the reform of state-owned enterprises in china: the art of the possible

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 11, NO. 4

THE REFORM OF STATE-OWNEDENTERPRISES IN CHINA:THE ART OF THE POSSIBLE

DEREK MORRISOriel College, Oxford

I. INTRODUCTION

During the period from 1978 to 1989, China carriedout a series of major economic reforms, the cumu-lative effect of which was, by any standard, extraor-dinarily successful. The agricultural system wasreformed and output almost doubled. Numerousreforms in the management and control of enter-prises were introduced, leading to substantial andsustained improvements in productivity and ex-ports. In many areas state planning was completelydismantled, prices were largely liberalized, andenterprise autonomy was first introduced and thenexpanded substantially via the contract responsibil-ity system. Tax and profit-delivery systems werereformed, and several powerful incentive mecha-nisms introduced both for managers and their em-ployees. Over the period 1978—89 gross nationalproduct (GNP) per head grew at 7.6 per cent perannum.

Despite these considerable successes, there werenone the less limitations on what was achieved, inthree areas in particular. First, while production asa process was increasingly determined by enter-prise managers, the factors of production, capitalinvestment, labour, and land, and their allocationwere still very largely controlled by local or centralstate bureaucracies. The price of factors was alsostill heavily controlled, and virtually all the socialresponsibilities associated with the work-force,housing, health, education, retirement, etc., re-mained firmly with enterprises, all of which con-strained enterprise efficiency gains.

Second, the provision and allocation of finance forindustry remained almost exclusively the preroga-tive of the higher authorities to which state-ownedenterprises (SOEs) were subordinate. This not onlylimited the scope for many enterprises to pursueprofit-increasing strategies, but also meant that

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there was in practice very little, if any, progress inlimiting or reducing the soft budget constraint facedby most SOEs. The evidence of such enterprisesbeing able to accept and sustain losses (which onWestern accounting standards would in many caseshave been much larger) without significant reper-cussions, and despite the existence of new bank-ruptcy laws, was probably the single biggest reasonadvanced for believing that the reforms of the 1980shad been heavily flawed.

Third, the difficult area of enterprise ownershipwas barely touched upon in this period. It is true thatenterprises started to adopt joint-stock status, theholding of shares became possible, two stock mar-kets commenced operations, and some private en-terprises emerged. In addition, ownership formssuch as collectives and TVEs (township and villageenterprises) grew rapidly, both absolutely and as aproportion of total industrial output. None the less,by the end of the decade most of the major indus-tries and virtually all large-scale industrial produc-tion occurred under the same form of state owner-ship as had been the case in 1978. Even in 1993,SOEs absorbed 61.5 per cent of all investment inChina, and collectives a further 17.9 per cent.

These three problems, enterprise ownership, con-trol, and financing are, of course, inextricably linked,and the relatively depressed years between 1989and 1992 exacerbated all three. The need for stabil-ity after the Tiananmen shootings led directly toincreased state control of enterprises to maintainoutput, employment, and wages independent ofcommercial considerations; losses increased dra-matically and were funded either directly by thestate or, increasingly, through the roll-over andbuild-up of bank debt; investment, in a world ofhighly negative real interest costs and little downsiderisk, had to be controlled ever more arbitrarily;China's growing market orientation began to revealever more clearly the extent of disguised unemploy-ment; and the much faster growth of more innova-tive forms of enterprise indicated that state owner-ship and reform of ownership were crucial issueswhich could not be dismissed as of.only minoreconomic significance. More generally, China'svery success in easing numerous other constraintson economic efficiency inevitably led to this newset of constraints becoming apparent.

Following Deng Xiao Peng's speech in Guangdongin January 1992, the 3rd Plenum of the 14th Na-tional People's Congress in December 1993 intro-duced a whole new wave of reforms. The structureof enterprises, management autonomy and control,remaining price controls, the financial system, thetax system, employment, housing and the socialsecurity system, international trade and finance, thelegal and accounting framework, company law, thestate's approach to enterprise losses, and even theissue of enterprise ownership are all now due to bemodified, in some cases substantially. In certainrespects these new reforms are already under way.If fully implemented and successful they wouldbring about a transformation of the Chinese economyat least as dramatic as that seen in the 1980s, if notmore so.

These reform proposals are interlinked in complexways, and they inevitably raise difficult questionsof sequencing. But the overarching objective is toimprove the efficiency of the Chinese industrialsector and at the centre of the reforms lies thequestion of corporate governance. In broad termsthis refers to the set of relationships that link own-ership and control of enterprises, the institutionalforms and setting through which these relationshipsoperate, the nature of the risks, incentives, andcontrol structures which emerge from them, and theeffectiveness of the enterprises which they gener-ate.

Paradoxically, although the current reform propos-als are very extensive, and could have far-reachingeffects on the system of corporate governance inChina, virtually every aspect of that system, asdefined above, has been left almost entirely un-specified, and therefore remains quite open at thepresent time. It is very unclear what will emerge,and by the same token there is substantial room fora flexible and innovative approach to this centralissue. In order to explore this, the next sectionbriefly reviews the current reform initiatives andsome of the difficulties inherent in them. Section HIidentifies the characteristics of an efficient corpo-rate governance system and the likely constraintswhich progress towards this will have to recognizein the Chinese context. Section IV then outlines away forward, and some of the advantages anddisadvantages of it.

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II. THE CURRENT REFORMPROGRAMME IN CHINA

(i) The Socialist Market Economy

The guiding principle of the new wave of reform inChina is the Socialist Market Economy. This in-volves, first, that enterprises not just 'face themarket' but that market signals, determined by theinterplay of supply and demand, should be the mainguiding determinants of enterprise activity, whetherin product, factor, or financial markets. Second,public ownership will remain dominant in theeconomy.

The 'dominant' role of the state can be interpretedat both macro- and microeconomic levels. Lookingat the macro level, collectives, TVEs, and jointventures where the state has majority ownership areall regarded as publicly owned. This is reasonablein that those involved have no realizable propertyright which they have the discretion to retain or sell.But given that these organizational forms wereresponsible for the majority of China's output in1993, it means that any proportion from zero tothree-quarters of enterprises formally designatedSOEs, which produce nearly half of gross industrialoutput, could be converted to private ownershipwithout reducing the ownership role of the public asa whole below 50 per cent. There is, in fact, noprospect of any sizeable privatization programmein China at the present time. But it is important tonote that the guiding principle of the SocialistMarket Economy does not, in fact, give any guid-ance as to the extent of ownership reform which iseither possible or being contemplated.

