China's emerging private enterprises : prospects for the new century

CHINA'S EMERGING PRIVATE ENTERPRISES PROSPECTS FOR THE NEW CENTURY 21120 September 2000 .-- -t--' e R r nb i _ h a t I n a In te r nati o nalI Fi n an ce Co rp or a ti on 2 00 0   CHINA'S EMERGING PRIVATE ENTERPRISES PROSPECTS FOR THE NEW CENTURY I n tern atIo n alI F Ina n ce C orp or a t Ion 2 00 0  Copyright i 2000 International Finance Corporation 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433 U.S.A. Telephone: 202-473-7711 www.ifc.org All rights reserved Manufactured in the United States of America First printing September 2000 The International Finance Corporation (IFC), an affiliate of the World Bank, promotes the economic development of its member countries through investment in the private sector. It is the world's largest multilateral organization providing financial assistance directly in the form of loans and equity to private enterprises in developing countries. This volume is a product of the staff of the International Finance Corporation. The conclusions and the judgments contained herein should not be attributed to, and do not necessarily reflect the views of, IFC or its Board of Directors, or the World Bank or its Executive Directors, or the countries they represent. IFC and the World Bank do not guarantee the accuracy of the data included in this publication and accept no responsibility whatsoever for any consequence of their use. Some sources cited in this volume may be informal documents that are not readily available. The material in this publication is copyrighted. Please contact the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A., for permission to reprint or reproduce portions of this work. For additional copies of this work, please contact Corporate Relations, IFC, 2121 Pennsylvania Ave., N.W., Washington, D.C. 20433. Visit our Website at www.IFC.org. Principal authors: Neil Gregory, Stoyan Tenev, and Dileep Wagle. Library of Congress Cataloging in Publication data applied for ISBN 0-8213-4849-3  O Preface v Executive Summary vii 1. Introduction I 2. Evolution and Status of the Domestic Private Sector 7 3. Informal Status of Domestic Private Enterprises 20 4.Toward a Rules-based Environment 35 5. Financing Domestic Private Enterprises 45 6.An Agenda for the Future 60 Notes 75 References 77 CHINA'S EMERGING PRIVATE ENTERPRISES iii   One of the important outcomes of market-oriented reforms in China over the past 20 years or so is the emergence of a significant private sector. Initially allowed only on the fringes of the economy, it now accounts for about a third of gross domestic product and is officially recognized as an important component of the economy. This recognition reflects the new internal and external realities facing China today. Internally, one of the main challenges is the reform of the state-owned enterprises (SOEs) and the related reform of the financial sector. Restructuring SOEs and recapitalizing the banks are likely to be expensive, both because of short-term employment losses and fiscal costs. The private sector has emerged as an important source of income and employment growth, which can mitigate the social costs of reforms. In addition, China is trying to address the growing regional disparities in growth and incomes. Private sector development in the interior of China could be one way to narrow the gap betweeni the interior and the coast. Externally, China is becoming increasinglv exposed to the opportunities and challenges of globalization. The prospect of membership in the World Trade Organization highlights the need for major and rapid adjustments in virtually all sectors of the economy. New private businesses are likely to be the main agents of this rapid change. These developments make this a good moment to take stock of the evolution of the domestic private sector thus far and to identify constraints and opportunities for its future contribution to China's development. This study is one of the first systematic attempts to do so. It is based on extensive surveys and interviews carried out in four locations: Beijing, Chengdu, Shunde, and Wenzhou. These were supplemented by additional discussions held by the authors with entrepreneurs, industry associations, govemment officials, and others in these locations, as well as in Chongqing and Shanghai. The report focuses on three main themes: the structure of private enterprises, the enabling environment for their development, and access to financing. For each of these areas, the report presents an analysis of constraints on private sector development and outlines an agenda for entrepreneurs, the government, and the financial sector for addressing these constraints. The principal authors are Neil Gregory, Stoyan Tenev, and Dileep Wagle. Extensive guidance and support were provided by Davin Mackenzie and Jianguo Cui from IFC's Beijing office. The State Economic and Trade Commission (SETC) supported and facilitated the study for its successful implementation. Wei Dong (director general, Small and Medium Enterprise Department), Tian Chuan (deputy director, Small and Medium Enterprise Department), Wang Xu (International Department), and other SETC staff provided valuable guidance and support throughout, and the fieldwork was supported by the Economic and Trade Commissions in each locality. A range of other government and non-government institutions at the central level and in the four localities also contributed information and perspectives. This partnership was supported by the government of Australia, which financed the costs of the study through the IFC Australia-China Trust Fund. Donnelle Wheeler gave encouragement and support to our work at all stages. The study draws heavily on a technical report by the Asia-Pacific School of Economics and Management (APSEM), Australian National University, which carried out the fieldwork for the study with the assistance of the China Center for Economic Research (CCER), Peking University. Ligang Song (APSEM) and YangYao (CCER) were the principal authors of the technical report, under the direction of Ross Garnaut (director, APSEM). The fieldwork team also included Xiaolu Wang (APSEM) and graduate students from CCER. CHINA'S EMERGING PRIVATE ENTERPRISES v  Additional inputs were provided by Gao Shi-Ji and Xu Gang on sources of equity capital under the supervision of Gary Fine (World Bank) and on the legal framework by Stephen Harder (Clifford Chance). A draft of the study was presented and discussed at a conference in Beijing in April 2000. Additional presentations and comments were made byYingyi Qian (University of Maryland), Wu Jinglian (State Council Research and Development Center), and Nicholas Lardy (Brookings Institution), which together with the discussions at the conference enriched the final study Ed Steinfeld (Massachusetts Institute of Technology) commented extensively on the technical report. The study also benefited from comments and insights from other IFC and World Bank staff, including Jean-Francois Arvis, Joseph Battat, Joan Bayard, Ravi Bugga, Amanda Carlier, Simeon Djankov, Xiaofeng Hua, Albert Keidel, Klaus Lorch, and Guy Pfeffermann. Finally, the study depended upon the insights and perspectives of the private entrepreneurs