Two decades of reform : the changing organization dynamics of Chinese industrial firms

WPS3806 Two Decades of Reform: The Changing Organization Dynamics of Chinese Industrial Firms Shahid Yusuf and Kaoru Nabeshima Development Economics Research Group The World Bank Abstract Since the early 1980s, China has begun gradually integrating with the global system. In doing so, the country has moved towards its own unique brand of market socialism, which recognizes private ownership, and is adopting market institutions and pursuing industrial change within the framework of an urban economic environment. The process of transition has now permeated every corner of Chinese life and no organization has been left untouched. Yet, industrial organization in China--especially in the state sector--has been slow to shed many of the distinctive structural characteristics of the old line Maoist era state enterprises. The main prong of the industrial strategy in support of urban change is ownership reform that transforms state- owned enterprises into corporate entities with majority state ownership or places them wholly in private hands. This strategy is bolstering the incentives for and the dynamism of the private sector. While the central government spearheads the ownership reform initiative, in the majority of cases the actual implementation is in the hands of municipal, county, and prefectural governments. This paper situates industrial change in China within the context of urban development and examines the interplay of broad reform strategy with local implementation, and its actual practice by the reformed firms. JEL Code: P31; R11; O14; O31 Key words: China, urban economy, state-owned enterprise, reform World Bank Policy Research Working Paper 3806, January 2006 The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org. The paper was prepared for the project on "Urban China in Transition" sponsored by the Urban China Network, SUNY Albany and was presented at a conference in New Orleans, January 15- 16, 2005. We greatly appreciate the constructive feedback from conference participants. Authors would like to thank, in particular, John Logan and Susan Fainstein for their helpful suggestions and Shiqing Xie for providing excellent research assistance.  Two Decades of Reform: The Changing Organization Dynamics of Chinese Industrial Firms by Shahid Yusuf and Kaoru Nabeshima I. Introduction China's adoption of the socialist model in the early 1950s and with it a largely autarchic approach to development resulted in an industrial structure and in industrial organizations quite different from those of more open, free market economies. The sub-sectoral mix favored heavy industry which was viewed as the backbone of the socialist economy. And the typical enterprise was on average smaller than its counterpart in a capitalist economy, vertically integrated, oriented towards a local or at best the provincial economy, administratively an extension of a supervisory industrial bureau, and tasked with providing social services to its workforce. Since the early 1980s, however, China has begun gradually integrating with the global system and in doing so it has moved towards its own unique brand of market socialism which recognizes private ownership, is adopting market institutions, and is pursing industrial change within the framework of an urban economic environment. The process of transition has already lasted a quarter century and it is far from over. It has now permeated every corner of Chinese life and no organization has been left untouched. Yet remarkably for an economy where the ratio of trade to GDP approaches 65%, industrial organization in China--especially in the state sector--has been slow to shed many of the distinctive structural characteristics of the old line Maoist era state enterprises. Both state-owned enterprises (SOEs) as well as many of the non-state enterprises remain embedded in a web of formal and informal relationships that link producers to the administrative or financial organs of the state. Similarly, while the evidence of change in the urban sector is everywhere and is impinging on organization, notable also is the tenacity of 1  institutions and administrative practices that emerged in the pre-reform era when the Chinese economy was on a different trajectory. China's level of urbanization, which is close to 40%, is significantly below that of countries at comparable stages of development and of developed countries.1 Many cities continue to enforce hukou (residence) based restrictions on permanent migration and have only slowly started to dismantle the plethora of regulatory controls over every form of economic activity that were the hallmark of a communist society. Chinese policymakers recognize that the urban sector can achieve a "balanced" development that holds poverty and inequality in check only if industrial