This situation has certain advantages. It allows forexperiment, for gradual transition to new owner-ship forms, all the while learning from the experi-ence gained. But it also creates some serious diffi-culties. First, in the absence of any overall view ofthe balance of the public and private sectors inenterprise ownership, few criteria have been estab-lished to determine where genuine ownership re-form is most appropriate. Transfer to private own-ership is easiest where the operations concerned areprofitable, often via some form ofjoint venture, andthere are strong local incentives to carry it out, but

this increasingly will leave the most problematicenterprises, including the substantial number ofloss-makers, in the public sector; however it isprecisely these which are most likely to gain fromprivate ownership disciplines. In addition, many ofthe largely fixed costs of the social obligationswhich enterprises in China bear will tend to be leftwith the poorly performing operations remaining inthe state's control.

In similar vein, it is often easiest to transfer owner-ship to the private sector in a competitive environ-ment, to avoid all the problems of creating privatesector monopolies, but the gains to ownership re-form are likely to be least in such cases.1 However,a longer-term strategy of restructuring dominant ormonopolistic firms as the first step in establishingprivate competitive markets is difficult in the ab-sence of any broad view of the optimal balance ofpublic and private ownership.

Second, the institutional arrangements which it isappropriate to establish for the reform and imple-mentation of corporate governance systems in Chinalargely depend on the extent of ownership reformeventually contemplated. If most SOEs are to re-main as such, then, given current problems withtheir control and efficiency, it will be necessary tofocus on new organizational arrangements withinan overall state structure designed to hold enter-prise shares and exercise ownership functions aseffectively as possible. These will need to addresscomplex problems concerning the relationship be-tween provincial and central government, betweenindustrial, financial, and administrative control,between monolithic versus multiple share holdingby state organizations, etc. Once established, anysuch superstructure of government ownership insti-tutions may be difficult to modify or remove.

If, on the other hand, industry is largely to move outfrom under direct state control, then very differentinstitutional structures are needed and very differ-ent problems arise. The role and regulation of stockmarkets becomes crucial and, here again, any par-ticular institutional arrangements which emerge,e.g. the legal provisions of different types ofshareholding, the extent of private holdings, thedegree to which these will be individual or institu-

See Hay and Morris (1991), section 17.7, pp. 632—4 for a survey of empirical results which support this contention.

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tional holdings, and in the latter case the type ofinstitutions, may become very resilient to change,even though evidence from the West suggests thatthese matters have important efficiency effects.2

These are by no means the only problems. Theappropriate reform of China's banking system cru-cially depends on the type of financial links and thedegree of financial autonomy enterprises will have,but this depends on the long-term balance betweenprivate- and public-sector enterprise. Nor can Chi-na's corporate governance problems be fully ad-dressed without knowing to what extent the finan-cial system itself, including both the banks and allmanner of non-bank financial intermediates(NBFIs), will be privately owned and funded. Theoptimal structure of industry itself, including hold-ing companies, enterprise groups, joint subsidiar-ies, and joint ventures etc., all of which are cur-rently undergoing substantial change, all depend onwho ultimately owns the assets involved and howcontrol is exercised. Company law and accountingprocedures, also now being transformed, will re-flect ownership patterns, and may well becomemajor obstacles to change in the future if the degreeof state ownership radically alters. And less com-mented upon, but by no means trivial, is the prob-lem of the redeployment of those who lose theirprevious responsibilities during the process of re-form. Unless there are clear views of the scale ofthis problem, and effective arrangements for deal-ing with it, then this can itself become a majorobstacle to change.

(ii) Governance Structures

The concept of the Socialist Market Economy, andthe uncertainty as to its implications for ownershipreform of enterprises, have a pervasive if some-times intangible effect on much of the rest of thereform programme. Recent changes introduce newcorporate forms, including sole proprietorships andpartnerships, limited liability companies, and pub-lic limited liability companies (also known as pri-vate stock companies), each with their own regula-tions. Stock markets have been established, withthe shares of a growing number of enterprises nowquoted on them. Other provisions allow for holdingcompanies, enterprise groups, and asset-manage-

D. J. Morris

ment bureaux, and there are now several thousandsuch organizations monitoring, supervising, andultimately controlling a much larger number ofenterprises. The government is also creating 100National Enterprise Groups (NEGs) to rationalizeand restructure industry in 12 subsections, withcompetition maintained by having more than oneNEG subsidiary in each sector of industry.

All of these reforms are likely to be beneficial, butin the context of the Socialist Market Economy theyactually leave most governance issues unresolved.First, of over 4,000 enterprises which by 1993 hadissued shares, only about 500 had issued them toanyone other than the state or employees, and onlya small minority actually had a stock-market quota-tion. While these numbers are growing fast,shareholding at present has very little to do withefficient governance arrangements, and the maineffect has just been to boost employee remunera-tion beyond the limit of wages plus bonuses. Mostholding companies are little more than loose, con-venient alliances of enterprises, more like businessassociations; and state asset-management bureauxhave generally been passive, largely accountingand reporting bodies, exercising few, if any, gov-ernance functions. Even where there are clear stra-tegic aims and a proper hierarchical control struc-ture, this still leaves open virtually all the maingovernance questions concerning financial sources,disposition of assets, response to lbsses, and otherkey ownership functions (see below).

Subsidiaries may well experience more autonomy,and be subject to much tighter budget constraints,because they are not directly controlled by govern-mental bodies and are dependent on their parentbody for financing; and in some cases this had ledto a substantially improved incentive structure andbetter performance. But these benefits are stilllimited by the absence of such effects on the parentbodies, and have not prevented a continuing build-up of loss-making enterprises and non-performingbank debt, despite strong recovery in the Chineseeconomysince 1992. It is still far from clear whetherthis type of industrial restructuring will lead togreater flexibility and accountability, and mucheasier transfer of resources from weak to strongenterprises; or whether it will just generate a differ-

: See Morris (1994) for evidence on this point

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ent pattern of rigidities through which non-com-mercial criteria are transmitted and poor perform-ance subsidized, with few if any efficiency gains.

Lying behind these difficulties is a more fundamen-tal problem. Nearly all these various institutionalforms of enterprise asset ownership are designed inone way or another to generate a measure of au-tonomy from governmental control, in what is hopedto be the interests of economic efficiency, but nonein a formal sense does this and, in many cases, thechanges serve only to cloud the relationship be-tween ownership and management. A joint-stocklimited-liability holding company may in practicehave no more autonomy, nor face any tighter budgetconstraint, than an enterprise which reports directlyto the industrial bureau of the provincial govern-ment. Ownership functions may well not change atall, and indeed may become more ambiguous ratherthan tightened or clarified. In many cases thereforeit is only the formal structure of corporate govern-ance rather than any of the effective elements,including not only ownership and control but theassociated economic mechanisms of incentives andrisk-bearing, which have changed. The formalchanges may eventually help to bring about thelatter, but do not by themselves, and have not to dateeither led to, or determined the nature of, the effec-tive system of corporate governance which willemerge in China.

