The following is the summary of a recently released report by the World Bank Beijing Office. The report, titled "Management of China's State-Owned Enterprises Portfolio: Lessons from International Experience", was written by William P. Mako and Chunlin Zhang, the two senior economists of World Bank Beijing Office.
Analysis of China's portfolio of 174,000 state-owned enterprises (as of end-2001) reveals a clear split. China has some reasonably profitable large SOEs, many of which are centrally administered and/or publicly listed - including some on the Hong Kong and New York stock exchanges. But just over half of China's SOEs are loss-making. The great majority of loss-makers are small/medium SOEs. Locally-administered SOEs pose significant risks of a "localization of benefits" (e.g., wages) and a "nationalization of liabilities" (e.g., additional bank re-capitalization requirements for non-performing loans, un-funded pension liabilities). Thus, China's SOE portfolio poses two issues for the management of State capital. First, what should be done with the cash generated through dividends or proceeds from the sale of relatively good SOEs? Second, what should be done to contain operating losses and the creation of new liabilities from China's many bad SOEs?
A modern capital management system. The preservation and enhancement of State capital will require implementation of a "modern capital management system" through (a) more widespread accounting and auditing reforms; (b) a segmented approach to the management of SOE portfolios; (c) a systematic approach to SOE dividend policy and capital re-investment; (d) central/local agreement on sharing of proceeds and curtailment of liabilities; and (e) enhanced risk management:
(a) Accounting standards now applied to listed companies and foreign-invested enterprises should also be applied to all medium/large SOEs. It would be useful for all large SOEs to experience the discipline of a public share offering (including the accounting standards, public disclosure, controls on related party transactions, and independent directors) - even including large SOEs that are not suitable for a public share offering. There should be a regular accounting for the central State Assets Supervision and Administration Commission (SASAC) portfolio and the portfolio of each local SASAC. Financial reporting for each SASAC portfolio should similarly reflect international accounting standards, with due consideration for unique Chinese circumstances. Improved management information systems should enable SASAC portfolio managers to focus on key portfolio performance measures. Given the "public" nature of SOEs, including those that are not publicly-listed on stock exchanges, it would be appropriate to increase the transparency of all large SOEs and SASAC portfolios - e.g., by requiring quarterly and annual financial statements and making these available to the public.
(b) It would also be useful for the central SASAC to develop guidelines for segmenting SOE portfolios and managing portfolio segments accordingly. Likely portfolio segments include the following:
· Small/medium SOEs ready for near-term ownership transformation;
· Medium/large SOEs in need of operational and/or financial restructuring;
· Medium/large SOEs whose business is non-viable, which should be liquidated; and
· Reasonably healthy large SOEs suitable for "normal" corporate governance.
Accurate cash flow reporting and projections are the starting point for assessing restructuring options. In turn, higher-quality accounting information is needed to provide accurate cash flow reports and projections.
(c ) Large SOEs should each have a formal dividend policy based on a realistic assessment of alternative uses of surplus cash. Cash surpluses on which management cannot expect to earn an adequate risk-adjusted return through reinvestment should be distributed to company shareholders, either through regular dividends or a 1-time dividend. SOE management and boards should avoid ill-considered diversification ("diworseification").
(d) Proceeds from SOE ownership transformation (e.g., sales) should be used to fund pension liabilities or reduce State debts instead ongoing operating expenses. Central institutions - especially the central SASAC, Ministry of Finance (MOF), large banks, China Banking Regulatory Commission, and National Social Security Fund (NSSF) - should liaise with local counterparts on how to control "localization of benefits-nationalization of liabilities." Current concerns about avoiding "loss of assets" should be complemented with concerns about avoiding additional accretions of liabilities.
(e) Large SOEs that remain in SASAC portfolios should each implement an appropriate risk management program. "Hard budget constraints," from adequate systems for creditor right/insolvency and supervision of financial institutions, are needed to support governance at large SOEs and at small/medium enterprises that undergo ownership transformation.
Ownership transformation. The most basic issue is whether China should follow an "open" or "closed" approach to SOE ownership transformation. Over the past decade, except for 1000 or so initial public offerings (IPOs) and foreign-invested joint ventures, ownership transformation has largely proceed through the closed process of management buy-outs (MBOs) or management-employee buy-outs (MEBOs). Apart from offering greater speed and flexibility, closed processes may forestall political debates on the merits of ownership transformation. But worldwide experience conclusively demonstrates the great advantages - both to the State shareholder/seller and individual enterprises - from an open process. Additional empirical work in China to examine this issue would be useful.
