China's business reforms: Institutional challenges in a globalized economy

Smyth, Russell (Ed.); Tam, On-kit (Ed.); Warner, Malcolm (Ed.); Zhu, Cherrie Jiuhua (Ed.) Book China's business reforms: Institutional challenges in a globalized economy Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Smyth, Russell (Ed.); Tam, On-kit (Ed.); Warner, Malcolm (Ed.); Zhu, Cherrie Jiuhua (Ed.) (2005) : China's business reforms: Institutional challenges in a globalized economy, ISBN 978-0-203-53703-9, Routledge, London, https://doi.org/10.4324/9780203537039 This Version is available at: https://hdl.handle.net/10419/251159 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Since 1993, China has been the second largest recipient of foreign direct investment in the world after the USA and is now considered to be the world’s third biggest economy after the USA and Japan. Its greater economic integration with the rest of the world, especially since its accession to the World Trade Organisation (WTO), has further accelerated its market-oriented economic reforms. China is now opening its protected markets and beginning to submit to the rule of international law. This ongoing transition and increasing participation in the world economy has resulted in significant changes in human resource, management and social welfare practices in China’s enterprises. The book examines the key areas, all of which are linked, where China is grappling with institutional reforms as it opens up to the outside world—state-owned enterprise reform; capital markets and financial reform; human resources and labour market reform; social welfare reform; and China’s accession to the WTO and the growth of the private sector. Russell Smyth is Professor of Economics and Director of the Asian Business and Economics Research Unit, Monash University. His research interests include Chinese economic reform, law and economics and applied time series econometrics. He has published widely in these areas. He is Editor of Economic Papers, the policy journal of the Economic Society of Australia and Associate Editor of Asia Pacific Law and Economics Review. On Kit Tam is Professor and Associate Dean International, Faculty of Business and Economics, Monash University. He is Co-Director of the Monash Governance Research Unit, and Director of China Research Center, Monash Asia Institute. His research interest is in corporate governance, China’s economic reform, financial development and foreign investment policy. Malcolm Warner is Professor and Fellow, Wolfson College and Senior Research Associate, Judge Institute of Management, University of Cambridge. He has written extensively on management and is the Editor-in-Chief of the International Encyclopedia of Business and Management. He is also Co-Editor of the Asia Pacific Business Review and is on the editorial boards of many international journals. Cherrie Jiuhua Zhu is Associate Professor and Director of the China Program in the Faculty of Business and Economics, Monash University. She has published papers in the areas of human resource management and international management. Her current research interests are globalization, marketization, social protection reform and their impact on management in China. China's Business Reforms Institutional challenges in a globalized economy Edited by Russell Smyth, On Kit Tam, Malcolm Warner and Cherrie Jiuhua Zhu First published 2005 by RoutledgeCurzon Published 2017 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN 711 Third Avenue, New York, NY 10017, USA Routledge is an imprint of the Taylor & Francis Group, an informa business Copyright© 2005 Editorial matter and selection, Russell Smyth, On Kit Tam, Malcolm Warner and Cherrie Jiuhua Zhu; individual chapters, the contributors The Open Access version of this book, available at www.tandfebooks.com, has been made available under a Creative Commons Attribution-Non Commercial-No Derivatives 4.0 license. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 978-0-415-34517-0 (hbk) Contents List of figures vii List of tables ix List of contributors xiii 1 Institutional challenges for China’s business reforms in a globalised economy RUSSELL SMYTH, ON KIT TAM, MALCOLM WARNER AND CHERRIE JIUHUA ZHU 1 SECTION ONE 2 Industrial restructuring and corporate governance in China’s large-scale state-owned enterprises DIC LO AND RUSSELL SMYTH 11 3 Regional comparative analysis of China’s banking system KYM BROWN AND MICHAEL SKULLY 26 4 Solving agency problems in a cross-border environment: Ten years of Chinese company listings in Hong Kong ALICE DE JONGE 45 5 Foreign banks—market entry and foreign investment ON KIT TAM 60 6 Accounting for intangible assets and the relevance of financial statements in developed and emerging capital markets: Australia and China JAYNE M.GODFREY AND WEI LU 78 SECTION TWO 7 Changing structure of Chinese enterprises and human resource management practices in China SHUMING ZHAO 97 8 The management of human resources in Shanghai A case study of policy responses to employment and unemployment in the People’s Republic of China GRACE O.M.LEE AND MALCOLM WARNER 115 SECTION THREE 9 Employee perceptions of social protection reform in Shanghai: diversity across ownership forms and occupations CHERRIE JIUHUA ZHU, CHRIS NYLAND AND BRIAN COOPER 129 10 Pension reform in China: imperatives, constraints and outcomes PETER SAUNDERS AND SUN LUJUN 146 11 Globalization and occupational health and safety regulation in China CHRIS NYLAND, RUSSELL SMYTH AND CHERRIE JIUHUA ZHU 165 SECTION FOUR 12 China’s entry to the WTO Effects of reducing tariff and non-tariff barriers and endogenous productivity growth YINHUA MAI 186 13 Raw entrepreneurship and the rise of the new private sector in western China The Hope Group of Chengdu, Sichuan province MARIKA VICZIANY AND GUIBIN ZHANG 198 Bibliography 213 Index 229 Figures 3.1 Growth of domestic credit and GDP in China 31 3.2 Domestic and international bank financing 32 3.3 World Economic Forum: financial market indicators for China 40 3.4 World Economic Forum: soundness of banks 41 7.1 China economic growth after 1978 reform 98 7.2 A comparison of different forms of corporations in China 103 8.1 Chinese labour market model 121 8.2 GDP growth of China and Shanghai, 1980–2001 125 8.3 Re-employment of laid-off workers in China and Shanghai, 1998–2000 126 12.1 Tariff reductions and endogenous productivity growth 188 1 Institutional challenges for China’s business reforms in a globalized economy Russell Smyth, On Kit Tam, Malcolm Warner and Cherrie Jiuhua Zhu 1.1 Introduction The reform of China’s economy and business environment and the opening up to the outside world over the last 25 years have occurred against a backdrop of increasing globalization and integration into the world economy. Indeed, we will argue that it is likely that the latter changes have been the driving force behind the former. Most observers of China’s reforms are united in the view that these have been successful in terms of promoting economic growth and improving the living standards of the masses, often with reservations vis-a-vis the increasing inequality of income and wealth. Few would question that the average Chinese is better off today than when the market reforms commenced in the late 1970s. ‘Winners’, on the whole, are likely to outnumber ‘losers’. However, China has clearly encountered problems and challenges in the building of new institutions required for the economy and society to function and thrive in the complex processes of marketization and globalization. Foremost among these from the perspective of business is the restructuring of Chinese state-owned enterprises (SOEs), reform of the financial and banking system and concomitant reforms to labour markets and social welfare provision, albeit with ‘Chinese characteristics’. China has now moved to a more efficient system of resource allocation. The link between economic restructuring and globalization was most recently brought into sharp focus following China’s accession to the World Trade Organisation (WTO), with China’s enterprises confronted with increasing levels of competition from foreign sources. The essays in this edited volume collectively provide an overview of how China’s economic reforms have evolved and how policy-makers and market participants are responding to the challenges of increased global competition. Many of them provide a fair degree of detailed analysis about how this has come to pass. Section One of the book, which consists of the next five chapters, examines corporate governance reform in SOEs and listed companies and the development and restructuring of China’s financial sector. It is fair to say that these are the two major institutional reforms that have occupied the business policy agenda in China over the last decade. Section Two of the book contains chapters on the evolution of human resource management (HRM) and labour market reform. One of the accompanying features of the increasing marketization of SOEs and corporate governance reform in listed companies has been the evolution of HRM in China and the growing pressures of unemployment as SOEs change their work practices. The chapters in Section Two review these developments. Section Three of the volume focuses on the changing nature of social welfare provision. There is increasing recognition among many scholars that globalization is more than likely a ‘double-edged sword’ (see Guan 2001a, Kapstein 2000, Milanovic 2003). While the globalization process has contributed to rising incomes in developing countries such as China through increased trade and investment flows, it has also made the need to create a sophisticated social protection regime to protect those who are made vulnerable from increased competition more pressing. These include the elderly, the unemployed and those in poor health. The chapters in Section Three examine how China has responded to the need to develop a social protection regime to protect the ‘losers’ from the globalization process and, at the same time, make the marketization process sustainable into the future. The final section of the book contains two chapters assessing the impact of China’s accession to the WTO on the economy and the emergence of the private sector and new breed of entrepreneur in China. We conclude the book with these two chapters since both examine topics that look to the future of Chinese business. How China adapts to being a member of the WTO will be probably the most important issue for business in China in coming years. The emerging importance of private enterprises has been one of the major developments in China’s business reforms in recent times and it is likely that private enterprise will play an even greater role in the future as the stateowned sector shrinks further. In the remainder of this chapter, we provide an overview of the institutional challenges facing China’s reforms and examine the contents of the chapters that make up the balance of this volume in greater detail. 1.2 Section one: corporate governance and financial reform Effective corporate governance, most authorities in the field agree, helps protect and enhance the interests of stakeholders in a company, particularly shareholders. Corporate governance now occupies the centre stage of enterprise reform in China (Tenev et al. 2002). The Fourth Plenum of the Chinese Communist Party’s Fifteenth Central Council, held in September 1999, identified corporate governance as ‘the core’ of the modern enterprise system. The main tenet of China’s approach to corporate governance development is the adoption of key features from the Anglo-American model of corporate governance, which requires the existence of certain institutional conditions including a well functioning financial and regulatory system for it to operate effectively (Tam 1999). The 1997 Asian financial crisis and the problematic mass privatization in Russia have highlighted the importance of having effective corporate governance arrangements in emerging and transitional economies (Frydman et al. 1996, Estrin and Rosevear 1999, Claessens et al. 2000). For a developing ‘transitional economy’ such as China, in which the government retains considerable influence, even if the apparatus of the old command economy has been virtually dismantled, the role of corporate governance is now widely accepted by scholars and policy-makers to be critical to the country’s enterprise and financial reform and to the development of a globally competitive economy (Chen 2003, Clarke 2003, Walter and Howie 2003). Globalization and corporate governance issues are now more intertwined than ever before, problems of corruption notwithstanding. With fast expanding international trade and inward foreign China’s business reforms 2 direct investment, the need to develop effective corporate governance and an efficient financial and banking system has taken on added significance. Chapter 2 by Dic Lo and Russell Smyth, Chapter 4 by Alice de Jonge and Chapter 6 by Jayne Godfrey and Wei Lu examine different aspects of corporate governance development in Chinese enterprises. In Chapter 2, Lo and Smyth provide an overview of reform of SOEs, focusing on the contribution of large SOEs and enterprise groups. There is a spirited debate in the literature on the role of large SOEs. Some authors see large SOEs as inefficient ‘dinosaurs’ dragging down the state-owned sector (see for example McNally and Lee 1998, Shieh 1999). Others, more controversially, argue that large SOEs have played a vital role in China’s economic success through supplying producer goods and establishing substantial linkages which have fuelled growth in downstream industries (Nolan 1996, Nolan and Zhang 2002). Lo and Smyth, whose sympathies lie with the second camp, focus on the positive contribution of large SOEs at a time when the role of the state sector has been shrinking. To explain how the share of large SOEs has held up over time, they offer a ‘non-orthodox’ account of industrial restructuring and changing corporate governance, focusing on the match (or mismatch) between the institutions and external demand conditions. In Chapter 4, de Jonge examines the emerging corporate governance structures of listed companies, focusing on the internal structure of Chinese-incorporated companies listed on the Hong Kong Stock Exchange (H-share enterprises). This démarche is particularly timely in a period when high profile accounting and corporate governance scandals in the United States have emphasized to the business community the need for improved corporate governance standards in securities markets throughout the world. De Jonge examines the way in which recent developments and reforms in laws and regulations governing H-share enterprises have started to alter the composition of boards and the relationship between shareholders and management. The chapter demonstrates both how things are changing for the better and the many deficiencies that still need to be addressed. Another aspect of corporate governance reform, which was highlighted by the US- based Enron and WorldCom collapses and other non-US ‘basket-cases’ such as the Italian conglomerate Parmalat, has been the need to develop sound financial reporting practices. Godfrey and Lu positively address this issue in Chapter 6. Existing research points to differences in the manner in which investors in developed countries value the intangible assets reported in firms’ financial statements. There is no research, however, into the association between the market value of firms in developing countries and their book values of intangible assets. Since the promulgation of China’s first ‘Western-style’ accounting standard in 1992, accounting standards and regulations issued by the Chinese government have become increasingly internationally compatible. This move opened up opportunities to examine the economic relevance of accounting in the emerging economy of China. Using a large sample of Australian and Chinese companies, Godfrey and Lu investigate the value relevance of capitalized intangible assets, both in aggregate and as individual capitalized items. One of their main findings is that in China, the book value of intangible assets is a very small proportion of the book value of total assets and none of the capitalized, intangible asset book values are significantly associated with the market value of equity. They cogently discuss the implications of this for financial reporting reform. Institutional challenges for China’s business 3 The 1990s saw the establishment of new nationwide shareholding banks, significant expansion of the insurance sector, development of a domestic capital market and the emergence of consumer and housing finance. The financial sector and particularly the securities market, however, still face many challenges that are inextricably tied up with corporate governance reform and in particular reform of the SOEs. These state firms receive the bulk of funds allocated through the formal credit system and non-commercial considerations, such as the need to sustain loss-making SOEs, continue to influence bank lending (see OECD 2002 for an overview). In 1999 the Chinese government announced an equity-for-debt swap (EDS) scheme to restructure the SOEs and clear up the bad loans of the state-owned banks. As Kym Brown and Michael Skully discuss in Chapter 3, official figures reported before the asset management companies took over bad loans were that non-performing loans were in the 25–30 per cent range, but in practice the actual percentage of non-performing loans was much higher. The limited empirical evidence which is available suggests that to this point the EDS has had limited success in restructuring SOEs or improving the bad loan situation of the banks. The problem is that in the end the EDS is only a financial scheme, an accounting solution to the problem of bad debts, while SOE reform is a real socio-economic problem that is subject to serious socio-economic and political constraints (see Smyth et al. 2004). Different aspects of the relationship between enterprise reform, foreign investment and banking reform in China are emphasized in Chapter 3, by Brown and Skully, and Chapter 5 by On Kit Tam. Brown and Skully compare China’s financial system with others in the Asia-Pacific region, emphasizing the banking system and its reform progress. The international perspective is interesting given China’s emerging financial importance in East Asia. As a proportion of GDP, China has the largest domestic banking system in East Asia and, when combined with international borrowings, it is third behind Hong Kong and Singapore. Brown and Skully make several recommendations for further reform to China’s financial sector, including: the full publication of financial statistics; the continued workout of non-performing loans; more bank supervisors; the development of other financing options for investors; and the removal of unprofitable SOE funding to policy banks. In Chapter 5, Tam analyses the main issues influencing the entry of foreign banks into China’s banking sector, with particular reference to the government’s aim to promote economic development in the western region. It is generally recognized that the Chinese banking sector has lagged behind other sectors in the reform process. As demonstrated by the beneficial impacts from the entry of foreign insurance companies in China during the last decade, Tam argues that an increase in the level of market competition in China’s banking sector from foreign banks will help the reform of this important economic sector while at the same time enhancing the country’s foreign investment environment, particularly in the western region. One of the implications of China’s integration into the global economy has been increasing regional disparities between the coastal provinces that attract the bulk of foreign investment and the lower-income central and western provinces. In response to these income divergences, through the ninth Five-Year Plan (1996–2000) and the State Council’s special administrative office, the Leading Group for Western Development, development of western China is now seen as a priority. Multilateral lending agencies are also targeting funds towards the development of western China. Tam argues that more rapid liberalization of market entry for foreign China’s business reforms 4 banks will assist in the economic development of China’s western region. He discusses how the entry of foreign banks into the region can have a positive effect on the flow of foreign direct investment into the region, thereby reducing the big regional income disparities. 1.3 Section two: human resources and labour market reform China’s labour force has experienced a profound transformation since the late 1970s, which has been a direct as well as an indirect result of enterprise restructuring to improve global competitiveness vis-a-vis the wider forces of globalization (see Warner 1995). In 1978, most of the labour force was employed in rural communes or in urban SOEs; by the end of the 1990s, one third of the rural labour force was engaged in non-agricultural activities and about three-fifths of the urban labour force was employed outside the state sector, in urban collectives, joint ventures and private enterprises (Fleisher and Yang 2003). Prior to 1978, HRM in China was characterized by the ‘three irons’ policy consisting of the ‘Iron armchair’ (tie jiaoyi), Iron rice-bowl’ (tie fanwan) and ‘Iron pay’ (tie gongzi). Labour arrangements under central planning were characterized by labour allocation by labour bureaus, the hukou (residence registration system), and strict control of the dang’an (personal file) by the danwei (work unit or employing organization; see Meng 2000). However, as Shuming Zhao discusses in Chapter 7, since the commencement of market reforms, HRM has undergone somewhat of a revolution. The labour contract system, earlier pioneered in Shenzhen, was first introduced nationally by way of a Labour Regulation in 1986 to cover new entrants into state and collective enterprises. In 1987, regulations calling for an extension of fixed-term contracts to incumbent workers were introduced. This step provided enterprises with some autonomy to make hiring decisions for the first time, and increased the risk of being laid off for employees who did not meet their employment obligations (Fleisher and Yang 2003), although these same regulations left a large residual role for planners to meet regional employment targets (Meng and Kidd 1997). A managerial responsibility system has also been introduced to link managerial performance and compensation (Groves et al. 1995), and by the second half of the 1990s some managers in SOEs were being employed on three-year contracts, which could be terminated for failure to meet performance criteria (Morris et al. 2001:711). As Zhao considers in more depth in Chapter 7, there have been related reforms to the hukou and dang’an systems to make labour markets more flexible. Since the late 1990s, unemployment has become a major problem in China, with huge numbers of workers being laid off from SOEs. The xiagang (lay-off) reforms were first experimented with in 1994 and were officially launched in 1997 with the intention of resolving the problem of inefficiency in the state sector by furloughing a quarter of its workers within four years (1997–2001) (Appleton et al. 2002). Between 1998 and 2002 there were 26 million workers laid off from SOEs (Armitage 2003, Solinger 2003). This large-scale shedding of labour has become a major socio-economic problem given that studies have found that those workers who have borne the brunt of the redundancies are the least able to find alternative work. This situation has the potential to create a ‘lumpenproletariat’ with feelings of betrayal (Morris et al. 2001). For example, using Institutional challenges for China’s business 5 household survey data for 1999/2000, Appleton et al. (2002) found that the risk of retrenchment was highest for the most vulnerable in society—namely women, the less educated, the low-skilled and the middle-aged, and that the duration of unemployment was longest for those in poor health, the less educated and women with children. The problem of redundancies has been exacerbated by China’s integration into the global economy, as the state-owned sector has been confronted with increasing levels of competition from the time of China’s accession to the WTO. Over the last two decades the ‘Gini coefficient’, measuring income inequality, has gone up from around 0.20 in the Maoist days to over 0.45 in the post-Deng era, more in line with other Asian economies. In Chapter 8, Grace Lee and Malcolm Warner argue that unemployment, hand in hand with poverty, now poses a serious threat to both social stability and the rule of the Chinese Communist Party, and that this demands an urgent human resources policy response. This concern is reflected in widespread documentation of worker unrest, with labour protest an everyday event in China’s cities (Morris et al. 2001, Solinger 2003). In their chapter Lee and Warner first examine the issues of employment and unemployment in China, explaining that the low official rate of joblessness of around 4 per cent, is in reality double that figure (possibly, indeed, even more), then move on to explain the institutional changes that brought the problem about, using Shanghai as a case study to explore the policy responses. However, although they find that the labour programme in Shanghai may have been relatively successful at first, they conclude by arguing that this does not necessarily mean that it would also succeed if implemented nationwide; its success in Shanghai, they suggest, is due primarily to the particularly rapid growth of the local economy there. 1.4 Section three: social welfare reform Prior to the introduction of market reforms, China’s social security system was predominantly a danwei-based (work-unit-based), defined-benefit, ‘pay-as-you-go’ type, primarily restricted to the public sector and confined to urban areas. For those who qualified, coverage was comprehensive. This policy included: old age care; health care; insurance for injury, disability or death irrespective of whether they were work-related; maternity benefits; and funeral subsidies (see Dong and Ye 2003 for an overview). However, by the mid-1980s it was clear that social security was lagging behind economic reform. The main problem was that that the danwei-based welfare system undermined the competitiveness of SOEs because it imposed a significant financial burden on the enterprise. The strategy now is to offload more of the welfare costs, either onto the individual or the community, or both. In response to the increasing financial pressure on SOEs, commencing with the ‘Decision of the Chinese Communist Party Central Committee on the Reform of the Economic System’ in October 1984, the state has adopted a series of social welfare reforms nationally. A critical feature of the ‘Decision’ was the requirement that enterprises practise independent accounting and assume responsibilities for their own profits and losses, therefore breaking the traditional tie between government and workbased social security (Dong and Ye 2003). Subsequent reforms have centred on the implementation of a number of social insurance programmes designed to cover the major China’s business reforms 6 risks confronting individuals working in both public and private sectors in a market economy (Saunders and Shang 2001, Zhu 2002, Whiteford 2003). The new social insurance regime is financed by individuals, enterprises and government. It has two major objectives (Nyland et al. 2004). One is to relieve enterprises in the public sector of the full responsibility for welfare provision and ensure that the burden is shouldered fairly between the major stakeholders. The other is to have the same social security system established in the private sector to protect employees and to curtail the prevalence of freeriding. Currently, all firms are required to pay a prescribed amount of social insurance. The national regulations mandate that employers must contribute 20 per cent of the wage bill for pension insurance, although in practice the amount varies between provinces from 15 per cent to 30 per cent. Employers are also required to contribute 6 per cent of payroll for health insurance (although this varies in different areas; in Shanghai, for example, it is 12 per cent), 2 per cent of payroll for unemployment insurance and 1 per cent of payroll each for industrial injury and maternity insurance (Whiteford 2003). Employees contribute 5 per cent of payroll for pension insurance, 2 per cent of payroll for health insurance and 1 per cent of payroll for unemployment insurance (Zhu 2002). In Chapter 9 Cherrie Zhu, Chris Nyland and Brian Cooper extend existing perception research for China by examining the diversity of employees’ views on social protection reform that prevail across firms with differing ownership forms and occupations. This is an interesting exercise because, as they point out, existing research on perceptions of social welfare coverage in China has tended to concentrate on views among workers in SOEs at a time when the Chinese government is committed to policies that are reducing the number and relative significance of SOEs while extending coverage in other ownership forms. Therefore, extant studies that focus on perceptions in SOEs are likely to tell only part of the story. The chapter suggests that ownership form has a significant impact on employee perception of social protection reform, with employees in private enterprises having a more positive attitude towards personal risk management, labour mobility and the role of trade unions, and a greater sense of security and satisfaction with social insurance policies than employees in either foreign-invested firms or SOEs. One notable demographic problem in China is the rapid increase in the dependency ratio in recent times. In 1978, China’s old-age dependency ratio (number of pensioners to number of active contributors) was 1:30. This figure changed to 1:5.4 in 1989 and 1:3.5 in 2001 and is projected to be 1:1.69 in 2050 (Zhu 2002:42). Peter Saunders and Lujun Sun tackle this issue through examining pension reform in the context of a broader study of income support for the aged in Chapter 10. In contrast to most recent studies of pension reform in China, Saunders and Sun emphasize the importance of looking beyond pensions (and by implication, beyond pension reform) in understanding the factors that contribute to wellbeing in old age and the opportunities to influence it. Specifically, the chapter reports some results from a project that is examining the living standards of the aged in China in 2000 and how these have changed in the time since 1992, a period characterized by rapid and expensive reform of policies affecting the aged. Saunders and Sun investigate what effect these policies have had on the economic status of older people, the role played by the family and how attitudes have changed towards these issues. Saunders and Sun consider the role of pensions in providing income support for the aged, how this has changed, and its consequences for support provided by family. Institutional challenges for China’s business 7 Over the last decade China has emerged as the ‘world’s factory floor’, and occupational health and safety (OHS) laws, regulations and implementing agencies are struggling to keep up with China’s rapid economic growth (Brown and O’Rourke 2003:299). In Chapter 11 Chris Nyland, Russell Smyth and Cherrie Zhu examine the interplay between fast rates of economic growth, globalization and recent developments with OHS and industrial injury insurance legislation. Nyland, Smyth and Zhu argue that marketization and globalization have had a dual effect on OHS. On the one hand, providing an effective social protection mechanism is a precondition for further marketization and opening up to the outside world. On the other hand, providing the institutional mechanisms to protect workers’ occupational health and safety is an integral part of protecting workers from the vicissitudes of globalization. Based on interviews with key stakeholders in Beijing, the chapter examines how China has managed this tension and discusses the extent to which the institutional and legal framework that it has put in place is effective in protecting workers’ health and safety in the face of increasing levels of global competition. 