Private sector firms have become the most dynamic sector of China (2)

Jonas Short: 4123861

Management for China: T14104

Private sector firms have become the most dynamic sector of China’s

economy. Yet the state sector is hugely privileged in access to capital,

licenses and various state approvals. Critically discuss how private firms

use networks and other means to overcome their liability of being private.

Ever since Deng Xiaoping paid a landmark visit to the South of China in 1992, the economic

landscape changed. Private enterprises are no longer entities to be vilified, but engines for

economic growth. The definition of private enterprises is split with individually-owned

enterprises having less than eight employees, and privately-owned enterprises with no such

limit. From 2002 to 2010, China’s registered private enterprises have swelled in number

from 2.6 million to 7.9 million by 2010 (Li & Fung, 2010). The number of individually-owned

private enterprises has increased from 23.8 million in 2002 to 33.3 million in 2010 (ibid.).

However, the statistics do not tell the whole story. Private enterprises still face multiple

constraints in the current business environment. State-owned enterprises in China create

returns by investing subsidized capital and using connections to win government contracts

(China Economic Review, 2012). The main constraints that private enterprises suffer in the

face of their state-owned rivals include access to capital, legislative barriers, and even threat

of asset confiscation. The private sector therefore must overcome many obstacles in order

to operate under China’s economic system to the extent where it is even a liability to be

private in many sectors. The private sector has had to discover means to overcome their

liability of being private. This would include the building of political networks and finding

other means to access capital.

1



Development of Private Enterprises

Private enterprises were not officially tolerated until 1988 through a constitutional

amendment, which merely allowed private enterprises to “exist and develop (emphasis

mine)” (Qian and Wu, 2000) within the limits prescribed by law. According to Flynn and

Carlisle (2005), before this constitutional amendment came to pass, private businesses were

prohibited from exporting their products, and were discriminated against by factory

managers and local officials both of whom feared retribution for not supporting the state.

Small individual businesses could employ no more than seven workers, and were not

allowed to combine capital. The 1988 regulation change legalised limited liability privately

owned companies without limiting their number of employees (Jie and Ward, 2003 pp. 107).

Peng (2000) maintains that an increasing influence of private ownership during economic

transitions has maintained an uneasy relationship with statist ideology. Tiananmen Square

caused a turbulent time for private enterprises. Owning to political and economic pressure,

the number of registered private companies fell from 90600 at the end of 1989 to 88000 by

June 1990 (Jie and Ward pp. 108). However, between 1991 and 1997, the average annual

growth rates of private industry surpassed 16 percent. Subsequently, the private sector

increased its share of industrial output nationally from 22 percent to more than 43 percent

during the 1990s (Walter and Howie, 2011 pp.132). In 1999, the tone became slightly more

tolerant concluding that the private sector could play “an important component of the

socialist market economy (emphasis mine)” (Qian and Wu, 2000). This landmark

amendment elevated the private sector’s status to such an extent as to allow them to buy

land, obtain finance, and secure property rights (New York Times, 1999). Indeed McNally

(2011) goes further to state that these new formal rules and legal rights have allowed many

private firms to clarify their ownership structures, the government openly acknowledged

2



the value of private enterprise to China’s economy. This was changed in 2001 upon entering

the WTO where the state “supports and guides… and exercises supervision and control

(emphasis mine)” (Qian and Wu, 2000). The state therefore leaves the private sector at a

point where they are still under the control of the state sector.

Liability: Lack of Access to Capital

China has a state-dominated banking sector with the four largest state-owned banks

accounting for about 55% of total banking assets at the end of 2005 (BOFIT, 2013).

However, private firms receive just 7% of bank lending (Firth et. al 2009). The disparity is

aimed towards the fact that state-owned firms are trusted; they are therefore able to

borrow large loans at favourable interest rates. Larger private firms do enjoy access to

capital, but this is because they can provide collateral such as their well-established land-use

rights (Jie and Ward, 2003 pp.113). For smaller businesses however, it can prove very

difficult; Feng and Wang (2010) recount the experience of Zhentao Wang, whom founded

Zhejiang AoKang shoes, a Zhe Shang. Despite owning one of the largest shoe factories in

China, he still could not obtain a state-owned bank loan (ibid.). The last few years have seen

a proliferation of credit into China’s economy, yet without discernable uptake in private

business spending, also known as household consumption (HC). This shows that the state

sector and select borrowers are absorbing the vast majority of the newly flooded capital.

