owned capital, ensuring its appreciation in value and raising its competitiveness, as well as enabling capital belonging to different types of ownership to draw on one another's strengths to offset weaknesses, stimulate each other, and develop together. We will allow more state-owned enterprises and enterprises belonging to other types of ownership to develop into mixed enterprises. We will allow non-state-owned capital to hold shares in projects invested by state-owned capital." (Article 6).

Huang Shuhe, Vice-Chairman of the State-owned Assets Supervision and Administration Commission of the State Council (SASAC), explains the specific content of the SOE reform as follows (Huang Shuhe, "The reform of SOEs is deepening," Qiushi Journal, March 2014):

When developing the mixed ownership economy, different policies are applied, depending on the function of the enterprise. First, SOEs related to national security, state-owned capital investment companies, and state-owned capital operating companies will have 100% state ownership. Second, for SOEs in key industries and areas with deep involvement in the national economy, state capital will maintain absolute control. Third, for important SOEs in industries that are mainstays of the national economy and high-technology and technologically innovative industries, state-owned capital will maintain relative control. Fourth, for other SOEs, the ownership ratio of the state will be kept low and, in some cases, withdrawn completely. At the same time, the listing of qualified SOEs will be encouraged, and the shareholder structure of SOEs that have yet to fulfill listing requirements will be diversified by introducing a variety of investors. Furthermore, strategic investors with the necessary capital, technology, and management knowhow as well as institutional investors such as the National Social Security Fund, general insurance funds, and equity investment funds will be encouraged to participate in the reform of SOEs.

Development of a modern corporate system

With respect to the development of a modern corporate system, the Decision states in Article 7: "SOEs must further deepen their reform by focusing on normalizing corporate decision making, maintaining and appreciating the value of state assets, competing on an equal footing, raising corporate efficiency, strengthening enterprise vitality, and bearing due social responsibilities." Specifically, reforms in the following five areas have been described (Huang Shuhe, op cit).

First, corporate governance of SOEs will be improved. Shareholders, directors, auditors, and management will play their respective roles in aiming to bring about true corporate governance. SOEs will build an effective incentive mechanism over the long term and strengthen the pursuit of their management and investment responsibilities.

Second, SOEs will delegate management to professionals who will act as entrepreneurs. For that purpose, they will increase the number of managers recruited from the market.

Third, reforms related to human resources, labor, and distribution inside SOEs ("three institutional reforms") will be promoted to enable them to compete freely in the market economy. At the same time, information disclosure will be strengthened, and the transparency of management will be improved.

Fourth, SOEs will standardize salary levels, benefits, welfare expenses, and business spending for management personnel and develop related rules. The compensation of managers and employees will be linked to company performance.

Finally, methods for employee shareholding in a mixed ownership company will be studied. SOEs will allow employee shareholding to create common interests between the owners of capital and workers.

Improvement of the supervision and administration of state-owned assets

The Decision at the Third Plenum shifted the objective of the supervision and administration of state-owned assets from the previous one of "managing enterprises" to the new one of "managing capital."

For a long time, SOEs in China were administered under different government departments and had no independent management, resulting in weak corporate governance and inefficiency. The creation of the SASAC in 2003 addressed the problem of diverse control by concentrating responsibility for the supervision and administration of SOEs (except for banks and certain other SOEs) in the new entity. Since then, however, several problems related to the SASAC's continued involvement in SOE management have become evident. First, the SASAC tends to play favorites by formulating policies favorable to the business of certain SOEs in exchange for their carrying out administrative as well as business activities. Moreover, besides simply managing state-owned assets, the SASAC tends to engage in other functions--such as employee assignment, workplace safety, and environmental practices--that should be managed by the SOEs themselves. Finally, the SASAC may not be able to adequately supervise SOEs because it lacks sufficient information and specialized knowledge of the actual business conditions that pertain to their management.

To address these problems, the Decision at the Third Plenum adopted a policy of "improving the state-owned asset management system, strengthening state-owned asset oversight with capital management at the core, reforming the authorized operation mechanism for state-owned capital, establishing a number of state-owned capital operating companies, and helping qualified SOEs to reorganize themselves into state-owned capital investment companies" (Article 6). The three-tiered structure that has already been introduced in cities such as Shanghai serves as a guide to how this policy will be implemented. That structure consists of the SASAC, state-owned capital operating (investment) companies, and SOEs (Figure).

Figure: Three-tiered Structure for the Supervision and Administration of State-Owned Assets
Figure1: Three-tiered Structure for the Supervision and Administration of State-Owned Assets
Source: Compiled by the author based on various materials.