Allied to this is the problem of system coherence. Itis clear that at one level, the level of policy devel-opment, a huge new programme of enterprise re-form is under way. At a second level, as is clearfrom the above, very much less change appearsactually to be happening, and few governance im-provements achieved. But at yet a third, and moredecentralized level, a massive amount of change isoccurring, though in a very fragmented and piece-meal fashion. The proliferation of subsidiaries,'restructuring, joint ventures, and new organiza-tional forms are leading to much less effectivecentralized control; new channels of finance andfinancial interlinkages between associated enter-prises are undermining existing financial controls,in the process tightening some budget constraintsand loosening others; a number of state or-ganizations, including some operating on a nationalscale, are becoming major economic players acrossa range of industries, using public sources of funds

but increasingly unaccountable in any real sense toa particular higher authority within the governmen-tal bureaucracy. This increasingly fragmented sys-tem is therefore undergoing reform, but in waysquite different from that implied by the authorities'own explicit reform programme. While coordina-tion is very far from being an essential characteris-tic for successful economic reform, the lack ofcoherence in current Chinese enterprise reformdoes mean that many of the governance problems,which the next phase of reform was in principlesupposed to solve, are not being addressed, butmerely by-passed on a case-by-case basis.

(iii) Managerial Autonomy

The New Operating Mechanism (NOM), intro-duced in 1992 through new regulations under the1988 enterprise law, gave managerial autonomyover production, most prices, marketing of outputand purchasing of inputs, import and export, invest-ment, disposal of assets, applying reserve funds,joint ventures or mergers, hiring, personnel man-agement, setting wages and bonuses, internal or-ganization, and, in principle of immense impor-tance, the right to refuse non-sanctioned govern-mental imposts, with scope for appeal to higherlevels of authority and the use of litigation to makethis effective (the so-called 14 autonomies). Withinthis, enterprises would be responsible for profitsand losses. Factory directors would become legallyresponsible for their operations and not subject tocontrol by Party officials.

In practice, despite some significant extension ofmanagerial autonomy over such matters, the situa-tion remains very different from that implied by theNOM regulations. First, the 14 autonomies aresubject to the approval of the 'relevant' governmentdepartments. In practice this can and probably willinclude all the central and local authorities whichhave previously exercised regulatory and/or inter-vention powers. In addition, these autonomies aresubject to the need to 'safeguard the interests of thestate and the public interest'. While this is a per-fectly laudable aim, in practice it allows substantialdiscretion for authorities to intervene in all sorts ofways. Nowhere are the objectives of the state asowner of an enterprise specified, and so theseinterventions may have all sorts of purposes and avariety of consequences, many of which may ap-

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pear very far from being in the public interest. Thedegree of managerial autonomy is, therefore, verymuch less developed than the NOM suggests.

More pervasively, there is a fundamental distinc-tion between the exercise of regulatory functions,be these tight or loose, through regulatory rules orownership rights, backed by enforcement mecha-nisms but with autonomy for economic agents tooperate within the rules of such a system; anddiscretionary intervention o n a n a ^ hoc or piece-meal basis, as and when the authorities deem thisdesirable. Nearly all China's enterprise reform ini-tiatives of the last 15 years have been designed tomove the system from the latter towards the former.Yet the caveats to the new rules, the weight ofhistorical practice and convention, the continuationof pre-existing institutions with predetermined pat-terns of behaviour and vested interests, all withinthe context of explicit state ownership of nearly alllarge-scale industry, mean that this shift has beenmuch less than would appear.3

(iv) The Financial System

There are parallel problems in the financial system,which bear directly upon enterprise reform. Sub-stantial reform is being carried out, including theprogressive development of the People's Bank ofChina towards the type of central bank recogniz-able in the West, able to exert some control overmonetary policy. At the same time, commercialbanks are being separated out from 'policy' lendingbanks, an inter-bank clearing system and new ac-counting procedures are being developed, the growthand operation of NBFIs are being monitored andincreasingly brought under control, and efforts madeto improve the asset/risk management of both eq-uity and debt instruments. Deregulation of interestrates, abolition of lending ceilings, the develop-ment of a reserve asset ratio system, and a greaterpresence for foreign bank are all envisaged or underway.

But from the enterprise governance perspectivethese changes have had few effects. With very littleaccess to new equity finance, enterprises are heav-ily dependent on banks for investment funds, butthere is no clear view on the extent to which banksshould be involved, if at all, in enterprise govern-ance arrangements. This has become both morepressing and a more intractable problem recentlybecause of the accumulating losses of many SOEs,and even more because, unlike in the 1980s, mostof these losses have been financed by roll-over orprovision of new debt finance from the banks, asubstantial proportion of which cannot be re-paid.4 Implementation of a tighter policy (whichin any event is still a matter for the authoritiesand not the banks themselves) generally justshifts the problem elsewhere in the banking sys-tem via movements in enterprises' debtor andcreditor positions.

In such a context, neither limited liability nor Chi-na's bankruptcy provisions are of much relevance.The need to avoid enterprise collapse, and with itthe loss of the employment and social securityfunctions which Chinese enterprises provide, meansthat banks are instructed to provide necessary fund-ing but have no role in trying to influence enterprisebehaviour in order to start to rectify the position.Indeed, in such circumstances, with negative realinterest rates, no hard budget constraint, but stillsizeable incentive payments arising from profitableoperations, it is clear why the authorities have hadsuch difficulty in restraining unsustainable invest-ment booms in recent years.

NBFIs have proliferated dramatically, but there isno clear legal framework for them, and no indica-tion of whether they should play a governance orpurely financial role. There is no policy on whoshould own them, or through what structures, howthey should be financed or regulated. Yet experi-ence from other countries suggests that the role ofbanks and NBFIs, for better or worse, is one of the

3 There has been a substantial increase in the proportion of output controlled by enterprises other than those formally designatedas state-owned, e.g. TVEs, collectives, joint ventures, private organizations, etc., but the great majority of these are highlydependent on SOEs, cither as suppliers to them or as their customers, which is another reason for believing that the extent ofeffective reform is less than appears from the reform measures, or from overall statistics on the growth of new organizational forms.

4 Estimates differ widely on the current extent of non-performing debt and, for obvious reasons, reliable data is not available;but it is not unrealistic to think that between 20 and 30 per cent of all outstanding debt falls into this category.

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crucial determinants of effective corporate govern-ance.

Financial system reform is crucial for enterprisereform. If, as at present, the financial system is notdesigned for, and cannot therefore play a role in,enterprise ownership and control, then this signifi-cantly limits the options available in designing anddeveloping effective enterprise governance sys-tems; and, it must be said, there are few plans if anyat present to develop China's financial system inorder to provide this function. But experience sug-gests that the economic system in China can de-velop very fast, and it would almost certainly be agrave mistake to believe that further enterprisereform should be conceived of only within thelimitations of the present financial system. The twoare necessarily intertwined, and it is important torecognize this in the process of policy design.