It is useful to think about ownership transformation in terms of discrete stages: (a) goals and policies; (b) institutional framework; (c) preparations for sale; (d) conduct of sale; and (e) after-sale:
(a) The goals of ownership transformation should be to maximize sales proceeds and to create the most favorable possible conditions for the future development of former SOEs. Outsiders should have an equal opportunity to compete with insiders to purchase enterprises. It is clear from international experience that outside owners are likely to be more effective in post-sale restructuring and in improving enterprise productivity and profitability. The ownership transformation process should be as open as possible, for example, through an emphasis on open auctions or open tenders. Open processes are needed to encourage bids from outsiders (who may well be more-qualified buyers), to maximize sales proceeds, and to provide needed transparency.
(b) Transparency and centralized decision-making are essential. Transparency is needed to maintain public support for ownership transformation and to forestall future allegations of corruption. Necessary transparency results from publication of clear and comprehensive rules and procedures to govern enterprise sales; publicity on upcoming sales; dissemination of reliable information on enterprises; a competitive sales process (e.g., public auction, tender, or share offering); equal treatment of domestic and foreign investors; rules on real or potential conflicts of interest; publication of enterprise sales results; and oversight by an appropriate public entity. At least for large or complex sales, use of an outside financial advisor should enhance transparency and sale results. SASACs should have wide discretion to organize and conclude ownership transformations, subject to higher-level approval only for particularly large or important transactions and to post-transaction reviews.
(c ) The pre-sale restructuring of SOEs should be minimized. Elaborate calculations of the "going concern" value of medium-sized SOEs are a waste of time and effort. A book value valuation, so long as it includes the value of any real estate (e.g., land use rights), is an adequate reference point for auctions or tender negotiations. An SOE is worth only what a ready and willing buyer will pay for it. Thus, rather than focusing beforehand on calculations of "enterprise value," SASACs should instead focus on procedures (e.g., bidder access to enterprise information, warranties or indemnifications to manage risks to the buyer, advertising) to maximize competition among potential buyers and minimize their potential uncertainty. This is the most practical approach to maximizing sales proceeds and attracting the most qualified buyers.
(d ) The sales method used in each ownership transformation should suit the characteristics and needs of each particular SOE:
· The sale of small SOEs and their valuation should focus on the transfer of real estate or access to real estate (e.g., land use rights, leaseholds). Adding other assets (e.g., inventory, fixtures) and liabilities (e.g., debt) to the transaction needlessly complicates the sale of small SOEs. If at all possible, small SOEs should be sold simply for the highest price through a public auction. From our analysis, it is clear that small/medium SOEs do not belong in China's SOE portfolio. Small/medium SOEs tend to be loss-makers; to diminish rather than enhance State capital; and to cumulatively pose significant liability risks. Full and rapid implementation of the 1999 4th Plenum Decision to "let go" small and medium SOEs and "grasp" the large makes more sense than ever. This, however, will precipitate a huge number of transactions. Hence, an efficient sales program for small/medium SOEs will be especially important.
· Liquidation of small SOEs as well as medium-sized SOEs that are insolvent or difficult-to-audit, through asset sale and separate settlement of claims, can be an extremely efficient method for ownership transformation.
· For the great majority of medium/large SOEs, a "trade sale" to a dominant shareholder (e.g., strategic investor) should be the preferred method for ownership transformation.
· Except in a few select cases, initial public offerings (IPOs) will not be worth the additional time, effort, expense, and risk to public shareholders. The use of IPOs should be limited to large, well-known, and well-run SOEs, whose public offering would contribute to capital market development and where protections for minority shareholders are adequate.
· Closed processes such as MBOs/MEBOs should be avoided, except perhaps in the case of small SOEs that are particularly dependent on the scientific/technical skills of enterprise staff. If an MBO/MEBO is used, insiders should be required to pay something for their shares - albeit perhaps at some discount to market value.
· Mixed sales, such as a trade sale plus an IPO, are a good way to combine the best features of different methods. For practical reasons (e.g., cost, complexity), however, mixed sales should be limited to medium/large SOEs able to attract strategic (e.g., foreign) investors.
