Broadening the Horizons of China's Domestic Private Sector as the Future Engine of Growth

Among the issues that the government's current initiative seeks to address are the privileges enjoyed by SOEs, including state protected monopolistic or dominant status in industries such as energy, aviation and tourism. The Opinion also seeks to make it easier for private enterprises to raise capital and obtain government approvals, in-line with the status currently enjoyed by SOEs. Although not benefiting from the same privileges as SOEs, FIEs also enjoy certain benefits, including tax benefits and permission to invest in industries that are not available to the domestic private sector.

THE GROWTH OF CHINA'S DOMESTIC PRIVATE SECTOR

On February 3 2005, the All-China Federation of Commerce and Industry, the United Front Work Department of the Chinese Communist Party, and the Chinese Private Business Research Institute published the Survey and Report on Chinese Private Enterprises. According to the survey, private enterprises are concentrated in the manufacturing, catering, construction, real property, retail and commerce sectors of the economy. The survey shows that from 2000 to the end of 2004, the number of Chinese private enterprises more than doubled from approximately 1.7 million to 3.8 million. Currently, the total workforce employed in the domestic private sector is estimated to exceed 47 million - more than half of whom are migrant workers that have left their farms and villages for towns and cities in search of better livelihoods. Approximately a quarter of the employees in China's private enterprises are workers who have been made redundant by the closure of failed SOEs. Among other things, these figures confirm that private enterprises have contributed significantly to reducing China's unemployment problems.

The survey also shows that the growth of the domestic private sector in China has contributed to the reform of SOEs, which is a priority for the government. Of the approximately 3,000 Chinese private enterprises surveyed, about 6.3% have merged with or acquired an SOE, while a further 10.2% are in the process of preparing to do so. An additional 18.3% are former SOEs that have been privatized. This has saved many SOEs that were in danger of being shut down due to insolvency, mismanagement or lack of competitiveness, which has in turn averted problems of mass unemployment and loss of economic output.

The survey also demonstrates that by supporting the domestic private sector the government is assisting in the upgrade of China's industrial production capabilities. According to the survey, an increasing number of private enterprises are in fact high-tech companies. The proportion of high-tech private enterprises in relation to the total number of private enterprises has increased from approximately 2.1% in 2002 to almost 5.5% in 2004.

The survey reveals that private enterprises would like to see reforms in various areas, principally:

1. Taxation;

2. Protection of privately owned assets and property (as set out in the Chinese constitution);

3. Changes in the roles of the government bodies overseeing the economy;

4. Establishment of a credit rating system and normal market order;

5. Access to monopoly markets.

The Opinion addresses many of the issues raised in the survey and sets forth seven broad measures to support the development of China's domestic private economy. These measures deal with the sector's most serious concerns, including market entry and financial and tax support. They emphasize the status and equal treatment of private business and raise compliance requirements for China's private enterprises, urging government authorities to improve their regulation of the domestic private economy.

RELAXATION OF MARKET ENTRY

Over the past 13 years, the government has repeatedly stated its determination to create a more market-driven economy. Many private enterprises have thrived in the new environment; but they have also faced barriers. By emphasizing market access for such entities, the government is now seeking to remove the prejudice and obstacles they have faced previously and create a more dynamic economy. There are compelling reasons to do this as the opening of new markets to the private domestic economy will contribute to sustainable economic development and growth.

The Opinion confirms that all sectors of the Chinese economy that are not restricted by law are open to domestic private enterprises. Currently, there are few explicit restrictions on such businesses, although they often face internal administrative or economic barriers that effectively preclude or restrict them from entering certain industries. The Opinion emphasizes that Chinese private enterprises should receive the same treatment as SOEs with respect to investment verification, financing, financial and tax policies, land use, foreign trade, and economic and technology cooperation.

One of the most significant changes contained in the Opinion is that Chinese private enterprises are encouraged to enter industries currently monopolized by SOEs, such as the power, telecommunications, railway, petroleum, and exploration and exploitation of mineral resources industries. It has been difficult for the domestic private sector to enter these industries in the past for various reasons, including high entry barriers (the aviation industry, for example, requires huge initial capital investment); the vested interests of local governments or government agencies in retaining monopolies; and a hostile and suspicious attitude towards private enterprises, which is a legacy of the centrally-planned economy. The opening-up of these industries, together with the state's encouragement of Chinese private enterprises to participate in the reform of SOEs, demonstrates the government's intention to abolish discrimination against the domestic private sector.

Private businesses in China are not only disadvantaged with respect to SOEs, they also fail to benefit from policies enjoyed by FIEs as a result of China's WTO entry. Seeking to remedy this, the Opinion emphasizes that those areas of the economy that are open to foreign investment are also open to domestic private enterprises.

STRENGTHENING THE FINANCIAL AND TAX SUPPORT FOR PRIVATE BUSINESSES

According to the Survey and Report on Chinese Private Enterprises, discussed earlier, most small and medium-sized private enterprises complain that they have difficulty in obtaining bank loans because of the complex procedures involved, the requirements for collateral, the unaffordable costs, and the stringent terms and conditions imposed by banks. This situation is not helped by the lack of a credit rating system for private enterprises in China.

