BOX 3.2 CHINESE INDUSTRY MOVES TOWARD THE MARKET

China possesses more than 100,000 state-owned enterprises (SOEs). They account for 43 percent of production, employ more than 100 million people, yield in aggregate a positive return on capital—and are increasingly thought to be posing serious problems. Despite reform efforts, close to 40 percent—up from a third not long ago—make losses. They also burden the banking system: in mid-1993, SOEs commanded 70 percent of all loans from state banks, of which an estimated 15 percent (or some $40 billion) are nonperforming. China's State Economic and Trade Commission has concluded that as much as half the public industrial sector requires radical restructuring, and another third could be declared bankrupt. The causes of the problems are evident: SOEs are heavily burdened with social objectives, such as maintenance, housing, and clinics. Their managers lack autonomy. Reforms that might result in increased unemployment are resisted fiercely.

These enterprises co-exist with several types of collectively owned enterprises (COEs). Numbering more than 1.8 million and employing 112 million people (in 1993), they account for at least 40 percent of industrial production (while absorbing only 30 percent of domestic investment) and produce 25 percent of industrial exports. COEs are growing at an average rate of 30 percent a year and, along with other types of private firms and joint ventures, account for three-fourths of China's industrial growth. Owned by subnational governments or collectives, their focus is on profits, and they are much less burdened with social objectives. The local officials controlling them can appoint and dismiss managers, assume direct control, dispose of assets (sell or close the firm), and control residual income. Operating in competitive markets, they can and do go out of business.

COE managers are rewarded and penalized on the basis of performance. They have much greater freedom than SOE managers to hire and fire according to need and to make decisions on plant location, product lines, and prices. COEs rely heavily on retained earnings and private capital for their investment needs. They come closer to private firms than to public enterprises. But those who control them are not private owners in that they do not have title to the assets. Further, unlike private owners, there is a need to respond to community demands, such as a preference for employment maintenance over maximizing profits.

Adapting this package of commercialization reforms to local conditions and implementing them in a wide range of public enterprises formed the bulk of IDA's public enterprise reform efforts in the 1 970s and early 1980s. And it continues as an important activity to this day in enterprises that, temporarily or indefinitely, will remain in the hands of the state (box 3.3). Commercialization is particularly applicable in low-income countries in transition, with their vast public enterprise sectors and difficulties in mounting rapid and mass privatization programs, and where the state typically remains as a major shareholder even after the first steps toward privatization. But experience clearly shows that successes in commercialization have been elusive—the record of reforming public enterprises without involving the private sector is largely unsatisfactory. Why is this so?

This midway position between public and private ownership would be difficult to replicate elsewhere. But evidence shows that COEs are performing much more productively than SOEs. A key reason is that the subnational governments and agencies that own the COEs rely crucially on the revenues they generate. Without COE profits, these governments would have no resources.

While many SOEs are creating less-constrained COEs and joint ventures, a massive amount of capital and labor (particularly in heavy industries) is still tied up and used inefficiently. The drag of the SOE sector could be tolerated during the recent period of high and stable growth, but the costs are greater and more evident in the current period of higher inflation—and threatening the health of the financial system. Recognizing these costs, the government is taking steps to:

· Experiment with supervisory arrangements that give greater autonomy and more focused oversight to SOE managers.

· Subject SOEs to market forces on both the debt and equity sides—by reducing guarantees, making SOEs compete for credit with nonstate firms, and floating minority shares of SOEs on stock exchanges inside and outside China.

· Remove social obligations from the SOEs, and transfer them to subnational governments.

· Impose a harder budget constraint on all SOEs.

· Close or severely downsize the most hopeless performers.

Partial reform

The first lies marshaling the wild and resources to install the complex and often contentious commercialization reform package. Partial reform does not do the job. In Africa, in South Asia, and in many low-income countries in transition, the landscape is littered with inadequate, unsustained attempts of government owners to keep output prices at cost-covering levels, to lay off excess workers, to restructure the powers and composition of boards of directors, and to increase the autonomy of managers to hire, fire, locate plants, and choose suppliers.

Soft budgets

Attempts to impose a hard budget constraint on public enterprises have all too often proven ineffective. Early reforms often stopped unjustified direct transfers to public enterprises from the budget. But they were quickly replaced by concessionary credits from the banking sector. When and where that flow has been fumed off, public enterprises have still managed to receive credits from nonbank financial institutions—and went unpunished when they did not pay taxes, dividends, customs duties, suppliers, or each other. Enterprises usually register improved performance when forced to operate with retained earnings, with what they can borrow on strictly commercial terms without a government guarantee, and with what they can raise from the private sector in terms of joint ventures or equity.