(e) Appropriate post-sale conditions are essential to accomplish the main goals of maximizing sales proceeds and promoting future development of former SOEs:
· Post-sale restrictions on the SOE or SOE buyer (e.g., on line of business, enterprise re-sale, worker layoffs) should be avoided, since these are unlikely to achieve any lasting effect - other than reducing sales proceeds.
· Similarly, post-sale commitments by the buyer (e.g., on capital investment, technology transfer) can be difficult and expensive for the State seller to monitor and enforce. A higher sales price is preferable to equivalent post-sale commitments by the buyer.
· Government regulations and incentives to deal with SOE environmental damage should be clear and predictable.
· SASACs should not insist on retaining residual shares, especially in the case of a trade sale.
· "Golden shares" - which may convey special powers to approve or veto such major initiatives as enterprise re-sale to a third party, sale of major assets, liquidation, or reorganization - should be used as infrequently as possible. Any golden share powers should be narrowly-defined, time-limited, and usable only under clearly-specified circumstances.
· Because a lack of wealth or access to financing will constrain many domestic buyers, at least for medium-sized SOEs, SASACs will continue to need to be prepared to agree to purchase financing through installment payments. Installment payments, however, should be carefully monitored. In cases where buyers fall behind on installment payments, it may make sense for SASACs to "outsource" resolution of the problem by selling delinquent balances to private investors or hiring commercial collection agents.
· The successful post-sale development of former SOEs will require complementary policies in a wide range of areas, including the liberalization of new business entry, macroeconomic stabilization, trade liberalization, creditor rights, banking reform, and business law reform.
· Finally, the clarification and protection of private property rights is essential. Past ownership transformations -even those resulting from questionable, non-transparent processes - should be respected. No enterprise owner should ever be divested or driven out of business - including for environmental, health, or safety reasons -by the government without "due process" according to clear and well-established rules, standards, and procedures.
Institutional capacity. The quality of its SOE portfolio will determine institutional requirements for each SASAC. Centrally-administered SOEs are more profitable, less indebted, and less likely to be in distress than locally-administered SOEs.
Hence, the central SASAC as well as local SASACs with higher-quality portfolios (e.g., Beijing, Shanghai) will be able to focus more on maximizing returns on SOE equity and the exercise of normal corporate governance. Core activities at such SASACs should include the monitoring of SOE business planning and performance; participation in annual and extraordinary shareholder meetings; development of SOE boards of directors; and the appointment of SOE directors. Periodically, these SASACs can also be expected to organize share sales in large SOEs. The central SASAC should also be prepared to liaise with local SASACs as well as national institutions to control liabilities growth among locally-administered SOEs. Among large and stable SOEs, their boards will be able to focus on director nominations, board committee structure, and procedures to enhance board oversight of SOE management. Management of such SOEs will be able, in turn, to focus on business plans, investments, and operations to maximize returns on State capital. Based on a portfolio of 196 SOEs, the central SASAC may need 40-100 staff to monitor these SOEs and a cadre of 200-300 individuals to serve as independent non-executive directors. To reinforce the distinction between administrative power and shareholder rights, civil servants should not be appointed as SOE directors. Establishment of a Directors Training Institute and directors accreditation program should facilitate the adoption of international best practices by directors at SASAC portfolio companies.
At the majority of local SASACs, there will be a much greater need for skills in organizing small/medium SOE sales and in restructuring or liquidating distressed or non-viable SOEs. As the nominal owner of these distressed SOEs, local SASACs should also be prepared to negotiate agreements with SOE workers, suppliers, financial institution creditors, and social insurance programs on loss-sharing. Local SASACs will need some training and institutional development in these "special situation" topics as well as in traditional corporate governance tasks. Since the great bulk of small/medium SOE sales, liquidations, and restructuring should occur over the next five years, local SASACs should seek to "outsource" SOE sale, restructuring, and liquidation functions as much as possible - instead of building in-house staff to perform temporary functions.
Market-based working conditions (including compensation) and performance monitoring will be important to attract appropriately-qualified individuals to serve as SASAC staff or SOE directors and to motivate superior performance.
Thus, this background note focuses on China's current SOE portfolio, development of "a modern capital management system," and SOE ownership transformation. A previous background note looked at state asset management reform and steps to enhance corporate governance at large SOEs. A future background note will consider issues and recommendations for enterprise restructuring.
(China.org.cn September 19, 2003)