reforms provide a sufficient growth impetus and jobs for the swelling workforce.2 The main prong of the industrial strategy in support of urban change is ownership reform that transforms SOEs into corporate entities with majority state ownership or places them wholly into private hands, in the process also bolstering the incentives for and the dynamism of the private sector. While the central government spearheads the ownership reform initiative in the majority of cases, the actual implementation is in the hands of municipal, county, and prefectural governments that must coordinate their efforts with other factors influencing urban changes. However, the ultimate success of the reforms rests substantially with the firms themselves, in particular, their managers and directors who must steer these enterprises through an environment that is increasingly competitive locally and integrating rapidly with the wider national and international economy. 1The reasons why the urbanization rate is low in China are the low fertility rate in urban areas because of the successful enforcement of one-child policy and the restriction on migration. For large cities such as Shanghai, the urban growth is almost entirely the result of the inflow of migrants (see Liang, Luong, and Chen 2005). 2So far the Chinese government was able to reduce the number of absolute poor in the urban areas, an impressive achievement compared to the experience elsewhere. However, inequality within the urban area is rising (see Appleton and Song 2005). 2  In a word, the purpose of this paper is to situate industrial change within the context of urban development and to examine the interplay of broad reform strategy with local implementation, and its actual practice by the reformed firms themselves. Industrial Development: The Early Years Industrialization has been the leitmotif of China's development since the mid 1950s. During the early stages, starting with the First Five Year Plan in 1950, the government's emphasis was on establishing state ownership and building heavy industry, following the lead of and material support from the USSR, and with guidance from Soviet advisers who helped China lay the foundation of a planned socialist economy.3 By the mid 1960s, a broad-based industrial system was emerging in China's traditional urban industrial heartland in Manchuria, in the Shanghai area and a few inland cities such as Wuhan (Andors 1977). At that time, little more than 15 percent of the population lived in the urban areas and the principal industrial cities dominated the urban landscape. Industry accounted for close to 50 percent of China's GDP with over half of this produced by heavy industries centered on ferrous metal manufacturing and machinery producers. The microstructure of the industrial system was comprised of enterprises subject to plans that set production targets and allocated commensurate volumes of inputs to each of the producers (Chow 1985). In effect, the manufacturing enterprise was no more than an extension of the bureaucratic apparatus--central and subnational--for controlling the economy.4 It had limited management capacity and management in turn had limited discretion (Richman 1969). The urban industrial labor force, while paid modest wages, was a highly privileged group because it enjoyed lifetime tenure and schooling, health, pension, and other benefits that set it 3Close to 45% of China's imports during 1950-1961 were from the USSR (Riskin 1987). See also Wheelwright and McFarlane (1970). 4In keeping with their lowly status, enterprises were called gongfang or factories. 3  apart from the rest of the workforce. These privileges were sustained by strictly limiting migration to the cities by instituting a household registration system (hukou) in the late 1950s (see, for instance, Fan 2004). In the latter half of the 1960s, when the Cultural Revolution was in full swing, the Third Front program dispersed industries from the urban centers in the East and Northeast to the interior provinces, especially the southwestern region, to increase their survival chances in the event of war and to plant the seeds of industrial capability throughout the country (Naughton 1988). This was followed by efforts to build small scale rural industries, and some decentralization of economic decision making to provincial or county level agencies (Riskin 1987). However, on the eve of the reform era towards the end of the 1970s, the organization of production and the working of enterprises still conformed closely to the model instituted two decades earlier. In particular, the large sized enterprises responsible for the lion's share of manufactured products remained under the tight control of central and provincial bureaus. The backwardness of China's industries relative to some of its East Asian neighbors, the inefficiencies of the centrally planned