themselves. We are extremely grateful to the hundreds of entrepreneurs who talked at length with interviewers during the fieldwork and to the hundreds more firms that returned survey questionnaires. The study reflects IFC's and the World Bank's increasing emphasis on improving the business environment as one of the main conditions for sustained growth and poverty reduction. It also reflects the evolution of lFC's strategy in China. The size and the breadth of IFC's program in China are in many ways a function of the development of the private sector in this transition economy. When the private sector was mostly small scale and informal, and the industrial and financial sectors were dominated by SOEs and joint ventures with foreign private investors, IFC's China program consisted largely of industrial projects sponsored by foreign investors. IFC had an important role to play as a provider of long-term project financing, which was not otherwise available for private projects. While this activity and this role will continue, the emergence of the domestic private sector has given us new opportunities to broaden our program to include support for local financial institutions, indigenous industrial and infrastructure enterprises, and small and medium enterprises. We hope this study will provide all those with an interest in the development of the domestic private sector in China with new insights into its status and new ideas for ways to support and participate in its future growth. Javed Hamid Director East Asia and Pacific Department International Finance Corporation September 2000 vi PREFACE  I : VN : [l IV, A A Ai China's economy has grown rapidly over the past decade. China has adopted a unique approach to market- At the same time, it has undergone a fundamental oriented reforms, with extensive local and sectoral change, from complete reliance on state-owned and experimentation and a "dual-track" reform process. collective enterprise to a mixed economy where This has influenced the way in which the domestic private enterprise also plays a strong role. By 1998 the private sector has developed since its reemergence in private sector had grown to about 33 percent of gross the late 1970s. Private enterprise first took hold domestic product, making it second to the state in the rural sector as an outgrowth of the restructur- enterprise sector in economic importance. A consti- ing of the rural economy. During the I 980s, tutional amendment in 1999 formally recognized this larger private enterprises grew out of these shift, thereby laying the foundation for the private rural and individual enterprises, and out of collectives sector to emerge from the shadows and play a promi- and state-owned enterprises, although they were not nent role in China's future development. officially recognized until 1988. In the 1990s, gov- ernment policy placed increasing emphasis on build- To date, analysis of China's private sector has concen- ing a market economy and shifted toward a rules- trated on the dramatic surge in foreign direct invest- based framework, which paved the way for rapid ment and has paid little attention to the growth of growth of private enterprises. This was given further domestic private enterprise. This study represents a impetus by policy changes that encouraged owner- first attempt to understand the domestic private sector: ship reform of smaller, nonstrategic state-owned where it has come from, its current status, and its enterprises and that allowed collectives to transform future prospects. But as Marx said, the point is not just into private enterprises. In many cases, such transfers to understand the world, but to change it. So the study were merely catching up with the reality of how these focuses as much on prescription as on description. It enterprises were operating. addresses the question, what needs to be done for domestic private enterprise to flourish? This question Owing to this pattern of development, the domestic is directed at the three main players in the story: the private sector exhibits a high degree of informality. private entrepreneurs themselves, the financial institu- Many enterprises possess only the vaguest of property tions that finance them, and the government, which rights, ownership structures, corporate governance controls the policy and regulatory environment. mechanisms, financial records, and rights to market access. They are often part of complex groups of To arrive at an answer, it is necessary to go beyond the companies, spanning many different activities. This rather limited statistics on the private sector and talk gives entrepreneurs great flexibility to respond to an directly to entrepreneurs, policymakers, and finan- uncertain world composed of unclear and rapidly ciers. This study is based on extensive surveys and changing government policies, taxes, and regulations. interviews in four locations: Beijing, Chengdu, However, it hampers their ability to raise capital, to Shunde, and Wenzhou. These cities were chosen not reward managers and employees, and to operate effi- as typical examples of the Chinese experience, but as ciently. As a result, even large, mature businesses instances of relatively advanced private sector develop- have many of the strengths and weaknesses more ment in different circumstances (capital city, inland often associated with small start-ups. The challenge province, coastal province, Pearl River delta). They for entrepreneurs now is to put their businesses on a therefore illustrate the constraints and opportunities firmer footing as the policy and regulatory framework the private sector is experiencing in its early stages. becomes more stable and accommodating. CHINA'S EMERGING PRIVATE ENTERPRISES vii  Up to now, the policy environment has been heavily move beyond the start-up, high-growth phase. As with biased in favor of state-owned enterprises, whether in other issues, the solution involves a combination of providing access to markets or to finance. Now that the straightforward regulatory changes (such as allowing government recognizes the private sector as a pillar of private firms greater access to equity markets) and the economy alongside the state sector, it faces a large more fundamental reform (such as building a com- agenda of reform if it is to level the playing field between mercial banking system that allocates credit on the the public and private sectors. A high priority will be to basis of commercial decisions rather than government shift from a discretionary, particularistic way of regulat- direction). However, access to finance will not improve ing and taxing the private sector toward a rules-based until private enterprises formalize and their financial system. Much of this will be a straightforward matter of position, corporate governance, and beneficial owner- making the registration of private enterprises simple, ship become more transparent. cheap, and automatic. But the future growth of private enterprise also depends on progress in more fundamen- China's impending accession to the WTO provides tal reforms, such as strengthening property rights and new impetus for moving toward a rules-based, nondis- ensuring the judicial system enforces them. criminatory policy