The domestic private sector's capacity to raise debt was restricted further in 2004, when the government implemented a series of macroeconomic austerity measures to prevent overheating in certain industries. Among other things, banks were discouraged from making loans and the one-year lending interest rate was raised by 0.27% from 5.31% to 5.58%. There exists few other viable means through which private businesses in China are able to raise capital. For example, the stringent requirements, costs and delays involved in raising finance from domestic or overseas capital markets mean that such financing is out of reach of most private enterprises. As a result, such businesses often resort to 'grey market' financing.

The Opinion addresses the difficulties Chinese private enterprises face in obtaining financing. City, provincial and municipal local governments with sufficient resources are required to allocate funds for the development of the domestic private sector, while banks are required to increase the ratio of commercial loans made to such enterprises. The Opinion also states that domestic private enterprises should be treated equally with regard to stock market listings - an area where traditionally SOEs have been favoured. In addition, the Opinion states that stock exchanges for small and medium-sized enterprises will be developed and qualified private enterprises will be encouraged to list overseas and issue bonds.

Further addressing some of the difficulties encountered by private enterprises with respect to obtaining finance, the Opinion tackles issues such as the lack of an effective credit rating system and the requirement to provide security for financing. It emphasizes improvement of credit rating systems for private businesses and the possibility of issuing credit-based loans to qualified entities. The Opinion also provides that, upon approval from relevant government authorities, Chinese private enterprises can use intangible property rights, such as industrial property rights or non-patented technology, to secure loans. With regard to the much discussed and anticipated tax support policy, however, the Opinion does not extend preferential tax policies to the domestic private sector, but states that relevant tax support policies will be studied and improved.

IMPROVEMENT IN SERVICES for PRIVATE BUSINESSES

The Opinion outlines policies to support private enterprises in China. The support services identified by the Opinion include services provided by intermediary agencies, such as marketing and management consulting services; training for management and employees; provision of technology services, such as information platforms; support for private enterprises to develop overseas markets; and development of dedicated credit rating systems for such enterprises. One important aspect of these provisions is that the government encourages and supports private enterprises to explore international markets.

PROTECTION OF LEGAL INTERESTS OF CHINESE PRIVATE ENTERPRISES AND THEIR EMPLOYEES

The Opinion reiterates the constitutional principle that the right to own property is protected by law. Government agencies are required to respond in a timely fashion to private enterprises' requests for administrative review of decisions that allegedly infringe their rights. The Opinion also requires private enterprises to ensure that their employees enjoy their legal rights, such as the minimum wage and mandatory social insurance and welfare benefits.

GUIDING CHINESE PRIVATE ENTERPRISES TO IMPROVE THEIR OWN QUALITIES

Statistics show that on average private enterprises in China close down seven years after incorporation and that each year 10% of existing private enterprises are wound up.³ In order to succeed in the long-term, the domestic private sector will have to improve the quality of its management and corporate governance. Many medium to large-sized Chinese private enterprises have failed to evolve from their start-up structures or have adopted management structures that are similar to those of SOEs. In general, managers of private enterprises tend not to emphasize legal compliance, social responsibility or corporate governance issues. The Opinion reminds the domestic private sector to abide by Chinese laws. It also suggests measures to improve government regulation and encourages the provision of training courses for management and workers.

Chinese private enterprises are encouraged to grow "stronger and bigger," an exhortation that used to be applied to SOEs. The Opinion encourages qualified entities to become group companies by way of mergers, acquisitions, consolidations, and cooperation. Further, private enterprises are encouraged to develop into multinational companies.

The Opinion also states that private enterprises are subject to the state's macro-economic control and should comply with tax collection regulations. The state encourages the domestic private sector to invest in new and high-tech industries, modern service industries, modern agricultural industry, and industries that require employment of a large workforce, such as processing trade, community services, processing of agricultural products and other labour intensive industries.

IMPROVEMENT OF THE GOVERNMENT'S REGULATION OF THE DOMESTIC PRIVATE SECTOR

The government is to be applauded for admitting that there are problems with the regulation of private enterprises and recognizing the importance of improving the quality of their supervision. The Opinion requires both central and local governments to improve their performance, to publish supervision regulations and to properly regulate their supervision functions. The levying of unauthorized charges and fines and the requisition of donations by government agencies have been a serious and widespread problem in China for many years. Chinese private enterprises are viewed as generally more vulnerable than SOEs to requests from government agencies and officials that have the power to revoke their licences and make life difficult in other ways. The Opinion emphasizes that the levying of unauthorized fees by government agencies is prohibited and that private enterprises can refuse to pay charity contributions, or for services provided by government agencies that they have not requested.

STRENGTHENING OF GUIDANCE AND POLICY COORDINATION FOR PRIVATE BUSINESSES

The Opinion states that various levels of government should include private enterprises in their planning for economic and social development. It further stresses that implementation should be carried out carefully and urges local governments to promulgate specific implementation rules.

