State-Owned Enterprise of China

 

The People's Republic of China (PRC) government acts with great freedom and latitude where domestic ownership rights are involved, but has less freedom where foreign ownership interests are at stake because intrusive interference with these interests may raise legal, political, or diplomatic issues not present in a domestic context. China's policy of fostering a market economy within an overall framework of socialism has been described as a form of state-controlled or state-managed capitalism. Certain sectors of the economy are permitted to develop and operate under market principles of supply and demand, but the state retains ultimate control of business enterprises either through a majority ownership interest or through regulatory powers. This system allows the state to carefully monitor and control reform, to periodically tighten or loosen controls, and to enforce retrenchment or austerity measures when necessary. When the PRC government considers extreme measures necessary, government control over the economy may become intrusive or overwhelming. These mechanisms allow the state to prevent reform from spiraling out of control and avoid the resulting problems of hyper-inflation, economic chaos, and political instability.

The performance of state-owned enterprises (SOEs) in China since the state enterprise reform has attracted much attention in the discussion of the Chinese economy. Inspired by the success of rural reform, the Chinese government introduced similar reform measures to its SOE sector. The gist of state enterprise reform is the gradual relaxation of the role of central planning, the introduction of a free market system and various kinds of profit-sharing schemes, and the increased autonomy in decision-making granted to SOEs (Huang and Duncan 1997, pp. 68-9). While some of the pre-reform legacy still lingers including the problem of soft budget, the enterprise reform is generally believed to have injected the fresh blood of economic rationalism to an ailing sector of the Chinese economy. Some even go further, arguing that profit maximization is now the most significant goal of SOEs both in practice and in the perception of the managers of SOEs (Perkins 1994, Groves et al. 1995, Yin 1998). According to Western standards, SOEs have performed reasonably well since the reform.

A number of authors have proposed various explanations for the poor performance of SOEs. Three leading explanations are the erosion of monopoly position due to the entry of other firms, accounting manipulation, and the lingering legacy of a soft budget constraint. The first explanation is not entirely satisfactory when one considers that not only SOEs but other forms of enterprises have experienced a similar increase in competition. While the explanation based on accounting manipulation does have bite as evidenced by Woo et al. (1993) and Sicular (1994), it bypasses the key incentive aspect of the reform, and is thus unable to offer an explanation as to whether SOEs were led to make efficient production decisions. Much attention has been paid to the problem of soft budget in enterprises in transition economies in general (Schaffer 1998), and SOEs in China in particular (Bai and Wang 1998, Li and Liang 1998). It is true that a soft budget constraint can significantly undermine incentives, an d without directly tackling this problem, further reform could well prove to be ineffective.

According to government statistics, state-owned enterprises are the key drivers of China's industrial economy, accounting for almost half of industrial production and more than two-thirds of fixed assets. Although most of them are in capital-intensive sectors, some are trading companies, service monopolies like airlines, and emerging business conglomerates. The very biggest are truly world-class in scale: their sales would comfortably place them among the US Fortune 500s. Further, above the individual enterprise level sit national corporations that oversee entire industry sectors. In the case of the Beijing Automotive Industry Holding Corporation, it currently suffers from an inflexible manufacturing system that grossly wastes capital investment. This makes production lead times lengthy and unreliable, and undermines the quality of products. The immediate need of these laggard producers is to learn from the proven production practices of the company to adopt serious lean-manufacturing initiatives, and to avoid the usual expedient of increasing capital investment whenever operational inefficiencies threaten to constrain capacity.

Since most global carmakers have had large investments in China only since 1999, it may seem odd to advocate scaling back the industry's capital investment now. Competition has been tight among the producers of automobile in the country. In the part of Beijing Automotive Industry Holding Corporation, they made a rapid transition from protected and subsidized operational units into full, standalone businesses. Thus, they are subjected to a situation where they must earn a profit or potentially face bankruptcy. Now responsible for the full range of business functions, from product development to distribution and sales, they are largely free to succeed -- or fail -- on their own. Similarly, the company has realized that obstacles to interprovincial trade disappear and import restrictions and foreign investment barriers collapsed when PRC signed the accession agreement with the WTO. The company realized that they must contend with active new competitors, both local and international. In the old days, the company would simply build its automobiles and then sell 85 percent of its output to the local state distributor, which covered only the city's western districts. Now, a local collective is stealing away share, international companies are entering the market, the state distributor has been disbanded, and the brewery has to repay the substantial debts incurred for a recent acquisition, manage its own distribution, and build a marketing function from scratch. It's a different world.