environment. This not only will expose the domestic private sector to new competition Critically, business cannot grow without access to from abroad but will also introduce new financial insti- finance. The domestic private sector is particularly tutions to serve the needs of private business. Hence poorly served: a very small portion of bank credit goes the environment for domestic private enterprise will to private firms, and only 1 percent of listings on the continue to evolve rapidly. The challenge for the gov- Shanghai and Shenzhen exchanges are private. As a ernment and for entrepreneurs alike is to put the result, private firms rely very heavily on self-financing domestic private sector on solid ground, so that it will for their growth. This will not be sustainable once they be ready to seize the new opportunities that will arise. viii EXECUTIVE SUMMARY  _|P"i IS:mre sol Zs a 9ML In 1999 China passed a constitutional amendment figure 1.4) and SOE employment is declining. As a giving formal recognition to the country's emerging result, the domestic private sector is becoming a major private sector.' This step, along with the buildup of engine of growth for the economy as a whole. foreign direct investment (FDI) and the reform of state-owned enterprises (SOEs), is setting China's A strong domestic private sector takes on additional economy on a course of major structural change. In a significance as China prepares for accession to the sense, the amendment was propelled by the sector World Trade Organization (WTO). This will involve itself, which in the past decade has experienced phasing out the preferential treatment given to foreign dynamic growth-in number of enterprises, employ- private enterprises to attract FDI and opening up ment, and output (see figures 1.1, 1.2, and 1.3). domestic markets to foreign enterprises (see box 1.1). The creation of a level playing field between domestic Already more than half of economic activity in China and foreign enterprises opens new opportunities for is in the private sector-nearly two-thirds, if agricul- the domestic private sector, but also poses the chal- tural and collective enterprises are counted, too (see lenge of new competition in domestic markets. During chapter 2). While the state-owned sector and foreign the preparatory period, it is critical for domestic private direct investment have stagnated, domestic private enterprises to improve their ability to compete under enterprises continue to grow rapidly. Between 1991 the new framework. and 1997 the output of domestic private firms grew on average 71 percent a year (figure 1.3) and employment Because of the sector's growing significance for China's 41 percent on average (figure 1.2). Though much of future development, this is a good time to take a first this growth represents a transfer of activity from the look at its evolution thus far and to identify state-owned enterprises and collective sector, many constraints and opportunities for its future contribu- individual enterprises are achieving double-digit tion to economic growth. With that purpose in mind, growth each year. Importantly, this growth has this study offers business owners, managers, and policy- occurred at the same time that FDI has slowed (see makers assistance in identifying an agenda of action Thousands of firms Millions of employees 1,200 15 1,000 1 800o 10 600 400 -5 200- 0 0 1991 1992 1993 1994 1995 1996 1997 1991 1992 1993 1994 1995 1996 1997 Source: Table 2. 1. Source.: Table 2. 1. CHINA'S EMERGING PRIVATE ENTERPRISES 1  Chengdu, Shunde, and Wenzhou (for a summary of the size of the domestic private sector in each location, see figure 1.5). Beijing provides an opportunity to observe how private enterprises emerge and develop in the Billions of RMB national capital and political center. Beijing has also 2,500 - witnessed rapid development of high-tech industries in its non-state sector in recent years. Chengdu is the 2,000 - capital of Sichuan Province and has maintained a good record of private sector development, presenting a case 1,500 - study of private enterprises in inland areas. Shunde is ooo0 ; *a county-level city in the Pearl River Delta in 1,000; Guangdong Province and has experienced rapid soo _ growth in its private sector following a comprehensive enterprise ownership reform program in the early 0 1 1 1 990s. Wenzhou, on the coast of Zhejiang Province, is 1991 1992 193 1the first city in modern China in which private enter- prises have flourished. These locations are described in Source: Table 2.1. further detail in the next section. Although these locations do not provide a representative sample of private enterprises across the whole of China, that caportunihel reduce thoseconstraintsandenhance they are cities in which such businesses have become an important part of the local economy. Hence their expe- rience reveals much about the constraints and opportu- This study was supported and facilitated by the State nrie vea enterprses fae insChintatday Economic and Trade Commission (SETC) and draws on fieldwork in China in the summer of 1999, along with discussions at a conference in Beijing in April Description 2000. It also draws on IFC's and the World Bank of the Fieldwork Locations Group's global experience in promoting private sector development. Private enterprise has flourished in each of the field- work locations. As mentioned earlier, the four cities The fieldwork focused on four cities with distinct were chosen for their distinctive approach to private approaches to private sector development: Beijing, sector development. Billions of current US dollars 50 - 40 - 30 - 20 - 10 - 0 1988 1989 1990 1991 1992 1993 1 1995 1 1997 1998 Source: World Bank. 2 INTRODUCTION  Box 1.1. China's Accession to the WTO 120n) or 30Number of firms (thousands) 100 - Output (billions of RMB) 80- 60 40 20 0 Beijing Chengdu Shunde Wenzhou Source: Bureau of Industry and Commerce Management. capital of RMB228,000 [US$27,500]) to 61,113 B gprivate firms (siyingJqiye) in 1998 (average size of Beijing, including its suburbs, has apopuregistered capital is RMB621,000 [US$75,000]). Recently, the municipal government issued a document calling for a speeding up of private sector development. Concrete policies promoting such development are under consideration. Chengdu Chengdu is the provincial capital of Sichuan and has a population of 9.9 million. Its GDP in 1998 was RMBIIO billion (US$13.29 billion), or RMB11,103 (US$1,341) per capita, and its industrial output was RMB121.9 billion (US$14.72 billion). The private sector in Bijin ha exprieced api devlopsector in Chengdu has become a significant contrib- utor to the city's economy. In the first half of 1998, its industrial output was RMB14.1 billion (US$1.7 bil- - - -- ~~~~~lion), or 30.8 percent of the city's total output, and its GDP was RMB10.7 billion (US$1.3 billion), or 22.3 percent of the city's total. In the period Beijing January-November 1998, the private sector con- Beijing, including its suburbs, has a population of tributed RMB607 million (US$73 million) of tax, or 12.4 million. In 1998 its gross domestic product was 10.3 percent of the city's total. In some counties, the RMB201 billion (US$24 billion), or RMB18,423 private