BOX 3.3 BENIN'S BROADLY BASED PROGRAM OF PUBLIC ENTERPRISE REFORM

Benin's experience shows the benefits of using a wide range of reform measures to address the problems of a poorly performing public enterprise sector. In 1986 the country had about 60 parastatal entities, accounting for 75 percent of industrial production and monopolizing most productive subsectors, including manufacturing, agricultural processing, mining, and transportation. These entities employed 28,000 people and utilized 55 percent of all bank credit to productive firms in the country. Enterprise performance was poor, suffering from both over-regulation and ineffective regulation, controlled prices, and lack of managerial autonomy.

But by the end of 1994, 32 enterprises remained in the government's portfolio, of which only 15 were commercial entities. Five more are scheduled to be divested in early 1995. In eight years, the number of firms has been cut by more than half. Employment in the sector has been reduced by about half. The percentage of total banking credit absorbed by public enterprises has declined to 18. The amount of enterprise debt guaranteed by government has fallen by 80 percent. And the turnover of privatized firms has more than doubled—from 9 billion CFAF in 1988 to 21 billion CFAF in 1993, indicating strong post-divestiture performance.

How did this come about? The government's reform program started in the mid-1980s when, alarmed by the increasing number of insolvent enterprises and the harm nonperforming debts posed to the banking system, IDA assistance was sought, and a program was adopted. Twenty-one lossmaking operations were liquidated, including the airline, a textile corporation, and a freight firm. Six operations were sold (some with IFC involvement), including the brewery and a cement company. And ten operations were subjected to restructuring measures, including management contracts for several hotels and increased rigor in the public investment review process. Although some of the liquidated firms were small, moribund units, the reform program as a whole has resulted in the withdrawal of the government from entire sectors of the economy, including imports, consumer goods distribution, transportation, brewing, and cement.

The removal of price controls, changes in the legal and regulatory frameworks, and major alterations to the banking sector, including the liquidation of the three former state banks and the introduction of private commercial banking, accompanied these divestiture measures. As downsizing produced layoffs, NGOs successfully launched a special program to generate jobs in small and medium-size private firms. These measures have set the conditions for the resumption of private sector growth, as evidenced by the improved performance of the firms transferred to private owners.

Benin's program illustrates most of the reform principles and measures espoused in this chapter. It attacked simultaneously enterprise reform and privatization. It took extensive and bold steps to liquidate persistent losers. It sold or closed firms that couldn't be sold immediately. It combined enterprise reforms with far-reaching financial sector reforms (including liquidation and reliance on new private entrants). And it made a concerted effort to make the transition palatable to those most directly affected. The next step in the process should be to expand privatization into the infrastructure fields—areas that still remain under state control (for an example of how this is being done elsewhere in Africa, see box 3.7 on the electricity sector in neighboring Cd'lvoire).

The upshot: Implementing the entire reform package has proven just about as difficult, administratively and politically, as privatization itself. Governments tend to pick and choose from the package those elements they find tolerable. Reforms tend to be partial—and therefore inadequate. Research has shown that some of the public enterprise reform mechanisms used most heavily in the past are of dubious utility. A 1994 World Bank study, for example, reviewed 12 agreements laying out the mutual obligations and responsibilities of the owner (the state) and public enterprise managers. It concluded that they did little to improve performance and in some cases may have contributed to performance declines (World Bank 1995).

Backsliding

Even in the few cases where the whole package of reforms is put in place, it tends not to stay in place—for backsliding is frequent. The common story is that bad times make for good policy. In crises, especially financial crises, governments muster the will to install tough reform packages that establish the precedence of commercial objectives, impose a hard budget constraint, reduce excess work forces, give managers the autonomy to achieve commercial aims, and pay them according to their performance.

But once the crisis fades, commitment fades with it, and the reforms are diluted or shelved—meaning that cost-cutting measures are stopped or reversed. For instance, Pakistan pioneered a system in the 1980s to measure industrial public enterprise performance each year and reward management for goal achievement—and for a time it produced positive results. But in 1993, supervisory officials indicated that the system was no longer being energetically applied. The conclusion: Even when not partial, reforms tend not to endure. While retreat from reform has also occurred in richer countries, backsliding has been both more common and more devastating in low-income countries, with their larger public enterprise sectors.