economy, agricultural stagnation, and the urgent need to accelerate growth and provide jobs that would reverse the spread of poverty empowered the reformers among the senior members of the Communist Party. Their initial proposals announced at the 3rd Plenum of the 11th Central Committee in 1978 have bit by bit transformed China's command economy (Riskin 1987) into a decentralized, socialist market economy with institutions and ownership rights that are coming to resemble those of the capitalist economies in East Asia and elsewhere. This process of institutional change has been a slow one. It has been interspersed with much experimentation through which reform ideas were subjected to trials on a limited scale before being adopted more widely. And throughout the past 25 years, each 4  tentative reform has been preceded by often intense debate and political dueling among reformers of all stripes, as well as between the reformers on the one hand and more orthodox elements in the Party opposed to the progressive dismantling of socialism in China on the other. Although early reforms mainly affected the agriculture sector where dissatisfaction with communist institutions was most pronounced,5 arguably the most far reaching reforms have impinged on industrial enterprises in the urban areas, particularly those in the coastal provinces. In the first half of the 1980s, the dramatic improvement in agricultural performance became the principal determinant of growth in GDP. Thereafter, regionally targeted policies ensured that growth was largely driven by the increase in industrial output and productivity (see Table 1) with industries located in cities along the Eastern coast contributing a disproportionately large share. And the competitiveness of these industries depends not just on reforms introduced by the center but on the efforts of the municipal authorities themselves to improve the municipal business environment, as well as on the readiness of firms to grasp market opportunities. Table 1: Contribution to GDP Growth by Sector 1980- 1985- 1990- 1995- 84 89 94 99 2000 2001 2002 2003 Agriculture 25.9% 9.9% 15.3% 8.8% 5.0% 5.9% 5.6% 4.2% Industry 43.5% 51.8% 59.2% 60.6% 60.4% 56.0% 62.8% 63.9% Of which Manufacturing 33.2% 42.4% 39.5% 39.2% 47.0% 39.4% 44.9% 53.6% Services 30.6% 38.4% 25.5% 30.6% 34.6% 38.1% 31.6% 31.9% Source: Author calculation using data from WDI 5The commune system inflicted great hardship especially in the less fertile areas of the country. By the late 1970s, the strength of grass roots opposition forced a loosening of the commune imposed restraints in Anhui and Sichuan. In Anhui, the first steps from the team-based system back to household farming in the Fengyang region were supported by Party Secretary Wan Li. Zhao Ziyang backed similar moves to the household responsibility system in Sichuan (Hutchings 2001; Perkins and Yusuf 1984). 5  Medium and Large State-owned Enterprises and Organizational Change The population of firms in China is vast and the diversity of organizational forms is on the rise. Not only are there SOEs, cooperatives, collectives and township and village enterprises (TVEs), to these have been added joint ventures (JVs) of many different kinds, wholly owned foreign subsidiaries and growing numbers of privately owned firms, following a constitutional amendment in 1988 legalizing individual ownership. Such proliferation makes it difficult to neatly trace the effects of reform or to typify organizational change. For this reason, we have chosen to examine one class of enterprises, the medium and large sized state-owned enterprise (MLSOEs). In addition, our attention is mainly focused on the major coastal cities where urban and organizational changes are in full swing and which stand at the apex of China's urban hierarchy. There are advantages of such a selectivity as well as drawbacks but the former, we will argue, outweigh the latter. Among the advantages first of all is the weight of the MLSOEs in the urban industrial economy. The total of some 7,500 enterprises are responsible for close to a fifth of industrial GDP and this share has shrunk relatively little over the past decade even though the overall share of SOEs output has declined from 55% in 1990 to 24% in 2002 as a result of the privatization or shuttering of tens of thousands of small SOEs and because of the rapid output growth registered by a variety of non-state firms. Moreover, MLSOEs are the source of 40% of China's exports and they account for nearly two-thirds of China's industrial fixed assets. A second consideration is the availability of information and detailed research on some of the leading MLSOE companies such as Baoshan Iron and Steel, CIMC, Lenovo, TCL International Holdings, and Kelon (see Table 2). The research is especially valuable because it adds depth and nuance to the dry statistics on the state sector. Third, the