sector dominates the local economy. In Xinjin (US$2,225) per capita. Industrial output was County, for example, the private sector (private firms RMB171.5 billion (US$20.7 billion). Although and getihu) contributed 90 percent of the total tax Beijing has more private firms than the other cities, revenue in 1998. they appear to be fairly small because their output and sales volume are the smallest. Even so, the private Since 1992 the number of large private firms in sector in Beijing has experienced rapid development. Chengdu (firms with registered capital of more than Its numbers increased from 1,428 registered private RMB5 million [US$604,000]) has climbed to 260. firms in 1992 (each firm on average had registered One of these, the Hope Group, is the largest private CHINA'S EMERGING PRIVATE ENTERPRISES 3  Industry Beijing Ch0ndu Shud ;Wenzhou Overail Chemicals 12 19 20 8 8 Electronics 19 10 18 35 35 and apparatus Foods and cigarettes 11 18 8 4 4 Garments and 31 18 28 14 14 other light products Machinery 7 11 8 29 29 Metal and nonmetal 9 14 10 10 10 manufacturing Primary Industries 3 5 6 0 0 Others 8 5 2 0 Source: Bureau of Industry and Commerce Management firm in China, with an annual sales volume of more Some large firms have emerged since the early stage of than RMB5 billion (US$600 million). Of the first 20 development, and now the city has 72 such firms, private firms to obtain the right of direct export in each with an annual sales volume of more than China, 5 were in Chengdu. In addition, some large RMB 100 million (US$12 million). In particular, it has private firms began to buy large SOEs, playing an become the nation's largest industrial base for home increasingly significant role in the state sector reform. electronics, producing every kind of home electronic The industrial distribution is quite balanced, as product except televisions. Several nationally shown in table 1.1. renowned firms have also emerged, notably Kelong (a major national refrigerator producer), MD (the Shunde world's largest electric fan producer and a major Shunde is a county-level city with a population of only national producer of air conditioners), Grand (the 1.4 million and a gross domestic product of RMB26 nation's largest microwave producer), Wanjiele (gas billion (US$3 billion), or RMB24,769 (US$2,991) per heater manufacturer), and Kangbao (the nation's largest capita. Industrial output is about RMB60.5 billion kitchen sterilizer producer). Together with Zhongshan, (US$7.3 billion). Situated on the west bank of the Pearl Nanhai, and Dongguan, Shunde is regarded as one of River estuary, the city lies outside the enterprise the four "small tigers" in Guangdong Province. zones on the east bank, which have attracted massive foreign investment, especially from Hong Kong. Wenzhou Shunde's private sector began to take shape largely as a Wenzhou is a prefecture-level city governing several result of its ownership reform program, which started in counties and county-level cities and has a population of 1992. Currently, there are almost no purely state- about 7.2 million. Its GDP in 1998 was RMB72 billion owned firms in Shunde. Its private sector ranks second (US$9 billion), or RMB9,986 (US$1,206) per capita. among the four cities in terms of sales. Before its own- Wenzhou has a long history of private sector develop- ership reform program, Shunde was renowned for its ment. In 1984 it became one of 14 coastal cities township-village enterprises (TVEs). Its leading indus- opened to foreign trade, and a national economic tries were small home appliances such as electric fans, development zone was established there. It has a his- rice cookers, and water heaters. tory of pioneering new forms of enterprise. The size of 4 INTRODUCTION  its private sector is the largest among the four cities in or chief accountants. A total of 2,400 such question- terms of the number of firms and sales volume. Its naires were posted to randomly selected firms in industries have formed several nationally renowned Beijing, Wenzhou, Shunde, and Chengdu. The number geographical clusters, such as electronic parts in collected amounted to 628, which represents a Hongqiao, low-voltage electrical products in Liushi, response rate of 26.2 percent. Because of inaccurate and buttons in Qiaotou. In addition, the garment indus- addresses, the response rate from actual recipients was try is a pillar of the local economy. Overall, the sample somewhat higher. enterprises are heavily concentrated in machinery and electronics (table 1.1). Sampling Strategy We adopted a stratified random sampling strategy, Fieldwork Methodology choosing firms from a database constructed and maintained by the Bureau of Industry and Commerce In view of the size of the Chinese economy, it is not Management in each city. This excludes privately possible with limited resources to undertake a controlled collectives and TVEs.2 Very small firms, comprehensive representative survey. Moreover, there those with no more than eight employees (known as is a trade-off between timeliness and thoroughness. geti gongshang hu, or getihu), were also excluded Therefore, in order to take a snapshot of the status of from the sampling because of the difficulty of obtain- the private sector and draw policy conclusions, we ing accurate information on them. Later, a few joint adopted a rapid assessment approach in the field- ventures and firms engaged in commerce and services work. That is to say, we analyzed specific locations were also surveyed. and segments of the private sector that could yield usable information and analytical insights within a The ratio of rural versus urban firms sampled in each limited time frame. This is therefore a preliminary locality was kept roughly the same as the ratio of rural analysis, which could provide further valuable infor- versus urban firms in that locality. This was achieved by mation if extended to cover more locations and other the random selection of firms within rural-urban strata segments of the private sector. in each locality. The share of each type of ownership examined-sole proprietorship, partnership, limited The fieldwork consisted of structured interviews of liability company, and so on-were kept roughly the government officials, banking officials, business same as their respective share in the population. associations, and chief executive officers (CEOs) of Finally, a number of newly emerging high-tech enter- 338 domestic private enterprises. This was supple- prises were included in the sample to ensure represen- mented by a mail-out survey of some 628 domestic tation of this group. Firms were selected randomly private enterprises. within each stratum. CEO Interviews The sampling strategy was difficult to apply, however, Guided by a questionnaire containing both structured because in many cases local government agencies did and open-ended questions, interviewers met with CEOs not have the required data, and many firms under the in a subset of 338 of the surveyed firms. CEOs filled in control of private domestic entrepreneurs were not the structured questions during interviews, and inter- registered as such and so could not be identified. Thus viewers posed the open-ended questions. These latter the enterprises