At the request of the Development Research Center of the State Council/Enterprise Research Institute, the World Bank has examined recent international experience in the governance of state-owned enterprises (SOEs). Lessons for China may be grouped under five themes:
A. The need to focus on large SOEs;
B. The need to focus on the efficient use of capital;
C. The need to focus state ownership rights in a separate “first tier” government agency and provide sufficient transparency;
D. The need to focus authority and responsibility for SOE strategy and operations in each SOE’s board and management; and
E. The need to provide an appropriate focus for “second tier” shareholders.
A. Focus on Large SOEs
The world’s most successful SOE governance regimes oversee relatively small numbers of SOEs: e.g., 16 in New Zealand; 59 in Sweden; and about 20 in Singapore. These countries have well-developed legal and financial systems to support commercial operations by either state-owned or private businesses. But narrower “spans of control” have also facilitated good SOE governance in these countries.
It would make sense for the Government to focus only on China’s large SOEs. Successful governance of this portfolio would itself represent a huge challenge. Meanwhile the near-term ownership transformation of China’s small/medium SOEs would be consistent with the 4th Plenum Decision of the 15th Central Committee of the Communist Party of China (CPC) in 1999 to “grasp” the large and “let go” the small.
A government focus on “grasping the large” would still allow for equity structure diversification, as mandated by the 1999 4th Plenum Decision. The Government has increasingly allowed for sales of SOE shares to strategic investors or partners, institutional financial investors, and the public. The Government should be ready to reduce the State’s share in many large SOEs to 51 percent -- or even lower. Even with a minority State shareholding, methods to protect vital strategic interests can be found or developed1.
B. Efficient Use of Capital as the Central Objective
The world’s best SOEs focus on the efficient use of capital. It is natural for the Chinese government to pursue different political and social objectives. But in exercising its ownership in large SOEs, the State shareholder should focus on maximizing returns on capital. This is best measured in terms of economic value-added (EVA), which considers the risk-based opportunity cost of debt and equity capital. A focus on maximizing returns on capital would facilitate full commercialization of SOEs to prepare for post-WTO competition.
To support this emphasis on EVA, all large SOEs should be required to improve their accounting practice so that Ownership Agencies can calculate EVA for each large SOE and evaluate their performance accordingly. In addition, all large SOEs should provide an Annual Statement that specifies goals to be achieved in the following 1-3 years. This would facilitate SOE performance monitoring and evaluation by the Ownership Agency. As in New Zealand, the Annual Statement for each SOE could specify the nature and scope of activities to be pursued; expected returns on state capital (e.g., EVA) and other performance targets for the next three years; expected dividends; treatment of workers and suppliers; and compliance with regulations (e.g., environmental, safety, fair trade).
C. Creation of Ownership Agency to Exercise State Ownership Rights
Establishment of Ownership Agencies will require decisions on the following issues: (1) legal form; (2) scope of portfolio; (3) mandate; (4) appropriate exercise of ownership rights; (5) authority; and (6) financial management.
1 The Ownership Agency should be commercially-focused and professional. It may be easier to cultivate these qualities if the Ownership Agency is organized as a “public service unit” (PSU), which reports to the State Council and whose work is reported to the annual National People’s Congress for its evaluation. The Ownership Agency should be staffed with full-time professionals whose compensation is market-based. Full-time staff are needed to ensure that the Ownership Agency is “real,” rather than “virtual” as in some localities. Ownership Agency staff compensation should be market-based in order to attract staff with the necessary skill sets. Ownership Agency staff should have the business training and/or experience to be able to make integrative assessments of an SOE’s marketing, production, financing, and other business plans and results. Such general management skills are more readily available in the non-state sector. To obtain a sufficient supply of necessary general business management skills, the Ownership Agency should have the ability and the readiness to match non-state salaries.
2 The Ownership Agency’s portfolio should include only for-profit, non-financial SOEs. Establishing effective state ownership over China’s large number of for-profit non-financial SOEs is a huge challenge. Assigning non-profit organizations, state assets in government departments, and other public service units to an Ownership Agency would be a major distraction. As for financial SOEs, it would be a bad idea to assign these to an Ownership Agency for non-financial SOEs. Assigning non-financial SOEs and financial SOEs to the same Ownership Agency would create or increase conflicts of interest -- e.g., pressures for directed lending, avoidance of enterprise restructuring2.