1.5 Section four: implications of China’s accession to the WTO and the rapid growth of the private sector The Chinese government has consistently argued that its decision to join the WTO is a ‘win-win’ deal for both sides (see for example People’s Daily 18 January 2000, Economic Daily 21 January 2000). Others are more sceptical. For instance, Nolan (2002) expresses grave doubts about the ability of China’s large firms to compete on a global level playing field. Warner (2002, 2003a) and Lee and Warner in this volume emphasize that China’s entry into the WTO, by speeding up the structural adjustment of industries, will put serious strain on the management of human resources and will increase employment pressures in the coming years as globalization increases. For this reason, as in any major economic restructuring process, China’s entry into the WTO is unlikely to be ‘Pareto-improving’ (in the sense that some are made better off, while no-one is made worse off). Instead, there are bound to be both ‘winners’ and ‘losers’ from the process, as suggested earlier. The real issue, therefore, is whether or not the potential gains outweigh the losses. Interest in estimating the potential effects of China joining the WTO on both the Chinese and world economies has led to a substantial and still growing computable general equilibrium (CGE) literature. The benefits from reductions in tariff and non-tariff barriers as estimated in the existing CGE literature are generally low, in the range 0.08 to 2.20 per cent of real GDP (see Gilbert and Wahl 2002 for an overview of existing studies). Yinhua Mai contributes to this literature in her examination of the effect of tariff and non-tariff barrier reductions in China in a CGE framework in Chapter 12. In contrast to the existing CGE literature, Mai takes account of the effect of endogenous productivity growth, which has been considered to be one possible reason for previous low estimates. She concludes that China’s gain in real GDP from the tariff reductions is much higher with the endogenous productivity growth than without it. With endogenous productivity growth, China’s real GDP is likely to be 2 per cent higher than the baseline by 2006, while without endogenous productivity growth China’s real GDP is likely to be 1 per cent China’s business reforms 8 higher than the baseline by 2006. Mai also draws some interesting conclusions about the regional effects of China joining the WTO, with the coastal cities/provinces such as Tianjin, Shanghai, Jiangsu, Zhejiang, Guangdong, and Fujian (which have high levels of export-oriented light manufacturing industries) expected to benefit most from tariff reductions. The private sector in China has experienced spectacular growth over the last few years (see Krug 2004). Between 1996 and 2001, private enterprises in China grew at an average annual rate of about 24 per cent. The final chapter, by Marika Vicziany and Guibin Zhang, contains a case study of the Hope Group, which is a particularly interesting example of private entrepreneurship because it has its origins in western China where the private sector is far smaller and less dynamic than in the more prosperous (and more often studied) coastal provinces. One of the reasons for this, as Tam discusses in Chapter 5 and elsewhere (Tam 2004), is the lack of access to capital. In spite of this obstacle the Hope Group has emerged as one of the most successful private companies in China and, according to Forbes magazine, the Liu brothers who founded it are the richest men in China today. 1.6 Conclusion We can conclude from the above discussion that the quest for economic growth and modernization through marketization and globalization has set the scene for a wide range of structural and infrastructural changes in the Chinese economy. The transformation of the economic system and the growing involvement of China in the international economy since the Open Door policy was launched in 1978 has resulted in the abandonment of structures of the old command economy and the building of new institutions created either from the grass roots or in a top-down fashion, reflecting China’s gradual and experimental approach to reform and development. China today is dramatically different from what it was when the Open Door policy began, let alone in Mao’s times. The contributions to this volume exemplify this theme in their respective ways but all reveal the breadth as well as the depth of change that has taken place. They have shown that on the whole China has dealt with the challenges in pragmatic and effective ways in creating a more vibrant and functioning business environment that contains sectors capable of competing in the global market, although there are clearly areas that require more fundamental changes. In many ways and for a variety of reasons, the Chinese government has tried to keep its changes ostensibly ‘Chinese’ (see Warner 2003a). Similarly to the development experience of other countries, it is clear that adaptation to the wider processes of globalization may often have a distinctly ‘national’ flavour. The transition to a market economy and a competitive society may well be mitigated by China’s historical and cultural incubus. However, a determination to keep control of the extension of market forces that may ultimately undermine the domination of the Party and state apparatus has also played a critical role in shaping the country’s economic and societal transformation in recent years. The last decade has nonetheless seen an even bolder foray into the world economy and greater political institutionalization, as well as further steps to ‘civility’ and ‘legality’ Institutional challenges for China’s business 9 (Dittmer 2003), all of which suggest that outgoing President Jiang Zemin’s political legacy, intertwined with ex-Premier Zhu Rongji’s pragmatic economic steering, was in fact more important than most observers would initially have expected. The next ‘Fourth’ generation of leadership has a tricky balancing act to perform. Already President Hu Jintao and Premier Wen Jiabao have, since their elevation to high office in late 2002, indicated their willingness to carry the torch of reform one pace further, but at the same time shown their compassion towards the ‘poor’ and the ‘laid off’. The message is clearly that ‘winners’ must support ‘losers’, if political stability and social cohesion in contemporary China are to be maintained. China’s business reforms 10 core members of the national team (XGTGZ 1999:325–333). While these 512 firms accounted for just 1 per cent of all SOEs, they were responsible for 55 per cent of assets, 60 per cent of sales and 80 per cent of taxes of the state industrial sector (CDBW, 14 January 1998, cited in Sutherland 2001). Supporting the establishment of the 120 enterprise groups and 512 key large and medium-sized enterprises, in 1994 the government began experimenting with the introduction of a ‘modern enterprise system’ in 100 large and medium enterprises (Smyth 1998). Of the 100 enterprises, 28 were classified as super-large and 67 as large and medium-sized enterprises. Together the 100 enterprises employed 1.5 million people and most were members of large enterprise groups in their own right (Sutherland 2001). The retention of a sizeable and expanding sector of LEs under state control indicates that the state has not reoriented itself to embrace the orthodox free market model. It denotes instead a primarily developmental concern: that the state is to retain control over the commanding heights of the economy and thereby to direct the path of overall development, amid the increasing integration of the country into the world market. This is in the spirit of the East Asian, or South Korean-Japanese model of late industrialization (Amsden 1989, Wade 1990, Burkett and Hart-Landsberg 2000). It is also in this spirit that the Chinese state has adopted a policy of promoting the development of Korean- Japanese-type business conglomerates. Paradoxically, rather than being deterred by the outbreak of the East Asian crisis, it was precisely in the years 1998–2000 that the policy made considerable headway in promoting enterprise groups. As can be seen from Table 2.3, which gives data on relative value-added per firm (that is the evolution of firm scale), there was a trend of relative decline of LEs until 1998 because of the market reform. In the subsequent years, though, the trend was reversed: the average scale of LEs relative to the industrial total increased from 290 times in 1998 to 332 times in 2001. The late industrialization perspective suggests that there is considerable precedent for building large firms and diversified business groups, based on the experience of other late industrializing countries (Amsden and Hikino 1994). Amsden (1989, 1992) stresses that the development path of conglomerates in late industrializing countries has been different from that in industrialized countries. Large firms in industrialized countries first Table 2.3 Relative per enterprise value-added, 1985–2001 Formal/Total SOEs/Total SOEs+/Total Large/Total 1985 13 49 669 1990 15 61 664 1995 9 28 342 1998 28 41 290 1999 30 45 302 2000 32 53 322 2001 33 62 332 Sources: Zhongguo Gongye Jingji Tongji Nianjian (China Industrial Economics Statist ical Industrial restructuring and corporate governance 17 Yearbook), Zhongguo Tongji Nianjian (China Statistical Yearbook), and Zhongguo Tongji Zhaiyao (China Statistical Abstract), various years; and Renmin Ribao (People’s Daily), 2 December 2002. specialized in producing a narrow product line based on core competences and then diversified into related industries. This was possible because large industrial enterprises that developed in Europe and the USA achieved Schumpeterian organizational and technological breakthroughs, which created international oligopolies. However, as its definition suggests, late industrialization is a process devoid of innovation (Amsden 1992). Hence, in contrast to firms in industrialized countries, firms in late industrializing countries have been forced to import and adapt foreign technologies and depend on learning through doing to compensate for the absence of core innovation. A common criticism of the zhuada process is that enterprises have been forced together via administrative mergers and, as a result, lack specific business strengths. For example, Shieh (1999:54) states: ‘There have been a number of reports that government authorities have pressured successful conglomerates to acquire loss-making enterprises— raising concerns that conglomerates are, in some cases, being formed on the basis of political considerations rather than economic ones.’ However, it can equally be argued that these sorts of concerns misconstrue the real economic rationale for merging big business groups with smaller loss-making firms in transitional economies, which is precisely to foster business strengths. Nolan and Wang (1999:190) observe: Merger can be an especially powerful process of advancing business capabilities in a transitional economy, since business and technical skills are not so widely available as in an advanced economy. The merger process led by capable firms with advanced technological and management skills can have a powerful positive externality effect, spreading business capability more rapidly than would be the case in the absence of merger. Moreover, the pressure for mergers is reinforced in a poor transitional economy such as China. [In China there are] especially large incentives for merger that are consequent upon the underdeveloped state of market institutions, which inhibits the capacity to obtain needed inputs easily and reliably through contracts mediated by the market mechanism. This last point has been stressed more generally by Khanna and Palepu (1997), who emphasize the knowledge-augmenting function of diversified business groups in overcoming institutional deficiencies in developing countries. Khanna and Palepu (1997) argue that business groups add value through diversification because they are better able to imitate the functions of institutions in advanced capitalist economies. Thus, while there has been a shift to more focused strategies in recent times in advanced capitalist economies, it does not follow that focused strategies will give the best results in emerging markets given institutional voids. Khanna and Palepu (1997:51) point out: [Groups] should not break up simply because their competitors are focused foreign companies from advanced economies. Western companies have access to advanced technology, cheap financing and sophisticated China’s business reforms 18 managerial know-how. In the absence of institutions providing these and other functions in emerging markets, diversification may be the best way to match-up with the competition. 2.3.2 Enterprise-level reform The gradual shift in state orientation from socialist commitments to developmental concerns is even more clearly evident in the evolution of China’s enterprise-level systemic reform. This evolution can be divided into four phases, which are well documented in the literature (see Choe and Yin 2000, Groves et al. 1994, Hay et al. 1994, Lo 1997 chapter 4, Yao 1997). The four stages of enterprise reform were the profit retention reform during 1979–83, the tax-for-profit reform during 1983–86, the adoption of the contract management system during 1987–92, and the corporatization of SOEs after 1992. This represents a gradual transition towards the establishment of a kind of institutional framework where SOEs and, to a lesser extent, collectively-owned enterprises, while institutionalizing their own interests, maintained close relationships with state authorities at various levels. The close state-enterprise relationships, though, were in no sense intended to preserve the socialist character of the enterprise system. In the first phase of reform, in the profit retention reforms from 1979 to 1983 enterprises began to be allowed to retain part of their profits at their own disposal, rather than handing in all profits to the state authorities. They were also granted autonomy in decision-making at the margin (in other words autonomy after fulfilling state planning targets). This represented a first step of departure from the central planning system where enterprises operated under state mandatory planning and were in nature just like divisions of the state administrative apparatus. The second phase was the tax-for-profit reform from 1983 to 1986. Its objective was to gradually substitute a uniform system of income taxes for the case-by-case bargaining regime of profit remittance, thereby leaving all enterprises to be responsible for their own profits and losses and to engage on an equal footing with each other in market competition. This reform was in pursuit of the separation of the government and enterprises, and was clearly inspired by the standard Walrasian-type notion of the ‘pure’ market. The problem, however, was that the state was not only the government (which collected taxes) but also the owner (which collected ‘dividends’ that were bound to vary across enterprises). Theoretically, it is seldom possible for the state to have an arm’slength relationship with SOEs. In practice, the state thus had to introduce an adjustment tax, the rate of which was negotiable for individual enterprises, in order to even out differences in profit-making across enterprises due to factors that were outside their control. The case-by-case bargaining regime was thus resumed. The third phase of reform was dominated by the adoption of the contract management system. This system abandoned the pursuit of a standardized, generally applicable rate of state-enterprise division over enterprise profits. Instead, its aim was to fix the base of tax- and-profit remittance and to allow enterprises to keep all the above-base profits—that is, it required enterprises to ensure steady increases in tax-and-profit remittance over the precontract amount which was taken as the base. In essence, this reform was in pursuit of the separation of ownership and control. While recognizing that the state as the owner needs to be involved in case-by-case bargaining over enterprise remittance (‘dividends’), the Industrial restructuring and corporate governance 19 reform sought to make the bargaining formal rather than ad hoc. And the bargaining was mainly to be done between the state and other outside interested parties through a unified contract-issuing committee, on the one hand, and the enterprise management which represented all the inside members, on the other. In practice, though, the inevitable asymmetry in information between the management and the owner tended to result in soft-budgeted behaviour. There was serious asymmetry between responsibility for profits and responsibility for losses. As a result, enterprises tended to over-expand in good times, and to ask for re-negotiation over profit remittance in bad times. The state had serious difficulties in checking such behaviour, because, ultimately, it had almost unlimited responsibility for the survival of the enterprises. This systemic feature distinguished Chinese SOEs under the contract management system from capitalist corporations that operate under separation of ownership and control. The fourth phase of reform was the corporatization of SOEs, which was initiated after 1992 with the aim of addressing this problem. It was implemented in order to separate socialist ownership, broadly defined to include the state’s responsibility for the survival of enterprises, from the state-owner’s property rights in enterprises. By transforming SOEs into different kinds of limited liability companies or shareholding companies, the state would have limited responsibility (up to the actual capital it invests) for enterprises—and the latter would have to be responsible for their own profits and losses, up to the point of bankruptcy. In terms of control, the state would reserve the power over the selection of the top management of enterprises and over their strategic decisionmaking. Enterprises would receive investment from the state (or, more precisely, state authorities of different levels and localities) and other legal entities, and the state would enjoy proportional returns from enterprise profits. Thus, after almost two decades of evolution, the Chinese authorities have a vision for the country’s enterprise system that appears to be akin to state-owned firms in capitalist economies. At the heart of the evolution described above is the changing relationship between the state and inside members of enterprises (that is workers), along with other main stakeholders such as local communities, the banks, and related business partners. Clearly the difficult process of negotiation over tax-and-profit remittance is no more than a bargaining over the distribution and redistribution of enterprise surplus between the two sides. More fundamentally, the unlimited responsibility of the state for enterprise survival is a reflection of the implicit contract between the state and workers, where the former was obliged to guarantee job security and a certain level of welfare provision for the latter. The corporatization of SOEs after 1992, by imposing a limit on state-owner responsibility for enterprises and enterprise responsibility for their workers, amounts to a breakdown of the contract. In this respect the state-sponsored downsizing drive in 1994– 97 appears to be a necessary condition for the state to carry out the corporatization of SOEs. However, whereas the central government’s stated policy was to transform most small and medium-scale SOEs into shareholding co-operatives, local authorities at different levels simply seized the opportunity to sell off the assets of enterprises and lay off workers—thus passing liabilities onto the centre. The corporatization of SOEs is not only about distribution. It has far-reaching ramifications for economic development as well. Up until the mid-1990s, the process of enterprise reform was characterized by a series of compromises among the main stakeholders including the state. As a result, the governance structure tended to be China’s business reforms 20 characterized by a complex web of checks and balances among these stakeholders, each having some degree of long-term commitment with the enterprise. This was particularly true for the workers, who had a strong collective voice in influencing the decisions of enterprises over surplus distribution as well as their bargaining positions vis-à-vis outside interested parties. It also appeared to be true for the banks, which, being the main source of external financing for industrial enterprises, continued to provide credit to enterprises despite the secular decline in industrial profitability. On the whole, the governance structure of industrial enterprises up until the mid-1990s could be characterized as comprising a system of rigid institutions—the employment relationship, the finance-industry relationship, the state-enterprise relationship, and so on—with a systemic focus on long-term orientation. What distinguished this system from the pre-reform system was the formation and consolidation of the distinctive interests of enterprises, that is of the inside members as a group, through the reform. What distinguished the system from that of a typical capitalist corporation was the indicated implicit contract between the state-owner and the inside members, and hence the state’s responsibility for enterprise survival. Finally, what distinguished this Chinese system from the canonical East Asian enterprise was that, in the Chinese case, egalitarianism tended to be the norm both in intra- and inter-firm income distribution: intra-firm because of the strong collective voice of workers, and inter-firm because of the implicit contract between the state and virtually the entire urban population. 2.3.3 Comparative efficiency attributes of institutions The rigid institutions described above appear in nature antithetical to the principle of the market, and hence are prone to cause allocative inefficiency. Indeed, it is precisely these systemic features that have been held responsible for the alleged economic problems indicated in the beginning of this chapter. However, the reformed enterprise system should be assessed against broader criteria of economic development, rather than just allocative efficiency alone. In the literature on East Asian industrialization, there is a range of arguments which suggest that an enterprise system of stakeholder accountability does have its distinctive advantages vis-à-vis one of shareholder accountability (see for example Aoki 1986, 1990, 1995, 1996, Amsden 1991, Lo 1999a). This literature suggests that the long-term commitment of major stakeholders of enterprises offers potential for collective learning and intensive horizontal co-operation, leading to incremental and continuous innovations that could form an important source of enterprise competitiveness. In other words, the possible sacrifice of allocative efficiency under the long-term-oriented system could be compensated by gains in productive efficiency that would be less likely to materialize under a system of shareholder accountability. The contract responsibility system made management in large SOEs autonomous from the government. It established a close relationship between firm performance and the prosperity of the regional authorities to which handovers were made (Nolan and Wang 1999:186). As a result, local authorities gave managers a high degree of autonomy in return for meeting the contracted hand-overs (Nolan and Wang 1999, Nolan 2001). This in turn forged a strong link between profits on one hand and retained earnings and capacity expansion on the other (Jefferson and Rawski 1994:52–55). When management is left to focus on long-term growth and maintaining workers’ earnings, the government Industrial restructuring and corporate governance 21 becomes in effect an external stakeholder. This is exactly what occurred in industries such as pharmaceuticals and steel where large-scale SOEs are dominant. Writing about Capital Iron and Steel (Shougang) and Sanjiu in the early 1990s, Nolan and Yeung (2001:463) write that senior management ‘worked for growth within their industries, rather than short-term profit maximization’. This is similar to the stakeholder arrangements in the stylized Japanese firm. In the stylized Japanese firm most of the capital is reserved inside the firm to finance further expansion; hence, the dividend to profit ratio is much lower than in other advanced capitalist economies. Most of the large SOEs and enterprise groups in China also plough back a large proportion of retained earnings to finance further expansion and modernization. For example, in the mid-1990s in Shougang 60 per cent of all retained earnings were devoted to technological modernization and improving production capabilities (Steinfeld 1998:176). Reflecting this trend, using data on a panel of 22,000 large and medium enterprises, Jefferson et al. (2003) found that between 1994 and 1999 research and development activity in large firms became much more intensive, with the number of patents almost doubling. This is symbolic of more general similarities between the institutional structure of large SOEs and the stylized Japanese firm in terms of promoting incremental innovation. One criticism of the main bank system in Japan is that the close relationship between the main bank and the Japanese firm is allocative-inefficient. Because the risk bearing and control functions of the main bank are asymmetric, the Japanese firm benefits from some degree of soft budget constraint. However, an important offsetting feature of the traditional Japanese firm is that the major stakeholders—banks, shareholders and workers—make a long-term commitment to the firm. Aoki (1990) argues that this promotes productive efficiency through cushioning the firm from the full rigours of financial and labour markets. The planning time horizon of the banks also tends to be longer in the stylized Japanese firm, which is conducive to collective learning or continuous incremental technical change in productivity growth. This is similar to large SOEs, suggesting that a trade-off exists between allocative and productive efficiency (Lo 1997, 1999a). Lo (1997:116) states that ‘the rigidities characteristic of China’s reformed enterprises, particularly in terms of low labour mobility and close government ties, though detrimental to allocative efficiency, might have been conducive for productive efficiency’. Similar to Japan, enterprise groups in China have used a high proportion of retained profits to import technologies and adapt them to local conditions. During the Meiji era in Japan (1868–1912), an important reason for high growth was the cultivation of so-called Meiji technologies from existing methods, which were better suited to local climatic conditions than their imported western counterparts. After the Second World War Japanese enterprises also imported technologies from Europe and the United States, making improvements through incremental innovation. The practice of importing and reverse engineering second-hand foreign technologies to meet local conditions has been well documented in a number of large Chinese SOEs. For example, Nolan and Yeung (2001:446–447) and Steinfeld (1998:201–202) discuss how the giant Shougang made large purchases of low-price second-hand equipment from Europe and the United States (circa 1950) and then updated it with a four-stage investment process. These arguments can be generalized to suggest a trade-off between the concepts of stakeholder accountability and shareholder accountability. Here we provide a brief China’s business reforms 22 outline of the conceptual framework (a detailed exposition of the conceptual framework is provided in Smyth and Lo 2000 and Lo and Smyth 2004). The starting point is that there are three basic organizational forms: markets, hierarchies and networks. These organizational forms are founded on different concepts of the division of labour and have their own efficiency attributes. The two principles of the division of labour are the detailed division of labour and the social division of labour. The detailed division of labour refers to the hierarchical relationship between capital and labour within the firm. The social division of labour refers to the relationship between capitalists in competition with each other as independent entities (Fine 1982:41). The two concepts can also be considered in terms of their respective cognitive bases. For the detailed division of labour, productivity growth is generated by the separation of conception and execution within the confinement of a given cognitive framework. The concrete manifestation in modern economies is the transition from the craft system to the factory system, and this transition has often been interpreted as being driven by the expansion of the scale of exchange. This is reflected in Adam Smith’s (1776 [1976]) often quoted dictum that ‘the division of labour is limited by the extent of the market’. In contrast, the social division of labour, which is characterized by the integration of conception and execution and productivity growth, is generated by the process of exploration between deepening the given cognitive framework and selecting a new cognitive framework (see Piore 1992:165–167). The market and hierarchy organizational forms are based on the principle of detailed division of labour because of the central importance that both attach to the notion of information. The relevant efficiency attribute is allocative efficiency or economies of scale. The network organizational form is based on the principle of the social division of labour because it centres on the notion of knowledge which is generated through collective learning. The relevant efficiency attribute is productive efficiency or economies of scope. The creation of knowledge stems from self-motivated learning by participants in the production process and from active co-operation between them. The concepts of reciprocity and social norms which underpin networks have been suggested as being responsible for re-integrating the social division of labour (Piore 1992). Both reciprocity and social norms required for facilitating collective learning are outgrowths of long-term relationships and are not reducible to individualistic rational choices. To sum up the preceding discussion, a corporate governance structure of stakeholder accountability, as evident in the stylized Japanese firm, is based on networks and exhibits the attribute of economies of scope founded on the principle of the social division of labour. Meanwhile, a structure of shareholder accountability, reflected in the stylized Anglo-American model of the firm, is based on either markets or hierarchies and exhibits the attribute of either allocative efficiency or economies of scale, both of which are founded on the detailed division of labour. The comparative efficiency of shareholder and stakeholder accountability depends, ultimately, on the appropriate match or otherwise between the organizational forms and the external, demand-side environment. Shareholder accountability is consistent with the situation where the degree of ex ante planning is zero. In this scenario the market is characterized by perfect competition and the external environment is highly unstable from the perspective of individual firms. Under such circumstances, the market is the appropriate