covered in the survey do not represent a questions elicited CEOs' opinions on the most important true cross-section of the domestic private sector. and pressing issues private enterprise is facing and the Rather, they are concentrated in the part of the private changes that are needed to improve the business and pol- sector that it is easiest to identify and contact. These icy environments in which private enterprise operates. tend to be among the larger, more mature private enterprises. Although they certainly offer insight into Mail-out Questionnaires domestic private enterprises, they do not necessarily The questionnaire mailed to firms contained structured reflect all the dimensions of the domestic private sec- questions on factual aspects of a firm's operation and tor. More extensive survey work would be required to development. These questions were to be answered by understand the full range of private sector activity in persons designated by CEOs, such as deputy managers China today. The distribution of sample enterprises CHINA'S EMERGING PRIVATE ENTERPRISES 5  by industry as a whole and in each city sample is institutions, and business associations. The official shown in table 1.1. institutions consisted of the Central Bank, tax/regula- tory agencies, and policy agencies. The financial insti- Other Interviews tutions included commercial banks and rural credit To gain a wider perspective on private enterprises, we unions. In some locations, we also interviewed people also interviewed officials of official institutions, financial at business associations. 6 INTRODUCTION  EVOLUTION AND STATUS OF THE DOMESTIC PiolY'131M11103:_ C hina's market-oriented reforms of recent external trade and payments (through the sharing of years have produced impressive results. foreign exchange between central and local govern- Perhaps the most important is the emer- ments, trade contracting, and foreign exchange trading gence of a significant private sector. This centers), and labor markets (through the contract chapter looks at the evolution and current status of system for new hires in the state sector). In a sense, the domestic private sector in the context of China's the same dual-track approach was adopted with overall approach to reform. respect to private sector development because transfer of ownership did not enter political debate until well Reform Approach into the second decade of market reforms. When the reforms began, the prevailing view was that activities One notable feature of China's approach to reform is in the private sector complemented those of the state its emphasis on gradual experimentation at the local sector. They were tolerated and even encouraged in and sectoral level (Gelb et al. 1993; Harold 1992). areas where large-scale state enterprises did not exist, Thus China took its first steps toward reform without such as services, light industry, and agriculture. a well-defined strategy or a clear blueprint. From the outset, Chinese leaders did not envision the private This dual-track approach is perhaps the most important sector as the driving force of economic growth. Rather, aspect of Chinese reforms since it was, at the time, an private business was revived in the period after the innovative solution to the political constraints on the Cultural Revolution as a quick way to respond to the direction and speed of reform. One such constraint mounting pressures of unemployment and economic was the emphasis on "consensus-making," meaning it stagnation. It was an experiment in itself and for most was imperative to "leave no one worse off than before" of the reform period has evolved through cycles of (Shirk 1993, pp. 130, 137, 334). As economic analysis unpublicized experimentation, followed by general "in has shown, the dual-track approach in China has been principle" approval, then by ratification and specific both efficiency-enhancing and Pareto-improving, that regulations, only after the reform in question has is, with no one made worse off (Laffont and Qian become well established. Oftentimes, new regulations 1999; Lau, Qian, and Roland 1997). It has allowed have been accompanied by "rectification" campaigns, economic agents participating in the market track to which have set the private sector back in its devclop- benefit from liberalization while protecting the vested ment. As the term "gradual" suggests, reforms are interests of state-owned enterprises and bureaucrats in implemented over time. Several years may elapse from different industries and sectors. Although the reforms the beginning of a reform experiment in one of the were controversial, the experimental dual-track way of Chinese provinces until it is endorsed from the center introducing them enabled reformers to bypass the formal or is imitated by other provinces. ideological debate usually required for public legislative sanction of reforms and also to use the successful results Another reform characteristic in China has been the of the reform as ammunition in the debate. use of partial reforms within sectors, also known as the dual-track approach. The first such tactic was two-tier Several features of China's social and political environ- pricing, introduced in rural areas in 1979 along with ment have contributed to this unique transition to the household responsibility system. Later it was market. One is decentralization. Since 1958, the applied to other sectors: industry (through the contract Chinese economy has been organized around a geo- management responsibility system), the national budg- graphical principle known as regional organization. By et (through the fiscal contract responsibility system), contrast, organization in the former Soviet Union was CHINA'S EMERGING PRIVATE ENTERPRISES 7  much more centralized, along sectoral lines (Qian creating the self-reinforcing character of Chinese 1999). A regional system has the important advantage reforms. There were not many rents for bureaucrats to of flexibility: it can experiment with reforms locally collect in poor rural areas where the household respon- because regional entities are self-contained and differ- sibility system was first introduced. The success of ent ingredients of reforms can be tested and matched reforms in agriculture brought needed savings, which without disrupting the organization as a whole. then had to be channeled into the industrial sectors in rural areas, where they fueled the big boom of the non- Added to this possibility for local experimentation were state industrial sector, that is, the TVEs. Local govern- powerful incentives to promote local economic devel- ments and new entrepreneurs alike shared in the opment. They were in the form of a fiscal contracting benefits of growth in this sector. The development of system known by the nickname "eating from separate the non-state sector in turn created pressure, but at the kitchens," which replaced the previous system of same time offered solutions, for the reform of the state "unified revenue collection and unified spending." sector. This generated a self-reinforcing virtuous cycle The new system encouraged and rewarded local govern- of reforms with growth, and the private sector ended ments for promoting economic development of their up playing