The Beijing Automotive Industry Holding Corporation works with an uneconomic configuration of almost 20 plants in nine locations plans to consolidate and upgrade its facilities using the proceeds from the sale of valuable real estate assets. Indeed, as a company owned by the government, Beijing Automotive Industry Holding Corporation is learning that market-oriented competition means paying strategic attention to issues of scale.

Another challenge is provided in a more microlevel of SOEs. The managers, who are considered powerful and most influential in the fate of a government owned corporation. For the SOE managers, specifically for Beijing Automotive Industry Holding Corporation, the changes meant that capital budgeting and investment decisions are no longer a government-driven exercise, but very much their own prerogative. So, too, with only minimal central government review, are the decisions to establish alliances or joint ventures with foreign companies and to make internal organizational and restructuring decisions are incipient. Nevertheless, provincial and local governments still have an important influence on these decisions, and constraints remain on hiring and firing. Along with these broader managerial rights come weighty financial responsibilities. The Beijing Automotive Industry Holding Corporation no longer able to depend on government handouts, thus they are now seeking alternative funding sources, including bank loans and equity investors. In this company as in others, distribution and other infrastructure bottlenecks may delay consolidation, but individual companies cannot put off the need to plan how they will participate in more economically rational industry structures.

In much the same spirit, China's vision is to have its automotive industry become a world-class contender and major exporter, taking advantage of the scale of its domestic market and competitive cost position. An ambitious program is under way to consolidate and upgrade the industry around a few leading production centers, each with a key foreign partner. As part of this effort, the government is restricting both new entrants and component assembly operations by existing players, and encouraging production of small, affordable cars for domestic consumers. At the provincial level, the Beijing Automotive Industry Holding Corporation has devoted much effort to assessing whether, how, and through which company, if any, it can make the transition from producing low-end items toward making higher-value, globally competitive products. Among the sectors for which it has developed scenarios are auto parts and electronics. Similar initiatives are under way in other provinces as well as at the national level.

The Beijing Automotive Industry Holding Corporation, however, will not be able to stand up to the challenges of a more competitive market and will be forced to sell all or part of their assets. In some cases, policymakers will actively encourage such sales to reduce debt, rationalize industries, and improve the scale, quality, and efficiency of the players that remain. Where SOEs enjoy meaningful cost advantages, they may well become serious competitors and/or global suppliers.

 

 

Joint Venture in China

 

Joint ventures can be defined as legally and economically distinct organizational entities created by two or more parent organizations that collectively invest capital and other resources to pursue certain strategic objectives (Pfeffer and Nowak, 1976). Joint ventures have long been a favored mode for entering foreign markets (Beamish and Banks, 1987). PRC law provides that the joint venture must be established under principles of equality and mutual benefit. The purpose of the joint venture law is to create independent business enterprises in the form of partnerships between foreign investors and local enterprises in order to promote the sharing of management techniques and technology with local enterprises and in order to foster the long-term development of China's economy.

An example of a joint venture in china is between US companies IBM, Oracle, Cisco, and UGS; and Chinese firm Chang'an Automobile Company. The venture is an initiative of the latter to sell small automobiles through the World Wide Web. Thus, Chang'an Automobile Company is considering a venture on e-business. Nevertheless, the company confirmed the continuing economic disparity between central, regional, and local governments and the effect it is having on partner compatibility in terms of orientation and government approvals. Although the central government has introduced economic reforms intended to reduce its dependence on local governments, its influence over them remains limited. This is complicated by a Confucian/Communists-based administrative system that is known for its bureaucratic, rigid, hierarchical structure at all levels. It is often difficult to identify the person or agency with the authority to give necessary approvals or authorizations so that work may proceed. Although the central government has now introduced tax reforms intended to reduce its fiscal dependence on local revenue processors, the consequences of its Open Door policy have diminished the influence it once had over local governments.

In the given joint venture, the Chinese partners continue to be a problem because they still attempt to dominate the foreign partner, knowing that the latter is heavily dependent on them. As board members, they tend to insist on a wait-and-see approach because of the uncertainties in China's economy and its still unproven ability to sustain its Open Door policy. Short-term oriented, Chinese partners stand in the way of progress. Foreign partners also see their Chinese counterparts as self-centered and motivated primarily by greed. Moreover, the Chinese partners tend to have political agendas that affect their attitude toward the joint venture and reduce the level of reciprocity that one would normally expect. An important reason for this is the Chinese belief that they have not been dealt with fairly over the decades and that now is time to even the score. This has exacerbated their cultural propensity to relentlessly pursue the addition, modification, or elimination of contractual terms already agreed upon rather than focus on compliance. At the same time, they show little flexibility during original negotiations or in most decision-making processes because they are predisposed to the mandates and guidelines of their government's latest Five-Year Plan.