(v) Other Reform Initiatives

A number of other elements in the latest reformprogramme will have substantial effects on enter-prise reform and enterprise performance. Theseinclude the development, now in place, of a morestandardized tax system with dual central and localtaxation; the development of a body of corporatelaw within which, in particular, contracts and vari-ous property rights will be better safeguarded;implementation of best practice accounting tech-niques, which has implications not just for properaccounting but for a whole range of governanceactivities, including performance monitoring, valu-ation, restructuring, transparency, taxation, etc.;increased employment flexibility; and a start to theprocess of shifting social obligations, includinghousing, health, education, pensions and other so-cial security functions away from enterprises. Thelast of these in particular is essential if other ele-ments of enterprise reform are to generate an effec-tive and economically efficient system of corporategovernance. Space does not permit development ofthese issues, but it should not be forgotten that theanalysis below is all subject to the constraintswhich these factors impose.

III. THE ENTERPRISE GOVERNANCEPROBLEM IN CHINA

Two points stand out very clearly from the abovesummary and assessment of the current position inChina. First, the authorities are embarked on a veryambitious and very far reaching new stage of re-form but, second, the nature of the corporate gov-ernance system which can or will emerge fromthese reforms is quite indeterminate. In order to laydown some guidelines for how such a system shouldevolve, we need to recognize at least three con-straints on the problem: (i) what are the maincharacteristics of a system of ownership and controlnecessary to promote efficient governance; (ii)what is economically and, more important what ispolitically feasible in the short to medium term inChina, in the context of the reform programme todate; and (iii) how can policy best be formulated ina situation where the speed, methods and even theobjectives of economic reform can change signifi-cantly. We look at each of these in turn, beforeassessing their implications.

(i) Efficient Corporate Governance

In organization theory terms, an enterprise is essen-tially a set of coordinating contracts which embodygrants of authority and which act as an alternativeresource-allocating mechanisms to spot marketcontracts.5 These contracts identify the parties in-volved, specify the relations between them, anddetermine their functions and their remuneration.The defining characteristic of management is that itcoordinates the contracts and the activities whichthey specify; hence management is the immediatemanifestation of the 'conscious power' which de-termines resource allocation, production, and dis-tribution.6 The defining characteristic of ownershipis the contractual power or right to determine (a)who will comprise the management, and their re-muneration, and (6) the allocation of residual gainsand losses.7

As a general principle, efficient governance re-quires that those who bear residual risk must either

3 For elaboration of this approach, in the context of the Chinese economy, see Hay et al. (1994), ch. 12.' See Coase (1937), pp. 386-405, for the seminal work on why firms appeared to be 'islands of conscious power in a sea of market

transactions', and why some transactions occur through conscious administrative fiat while others occur through markets.7 Note that, while it is usual to think of owners actually bearing residual risk, in fact this element of ownership can in principle

be contracted away, so that it is only the power to allocate the residual gains or losses that is entailed by ownership.

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have effective control of managerial decision-tak-ing, or are able to trade in residual risk rights, orboth.8 In practical terms, no one will normally beprepared to bear residual risk if they have neitherany power to influence the decisions which deter-mine their gains or losses, nor any scope to escapethe consequent risks.9 It is more important, how-ever, to formulate this in terms of incentives. Ifresidual gains or losses accrue to individuals whocan neither escape the consequences nor influencethe decisions which determine them, then incen-tives for enterprise efficiency are weak. They areirrelevant to the residual risk bearers as they haveno discretion to respond, and they are irrelevant tomanagerial decision takers because the conse-quences of their performance can be shifted to theresidual risk bearers. This is not the case if eithertheresidual risk and management functions overlap, orif residual risk is tradeable, because poorly per-forming managers may then not be able to find orretain residual risk bearers.

The generally supposed superior efficiency charac-teristics of private enterprise flow from the fact thatit meets this basic criterion with, in very broadterms, the tradeable risk approach corresponding tothe Anglo-American dispersed stock market model,and the other corresponding more to the 'inside'control existing in many other industrialized coun-tries and in unquoted companies in the US and theUK.10 In contrast, under state ownership, typicallyownership functionally lies with various institu-tions of the state, in that they appoint, remunerate,and control management and allocate residual risk.However, this allocation results in others, in somecases other institutions but more general ly the popu-lation as a whole, bearing the residual risk, viaimplicit or actual taxation. The managerial andresidual risk-bearing functions do not overlapgreatly, nor can the bearers of residual risk trade init, with resulting reduction, sometimes of hugeproportions, in enterprise efficiency."

Within this perspective, China has had two advan-tages in comparison to, for example, the formerSoviet Union. First, the system of taxation in the1980s meant that at least some enterprise risk wasborne by local institutions of the state in terms of theresources available to them and the position andcareers of the officials who ran them. Second, thecontract responsibility and bonus systems shifted atleast some residual risk to enterprise managers andemployees. Many informal mechanisms interferedwith this, but none the less it is not surprising, giventhese characteristics, that China was so much moresuccessful with its enterprise reforms than else-where.

These advantages none the less are limited. Muchresidual risk is still borne by the population at large;and the objectives of those controlling the owner-ship institutions of the state were and remain muchwider than efficiency or profitability, with sales taxrevenue, employment, and even social stability allbeing related much more to the level of economicactivity rather than efficiency or even solvency.The reason why nearly all of the programme inChina to date of introducing joint stock status andlimited liability is, in itself, of little consequence isprecisely because so far it has not changed thelocation of, or relations between managerial deci-sion taking and residual risk. There is therefore inChina, as elsewhere in the world, a fundamentalobstacle to meeting the requirements of efficientcorporate governance within a system of state own-ership, and evidence on this is almost universal inindicating that transfer of productive assets to pri-vate ownership increases productive efficiency.12

(ii) Political Constraints on Reform

It would be easy to conclude from the above thatChina should embark on a major programme ofprivatization, as many other countries have done inrecent .years; and the number of privately owned

• For elaboration of this see Hay et al. (1994), ch. 12.9 It may be sufficient in some cases to load some residual risk on to managers, or link their remuneration to it, but such

arrangements typically still generate significant principal-agent problems.10 For an assessment of inside and outside control structures, see Morris (1994).1' To illustrate this, if a body ofstate officials were fully to take on residual risk, i.e. if they were to keep the net profits and fund

the losses of an enterprise under their responsibility, then, in many people's view, this would, consistent with the analysis here,represent partial transfer to private ownership. It may well be that such events have actually occurred, both in China and in othertransition economies. •

12 See Galal etal. (1992), ch. 19.

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enterprises is growing, particularly among smallerscale operations. In addition, TVEs, though offi-cially classified as state owned, are largely outsidethe state's control and do meet the basic require-ments for enterprise efficiency discussed above.Their superior productivity record in recent yearsand their phenomenal growth not only underline thesignificance of the efficiency criteria but have led toa considerably greater proportion of Chinese indus-try operating under governance systems which canbe efficient.l3 Nor does the guiding principle of theSocialist Market Economy rule out further transferof ownership to the private sector.

