Name: Paul Brian McNeill Student Reference Number: 080267487 Module Code: 2009s5C249 Assignment: A02 January 10 2010

0 Word Count: 2498 Assignment 2 In Yasheng Huangs book Capitalism with Chinese Characteristics (2008), he has argued that the success of private enterprises, such as Lenovo, is at least partly due to their ability to escape weak domestic institutions. Critically evaluate this view in the light of your study of Chinas private sector and support your answer by drawing on relevant case material. Explain and illustrate your answer in no more than 2,500 words altogether. Answers that exceed this limit may result in a loss of marks The Great Escape? Dictionary.coms first three definitions of escape could all be relevant to Chinese private enterprise entrepreneurs in different situations, depending on their prevailing business practices; 1. 2. to slip or get away, as from confinement or restraint; gain or regain liberty: to escape from jail. to slip away from pursuit or peril; avoid capture, punishment, or any threatened evil.

3. to issue from a confining enclosure, as a fluid. (Dictionary.com escape) For the sake of this essay we will focus on the definition of escape as trying to avoid the yoke and confinements of the Chinese prevailing regulatory, financial and legal institutions by listing on an overseas stock-market. What this succinct definition does not cover however is an escape from prevailing mainland Chinese business practices. Chinese companies have come a long way since the initial market reforms that started in 1978. As the State Owned Companies (SOEs) moved from beyond their centrally planned raison dtre of providing for the proletariat, they morphed in many cases into respectable and in some cases world class companies. For many it was an extremely bumpy ride that they did not survive, for others it was a case of evolve or face extinction. Under the planned economy, what was called the enterprise was really a constituent part of an enormous bureaucracy, it did not possess

any strategic planning, marketing, logistics or personnel capabilities (Naughton 2007). This opened many new opportunities, initially through the lee-way that rural communities were given to run town and village enterprises (TVE) outside the plan and eventually the reduction of the states monopoly led to rapid entry of new firms (Naughton 2007). This in turn necessitated the need for regulatory and administrative restructuring to try to keep up with the pace of change. As Naughton (2007) states, It was always assumed that system transformation would have to take place concurrently with economic development and indeed the process of economic development would drive market transition forward and guarantee its eventual success.

Chinese Private Enterprises So what actually is a Chinese private enterprise? In most instances a private enterprise would be a non-state organisation, operating a commercial business that in most cases has as its main goal, to maximize share-holder revenue and profits, however in China there are many shades of grey, all of which lead back to, or have their origins in a relationship with a government entity. So defining which companies qualify for the distinction of being pure-play private enterprises will all depend on how the goal-posts are set, however the OECD (2005) separates ownership according to the controlling shareholder, based on firm theory which suggests that ownership should be defined in terms of who controls the residual rights of the firm. By this definition the OECD (2005) estimates that in 2003 59.2% of enterprises were operating in the private sector. In 2006 the Chinese Academy of Social Sciences (CASS) estimated that there were 4.98 million private enterprises in China employing 120 million people (China Daily, Jan 29 2008), averaging 24 people per enterprise. Obviously a miniscule proportion of these companies will ever have the willingness and the opportunity to list their company either on a local or an overseas stockmarket, and commercial success is something that they will have to achieve without an overseas listing. Tongue in cheek aside, of the aforementioned 4.98 million private enterprises there are a significant number of large enterprises that do have the goal to open their company up to outside investment by listing their company in the not too distant future. In June 2009 the Economist reported that 30 companies have received regulatory approval for a local listing and that another 400 are waiting in a queue to be approved (Economist, June 25 2009). Currently there are 1731 stocks traded on the local Chinese stock exchanges (Alibaba, 2009), with the majority of these China listed companies still being SOEs, leaving a small minority of companies to be truly private listed companies. A further 140 Chinese companies are listed in HK (CSRC 2006), 140 on the US stock markets (China Analyst 2010) and more still on other markets across the globe, bringing a grand total of around 300 overseas listed Chinese companies, approx. 15%

of all listed companies. A minute number in comparison with the total amount of companies, an escape to an overseas listing is only achievable for a rarefied group.