institutional arrangement. Firms in perfect competition have a short-term orientation and have institutional arrangements Industrial restructuring and corporate governance 23 that are conducive to providing the highest degree of flexibility. This allows the firm to make a series of adjustments in response to rapid fluctuations in the external environment. When the external environment is unstable, such firms are comparatively efficient, and the main source of their competitiveness is allocative efficiency. Shareholder accountability is also consistent with the situation at the opposite end of the spectrum where the degree of planning is high and flexibility is not an important factor in accounting for the comparative efficiency of the firm. In this scenario hierarchies are the appropriate institutional mode. The focus of the firm is on ex ante and centralized planning, which has the advantage of maximizing the comparative efficiency of the detailed division of labour within the firm. The main source of competitiveness is economies of scale. Stakeholder accountability is consistent with the intermediate case where the external environment is continuously changing in a steady but not violent fashion. In this situation networks are the appropriate institutional mode. The focus of the firm is on decentralized collective learning, which has the advantage of generating continuous and incremental innovations both to adapt to and to govern the changes in the external environment. In these circumstances, the main source of competitiveness is economies of scope. From this theoretical reasoning, and based on the observations on performance indicated in the previous section, it is thus possible to make an overall assessment of the corporate governance of Chinese industry depicted above. In a nutshell, in the context of China’s specific pattern of economic development and systemic change, the governance structure of large-scale enterprises has appeared to be on balance conducive to the creation of comparative efficiency vis-à-vis the rest of Chinese industry. We conclude this section by stressing three features of the reforms, which are consistent with our argument. First, against the backdrop of the institutionalization of their distinctive interests, LEs have still continued to maintain close and long-term relationships with their stakeholders. This is unlike small and medium firms (SOEs or otherwise) which have now been mostly marketized. This point can be illustrated with reference to the extreme case of firms which have been listed on the stock market. While being the most marketized of all LEs, these firms have retained close and long-term relationships with their stakeholders (see ZGFB 2000, chapters 26 and 28). Second, market demand in most Chinese industries has been steadily expanding, although at different speeds in different periods, despite the widespread existence of excess capacity since the early 1990s, which has been caused by the lack of exit options for failed firms. Third, in an environment of expanding market demand cum excess capacity and hence acute competition, LEs have done better financially than small firms (Cheng and Lo 2002). The connection between relative performance and the characterized institutions rests on two observations. One is that although profitability indicators are much better for LEs, loss-making indicators are similar between firms of different scales. The other observation is that the profitability gap between LEs and other firms was much bigger in the boom periods of 1986–1988 and 1993–1997 than in the demand-stagnant period of 1998–2000. Both of these observations are consistent with LEs having more rigid institutional arrangements and, unlike small firms, not having an exit option. China’s business reforms 24 2.4 Future prospects and conclusions The exposition in the preceding section, while delineating the strength of the process of industrial restructuring and the evolution of corporate governance in Chinese SOEs, also clarifies their weakness. The comparative efficiency of the reformed enterprise system, as indicated, depends on its appropriate match or otherwise with the external demand-side environment. The implication is that the appropriate match that has been achieved so far over the reform era in China is inherently unstable, and the future prospects rest on the capability of enterprises in continuously adjusting their institutional arrangements in relation to the changing environment. Anything less than that could result in severe difficulty for enterprises, as was clearly evident in the developments in the second half of the 1990s. Prima facie, the outbreak of the East Asian financial and economic crisis was the immediate cause of the worsening demand conditions faced by Chinese industry, particularly for LEs—a main symptom being the fact that deflation began to occur in China from late 1997. However, it is worth noting that demand deficiency had already been very serious in the preceding years. The gradual erosion of the egalitarian pattern of income distribution under the market-oriented reform had undermined mass consumption in the domestic market. The enterprise downsizing drive in 1994–97, by causing mass unemployment and thereby the slowdown in the expansion of consumption, only exacerbated the situation. This resulted in a fundamental re-orientation of state economic policy from 1998 to 2000, from pursuing fast marketization to the adoption of a range of market-supplanting anti-crisis policies, which stabilized the trend of worsening demand deficiency. Central to this change in focus were Keynesian-type fiscal stimulus policies, welfare-state policies, measures for revitalizing SOEs and tighter regulations over external transactions. With these policies Chinese industrial enterprises, and LEs in particular, have since been able to substantially improve their financial performance. Looking forward to the future, one might speculate that the need for Chinese industrial enterprises to adjust their institutional arrangements will become even more pressing. Now that most small and medium-scale SOEs have been liquidated, and that the collectively-owned sector is in a state of stagnation, the pattern of income distribution is likely to become increasingly uneven. Mass consumption in the domestic market is thus likely to be undermined. Chinese industrial enterprises are also facing direct competition from multinational corporations following China’s accession to the World Trade Organisation in late 2001. The transition towards a largely market-based system, in short, implies that demand deficiency is likely to be a prevailing feature. In this context, a major source of hope for Chinese industrial enterprises is the possibility of opening up foreign markets as a supplementary source of demand. This is not all wishful thinking. There is ample evidence that, after two and a half decades of reform and rapid economic development, Chinese industrial enterprises have largely increased their international competitiveness in a wide range of industries. How well they will perform into the future will be an even more severe test for the comparative efficiency of their corporate governance structure. Industrial restructuring and corporate governance 25 3 Regional comparative analysis of China’s banking system Kym Brown and Michael Skully 3.1 Introduction China’s banking system is massive, providing some US$2.1 trillion of its domestic financial sector’s US$3.3 trillion at the end of 2002. Faced with the massive inefficiencies of the banking system that formally supported state-owned enterprises (SOEs), and a substantial informal banking sector that grew along with economic growth, the Chinese government had few options but to agree to more foreign participation by signing the World Trade Organisation (WTO) agreement on Trade in Services. Like other transitional and developed economies, China is in the process of reforming and liberalizing its banking sector from full state ownership. Inextricably connected with this banking reform are social and economic issues concerning SOEs, which had traditionally received funding from state-owned banks (SOBs), regardless of credit risk. Quandaries with such moves include the SOBs then employing fewer staff and requiring risk assessment of potential outcomes—a change in culture from past practices reliant on state direction and full employment for the people.1 Reform of the Chinese banking and financial system covers several areas. First, we review the bank restructuring literature for transitional economies. Claessens (1996) recommends that new entrants to the banking sector may help to invigorate the prior centrally planned system and that SOBs could be privatized. At the same time regulatory, legal and accounting standards need to be improved to support market-based systems, and compliance needs to be strengthened. Dziobek and Pazarbasioglu (1997) highlight an important policy decision that losses need to be suitably shared between the state, the banks and the public. A key indicator of progress is that a country publishes statistical data (see Jaffee and Levonian 2001). Based on Eastern European and Central Asian countries’ experiences, Zoli (2001) found that the fiscal cost of restructuring a system depended on the size of bad loans inherited from the centrally planned system and weaknesses in the restructuring policies. The usual pathway for transitional economies begins with the provision of entrepreneurial finance, including self-financing from friends and family, trade credit and micro finance from the government. Then, as a firm grows, it will be able to access bank finance. Finally capital markets develop, domestically and perhaps internationally (see Bonin and Wachtel 2003). Second, the foreign bank entry literature cites a number of advantages for their participation within an economy. These advantages include: the cost of finance for domestic firms; the fact that foreign banks will be more independent of the government; improvement of existing banks through the efficiency, technology and management skills CR3 and CR5, are in accordance with other economies.12 The interest margin is also comparable, although interest rates are controlled.13 The 2001 ROAE and ROAA appear good for China; however, the SOBs in particular had reportedly poor profitability levels in the late 1990s. The cost-to-income ratio is one measure of bank efficiency by measuring the costs incurred by a bank against the income level. China had a rate of 56.7 per cent in 2002, ranking sixth. Unfortunately as Chinese NPLs are not provisioned at their true levels, this figure may provide a misleading guide. Table 3.4 Banking sector, international banking: loans to deposits ratio (all expressed as percentages) Dec 1997 Dec 2002 Australia 182 142 China 110 35 Hong Kong 194 50 Indonesia 302 103 Japan 85 110 Malaysia 226 150 New Zealand 400 331 Philippines 143 108 Singapore 138 77 South Korea 178 162 Taiwan 67 34 Thailand 857 144 Source: Bank for International Settlements. Note External loans are liabilities and external deposits are assets to the salient country. Table 3.5 Commercial bank descriptive statistics (2001) Size Performance (%) Total Assets (bill USD) Equity (bill USD) CR3 (%) CR5 (%) Net Interest Margin ROAE ROAA Cost/ Income Australia 445.2 31.0 64.0 85.1 1.9 .81 −0.1 69.4 China 1,811.5 93.9 64.8 86.2 2.2 8.8 0.4 56.7 Hong 449.1 45.0 71.2 79.5 2.9 9.4 1.4 57.3 Regional comparative analysis of China’s banking 33 Kong Indonesia 82.7 5.38 58.9 74.3 4.2 11.5 1.1 55.4 Japan 5,088.0 204.3 34.4 48.9 1.9 −9.7 −0.4 69.7 Korea 477.9 22.4 46.9 64.7 2.4 16.9 0.6 48.4 Malaysia 131.8 11.2 43.9 57.0 2.9 9.5 1.0 43.6 Philippines 45.3 5.8 52.8 71.1 3.6 3.4 0.5 74.2 Singapore 158.1 18.3 80.5 98.2 2.0 12.3 1.0 44.6 Taiwan 501.0 37.4 28.7 42.3 2.3 1.6 0.2 53.5 Thailand 134.8 6.7 50.2 51.3 1.6 11.6 2.6 110.6 Source: Bankscope database. Up to this point the empirics have been good for China. On the negative side, a large proportion of bank loans are unlikely to be repaid. Table 3.6 clearly illustrates that the Chinese banking market is problematic, with NPLs estimated as up to 45 per cent with only a 20 per cent recovery rate. China ranks last in this regard. The lowest levels of risk and NPLs are found in Australia, Hong Kong and Singapore. The economic and industry risk levels for China are rated ‘very high’ because of the risks involved when liberalizing an economy from a transitional state. The central bank estimated NPLs for the SOBs at just 27 per cent in 2001 (see OECD 2002); independent assessments, however, were much higher. The low figure reported in 2001 was after the removal of billions of NPLs to the AMCs. Figures reported before the AMCs took over bad loans were also in line with the 25–30 per cent range, but obviously were much higher in reality. The regulator would like NPLs to reduce to 15 per cent by 2005. While this is a commendable goal, Chinese NPL figures are often reported as what bank officials would like rather than the actual position (Standard and Poors 2003c). Table 3.6 Banking sector risk and non-performing loans Economy Economic Risk Industry Risk Gross Problematic Assets (%) Estimated Peak NPLs end 1997– 1998 crisis (%) Estimated NPL end- 2003 (%) Estimated Recovery Rate on NPLs (%) Australia Low Moderately low 5–15 <1 <1 70 China Very high Very high 35–70 n.a. 44–45 20 Hong Kong Moderate Mod. low—mod. 10–20 7 5–6 50 Indonesia Very high Very high 35–70 75–80 15–17 15 China’s business reforms 34 Japan Mod. low Moderately high 15–30 9 12–13 30 Korea Moderate Moderately high 15–30 22 6–7 35 Malaysia Mod. high Moderately high 25–40 27 13–14 45 New Zealand Mod. low Mod. low 10–20 <1 <1 70 Philippines High High 25–40 30 30 25 Singapore Mod. low Mod. low—mod. 10–20 11 7–8 75 Taiwan Moderate Moderately high 15–30 18 10 40 Thailand High Mod. High—high 35–70 50 28–29 30 Source: Standard and Poors (2003a, 2003c). Notes Gross Problematic Assets represent the potential peak in the ratio of gross problematic assets as a percentage of domestic credit to the private sector and non-financial public enterprises during a potential cyclical downturn. Holz and Zhu (2002) believe that NPLs are due to firms’ poor compliance with accounting standards and avoidance of debt repayment. For instance 32,140 firms, including SOEs, managed to avoid paying 18.51 billion RMB to the SOBs in 2000 simply by changing their structure. The courts have not upheld creditors’ rights, thus frustrating recovery efforts. Another example is based on the period 1993 to 1995 when 1,520 enterprises were bankrupted with just a 9.2 per cent recovery rate. Local banking supervision practices can further explain country differences. Table 3.7 shows that the Chinese banking sector is quite restricted in other activities such as securities, insurance and real estate. With further reform this will probably change. Barth, Dopico, Nolle and Wilcox (2002) performed a large-scale worldwide study on bank supervisory practices. Banks were found to be increasingly able to undertake other activities to extend services and profitability. These activities were classified under securities, insurance and real estate.14 Many countries place restrictions on banks’ insurance and real estate activities to some extent (see Barth, Dopico, Nolle and Wilcox 2002); China is therefore not unique in that regard, but reportedly imposes higher levels of restrictions. Following from Table 3.7, which illustrates the tight restrictions of Chinese banks, an analysis of a sample of bank balance sheets (from the Bankscope database) can clearly indicate how the various banking markets differ in their use of debt securities and equities (see Table 3.8). Security investments (assets) by Chinese banks have fallen from US$4.1 billion in 1997 to just US$0.9 billion in 2001, ranking Chinese bank use of debt securities assets the lowest in the region. Nevertheless, Chinese banks have issued an increasing quantity of short-term money market instruments (liabilities) and reduced amounts of Regional comparative analysis of China’s banking 35 ‘other funding’, which in this case was mainly classified as ‘other bonds’ (not convertible bonds). Since the 1997/98 financial crisis banks in the region have increasingly been issuing domestic debt securities. Table 3.7 Banking powers across countries Economy Securities Activities Insurance Activities Real Estate Activities Index of Restrictiveness Australia Unrestricted Permitted Restricted 6 China Prohibited Restricted Prohibited 11 Indonesia Permitted Prohibited Prohibited 10 Japan Restricted Prohibited Restricted 10 South Korea Permitted Permitted Permitted 6 Malaysia Permitted Permitted Restricted 7 Philippines Unrestricted Permitted Permitted 5 Singapore Unrestricted Permitted Restricted 6 Taiwan Unrestricted Prohibited Prohibited 9 Thailand Permitted Permitted Permitted 6 Source: Barth, Dopico, Nolle and Wilcox (2002). Notes Unrestricted—the full range of activities can be conducted directly in the bank. Permitted—the full range of activities can be conducted, but some activities must be housed in affiliates of the bank rather than directly in the bank. Restricted—less than a full range of activities is permitted. Prohibited—banks are not permitted to engage in the activities. Securities activities include underwriting, dealing and brokerage services for securities and mutual funds. Insurance activities include underwriting and selling for all kinds of insurance, and acting as a principal or agent. Real estate services include investment, development and management. Index of Restrictiveness: range 0–12 (higher values indicate more restrictions) Table 3.8 Commercial banks’ securities and equities (billions of US dollars) Assets (Investments) Liabilities (Issued) Country No. of Banks in sample Total Loans Govt Securities Total Securities Equity Investments Total Money Market Fundinga Total Other Fundingb Australia 1997 22 269.2 −35.8 16.1 37.7 22.2 2001 21 312.6 −40.8 18.4 51.5 49.1 China 1997 28 728.1 0.07 4.1 −0.3 31.3 China’s business reforms 36 2001 25 1,016.1 0.7 0.9 −4.6 7.6 Hong Kong 1997 37 168.1 −14.4 8.5 19.4 3.1 2001 35 195.3 −65.2 19.3 15.4 2.8 Indonesia 1997 40 38.8 0.1 2.8 0.1 2.3 12.4 2001 43 19.1 37.4 42.7 0.1 1.1 8.7 Japan 1997 125 3,768.3 271.6 706.7 301.8 352.4 495.5 2001 118 3,108.6 491.7 982.5 236.4 325.9 319.0 Malaysia 1997 25 52.7 2.8 11.6 1.3 7.5 0.9 2001 26 85.4 6.9 17.6 2.9 6.7 1.2 Philippines 1997 26 24.9 0 1.4 0.4 5.0 0.03 2001 23 22.7 −1.1 0.4 3.7 0.1 Singapore 1997 10 54.9 0.2 1.2 2.4 0.5 0.8 2001 9 57.5 0.2 3.4 15.2 0.1 7.0 South Korea 1997 15 145.8 1.5 33.6 0.8 18.5 16.4 2001 15 286.8 2.1 103.5 6.8 32.0 26.0 Taiwan 1997 37 297.8 4.0 18.5 4.8 n.a. 5.0 2001 40 339.3 8.4 38.5 8.6 n.a. 7.7 Thailand 1997 14 98.0 2.8 7.1 1.0 0.2 6.3 2001 14 76.6 23.0 28.8 1.3 0.02 7.0 Source: Bankscope database. Notes a Total Money Market Funding includes certificates of deposit, commercial papers, debt securities and securities loaned. b Total Other Funding includes convertible bonds, mortgage bonds, hybrid capital and subordinated debt. China has explicit insurance for the SOBs in order to avoid massive bank runs and consequent liquidity problems or even bankruptcy for the government. Other domestic banks have implicit insurance, meaning that it is expected that the government would help repay depositor monies (they are not, however, officially obligated). According to Barth, Dopico, Nolle and Wilcox (2002), central bank supervisors are more restrictive on regulations. The structure of bank supervision has been found to have little effect on the performance of banks, however (Barth, Dopico, Nolle and Wilcox 2002). It is worth noting the low level of professional bank supervisors per bank in China at just 0.9 supervisors per bank in 2000 (see Table 3.9). Only Singapore has a lower level, with only 0.7 per bank; that is quite well justified, however, given the geographically small country size and its large number of foreign banks. Regional comparative analysis of China’s banking 37 China had the highest level of government ownership of banks in 1995 and 1970 in our sample of countries, based on the study by La Porta, Lopes-De-Silanes and Shleifer (2002). Interestingly, Taiwan was the only market with increasing levels of government ownership (see Table 3.10). Worldwide the trend is declining, and China also has experienced declining government ownership of banks.15 When the government has a larger level of bank ownership, politically directed loans are more likely to occur and so bank efficiency and development are generally lower (see Barth et al. 2002). Therefore a decline in government ownership is a signal of reform. Governments generally own banks when per capita income is low and property rights are poorly protected (see La Porta, Lopes-De-Silanes and Shleifer, 2002). Control of the banking system has enabled China’s socialist government to influence large industries within the economy. Table 3.9 Bank supervision Economy Licensing Authority No. of banks Total no. professional bank supervisors No. of bank supervisors per bank China People’s Bank of China 105 100 0.9 Indonesia Bank Indonesia 165 300 1.8 Japan The Financial Services Agency 294 350 1.1 South Korea Ministry of Finance & Economy 21 518 24.6 Malaysia Ministry of Finance 34 160 4.7 Philippines Bangko Sentral ng Pilipinas 51 359 7.0 Singapore Monetary Authority of Singapore 138 <100 0.7 Taiwan Bureau of Monetary Affairs, MOF 34 643 18.9 Thailand Ministry of Finance 13 503 38.6 Source: World Bank Database, Bank Regulation and Supervision (2001). Note These data are not current. The new regulator for China from March 2003 has been the China Banking Regulatory Commission. Table 3.10 Government ownership of top 10 banks Economy 1995 1970 GC10 Australia 12.3 20.8 20.9 China 99.4 100 100 Hong Kong 0 0 0 China’s business reforms 38 Indonesia 42.9 74.8 42.9 Japan 0 6.9 0 South Korea 25.4 56.6 41.56 Malaysia 9.9 20 9.93 Philippines 27.2 52.1 34.41 Singapore 13.5 12.8 34.35 Taiwan 76.5 50.4 100 Thailand 17.0 24.0 21.78 Source: La Porta, Lopes-De-Silanes and Shleifer (2002). Notes 1995: Share of government ownership in top 10 banks in 1995. 1970: Share of government ownership in top 10 banks in 1970. GC10: Sum of assets of all government owned banks divided by total assets of 10 largest banks in country in 1995. Foreign banks in China are currently primarily involved in foreign exchange activities, but also in trade financing, wholesale banking and corporate lending (see Table 3.11). As noted earlier foreign banks are quite restricted in China. As the reform process continues however, it is not expected that foreign banks will dominate (see Stephens 2003; OECD 2002). Foreign banks have managed to take over markets to a greater extent in Latin America and Eastern Europe than within Asia. Generally foreign banks are expected to have their niche markets where they offer services that supplement domestic bank services. Domestic banks in China already have a diverse branch network across the country and strong customer relations. Given the currently poor ability to recover NPLs, foreign banks are unlikely to vie for large-scale domestic lending (see Stephens 2003).16 Business executives within China report improvements in financial market sophistication, access to credit for their business, soundness of banks and access to bank loans (see Figure 3.3).17 The reforms are clearly moving sentiments forward regarding the banking and financial system development and reform. Chinese banks, along with most regional economies, have improved the perceived strength of their balance sheets since 1998 (see Figure 3.4). Given that 1998 was at the uncertain time of the Asian financial crisis, this improvement is not surprising. Table 3.11 Niche business activities of foreign banks in Asia Project Financing Trade Financing Foreign Exchange Wholesale Banking Investment/ Offshore Banking Retail Banking Corporate Lending China √ √* √ √ Hong Kong √ √* √ √ Regional comparative analysis of China’s banking 39 Indonesia √* √ √ Japan √ √* √ √ Malaysia √ √ √ √* √ Philippines √ √ √ √ √ Singapore √ √ √* √ √ √ South Korea √ √ √ Taiwan √ √ √ Thailand √ √ √* √ Source: OECD (2002, p. 255). Note * primary activity. Figure 3.3 World Economic Forum: financial market indicators for China Source: World Economic Forum (1998, 2003). Internet banking may also offer possible future cost-effective solutions in China. EBucks in South Africa, for instance, part of FirstRand Bank, has implemented a new online banking system involving the combination of Gemstone and Sun Microsystems products and was able to save one third on costs compared with traditional computing online systems. Claessens, Glaessner and Klingebiel (2002) note that if internet banking develops in emerging countries, then emphasis on development of bank supervision and guarantee over deposits is not so important except for local banks. This is because of the increasing use of foreign banks with home country regulators. Table 3.12 illustrates the use of online banking; data for China were not, however, available. Online banking is China’s business reforms 40 limited by online computer access. The uptake of the internet in China by 2003 was only 5.2 per cent of the whole population, but even this represents a massive client market. Figure 3.4 World Economic Forum: soundness of banks Source: World Economic Forum (1998, 2003). Table 3.12 Internet banking in Asia Banks Offering Online Services—2000 (%) Bank Customers Using Online Banking—2000 (%) Internet Population Penetration 2003 (%) Australia 90 4 63.3 China N/a N/a 5.2 Hong Kong 25 <2 67.0 Indonesia 0 0 1.8 Malaysia 10 <1 32.5 Philippines 15 <1 2.4 Singapore 95 5 54.6 South Korea 90 3 56.1 Taiwan 10 0 49.7 Thailand 0 0 7.6 Source: Claessens, Glaessner and Klingebiel (2002), Internet World Statistics. Regional comparative analysis of China’s banking 41 3.4 Conclusions China has the largest domestic banking system to GDP in the East Asian region even with its tight prudential restrictions on other activities permissible to banks. When combined with international borrowings, it is third only to the international financial centres of Hong Kong and Singapore. Nevertheless, China faces the massive task of tackling 45 per cent NPLs that are proving difficult to recover or sell. The Chinese banking market has the highest level of government ownership in the region, although reform may gradually reduce this. Unlike in other transitional states such as Russia, people still trust the banking system and maintain extremely high savings rates (over 38 per cent and quasi-money to GDP of 111 per cent in 2002). The true debt position is not known, as the figure when reported excludes many items such as the bad loans of the SOBs. Provided depositors do not change their views, Chinese banks are likely to continue with adequate liquidity because of the high savings rates. While the capital adequacy levels fall short of the required 8 per cent, the explicit deposit insurance for SOBs provides some security. Even as the formal financial system is developed and further regulated there is still the massive informal sector. Until the banks can offer lower cost finance to entrepreneurs, these informal financiers are likely to continue operating. The number of supervisors per bank needs to be increased, especially given the geographical size of the country. Other financing options need to be developed in China also, such as the equity and bond markets (see OECD 2002). In 2002 the government agreed to work with the IMF to improve the statistical reporting situation, which is a good signal of reform. Statistical data (such as NPLs) need to be reported regardless of positive or negative information content. Publishing negative financial information may help to force reform. NPLs should not be further removed from the SOBs by the AMCs, which will then keep bank management under media scrutiny (Woo 2002). There have been calls for further removal of NPLs from SOBs’ balance sheets; however, after the massive injection of funds to AMCs in 1998, high levels of NPLs persisted with some defaulters obtaining further finance (see Steinfeld 2001). Chinese bank managers are best left to deal with NPLs, though it is acknowledged that prior state-directed loans were not within their control. The consensus seems to be that China will survive the reform process and that foreign banks will develop their niche markets. Cynics do not believe that China will fully comply with WTO agreements given their massive problems. Yet with continued economic growth and NPLs held constant, it would be possible for China to outgrow the problem within nine years (see Holz and Zhu 2002). Standard and Poors (2003b) provide a less positive assessment, with NPL recovery estimated to take some 23 years. Notes 1 In fact, analysis and research of China’s financial system is stimulating because large structural issues need to be addressed, while in the future academics and economists can concentrate on micro issues such as the effects of changing interest rates by 1 per cent (see Perkins 2002). China’s business reforms 42 the Qingdao State-Owned Assets Bureau, which held 399,820,000 state shares or 44.42 per cent of the company’s total authorized share capital of 900,000,000 shares in 1993. Also non-tradable, were the 53,330,000 PRC legal person shares issued by Tsingtao, comprising 5.93 per cent of total share capital and owned primarily by state-controlled ‘legal persons’ such as the Bank of China Shandong Province Branch (3.25 per cent of total share equity from 1993 to 2000), and the People’s Construction Bank of China, Qingdao Branch (2.12 per cent for 1993–2000). There were 100,000,000 tradable A- shares of the company listed in Shanghai, and 346,850,000 tradable H-shares listed in Hong Kong. This ownership structure remained unchanged until 2001, when the total authorized share capital of the company was increased to 1,000,000,000 shares. An additional 100,000,000 ordinary A-shares were issued and listed in Shanghai, bringing the total number of PRC-listed tradable A-shares to 200,000,000. Most of the listed A-shares by this stage were held by securities investment funds and other institutional investors. On 21 October 2002, Tsingtao entered into a strategic alliance with Anheuser-Busch Companies Inc (A-B), the world’s largest brewery, and agreed to issue an aggregate of approximately USD182 million convertible bonds to A-B in three tranches. The conversion of the first tranche of convertible bonds into 60,000,000 additional new overseas-listed foreign-invested shares was completed by mid-2003, bringing the total share capital of the company to 1,060,000,000 shares. The 2002 strategic investment agreement also laid the groundwork for the conversion of the second tranche of convertible bonds into 134,000,000 additional new overseas-listed shares, and conversion of the third tranche of convertible bonds into 114,219,178 foreign-invested shares, both within seven years. Upon the conversion of all three tranches of convertible bonds into a total of 308,219,178 additional new overseas-listed shares, the registered capital of the company will rise to RMB 1,308,219,178 and the share structure of Tsingtao will be 1,308,219,178 ordinary shares, of which the Qingdao State-Owned Assets Administration Office will hold 399,820,000 shares, holders of domestic invested shares listed in the PRC will hold 200,000,000, legal-person A-share holders will own 53,330,000, and holders of overseaslisted foreign-invested shares will hold 655,069,178.4 In other words, state-controlled equity in the company will fall to 30.56 per cent, and foreign-controlled equity will rise to 50.07 per cent. If all goes well, Tsingtao Brewery will be transformed from a majority state-owned enterprise, to a majority foreign-owned company. And this in turn will help to transform the composition of that company’s management team, as will be discussed further below. 