China's Hunan lesson

In most countries privatization goes through the stock market. That's not the case in China due to a fear that the sell off of government shareholdings will cause share prices to collapse. So while SOEs have been listing, they only float around 25% of their shares, and their government controlled structure remains intact. Does that account for the relatively low profile of China's privatization experiment?

Zhang Jun: Selling state assets is always controversial, especially in a communist country, because traditionally all assets belong to the people. Valuations are difficult - look at the scandal surrounding how the new Russian plutocracy made its money from buying cheap state assets. In China, selling off state-owned enterprises (SOEs) is especially sensitive because of the huge social dislocation it entails. It's true the stock market has not been the main instrument for SOE privatization. That has occurred primarily through bilateral negotiations on a case-by-case basis, and through the recently legalized, local property rights exchange centres.

A number of years ago the International Finance Corporation (IFC) suggested that if agriculture is included the private sector accounted for two thirds of China's GDP? Has that proportion changed?

That's still broadly correct. But we do see an increasing contribution every year of the private sector to GDP growth. And with the privatization and consolidation of SOEs over time, the private sector will definitely dominate and account for a larger proportion of GDP.

What is currently driving privatization of SOEs?

SOE reform and/or privatization has been a topic of debate for at least the last 10 years, but reform has been postponed many times. That's not surprising: If you think about it, SOE reform through privatization is a hugely expensive business. The social cost of laying people off, providing them with alternative accommodation, education, hospital treatment and decades-long pension payments has delayed a solution. In the early stages of reform, it was certainly not something that was easy to carry out. In fact, the delay has been beneficial since the longer the government has waited the more valuable its assets have become! These government assets represent an enormous source of wealth going forward.

Another important factor driving reform is the aging of China's population. In 20 years time, the number of old people in China will be equal to the workforce. That's a huge problem, which is driving the most senior levels of government to grasp the nettle of SOE reform.

You're implying that privatization is finally really taking off.

Looking back, it's clear the government was right to attack the problem in a gradual manner. Immediate closure would have led to starvation and chaos. However, we've now had 20 years of the explosive growth of the private sector. The private sector is wealthy enough to absorb larger and larger numbers of laid off workers. And the social security system has also been hugely improved, further lowering costs for enterprises that wish to reform. Higher levels of wealth, generated by the private sector and better welfare are helping the government shrug off its burden of excessive ownership.

Is this what is happening in the former heavy industry heartland in the North East of the country?

No, precisely because of the factors I mentioned. There is very little private sector development in the North East, keeping it impoverished and slowing reform. That's the whole problem - generating the money to make reform possible in the first place. However, the government is pouring funds into the North East and it's a particular focus of development.

So where has privatization been most successful?

It's fascinating that one of the most pioneering areas of China in this regard is Hunan province, smack in the middle of rural China. Perhaps it was desperation that led the local government to implement a very successful series of reforms which the government wishes to see spread over all of China.

How does it work?

As many foreign investors will tell you, a huge complication in acquiring SOEs has been the issue of land - the single most valuable asset of many loss-making SOEs. The other issue, as mentioned above, is the cost of privatizing SOEs. The Hunan government has killed two birds with one stone. It has arranged for the SOE to acquire land usage rights (not the land itself) from the city government for, on average, Rmb 200,000. With legal access to the land, the SOE can then invite a strategic investor, foreign or local, and put the land at their disposal - legally!

The next step, and by far the most profitable, is when the SOE, taken over to whatever extent by the strategic investor, starts paying rent to the city government for land use. These funds are then concentrated into a fund operated by a government company called an 'assets operation company'. The fund is then made available to much poorer SOEs. These SOEs are poor because their land may be less valuable than SOEs lucky enough to have acres of land in the middle of a city or other strategic location. These poorer SOEs can then use the resources of the fund to lay off staff or close down their operations before offering the land use rights to strategic investors. The latter, for their part, don't have to worry about taking over all the attendant welfare costs. It's a very promising model.

One issue that always troubles investors is valuation. That's especially a concern given the stock market plays such a minor role.

Yes. Assets may not be sold to the strategic investor for less than Net Asset Value. Apart from that, valuations are based on hard bargaining. It's true that calculating a market price is difficult when the market is in its early stages.

Moral hazard is also perhaps an issue if SOEs feel they can be bailed out by the fund instead of reforming.

Actually, the point is that the fund is only used for privatization purposes, not for working capital. Once a company is privatized, it gets easier to expose it to market discipline. For example, it's much easier for the local government to force a company out of business that doesn't have thousands of desperate dependents. Essentially, the scheme breaks the deadlock of raising the initial revenue to tide the SOE over its restructuring and privatization period. The second vital point is that the whole process has been codified and legalized in Hunan. Previously, investors were often engaged in disputes with the city government over land.

You emphasized earlier that these reforms are especially relevant to small to medium SOEs, and Hunan is after all a very rural province with specific problems. What's happening to other larger, urban SOEs?

Yes, that's a slightly different kettle of fish. In Shanghai we have 20,000 so-called 'large' SOEs. Some of them are indeed huge and relatively efficient, such as Bao Steel. Nobody is allowed to touch these as they are run by the State Assets Supervision and Administration Commission (SASAC), which supervises a core group of 196 very large, centrally-run companies for whom privatization is not on the agenda.

With the remainder we are also seeing some changes. In order to encourage diversification of ownership, the government level just above the SOE (the bureau), has been transformed into a shareholder in the company. The bureaus have been corporatized and renamed investment and operation companies. They are even allowed to cash out their investment in the SOE to another buyer, for example. The other point is that the bureaus no longer have the right to oversee operations of the SOE and appoint the CEO. And making them into shareholders makes shareholdings in SOEs far more liquid.

Shanghai is leading this move but it is now the government-recommended model for the rest of China, especially in the major cities. It all adds up to what I believe is a huge boost to China's economic development