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Mitchell, Arthur "Privatization and Reform of the Financial Sector in the People's Republic of China" [2005] ADBLPRes 24 (5 December 2005)

Privatization and Reform of the Financial Sector in the People’s Republic of China

Remarks
of
Arthur M. Mitchell
General Counsel
Asian Development Bank

5 December 2005

ADB recently made a small equity investment in the Bank of China as one of the partners who will strengthen corporate governance and help pave the way for further privatizations in China. In the People’s Republic of China (PRC), the share of state-owned enterprises (SOEs) in gross domestic product (GDP) has come down from 77.6% at the beginning of the economic reform period in 1978, to less than 30% now. Yet there are still some 170,000 SOEs with assets totaling 6.9 trillion yuan, more than any other country, and not a single listed former SOE has been fully privatized. Few doubt the need to face down this mountainous and moribund state sector, and the PRC has made clear that it hopes to address the problem through privatization, deregulation, and reform of its financial system. Indeed, to maintain current high economic growth levels, and raise the funds to finance it, privatization is imperative.

The start of a trend

The management guru, Peter Drucker, introduced the notion of privatization as early as 1969. It later took off with the 1979 election of Margaret Thatcher in Britain, as her government began a series of privatizations that year with British Petroleum, and British Aerospace in 1981. By 1998, about 75,000 medium- and large-sized firms had been privatized, along with hundreds of thousands of small business units, generating proceeds in excess of $735 billion, according to Privatization International. Today, except for Cuba and the Democratic People’s Republic of Korea, virtually every country has since followed the privatization path in some measure.

The PRC was first among socialist countries to privatize state-owned enterprises, beginning with agriculture in 1978. Recently, the State Asset Management Commission has announced that out of an enormous pool of enterprises that remain in state hands, only 196 large enterprises will be retained while the remainder will be transferred to local governments to either sell or restructure.

Why privatize?

The need for privatization stems from the inefficiency, poor management and low productivity common to many state-owned enterprises. Under state ownership, bureaucrats who have no rights to the cash flow generated by the business are often motivated instead by political favoritism and corruption. Poor quality of goods and services, mounting losses and rising debts are the result. Privatization realigns motivation toward better allocation of cash flows through managerial and technological innovations.

However, privatization of monopolies without appropriate regulatory restrictions may create unfair profit opportunities and overall welfare losses. Post-1992 Russia is the most notable example of how privatization of SOEs can lead to oligarchy and monopoly. Indeed, privatization has been dogged by concerns about rising unemployment and social dislocation. Where transactions lack transparency, they signal corruption and illicit private gain in the name of public interest.

Getting it right, step by step

Many countries have been able to manage the privatization process through a framework that adequately deals with the legitimate interests of all stakeholders. The experiences of these countries tell us that a successful privatization strategy must take into account the following steps, which can help mitigate concerns arising from the privatization process.

Step 1: Set clear goals

The goals of privatization should be made clear and the strategy for privatization must derive from those goals. If not, the process may be captured by private interests and lose legitimacy. By establishing the principles early that will govern what assets and services will remain under state control, privatization can help attract new capital, technologies and management and spur added competition. It can supplement state revenues, and it can help minimize the drain on state budgets.

Step 2: Reform the regulatory framework

The regulatory framework governing privatized firms should be established prior to privatization.¹ Studies have shown that investors will pay substantially more for firms in countries where regulatory reform took place before privatization.

A regulatory framework that attracts investments is one that nurtures competition, promotes good corporate governance, and provides that the government’s role as owner must be separated from its role as regulator. PRC has already made progress reforming its basic financial architecture by establishing regulatory commissions for the banking, securities and insurance industries and establishing a Code of Corporate Governance for listed companies. More work is needed to address issues including the rule of law, creditor rights, shareholder rights, accounting standards, foreign bank presence and the elimination of state ownership of the banking sector.

Step 3: Build political and social support

Government must take time to ensure political and social support for privatization. Support for privatization in Europe and the United States has waned whenever the private sector lacked accountability and social commitment. Without significant and appreciable political and social support for privatization, workers may fear job losses or future job security; government bureaucrats may fear a loss of privileges; and even consumers in rural or other marginalized areas may fear a privately-owned company will may no longer provide them services.

Step 4: Ensure transparency and competitiveness

The method of privatization must be transparent and competitive. Whatever method is chosen, information should be shared with key constituents such as workers. Often, the lack of information and stakeholders’ lack of involvement in the process stirs unwarranted fear and opposition.

Step 5: Promote institutional development

The government needs to build institutional capacity to support privatization. To successfully execute a privatization program, governments must be able to analyze complex policy and strategic issues, introduce new laws, weigh different privatization options and negotiate and complete deals. Skills in financial restructuring, valuation and regulatory systems are essential. Without them, privatization will always face higher risks. In addition, governments must strengthen core institutions, such as the “rule of law,” to encourage the development of capital markets and proper reform of the financial system.

Step 6: Enhance domestic capital markets

Finally, measures must be taken to enhance domestic capital markets. The PRC relies disproportionately on banks for the provision of financial services, and is vulnerable to financial and macroeconomic instability. The weakness of the domestic capital market compounds the problem. In the long run, a robust debt and equity market within PRC will ease the privatization process. It will help broaden access to the capital markets to medium sized enterprises, and, as aspiring market entrants, encourage corporate good governance and accountability.