4.3 Protection for the rights and interests of minority shareholders The PRC Company Law is substantially different from Hong Kong Company Law, particularly in the area of shareholders’ protection and directors’ duties towards a company and its shareholders. Protection for minority shareholders is particularly notable for its absence. The lack of shareholder protection under PRC Company Law is compensated only to a limited extent by the introduction of Mandatory Provisions in the articles of association of all Chinese companies listed on the HKSX. These Mandatory Solving agency problems in a cross-border 49 Provisions resulted from joint efforts by the Hong Kong Securities Commission and the State Restructuring Commission of the PRC to facilitate the offer and listing of PRC companies overseas, and to regulate the behaviour of companies with shares listed overseas. In Hong Kong, the Mandatory Provisions are required under, and supplemented by, the HKSX Listing Rules. In the PRC they are enforced through, and supplemented by, the Special Regulations. 4.3.1 The shareholders’ meeting Chapter VII of the Mandatory Provisions deals with the rights and obligations of shareholders and the powers of the shareholders’ meeting. Two or more shareholders with combined title to 10 per cent or more of shares with voting rights at a shareholders’ meeting may require the board of directors to convene an interim shareholders’ meeting or a meeting of a specific category of shareholders (Article 72). Shareholders representing 5 per cent or more of the company’s shareholders with voting rights have the power to raise proposals for agenda inclusion and discussion at a shareholders’ meeting. The shareholders’ meeting is the company’s most powerful authority, and exercises its decision-making powers, including inter alia the power to elect and replace directors and supervisors of the company, and determine their remuneration.5 If the company wishes to expand, reduce or otherwise alter its share capital and/or share composition, or amend its articles of association, the approval of at least two-thirds of the shareholders who are present at an annual or interim meeting must first be obtained (Article 71). The board of directors also cannot dispose of major fixed assets of the company without the approval of the shareholders’ meeting (Article 89). Article 47 expressly restricts the rights and powers able to be exercised by a controlling shareholder. A controlling shareholder is defined broadly, and includes any shareholder who is in a position to: control the election of a majority of directors; exercise control over 30 per cent or more of the company’s voting rights, or over 30 per cent or more of the company’s issued shares; or to exercise actual control over the company in any other way. A controlling shareholder is prohibited from exercising per cent voting rights to make decisions on the following matters which harm the interests of all or some shareholders: • To relieve a director or supervisor from his/her responsibility on the basis that this is in the best interests of the company; • To approve that a director or supervisor, whether for his/her own interests or another’s interests, expropriate company property using any means including (but not limited to) any opportunity which is beneficial to the company; • To approve that a director or supervisor, whether for his/her own interests or another’s interests, divest other shareholders of individual rights and interests including (but not limited to) any distribution rights and voting rights, but not including where the matter is submitted to the shareholders’ meeting for adoption in accordance with the company’s articles of association that there be a reorganization of the company. China’s business reforms 50 4.3.2 Individual shareholder rights Hong Kong law permits minority shareholders to start a derivative action in the name of such shareholders in cases where directors have breached their fiduciary duties. The PRC Civil Procedure Law does not provide for any such procedure. The closest thing to a derivative action under PRC law is Article 111 of the Company Law, which gives shareholders the right to initiate proceedings in the People’s Court to restrain any resolution adopted by shareholders in the general meeting or meeting of the board of directors if the resolution is in breach of any law or infringes the lawful rights and interests of the shareholders. There is no attempt in the Company Law however to guard against or deal with oppression of minority shareholders by the majority shareholders of a listed firm. It was therefore left for the Hong Kong authorities, under the HKSX Listing Rules, to ensure that all listed H-share enterprises contain in their articles of association provisions which allow minority shareholders to commence action against defaulting directors, and which also accord minority protection similar to that available under Hong Kong law. Until recently, however, political hang-ups and the absence of a case-law system in China have presented major obstacles to such actions (Lawrence 2002a). But then in January 2002, the Supreme People’s Court in Beijing issued a circular effectively allowing stock investors to sue for compensation from fraudulent listed companies (Bei 2002b). The Questions Concerning the Acceptance of Civil Tort Dispute Cases Arising from Misrepresentation in the Securities Market Circular effectively lifted a four-month freeze on shareholder actions against companies found to have falsified information. More importantly, it was followed by the introduction of the necessary detailed trial guidelines to allow such actions to proceed. The Trial of Civil Damages Cases Arising from Misrepresentation in the Securities Market Several Provisions (the Provisions) came into effect on 1 February 2003. Containing 37 Articles, the Provisions not only solve important procedural questions, but also operate to significantly expand the scope of legal avenues available for aggrieved shareholders to pursue. Then in early November 2002, a 60 year-old Shanghai housewife became the first mainland stock investor to win a settlement from a mainland-listed company for false disclosure (Bei 2002b). A new set of ‘Guidelines for Corporate Governance of Listing Companies’ issued by the CSRC in early 2002 also places significance on shareholder rights. Chapter One of the Code deals specifically with shareholder rights, while Chapter Two deals with the particular position and behaviour of the controlling shareholder. Article 2 states that minority shareholders should have equal status with other shareholders, while Article 4 gives all shareholders the right to protect their interests through civil litigation and other legal action. Article 8 requires that companies make a genuine effort to use modern technologies in shareholders’ annual general meetings to improve shareholder participation. Also, Article 11 gives institutional investors more weight in the decisionmaking processes, including the nomination of directors. Solving agency problems in a cross-border 51 4.4 The introduction of independent directors in Chinese listed companies The board of directors is the critical link between ownership and corporate governance. This is the setting where governance takes place and some of the solutions to corporate governance problems can be sought. Thus, perhaps the most important implication of the dominant role of state ownership in China’s listed companies is the control the government can exercise over directorship and managerial appointments and incentives, and thereby over companies’ behaviour. According to the Company Law, a board of directors should consist of five to 19 directors. The Mandatory Provisions then establish the typical corporate structure whereby the board of directors is made directly accountable to the shareholders’ meeting, and under which directors, supervisors and managers owe specific fiduciary duties to the company and its owners. A certain degree of independence is required of all directors and supervisors in that they must avoid conflict-of-interest situations in the performance of their duties. Directors must make full disclosure and must not vote in respect of any board resolution in which they have a direct or indirect interest A director, supervisor, manager or other member of senior company personnel must not incite or be implicated in the doing by any related party of any act which the director, supervisor, manager or other senior management officer may not do. Related parties are defined broadly to include any family member, partner, trustee or controlled company of the director, supervisor, manager or member of senior personnel concerned. The Mandatory Provisions also specifically prohibit the company from giving any loan, or providing any guarantee to secure a loan made, to any director, supervisor or officer of the company. Share ownership and remuneration levels of directors, supervisors and senior management must be disclosed in every annual report In 2002, the business journal Asiamoney conducted a corporate governance poll of companies throughout the Asian region. Of 121 firms a total 197 companies polled responded to the survey; 12 of the respondents came from China. Given the care taken in designing the survey methodology and in selecting candidates for polling, the survey results can be taken as a fair representation of what counts as the ‘average’ Asian country, at least at a superficial level. Responses provided by the 12 Chinese firms that returned completed questionnaires indicate that in the average Chinese firm: • the board of directors has about 15 directors, of whom perhaps three or four are independent non-executives; • the full board formally meets for two or four meetings per year; and • most Chinese companies take votes at shareholder meetings through a poll (proportionate to the number of shares held) rather than through a show of hands (Asiamoney 2002:36). By far the greatest majority of directors of H-share companies are nominated by the controlling shareholder (the state), but this situation is beginning to change, especially for those companies such as Tsingtao Brewery which have invited a greater level of foreign involvement, and where nomination committees have been established. China’s business reforms 52 In the case of Tsingtao, when the company began trading on 15 July 1993, its board of directors comprised nine directors, of which six were executive directors. Of the three non-executive directors, two came from the state-controlled bank sector and had significant connections and experience in local branches of state-controlled banks.6 Following the 2003 conversion of the first tranche of convertible bonds issued to Anheuser-Busch into 60,000,000 overseas-listed shares, A-B became entitled to nominate a non-executive director and one supervisor to the board and supervisory committee of Tsingtao respectively. Then, at the Extraordinary General Meeting held in August 2003, shareholders were asked to amend the company’s articles of association to provide for a board of directors of 10 directors, of whom at least half would be external (that is nonexecutive) directors. At least one third of the board would be comprised of independent directors, with at least one of the independent directors to be an accounting professional. The supervisory committee would grow to eight supervisors, with the chairman of the supervisory committee to be elected by at least two thirds of the committee. Five of the supervisors would be shareholder representatives elected by shareholders in general meeting, and three supervisors would be elected to represent staff and workers of the company. There is little doubt that the role played by the state in the management of Tsingtao will be altered significantly as a result of these changes. Other companies are also making changes to the composition and operation of their boards to ensure compliance with the ‘Guideline Regarding Independent Directors in Listing Companies’ (the ‘Independent Director Guidelines’) issued by the CSRC in August 2001, and the ‘Guidelines for Corporate Governance of Listing Companies’ issued by the CSRC in early 2002. It is worth noting that the Independent Director Guidelines are at least as strict as, and in some cases stricter than, similar provisions contained in the ‘Code of Best Practice’ found in Appendix 14 of the Hong Kong Main- Board Listing Rules. The rest of this chapter outlines the newly reformed system for independent directors in H-share firms, and highlights some of the more important shortcomings of that system. The Independent Director Guidelines provide that by 30 June 2003 all listed companies must ensure that at least one third of the board of directors are independent directors (Article I(3)). Independent directors can be nominated by the board of directors, the supervisory board or any shareholder holding more than 1 per cent of shares issued by the company. All nominations must first be examined and approved by the CSRC. Independent directors serve the same length of term as the other directors of the company, but can be re-elected only once and cannot serve any consecutive term in excess of six years. In principle, an independent director may only concurrently hold the position of independent director in a maximum of five listed companies. If an independent director fails to attend a board meeting in person for three consecutive times, he or she may be removed from his or her position at the next shareholders’ meeting. The only other reason for which an independent director may be removed from office is where the independent director concerned fails to meet the ‘independence’ requirements imposed by the Guidelines, or becomes no longer qualified to hold the position of a director as stipulated in the Company Law. A person fails to meet the ‘independence’ requirements of the Guidelines if: Solving agency problems in a cross-border 53 • the person, or any of his or her relatives, holds a position in the listed company or its affiliates; • the person, or any of his or her relatives, holds more than 1 per cent of the shares of the listed company directly or indirectly, or shares in any of the 10 largest shareholders of the listed company; • the person, or any of his or her relatives, holds a position in any unit which holds more than 5 per cent of the shares of the listed company directly or indirectly, or any unit which ranks amongst the five largest shareholders of the listed company; • the person met any one of the three conditions mentioned above at any time during the 12 months immediately preceding the date of nomination or appointment as independent director; or • the person is not qualified to act as independent director for any other reason spelt out in the listed company’s articles of association or as determined by the CSRC (Article III). The Guidelines also operate to provide independent directors with the protection of guaranteed security of tenure for the entire period of the term for which they have been appointed. If an independent director resigns or is removed from office, the CSRC in China and the HKSX in Hong Kong must be notified (Article IV of the Guidelines; and in Appendix 14 of the Hong Kong Listing Rules see Articles 7 and 12). The role of the independent director is to safeguard the overall interests of the company with particular attention paid to protecting the rights and interests of minority shareholders (Article 1(2)). Independent directors are specifically vested by the Guidelines with special powers additional to those stipulated in the Company and other relevant laws and regulations. In particular, all major related party transactions must first be vetted by each independent director before being submitted to the board of directors for discussion.7 In addition, with the approval of at least half of all the independent directors, any independent director may: • independently engage the services of an external auditing or consulting organization; • propose to the board of directors the appointment or removal of an accounting firm engaged by the company; • propose the holding of an interim shareholders’ meeting; or • solicit proxies before the holding of a shareholders’ meeting. The independent directors of a listed company must provide an independent opinion on any of the following matters coming before the board of directors or the shareholders’ meeting: • nomination, appointment or replacement of any director or member of senior management; • remuneration for directors or senior management; • any existing or new loan borrowed from the listed company or other funds transfer made by the company’s shareholders, actual controllers or affiliated enterprises that exceeds RMB 3 million or 5 per cent of the company’s net assets as recently audited (including an opinion as to whether reasonable steps have been taken to recover the amount due from the debtor); China’s business reforms 54 • any proposal or event that the independent director considers to be detrimental to the interests of minority shareholders; or • any other matter as stipulated by the company’s articles of association. Finally, and importantly, listed companies must provide all necessary assistance and support, including financial assistance, for independent directors to properly and effectively perform all of their functions and duties (Article VII of the Guidelines; and in Appendix 14 of the Hong Kong Listing Rules see Article 9). By 2003, nearly all listed companies in Hong Kong had established compliance with the Appendix 14 Code of Best Practice, and most contain a statement to that effect in their latest Annual Report (Webb-site 2002). The main reason for such a high level of compliance is not only that the Code is relatively easy to comply with, but also that noncompliant companies are expressly required to justify their non-compliance under paragraph 34 of Appendix 16 of the Hong Kong Listing Rules. 4.4.1 Lack of a committee system on the boards of listed Chinese companies All listed companies are required by the Independent Director Guidelines to ensure that any subordinate committee established on the board of directors in accordance with the recently introduced Code of Good Governance must have independent directors making up at least one half of its membership. The Code of Good Corporate Governance establishes recommended, but not mandatory, guidelines for the establishment of a number of subordinate committees on the boards of all listed enterprises, such as a nomination committee, a remuneration committee, and/or an auditing committee. The Code of Best Practice contained in Appendix 14 of the Hong Kong Listing Rules provides, in Article 14, that listed company boards should establish audit committees to supervise the company’s financial reporting processes and internal financial controls. The committee should be appointed from amongst the non-executive directors and a majority of the non-executive directors should be independent Article 14 then refers its readers to the ‘Guide for the Formation of an Audit Committee’ published by the Hong Kong Society of Accountants in December 1997 for further guidance on the establishment of audit committees. Given the high degree of compliance with the Appendix 14 Code as mentioned above, most Hong Kong listed companies, including most H-share companies, have now established audit committees. Other committees, such as nomination and remuneration committees, have been introduced more slowly, but they are appearing. The Tsingtao Brewery board, for example, established three special committees in 2001—a nomination committee, an audit committee and a remuneration committee (Tsingtao 2001 Annual Report, at 29). By the end of 2002, these committees had been restructured to form a strategy and investment committee, an audit and finance committee and a human resource and corporate governance committee. As at the end of 2002, independent directors representing the majority assumed chairmanship in all but the strategy and investment committee (Tsingtao 2001 Annual Report, at 28–29). In regards to remuneration committees, Shi and Weisert (2003:10) have pointed out that ‘most listed companies in China lack an incentive mechanism that ties the management team’s performance to its compensation’. While the increasing presence of Solving agency problems in a cross-border 55 remuneration committees in listed Chinese firms may well help to promote the use of corporate compensation mechanisms that link executive remuneration packages to company performance, it will not be enough by itself. For example, the local Chinese market needs to develop a broader range of readily available financial instruments for companies to choose from in designing individual remuneration packages. Stock options, for example, which are commonly used in remuneration packages by Hong Kong companies, have only recently become legally available as a financial instrument in mainland China. 4.4.2 The role and status of supervisory committees in listed Chinese firms Although the new Independent Director Guidelines ensure that independent directors now exist on the boards of all listed Chinese companies, no similar requirement exists in relation to the supervisory committee, despite the important role which that committee plays in the management of the firm. Under the Company Law and the Mandatory Provisions, the role of the supervisory committee is to supervise the actions and decisions of directors and officers, and in particular to: • investigate the company’s financial affairs and check the financial and business reports, profit distribution plans and other financial documents submitted to the shareholders’ meeting and to commission accountants and/or auditors to assist in the verification of documents in respect of which doubts are raised; • supervise the actions of the company’s directors, managers and other senior management personnel during the performance of their duties, and to respond appropriately in respect of actions which are in violation of the law, regulations or the company’s articles of association; • represent the company in negotiations with directors or in initiating legal proceedings against a director; and • propose the convening of interim shareholders’ meetings as required (Article 108). Supervisors are required to attend meetings of the board of directors as non-voting delegates. Article 106 of the Mandatory Provisions attempts to ensure the independence of the supervisory committee and its members by prohibiting any director, manager or chief financial officer of the company from concurrently holding the position of supervisor. But directors or senior personnel of one company can, it would appear, hold a position as supervisor on the supervisory committee of any other enterprise, including any related enterprise. There is also a need to strengthen the role and powers of the supervisory committee itself. Under the current system, the supervisory committee in most listed companies is considerably weaker than the board of directors, and in particular typically has almost no decisive power to stop or correct any actions of directors or senior officers. Nearly always, the supervisory committee can only report to the shareholders’ general meeting, which may itself, as noted above, be controlled by one or two majority shareholders (Cai and Deng 2002). China’s business reforms 56 4.4.3 Lack of qualified manpower Another shortcoming of the independent director system in China is the fact that all too many independent directors simply do not fully understand their responsibilities or do not have the training or experience required to perform their functions effectively. In more developed markets, directors are more likely to be brought in on the basis of their professional qualifications and experience. Well qualified directors can be active advisors, and can effectively supervise the overall health of the company. In China, however Most corporate managers still aspire to a civil service rank, and are concerned about how their superiors in the political and administrative hierarchy assess their performance. This assessment may be quite arbitrary or subjective and be based on such indicators as profits, political correctness, and the discharge of social obligations. Furthermore, local governments may have incentives that are not aligned with the plans of companies that operate on a national or international scale. (World Bank 1997a) Recent corporate scandals in America and other developed markets show that even highly qualified and experienced directors do not always fulfil their duties or act honestly, but the lack of managerial expertise in China creates equally serious problems. A number of Chinese enterprises are solving the lack of local qualified personnel by turning elsewhere, and paying high salaries for top talent from other markets.8 But the lack of qualified personnel in China remains a problem, and it will take many years before China can provide the kind of homegrown talent it now needs.9 But steps are being taken to lay the ground for newly qualified younger professionals entering the Chinese corporate scene. Article I(3) of the Independent Director Guidelines now provides that at least one of the independent directors must be an accounting professional (that is, a person with senior professional title or certified public accountant). Article I(5) also ensures that independent directors and nominees for independent director positions must take part in the training organized by CSRC and its authorized institutions. And Article II provides that as well as having all of the ordinary qualifications required for all persons acting as directors of listed companies, persons acting in the position of independent director must also have a basic knowledge of the operation of listed companies and be familiar with the relevant laws and regulations. In addition, all independent directors must have no less than five years’ work experience in law, economics or some other professional area required by his or her performance of the duties of an independent director. These provisions reflect similar provisions in the US National Association of Securities Dealers requirements, which provide that independent directors should be able to understand the company’s financial statement and that the issuer should make sure that the auditing committee has at least one member with a professional background in financial accounting (Leung et al. 2002). Solving agency problems in a cross-border 57 4.4.4 The need for an independent company secretary profession in China The Hong Kong Institute of Company Secretaries has argued that the development of a designated and specified company secretary profession in China is vital to ensuring that all Chinese executives are able to fulfil their company-related responsibilities effectively. At present, ‘board secretaries’ in mainland China are expected to concern themselves primarily with providing secretarial support to and ‘serving’ the board of directors and its members. In contrast, company secretaries in more developed markets have a much broader role in the capacity of secretary for the entire company, not just its board. The title ‘board secretary’, rather than ‘company secretary’ as in Hong Kong, or ‘corporate secretary’ as in North America, also serves to imply a lesser status, and to downgrade the overall importance of the role they perform (Leung 2003:17). Enhancing their status would also encourage secretaries in China to develop practices such as performing unpaid, voluntary and non governmental-directed jobs in addition to fulfilling their corporate responsibilities—something that is now quite common in Hong Kong and elsewhere. The Hong Kong Institute of Company Secretaries has provided some assistance towards the establishment of a company secretary profession in mainland China, including the introduction of professional training courses for PRC board secretaries and senior management Most recently, a new Association of Board Secretaries of Listed Companies was established in Shanghai. But as the Hong Kong Institute of Company Secretaries has pointed out, the new Shanghai association was established under the direction and supervision of, and remains dependent upon, the securities authorities in Shanghai. In sharp contrast, the Institute of Company Secretaries in Hong Kong operates as an independent professional organization, and is neither controlled by, nor financially dependent on, the SAR government authorities (Leung 2003:17). Notes 1 Similar agreements also exist between the CSRC and the stock exchanges of New York, London and singapore 2 See also the Measures for the Administration of Disclosure of Shareholder Equity Changes of Listed Companies (CSRC, promulgated 28 September 2002, effective 1 December 2002). 3 The catalogue, which took effect on 1 April 2002, excludes foreign firms from taking large or controlling stakes in strategic industries such as military facilities, airlines and civil airport construction and airport operation firms (see Sito 2002, Bei 2002a and Baker 2002). 4 Circular (dated 4 July 2003) issued by the company to all holders of H-shares and received by the writer as a holder of such shares later the same month. See also Notice of Extraordinary General Meeting issued by Tsingtao Brewery Company and dated 26 June 2003. 5 See Article 49, Article 50 and Article 70. 