In practice, however, there is no prospect of anymajor transformation of ownership of the great bulkof state-owned enterprises to the private sector inChina in the foreseeable future, irrespective of whatthe evidence will turn out to be on the effect of suchprogrammes in numerous other countries. Thereare of course major uncertainties about the path ofeconomic reform in the post-Deng period, but thereis little prospect of any individual or group ofreformers coming to power and being sufficientlypowerful not just to maintain the present ambitiousreform programme but actually willing and able todismantle the concept of the Socialist MarketEconomy around which so much of the programmeis built. Indeed, on this issue, retrenchment is amore likely prospect, given the problems that haveemerged in recent years, which many politicallypowerful figures attribute to the reforms or to theirtoo rapid implementation.

The only major exception to all this is the role ofjoint ventures with foreign firms, which continue toproliferate rapidly. Many of these are designed notjust to obtain the benefit of foreign funding andtechnology in return for access to competitive pro-duction facilities and large new product markets.They are also specifically structured to ensure ef-fective and efficient governance structures, in partby linking managerial control with residual riskbearing, but in the context, at least nominally, ofoverall state ownership.

A typical example would be for a division of anSOE with good commercial prospects to be hived

off from the rest of the SOE.and given joint stockstatus with, for example, 30 per cent of the sharesowned by the SOE and 70 per cent by a new jointventure. This in turn would be 40 per cent owned bythe SOE and 60 per cent by the overseas company.The state then has the 'dominant role' in ownership,with a 58 per cent stake, but control of the divisionlies entirely with the joint venture, control of whichin turn lies with the foreign company. In addition,while there is a substantial difference between theownership pattern and control, there is none the lesssome significant overlap between managerial con-trol and residual risk.

It is not surprising therefore that many of these jointventures are proving successful. All those involvedhave strong incentives to enter such arrangementsand to make them work. In particular they bringfinance, technology and employment opportunitiesto the SOE, as well as the prospect of efficientgovernance. There are, however, two drawbacks.First, the SOE or, more often, the higher authorityfor the SOE may not like, on commercial or socialgrounds, certain decisions of the overseas companywhich formally speaking has effective control. Insuch circumstances the shareholding structure andthe legal responsibilities which go with it may notcount a great deal, and if the SOE or its subsidiarydoes not comply or cooperate with its foreign parentthen there is little chance of legal redress. Thus theabsence of a full code of corporate and contract law,and the means to implement it, means that statecontrol may be far greater, indeed in extreme cir-cumstances, absolute, irrespective of the govern-ance structure put in place to avoid this. In somecases this has led to joint ventures either deteriorat-ing or, where agreement can be obtained, beingrestructured to give the overseas company fullownership and control, in other words a full sell-off.

The second problem is the one which this jointventure activity poses for the Chinese authorities.Even if entirely successful in terms of the opera-tions placed under joint venture control, it meansthat those operations of SOEs which do not havegood prospects (and that includes a huge swathe ofheavily outdated and grossly inefficient plant in a

13 There have, however, been severe externality problems, in particular uncontrolled pollution, which must be taken into accountin any assessment of the overall impact on economic efficiency.

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number of basic industries) are left under statecontrol, with no effective governance structure,becoming in many cases a progressively bigger andbigger burden on the financial resources of thebanking system and the economy generally.

At first sight this is an easy problem to solve, byrequiring that all of the operations of an SOE areinvolved in the joint venture, with the foreigncompany using its resources and expertise to re-structure, save what is salvageable, close downirredeemably inefficient plant, and draw up plansfor redevelopment, diversification, etc. But fewprivate companies will want to be exposed to thelarge risks involved in such activity without effec-tive control, which is just to reiterate the basicefficient governance proposition. But this wouldrequire 51 per cent ownership, which is not consist-ent with the state retaining a dominant role inownership and which, in any event, the Chineseauthorities are not prepared to contemplate exceptin certain specific cases. This cannot, therefore, bea blueprint for a general solution to the problem ofinefficient enterprises. In short there is, to date, noobvious mechanism for achieving efficient enter-prise governance within the dictates of currentgovernment policy which can be applied on a largescale as a basis for the next major stage of reform,even though much is proposed and much activity istaking place.

(iii) The Pace and Objectives of Reform

The third constraint is simply stated but difficult tohandle. Economic reform continues, in many re-spects, to move forward rapidly, even if less fastthan a superficial look would suggest. The interimobjectives of reform also change, as does theirprioritization, and there is no reason to think thatfurther changes in the speed and direction of reformwill not continue. It is important that current policyinitiatives recognize this. Reforms of enterprisegovernance must not only make sense in their ownterms, and fit in with current reform guidelines,they must be flexible enough to provide a soundbasis for more than one end point of the reformprocess. At one, perhaps rather sceptical level, theymust be such as not to hinder a much stronger movetowards private ownership if, at some point in the

future, that became an element in Chinese eco-nomic reform thinking. But of more immediateimportance, they should be such that a range ofdifferent types of governance structures couldemerge, depending on evidence as to what appearsmost successful in the Chinese context and on whatfits best with related reforms in other areas of theChinese economic system, many of which currentlyare in only a rudimentary state or no more than itemson the reform agenda.

Finally, despite the speed of reform in China, ahallmark of progress in the past 15 years has beengradualism, in two distinct senses. First, the au-thorities have been keen to experiment on a smallscale first, tending to shun reform proposals thatinvolve full-scale, and therefore irreversible change,even if applied to only one part of the economicsystem. Second, the various reforms have them-selves been staggered rather than simultaneous.This has rarely been because of a master plandetailing the proper sequencing of reforms, much asthis subject has been discussed; and if there has inretrospect been some logic to the sequence ofreforms in China it has been as much luck asjudgement. Moreover, the present wave of reformis certainly looking at a large number of interrelatedreforms simultaneously. But there is still an impor-tant sense in which the Chinese appear to want toavoid any type of 'big bang' approach, in which anumber of important reforms are all implementedon a large scale at the same time, in part because ofthe problems which this has caused elsewhere; butalso because the economic, and indeed the socialconsequences will be very unclear, and the authori-ties are concerned to retain control of the reformprocess to a degree which a 'big bang' approachwould undermine.

Overall, therefore, reform in this area must bedesigned to obtain as many of the benefits of anefficient corporate governance structure as possi-ble, while remaining within the range of what ispolitically feasible at the present time, utilizing agradualist approach, and in a flexible and transi-tional manner which, as far as possible, does notinhibit scope for change in the direction of thereform programme in the future. It is to such devel-opments that we now turn.