To date, the SASAC has been directly administering the human resources, management, and finance of SOEs. In addition, as the principal-agent relationship over state-owned property rights has not been legally defined, the government intervenes excessively in SOEs and often compensates for their deficits. The resulting soft budget constraints create a serious threat of moral hazard. Moreover, the illiquidity of state-owned property rights hampers entry into new business areas and withdrawal from old areas and makes capital efficiency extremely low. Going forward, the top-tier SASAC will focus on the supervision and administration of state-owned capital operating (investment) companies, the middle tier.

The state-owned capital operating (investment) companies will manage capitalized and securitized state-owned assets, or state-owned capital, instead of managing SOEs directly. The main function of the middle tier entities is to serve as the shareholders of the state-owned enterprises with mixed ownership, that is, to exercise governance on these companies through the board of directors, to examine their business performance, to increase or decrease the number of state-owned shares, and to seek new investment. There are already several entities carrying out these functions including: the National Social Security Fund; asset management companies such as China Cinda Asset Management Co., Ltd. and China Huarong Asset Management Co. Ltd.; China Investment Corporation (CIC), which manages certain foreign currency reserves; and Central Huijin Investment Co., Ltd.

In the future, the treatment of SOEs will vary, depending on their nature. The Decision states: "State-owned capital investment operations must serve the strategic goals of the state, invest more in key industries and areas that are vital to national security and are the lifeblood of the economy, focusing on offering public services, developing important and forward-looking strategic industries, protecting the environment, supporting scientific and technological progress, and guaranteeing national security" (Article 6), and "We will ensure state-owned capital increases its input into public welfare enterprises and makes greater contributions in the provision of public services. In natural monopoly industries in which state-owned capital continues to be the controlling shareholder, we will carry out reform focusing on separating government administration from enterprise management, separating government administration from state asset management, franchise operation, and government oversight, separating maintenance departments from operations departments, and deregulating competitive businesses based on the industry's characteristics, and we will make public resource allocation more market-oriented. We will continue to break up all forms of administrative monopoly." (Article 7).

These reforms are anticipated to have the following effects. First, intervention by the SASAC into SOEs will be eliminated with the establishment of specialized organizations to manage state-owned capital. Second, as state-owned assets will be capitalized (physical assets and monetary assets of SOEs will be converted into shareholders' equity), it will be easier for the state to manage its investment portfolio. In particular, as the liquidity of state-owned capital increases, it will be easier to enter into and withdraw from industries, so that resources will be allocated more efficiently. In addition, the capitalization of state-owned assets will facilitate the entry of other forms of capital, which will promote the diversification of the capital of SOEs.

To make sure that the public also shares the profits generated by state-owned capital, the Decision stipulates the following policy: "We will transfer part of state-owned capital to social security funds. We will improve the budgeting system for the operation of state-owned capital, and increase the proportion of state-owned capital gains that are turned over to the public finance to 30% by 2020, to be used to ensure and improve the people's livelihood" (Article 6) (Note 2). In contrast, in 2013, SOEs that are subject to the budget for the operation of central state-owned capital paid only 103.9 billion yuan to the national treasury, less than 10% of their total recorded net income of 1,169.0 billion yuan (Ministry of Finance, "Explanation of the Budget for the Operation of Central State-owned Capital in 2014," March 2014). In addition, until now, most net income that SOEs turn over to public finance flows back into them in the name of "spending for state-owned economy structural adjustment," "spending on priority items," and "spending for industrial advancement and development."

Remaining issues

Many problems with SOEs are the result of inadequate corporate governance. While the separation between ownership and management means that even in a developed capitalist economy managers can infringe on the interests of owners, this problem is particularly serious in China where ownership of SOEs is ambiguous. While, in principle, every one of China's 1.3 billion citizens owns 1/1.3 billionth of the country's SOEs, in fact, they have neither the capability nor the incentive to supervise the hundreds of thousands of these enterprises. Even if people had the motivation, they would not be able to attend a general meeting of shareholders. Therefore, the people have to delegate their rights as shareholders of SOEs to government institutions as their agent, but the government's purpose in running an SOE varies widely, from maximizing profits to creating jobs and stabilizing society. Government officials who formulate and implement policies are constantly exposed to the temptation to give preference to their own interests over the interests of the public and the state. Given that it is difficult to solve this problem even in developed countries where democratic institutions such as elections and parliaments have been put in place, it is all the more difficult in China, which has a single-party political system that is hard for the public to scrutinize. As long as state ownership is the source of problems of corporate management, we might say that it is impossible to establish corporate governance unless SOEs are privatized.