A Fishy Tail As SOEs started to downsize to increase productivity and the government introduced the Company Law in 1994 leading to the framework for corporatizing SOEs (Naughton 2007) this led to the opportunity for many smaller and inefficient SOEs from the non-protected sectors to be sold off to private buyers. The unique thing about these sell-offs was that in 92% of the cases the buyer of the company was an insider , typically the original manager and other employees, with the manager owning by far the largest part of the privately held shares, equating to nearly 70% (Li et al. 2003). In the remainder of the cases Li et al. found that the new outside owners were the only person bidding for the purchase and that they had insider knowledge of the organisation. The new owners of these new firms are in many cases the wealthy classes of todays modern China. There still exists a strong feeling among the local population that these ex-state employees have enriched themselves at the expense of the government and by extension and the cost of the working class majority. China reports thousands, sometimes tens of thousands, of what it calls mass incidents each year but these disturbances are usually small in scale and easily suppressed by local authorities (Sheridan, 2009), many of these incidents have their roots in the perceived corruption of local officials. In whatever manner of deals these initial new companies were acquired (in many cases a fair book value price seems to have been paid (Li et al., 2003)), what remains is that most of the managers were products of the state management system and would have brought with them a disposition towards weak corporate governance and close (and in many cases corrupt) ties with the local government officials. In the research conducted by Li et al. (2003) into privatization in rural China, companies that were bought for a premium tended to have a significantly improved performance above those that were sold for a discounted price. Less striking is the finding that there is a high correlation between the premium paying new owners working harder than the owners of the discounted firms, Li et al. (2003) suggest that barring some other difference, the owner of a discounted and premium-paying firm should act the same. Rather, it is possible that after acquiring the firm for a discount, the incentives faced by the new owners may not be as strong as for those who paid a premium, alluding to the fact that the TVE leader who sold off the firm to a buyer for a heavy discount was able to claim part of the firms future profits, leaving the so-called tail in the leaders hands.

Piggy Banks and Pork Barrel Projects

As a key cog in the wheel to lubricate the transformation and expansion of the decommissioned central planning, the Chinese banks have played a crucial role, for good and for bad. In the years preceding 1979 China had one holding bank that acted as a cash register for the government, dispensing wages to households and allocating capital to the enterprises (Tobin 2009). According to Naughton (2007) the banking sector has gotten much deeper, allowing for a mobilization of savings for investment through the introduction of a raft of different types of banks to cater for all sectors of the economy, however the Chinese banking sector is still narrow in that it is still dominated by the banking sector leaving very limited room for other types of financial institutions, although these are slowly gaining more traction. Although the banks in the early days had a clear mandate of what their responsibilities were, a lack of experience in pricing loans and above all the political decision to have soft-budget constraints on the lending practices of the banks allowed local party officials and their SOE counterparts to use the local banks as their piggy-banks to increase capital expenditure for their business and to fund local projects (Naughton, 2007). This led to non-performing loans on an epic scale and saddled the government up with an estimated RMB 5 trillion bill to foot (Ma, 2006). Given this enormous deficit the government took on, it is quite wondrous that before the financial crisis of 2008 a raft of international banks piled into the Chinese market to buy slices of some well known and some distinctly lesser known local Chinese banks. Some of these banks however have now become some of the biggest companies in the world in terms of market capitalization and have managed to provide a tidy return for some early investors. Though of more interest and of more relevance to the Chinese economy is the internal transformation that followed the contact with international banks and subsequent international listings that followed suit. The key triggers for the transformation of the banking sector were initially set in motion with the looming accession of China to the WTO. As part of Chinas accession commitments to the WTO, it had to open up its banking sector to foreign banks, whereby over a period of five years international banks would be allowed to gradually compete with local banks. Lu (2006) notes that, the technical insolvency of the major state owned banks, made these banks highly vulnerable to competition from foreign banks. The upside was an introduction of fresh capital into the domestic banking sector and with it international expertise (Lu 2006).