Similarly, managerial problems in joint ventures among the five companies are extensive. Chinese partners are often affiliated with the government and are assigned by its as managers of the joint venture. Worse still, they are generally rotated to other assignments every three or four years. Thus, they are not only short-term oriented but they have developed no managerial skills specific to the joint venture. Accordingly, decisions on the Chinese side tend to be based on political factors made by people who prefer to merge themselves in the group and who have little or no knowledge relevant to the joint venture. They are inflexible, prefer the status quo, and tend to concentrate on the micro-management of minor matters. They also harbor an order taking deference towards the central government.

The foreign partners also realized that the Chinese partner in the joint venture is often more than 50% overstaffed and tends to employ workers of a very low educational level. Quan xi ("connections") among the Chinese, which the foreign partner feels obliged to respect, is largely responsible for this phenomenon. Also, training such employees is a direct cost to the joint venture because universities and technical institutes are not sufficiently subsidized to provide it. Thus, quality control of items manufactured by local suppliers has provided an additional cause for concern. Naturally, local sourcing is an objective of most foreign investors because it reduces transportation costs. However, is not only expensive but requires a relatively long lead-time to establish. Quality control of services has also been difficult to maintain. In fact, quality in both services and goods remains the foreign investor's primary concern in China because much of its technology is obsolete, and the training of its workers is mostly theoretical. Further, workers lack hands-on experience with machinery and are not conscientious about equipment maintenance.

Concurrently, employee loyalty is difficult to come by. To illustrate, the joint venture among the five companies reported that its Chinese partner used the company's name without authorization and "loaned" it to two of the company's major competitors in China. To prevent other loyalty breaches, the foreign partner now disguises important information. All of the companies knew of similar examples, and they viewed this problem as symptomatic of a culture-based, negative attitude toward the joint venture.

Foreign Firms Based in China

 

The selection process is important for another reason. Due to the central government's belief that private firms should be absorbing excess workers from the state-owned sector, overstaffing can be a concern. As a result, foreign partners in joint ventures often find excess personal can be assigned to the venture, sometimes composing as much as 50% of the venture's employees (Wong et al., 1999). Extra employees can be removed from the organization, but this is time consuming and must be done with care. China has a number of well-established institutional elements that can be traced to its long history and rich culture, but formal institutions such as codified laws and case precedent were not parts of the institutional fabric (Jenner, 1992; Tuchman, 1971). In addition, certain normative and cultural elements and taken-for-granted conventions complicate doing business in China, as evidenced by the heavy reliance on relationships, the low level of trust in the society, and lack of respect for the formal rule of law (Fukuyama, 1995). While trust building, connections, and alliances with key individuals and organizations remain important, firms should not attempt to do business in China without formal contracts. One consultant argued that this was similar to managing human resources in China, where foreign firms need to carefully explain exactly what is expected of local employees, including as many details as possible (Bruton, Ahlstrom and Chan, 2000). Similarly, when doing business in China with new business partners, contracts need to spell out each party's obligations as carefully as possible.

China's institutional environment has implications for foreign firms because it greatly affects the way they do business (Peng, 2000). Many firms and investors do not completely comprehend the unusual institutional and legal structures enveloping the Chinese commercial environment. The large numbers of foreign firms entering China for the first time must understand the legal environment, especially in parts of the country with less commercial tradition and few formal rules governing firms and business transactions.

While a significant private sector has been created, private firms in China still face a number of problems in the conduct of their day-to-day operations. Despite the government's declaration that private businesses are an important component of the socialist market economy, the playing field is not yet level. This can be particularly acute for foreign private firms (including both joint ventures and wholly owned firms) that are still acclimating to the local commercial and institutional environment (Wong, Maher, Jenner, Appell & Herbert, 1999). China's long isolation and command economy virtually eliminated several commercial functions until recently. One must also reiterate the presence of guanxi or connections, which have historically been critical to facilitating business (Tsang, 1998). These informal social networks are developed through natural relationships such as family, marriage, schooling, and work (Wank, 1996). Guanxi is important not only for individuals but also for firms. Businesses with connections, especially at various levels of government, have good access to people and resources that can enhance their ability to get things done (Ahlstrom, Bruton & Lui, 2000). But for foreign firms new to China, this can be a challenge.

