MONGOLIA DEVELOPMENT STRATEGY INSTITUTE

The SOEs in the People’s Republic of China (PRC) are extensions of their state and in the corporate governance area they exhibit features specific to the PRC as a state. At the same time, these are not merely public government organizations and are corporate entities with their own governance model. This is the argument made in this paper.

The nature of the state as a decisive factor in the SOEs’ corporate governance is a rather common sense proposition. States vary in their legal structures, capacities and political context that they are set in and the corporate governance of the SOEs would necessarily reflect it. However, the review of theoretical frameworks and various empirical studies of corporate governance in the PRC reveal that the features of the state per se do not play a prominent role in the current corporate governance debate. As the description provided in the paper shows, within the prevailing framework of corporate governance theories, the state is perceived as just another shareholder in the context of principal-agent (PA) relations. Review of political economy, legal and economic research in line with PA theory shows that mechanisms of corporate governance, deemed important under the PA theory (i.e., independent boards, committees, markets for equity and debt, security of property rights and the rule of law, etc.), are missing or still weak.  Consequently, the SOEs are likely either to be “captured” by their managers or political masters for the personal benefit or should continue on the way of reform to create fully the necessary mechanisms.

This leads to the research question: If corporate governance mechanisms central to the corporate law, that usually had developed within the context of Western, especially US corporate law history, are weak and non-existent, what is the legal framework that replaces them in case of the SOEs in the PRC? Obviously, SOEs cannot do without it, just working through informal structures. The PRC’s SOEs are still among the top publicly listed companies globally and no state, even very rich one, could sustain gigantic failing companies for so long.

The methodology employed in this paper is a comparative institutional research based on the existing legal theories of corporate governance and experiences of the East Asian developmental states. As mentioned earlier, review of existing legal framework under the PA theory suggests that they are weak and underdeveloped in the PRC. Hence, the need for alternative theories: this paper looks to “developmental state” theories based on the experiences of Japan, South Korea, Taiwan and Singapore.

This paper suggests that the SOEs in the PRC are torn between their dual identities. As companies, their primary goal written in their corporate statements is to serve the interest of maximizing shareholders’ value (including sometimes those of private, usually minority shareholder, investors) and enhancing corporate gains. Even so, they are usually under the tight grip of the largest controlling shareholder - the government - and still follow its orders and perform various goals, sometimes political, set by it. More importantly, the SOEs originally were created and still now are instruments of industrial policy. Their goal was to intensify the economic development and create from the scratch entire industries, which in some cases are viewed as contrary to the country’s competitive advantage. Simplistically, they are the main drivers of catch-up growth with the industrialized nations.

This multiplicity of seemingly contradicting roles, i.e. enhancing the shareholder value, maximizing corporate wealth and participating in the nation-building, seems to be an important feature behind the lack of clarity in identifying the true nature of corporate governance of the PRC’s largest SOEs.

Complicating things further, the scene of SOEs’ corporate governance is much more complex and uncertain compared to more conventional companies. In a more traditional corporate governance setting, there are main actors such as shareholders, managers, suppliers, customers, financiers, external market forces with a relatively clear set of interests and incentives.

In the case of the PRC’s SOEs, identifying the actors, their relative power and incentives is contingent on many non-market factors, sometimes highly contextual and political. Those actors do not only play within the rules set by the market or the law, sometimes they are the law and the market and can change the rules to their liking. Hence, balancing not only contradicting roles inherent in its nature as a SOE but also balancing interests of main stakeholders with interactive influence is the main trick.

To understand this complexity, this paper looks at the corporate governance of the PRC’s SOEs through the prism of developmental political economic theories. It discusses extensively an innovative model of the SOEs proposed by Li-Wen Lin and Curtis J. Milhaupt that views the party-state of the PRC as an encompassing organization. According to their model, the party-state is built on “networked hierarchy”, which runs from the highest governmental executive bodies down to the lowest level subsidiaries, and “institutional bridges”, which comprise all party, state and social institutions. In their view, the “networked hierarchy” and “institutional bridges” create a unified and cohesive ruling elite.