6 Zhang Zhenduo was deputy manager of the Shandong Branch of the Bank of China, and Yu Fuzhong was General Manager of the Industrial and Commercial Bank of China, Qingdao 7 ‘Major related party transactions’ are defined as any transaction that the listed company intends to conclude with a related party the total value of which exceeds RMB 3 million or 5 per cent of the company’s net assets as recently audited. Independent Directors are specifically vested with the ability to engage the services of an intermediary agency to produce an independent financial China’s business reforms 58 • More broadly, foreign bank presence in emerging market financial systems is argued to contribute to an improved financial system infrastructure by encouraging higher standards in auditing, accounting and disclosure, credit risk underwriting and reserving, and supervision (Crystal et al. 2001). At the level of bank operation, the beneficial effects of foreign bank ownership can be gauged by the expected changes in the key factors that constitute a bank’s strength. Crystal et al.’s (2001) summary of what is termed the CAMEL Framework for assessing domestic bank strength in the event of foreign bank acquisition may be relevant here, and is presented in Table 5.1. Table 5.1 CAMEL analysis of bank strength Components of CAMEL Analysis Possible Implications of Foreign Ownership Capital Adequacy Compliance with regulatory standards; Adequacy given nature/level of risks, and future expansion plans; Quality of bank capital. Improved access to and increased diversification of bank capital, leading to stronger and more stable capital levels. Asset Quality Creditworthiness of bank loans and investments; Adequacy of credit policies and procedures; Adequacy of loan loss reserve policies and levels; Level of impaired assets to capital and reserves. Improved credit underwriting and administration leading to lower nonperforming loan levels and higher reserve coverage of NPLs. Management Fitness and experience levels; Adequacy of strategic and operating plans; Risk management and control environment; Succession planning. Secondment of management from head office, coupled with risk management and internal control practices closer to international norms, leading to better corporate governance. Earnings Quantity and quality; Diversification; Sensitivity to market risk. Wider variety of products and services, stronger corporate governance, and potentially lower funding costs, leading to higher and more stable bank earnings. Liquidity Adequacy of asset/liability management policies and procedures; Appropriate level of asset and liability liquidity; Diversification of funding sources; Contingent funding plans. Foreign bank access to parent bank liquidity and international funding markets, in combination with a higher credit standing of the parent and more sophisticated balance sheet management techniques, leading to better liquidity management. Note CAMEL framework consists of individual assessments of core aspects of a bank’s financial condition and performance: Capital Adequacy, Asset Quality, Management, Earnings and Liquidity. Foreign banks 65 Crystal et al.’s (2001) comparative study of foreign and domestic banks in the seven largest economies in South America (Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela) finds that foreign banks have consistently stronger average credit growth, take more aggressive action to deal with asset quality deterioration, and possess the capacity and willingness to sacrifice short-term profitability for longer-term soundness. The findings suggest that foreign ownership may have quite positive implications for financial sector stability, development, and efficiency. The effects given in Table 5.1 primarily refer to a complete or partial change in bank ownership. It may be argued that, a priori, most of these impacts will be strengthened in the case of the establishment of foreign bank branches because the positive effects of full ownership and control will be realized. In the context of China’s development this is particularly relevant as foreign banks have so far opted mainly for the creation of a branch as the market entry mode. From recent experience in countries where the domestic banking sector is under stress, the entry of foreign banks through mergers and acquisition activities has clearly worked to produce positive outcomes. There is now clear empirical evidence to show that, particularly among emerging economies, foreign bank entry has led to improvements in a country’s banking system efficiency (Roldos 2002). There is also some evidence to suggest that a greater foreign bank presence contributes to a more stable banking system and less volatility in the availability of credit (Dages et al. 2000; Clarke et al. 2002). Given the potential problems posed by the high level of NPLs, any policy action and regulatory initiative to encourage such activities in China will have similar benefits. Of no less importance and relevance for the development of China’s western region is the positive contributions that foreign bank presence will make to enhancing the attractiveness of the foreign investment environment. In a review of empirical evidence on the role of foreign banks in a large sample of economies, the following positive impacts are found (Poret 2001): • Based on a study of 21 transition economies, a clear correlation is found between foreign bank participation in a country and various key indicators of banking reform; • There is evidence that foreign bank entry at various times in Nordic countries, Hungary, Korea, and Mexico has helped countries recover faster from banking crises, partly through the broadening of the capital base of the country’s banking and financial sector; • The benefits from the transfer of financial knowhow and increased efficiency are extensive. For instance, after acquiring the Midland Bank in the United Kingdom, HSBC has successfully brought from Asia a cash-flow method of assessing lending to SMEs; and • Prudential standards and compliance have been upgraded. Foreign banks are already subject to Basel and other internationally accepted requirements and practices relating to capital adequacy, risk management and information disclosure. Their entry into the domestic market has tended to lift the performance of local banks in these important areas. In terms of creating an attractive environment for FDI, the benefits from the entry of foreign banks are not limited to the various static gains discussed above. There are also important dynamic benefits in the form of the evolution of a more efficient, internationally competitive financial sector that provide a basis for the country’s long- China’s business reforms 66 term economic development in a sustainable way. On the other hand there are also some commonly held beliefs in the possible negative impacts from foreign bank entry: • The limited ability of local banks to compete with the larger global banks and the consequent adverse impact on their performance; • Foreign banks concentrate only on the profitable high value-added end of the market, and leave the more risky customers to the less competitive local banks; and • Foreign bank entry introduces instability to the banking system because of the additional avenues for capital flight. However, some of these concerns are based on a notion of banks as having certain national strategic importance, and from the perspective of local banks that are usually bestowed with monopolistic profit opportunities from having a bank license as a scarce and administratively allocated resource. In any case, as the empirical evidence noted in the preceding paragraphs has demonstrated, foreign bank entry does not as a rule result in any of those feared negative outcomes. Furthermore, given that foreign banks in China only account for about 2 per cent of the market at present, and are not expected to exceed 15 per cent within the next fifteen years according to estimates by the Citibank Group, the feared market effect on domestic banks is unlikely to be systemically devastating for the sector although with foreign entry individual banks may suffer a decline in their share of a growing but more competitive market. 5.3.3 The insurance industry experience Indeed, the benefits from the competition of foreign life insurance companies in Shanghai in which the life insurance market has seen impressive growth amply demonstrate the positive role that market entry of foreign competitors can play in transforming and lifting the industry’s capacity and performance. The city is where most of the foreign insurance companies are initially allowed to start up joint ventures to sell insurance policies (except in the special case of the American company AIG which has been allowed to operate as a wholly foreign-owned company up to the present). Shanghai is the base for 8 of the 17 foreign life insurance companies in operation or about to set up business as of 2002, and 7 of the 11 foreign property insurance companies (Caijing 2002). However, on all counts the entry of foreign insurers has directly contributed to a growing and vibrant insurance market in Shanghai and China. Foreign entry did not decimate the Shanghai insurance market and has not resulted in any instability. On the contrary, the city’s insurance premium income has continued to grow at an average annual rate of over 30 per cent since the mid-1990s. The total profits of Shanghai’s Chinese and foreign-participated insurance companies accounted for 25 per cent of the total profits of the insurance industry of the country in 2003. There is no doubt that Chinese insurance companies have benefited from the presence of foreign entrants and there is much that local companies need to catch up (including business models, management, product development, marketing, financial control and claims administration, and investment systems). The less obvious but equally important contributions that foreign insurance companies make are to do with establishing benchmarks of professionalism, ethical standards, accountability, and transparency in the conduct of business and the behavior of insurance Foreign banks 67 agents in this emerging industry. Insurance products, whether life or property insurance policies, are a new and unknown commodity for the majority of the Chinese population. The entry of foreign companies with their experience and expertise, and the competitive pressure this exerts on Chinese companies, have helped create an awareness, acceptance and demand for insurance products among an increasing proportion of Chinese consumers. There is no doubt that the kinds of contributions that foreign insurance companies have made to the development of China’s insurance industry can similarly be repeated under a more liberal entry environment by foreign bank entry in the western region. Given the fact that the western region lacks most of the complementary economic fundamentals that provide an attractive FDI environment, there is no alternative but to create a financial infrastructure that should be one of the most market-friendly and efficient in the country in order to better facilitate FDI inflows and to gain a competitive advantage position in attracting foreign investment. 5.4 Foreign bank entry While the case for a stronger and more extensive presence of foreign banks in the western region can be established, it remains the decision of the foreign financial institutions themselves whether they are willing and able to conduct banking business at locations in the western region. Of the total number of foreign bank branches and foreign bank representative offices in China, most are located in cities of the coastal region. In the capital of Sichuan, Chengdu, there were only one foreign bank branch (compared to 45 in Shanghai and 24 in Shenzhen) and seven foreign bank representative offices, and for the whole of the western region there were only three foreign bank branches in 2000. At the time of writing, a foreign bank in China could take one of three forms permitted by Chinese law: • Solely foreign-funded foreign bank with its headquarters located in China; • Joint equity bank whereby a foreign financial institution and a Chinese financial institution jointly fund and run the operation in China; or • Foreign bank branch established in China by a foreign bank. 5.4.1 Entry mode In China, establishing a foreign bank branch has been the most common entry mode. Because the establishment of bank branches imposes various legal and financial obligations on the parent bank in the home country, this may have provided a degree of comfort to the Chinese government, particularly in the early days of the open-door policy when the system of supervision and regulation was being developed from scratch. From the perspective of the Chinese monetary authorities, the tradeoff is that a foreign bank branch is part of the parent bank which is a foreign legal entity subject to the supervision and regulations of the home country’s monetary authorities (although China does nonetheless impose a range of prudential requirements of its own on foreign bank branches). On the other hand, there may be some attraction for foreign financial China’s business reforms 68 institutions in opting for the bank branch mode because of the high level of control and organizational integration with the parent bank. While many foreign financial institutions do have strategic ambitions to enter and develop the China market, the Chinese government has been very cautious in the opening up process. The aim to protect the domestic banking industry against foreign competition has clearly played a part in that approach. Under its WTO membership commitments, China has undertaken the gradual process of phasing in the removal of restrictions in respect of conducting Chinese currency business and the geographical location of businesses (see Table 5.2). However, even as these types of entry restrictions are being dismantled, there remains a range of barriers (some of which may not necessarily be based on prudential considerations) that serve to constrain the capacity of foreign banks to expand their operations in China, and may even deter foreign bank entry. Of course as in the general case of the well understood area of non-tariff barriers to international trade in the literature, it is not unthinkable that certain prudential requirements can be unintentionally or deliberately used as barriers to foreign entry into the market. Table 5.3 summarizes the basic requirements for establishing and operating the three forms of foreign banking institutions in China. On the basis of the initial set of regulations governing the entry of foreign banks and finance companies (Regulations on the Administration of Foreign Invested Financial Institutions in the People’s Republic of China, 25 February 1994), the Chinese government has updated and provided more details in a revised set that came into force in February 2002 (Stipulations on the Enforcement of the Regulations on the Administration of Foreign Invested Financial Institutions in the People’s Republic of China). Having experienced a period of quite chaotic growth of non-bank financial institutions in the early 1990s and the ever-present systemic threat of the NPL problem with the stateowned banks, the Chinese monetary authorities have taken a very cautious approach to foreign financial institutions entering the Chinese market. The capital and asset requirements for a foreign bank to establish business in China are set at relatively high levels which will vary according to the extent of the foreign bank’s business scope in foreign currency and RMB. For the most common mode of foreign bank entry, via the establishment of a bank branch, the capital requirement to conduct all the permitted scope of foreign currency business is for the parent company to allocate to the branch an amount of non-recallable freely convertible currencies equivalent to at least RMB200 million (US$24 million) (Table 5.3). If the foreign bank branch were to conduct the complete permitted business scope of RMB business in addition to full foreign currency business, then the amount would rise to RMB600 million (US$72 million) (People’s Bank of China 2002, Article 36). Table 5.2 China’s WTO commitment to the opening of its banking system, 2002 Timetable Foreign currency business RMB local currency business Customers Location Upon entry to Chinese enterprises and Foreign - invested Shanghai, Shenzhen, Foreign banks 69 WTO (December 2001) individuals (i.e. all restrictions on customers removed) enterprises, foreign residents Tianjin, Dalian 1 December 2002 as above as above Guangzhou, Zhuhai, Qingdao, Nanjing, Wuhan Within 2 years of WTO membership as above Chinese enterprises Jinan, Fuzhou, Chengdu, Chongqing Within 3 years of WTO membership as above as above Kunming, Beijing, Xiamen Within 4 years of WTO membership as above as above Shantou, Ningbo, Shenyang, Xi’an Within 5 years of WTO membership as above All customers in China Location restrictions terminated Notes: To conduct Renminbi business, a foreign-funded financial institution must satisfy the following requirements: • it must have operated in China for at least three years prior to the application; • it must have been making profits for the two consecutive years prior to the application; and • it must meet other prudential requirements prescribed by the People’s Bank of China. Some foreign banks regard this requirement as unnecessarily excessive and acting as a deterrent to expanding their operation in China, particularly into regions where business needs to be gradually built up before returning a profit. Because bank branches are an integral part of the parent organization, a high level of capital requirement is therefore considered to be superfluous. Compared with domestic Chinese banks, the initial capital cost of funding one foreign bank branch operation is therefore not insignificant, even though most major international banks will not be unduly affected in their market entry plan. As discussed earlier, a foreign bank must also satisfy additional conditions of three years of operation and two consecutive years of profitability before being allowed to conduct RMB business. Taken together, these constitute in practice extra costs and another impediment that deters and slows foreign bank entry. Table 5.3 Regulation of foreign banks in China— basic elements Establishment of Business Capital Requirements Minimum registered capital: Solely foreign-funded bank & joint-equity bank Freely convertible currencies equivalent to RMB300 million yuan (for partial services in foreign currency business with foreign-invested enterprises and foreign individuals) (for complete services in foreign currency business with foreign-invested enterprises and foreign individuals, the minimum moves up to RMB400 million) Operating capital: China’s business reforms 70 Foreign bank branch Non-recallable allocation from head office of freely convertible currencies equivalent of no less than RMB 100 million yuan (for partial services in foreign currency business with foreign-invested enterprises and foreign individuals) (for complete services in foreign currency business with foreigninvested enterprises and foreign individuals, the minimum moves up to RMB200 million) Representative Office Minimum period of maintaining a representative office in China Solely foreign-funded bank, joint-equity bank and foreign branch At least two years Assets of Applicant Minimum amount of total assets of the foreign financial institution applying for license in China Solely foreign-funded bank & joint-equity bank US$10 billion Foreign bank branch US$20 billion, and a capital adequacy ratio of at least 8 per cent Business Scope Permitted Scope Identical for all three types of foreign bank Deposit taking, lending, acceptance and discounting of negotiable instruments, trading of government and financial bonds, trading of foreign currency securities other than stocks, letters of credit and guarantee, domestic and foreign settlement, trading of foreign exchange and acting as an agent, exchange of foreign currencies, inter-bank lending, bank card business, safe deposit boxes, credit and financial standing investigation and related consultancy, other businesses approved by the People’s Bank of China (PBC) Supervision and Regulations Interest Rates Solely foreign-funded bank, joint-equity bank and foreign branch: Interest rates of deposit and loans, and service fees determined by banks in accordance with relevant provisions of PBC Required Reserves Solely foreign-funded bank, joint-equity bank and foreign branch: Must deposit with PBC the required ratio of reserves determined by the PBC Operating Capital Foreign bank branch: 30 per cent of the operating capital must be maintained in the form of interestbearing assets as prescribed by PBC, including deposits with banks designated by PBC Capital Adequacy Ratio Solely foreign-funded bank and joint-equity bank: Foreign banks 71 Not less than 8 per cent Domestic Source of Deposits Solely foreign-funded bank, joint-equity bank and foreign branch: The maximum of deposits from within China cannot exceed 40 per cent of total assets Source: Regulations on the Administration of Foreign Invested Financial Institutions in the People’s Republic of China, 25 February 1994; Stipulations on the Enforcement of the Regulations on the Administration of Foreign Invested Financial Institutions in the People’s Republic of China, 29 January 2002. However, almost without exception, all the foreign banks interviewed by this author5 expressed greatest concern over the 40 per cent limit on the amount of a foreign bank’s RMB liabilities that can be obtained through inter-bank lending from Chinese banks. At the end of 2001, 33 foreign banking institutions (out of a total of 158) were permitted to conduct RMB business with foreign-invested enterprises and foreign residents. Owing to the absence of a branch network, their ability to attract RMB deposits is limited. It is estimated that 50 to 80 per cent of their RMB funds were obtained through inter-bank lending from Chinese banks (Guoji Jinrongbao, 24 July 2002). This restriction on sources of RMB funds represents a serious barrier to foreign banks in their business development and is probably construed as a protective measure against foreign competition. As Table 5.3 indicates, all three forms of foreign banks are required to have reserves with the Chinese central bank. For a foreign bank branch, 30 per cent of the operating capital must also be maintained in the form of interest-bearing assets as prescribed by PBC, including deposits with banks designated by PBC. These requirements, particularly the last, impose some constraints on the ability of the foreign bank branch to conduct its business as it sees fit. In this context, the more serious concern expressed by foreign banks in China is the onerous approval processes imposed on the business of providing foreign currency credit to enterprises for which each loan must have given pre-approval and approval by the Chinese monetary authorities. The introduction of any financial product is in fact subject to government approval. Thus, foreign banks face constraints in the pricing, quantity, types of products, and scope of business that they can carry out in China. The demand for a more level playing field is very evident among foreign banks in China. 5.4.2 Impediments to expanding foreign bank branch networks For those foreign banks already operating in China, the objective of expanding their business through additional branches faces some significant obstacles. As Tables 5.4 and 5.5 show, domestic Chinese shareholding banks have much more lenient regulatory conditions for gaining approval to create new bank branches than foreign banks. Chinese banks can be granted permission to add new branches even though their basic financials cannot usually match those of the foreign banks in China. More importantly, foreign banks are in effect restricted to a maximum of one new branch per year, while Chinese China’s business reforms 72 shareholding banks can have up to four in the western region and three in the rest of the country. This one branch per year barrier is viewed by foreign banks as one of the most severe constraints upon their business development in China. It is relevant to note that while the parent company of foreign bank branches is required to have at least US$20 billion in assets, only 4 of the 11 Chinese shareholding banks had reached that size in 2001 (Table 5.6). In fact most foreign banks currently in China (such as Bank of America, HSBC and Citibank) are much bigger than the minimum size required. Table 5.4 Conditions for foreign banks to add a new branch Foreign bank branch (1) Representative office for two years. (2) Minimum amount of total assets of the foreign financial institution applying for a new branch should be US$20 billion. (3) Existing branch in China should have good business performance, and should have no record of major activities that are contrary to the law and regulations. (4) Application for an additional branch can only be made one year after the last approval by PBC for establishing a branch (i.e. maximum of one new branch per year). Solely foreign-funded bank and foreign joint-equity bank (1) Operation in China over three years; profits in the last two consecutive years. (2) Capital adequacy ratio not lower than 8 per cent. (3) Application for an additional branch can only be made one year after the last approval by PBC for establishing a branch. (4) For each additional branch, applicant must pay no less than 100 million RMB equivalent fully convertible currency as its operating capital; the total accumulated amount of payments for operating capital for a foreign bank’s branches (including any planned additional one) cannot exceed 60 per cent of the registered capital of the bank in China). (5) Other prudential requirements prescribed by the PBC. Source: Stipulations on the Enforcement of the Regulations on the Administration of Foreign Invested Financial Institutions in the People’s Republic of China, Article 15. Table 5.5 Selected requirements for Chinese shareholding banks to open new branches (1) In general the number of new branches per year for each applicant bank should be no more than 3; for branches in the western region, the limit could be raised to 4. (2) Applicant bank should in general reach the 8 per cent capital adequacy ratio. For those banks under 4 per cent, new branches should be restricted. (3) Applicant bank should have an NPL ratio of less than 15 per cent. For those with a ratio over 15 per cent, if t he ratio is declining, considerations along with other factors can be taken into Foreign banks 73 account. Source: Yinfa [2002] Number 244—Notice by the People’s Bank of China on Questions Concerning the Adjustment of Investigation Approval Systems for the Establishment of New Branches by Shareholding Banks. Hence if the same prudential consideration based on bank size being an indication of strength is applied, the case for limiting new foreign bank branches is weak, particularly when each foreign bank branch will still be subject to the usual capital and prudential conditions before it can be established. And if Chinese banks are given the incentive to expand into the western region by being allowed one more branch per year, there is no reason why foreign bank entry into the western region should not be encouraged by similar measures. For instance, the Chinese government could quite easily relax the one new branch per year rule for foreign banks by simply excluding the application of this rule to any new branch to be established in the western region. The requirement that a foreign bank must have made a profit for two consecutive years before it can apply to set up a new branch presents a real problem for many foreign banks in China. It is common knowledge that new bank entrants do not normally generate positive returns during the early years of operation in a new market. That is in fact why foreign financial institutions often have to justify their business development and entry into China as a long-term strategic move. On the basis of interviews with foreign bank representatives in China, this is one of the major concerns and is seen as an unnecessary deterrent to the development of foreign banking networks in the country. After all, the financial parameters of a branch operation are consolidated into the parent banks. Ultimately it is the bank which should determine whether it is commercially advantageous to expand its branch network if genuine prudential requirements are met. The regulator should have no role in deciding what is essentially a commercial decision. Table 5.6 Chinese shareholding banks, total assets (end of 2000) US$ billion Bank of Communications 79 CITIC Industrial Bank 29 China Merchants Bank 27 China Everbright Bank 26 Guangdong Development Bank 19 Shanghai Pudong Development Bank 16 Huaxia Bank 12 Fujian Industrial Bank 11 China Minsheng Bank 9 Shenzhen Development Bank 8 China’s business reforms 74 Accounting for Goodwill (AASB 1013) classifies unidentifiable intangible assets into two categories: internally generated goodwill and purchased goodwill. The standard requires purchased goodwill to be capitalized and amortized through earnings using a straight-line method over a period of 5 to 20 years (Australian Accounting Standards Board 1996). If the economic benefits of the purchased goodwill are deemed to have fully expired, the goodwill is to be completely written off through earnings. Capitalization of internally generated goodwill is not permitted. Australia is currently preparing to adopt a new approach to accounting for goodwill. Under this approach, goodwill will not be amortized systematically. Instead, it will be written off as it is deemed to have been impaired. This means that goodwill may be carried in the accounts at an unamortized amount for several years; alternatively, it may be written off very rapidly, depending upon assessments of the economic circumstances that affect goodwill valuation. 6.3.2 Identifiable intangible assets Generally, rules governing the accounting for identifiable intangible assets are the subject of standards relating to individual types of intangibles. However, there have been some attempts to develop general standards governing the full range of these assets, most notably in Australia and in the International Financial Reporting Standards (IFRS) developed by the International Accounting Standards Board (IASB). In 1989 the Australian Accounting Research Foundation (AARF) issued an exposure draft, Accounting for Identifiable Intangible Assets (ED 49), dealing with accounting for identifiable intangible assets such as brand names and other related intangibles. ED 49’s general proposition was that both purchased and internally developed intangible assets are to be brought to account (Alfredson 2001). Under ED 49, purchased identifiable intangible assets were recorded at the cost of acquisition and internally generated identifiable intangible assets were recorded either at cost or at the lowest cost at which they could currently be obtained in the normal course of business, as determined by independent valuers. ED 49 required amortization of intangible assets but it nominated no maximum period. Because of the lack of consensus on a number of issues, such as the requirement to amortize all identifiable intangible assets (including brand names), the exposure draft was withdrawn in 1992. In 1996 the AASB initiated its International Harmonization Project, planning to revise more than 20 Australian Accounting Standards to accord with International Accounting Standards (Collett et al. 2001). In addition, a new accounting standard on intangible assets was to be issued (Parker 1997). The intangibles project was delayed significantly as the board dealt with some highly contentious issues, such as the treatment of brand names during a period when firms were accused of opportunistic overstatement of brand name values, and with the issuance of IAS 38, Intangible Assets in 1998. IAS 38 specifies that the deemed useful life of an intangible asset should not exceed 20 years, and an intangible asset is to be carried at its cost less any accumulated amortization and impairment losses. The standard prohibits the recognition of internally generated brands, mastheads, publishing titles and similar intangibles and permits revaluation of intangibles only where there is an active market. These requirements sparked a highly charged debate Accounting for intangible assets 81 on the proper treatment of identifiable intangibles. Most lobbyists strongly opposed Australia’s harmonization with IAS 38. The International Accounting Standards Board’s December 2002 proposed amendments to IAS 36 Impairment of Assets and IAS 38 Intangible Assets propose to remove the presumption that the useful life of an intangible asset will always be finite and that the useful life cannot exceed twenty years from the date the asset is available for use. The draft also proposes that an intangible asset with an indefinite useful life should not be amortized and its useful life should be reviewed every year. Proposed amendments to International Accounting Standards, now known as International Financial Reporting Standards (IFRS) will see some assets no longer recognized (such as internally generated brands, mastheads, or publishing lists). This has been extremely controversial in Australia, but it does not affect the accounts for the period of this study. 