The state-owned privilege in accessing capital is thus evidenced in figure 1 below.

3



19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

2011Yea

r0%

20%40%60%80%

100%120%140%160%180%200%

Bank loan growth from 1995 - 2011

M2/GDPHC/GDP

Year

Debt

to G

DP ra

tio

Source: China Statistical Yearbook 2012

HC (red line) stands for household consumption. Household consumption can be defined as

expenditure for each household on goods and services; it is a reflection on the health of an

economy. The figure is divided by GDP so that inflation is discounted, giving a ‘real’ figure.

M2 (blue line) can be defined as the level of money supply in the economy from bank

lending. In any functioning economy, if there is a proliferation of bank lending then

household consumption should also rise. However, bank lending (M2) has been allowed to

run away, particularly since the government’s economic stimulus in 2009 where a sharp rise

in M2 is evident on the graph. The gap between household consumption and M2 has

widened considerably since 1995, this shows that growth is being financed by bank lending,

yet private enterprises are evidently receiving very little of this capital. The problem

becomes more acute when the government periodically tightens liquidity in order to stem

inflation. However, this has the unintended consequence of freezing credit for private

enterprises since it becomes more expensive for banks to lend capital. Zhang (2013) notes

4



that small businesses and farming are most affected by a liquidity tightening. Since M2 is

growing so quickly, the government will soon have to tighten again. Limited credit is often

fully subscribed by state-owned enterprises, meaning private enterprises are crowded out

and thus are denied access to fresh capital (Zhang, 2013).

Liability: Legislative Constraint

The law towards private firms are subject to the interpretation of a range of officials who

enforce them (Ahlstrom and Bruton, 2001). This can lead to many legislative and financial

headaches for private firms. Carlisle and Flynn (2005) list a series of environmental factors

that affect firm performance putting the state regulatory regime as the most influential.

Indeed, for many private enterprises lacking effective networks, registered companies

operate under a considerable liability where a firm’s assets could even be confiscated. Feng

and Wang (2010) report how especially during the 1990s, it was a common concern among

entrepreneurs that their property would be seized by the state. In recent years, the state

has been less blatant about the seizing of assets and instead turned to ad hoc windfall taxes

on firm profits. In addition, the practice has extended to party members unexpectedly

appearing at a business requesting a share of returns; this phenomenon is known as Tanpai

(ibid.). The costs of Tanpai have been illustrated by Feng and Wang (2010) after using five

nationwide surveys from 1999 to 2006. There is an encouraging downward trend of the cost

of Tanpai, falling from 9 percent 1996 to 3.1 percent 2005. However the extra tax is very

costly for private firms, perturbing reinvestment which would assist the growth of a

business. Local Industrial and Commercial Bureau have quotas for fines for example, so it is

natural that private firms which are known to have resources are targeted by the

5



authorities. Indeed the state has been known to add a variety of ad hoc fees and fines

particularly from well performing enterprises (Jie and Ward, 2003 pp. 113).

However, despite the financial and relationship constraints the private sector has thrived

next to the state sector. As is evidenced in figure 2 below, the private sector is far more

dynamic than the state sector.

2012 2011 2010 2009 2008 2007 20060

5000

10000

15000

20000

Private Sector v. State Sector Profits

Private Enterprises' Overall ProfitsState-Owned Enterprises' Overall Profits

Year

Profi

ts (b

illio

n Yu

an)

Source: China Statistical Yearbook 2006-2012

2010 became the first year private sector profits overtook state sector profits. The year-on-

year growth rate of private sector profits eclipsed the state sector virtually every year in

recent years. The private sector proved its dynamism when during the financial crisis state

sector profits declined from 10785.19 billion Yuan in 2007 to 9287.03 billion Yuan in 2010,

while private sector profits almost doubled in that same period. This has been despite the

state sector enjoying easier access to cheaper capital and fewer unexpected overheads from

ad hoc costs such as Tanpai. The private sector has thus found ways to overcome its liability

of lacking access to funds and connections.