a key role in the process. local economies. The nature of local experimentation, however, was heavily influenced by the existing Major Turning Points political structure. in Private Sector Development The fact that China adopted a new policy course with- out political liberalization and under the same political The cycles of experimentation discussed in the pre- structure practically ruled out experiments that would ceding section make it possible to distinguish three create losers on a large scale within the bureaucracy. phases in the development of the private sector: the Consequently, the experiments had to be of the dual- first from 1978 to 1983, the second from 1984 to track type, so as to preserve the vested interests of the 1992, and the third from 1993 to the present. bureaucracy and a level of political stability. Despite the lack of political liberalization, China has been able Phase 1: 1978-83 to transform its bureaucratic system substantially This phase is marked by the official revival of private with a mandatory retirement program for the revolu- business. However, the private sector was limited to tionary veterans, a drive for administrative and fiscal individual businesses (getihu), which developed first in decentralization, and the decision to allow bureau- a regulatory vacuum. These businesses had a strong crats to quit the bureaucracy and join businesses (Li experimental flavor. Regulations came later in the 1998). As a result, the bureaucracy tends to function process and were followed by a short "rectification" cam- as a "helping hand" for economic development, is inti- paign. The sector was intended to play a marginal, stop- mately involved in promoting private economic activity, gap role and to act as a "supplement" to the state and supporting some firms and inhibiting others, pursuing collective sectors, "filling the gaps" they left in the econ- industrial policy, and often having close economic and omy, particularly in the distribution of consumer goods family ties to entrepreneurs (Frye and Shleifer 1997; and services and in employment. Official attention Walder 1995). Under such incentives, central and local focused on the urban private sector, although perhaps governments have the capacity to act like Olsonian deeper changes were taking place in the rural areas. encompassing organizations, exercising self-restraint and not expropriating efficiency gains through ratchet- The Third Plenum of the Chinese Communist Party's ing (Olson 1992). The township and village enterprises, 11th Central Committee in December 1978 is said to in which local governments have direct ownership mark the beginning of market-oriented reforms in and management stakes, were one incarnation of this China. Although the plenum itself made no specific long-term interest in promoting local development (Jin announcements concerning private business, it signi- and Qian 1998). fied the official adoption of economic modernization and growth as the paramount concern of the The political constraints may have also accounted for Communist Party. It emphasized economic develop- the choice of agriculture as the starting locus of the ment and individualistic incentives, which gave impetus changes, a decision that played an important role in to the revival of private business. 8 EVOLUTION OF PRIVATE SECTOR  In fact, the individual economy was already develop- Larger private enterprises developed in different ways. ing by that time, in response to economic pressures to Some were getihu that grew and took on more increase employment opportunities and to improve employees. According to a 300-village survey con- living standards. Once the shift in policy was official- ducted by a research branch of the State Council in ly announced at the Third Plenum, local governments 1987, 0.2 percent of the farm households hired more began to formulate procedures for the administration than eight people in 1986. Taking the survey as a of the individual economy. Yet the individual economy representative sample, it was estimated that by the still had an experimental flavor and was confirmed end of 1988, China had 500,000 getihu that could be only by a set of State Council regulations on the called private firms (Zhang and Liu 1995, p. 55). urban, nonagricultural individual economy in July 1981. These regulations defined a new business Some larger private enterprises emerged from the leasing category, geti gongshang hu, or single industrial and of state or collective enterprises to individuals. By 1984 commercial proprietor. The government moved with the share of such firms in the total number of collective caution in developing the getihu. The July 1981 firms had reached 50 percent in some localities (Zhang document capped the number of employees a getihu and Liu 1995, p. 29). The private entrepreneur paid the could hire at eight. In addition, it specified that indi- collective a fixed rent and operated the firm as if it was vidual businesses were only supplements to the state his own and in many cases accumulated considerable and collective economic units, and could develop assets. These enabled him to reduce the share of only within certain limits. collective ownership and gradually transform the enterprise into a solely owned firm. The private enterprise boom began in rural areas. The contract responsibility system evolved into a Yet siying qiye were not officially registered as a category fundamental reform in agriculture because economic until June 1988. Administrative bodies dealt with such management devolved to households. Some house- enterprises in various ways. First, they could be regis- holds then specialized in nonagricultural activities tered as getihu but be given permission to employ more and became "specialized households" (zhuianyehut). than eight people. This practice was more prevalent in Many of these were in fact private nonagricultural urban areas. In rural areas, larger private enterprises businesses. Because they originated within the were able to gain at least partial entry into the collective collective agricultural economy, however, their category by one means or another. Second, firms could private nature could be ignored for the time being obtain a collective license by paying an "administration and obviated the need for guidelines or regulations fee" to a state or collective unit or local government dealing with them as such. organization and thereby receive its stamp on the appli- cation for registration. Such firms were called "red hat In 1983 China introduced a series of central and local firms," meaning that the private owners put on a hat of regulations for the licensing and control of individual collective ownership to evade the government's prohibi- businesses, taxation, product quality and hygiene, and tion of private firms and its ideological harassment. This free markets. These were followed by inspection kind of firm continued to exist even after the regulations drives. "Market rectification" drives became an oppor- on private enterprises were issued in 1988. In Shunde, tunity to attack private business. for example, almost all firms at the village level were red hat firms before the enterprise ownership reform pro- Phase 2:1984-92 gram took