6.3.3 Research and development In an international context, Australia’s regulations tend to be relatively flexible. In some countries, such as the US, capitalization of research and development (R&D) is not permitted except for computer software development costs. AASB 1011 Accounting for Research and Development Costs states that R&D shall be charged to earnings when incurred. However, capitalization of these costs is allowed if they are expected beyond any reasonable doubt to be recoverable. Capitalized R&D costs must be amortized over future financial years to match them with related benefits, beginning with the commercial production of the product. It is expected that when Australia adopts IFRS from 1 January 2005, companies will not be permitted to recognize intangible assets arising from research (or from the research phase of an internal project). Development costs will be capitalizable only if certain criteria, such as recoverability, are met. 6.3.4 Brands and other related intangibles The treatment of brand names has been particularly contentious since the collapse of companies whose financial statements had reported brand name assets with high values, but whose capitalized brand values did not withstand market forces. In contrast, it has been argued that a motive for some companies capitalizing brands has been to ensure that they are not undervalued by the capital market, especially in a manner that could lead to possible takeover.2 Many international mergers and acquisitions involve acquiring famous brand names, trademarks, patents, licenses and other such intangibles. As such, the treatment of brands and other intangibles is inevitably associated with the treatment of goodwill. Internationally, there is significant variation in the treatment of purchased brand names. In Australia, regulators prefer the assets to be capitalized and amortized separately from goodwill, and in the US under the new accounting standard FASB 141 Business Combinations identifiable intangible assets with indefinite useful lives, including brands, are not to be amortized and measures are reviewed for impairment. Intangible assets with limited useful lives continue to be amortized. China’s business reforms 82 Treatment of internally developed brand names is even more diverse. In Australia the capitalization of home-grown brands is permitted. The recent IASB Exposure Draft amendments to IAS 383, which are likely to be adopted in Australia in 2005, stipulate that internally generated brands, mastheads, publishing titles, customer lists and items similar in substance should not be recognized as intangible assets. As with goodwill, this likely change does not affect the period of this study. 6.3.5 Deferred costs Deferred costs include a variety of capitalized expenditures on such things as advertising, customer acquisition commissions that are expected to provide benefits for several years into the future, and future income tax benefits arising because taxes have been paid in advance of their recognition as an expense for financial reporting purposes. Generally, deferred costs fall within the definition of assets in various countries’ conceptual frameworks since they are incurred with a view to deriving future economic benefits. With the exception of future income tax benefits, their accounting is not particularly contentious since they are usually written off against earnings only a short number of years after their initial capitalization. 6.3.6 Licence costs Licence costs are the up-front payments for agreements such as software licences that allow the use and/or sale of particular software. In Australia it has long been accepted practice to value internally generated licences, copyrights, and publishing rights. Under the proposed IASB changes internally generated brands, mastheads, publishing titles, customer lists and items similar in substance are not recognized as intangible assets. The AASB agreed to expose this change and highlight its implications in the Australian environment. 6.4 China In December 1992, Chinese Accounting Standard for Enterprises was formally promulgated by the Ministry of Finance (MOF) in China (MOF 1992). Compared with International Accounting Standards and the standards in Australia, the US, and the UK, this first Chinese accounting standard is more like a conceptual framework than a detailed prescription of how to account for a particular issue (Chen et al. 2001). It is a guideline about how to set accounting standards. Since the promulgation of that first Chinese accounting standard, the Ministry of Finance has endeavoured to set up the new accounting regulation system by issuing specific accounting standards. However, this procedure is more complicated because of the coexistence of the unified accounting systems and accounting standards (Chen et al. 1997). So far, thirty specific accounting standards have been drafted and circulated for public comment. The major criticism of those drafts of accounting standards is that they are not suitable for the Chinese situation because they mainly copy International Accounting Standards and GAAP in the United States. Accounting for intangible assets 83 The Ministry of Finance planned to establish the accounting standards system in three years, with 32 specific standards in 1993 (Aiken et al. 1995). However, so far only 13 specific standards have been formally promulgated. They are: Accounting for Changes of Accounting Policies and Estimations and Mistakes; Accounting for Revenues; Accounting for Investments; Accounting for Construction Contracts; Accounting for Reorganization of Debt; Accounting for Intangibles; Accounting for Contingencies; Accounting for Borrowing Costs; Accounting for Leasing; Accounting for Non-cash Transactions; Accounting for After-balance Date Events; Cash Flow Statement; and Disclosure of Related-party Transactions. The standard which relates to intangible assets is: Accounting Standard for Business Enterprise: Accounting for Intangibles. Similar to the Australian case, intangible assets can be classified as either identifiable intangible assets or non-identifiable intangible assets. Identifiable intangible assets include patents, non-proprietary technologies, brand names, copyrights, land use rights, franchises and suchlike. ‘Non-identifiable intangible assets’ refers to goodwill. In this standard intangibles, including goodwill, are required to be amortized using the straight-line method over their useful lives and no more than 10 years (MOF 2001). Firms are to value their intangibles each year, and if the book value is greater than their recoverable value, they are required to provide for the devaluation. Both in China and Australia, internally generated goodwill is not allowed to be recognized as an asset. In China, R&D costs incurred prior to legally obtaining an intangible asset such as a patent are to be expensed in the period when they are incurred. All intangible assets that are developed by the enterprise itself and are obtained by legal application, including patents, brand names, copyrights and franchises, should be measured at cost, including expenditure such as registration fees and legal fees incurred for legal application of obtaining the asset (Ministry of Finance 2001). 6.5 Hypothesis development This chapter addresses two fundamental accounting research questions: • Are accounting treatments of intangible assets associated with the investment market’s valuation of the firm? • Does capitalization of intangible assets have different relevance to the market valuation of firms in countries with developed and developing capital markets, and with different accounting rules (in particular in Australia and China)? Although research on intangibles is limited by the availability of data, the extant research nonetheless provides insights into the issue. Researchers have found that there is a strong association between the capitalization of intangible assets and firm valuation. Most of their work focuses on assessing whether investors value separate categories of two capitalized identifiable intangibles: goodwill and R&D. Lev and Sougiannis (1996) investigate the value relevance of R&D in the US, where R&D must be expensed as incurred. By estimating amounts that would be capitalized according to the historical success of R&D, they find that notional capitalization of R&D is strongly associated with stock prices and returns. Their findings indicate that the R&D China’s business reforms 84 capitalization process yields value-relevant information for investors. Aboody and Lev (1998) further examine the relevance to investors of information on the capitalization of software development costs. Capitalization of software is the only exception in the US to the full expensing rule for R&D. They find that annually capitalized development costs are positively associated with share returns, and the accumulated software asset reported on the balance sheet is associated with share prices. They suggest that there is no evidence to support the view that software capitalization decreases the quality of reported earnings. Consistent with the US findings, Abrahams and Sidhu (1998) find that R&D capitalization by managers of Australian firms is value-relevant and that R&D capitalization improves accounting-based measures of firm performance for Australian firms in industries where R&D activity is widespread. In contrast, while Godfrey and Koh (2001) find that capitalized intangible assets in aggregate and capitalized goodwill and capitalized identifiable intangible assets other than R&D are value-relevant, they also find that capitalized R&D is not value-relevant.4 Godfrey and Koh (2001) attribute the differences between their results and those of Abrahams and Sidhu (1998) mostly to the Abrahams and Sidhu (1998) use of a larger sample that includes smaller firms whose equity values are likely to be more reliant upon R&D growth options. Barth and Clinch (1996) investigate the value relevance of goodwill to US-listed UK, Australian, and Canadian firms. They find that differences in accounting for goodwill provide incremental power in explaining share returns or prices. This chapter extends their research by including firms that are not US listed, and by investigating accounting practices in relation to other intangibles. This is important as US listing is likely to affect a firm’s share price, not only in the US but also on other stock exchanges such as the London Stock Exchange or the Australian Stock Exchange. While investigating goodwill-accounting relevance to US share prices is important, the findings do not necessarily apply to the many firms that are not US listed, nor to domestic pricing of cross-listed firms. Research on the value relevance of financial reporting disclosures in general in an emerging capital market such as China is very limited.5 Investigation into the value relevance of certain areas of financial reporting (such as intangible assets) is even more limited. There are probably two reasons for this. First, the data for Chinese listed companies in the Shanghai and Shenzhen Stock Exchanges cannot be obtained easily. However, the situation is improving as some databases such as COMPUSTAT and Datastream begin to include Chinese firms. Although these databases’ coverage of Chinese listed firms is not as complete as for Australian, US or UK firms, it is nonetheless useful for research. Second, the unique institutional environment in China (such as the dominance of state ownership) has sometimes been seen as a barrier to conducting this kind of research. Within the Australian accounting conceptual framework, assets are future economic benefits controlled by an entity (AASB 1995). Similar definitions are used worldwide, and in China assets are defined as economic resources which are measurable by money value and which are owned or controlled by an enterprise (MOF 2001). Furthermore, accounting rules internationally tend to be conservative in prescribing when assets can be recognized in the accounts. In Australia, they may only be recognized when it is probable that the benefits will be perceived (probability >50 per cent) and the asset can be Accounting for intangible assets 85 measured reliably (AASB 1995). Thereafter specific rules apply, as has been explained in the context of intangible assets. As a general proposition, if managers capitalize only those expenditures that give rise to future economic benefits, there should be a positive association between capitalized intangible assets and the market value of equity. This gives rise to hypothesis 1. Hypothesis 1: There is a positive association between the market value of equity and the book values of capitalized intangible assets. More specifically, investors are likely to value individual classes of intangibles differently, according to the probable timing and magnitude of the potential benefits to be realized. As such, hypothesis 1 lends itself to subdivision as follows: There is a positive association between the market value of equity and the book values of: • capitalized goodwill (hypothesis 1a) • capitalized R&D (hypothesis 1b) • capitalized brand names (hypothesis 1c) • capitalized licence costs (hypothesis 1d) • capitalized deferred costs (hypothesis 1e) The value of equity is derived from the value of tangible and intangible assets less the value of liabilities. As such, if the market value of equity is modelled as a function of the value of tangible assets less liabilities, inclusion of intangibles should improve the model and explain more of the value of equity. Adopting the approach used to expand hypothesis 1 leads to the following predictions: Hypothesis 2: Including the total of capitalized intangible assets significantly increases the explanatory power of models of the market value of equity as a function of total tangible assets less total liabilities. The explanatory power of models of the market value of equity as a function of the book values of total tangible assets less total liabilities increases significantly when the following classes of assets are included in the model: • capitalized goodwill (hypothesis 2a) • capitalized R&D (hypothesis 2b) • capitalized brand names (hypothesis 2c) • capitalized licence costs (hypothesis 2d) • capitalized deferred costs (hypothesis 2e) China’s business reforms 86 6.6 Research method 6.6.1 Valuation models Tests of the hypotheses use the simple model applied by Abrahams and Sidhu (1998) and Godfrey and Koh (2001). Intangible assets are divided into five categories: goodwill, R&D, brand names, deferred costs, and licences. The base model is as follows: Including intangible assets at different levels of disaggregation leads to the following models: Where MVE = market value of equity TTA = total tangible assets TL = total liabilities TIA = total intangible assets GW = goodwill RD = research & development; IIA = total identifiable intangible assets other than R&D BN = brand names & patents DC = deferred cost LC = licences costs Following the Abrahams and Sidhu (1998) approach, all variables are scaled by total paid up ordinary capital to reduce heteroskedasticity. Equation (2) tests the value-relevance of capitalized total intangible assets. If capitalization of intangible assets is value relevant, then α3 will be significantly greater than zero. Equations (3) and (4) test the value relevance of individual groups of capitalized intangible assets. If α4, α5, α7, α8 or α9 is significantly greater than zero, then investors deem capitalization of the associated individual type of intangible assets to be value-relevant and to be measured with some reliability (Barth 2000). As well as examining whether capitalized intangible assets are value-relevant, the study investigates the extent to which capitalized intangible assets add to the power of other balance sheet items, such as total liabilities and total tangible assets, to explain equity value. Hierarchical multiple regression analysis measures the incremental explanatory power of an additional independent variable or a block of independent Accounting for intangible assets 87 variables. It does this by testing whether there is a statistically significant increase in the power of several variables (such as tangible assets, liabilities) to explain variation in a dependent variable (such as equity market value) as a result of the additional independent variable or block of independent variables (Tabachnick and Fidell 1989). 6.7 Sample selection As reported in Table 6.2, the Australian and Chinese samples include all firms that (1) are included in the Company Analysis database for 2001 for each country;6 and (2) report goodwill or other types of intangible assets7 in their 2001 annual reports. These two criteria result in 636 Australian and 197 Chinese firms respectively. Table 6.2 Sample selection Sample Selection Sample Company Analysis database coverage: Australia 1324 China 272 Final sample size after omission of firms with negative book value and missing observation of market value, intangibles (2001) Sample size Australia 636 China 197 Total 2429 6.7 Results and discussion 6.7.1 Descriptive statistics Table 6.3 summarizes the industry distribution of these firms. It also provides information about different types of intangible assets reported by these firms according to the industry and country of firm listing. Table 6.3 shows that in Australia 419 firms (66 per cent) report goodwill. This contrasts with the Godfrey and Koh (2001) sample where 85 per cent of companies report goodwill. The difference is due to the sample of this study encompassing smaller firms that have not engaged in business acquisitions.8 In contrast, 129 out of 636 firms capitalize R&D (20 per cent of the sample firms). The majority of the 216 firms (34 per cent) that capitalize and amortize R&D are in the automobiles & parts, banking, electronic & electrical, food & drug retail and software & computer service industries. China’s business reforms 88 Other identifiable intangibles capitalized by the sample firms include brand names & patents, licences, and deferred costs. Fifty per cent of firms report at least one identifiable intangible asset. Thirty-four per cent of firms report brand names and patents, 22 per cent report licences, and 25 per cent report deferred costs. Of the 216 firms that capitalize brand names and patents 53 firms (38 per cent) do not amortize them. This includes 41 firms with capitalized brands exceeding 10 per cent of their total reported assets. Table 6.3 Industry distributions Accounting for intangible assets 89 Approximately 25 per cent of the Chinese sample capitalizes brand names and almost 50 per cent of the firms capitalize deferred costs and licence costs. Table 6.4 shows descriptive statistics for the two countries’ dependent and independent variables. After allowing for currency exchange rates, it is clear that Australian firms are larger than Chinese firms. For all firms the data are skewed, and additional transformations normalize the measures and ensure reduced heteroskedasticity for hypothesis testing. For Australia, intangible assets comprise 20 per cent of reported total assets respectively. For China, they comprise only 2 per cent. China’s business reforms 90 SECTION TWO 7 Changing structure of Chinese enterprises and human resource management practices in China Shuming Zhao* 7.1 Introduction Economic reform and opening up to the outside world have made profound changes to the economic and social development of China. The most dramatic changes are in two areas. One is the change in the economic system. China has transformed its economic system from a highly centralized, planned economy to a market economy. Though people hold different views on whether or not China has set up a complete market economic system, the transformation has been profound and irreversible. Moreover, it has been necessary to speed up the reform process, especially since China’s entry into the World Trade Organisation (WTO). The other change has been in the ownership structure of enterprises. China began its open-door policy and economic reform in 1978. The reform started in rural areas (with farmers signing contracts with government for production) and was later introduced in industries (with managers signing contracts with the government). Deng Xiaoping’s famous tour of Southern China in 1992 accelerated the pace of economic reform. The continuation of economic reform gained support from China’s tenth Five- Year Plan (2002–2005), and was approved at the Ninth National People’s Congress (NPC) in 2001. The sixteenth Party Congress in 2002 introduced a strategic plan to build a high-level consumption-oriented society, to deepen the reform of state-owned enterprises (SOEs), to strengthen the operation of the market, to further the open-door policy, to accelerate the development of science and technology and to reduce corruption over the next few years. All of this indicates that China’s reforms are entering into a new period. Figure 7.1 shows China’s economic growth over the past 24 years, indicating that China’s average annual growth rate in GDP from 1978 to 2002 was 8 per cent, much higher than the world average of 3 per cent. Figure 7.1 China economic growth after 1978 reform (GDP: billion RMB) Other data also indicate that Chinese society has witnessed extensive development. Foreign exchange reserves totaled US$280 billion by the end of 2002. In the same year, the total volume of imports and exports reached US$600.79 billion, consisting of US$325.57 billion in exports and US$295.22 billion in imports, a rise of 22.3 per cent and 21.2 per cent respectively from their 2001 levels. Moreover, life expectancy has increased from 35 years, prior to the founding of New China in 1949, to 71.4 years in 2003. China’s economy is expected to continue to grow despite the effect of SARS in 2003. The latest data show that in the first quarter of 2003, China’s GDP reached 2356.16 billion RMB, an increase of 9.9 per cent from the same quarter in 2002. And from January to May 2003, investment in China reached 1057.78 billion RMB, an increase of 31.7 per cent from 2002. It should not be difficult to reach the growth targets of investment (16 per cent) and GDP (7.9–8.2 per cent) for 2003. 7.2 The history of personnel management in China Since economic reform began in China in 1978, several changes have taken place in human resource management. Before 1978 China had for decades operated a highly centralized planned economy. The same is true for the personnel management system. College graduates were assigned jobs. Companies and other organizations had to apply for personnel quotas from the government personnel department. Personnel management practices are described in Table 7.1. The characteristics of personnel management immediately before 1978 were based on the “three irons” policy. The “three irons” practices can be described as follows: China’s business reforms 98 a. “Iron armchair”, which refers to the management of executives and technicians under a permanent job system. Once a person was recruited, he or she would be entitled to hold the position for his or her entire life. b. “Iron rice-bowl”, which refers to the system of employment that created boundaries between “cadres” and “workers”. A lifelong guarantee of a cadre’s position, and the policy that cadres could be promoted but never demoted. led to a surplus of unproductive personnel. c. “Iron wages”, which describes the wage distribution system. In the highly centralized planned economic system, the state played an authoritative role in the compensation system of enterprises. Evenly distributed pay had little to do with profits and individual performance. Since the start of economic reform in 1978, China began changing the personnel management system, especially after 1994 when the market economic system was officially adopted. There are two main reasons for the changes. First, it was necessary to change the personnel management system along with the establishment of the market system. Second, the open door policy attracted many multinational firms to invest in China, and Chinese enterprises faced fierce competition from multinational corporations in attracting and keeping high quality personnel. Table 7.2 describes the process of the change since the economic reform in 1978. Table 7.1 Characteristics of personnel management before 1978 Year Stage of personnel management Characteristics 1949– 1952 Preliminary Stage Fixed employment; state monopoly of recruitment and labor allocation 1952– 1957 Beginning Stage Soviet management model with authoritarian leadership; piece rate wages; merit-oriented payment 1957– 1966 Development Stage Chief leader responsibility system; committees with employee delegation; democratic management with employee participation 1966– 1977 Stagnation Stage “Three irons” policy strengthened Source: Zhao (1998). The main characteristics of human resource management in China after the 1978 reforms can be described as follows (Zhao 2001): a. The key human resource management transition in China was the shift from a political and administrative relationship to an economic relationship between government and enterprise. b. The highly centralized labor allocation system shifted to “two-way” selection. c. The fixed wage system shifted to an enterprise-determined compensation package. Changing structure of Chinese enterprises 99 d. The centralized control wage system failed to play an effective role within enterprises, and led to the existence of “low salary, low price”. e. The central government relaxed ceilings on executive pay for SOEs. f. Competition for talent has increased since China’s entry into the WTO in December 2001. Table 7.2 The development of the personnel system in China since the early 1980s Time and period Stage Characteristics Traits Early 1980s to mid 1980s Exploration Stage Reform of recruitment methods to enlarge the pool of candidates to include the entire population; strengthening of skill training Decentralization of labor relations and employment Mid to late 1980s Breakthrough stage Use of contracts Enterprises become main agency of employment; employers and employees can make mutual employment decisions; labor relations determined through contracts Early 1990s to present Development stage Abolishment of “3 irons” policy; use of employment contracts expanded to include all employees according to “labor law”; appropriate macrolevel reforms Transfer to human resource management system Source: Zhao (1998). 7.3 Changes in the structure of enterprise ownership The Fifteenth Party Congress, which was in session in Beijing in 1997, introduced the policy that mixed ownership forms should coexist with SOEs. Since that announcement, the forms and ownership structure of Chinese enterprises have changed a great deal. We can see from Tables 7.3 and 7.4 the changes in the forms and ownership structure of enterprises in China from 1996 to 2001. China’s business reforms 100 Table 7.3 Number of corporations and ownership structure of enterprises in China (December 31, 1996) Corporation (10 thousand) (%) Total 262.8 100.0 State-owned companies 44.2 16.8 Collective companies 150.1 57.1 Private companies 44.3 16.9 United companies 4.4 1.7 Share companies 7.2 2.7 Foreign-invested and Hong Kong, Macau, Taiwan-invested companies 11.1 4.2 Others 1.5 0.6 Source: SSB (1998). Table 7.4 Number of corporations, ownership structure, number of employees and percentage of employees of each type in firm (December 31,2001) Corporation (10 thousand) % Employees (10 thousand) % Total 302.6 100.0 16502.2 100.0 State-owned companies 36.9 12.2 5056.8 30.6 Collectively owned companies 85.8 28.3 3763.1 22.8 Private companies 132.3 43.7 3170.3 19.2 Share companies 30.0 9.9 2746.6 16.6 Foreign-invested companies 5.7 1.9 644.0 3.9 Hong Kong, Macau, and Taiwaninvested companies 8.2 2.7 997.4 6.1 Others 3.7 1.3 124.0 0.8 Source: SSB (2003b). Changing structure of Chinese enterprises 101 The present situation of Chinese enterprises can be described as follows: a. State-owned enterprises are still the pillar of the Chinese national economy, though the number of SOEs has decreased and the ownership structure has changed. From January to May 2003, SOEs accounted for 52 per cent of the total output value in the whole country (SSB 2003a). State-owned or state-controlled large enterprises still monopolized some industries, such as telecommunications, oil and petroleum. It seems that China’s SOEs will continue to play a leading role in the national economy in the coming years. b. A modern enterprise system is being set up gradually. Before the introduction of market reforms, Chinese enterprises were not real corporations; rather, they resembled workshops of a large factory. The Chinese government had controlled the production decisions of enterprises since 1949. What to produce, how many products to produce, to whom products were to be sold and the pricing of the products were all decided by government. Sometimes the government interfered directly in the daily operations of business. With the establishment of the market economic system and the deepening of the economic reform, Chinese enterprises gradually gained autonomy, and faced market competition directly. c. Mixed ownership firms coexist with privately owned enterprises, and both ownership forms have developed quickly. From Figure 7.2, we can see clearly that the number of private enterprises has increased very fast in recent years. Currently, one-third of the employees in urban areas are working for private enterprises. And private enterprises make up more than 30 per cent of the country’s gross domestic product. In Zhejiang Province, private enterprises have increased to more than 200,000. At present the largest source of taxation revenue in Zhejiang comes from private businesses (People’s Daily 2003b). d. The number of foreign-invested enterprises has been increasing annually. Foreign direct investment (FDI) in China soared by 48.15 per cent (on an annualized basis) to US$23.271 billion in the first five months of 2003, according to the latest statistics from the Ministry of Commerce (MOC). A total of 439,371 foreign and overseasfunded enterprises have been set up since China adopted its policy of economic reform and opening up in 1978 (Xinhua News Agency 2003). e. Many manufacturing enterprises have been merged. Notable instances are the five mergers of the ten national SOEs under the supervision of the newly established stateowned Assets Supervision and Administration Commission (SASAC). China Coal Construction Group merged with China Coal Energy Co.; China Scientific Instruments I&E Co. merged with China Biotech Group; China Food-Fermentation Industrial Institute merged with China Light Industry Group; China Crude Drugs Group merged with China Medicinal Group; and China Huaqing Co. merged with China Art & Craft Co. (CCTV 2 2003). There are still some problems that have hindered the development of Chinese enterprises during the transition period. First, private enterprises have problems in getting loans from banks. Many private enterprises have entered the new high-tech sectors, and obtaining loans has been particularly problematic for them. Other sources of financing for private firms are also China’s business reforms 102 limited. There were only 139 private companies listed on China’s stock markets at the end of 2002, accounting for 11.8 per cent of all listed companies (People’s Daily 2003b). Second, the government still carries out some enterprise functions, though a modern enterprise system has been gradually set up. Because of the long duration of the highly centralized planned economy, governments cannot transfer their responsibilities immediately. And enterprises, especially SOEs, cannot get rid of the old habits that follow from the government’s administration. Enterprises need time to adjust. Figure 7.2 A comparison of different forms of corporations in China (10 thousand) Source: SSB (1998, 2003b). Third, China has recently issued relevant laws and regulations on corporate governance, such as the Law for the Promotion of Small & Medium-sized Enterprises, which came into operation on January 1, 2003. The legal system is still imperfect, however, and the legal system for protecting private property remains very weak. A report to China’s People’s Political Consultative Committee from the All-China Federation of Industry and Commerce recently indicated that the lack of effective legal protection is a major problem in protecting both private property and property rights. This hinders the development of private enterprises. 