Capitalist Markets One of the key institutions for a capitalist market is the ability for home grown companies to be able to raise capital through public listings. China launched its first stock exchanges in 1990 following informal over-the-counter (OTC) trading of SOE share issues in the mid 1980s (Tobin, 2009). A majority of the newly listed companies were SOEs that were allowed to privatise up to

one third of their shares, whereby the other two thirds were split between a state-owned asset management company and the SOE or issuing government agency, with all proceeds going to the SOE (Green 2005). The initial public offerings provided a huge opportunity for insiders with chronic, institutionalized manipulation of the market (Naughton 2007) and with an average first day return of 258% over the 12 year period 1992 to 2003 (Wong 2006), many a fortune was made by insiders. The China Securities and Regulatory Committee (CSRC) launched in 1992 to curb stock exchange scandals and appease the fledgling investment community that had come up in arms at the perceived injustices. Not until 1999 with the introduction of the Chinese Securities Law (Tobin 2009) did the punter on the street have any protection from insider trading scams and other nefarious schemes, and even then, the judiciary was another hurdle to tackle (Wong 2006). Institutional investors, such as mutual funds, pension funds and insurance companies are traditionally large players in local stock markets, but the limitations on Chinas stock market development have had an effect on the development of institutional investors (Naughton 2007). In 2001 China enacted some stock market reforms to entice institutional investors, including the permission granted to qualified foreign investment institutions (QFII) in 2002 (Naughton 2007). But this slow start has had a trickledown effect on the market and to this day 85% of investors in the SSE are still non-institutional investors (alibaba.com 2009). This in turn leads OTC investors to have a disproportionate effect on the market and causes swings in the stock market that would otherwise be negated by long-term institutional investors, dubbing the China stock market a casino (Wong 2006). This provides another strong reason for leading Chinese companies to seek an overseas listing in more mature and less volatile capital markets.

Escapism So does a Chinese private enterprise still need to escape the weak domestic institutions to achieve success? Tobin et al. (2008) points out that innovative firms that are willing to bond themselves and commit to higher standards of governance can overcome the barrier of institutional thresholds. Direct benefits include finance, the standardization of property relations and better financial performance. Collateral benefits include regulatory competition, improved disclosure and transparency, leading to long-term access to capital and technology organizational learning and knowledge assimilation (Tobin et al., 2008). This is obviously something that any Chinese company with global aspirations should aspire to achieve and probably comes closest to Huangs assertion that for a private enterprise to achieve success it needs to escape the weak domestic institutions. However desirable an overseas listing may be, the SSE still has a market capitalisation of approx. US$ 2.7 trillion and on a par with the HK Hang Seng (Alibaba.com 2009) and is still a very good place for local enterprises to raise cash. This

enormous investment has been put to very efficient use allowing China to achieve an annual average total factor productivity (TFP) of 4% since 1990, a multiple of four in comparison with US, Japan, UK, France and Germany and markedly higher than Russia and Brazil (Economist, Nov 2009). The Economist attributes this remarkable achievement to the fact that Chinas productivity has been lifted by a massive expansion of private enterprise, and a shift of labour out of agricultural work and into more productive jobs in industry (Economist, Nov 2009). So maybe China is not such a bad place after all to try and achieve success. A final cautionary note is on the idea of trying to escape. All companies that want to succeed within China will still have to deal with the lay of the land and the whims of the Chinese government. Google has raised the stakes by saying that they may pull out of China, most probably bringing a round of cheers to the apparatchiks at the departments of information and propaganda. The following quote sums up quite well the daily reality of business in China from two successful foreign companies operating in China; Sina Corp and Focus Media Holding said on Monday they would effectively scrap their $1.4bn merger after months of government stonewalling over a deal that would have created Chinas biggest private sector media company (Reuters/ FT.com 29 Sep 2009), at first sight the abovementioned quote brings to the forefront just another case of Chinese companies kowtowing to the whims of the Chinese Government. In essence this is true, but as both companies are public listed companies on the US Nasdaq, the question then arises; in what for guise have they actually escaped the farreaching tentacles of the Chinese Government and the institutions that represent it? Chinese companies can raise their game by adapting international standards and practices, but when they want to operate in their own backyard, there is no escape from domestic institutions.