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IV. A TRANSITIONAL MODEL OFGOVERNANCE REFORM IN CHINA

(i) The Transitional Model

Given what has been said concerning the require-ments of an efficient governance system, it is clearthat there is no first-best solution to the reformproblem while retaining state ownership. The needis to identify a second-best solution which can, intime, form the basis of more radical reform. Weargue here that the key to developing such a transi-tional model lies in the evolution of a certain type ofstate-owned financial institution, which can thenplay a central role in the governance of commercialand industrial enterprises. Rather than go throughthe logic which leads to the need for these institu-tions, it is easier and quicker to outline the nature ofsuch financial institutions and how they wouldoperate first, then go on to illustrate why thisappears to be the best way forward within existingconstraints.

We assume that a substantial proportion of SOEsconvert to joint-stock status. This process is wellunder way, but of course by itself has no implica-tions for enterprise governance. The transitionalmodel then requires that a significant proportion(what percentage this might constitute is examinedbelow) of the equity of an enterprise is held by astate-owned financial institution of a particularform, which we designate a SOFI to distinguishfrom existing state-owned financial organizations.The main characteristics of a SOFI are as follows.

(a) It is itself established as a joint-stock company.(6) Most or all of its shares are held by a number ofstate-owned but non-governmental institutions.These would largely comprise existing state-ownedbanks, but could in principle also include financialoffshoots of large industrial enterprises, state-ownedinvestment companies, and other NBFIs. They wouldnot normally include ministries, industrial bureaux, orother bodies within the governmental structure of thestate's bureaucracy, though there could be exceptionsto this. Typically aSOFI mighthavethree to five mainshareholders, and perhaps anumber of smaller share-holders, particularly if this was a prelude to increas-ing or decreasing an equity stake.

(c) It has at its disposal financial resources whichare primarily, though not necessarily exclusively,raised from its shareholders. This would to a sub-stantial extent be on an equity basis, but could alsoinclude debt contracts from both shareholders andfrom other financial institutions.(d) These resources are then used to take equitypositions in a range of commercial and industrialenterprises. These would normally be 'block' hold-ings, that is to say typically of at least 5-10 per centof the equity of an enterprise, carrying with it one ormore seats on the board of directors of the enter-prise. This means that they would usually be toolarge to be able to be disposed of quickly in anystock market which develops for the shares ofsuch enterprises. In other words, this is an 'in-side' control structure of the type found in Ger-many or Japan (though these two differ greatly ina number of respects) rather than the 'outside'control exercised through the threat of takeover indispersed stock markets, primarily those in the USand the UK.

For illustrative purposes, initial distribution of theequity of a large enterprise might be held as fol-lows:

• 30 per cent held by the industrial bureaux, min-istry, etc. which is currently the higher authorityfor the enterprise;

• 40 per cent held by several new SOFIs, each ofthese in turn owned mainly by a number of theemerging commercial banks;

• 25 per cent held by other investors, includingother SOEs, investment companies, and privateinvestors, primarilyforeign institutions, but alsosome individual shareholdings;

• 5 per cent held by managers and employees ofthe enterprise.

These figures could vary substantially betweenenterprises; for example, managers and employeesmight have a bigger stake in a smaller company.The only requirement is that the holdings of the firsttwo groups together exceed 50 per cent. Each groupwould be represented on the board of directors inrough proportion to their shareholding, and themanagement of the company would be directly andsolely responsible to the board of directors.

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At first sight there is no particularly obvious gainfrom establishing this new type of financial inter-mediary. Like virtually all existing ones they willremain majority state-owned and therefore in prin-ciple subject to all the governance problems associ-ated with state ownership which we have alreadylisted. Their financial resources will very largelycome from banks so that, for a given stance ofmonetary policy, an equivalent sum will cease to beavailable directly to enterprises. It may even beobjected that this merely introduces another layerof bureaucracy into a system already bedevilled byfar too much of it.

Such responses, however, particularly the last one,would be very superficial. This is because the nexusof risks, control, and incentives which constitute agovernance system would be radically different andwould in a number of important ways operate moresimply than at present. The first, and perhaps centraldifference concerns the separation of ownershipand management functions. At present most enter-prises report directly to a single higher authorityand are dependent on it for all strategic decisions,including capital investment and external financeand even the use of internally generated funds. Thisdirect involvement of the state as owner, as has beenseen, gives the government effective control overany aspect of an enterprise' s operations that it caresto exercise, enables any objectives of the govern-ment to be pursued, irrespective of its efficiencyimplications, and creates both the opportunity andthe obligation for the state to maintain inefficientand/or loss-making activities indefinitely.

Exercise of such discretion through a SOFI wouldbe very much more difficult. This is not just becausegovernmental bodies would not have any directcontrol of, or representation on SOFIs, though thisis of course important. Nor is it only because, toexert such influence or control, a governmentalagency would need to instruct a bank to instruct itsrepresentative on the board of a SOFI to instruct anindustrial enterprise to operate in a particular waythough, here again, the indirectness of this chain ofresponsibility would make decisions which weredetrimental to enterprise efficiency much moredifficult to enforce. Primarily it is the multiplicityof equity providers to any given SOFI, and themultiplicity of SOFIs on the board of any given

enterprise, which dramatically reduces, though itcannot of course ever eliminate, the scope for statecontrol to interfere with management functions andallocate the associated risks to others.

Dispersion of state ownership works through threerelated channels. First, in few cases would local ornational government agencies have influence, stillless control, over the range of financial institutionswhich would have an equity stake in any givenSOFI. Even if it were possible to exercise effectivecontrol over a SOFI, this would still typically holdonly a relatively small percentage of the equity of anenterprise. This is in sharp distinction to the presentsituation where typically an enterprise is dependenton one higher authority which also exercises effec-tive control over the enterprise's source of bankfinance.

Second, to the extent that there will still be interven-tion, this will reduced by the divergence of objec-tives which different SOFIs will have. For example,the incentive for any one body to provide or author-ize unwarranted or indiscriminate subsidies will besubstantially reduced, given that much of the ben-efit will accrue elsewhere. The opportunity to makeunwarranted discretionary imposts will be muchreduced, because of the damage it will inflict on theinterest of the other parties involved in the govern-ance of the enterprise. Likewise, authorization oflarge-scale and ill-considered investment projects,and authorization of the funding necessary to carrythem out, which has been a perennial problem inChinese industry, will be much more difficult whenit requires agreement from a number of sources offinance rather than just one.

Third, in any hierarchical system, managers andadministrators within it are judged by certain crite-ria, explicit or otherwise, and rewarded, finan-cially, through promotion or in other less tangibleways in the light of those criteria. In the presentessentially monolithic structure, the criteria of suc-cess and associated rewards for managers in enter-prises and for those in the banking system arelargely those of fulfilling whatever the higher au-thorities to whom they are responsible wish them todo. It is self-evident, indeed almost a truism, that theauthorities will have certain objectives, be theserelated to enterprise efficiency or not, will make

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these known to subordinates, and will reward themin relation to their success in furthering those objec-tives.