3 The Ownership Agency’s mandate should include both management of state shares and sale of state shares (equity). In performing its share management function, the Ownership Agency would ultimately be responsible for the value of State shares in SOEs. In organizing sales of state shares (equity), the Ownership Agency’s goals would include maximization of sale proceeds. There is no inconsistency between the share management and share sale functions. Indeed, since maximizing the value of state shares would help maximize the proceeds from any share sale, it makes sense to link these two functions3. Assuming that small/medium SOEs are assigned to local Ownership Agencies (LOAs) and that the 4th Plenum Decision to “let go” is fully and expeditiously implemented, the LOAs would assume major responsibility for the sale of small/medium SOEs.
4 State shareholder interests should be exercised through normal means, i.e., annual shareholder meetings and SOE board appointments. “Shareholder interests” include seeing that the company’s business plan, capital investment, financing, financial performance, risk management, key management appointments, staffing, compensation, and other business practices combine to produce positive EVA and a sufficiently robust balance sheet. According to best international practice, the state shareholder’s right to pursue these shareholder interests is normally exercised through annual shareholder meetings and board appointments. This should also be the pattern for China’s SOEs. The Government’s other non-shareholder interests (e.g., SOE fulfillment of contractual obligations or SOE compliance with health, safety, labor, competition, or environmental regulations) should be pursued through the appropriate commercial or administrative law channels. The “normal” exercise of shareholder rights will require the Ownership Agency to focus on making good appointments to SOE boards and on monitoring development and implementation of SOE business plans. Proportional to its shareholding, the Ownership Agency would appoint directors to 2nd tier enterprise group parent companies and to 3rd tier SOEs that are not affiliated with an enterprise group. Proportional to its shareholding, a 2nd tier enterprise group parent company would appoint directors to 3rd tier subsidiaries during annual shareholder meetings.
5 The Ownership Agency should have (i) broad authority to perform its share management and share sale functions and (ii) sole authority to vote the State’s shares at SOE annual shareholder meetings and to make SOE director appointments (proportional to the State’s shareholding). This would be consistent with a non-political, commercial, and professional approach to the management of state capital. The Ownership Agency director would be responsible for liaising with the government and maintaining political support for the Ownership Agency’s share management/sale mandate. The government would presumably provide financial performance targets and other guidelines (e.g., on appointments, conflicts, risk management) for the Ownership Agency. As long as it conforms with these guidelines, the Ownership Agency should have substantial autonomy to carry out its share management/sale mandate in pursuit of agreed financial targets4. Consolidation of shareholder rights and responsibilities in an Ownership Agency is a major change from recent practice. The Ownership Agency must have sufficient authority to perform its mandate in order to be effective.
6 While seeking to maximize the efficient use of state capital, the Ownership Agency should implement financial management procedures that provide transparency and minimize risk. The Ownership Agency’s financial goals would presumably include both dividend payments from 2nd tier shareholders and 3rd tier SOEs as well as increases in the value of SOE equity. The Premier (or local equivalent) and the Ownership Agency would need to agree on “dividend policy” on whether SOE profits should be reinvested or paid as dividends. Measurement of SOE equity value should be as objective as possible -- e.g., market value for listed companies, book value, EVA, or a valuation based on a multiple of dividend yield or cash flow. The Ownership Agency should have the authority to make additional equity investments in portfolio companies. But the Ownership Agency should be prohibited from providing, guaranteeing, or directing debt financing for 2nd tier shareholders or 3rd tier SOEs. International experience (e.g., Italy’s IRI and Austria’s OIAG) show how dangerous it can be for a state shareholding fund or state shareholder to provide or facilitate SOE debt financing. Lastly, the Ownership Agency should not invest in or operate any other businesses. The Ownership Agency’s sole mandate should be to manage or sell shares in SOEs assigned to it.