MLSOEs provide employment to a 6  sizable segment of the urban workforce and these firms still shoulder substantial social obligations to the remnants of their core tenured workforce. Although the urban social safety net is no longer a responsibility of the state enterprise sector, the residual role of state firms is by no means trivial. Fourth, because the MLSOEs include firms with some of the most advanced manufacturing and technological capabilities, as well as ties with the regulatory agencies, they have attracted the attention of foreign multinational corporations (MNCs) seeking local partners in order to enter and navigate successfully in the Chinese market. Hence, foreign direct investment (FDI) has flowed into China's cities and many MLSOEs have entered into joint ventures with foreign investors which in turn has led to assimilation of hard and soft technologies by Chinese enterprises. Fifth, since 1997, the authorities have moved aggressively to reform the ownership structure of MLSOEs and to privatize, divest or close the smaller SOEs.6 By introducing new governance and management practices, ownership changes are reinforcing pressures exerted by market competition on the state enterprise sector. Thus, the large economic and social roles of MLSOEs in the urban economy and their exposure to the global environment, to FDI, to new technologies and to reforms, make them a natural focus for research. 6Approximately 120,000 of the smaller SOEs have been divested. 7  Table 2: Top 30 Selected Major Manufacturing Companies in China Rank Rank Company Major Products Revenues Profits Profits as Market ValueProfits as % Controlling 2003 2002 % Revenue Market Value Ownershipa 6 5 Baoshan Iron & Steel Iron and steel $4,092.70 $516.10 12.61% $6,227.70 8.29% Stateb 13 6 Legend Group Computers $2,593.30 $133.80 5.16% $2,490.90 5.37% State 21 22 TCL International Holdings Home appliances $1,562.40 $78.00 4.99% $806.60 9.67% State 22 24 Sichuan Changhong Electric Home appliances $1,520.40 $21.30 1.40% $1,759.60 1.21% State 23 18 Beijing Shougang Iron and steel $1,519.90 $82.50 5.43% $1,593.50 5.18% State 27 20 Qingdao Haier Holdings Home appliances $1,395.80 $48.00 3.44% $895.20 5.36% Collective 30 21 Guangdong Midea Holding Home appliances $1,312.90 $18.70 1.42% $402.40 4.65% State 31 25 Angang New Steel Metal fabrication and $1,301.30 $71.80 5.52% $910.90 7.88% hardware State 33 36 Chongqing Changan Automobile Auto manufacturing $1,194.10 $100.90 8.45% $1,013.00 9.96% State 37 43 China International Marine Containers Packaging and $1,096.80 $56.20 5.12% $5,304.80 1.06% Group containers State 39 28 Jinzhou Petrochemical Chemicals $1,091.10 $1.50 0.14% $479.50 0.31% State 40 57 Great Wall Technology Computers $1,056.20 $8.40 0.80% $47.70 17.61% Foreign 41 -- TCL Communications Equipment Home appliances $1,053.80 $33.40 3.17% $318.40 10.49% State 47 44 Konka Group Home appliances $971.50 $4.30 0.44% $428.50 1.00% Private 55 79 Beiqi Futian Vehicle Auto manufacturing $915.70 $15.30 1.67% $316.50 4.83% State 57 53 Brilliance China Automotive Holdings Auto manufacturing $884.30 $91.70 10.37% $628.90 14.58% State 62 46 Gree Electric Appliances of Zhuhai Home appliances $849.30 $35.90 4.23% $541.00 6.64% Collective 64 75 Dongfeng Automobile Auto parts and equipment $845.70 $74.50 8.81% $1,824.20 4.08% State 65 63 Tsingtao Brewery Beverages $838.00 $27.90 3.33% $784.50 3.56% State 66 51 Wuhan Steel Processing Iron and steel $816.50 $7.80 0.96% $506.00 1.54% State 72 -- Ningbo Bird Diversified holdings $769.30 $26.10 3.39% $391.80 6.66% Joint-Venturec 73 85 Shenzhen Kaifa Technology Computers $746.50 $7.30 0.98% $897.00 0.81% Joint-Venture 77 88 Hisense Electric Home appliances $679.40 $4.20 0.62% $385.40 1.09% State 80 69 Tsinghua Tongfang Computers $657.20 $22.20 3.38% $758.20 2.93% State 86 73 Guangdong Kelon Electrical Holdings Home appliances $589.30 $12.20 2.07% $5,518.70 0.22% Collective 89 92 Shanghai Automotive Auto parts and equipment $576.20 $129.30 22.44% $2,085.40 6.20% State 91 97 FAW Car Auto manufacturing $574.50 $29.90 5.20% $1,166.00 2.56% State 93 80 SVA Electron Electronics $562.50 $12.60 2.24% $2,054.40 0.61% Joint-Venture 96 93 Shanghai Founder Yanzhong Sci. Computers $545.20 $15.60 2.86% $364.80 4.28% State 97 -- Amoisonic Electronics Electronics $542.00 $73.30 13.52% $584.20 12.55% Joint-Venture SOURCE: The statistics are derived from "China's 100 Largest Companies," FORTUNE, Monday, August 25, 2003 a. Controlling ownership is based on a phone inquiry into China Enterprises Confederation and online research. b. State-owned enterprises include enterprises with controlling shares hold by the state. c. Joint-Venture enterprises may also include enterprises with shares by state or collective or private. 8  Although urban concentration in China is well below that of comparative countries and the world average