There have been encouraging signs of the government's determination in this regard. On April 4 2005, for example, the State Council issued certain Opinions on Intensifying the Reform of the Economic System for the Year 2005, which reiterate the task of effectively enforcing the Opinion and revising corresponding laws and regulations on an accelerated basis. Various government agencies have also responded to the latter Opinion. For example, the State Administration for Industry and Commerce issued a notice on March 21 2005 facilitating enterprise registration and administration services for private enterprises. On April 13 2005, meanwhile, the State Council issued Entry into the Cultural Sector of Non-publicly Owned Capital Several Decisions (关于非公有资本进入文化产业的若干决定)to provide clear rules regarding market access for private enterprises.

Among other things, the Decisions provide that private enterprises can own a controlling stake in cable TV businesses that provide community services. Local governments, especially those in regions where private business is booming, are also taking action. On May 18 2005, the Shanghai government announced that it had promulgated the Thorough Implementation of the Opinions. At a Shanghai government press conference held on the day the Implementing Opinions were promulgated, a spokesperson stated that they were issued in order to fully implement the Opinion, by focusing on "equal treatment, opening up the market, providing industry guidance, making structural adjustments and promoting innovative service."

The Opinion recognizes that a sympathetic media environment is beneficial for the support of private enterprises and encourages the media to publicize the important status and role of the domestic private sector. This is in sharp contrast to previous media culture, which tended to diminish the role of private enterprises.

The overriding principle informing the Opinion is that private enterprises should be treated equally and fairly, so they can develop and compete with SOEs and FIEs. In areas such as market access, corporate finance, taxation and social support services, where private enterprises are currently at a disadvantage, the Opinion expressly sets out measures to support the domestic private sector.

There are signs that the government's initiative is receiving a positive response and that the domestic private sector is obtaining greater market access. In the refined petroleum sector, for example, private enterprises have been given market access to match that of foreign investors. Since 1999, the refined petroleum sector has been monopolized by two SOEs - China National Petroleum Corporation (CNPC) and China Petroleum & Chemical Corporation (SINOPEC). In 2001, the State Council granted CNPC and SINOPEC monopoly rights in connection with the retail of refined petroleum (i.e. gas stations should be either wholly owned by CNPC or SINOPEC, or controlled by them).

On December 11 2004, China opened up its retail petroleum sector to foreign investors under its WTO commitment, and by the end of 2006 it will open the refined petroleum wholesale sector to foreign investors. Historically, private enterprises have not participated in the refined petroleum industry and CNPC and SINOPEC have favoured multinational oil companies as their joint venture partners. In an attempt to counteract this, on December 11 2004 the industry established the China Chamber of Commerce for the Petroleum Industry - with over 100 member companies - to act as spokesperson and lobby for the private oil industry. Soon thereafter the Ministry of Commerce issued the Administration of the Oil Products Market Tentative Procedures, which allows private enterprises to operate wholly privately owned gas stations as of January 1 2005. It is possible that these measures may signal a further relaxation of market access to other areas of the petroleum business in the future.

There have also been developments in China's civil aviation business. On March 5 2005, China's first private airline company, Okay Airways Company, made its maiden flight. In May 2005, two private companies - Yi Yang Group and Hui Run Investments - outbid China's second largest carrier, Air China, for 65% ownership of Shenzhen Airlines. Foreign investment in the civil aviation sector is limited to less than 50% ownership of PRC civil aviation companies.

Private enterprises in China have come a long way from being accepted as "complementary to the public economy" to being recognized as "an important component of the PRC's market economy."⁴ Among other things, this reflects the constitutional protection for private property rights, which has evolved from the basic concepts of recognition of the lawful status of the domestic private economy expressed in the 1988 Amendment to the Constitution to the specific protection of private property rights contained in the 2004 Amendment to the Constitution.

While the state sector is still the largest and most dominant component of the Chinese economy, the domestic private sector is catching up fast. As it continues to grow, China's economy will become increasingly dependent on private enterprises. Although the domestic private sector forms a significant part of the mainland economy, with rare exceptions such as Lenovo, few are strong enough to be leaders in their respective industries and most are small or medium-sized business. Some commentators have predicted that China's economy will eventually resemble many European economies in which nationalized entities co-exist with a larger private sector.⁵ The Opinion will certainly help private enterprises in achieving this, but whether and when this prediction becomes a reality will depend on persistent and long-term efforts by both the Chinese government and the private sector itself.

Endnotes

1 See The China Statistical Year Book 2004. In 2003, all Chinese domestic business entities, including SOEs, private enterprises, collectively-owned enterprises, cooperative equity enterprises, jointly-run enterprises, limited liability companies and companies limited by shares, contributed approximately 68.82% of China's industrial production; enterprises with investment from Hong Kong, Macau or Taiwan contributed about 12.25%; and FIEs contributed the remaining 18.93%.

2 Ibid.

3 See China Private Economy Research Association.

4 1988 Amendment to the Constitution, Article 1, approved by the First Session of the Seventh National People's Congress on April 12 1988; and 1999 Amendment to the Constitution, Article 16, approved by the First Session of the Ninth National People's Congress on March 15 1999.

5 The Privatization of China, by Howard Chao, Head of Asia Practice, O'Melveny & Myers LLP.