Overcoming the liability of lacking political connections

6



In order for a firm to secure its future, Ahlstrom and Bruton (2001) believe that this is

achieved when its structure and appearance are taken for granted by both public and by

state. In China, some private firms engage in a joint-venture structure to align closely with

organizations that have greater standing in the eyes of the government (ibid.). Foreign

investors for example bring advanced technology and management techniques; learning

from foreign expertise elevates the status of a domestic partner making troublesome

legislative intervention less likely. Some private firms deceptively list themselves titles such

as ‘service department’, and hire local officials as advisors or board members (Jie and Ward

2003 pp. 109). Many firms engage in a network with a state-owned company, otherwise

known as ‘putting on a red hat’, this is a practice some private firms have used to overcome

their liability of not having high-level connections. Jie and Ward (2003 pp. 130) interviewed

a paper entrepreneur who paired with a loss-making state-owned company to publish

papers and is now a very successful joint venture. Some private firms even pay a state-

owned unit in order to use their name on their books. The government therefore cannot

prosecute the firm, and thus the enterprise can avoid legislative issues (ibid. 109). In recent

years to enhance firm success, private entrepreneurs embed themselves in party-state

institutions (McNally, 2011). According to the Hurun report (2013), a study into China’s

wealthy individuals, 153 entrepreneurs from the report have been appointed to the 12 th

National Peoples’ Congress (NPC). Given that the minimum net worth required to be

recognised by the Hurun report is $150 million, this constitutes a proliferation of wealthy

entrepreneur inclusion. Zong Qinghou founder of Wahaha Group is China’s second richest

man with a fortune of $17.2 billion and is also member of the NPC (Bloomberg News, 2012).

However, there are risks associated with this strategy to overcome the liability of being

private. Work by Pei et. al (2011) assessed the impact of former Shanghai-based politburo

7



member Chen Liangyu’s sudden dismissal and subsequent arrest on listed companies. Their

research concludes that firms whom shared a political network with the Shanghai municipal

government suffered the most negative cumulative average return on investment upon the

damage of the local political network. Carlisle and Flynn (2005) suggest that a network with

a few top officials may not be sufficient; a solid customer base and long history ensures firm

survival. However, if the government challenges the firms’ right to exist, their assets can be

confiscated. Without secure legal and property rights, overcoming liability becomes

essential (Ahlstrom et. al 2008). Given the power of the state to grant or withdraw licences,

firms must pay Tanpai unless a firm has a powerful political network. This has resulted in

firms under-cooking their books to the authorities to remain out of government crosshairs.

As a result of an unstable regulatory environment, manipulating accounts to hide company

resources is a necessary defensive strategy (Jie and Ward, 2003). The unreliability of

accounts also however explains the reluctance of banks to finance firms without

government backing, since there is little reliable data on which to risk assess.

Overcoming the liability of difficult access to capital

The liability of lack of access to capital has forced many private enterprises to find sources of

funding from other means. 90% of the private enterprises observed by the IMF (2001)

obtained start-up capital from outside the state-owned banking system. Finance was either

obtained from the entrepreneurs themselves, their families and friends, shadow banks, or

from venture capital. Research from Melzer (2011) shows that the source of informal

finance is important since finance from family members, friends, and suppliers enhances

firm growth, yet short-term bank loans with high interest rates can hamper growth. This

sounds obvious but yet because of a lack of collateral and connections, shadow banks are a

8



very popular method of obtaining finance despite the high interest rates. Microcredit is one

avenue that many private enterprises use to obtain capital. Joe Zhang was the chairman of a

Shenzhen based microcredit company called Wansui, his firm is allowed to charge 4 times

the bank’s prime lending rate which is at 6%, meaning private enterprises are charged 24%

per annum. While that may seem excessive, Zhang (2013) makes the point that firms charge

customers 25% per annum and providing customers recycle the money three or four times a

year, the interest rate is affordable. This is also an alternative to the cumbersome state-

owned lending process which involves tedious procedures, long waiting periods, and

uncertainty. The high interest rates would mean that private enterprises would have to be

either very fast growing or lend money to other businesses in a financial pass-the-parcel

otherwise face the option of going bankrupt. However, if liquidity was urgent then shadow

banking certainly serves an important purpose for private enterprises. As previously