place in 1992. The red hat phenomenon This phase is characterized by the rise of the siying remains important even today. Third, in certain cases, qiye (privately run enterprises), to be distinguished distributing shares or profits as bonuses to employees from the smaller getihu (individual enterprises). wvas enough to qualify a private enterprise as a collective. Such enterprises, defined as privately owned enter- prises employing more than eight people, began to In June 1988, the State Council issued the so-called develop as early as 1981, but they did not come Tentative Stipulations on Private Enterprises (TSPE) under regulation until 1988. However, in 1989 the to govern the registration and management of private development of the sector suffered a setback. The firms. This document defined a private firm as "a for- private sector continued to be regarded as a supple- profit organization that is owned by individuals and ment to the public sector. employs more than eight people."' Firms that hired CHINA'S EMERGING PRIVATE ENTERPRISES 9  eight employees or less could still be registered as Once Deng Xiaoping called for further market- getihu.2 The TSPE identified three types of private oriented reforms, attitudes toward private firms firms: those under sole ownership, partnerships, and changed, providing private entrepreneurs with a limited liability companies. Siying qiye, defined as more hospitable social and psychological environ- enterprises with privately owned assets and employ- ment. By the end of 1992, China had 27 million reg- ing more than eight people, were recognized as a sup- istered getihu and 140,000 private firms. But the plement to the socialist, publicly owned economy and most rapid private firm development occurred from enjoyed the protection of the state. By the end of 1992 to 1994, not only with respect to the number of 1989, the total number of registered private firms had private firms and employment but also with respect reached 90,600. to output (table 2.1). The number of registered getihu declined from 23.1 Perhaps the greatest change in official attitude million at the end of 1988 to 19.4 million at the end of toward private ownership came at the Fifteenth Party 1989, and the number of registered private firms Congress held in September 1997, when private declined from 90,600 at the end of 1989 to 88,000 in enterprise was recognized as an important compo- June 1990. Of the firms closed down, a considerable nent of the economy. The forum also stressed the number were transferred into collective firms or had rule of law and its crucial role for a modern market their employees reduced to fewer than eight people. economy to work well. Private ownership and the According to a survey of 286 private firms closed in the rule of law were incorporated into the Chinese period January to April 1991, 22.7 percent of these Constitution in March 1999. firms were transferred to collective ownership and 20.3 percent had their employees cut to under eight (Zhang Patterns and Liu 1995, pp. 50-51). of Private Sector Evolution Phase 3: 1993 to the Present This period has been marked by important changes in For historical and ideological reasons, private businesses China's overall approach to reforms and its official atti- first emerged as individual enterprises in rural areas tude to the role of the private sector. While experi- and in sectors such as trade and services, where there mentation continued, a coherent strategy of transition were a limited number of large state enterprises, and to a market system began to emerge. The strategy distortions from central planning created market envisages a market system based on the rule of law, in opportunities for private entrepreneurs. The scope of which the private sector is an important component. private sector activities then gradually expanded, as their legal and organizational framework, geographic Deng Xiaoping's famous southern tour in September distribution, and presence in various sectors increased. 1992, when he called for a continuing of the reform Comparisons with other transition economies suggest effort, was a defining moment in China's transition that this pattern is by and large consistent with the to market. It was followed by the big ideological normal evolution of private business. For example, one breakthrough at the Fourteenth Party Congress: for of the most important inroads of private activity in the first time, the socialist market economy was other socialist economies occurred through private endorsed as China's goal of reform. And in 1993 the farming and in the service, transport, and construction government designed the first "grand strategy" of industries (Kornai 1990). Once China allowed some transition to a market economy, with an emphasis on room for private activities to emerge, this was enough a rule-based system and on the building of market- to trigger the spontaneous development of the Chinese supporting institutions. This was the turning point for private sector, despite the remaining plethora of China on the road to markets. The new approach restrictions and biases. When the internal dynamics of advocated a coherent package of reforms; it called for this movement ran counter to existing formal restric- creating a level playing field through a rule-based mar- tions, the system was flexible enough to accommodate ket system, as opposed to particularistic contracting; the new realities until formal constraints were relaxed and it addressed the enterprise reform issue in terms and new room was created for the expansion of private of property rights and ownership, thus opening the sector activities. This flexibility, as explained earlier, was door for the transformation (gaizhi) of SOEs. largely due to factors related to decentralization and 10 EVOLUTION OF PRIVATE SECTOR  Table 2.1. Private Firm Development since 1991 i~~~~~~r _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ I!uiribor GroEiit4 N u mls Grx-4h I1uGrowth (tflousandfs Oh) (icusns} (% (b1iortS of iWiBa) (N) 1991 107.8 1839.0 93.7 1992 139.6 29.5 2318.4 26.1 116.0 23.8 1993 237.9 70.4 3726.3 60.7 260.1 124.2 1994 432.2 81.7 6483.4 74.0 551.7 112.1 1995 654.5 51.4 9559.7 47.4 1,005.3 82.2 1996 819.3 25.2 11711.3 22.5 1,592.3 58.4 1997 960.7 17.3 13492.6 15.2 1,983.7 24.6 Average 45.9 41 i. 7 la. l Note: 'Private' refers to siying qiye. B In 1995 constant prices. Sources: Yearbook of China Industrial and Commerce Administrative Management, 1992-98; China Statistical Yearbook, 1992-98. bureaucratic incentives and became a key factor in especially in the early phase, because major reforms ensuring the continuity and the cumulative nature of were first tried and proved successful in agriculture. private sector development. Indeed, until 1993 employment in siying qiye was higher in rural areas than in urban areas (figure 2. 