7.4 Recent challenges to human resource management in China 7.4.1 Recent developments Since the start of economic reform, China’s personnel system (under the highly centralized planned economic system) has been changed into human resource Changing structure of Chinese enterprises 103 management under the market economy. Many changes have been taking place in recent years because of the restructuring of SOEs and the changing ownership structure. Some of the major recent changes are as follows. Residency card Generally speaking, from the 1950s until the 1990s Chinese citizens were divided into two categories in terms of residency registration (hukou). These two categories were agricultural residence (nongye hukou) and non-agricultural residence (fei nongye hukou) or urban residence (chengshi hukou). Residents of these different constituencies received very different treatment in employment, insurance and so on. If someone held an agricultural residency card, he or she could not work or live in the city unless he or she received a bachelor’s degree or above, served in the army or was promoted to cadre status. Under these circumstances an individual could change his or her status from agricultural resident to urban resident. Restrictions on mobility became a serious problem for companies wishing to recruit people from rural areas or to hire talent from other cities. From 1993, China started to reform the residency registration system. The goal of this reform was to implement the same citizen registration in the whole country. In late 2001, several provinces (such as Jilin, Hunan, Guangdong, Fujian and Liaoning) abolished residential divisions. In 2002, the new residence registration reform began. Chinese citizens who have a place to live in the city, hold a job and receive a stable income may now apply for their regular residential status from the local police office. Early in 2003, Jiangsu Provincial Government issued a document stating that all residents in Jiangsu Province would have the same equal residential status from 1 May 2003. This will help talent to move to the places where the market needs it (Xinhua 2002). Personal file or record The personal file (dang’an), which a citizen is not allowed to see, records an individual’s education and work experience, including high-school and university transcripts, reviews and comments from former and present employers. At present, state-owned companies have the right to keep employees’ personal records. Employees in other companies (such as overseas-funded firms) have to pay authorized human resources agencies, such as personnel exchange centers, 20 RMB (about US$2.4) a month per employee for keeping their files. This is a system that a growing number of locals say is out of step with China’s shift to a market economy. Companies cannot sign a contract with a new employee without first obtaining his or her file. The files are required for people to move from one place to another or to move from one organization to another. However, the importance of personal files is declining. Some provincial and municipal governments have set up new personal files and ignored the old ones in order to help local firms and other organizations to attract more talent. China’s business reforms 104 Social security system During the State’s ninth Five-Year Plan period (from 1996 to 2000), the State Council issued a series of regulations about social insurance. With these regulations, a new social security system has been established. At present, China’s new social security consists of life insurance, unemployment insurance, industrial injury insurance, medical insurance and housing subsidies. The latest survey shows that the current social security policy has problems, such as not enough money for all these different kinds of insurance. One of the important tasks of the reform of the Chinese social security system now is to expand the coverage rate of social insurance. And to achieve the reform, a greater amount of money to pay the conversion cost is needed. The issue of how to raise funds in order to pay for this is an extremely important problem. Housing In the past, under the highly centralized planned economy, the government allocated money to all public organizations to build apartments, and enterprises distributed housing to their employees nearly for free. As a result, the government had a heavy financial burden, the living conditions of the residents were poor and an urban real estate market was unable to develop. Reform of the housing policy was essential, and the process began in the late 1990s. The housing policy has now been reformed in many aspects, including the following: a. Individuals are allowed to purchase their houses. b. A second-hand housing market has been introduced. c. A multi-tier system of housing has been set up. People with high incomes are permitted to buy apartments at market prices and can sell and buy housing on the market. People with low and middle incomes can purchase economic and functional housing. People with the lowest income can apply for low-rent housing that is managed directly by the government’s housing department. 7.4.2 The present situation of Chinese human resources management Recruiting Since China’s Labor Law became effective on 1 January 1995, the contract employment system has been widely used in Chinese enterprises and the former system of assigning jobs to each individual has been abolished. Enterprises have the right to recruit and select their employees from the labor market or personnel exchange centers all over China. In early 2003, the end of “jobs-for-life” for the 30 million public employees was announced, and the reform of China’s public institutions was launched. This reform has been one of the biggest restructuring efforts in the field of employment in China and as such is a vital part of the country’s modernization program. Public institutions have begun the practice of signing contracts with individuals instead of offering permanent jobs. The reform of Changing structure of Chinese enterprises 105 human resources in public institutions will be completed within five years, by 2008, and at that time the contract employment system will be extended to other enterprises. One feature of human resources in China is that there are abundant laborers, but there is a scarcity of skilled labor. China is a large country with a population of 1.3 billion people. However, most of the people have not received a high level of education. In 2000, the average education of Chinese workers was only 7.42 years, about five years less than in the United States (Ministry of Education 2003). Closing this gap is a difficult and important task for developing human resources in China. Foreign-invested corporations offer more attractive compensation and opportunities for further training than do most Chinese enterprises. Young people, especially those who have received a good education, often prefer to work in foreign-invested firms. Training Training is a rather random business in most Chinese SOEs. Most Chinese enterprises have been aware of the importance of training, but systematic training structures have not been encouraged. Training is not connected with corporate strategy or with employees’ career development. Some enterprises do not know the real purpose of training, and therefore training becomes simply a formality. Training plays an important motivational role for top management and senior staff. Top managers pay more attention to training opportunities than others do, because they want to improve themselves. Some enterprises that have set up human resource management systems have introduced training as a special benefit for high-level staff in order to attract talented people. Technical training is receiving more emphasis as the shortage of technical workers is becoming a serious problem in China. In particular, a lack of senior technical workers is one of the most urgent needs in Shanghai, China’s biggest city. Performance evaluation Performance evaluation is widely used in China nowadays. But it is not effective without motivation and supervision. There are no systematic performance evaluation systems. As a result, performance evaluation does not work well in most Chinese enterprises. Human resource management scholars and practitioners have been trying their best to develop performance evaluation systems that fit Chinese enterprises. Performance evaluation is highly regarded by employees because it is connected to their incomes. Compensation system Compensation reform in Chinese enterprises has been introduced gradually since the 1990s. For example, the Shenzhen Municipal Government set up a regulation on compensation for the top management of Shenzhen City SOEs in the late 1990s and renewed it in early 2003. Beginning from 2003 compensation for managers of SOEs in Shenzhen City has three components: basic salary, performance reward, and annual bonus. The basic salaries for managers at three different levels of SOEs are: 120,000 RMB for first-level enterprise managers, 108,000 RMB for second level and 96,000 China’s business reforms 106 a. Establishing P&G scholarships at top Chinese universities. b. Lecturing and giving presentations on the campuses. c. Designing a competitive recruitment and selection program. P&G in China has become the most popular foreign company in Chinese universities and has attracted thousands of outstanding graduates. The promotion system in P&G is designed to be fair to every employee. It includes internal promotion, international promotion, challenging career experience and management opportunities for local Chinese staff. Training is used to invest in human resources and motivate employees. P&G provides all different kinds of training programs for its employees. All employees are encouraged to participate in lifelong learning and organization building. P&G’s compensation system is designed in accordance with international standards. The market determines the group average level of compensation. The modern compensation structure includes salary, various welfare benefits, stock options and other methods, for rewarding performance. Profit sharing is also used to retain good employees. Haier Group The Haier Corporation was established in 1984 manufacturing only refrigerators. Over the past 20 years, the Haier Corporation has grown from one small factory into a large transnational company widely recognized in the world community. The Haier Group now manufactures a broad range of household electrical appliances in 86 categories with 13,000 specifications and exports products to more than 160 countries. Haier’s global sales in 2002 totaled RMB71.1 billion, including overseas turnover of US$1 billion. Haier tries to build a fair, open, and just atmosphere for employees. There are four human resource development principles in Haier. First, the Human Resource Development Center studies corporate human resource management policies to tap employees’ potential and motivate people. They have designed three kinds of career development program for all employees. One program is for people whose career path is in management; another is designed for professional personnel, and the third is designed for blue-collar workers. Second, management staff who are already in their positions are supervised and evaluated. Promotion is the result of competition. Third, managers should be trained at different departments at a lower level before being promoted to a higher position. And last, a small percentage of personnel are removed from their positions based on poor performance. 7.5 Conclusion Many changes have taken place in Chinese enterprises since China started economic reform and opening up to the outside world in 1978, especially in recent years. The changing structure of Chinese enterprises has brought attention to some critical issues concerning human resource management. The purpose of this chapter was to outline some of the changes that have taken place in Chinese enterprises since China began its economic reforms and opening up to the outside world, and to describe the changing Changing structure of Chinese enterprises 113 structure of human resource management in those enterprises. The chapter analyzes the present situation, discussing problems and challenges of Chinese enterprises and the main characteristics of human resource management in China, with brief reference to recruiting, training and development, performance evaluation, and compensation practices in two specific enterprises. Notes *This chapter is part of a research project supported by the National Natural Science Foundation of China, Project number: 70372036; Ministry of Education research project, 03JB630014; and Business Administration National Key Specialty of Nanjing University. China’s business reforms 114 8 The management of human resources in Shanghai A case study of policy responses to employment and unemployment in the People’s Republic of China Grace O.M.Lee and Malcolm Warner* 8.1 Introduction The management of human resources—broadly conceived—in the People’s Republic of China (henceforth to be referred to as China) was associated with a Soviet-style command economy and lifetime employment from 1949 (when Mao Zedong took power) until 1978 (when Deng Xiaoping’s economic reforms were initially launched). The Chinese worker in the 1950s saw the implementation of a ‘jobs for life’ and ‘cradle to the grave’ welfare policy for those working in the urban industrial state-owned enterprises (SOEs). This system was widely known in Chinese parlance as the ‘iron ricebowl’ (tie fanwan) and the phrase became a widely used shorthand term for the management status quo amongst informed outsiders interested in what is happening in that country (see Child 1994). The system was partly derived from earlier Chinese Communist experience in the so-called ‘liberated zones’ during the war with Japan, as well as later, Soviet practice, but may in addition have had roots in Japanese precedents in occupied Manchuria—and it is likely that there was a wide range of earlier influences that shaped the evolution of the ‘iron rice-bowl’. It had become definitively embedded in industrial life and fully institutionalized by the mid-1950s. Labour market imbalances were to be addressed at the company level rather than in the open market. As with the Japanese labour market policy model, the emphasis was on the ‘internal’ labour market within the enterprise as opposed to the ‘external’ labour market outside the enterprise. It is an enterprise-centred and industry-driven form of labour market management. In this context, labour market policies may be considered as social protection, both in theory and in practice, and as intended as a form of employment protection (Abrahart and Verme 2001:60). Several writers (such as Walder 1986 or Warner 1995) have seen the ‘iron ricebowl’ relationship as ‘organizational dependency’, and as an important theoretical support for their analysis, to which we will return later. The mindsets associated with this relationship became deep-rooted and difficult to modify or change. Even so, with the beginnings of the economic reforms, the guarantees of the ‘iron rice-bowl’ began to be eroded. But this only came about gradually in the reform period. The policy of jobs for life lingered on in the 1980s, and it was not until the 1990s that the ‘iron rice-bowl’ began to be effectively replaced by a market-oriented set of labour and personnel reforms. The ‘lifetime’ employment system was generally believed by economics and management scholars to be associated with weak people-management and to reinforce factorimmobility and inefficiency (see Warner 1995, 1999 and 2000 on the background literature on this). The government acknowledged the existence of unemployment as a necessary temporary condition to facilitate and maximize the allocation of labour, and the government’s role has become mainly to support the unemployed with income maintenance and training schemes so as to facilitate job seeking and placement. Managers were now allowed more autonomy to hire and fire, particularly in SOEs; decision-making was to become more decentralized in not only personnel but also marketing and purchasing domains. A reform-inspired workplace practice adopted from the mid-1980s onwards had been the implementation of ‘labour contracts’. By defining the length of the contract, the period of employment became sharply delineated and this displaced the previously enshrined practice of permanent ‘lifetime employment’. In theory, workers in China had since the 1950s been the ‘masters of the country’ (guojia zhuren), with the bad old days of job insecurity a bygone feature; by definition, unemployment could not exist. The key question of the day was the ‘right to work’ (gongzuo quan) and ‘full employment’ (quanmin jiuye). Unemployment, sanitized in the phrase ‘waiting for work’ (daiye), intertwined in turn with poverty, now poses such a major threat to both social stability and the rule of the Chinese Communist Party (CCP), however, that it demands an urgent policy response. This chapter begins with an examination of the issue of employment and unemployment in China, then moves on to explain the institutional changes that brought about the problem. We then discuss our research methodology. Shanghai will be taken as a case study to explore policy responses; in the next section a labour market model will be developed to discuss both active and passive labour market programmes in Shanghai. Despite the apparent success of the Shanghai model, its general applicability to other cities remains uncertain, particularly in view of China’s entry to the World Trade Organisation (WTO), the subject of the discussion section that follows. The final section presents some conclusions. 8.2 Employment and unemployment in China At the present time, China’s billion and a quarter population and vast labour force, the largest in the world (see Warner 1995), puts human resources high on the agenda as far as the recent WTO entry (in late December 2001) is concerned. Many of the labour force of over 700 million are country-dwellers and still live in townships and villages. There has been until lately a strict ‘one-child policy’ in most of the People’s Republic to restrain population numbers, as new citizens as well as existing ones have to be fed, housed and employed—no easy challenge. Half of the labour force work on the land, but it is estimated that over 200 million of these are surplus to economic requirements. Already over 100 million are on the move, making their way into the towns as part of the ‘floating’ migrant population known as the mingong. Over a third of China’s population live in urban areas. Those out of work in the towns were officially calculated at 3.5 per cent of the urban workforce in the late 1990s, but in reality this figure could be much higher, as we shall shortly see. China’s business reforms 116 Shanghai, China’s largest city, was no exception. Unemployment was officially unknown throughout the Maoist years. Jobs for life were de rigueur. The unemployment rate in Shanghai even by 2001 was officially seen as low as 4.3 per cent, in spite of the industrial restructuring that had taken place in that conurbation (Shanghai Statistical Bureau 2002). It is more than likely to be an underestimate. As Solinger has rightly pointed out, ‘accurate data are hard to come by, since government statistics are murky and often presented in a way that suggest that the numbers are not all that large’ (Solinger 2002:304). The State Council’s Development Research Centre issued a report that contradicts official figures for the current unemployment rate. In contrast to the very recent official rate of 4.5 per cent in China, the report indicates that the urban unemployment rate is already 10 per cent, and will rise to 15 per cent under the impact of World Trade Organisation entry.1 Politics has plagued the use of statistics from the beginning of the People’s Republic. As long as high GDP growth rates and low unemployment are treated as political targets, and are used to bolster the careers of provincial officials, these problems will remain. One phrase that is commonly heard among Chinese economists is that ‘data make officials, and officials make up the data’ (shuju chengjiu guanyuan, guanyuan chengjiu shuju). Euphemisms abound in this sphere. Here are a few examples (see Kynge 2003): • daiye, waiting for work; • fenliu, attached to one unit but working for another; • neitui, retired early but getting a stipend; • tingxin liuzhi, keeping a job but without pay; • liangbuzhao, similar but with more emphasis; • fang changjia, on a long vacation; • tiqian tuixiu, early retirement; • fuyu renyuan, no work but a token wage. Indeed caution has to be paid to differences in definitions. China defines the jobless in a highly distinctive way. According to the State Statistical Bureau, unemployment refers to the urban registered unemployed who (a) possess non-agricultural residence; (b) are within a certain age range (16 to 50 for males and 16 to 45 for females); (c) are able and willing to work; and (d) have registered with the local labour bureau for employment (State Statistical Bureau, 2002:588). Only the openly unemployed are eligible for what are known in the PRC officially as ‘unemployment benefits’. In fact, another form of joblessness is perhaps more pervasive—‘hidden’ unemployment’—referring to workers, often in the state sector, who have been laid off (xiagang). The State Statistical Bureau defines ‘laid off workers to be ‘workers who have left their posts and are not engaged in other types of work in the same unit, but still maintain a relationship with the unit that they have worked in’ (State Statistical Bureau 2002:588). Workers who have been laid off are only given very basic living subsidies (shenghuofei) at subsistence levels, instead of unemployment benefits, and are not included in the registered unemployment rate. This convention has led to confusion by overseas observers, and accounts for the allegedly low rate of joblessness in China. A White Paper on Employment and Social Welfare issued by the State Council stated that from 1998 to 2001, more than 25.5 million people were laid off from state-owned enterprises, of which 16.8 million managed to rearrange employment (as cited in O’Neill The management of human resources 117 2002: A01). These figures would suggest that 8.7 million are still laid off. Wang Dongjin, Vice-Minister of Labour and Social Security, pointed out that many of the jobless and those laid off from state-owned enterprises were low-skilled and middle-aged workers who had had a poor education and had been employed in traditional sectors such as coal, textiles and machinery (as cited in O’Neill 2002: A01). Wang’s observation is supported by Maurer-Fazio’s (2002) empirical analysis that demonstrates that education has become a key determinant of labour market outcomes in China’s rapidly changing work environment. Educational attainment is now an important factor in the ‘layoff decision’: the more education a worker has, the better his/her protection from layoff. Similarly, the more education a worker has, the better his/her chances of finding new employment. Wang openly acknowledged that China was facing a severe employment situation, and the numbers that had newly joined the labour force were at an unprecedented peak. In the coming few years, 12 to 13 million will enter the labour market every year. Even if China retains its current 7 per cent economic growth per year, only 8 million jobs will be created. This means the annual newly added unemployed will be 4 to 5 million. By the end of 2005, a new unemployed force of 20 million is expected to appear. While the precise total aggregates may be in doubt, this description seems plausible. Unemployment, intertwined with poverty, now poses a huge threat to both social stability and the rule of the Chinese Communist Party (CCP), and this demands an urgent policy response. Labour market programmes have emerged as an important employment policy tool in the reform era. The following section examines the institutional changes in the Chinese labour market in the pre- and post-reform era. 8.3 Institutional changes in the Chinese labour market In their theoretical analysis of the recent economic reform process, Hussain, Stern and Stiglitz (2000:4) argued most persuasively that the more successful aspects of China’s Table 8.1 Institutional changes in the Chinese labour market Pre-reform era Post-reform era Role of the state Socialist ideology Market principles Direct allocation of jobs Facilitating job search Provisions from ‘cradle to grave’ Individual self-reliant State-owned enterprises Centralization Decentralization Life-long employment Contract terms Tool for full employment Layoffs for efficiency Workers as ‘masters’ Workers as ‘proletarians’ China’s business reforms 118 transformation have been based on ‘a process of institutional change that preserved and built on its basic codes and practices of behaviour’. Table 8.1 shows a comparison of the institutional changes in the pre- and post-reform era. China’s pre-reform labour system was the antithesis of the free market. The state claimed ownership of labour services and bureaucratically assigned workers to enterprises for life (tongyi fenpei). Workers’ preferences concerning occupation or location mattered little. On the enterprise side, managers for the most part had to accept any and all workers allocated to them. Job mobility was minimal and would occur mostly as the result of workers’ reassignments or transfers to satisfy the need of state-run organizations (Walder 1986:8). Under these circumstances, where individuals are discouraged from searching for jobs, information about jobs is unimportant and meaningless. Around 1992–1993, the policy of state job assignment was largely abolished. By the mid-1990s, the tongyi fenpei system remained only residually in large cities such as Shanghai (Davis 1999:22–43). School graduates still have access to state-sponsored channels for employment, but they now have the option of using market channels such as advertisements, job fairs and employment agencies. The number of private enterprises, foreign-funded firms and other non-state controlled businesses has significantly increased. Seen positively, the operation of labour markets made it legitimate for individuals to use all kinds of channels to search for jobs. Bian’s (2002) study of job mobility in five Chinese cities indicated that from the pre-reform period to the 1980–92 and the post-1992 period, job mobility through hierarchical channels2 declined sharply from 76 per cent to 52 per cent to 10 per cent respectively. Meanwhile, job mobility through market channels increased from 15 per cent to 32 per cent to 60 per cent respectively. These changes point to the decline of job assignments and the growth of labour markets in Chinese cities from 1980 to 1999 (Bian 2002:4–7). On the other hand, the abolition of the state allocation system also means that concerns about state-sector inefficiency began to override concerns about dismissals and layoffs. Enterprise reforms replaced the ‘iron rice-bowl’ with performance-based hiring, firing, and compensation. State-owned enterprises have begun to use labour contracts, adopt wage reform, and decentralize labour management. The policy of laying off workers (making them xiagang) was first experimented with and then applied nationwide in 1997. The effects were profound. The security once enjoyed by urban workers rapidly eroded. Chinese urban workers are no longer shielded from market forces. They bear the brunt of the adjustment costs as enterprises shed redundant workers in their attempts to become more efficient and profitable. Laid-off workers experience substantial periods of unemployment with minimal stipends. To address this issue, various localities have devised their own ‘re-employment projects’ (zaijiuye gongcheng). Shanghai was chosen for our study because it was the pioneer in establishing the Re-employment Service Centre. Combining welfare provision, employment services and retraining programmes, the Shanghai Re-employment Service Centre was recognized by the central government as a ‘learning model’ for other local governments. These changes exemplify the notion that state institutions constantly readjust and revise themselves in response to new demands and circumstances, an important feature of the transitional economy (Solinger 1999 cited in Fan 2002:107). We now briefly sketch out the research approach we used in the case study. The management of human resources 119 8.4 Research methodology The main research methods we used in the citywide case study presented here draw on evidence gleaned mainly from both primary and secondary documents, media reports and official statistics. These we consistently approached with caution to build up an analysis and evaluation of the Shanghai re-employment model. Empirical field research in Shanghai in the form of over fifty open-ended, qualitative interviews with policymakers, managers, trade union representatives, workers and unemployed persons in the late 1990s and, with recent further contacts, up to the end of the year 2001, also provided supplementary valuable data. Visits were made to government departments such as the Labour and Social Security Bureau in Shanghai, as well as the Re-employment Service Centres. The operation of the placement service, retraining services and social security insurance was observed at first hand.3 The evidence we present below, we believe, has therefore robust empirical underpinnings. 8.5 The Shanghai labour market model Figure 8.1 depicts a labour market model that summarizes the operation of the system in Shanghai. Over the past 40 years, ‘active’ labour market programmes have emerged as an important employment-policy tool, particularly in developed countries. This policy envelope includes a wide range of activities intended to increase the quality of labour supply (for example retraining), to increase labour demand (for example direct job creation), or to improve the matching of workers and jobs (for example job-search assistance). The objective of these measures is primarily economic: to increase the probability that the unemployed will find jobs or that the underemployed will increase their productivity and earnings. However, more recently the case for active labour market policies has also emphasized the potential social benefits in the form of the inclusion and participation that comes from productive employment (Betcherman et al 2000:1). Labour supply (school leavers, job changers and laid-off workers) is the primary input to the systems model. This supply of labour, it is hoped, will be transformed by the active labour market programmes of the government, leading to positive output of employment. Shanghai has also established a ‘passive’ labour market policy of unemployment insurance. 8.5.1 Retraining Public support can come in the form of direct provision of training (for example through public training institutes), financial support for trainees (for example by funding training costs and/or subsidizing trainees) or providing ‘infrastructure’ services (such as labour market information, licensing, monitoring and credential services). State and city governments have a range of potential roles: direct provision, regulation, providing information and standards, and financing. Many governments are moving away from the role of direct provider and focusing more on addressing market failures in information and financing, while leaving more of the delivery to private providers (Betcherman et al 2000:5), but the role of the state is prominent in Shanghai. The training programmes are China’s business reforms 120 Figure 8.1 Chinese labour market model designed, financed and delivered by the government. The training centres are attached to the placement centres, widely known in Shanghai by the description qiandian hou The management of human resources 121 gongchang (employment-service provided in the shop, training in the backyard). Each class will have about 40 trainees. The length of training differs from job to job: domestic helpers will be trained for three weeks, six hours a day; cooks and technicians will receive training for half a year, but only three days a week. According to the head of the training centre visited, the success rate in job placement is often boosted from the normal rate of below 30 per cent to as high as 70 per cent for domestic helpers (field interviews, June 1999). In Shanghai, retraining is free of charge for jobseekers certified to be xiagang workers and unemployed. Some laid-off workers do benefit from various training programmes, ranging from cooking and hairdressing to public relations, law and marketing (China Daily, 30 January 2001). If training is for self-development purposes, however, each trainee will have to pay 300 RMB to take part in the course. 