It is very much more difficult to establish or main-tain such a system when ownership and effectivecontrol are more dispersed. Both SOFIs and theenterprises in which they invest will have moreimmediate discretion, because of the dispersion oftheir ownership. This does not mean that they ceaseto be controlled, but that such control has, to a muchgreater extent than before, to be exercised throughthe setting of targets and the basing of rewards onthe extent to which they are met. This need forgreater transparency in a more dispersed ownershipstructure does not eliminate the scope for non-commercial criteria, but it makes it much moredifficult to specify and implement them. In con-trast, the greater emphasis on commercially soundeconomic criteria in the development of strategy,for SOFIs and enterprises, means that there will bemuch greater incentives for the managers involvedto meet these.14

Beyond these three elements, however, there is amore fundamental reason for believing that theownership structure described will improve gov-ernance efficiency substantially, and that can beseen by going back to the basic principle of govern-ance efficiency. The structure clarifies ownershiprights and the distinction between management andownership functions, but these characteristics areby no means unique to this structure. What, inaddition, it does on the basis of this clarification is,first, to create some overlap between control andresidual risk and, second, create scope for thetrading of residual risk rights. We look at each ofthese in turn.

With regard to the first, under present arrange-ments, no institution responsible for exercisingownership functions or providing finance for enter-prises is monitored or held accountable for thefinancial performance of enterprises in any effec-tive manner. This is, in essence, the origin of thesoft budget constraint problem. Governmental andministerial bodies to whom enterprises report havea plethora of objectives, influence over the flow of

taxation and the allocation of its use, and onlylimited incentives to enforce efficiency criteria.Banks which make loans to enterprises have little ifany independent discretion over financing, andcannot in any meaningful sense be held accountablefor the performance of their portfolio of loans.

For a SOFI, however, virtually none of this is true.Its only real objective is portfolio management andthe success of its individual investment stakes; ithas no role in the budgetary process; and it hasmuch stronger incentives to perform in that, if itsfinancial position weakens, then it can expect fewif any of its shareholders to want to provide com-mercially unsound support. Its managers will there-fore have a much greater incentive to encourageefficient performance of the enterprises in which ithas a stake and, over time, to adjust its portfoliotowards successful enterprises. And, unlike banksat present, the board of a SOFI would have consid-erable discretion in the handling of its loans andinvestments. Overarching state ownership couldstill weaken a number of aspects of the financialdisciplines involved, but the particular structure ofstate ownership proposed would result in muchgreater overlap between enterprise control and thebearing of the residual risks associated with theenterprise.

On the second point, the development of the systemof corporate governance described above wouldencourage an initiative already under way, indeedrequire it, namely the ability to value various finan-cial stakes. This does not necessarily imply theexistence of a liquid market in equity, with dailymovements in a market-determined valuation.Rather, in a fashion similar to that for unquotedcompanies in many countries, it would generateprinciples of valuation which would allow suchstakes to be valued on a frequent if intermittentbasis. But this is the first crucial step in the creationof scope for trade in such stakes between SOFIsand/or other institutions which have such holdings,not only facilitating the process of industrial re-structuring which is already happening in China,but facilitating the transfer of both the ownershipand the management of enterprise assets to moreefficient institutions.

14 This is similar in some ways to the governance advantages of holding company structures.

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Therefore, although SOFIs remain majority state-owned, and must do in order to play a role in aSocialist Market Economy as understood in China,the new governance structure which they representcan provide many, though not all, of the benefits ofthe governance gains normally associated with pri-vate ownership.

(ii) Advantages of the Transitional Model

The main advantage of the transitional model is thatit is a feasible way of improving corporate govern-ance in China, as outlined above, within the con-fines of present reform policy. It has, however, anumber of other advantages. First, it deals withwhat is currently a fundamental problem in thesystem of governance in China, namely the generallack of any domestically held equity instruments inthe system of financial intermediation. This willmean that the financial structure of both projectsand enterprises can be made more appropriate totheir risk profile, and permits a proper distinctionbetween the commercially valid input of state con-trolled equity into viable projects and the puresubsidization of non-commercial projects. Atpresent this distinction barely exists and makes thesolving of the soft budget constraint problem virtu-ally insoluble.

Second, and following on from this, wheresubsidization is to occur, whether for sound eco-nomic reasons, such as re-equipping in a worlddevoid of flexible capital markets, infant industrytype reasons, etc., or for other, economically inef-ficient reasons, this can be done much more trans-parently, in the light of specific performance im-provement targets, with effective monitoring, fol-lowing an agreed trajectory over time and withvarious forms of performance conditionality builtin. Where insolvency is unavoidable, then restruc-turing of assets under new enterprises and with newmanagement, which to some extent is already hap-pening, will be facilitated.

The other great advantage is that transition to thenew structure, though requiring a clear initial com-mitment, can be gradual in the sense that it can be

D. J. Morris

introduced experimentally first in a relatively smallnumber of enterprises, but also in the sense that theshareholdings of SOFIs can start at a quite a smalllevel and increase over time, not least as new equityis provided to successful enterprises from this source.Over time, there is scope for SOFIs to replaceexisting institutions of state ownership if that ap-pears desirable, but is not a necessary feature of thereform; and over the longer term a transition tomajority private ownership can occur, as and whendeemed appropriate, by the expedient of a sale ofshares from the SOFI or from any other stateshareholding institution, to existing or new share-holders.

In all this, however, the existence and role of SOFIsis crucial. They permit overall state ownership,while at the same time giving, in the illustrativeexample, an incentive structure in which 70 per centof the shareholders have little interest in their stakesother than the efficient performance, profit andgrowth of the enterprise concerned. It is they whoresolve the asymmetric information and associatedprincipal-agent problems inherent in corporate gov-ernance structures in that they form the linchpin ofan inside control system, in which the main share-holders are few'in number, have representation and,as a result, actual power over the enterprises con-cerned, while still leaving managers the properdiscretion to manage their enterprises on a day-to-day basis. A more centralized monolithic owner-ship structure would have the drawbacks evident inmany SOEs today, but a more decentralized onewould be difficult to implement with state owner-ship.15

(iii) Disadvantages of the Transitional Model

There are a number of serious obstacles to theeffective implementation of such a system. It willnot, of course, be as efficient as private ownership,but we do not take this as a drawback because thewhole purpose of the exercise is to improve enter-prise governance in those cases where privatizationwill not be pursued (though, as we have seen; it willby no means inhibit, and indeed in time couldfacilitate such a move).

13 There is in all this a clear trade-off between the drawbacks of fully effective state control on the one hand, and the potentialfor political instability if the state remains the nominal owner but loses all power to implement policy. All reforms in this area mustend up being some sort of compromise between these two extremes, but the inside control structure proposed here is likely to bea better solution than the more extensive fragmentation of state ownership involved in some alternative proposals.