References and Websites Alibaba.com (2009), FACTBOX-Hong Kong vs Shanghai as global financial centres, 10 December 2009 http://news.alibaba.com/article/detail/markets/100215254-1-factbox-hong-kong-vs-shanghaiglobal.html Bonin, JP and Y Huang (2002), Foreign Entry into Chinese Banking: Does WTO Membership Threaten Domestic Banks?, World Economy, Vol. 28, No. 8 (Aug 2002): pp.1077-93 China Analyst (2010) Analyst Ranking and Rating of US Listed Stocks, January 12 2010 http://www.cnanalyst.com/rating/ China Securities Regulatory Commission (2010), A Scroll of Chinese Companies Listed Overseas (GEM), January 12, 2010 http://www.csrc.gov.cn/n575458/n4001948/n4002195/n4003695/n4003785/n4003905/865 3591.html China Securities Regulatory Commission (2010), A Scroll of Chinese Companies Listed Overseas (Mainboard Market), January 12, 2010 http://www.csrc.gov.cn/n575458/n4001948/n4002195/n4003695/n4003785/n4003905/10389 174.html Dictionary.com (2010), escape. January 12, 2010 Economist.com (2009), Secret Sauce, November 29, 2009 http://www.economist.com/businessfinance/economicsfocus/displaystory.cfm?story_id=14 844987 Green, Stephen (2005), The Privatisation two-step at Chinas Listed Firms, in Stephen Green and Guy S. Liu (Eds) Exit the Dragon? Privatization and State Control in China, Oxford: Blackwell Publishing Hang Seng Indexes (2010) Real Time Indexes, January 12, 2010 http://www.hsi.com.hk/HSI-Net/HSI-Net Huang, Yasheng (2008) pages 1-12 of the excerpt from Chapter 1 Just How Capitalist is China?, Capitalism with Chinese Characteristics, Cambridge University Press

Konyn, Mark (2009), FT.com China Gets Back Into the IPO Habit, December 6, 2009 http://www.ft.com/cms/s/0/4eea6ce8-e128-11de-af7a-00144feab49a.html Li, Hongbin and Scott Rozelle (2003), Privatising Rural China: Insider Privatisation, Innovative Contracts and the Performance of Township Enterprises, The China Quarterly, pp. 981-1005 Liu, Jie and Tong, Hao (2008), Private Companies Playing a Bigger Role, China Daily, January 29, 2008 http://www.chinadaily.com.cn/bizchina/2008-01/29/content_6428007.htm Lu, Ding (2004), Chinas Capability to Control Its Exchange Rate, China Economic Review, 24 April 2004 Lu, Ding (2006), Chinas Banking Sector Meeting the WTO Agenda, University of Nottingham China Policy Institute, Discussion Paper No. 5, (April 2006) Ma, Guonan (2006), Who Pays Chinas Bank Restructuring Bill? McKinsey & Company, May 2006. Website: mckinsey.com/mgi/ McMillan, J and Naughton, Barry (2001), How to reform a Planned Economy: Lessons from China, in Garnaut and Huang, op cit., pp. 459-73 Naughton, Barry (2007), The Chinese Economy: Transitions and Growth, Cambridge Massachusetts:MIT Press Organization for Economic Co-operation and Development (2005), OECD Economic Surveys: China, Vol. 2005, 13 September, Paris: OECD Pagani, M, AA Roell and J Zechner (2002), The Geography of Equity Listing: Why do Companies List Abroad?, Journal of Finance 57 (^), PP. 2651-94 Reuters, FT.com (2009), Sina and Focus Media Drop Merger Plan, September 29, 2009 http://www.ft.com/cms/s/0/b0f21d66-acc9-11de-91dc-00144feabdc0.html Shenzhen Stock Exchange (2010), Market Overview, January 12, 2010 http://www.szse.cn/main/en/ Sheridan, Michael (2009), Violent Unrest Hits China as Crisis Hits, Timesonline, February 1, 2009 http://business.timesonline.co.uk/tol/business/economics/article5627687.ece

Sun, Laixiang (2002)Fading out of Local Government Ownership: Recent Ownership Reform in Chinas Township and Village Enterprises, Economic Systems, Vol. 26. Pp.249-69 Tobin, Damian (2009), Management in China: Domestic Development, Centre for Financial and Management Studies, SOAS, University of London, Third Edition 2010 Tobin, Damian and Laixiang Sun (2009), International Listing as a Means to Mobilise the Benefits of Financial Globalisation: Micro Level Evidence from China, World Development, 37 (4) pp. 825-838 Wong, Sonia M.L. (2006), Chinas Stock Market: A Marriage of Capitalism and Socialism Cato Journal, Vol. 26 No.3 (Fall 2006) http://www.cato.org/pubs/journal/cj26n3/cj26n3-1.pdf