As a result of such difficulties, foreign firms in China have typically sought to aggressively develop their own social networks rather than depending on those of an alliance partner alone. Shenzhen-based economist  Q.L. He (1997: p. 148) found that in some cities in coastal China advertisements for new employees openly state that preferred candidates should have good relationships with certain government departments and officials. Thus, foreign firms have found it is important to try to hire managers that already have connections with important local officials. Given the level of interference that foreign firms can face, the employee selection process can be particularly crucial to the firm's success (Mann, 1989).

Nevertheless, a recent development as an immediate result of WTO entry increased the flows of foreign direct investment into China (Panitchpakdi and Clifford, 2001). The WTO agreement will also give foreign firms' more freedom to operate in a variety of industrial sectors and regions of the country (Nolan, 2001). Restrictions on retailing and distribution will ease as foreign retail firms are able to set up wholly owned outlets; no longer will most goods sold have to be produced in China. Significant restrictions on distribution will be phased out over three years (Panitchpakdi and Clifford, 2001). In automobile industry, foreign players will be able to buy up to 50% of the carriers. A number of other regulations will be loosened, opening up a range of previously closed industries. In addition, the Chinese government is encouraging firms to locate in the country's more remote areas (Schevogt, 2001).

The Volkswagen Automobile Co Ltd office in Shanghai heeded this call. They have experienced a cumulative effect of the relaxation of restrictions on foreign firms with the WTO not only bringing more foreign firms to China, but will offer them unprecedented access, particularly in industrial sectors and geographic regions that have seen few foreign enterprises of any kind. Prior to WTO accession, foreign firms such as Volkswagen were compelled to enter China under strict guidelines and were limited to certain sectors. They typically chose to locate in the more developed coastal areas of the country where regulations were codified and commercial traditions well established (Scarborough, 1998). Therefore, a foreign manufacturer could expect to encounter fairly clear (if not always logically consistent) laws and commonly accepted commercial practices in the most likely locations for businesses in that sector (usually manufacturing). As significant numbers of foreign firms enter China after WTO, they have unprecedented access to different regions and industrial sectors. However, these are locations and industries with less established commercial law and little experience in commercial practice. The institutional environment will differ from what foreign firms are familiar with (Bruton and Ahlstrom, 2002). Competing in China involves big money: a capital investment of $1.7 billion for the two facilities of VW'. Thanks to protection of the industry, this investment has largely paid off: with tariffs ranging from 80 to 100 percent, models bear price tags up to 150 percent higher than those in the United States and Europe, allowing successful joint ventures in China to enjoy levels of profitability not seen anywhere else.

Initially, Volkswagen is considered as a wholly foreign-owned enterprise (WFOE) where the MNE is freed from any constraints imposed by a partner are. Under current PRC laws and practice, government approval of wholly-owned enterprise status may be difficult to obtain. WFOEs are completely prohibited in some industries and restricted in others. As a result, this path is simply not viable for a number of MNEs. In other instances, the foreign investor may obtain approval for a WFOE only by satisfying certain onerous conditions such as high export requirements. Even when Volkswagen obtained WFOE status, it may still be advantageous to the MNE to be the control group within a joint venture. The chairman of the joint venture's board, who is appointed by the local partner, may have close relationships with local government and may be very effective in helping the joint venture obtain favorable government treatment, in navigating the joint venture through government requirements, and in obtaining contacts that are required of every business venture in China. In addition, a joint venture is closely identified with Chinese participation, and because the local partner is often a state-owned enterprise, the state is considered an owner of the joint venture. These elements are missing in the case of a WFOE. An optimal strategy may be to first establish a series of joint ventures under a wholly foreign-owned management company and to gradually add Volkswagen to the network in strategic locations where the MNE has particularly strong local connections. Over time, the MNE may seek to convert some of the joint ventures into Volkswagen by purchasing the Chinese partner's equity interest. Under ideal conditions, all of the business entities under the management company would eventually be converted to wholly owned entities. It appears unlikely that political and economic conditions will allow this arrangement in the near future. The current strategy of establishing what amount to limited partnerships with Chinese partners comes closest to achieving the objective of corporate control.

 

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