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The biggest immediate obstacle is the current veryfragile state of banks' balance sheets, the continu-ing losses of a substantial number of enterprises,and the continuing pressure on the banks to main-tain, roll over, and even expand their non-perform-ing loans. Privatization of the banking system isneither politically nor, at the presenttime, economi-cally feasible on any significant scale. Recapitaliz-ation by means of new bond issues may help, butonly in those cases where there is some realisticprospect of debt repayment. Another possibility,canvassed in some parts of Eastern Europe, is towrite off the debts, remove an equal volume ofdeposits, place these with new financial institu-tions, which in the present context would be SOFIs,coupled to the issue of an equivalent amount ofbonds, and then allow these institutions to take debtand/or equity positions in the way we have de-scribed. This would be feasible irrespective ofwhether SOFIs were deposit-taking institutions intheir own right, or merely subsidiary to a range ofdeposit-taking institutions.16

The second major hurdle is the dearth, indeedalmost complete absence, of the management andinvestment appraisal skills required by the SOFIsproposed. Few in the current banking system havesuch experience, and history suggests that the gov-ernmental and party machine would move to placemany of its existing bureaucrats into the potentiallyvery powerful new senior management positions inSOFIs. There is no easy answer to this, and theproblem is a feature of virtually all major economictransition programmes. However, the Chinese haveshown, not least in the last 15 years, that there aresubstantial reserves of entrepreneurial talent; thereforms to date have generated a growing number ofpeople who have been successful in running largeenterprises, often of a conglomerate nature, whomight take up such responsibilities quite well; andthere would be considerable scope to bring inWestern advice and Western-trained personnel toassist in the initial stages of the process.

A third problem is how the structure of ownershipwould change as and when new external equity was

introduced into an enterprise. Normally this createsno problem, but just involves the issue of newshares and an element of dilution of control ofexisting shareholders. To the extent that SOFIswere the main source of new external equity, thiswould not be a problem, nor of course would newdebt finance; but new private finance, perhapsrequired as a result of prudent controls on publicfinances or the degree of intermediation goingthrough the public sector, might prove difficult ifoverall state control were to be retained. Even inhighly developed capital markets in the West thismixing of public and private funding has proveddifficult to handle, but this should not be a majorproblem in the initial years, and is not exacerbatedby the reforms proposed.

Finally, for such a system to work it is vital thatChinamoves increasingly to best international prac-tice in terms of accounting principles and auditingprocedures. However, initiatives are already underway in this respect, in part prompted by the desireof a number of Chinese enterprises to have theirstock quoted on foreign stock exchanges, and it is tobe expected that this process will accelerate giventhe stimulus of further enterprise reform.

Many other aspects of this reform approach need tobe explored, but space constraints do not permit ithere. These include the important question ofsequencing of financial reform, enterprise reformand enterprise restructuring; and the increased rolefor regulation, of the financial system, of enterprisebehaviour in a more decentralized environment,and of competition, both in terms of industrialstructure and anti-competitive behaviour. Improve-ment in contract law and its enforceability, in thetransparency of the tax regime, in the rules govern-ing the flexibility of thelabour market and, perhapsabove all else, in hiving off the social functionscurrently attached to enterprises will also all becrucial elements. But these are problems facing theChinese authorities irrespective of the governancereforms they pursue, and in all cases will almostcertainly be helped rather than hindered by theenterprise reforms discussed above.

16 Substantial conversion of debt into equity as part of the reform may be thought to sit oddly in the present Chinese financialsystem; but it should be stressed that, de facto, much of the funding of enterprises is in practice in equity form. One central roleof financial reform is to make the nature of different financial instruments clear, and to ensure that a substantial proportion of allenterprise finance reflects the ownership functions of equity.

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V. CONCLUSIONS

There can be little doubt that, barring major politi-cal crisis after Deng dies, China will continue tofollow a path of rapid economic reform in the nextfew years. This will continue to fuel rapid growth,particularly in the south. But enterprise behaviourand performance are at the heart of this, and herethere is still huge uncertainty, as to both the rate andthe nature of reform. There are both political andeconomic constraints on the improvements in gov-ernance structures which are possible; they areintimately bound up with complex issues of finan-cial system reform; and they require major, even ifgradual, changes in the distribution of political andeconomic power in the country.

At present there is considerable activity in this area,much of it successful, but it may be creating amomentum of change which, at the least, will causedifficulties for the authorities and at worst may takethe reform process in the wrong direction. Cherry-picking joint ventures can make governance reformelsewhere more difficult and, in any event, most ofthe requirements for efficient governance and mostof the obstacles to its implementation occur preciselywhere the business environment and enterpriseoperations are poor. The development of stock mar-kets in China may seem to signal progress in this areabut it is very limited in scale and likely toclash heavilywith the explicit objectives of the current reformprogramme if extended to any significant degree.Equally important, existing shareholdings and trad-ing in shares, and the development of any moreextensive market in share trading are likely to haveonly limited effect on the exercise of ownershipfunctions in the enterprises concerned and, in thelonger term, direct reform towards a form of gov-ernance which evidence suggests is far from ideal.

All economies need institutions which can interme-diate between secure deposit-taking from the popu-lation at large and investment in large-scale riskyprojects. Even some highly developed industrialeconomies still face problems in achieving thisoptimally, and it is one of the most fundamentalproblems facing China. The transitional modelwhich we have presented here, as a basis for the nextphase of reform, has the advantage of trying to helpthis process forward while trying to meet the dic-tates of efficient governance. This transitional modelbuilds on some of the changes already occurring,and in a general sense flows with the tide of currentreform; it tries to grasp the problem that, by designor default, enterprise reform and financial systemreform are inextricably linked, but recognizes thatsome types of linkage are more conducive to effi-ciency improvements than others; and potentiallyprovides a strong basis for extensions of the reformprocess without being too prescriptive or restrictivewith regard to what the end point of the process willbe.

As with virtually all elements of reform in China atpresent, there are serious obstacles on the way,which we have described. None, however, looks tobe insuperable and, as so often in the past, theChinese authorities can introduce the transitionalmodel on a relatively small scale to start with,learning from the process as it goes, and extendingit throughout China only when it has been througha sound series of tests. As with agricultural reform,with the reform of prices, and with the contractresponsibility system, success on a small scale byitself precipitates much wider spread change. Simi-lar success in the field of enterprise governancereform would play a key role, perhaps the crucialrole, in determining China's economic develop-ment into the next century.

REFERENCES

Coase, R. (1937), "The Nature of the Firm', Economica, 4,386-^105.Galal, A., et al. (1992), 'Welfare Consequences of Selling Public Enterprises', World Bank Conference Paper.Hay, D., and Morris, D. (1991), Industrial Economics and Organisation, Oxford, Oxford University Press, 632-4.— — Liu, G., and Yao, S. (1994), Economic Reform and State-Owned Enterprises in China 1979-87, Oxford,

Clarendon Press.Morris, D. (1994), "The Stock Market and Problems of Corporate Control in the UK', in T. Buxton et al. (eds),

Britain's Economic Performance, Routledge.

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the reform of state-owned enterprises in china: the art of the possible

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