The Ownership Agency should focus on monitoring the performance of its SOEs and SOE boards and on board appointments and the development of SOE boards. The SOE governance framework outlined in this policy note will require a substantially higher degree of transparency in order to work -- especially given the emphasis on more efficient use of state capital. All large SOEs should be required to adopt the accounting and disclosure standards applied to listed companies in a specified period of time, say three years. Annual reports of large SOEs should be made available in the public domain. All “second tier” shareholders (e.g., AMCs and the NSSF) should also make their consolidated financial statement available to the public. The Ownership Agency or the NPC may wish to mobilize outside professionals such as investment bankers and accountants to publicly evaluate the performance of certain SOEs and second tier shareholders in terms of efficiency of their use of capital.
D. Empowering SOE Boards of Directors
Worldwide experience shows that a reasonably independent SOE board can facilitate value creation. The composition of boards for China’s large SOEs should strike an appropriate balance between independent perspectives and liaison with the State shareholder. It would make sense for the Ownership Agency to appoint one or more directors and for any second tier financial institution shareholder(s) to have some proportional representation. To reinforce the distinction between administrative power and shareholder rights, civil servants should not be appointed as SOE directors. If the Ownership Agency is constituted as a PSU, it would be appropriate for Ownership Agency staff to serve as SOE directors. Such directors should be supplemented with the appointment of qualified individuals from business, other professions, or academia. Such outsider directors would provide an independent perspective. Demonstrated business management skills should be the key criteria for all appointments of SOE directors. The Ownership Agency should take extra care in appointing directors who have spent most of their working life in government administration. Additional “board empowerment” measures worth consideration include the following:
Setting a fixed term for SOE directors (e.g., 3-5 years);
Making administration of SOEs subject to the same law as applies to private companies;
Encouraging further ownership diversification through SOE share sales;
Making SOE directors personally liable for any damage caused to the SOE; and
Codifying the fiduciary responsibility of SOE directors, toward all shareholders, to show care in administering the SOE and to avoid any conflict of interest.
The development of effective SOE boards will require careful attention to board appointments and directors’ training as well as to board organization and procedures. Global best practices on formation and use of board committees -- e.g., for audit and for compensation -- should be considered. Annual adoption by SOE boards of board rules of procedure also warrants consideration. Sweden and Singapore provide useful models.
E. Focus for Second Tier Shareholders
In the “second tier” of a streamlined configuration, there would be no need for new asset management companies below the Ownership Agency. Indeed, with the “letting go” of small/medium SOEs, it might be possible to disestablish some existing second-tier asset managers.
Most of the necessary second-tier asset management function could be performed by transforming the parent companies of enterprise groups. To begin to function effectively, these enterprise group parent companies would need to transform their approach to financial management of affiliated companies, internal controls, accounting systems, and human resources skills mix. Transformed parent companies of enterprise groups would be the main second tier agent for governing “third tier” affiliated SOEs.
Institutional investors (e.g., the NSSF) could play a supplemental governance role by appointing directors to the boards of SOEs -- enterprise group parent companies, group-affiliated companies, and large unaffiliated companies. Board appointments would presumably be proportional to shareholdings. For risk management purposes, shareholdings by the NSSF or any pension fund should be limited both in terms of each investors capital and shareholdings in any single SOE. By pooling their votes, however, these investors might be able to place one or more directors on the boards of SOEs in which they hold shares.
As for the four AMCs, global experience shows public AMCs are not well-suited for turning around distressed enterprises. Thus, China’s AMCs should seek to sell their assets -- corporate equity as well as unrestructured NPLs -- as soon as possible to investors better-positioned to create value. But in the interim, while the AMC still holds corporate equity, it should enjoy full shareholder rights proportional to its shareholding.
Full text of the report is available in the website of www.worldbank.org.cn.
Notes
1 International examples include use of a blocking minority shareholding (Austria), narrowly defined “golden share” powers (U.K.), and development of domestic institutional investors (e.g., South Korea).
2 State-owned commercial banks and other financial institutions should be corporatized and assigned to a different shareholder.
3 Share management and share sale functions are linked in other countries, e.g., Austria’s OIAG, Singapore’s Temasek, Sweden, and Norway.
4 In the case of particularly large share sales, the government may wish to retain authority to review and approve.
(China.org.cn January 16, 2003)