8.5.2 Creation of employment In general, job creation programmes across the world are designed to support the creation of new jobs or the maintenance of existing ones. Three broad types of programmes fall under this category. First, there are subsidies to encourage employers to hire new workers or to keep employees who might otherwise have been laid off for business reasons. These can take the form of direct wage subsidies (for either the employer or worker) or social security payment offsets. These types of subsidies are always targeted to a particular category of worker or employer. The second category involves direct job creation in the public or non-profit sector through public works or related programmes. Typically, government funds used for these programmes cover compensation costs to hire previously unemployed workers, usually on a temporary basis. Third, support is sometimes offered to unemployed workers to start their own enterprises (Betcherman et al 2000:6). Direct public employment creation policies are set up to lessen unemployment by creating jobs and hiring the unemployed directly. Such policies target the displaced and the long-term unemployed, with a view to help them regain contact with the labour market, thereby minimizing the likelihood of stigmatization, skills obsolescence and marginalization. In devising solutions to the employment problem, the Shanghai government has created more employment opportunities by any reckoning. The Shanghai Labour Bureau has, for instance, invested in minor improvement programmes at the district level, and has allegedly created over 20,000 vacancies. These vacancies concentrate on public hygiene (baojian), public security (bao’an), environmental protection (baolu), and the maintenance of public facilities (baoyang).4 Street committees also help in providing employment programmes. These committees retrain laid-off workers to do work such as the maintenance of buildings and ‘green’ areas, sanitation, domestic services and security. Funding for some of these programmes comes from individual households, with each paying about 36 cents (in Chinese currency denomination) per month for committee services including window-cleaning, garbagedisposal, maintaining recreational facilities and activities, maid-services and even providing haircuts (Erickson and Hsieh 1998:52). These services have clearly become ‘affordable’ as urban dwellers in China become wealthier.5 Another type of job creation that is important to cite is the Self-Employment Creation Measure or Micro-Enterprise Development Assistance. Technical assistance, credit and China’s business reforms 122 SECTION THREE 9 Employee perceptions of social protection reform in Shanghai: diversity across ownership forms and occupations Cherrie Jiuhua Zhu, Chris Nyland and Brian Cooper 9.1 Introduction As China has expanded the scope and role of the market within its economy and society, the job security of its citizens and workers has been undermined by the associated dismantling of the old system of social insurance (the ‘iron ricebowl’) that prevailed through the period of command socialism. Consequently the government has begun the construction of a social protection regime that is suited to a market economy. This is a process which the state recognizes needs to be managed with care and sophistication if social stability and a high growth rate are to be sustained. It is also recognized by the government that it is important to have a clear understanding of how the reforms are perceived by the population. Recognition of this need and a genuine concern for the plight of the dispossessed has induced both Chinese and international scholars to monitor closely how the broad population and strategic elements within the community are perceiving the reforms. Underpinning this sensitivity is also an awareness that perceptions affect how individuals and groups cope when confronted with fundamental changes to practices and institutions central to their needs. Shanghai has been an important focus for those undertaking research related to perceptions because the city’s administrators have played a pioneering role in the development of the emergent social protection regime. In this chapter, we extend the perception research by detailing the diversity of employee views on social protection reform that prevail across firms with differing ownership forms and occupations. The research on perception has so far tended to concentrate on state-owned enterprises (SOEs) at a time when China’s government is committed to policies that are bound to further decrease the number and relative significance of state enterprises. The chapter has five sections. First, we highlight changes in the ownership structures of enterprises and the social protection system. Second, we review the results of previous studies that have sought to determine how the reform of the social protection regime is perceived in China. We then explain the research method employed including the background of the survey that was conducted in 2002 to determine whether and how employees’ views of social protection reform vary across ownership types and occupations, and detail the measures used in the survey questionnaire. In part four, we proceed to recount the results of the survey. Based on a sample of 299 employees, variations in attitudes towards social protection reform across several dimensions are reported. These include the changing business environment, enterprise competitiveness, personal risk management, labour mobility between public and non-public sectors, motivation due to the sense of security provided by the new protection system, and labour relations. We then apply multivariate analysis to the survey data to examine determinants of employee satisfaction with social protection policies. We conclude by discussing the survey results and their implications for employees, managers and policymakers. 9.2 Changes in the ownership structure and social protection system Among the firms surveyed in this study, there were four major ownership forms: stateowned enterprises (SOEs), privately owned enterprises (POEs), foreign-invested enterprises (FIEs) and shareholding enterprises (SHEs). These organizations were generally classified as state (SOEs) and non-state (POEs, FIEs and SHEs) sectors. While POEs and FIEs started their development in the early 1980s, shareholding or joint-stock structure has been used widely to reform and restructure the massive state-owned sector only since the mid 1990s. For example, the number of SHEs increased from 72,000 in 1997 to over 300,000 in 2001 (an increase of 320 per cent), and the number of people employed also increased more than threefold from 6.44 million to 27.47 million (Census Centre of the China Statistical Bureau 2003). According to the second nationwide organization census in 2002, the shareholding structure has become a major ownership form for companies and enterprises in China. It usually has mixed ownership because the majority of SHEs are not publicly listed companies and have mixed investors from both public (for example state and collectively owned organizations) and private sectors (for example POEs, FIEs or individuals) (Census Centre of the China Statistical Bureau 2003). In the Third Plenary Session of the 16th Communist Party Congress held in October 2003, the CCP leaders outlined the need for more diversified forms of public ownership and stated that the ideal approach was a ‘shareholding system that absorbs investment from various channels’ (AFR 16 October 2003:10). In the last 25 years, China has witnessed a rapid growth in the number of non-state enterprises as a result of economic transition and reform in the public sector. For example, the percentage of the total number of POEs, FIEs and SHEs in relation to the total number of enterprises in China increased from 29.1 per cent in 1996 to 58.2 per cent in 2001 (Zhao 2003). Furthermore, in 2001 the total industrial output from POEs increased by 69.2 per cent compared with 2000, and FIEs produced an increase of 30.7 per cent in contrast to a 14.9 per cent decrease in output from SOEs (Wang 2003). In 2002 Shanghai had 210,000 private enterprises employing 2.3 million people, or one in every three Shanghai workers (China Daily October 8 2002). In the planning communiqué issued by the 2003 Communist Party Congress, the Party identified ‘the China’s business reforms 130 need for greater promotion of the economy’s private sector’ and proposed that ‘private firms be given equal rights in investment, lending, tax, land use and foreign trade’ (AFR 16 October 2003:10). While the transition has increased diversity in the workforce in China in terms of different types of enterprises and a diverse range of employees, it has challenged the traditional ‘iron rice-bowl’ form of social protection that had previously characterized China’s work units or organizations (danwei) in the public sector. Before the social protection reforms started in the 1990s, the Chinese social insurance system had two major features: the separation of urban and rural areas and segmentation of urban enterprises based on their ownership status (Hussain 2000). Private industry was negligible during Mao’s regime and no social protection programs existed in that sector (Chen 1990; Lee 1993; World Bank 1990). In the public sector, social protection was tied to the ‘work unit’, not to society, and work units generally provided urban workers with permanent employment and a range of social insurance benefits that were noncontributory and included food and housing subsidies, pensions, health services, maternity assistance, and insurance against injury, disability, and death (Li 2000; Guan 2000; Wang 2001). The highly decentralized administration lacked an established mechanism for portability of eligibility and benefits, which discouraged employees from moving across organizations, industries or sectors (Dai 1999; Song and Chu 1997); consequently, employees in China were called ‘unit people’ (danwei ren) rather than ‘social people’ (shehui ren). Urban employees in the state sector enjoyed cradle-to-grave benefits, and work units were responsible for their welfare even after retirement (Whiteley et al 2000). By the end of 1994, about 90 per cent of workers in SOEs and about 70 per cent in collectively owned enterprises were covered by the social protection system (Ge 1996). By contrast, the new regime currently being developed links job security to the market, provides a less encompassing range of benefits, and greatly increases the share of the cost borne by individuals. Guan (2000) has accurately described the emerging regime as ‘societalization’ (shehuihua): that is, a society wide system in which everyone receives the same level of social protection irrespective of where they are employed. Shanghai, for example, has introduced a three-tiered pension and medical insurance system to every type of enterprise from the late 1990s, and the traditional ‘direct-planned welfare provision’ has been replaced by a ‘redistributive process’ in welfare provision (Guan 2000:119). As a result, employees in different sectors are theoretically treated equally in terms of their social protection. While many researchers have focused on the decreased social security accorded to employees in SOEs through the breaking of the iron rice-bowl (see for example Warner 2000), little attention had been paid to the fact that the establishment of a comprehensive national social security system would in fact heighten the security enjoyed by the majority of city workers. This is because an increasing number of people are employed outside the state owned sector, and these people (especially employees working in the private sector) would not enjoy any substantial protection from the vagaries of the market but for the reforms. The new social security system is expected to assist employees from either state or non-state enterprises to handle risks including those induced by the new market economy (such as retrenchment or unemployment). Furthermore, as the new social security system maintains employees’ coverage from job to job, it will facilitate Employee perceptions of social protection reform in Shanghai 131 labour mobility across enterprises with different ownership structures. As a consequence, under the new system, it is more likely employees will select their jobs based on their skill rather than the ownership type of the enterprise. Precisely how employees respond to these changes, however, will be dependent to a significant degree on how they perceive the changes to the regime. It is to this issue that we now turn. 9.3 Monitioring perceptions and coping strategies Researchers who have examined the marketization of China’s social protection regime have concentrated on analysing the way the reforms are financed and governed (Chen 2001; He 2003; Meng 2003; Tian 2003; Yin et al 2000), the social and political implications of associated regulations and programs (Guan 2000, 2001b; Leckie 2003; Saunders and Shang, 2001; Wang 2001; Whiteford 2003), and the costs to employees induced by breaking the iron rice bowl (Cook 2002; Mok et al. 2002; Price and Fang 2002; Smyth 1999; Zhu et al 2004). This research is of great value but does not necessarily clarify how the populace views the market-oriented universal social protection regime that is being introduced across China. Understanding how workers perceive the reform of social protection is important because there is a spectre haunting China, the spectre of organized resistance on the part of those whom the market has dispossessed. To contain this danger, governments and others with a stake in policy management need to be aware of how the reforms are being perceived by the populace. A clear understanding of these perceptions can also assist the attainment of a number of more limited goals. For example, such knowledge can play an important part in the development and maintenance of active labour market policies and human resource management strategies. That there is a need to incorporate the social security dimension into the analysis of labour market and industrial reform often goes unappreciated. Price and Fang (2002), for example, surveyed unemployed workers across seven cities to assess their coping strategies, but failed to include access to welfare provisions amongst the explanatory variables they considered. This was despite the fact that welfare provisions for the unemployed vary markedly across the cities of China. The need to include the social insurance variable in analyses of both the labour market and individuals’ coping strategies is also evidenced by the fact that though marketization has made alternative forms of employment available, the non-state sector remains an unattractive employment locale for many workers. This is especially so for those retrenched and unable to gain jobs that provide adequate social insurance provisions (Maurer-Fazio 1995; Smyth 1999). As Gu has observed: The majority of workers laid off from the state sector prefer to be reemployed by their original work units or by other work units in that sector (or the collective sector) rather than in the private sector. This is a rational preference because within the institutional configuration of the private sector, no systematic welfare provisions have been established. Workers are afraid that if they join the private sector and then lose their jobs, they will lose unemployment benefits, lay-off aid, medical care, and (most China’s business reforms 132 important) pensions. Even if they have job opportunities in the private sector, many decline them and maintain their status as laid-off workers unless new offers have some specific attractions (Gu 2001b:106). That there is a need to have a clear understanding of the way social protection reform is perceived by the population is appreciated by China’s government. This is evidenced by the fact that social security was explored in a State Statistical Bureau survey of 40,000 urban families undertaken in 2000 in preparation for the White Paper on labour and social security that was issued in April 2002. In undertaking this survey the researchers took particular care to determine how interviewees perceived the increasing social inequality that has become a characteristic of China’s marketization process, and discovered that this was an issue of deep concern to many (Lee et al 2002). Determining the importance that individuals place on social protection and whether social protection reform is an area of concern has also become a tool and a product of private market researchers. These firms have explored this topic primarily in order to provide for the needs of the emerging private insurance industry. China Mainland Marketing Research Co. (CMMR), for example, conducted random sample questionnaire investigations in 31 cities across China in October and November 2002 to determine citizens’ views on ‘social life issues and household life status’ (China Daily 27 December 2002). The researchers surveyed over 12,500 urban citizens aged between 18 and 69. It was found that a large majority of citizens believed their living standard had improved markedly over the previous five years and most interviewees were optimistic about the future. When asked to rank the social issues of most concern, employment and medical system reform rated highly as worries but social security ‘topped the list’ (see Table 9.1). Not unexpectedly, views regarding social security and unemployment differed across the social spectrum (see Table 9.2). Table 9.2 indicates that while over half of the people ranked in the ‘bottom stratum’ (54.3 per cent) showed deep concern about the issue of ‘social security’, there was less concern amongst the more affluent. Nevertheless, over 40 per cent of people at all but the ‘upper layer of the top stratum’ shared the same concern. In summarizing their results, CMMR concluded that ‘people in lower social strata care more about their daily life while people in higher strata care more about national affairs and tend to have more political orientation’ (CMMR 2003, see Table 9.2). Table 9.1 The ranking of ‘Hotspot’ social topics among urban citizens (multiple choice) Type of social topics Ranking % Type of social topics Ranking % Social security 1 45.5 Environmental control 9 12.3 Unemployment and employment 2 33.8 Motherland unification 10 7.4 Medical system reform 3 31.3 Western China Development 11 7.2 Public order 4 28.6 Salary increase of civil servants 12 6.2 Anti-corruption 5 27.2 Increase of overall national strength 13 6.2 Employee perceptions of social protection reform in Shanghai 133 Education system reform 6 17.5 Reform of state-owned enterprises 14 6.2 Impacts of WTO entry 7 13.7 Teenager education 15 6.1 Medicine price 8 14.3 Others 16 5.0 Source: CMMR (2003) Table 9.2 Hotspot social topics most concerned among different social strata in cities in 2002 (%, multiple choice) Source: CMMR(2003) The social protection perception literature generated by state and market researchers has also been enriched by academics. Notable amongst the latter is a report by the Institute of Development Studies undertaken in collaboration with the China Women’s College. Prepared by Cook and Jolly (2000), this study explored the perceptions of workers who had been made redundant by restructured SOEs. Interviews were undertaken with people laid off in three cities, with the explicit intention of informing policy interventions. It was found that not all laid off workers were poor but many suffered from a perceived loss of status, feelings of worthlessness and vulnerability to discrimination, exploitation or exclusion. Most believed unemployment and the inadequacy of social security benefits had compelled them to take up livelihoods formerly despised, restrict their diet, spend China’s business reforms 134 less on educating their children and elderly parents and curtail their social interactions. Cook and Jolly also report that male worker resentment is compounded by the fact that many unemployed men suffer guilt because without a job or adequate social security they are compelled to rely on their wives for support. Conversely, women tend to find it easier to accept new forms of work but they deeply resent losing the esteem they enjoyed when depicted as model socialist workers, and feel bitter about the loss of the social insurance benefits that were associated with this high-status position. Generational differences in perceptions were also apparent. Despair and resentment was especially acute amongst the young with individuals in their thirties perceiving themselves as old, unemployable and unable to compete for jobs. Similar perception research has subsequently been reported by Mok et al. (2002). Again it was found that the vast majority of the retrenched had limited access to social security benefits, and few welfare entitlements with the exception of medical insurance. And again it was found that the combination of unemployment and the lack of adequate social insurance benefits has generated a’strong sense of destitution and betrayal’ amongst those who once were ‘labour aristocrats’. The breadth and intensity of these perceptions, Mok et al. (2002) conclude, need to be appreciated by China’s government which, they also insist, needs to do much more than is presently being done in the areas of unemployment, medical insurance and pensions. While the researchers discussed above have focused on how citizens and workers perceive the current social protection situation, Wong et al (2000) have explored popular perceptions regarding responsibility for the provision of social protection. Focusing on Shanghai, because this is arguably the city in China most advanced on the path of marketization, they sought to determine where citizens tend to locate responsibility for social security and who they blame for the prevalence of insecurity and immiseration. Wong et al. (2000) collected their data by random sampling across 16 districts of Shanghai. They found that the overwhelming majority of respondents accepted that they had experienced substantial improvement in their lives and that there were many new opportunities available to further improve living standards. However, when the researchers turned their attention to individual life satisfaction, they found that barely half the respondents were satisfied with many practical areas of life and that it was widely believed inequality was unacceptably high. It was also found that most interviewees blamed poverty on institutionalized social injustice rather than on government policy failure, adhered to a clear and strong pro-welfarist orientation, and strongly believed that the state has the primary responsibility for providing for the social protection needs of the community. The respondents were overwhelmingly clear about the four traditionally welfarist functions of the state: nine-tenths were in favour of guaranteed jobs; nearly all favoured equal education for children; nearly seven-eighths endorsed the narrowing of the income gap; and nine-tenths endorsed a guaranteed basic income (Wong and Lee 2000:113). Similarly, Beijing Social Psychology Research Institute conducted surveys on the social protection provided to the people in Beijing in 2001 and 2002 among over 1000 residents living in the eight districts of the city (http://www.chinaminyi.org.cn/). Three major findings of the research are related to the social protection enjoyed by people from different types of organization, the responsibility for individuals’ future social protection, and the purchasing power of commercial insurance. It was found that compared with Employee perceptions of social protection reform in Shanghai 135 people working in other types of organization, those from POEs had the lowest coverage of social protection; 25 per cent of the respondents from POEs reported there was no social insurance paid for them, while another 14 per cent said they had no idea whether or not the enterprises paid insurance for them. Consistent with the findings from Shanghai in terms of who is responsible for the individual’s security and future life, Beijing people ranked the government first, the organisation second and the individual last to assume such a responsibility; this indicates a legacy from the command economy and the iron rice-bowl mentality. The Beijing study also found that more people purchased commercial insurances in 2002 than they did in 2001 (56 per cent compared to 38 per cent of people surveyed), especially medical insurance (35 per cent in 2002 compared to 14 per cent in 2001). In closing this discussion of the literature, we suggest that the research on perception has shown that social protection is a major source of concern within China. What the literature also suggests is that there is diversity of perspective across gender, age and social stratum. What we shall do in the next section is determine if diversity of perspective can also be discerned from employees across firms characterized by different types of ownership and occupations. As observed above, ownership is an issue that is very significant given that the development policies being furthered by the government are dramatically changing the ownership form of business enterprises within China. 9.4 Research method This section is focused on the background of the survey conducted in 2002 in Shanghai, and the measures used in the survey questionnaire. 9.4.1 Sample Our survey, based on a convenience sample, was conducted mainly in industrial enterprises in Shanghai in early 2002. Anonymous questionnaires were distributed to 650 respondents, from enterprises with different types of ownership. The response rate was 46 per cent with a total of 299 usable questionnaires received. Of the respondents, 32 per cent were from SOEs, 36 per cent from foreign invested enterprises (FIEs), 19 per cent from shareholding enterprises (SHEs), and 13 per cent from privately owned enterprises (POEs). Selected demographic characteristics of the respondents are shown in Table 9.3. Of the respondents, 60 per cent were male and 40 per cent female. The majority of respondents (60 per cent) were aged 30–50. Most were qualified, with 40 per cent having a tertiary diploma (equivalent to a TAFE diploma in Australia), and 28 per cent possessing a university graduate degree or higher. Over half (56 per cent) of the respondents were non-managerial staff (workers, technical, and clerical staff) and 44 per cent managerial employees (supervisors and managers at different levels). China’s business reforms 136 Table 9.3 Profile of survey respondents Variables % Age (N=277) Under 30 15 30–39 21 40–49 39 50–59 24 60 and over 1 Gender (N=266) Female 40 Male 60 Occupation (N=268) Non-managerial (workers, technical and clerical staff) 56 Managerial (supervisors and managers at different levels) 44 Level of education (N=267) High school certificate or less 32 Tertiary diploma (2-year university certificate, dazhuan) 40 Tertiary degree (4-year university Bachelor’s degree, benke) 25 Post-graduate degree (Master degree or above) 3 Ownership (N=290) State-owned enterprises (SOEs) 32 Privately owned enterprises (POEs) 13 Foreign-invested enterprises (FIEs) 36 Shareholding enterprises (SHEs) 19 9.4.2 Measures The survey requested data on the respondent’s demographic characteristics, perceived changes in China’s business environment, and his/her perception of the current social insurance policies. As recommended for international research (Cavusgil & Das 1997), after the survey questionnaire was designed by the authors, it was translated and backtranslated to check that the meaning of the original questions was intact. Based on literature and the qualitative research conducted by Zhu et al. (Zhu and Nyland 2004; Zhu, Nyland & Yang 2004), we developed scales measuring the perception of the changing business environment in China, enterprise competitiveness and attitudes towards social protection reform across dimensions of personal risk management/labour Employee perceptions of social protection reform in Shanghai 137 mobility, motivation/sense of security, role of trade unions and employee satisfaction. Respondents were asked to rate each item on a 5-point scale from ‘l=strongly disagree’ to ‘5=strongly agree,’ with a neutral midpoint. We averaged the items on each dimension (possible score range is thus from 1 to 5) to form composite scales. A higher score on each scale indicates a greater amount of the variable being measured. Items related to these attitudinal dimensions are detailed below. The changing business environment in China was measured by five items: (1) marketplace competition has increased dramatically from domestic competitors; (2) marketplace competition has increased dramatically from foreign competitors, (3) conditions in our business environment are rapidly changing; and (4) government intervention is rapidly declining and (5) the technology in our product/service is becoming more complicated. Scores on this scale had acceptable internal consistency with a Cronbach’s alpha coefficient of .71. Enterprise competitiveness was measured by four items: (1) social protection reform can help a company to focus on its economic activities and improve its competitiveness; (2) social protection reform will enable social insurance funds to be managed in a more efficient way; (3) current social protection system has speeded up the abolition of the iron rice-bowl system, and (4) social insurance policies have made welfare items transparent, which helps remove hidden costs paid by the enterprise. Cronbach’s alpha for scores on this scale was .74. Personal risk management/labour mobility was measured by three items: (1) as a ‘social person’, I can easily quit and look for better opportunities elsewhere; (2) now I can change my job more freely across different sectors based on my skills rather than the welfare offered by the firm; and (3) with new social insurance policies, I can better handle retrenchment as I may start my own business or get a job somewhere else. Cronbach’s alpha coefficient for scores on this scale was .75. Motivation/sense of security was measured by two items: (1) I feel more motivated to work under the current social protection system than the previous welfare system, as I can rely less on the enterprise; and (2) my current personal insurance policy has increased my sense of security for my future retirement. Cronbach’s alpha coefficient for scores on this scale was .72. The role of trade unions was measured by three items: (1) it is necessary to have trade unions to facilitate social protection reform, as they will protect worker’s rights; (2) trade unions have played an important role in the implementation of new social insurance policies; and (3) the supplementary medical insurance supplied by the Shanghai Workers’ Mutual Association (SWMA, an organization of the trade unions) has reduced resistance to the implementation of new policy. Cronbach’s alpha coefficient for scores on this scale was .68. Finally, employee satisfaction with social protection policies was measured by eight items: satisfaction with the compulsory and supplementary pension policies, unemployment benefits, medical insurance policies for outpatients and inpatients, supplementary medical insurance, maternity insurance, and work injury compensation. Cronbach’s alpha coefficient for scores on this scale was .90. China’s business reforms 138