Nevertheless, even though it emphasizes the promotion of a mixed ownership economy, the development of a modern corporate system, and the improvement of the supervision and administration of state-owned assets, the Decision states: "We must unswervingly consolidate and develop the public economy, persist in the dominant position of public ownership, give full play to the leading role of the state-owned sector, and continuously increase its vitality, controlling force and influence" (Introduction to Chapter II - Adhering to and Improving the Basic Economic System), This means that the ideological barrier hindering the reform of SOEs has not yet been removed.

While the development of a mixed ownership economy is expected to encourage the privatization of SOEs, it could also be abused as a tool to expand the dominance of state-owned capital and strengthen the leading position of public ownership. In that case, the goal of breaking down the administrative monopoly cannot be realized.

In addition, China still has a rocky road ahead in replacing the senior managers of SOEs who are drawn from cadres of the Communist Party or the government with professional corporate managers, and also in pulling SOEs out of competitive sectors that can be left to private firms, as vested interest groups will exert strong resistance to such changes.

Finally, the supervision and administration of state-owned assets cannot be fair and disinterested under the SASAC. While the SASAC is supposed to be a disinterested referee, it is also a player in the game of preserving state-owned assets. When guiding the overall operation of SOEs, the SASAC lacks strategic thinking and is not so much concerned with the desired role and status of the SOEs in the national economy, but instead seeks to strengthen the state-owned economy alone. Furthermore, the issue of who should supervise the supervisory authorities, including the SASAC, remains unsolved.

In this way, although it has headed in the right direction, the Decision has not provided fundamental solutions to many difficult and long-standing problems regarding the reform of China's SOEs, such as the ideological issue, dismantling the administrative monopoly, separating administration and corporate management, exiting of SOEs from competitive sectors (that can be left to private firms), and improving the supervision and administration of state-owned assets. Therefore, whether the government will be able to achieve the desired effects remains open to question.

Small and micro SOEs with net income of 100,000 yuan or less are exempt from payments to the national treasury under the intent of Category V.

The Third Plenum, determined to raise by 5 percentage points the share of net income after taxes paid to the national treasury applied to SOEs in Category I through Category V (Ministry of Finance, "Notice of Further Hike of the Collection Rate of Income of State-owned Capital of Central Enterprises," May 2014).

The original text in Japanese was posted on June 4, 2014.

  1. ^

    "Mixed ownership economy" is not a new concept. The Decision of the Central Committee of the Communist Party of China on Several Major Issues Concerning the Reform and Development of State-Owned Enterprises made at the Fourth Plenary Session of the 15th Central Committee of the Communist Party of China in 1999 stipulated "State-owned capital can attract and organize social capital through the shareholding system, expand the function of state-owned capital and increase the control, influence, and driving power of the state-owned economy. State-owned large and medium enterprises, particularly those which have an advantage, are suited for the implementation of the shareholding system, and we will change them to shareholding companies and develop the mixed ownership economy in forms such as listing according to rules, joint ventures with foreign companies, and mutual investment. In the case of important enterprises, the state will be the controlling shareholder." The Decision of the Central Committee of the Communist Party of China on Several Issues Concerning the Development of the Socialist Market Economy at the Third Plenary Session of the 16th Central Committee of the Communist Party of China in 2003 also states: "We will greatly advance the mixed ownership economy in which state-owned capital, collective capital, and non-publicly-owned capital are jointly invested and make the shareholding system the main form to realize the public ownership system."

  2. ^

    As of 2013, the share of net income after taxes (subtracting previous fiscal year's losses and legal reserves from net income) paid to the National Treasury by SOEs under direct control of the central government is classified into the five categories (Ministry of Finance, "Explanation of the Budget for the Operation of Central State-owned Capital in 2013," March 2013).

    • Category I: Tobacco enterprises, 20%
    • Category II: Resource monopoly enterprises such as petrochemical, utilities, telecommunications, and coal, 15%
    • Category III: Enterprises in general competitive industries, such as steel, transportation, electronics, foreign trade, and construction, 10%
    • Category IV: Defense enterprises, scientific research institutes that have incorporated, China Post Group, and enterprises that became subject to the budget for the operation of central state-owned capital in 2011 and 2012, 5%
    • Category V: Policy-related enterprises including China Grain Reserves Corporation (Sinograin) and China National Cotton Reserves Corporation (CNCRC), 0%

June 4, 2014