mentioned, state-owned banks require considerable collateral, fledgling enterprises cannot

provide this denying them access to credit. Wansui Microcedit Lending Company however

emphasizes cash flows and de-emphasizes collateral and guarantees. If a loan has to be

repaid by selling collateral or calling the guarantor, Zhang chastises Wansui’s credit officers

for failing at credit evaluation (Zhang, 2013). According to the IMF (2001) the amount of

bank loans to private firms in China as a proportion of additional finance following start-up

did increase with the size of firms. It rose from under 4 percent for those with less than 51

employees to 25 percent for those with over 500 (Gregory and Tenev, 2001). Much of this

increased access to bank loans can be attributed to the greater collateral available to larger

firms that have acquired long-term land use rights.

9



Over the last few decades during China’s economic transition state owned enterprises have

enjoyed preferential treatment to the detriment of the private sector. Under the threat of

asset confiscation, private enterprises have had to utilise various methods to overcome this

liability, namely establishing robust political connections. Through ‘wearing the red hat’,

joining foreign firms, and establishing party membership, private firms and entrepreneurs

have managed to overcome this liability. A further liability for private firms is the lack of

access to capital. Through lack of secure property rights, the required collateral to obtain a

state-approved bank loan denies many private firms access to capital. In order to overcome

this liability, private firms have utilised shadow banks, as well as family loans or profit

reinvestment. However, in recent years, increased private sector involvement in the

economy has encouraged the use of contracts, formal institutional arrangements and

modern corporate forms (McNally, 2011). According to NSBO’s assessment of the Third

Plenum (2013) the way to promote private investment is to remove local government

activity in key, as well as introducing private investment into sectors such as railways,

banking and defence. There are plans in place for the privatisation of such strategic

industries. NSBO contends however that by contrast, the likelihood of significant private

investment in the central SOE arena is low.

10



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Appendix I

Year State-owned Enterprises Private Enterprises2012 16457.57 18155.522011 14737.65 15102.52010 9287.03 9677.692009 9063.59 8302.062008 10795.19 5053.742007 8485.46 3191.052006 6519.75 2120.65

14

2012 2011 2010 2009 2008 2007 20060

2000400060008000

100001200014000160001800020000

Private Sector v. State Sector Profits

Private Enterprises' Overall ProfitsState-Owned Enterprises' Overall Profits

Year

Profi

ts (b

illio

n Yu

an)



Appendix II

Year Year

Gross

M2 Broad money supply Domestic

Year M2/GDP HC/GDP1990 15293.4 1991 21781.51991 19349.9 1992 26923.5 1991 89%1992 25402.2 1993 35333.9 1992 94%1993 34879.8 1994 48197.9 1993 99%1994 46923.5 1995 60793.7 1994 97%1995 60750.5 1996 71176.6 1995 100%1996 76094.9 1997 78973.0 1996 107%1997 90995.3 1998 84402.3 1997 115%1998 104498.5 1999 89677.1 1998 124%1999 119897.9 2000 99214.6 1999 134%2000 134610.3 2001 109655.2 2000 136%2001 158301.9 2002 120332.7 2001 144%2002 185007.0 2003 135822.8 2002 154%2003 221222.8 2004 159878.3 2003 163%2004 254107.0 2005 184937.4 2004 159%2005 298755.7 2006 216314.4 2005 162%2006 345603.6 2007 265810.3 2006 160%2007 403442.2 2008 314045.4 2007 152%2008 475166.6 2009 340902.8 2008 151%2009 606225.0 2010 401512.8 2009 178%2010 725851.8 2011 472881.6 2010 181%2011 851590.9 2011 180%

2-19 Household Consumption

Data in this table are calculated at current prices.

(100 million yuan)1990 8031995 2236 Item 2004 2005 2006 20071996 26411997 2834 Total 63833.5 71217.5 80476.9 93317.2

15



1998 29721999 3138 Item 2008 2009 2010 20112000 33972001 3609 Total 111670.4 123584.6 140756 164945.22002 38182003 4089

16

19951997

19992001

20032005

20072009

20110%

50%

100%

150%

200%

Bank loan growth from 1995

M2/GDPHC/GDP

Year

Debt to GDP ratio

Documents

Private sector firms have become the most dynamic sector of China (2)