1). From Rural to Urban As just mentioned, the rural enterprise played a domi- Self-employment in rural areas continues to exceed nant role in private sector development in China, urban self-employment by a wide margin. Rural areas, Figure 2.1. Self-Employment and Private Employment in Rural and Urban Areas in China, 1990-98 1998 - k ffi Rural self-employment U Rural private employment 1997 1997 _ _ = Urban self-employment 1996 _ Urban private employment 1995 1994 1993 1992 1991 1990 . . I ' ' ' I I I 0 5 10 15 20 25 30 35 40 45 Millions of employees L Source: China Statistical Yearbook, 1999. CHINA'S EMERGING PRIVATE ENTERPRISES 11  Table 2.2. Distribution of Private Firms by Region Yea Firms Employment Rim Employment Firms Ermloyment :thousands1 ~thousan8s0 (thousands) 1991 95.4 1754.5 24.5 453.4 19.7 380.5 1993 159.3 2351.3 44.6 768.9 34.1 600.6 1996 529.2 7232.8 178.6 2741.2 111.4 1737.4 1997 610.1 8235.5 211.1 3189.7 139.5 2067.4 Note: "Private' refers to siying qiye. a Liaoning, Hebei, Beijing, Tianjin, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian, Guangdong. b Heilongjiang, Jilin, Shanxi, Henan, Hubel, Anhui, Jiangxi, Hunan, Hainan. Inner Mongolia, Shaanxi, Ningxia, Gansu, Qinghai, Xinjiang, Tibet, Sichuan, Guizhou, Yunnan, Guangxi. Source: Yearbook of China Industrial and Commerce Administrative Management, 1992-98. being somewhat detached from central bureaucratic ratio of the number of firms in the western, central, control, spawned a private sector whose nature and role and coastal areas was 21:26:100 in 1992 and differed from those of the urban private sector. One 23:34:100 in 1997. In terms of employment, the ratio notable difference can be seen in the ratio of getihu to was 22:26:100 in 1992 and 25:39:100 in 1997. In siying qiye, which is much higher in rural than in urban terms of both numbers of firms and employment, the areas. Historically, the industrial structure of the private central provinces were able to catch up with the coast sector has also differed significantly in rural and urban faster than the western provinces. areas. In the cities, private businesses have clustered in the small-scale retail, service, or food service industries, As figure 2.2 shows, however, the relative shares in urban which have had a disproportionately strong impact on employment are not that different. The coast has the the public perception that private business is interested lowest shares of both SOE and private sector employ- primarily in "nonproductive" activities. At the same time, ment (siying qiye and getihu) but the highest shares of largely hidden from the public eye, more than 75 per- employment in the foreign-invested and collective enter- cent of private businesses developed in rural areas, after prise sector. The central region had the highest share of reforms promoted a surge in the growth of rural enter- domestic private sector employment as of 1998. Within prises. Of these, nearly 40 percent were engaged in the domestic private sector, however, the coast has the manufacturing or processing (Young 1995). highest share of employment in private enterprises with more than eight employees (siying qiye), and the highest From East 2o West ratio of siying qiye to self-employed. The latter closely Because of China's emphasis on decentralization and resembles the urban-rural dimension of the relationship local experimentation with reforms, private sector between siying qiye and getihu. Overall, the share of the development was greatly influenced by local condi- non-state sector in urban employment is highest in the tions, including the attitude of local governments to coastal area and lowest in the western provinces. the role of the market. As a result, the patterns of development differ from region to region. The differ- From ln normality and PariVcularisim ences between coastal and interior provinces are espe- 2io tlh$ RuWe og Law cially pronounced. Some of the unique features of private business in China derive from the fact that the private sector The regional distribution of siying qiye is strikingly dif- developed experimentally, in an environment of politi- ferent across the country, as shown in table 2.2. The cal, legal, and regulatory uncertainty. The typical 12 EVOLUTION OF PRIVATE SECTOR  Figure 2.2. Ownership Structure of Urban Employment by Regions in China, 1998 West W Collectives Private sector Central USelf-employed (including getihu) Foreign Coast -, 0 20% 40% 60% 80% 100% Source: China Statistical Yearbook, 1999. sequence of development-unpublicized experimenta- However, unclear property rights have slowed the tion, followed by general "in principle" approval, then growth of many firms, and the hybrid forms of owner- by ratification and specific regulations-implies that ship that resulted created perverse incentives, which for most of the reform period private businesses have become a drain on the resources of enterprises evolved without clearly defined and secure property and the government alike (see chapter 3). The particu- rights. Political uncertainty remained substantial as laristic approach, as opposed to universally applicable long as activities in the sector were viewed as a tempo- rules, forced local officials and enterprise managers to rary solution to some economic problems of the day concentrate on rent-seeking rather than economic and as a supplement to state and collective sectors, returns. It led to collusion between local governments "filling the gaps" the latter left in the economy. and enterprises, with the local governments acting as patrons rather than regulators. Moreover, the process The Chinese experience therefore seems to suggest made private entrepreneurs more susceptible to inter- that a system of well-defined and secure property rights ference from local bureaucrats. The former reliance on is not necessarily a precondition for the emergence and personal connections in the relationship with the gov- initial development of a private sector (McKinnon ernment has been transplanted to the marketplace and 1992). Rather, the growth of private enterprise and mar- now dominates exchanges there. The highly particular- ket institutions over time can create a demand for a istic nature of market transactions makes it difficult to clear definition and enforcement of private property gain reliable information about people, commodities, rights. Small businesses, which constitute the bulk of prices, and distribution channels. the private sector in the initial stage of development, need little in the way of legal protection (Murrell The market has therefore become highly fragmented 1992; Rapaczynski 1996). They are typically owned by and relies on personal relationships for vital information. a single individual or a small group of people who In interprovincial market transactions, this particularism know each other very well; they do not raise capital has created a high degree of local protectionism. Fiscal from the public; and debt capital plays an insignificant decentralization and patronage over local enterprises role in their financing. What they need most is to have encourage local officials to protect local markets for the state eliminate the obstacles that it has been put- their own factories by erecting administrative blockades. ting in their path. Indeed, local governments in China Thus perhaps the biggest challenge for the develop- often interpreted new regulations as a signal allowing ment of the domestic private sector in China today is them to attack and interfere in private sector activities. to establish the rule of law. CHINA'S EMERGING PRIVATE ENTERPRISES 1L3  801F MD= 1F0? Mop