The theory is a big step forward because it brings in the specific features of the modern PRC’s state into the equation of corporate governance. For the first time a corporate governance study of China covers all the elements such as the state organizations, party organizations and the company. There were studies of different elements separately, but this paper brings all these elements together. 

However, limits of the explanatory power of the model lay in its monolithic and non-dynamic perception of the modern Chinese state. Encompassing organization, as viewed by Li-Wen Lin and C.Milhaupt, explains “what” the SOEs are but provide incomplete explanation on “why” they presumably could fail or succeed.

They rely on the underlying theory proposed by M.Olson that denies the active role of the state in the economic development, which contradicts the whole nature of the Chinese SOEs and the state. They assume the PRC state and the SOEs to be unified and unifying structures with little regard to such factors as competing political-economic factions and government entities. Finally, by highlighting the importance of corporate form and suggesting little role played by corporate law, they tend to overlook incentives that direct the actions of actors within this model.  

  

In order to address these issues, the paper looks at “developmental state” theories that sought to describe experiences of Japan, South Korea, Taiwan and Singapore at the time of their most rapid growth. It highlights the common features in this literature and the recently emerging literature on the PRC’s “state capitalism”. And it comes up with three dynamic mechanisms that are persistently raised throughout this literature: meritocratic bureaucracy, its autonomy and embeddedness.

To address the issues raised with regard to Li-Wen Lin and C.Milhaupt’s model, while maintaining the networked hierarchy and institutional bridges as the unit of analysis, this paper proposes to focus mostly on the dynamic mechanisms. Focus on these mechanisms would shed more light on “why” the corporate governance of the SOEs in the PRC works as it does and allow to step away from the presumption that the party-state is prone to producing only national champions or, alternatively, only failed SOEs.

The paper suggests that there are both merit and anti-merit forces in SOEs’ corporate governance. It highlights the laws and regulations that make political commitment to the Communist Party of China (CPC) policies a requirement for promotion. This contradicts the fundamental notion of bureaucracy as impartial instrument answerable only to rules and regulations whose main feature is knowledge and skills. However, there are also other rules and regulations that pool to the opposite, merit, direction. Early in the reform, a ruling was adopted which required that all hired by the SOEs must have university education. It is interesting how a simple rule could serve as a foundation of rather significant feature of the SOEs.

Similar to the early literature on the Japanese “economic miracle”, meritocratic bureaucracy mechanism highlights recruitment practices that attract the “best and brightest” from top national universities. These universities, in turn, admit students based on top scores in the “National Entrance Exam - Gaokao”. The Gaokao examination is widely perceived as relatively fair process of selecting the top performers across the country and social groups.

What is very different from Japanese model and peculiar to the PRC, all positions in the SOEs have corresponding levels in the “cadre” party-state bureaucracy. Benefits such as apartment allowances, chauffeured cars, secretaries, free of charge (fully or partially) health care, pensions of certain amount, etc., follow throughout the inter-changeable careers between the SOEs, the state and/or the party. Leaving the “cadre” status, voluntarily or involuntarily, means leaving behind all these and other untold benefits, therefore, they also serve as a reward and disciplining tool for meritocratic bureaucracy.

Relatively strict age and tenure rules ensure that rarely even at the highest levels leaders at the SOEs stay beyond the age 63 and do not serve more than two 5 year terms at one post, usually the highest. Similar to Japanese corporate practices, promotions are based on merit and seniority and follow a relatively strict step-by-step rule. Being “parachuted” through several ranks without serving “due time” at required levels is rather uncommon and are outright prohibited in the regulations. The rule is enforced to all positions especially at the lower levels. These rules leave little room for “learning on the job” and increased levels of professionalization and education of the SOEs’ leaders is one significant outcome.  

Therefore, the way to the top of the SOEs requires graduation from a top university and step-by-step career (more often now it is a career in the SOEs themselves) distinguished by recognizable achievements during relatively short tenure and absence of obvious missteps. Of course, political activity and “cadre” relations do have an influence over promotions, but minimum levels are certainly required and largely disqualify obviously non-meritocratic contenders.

Autonomy is the defining character of bureaucracies and the state in the “developmental state” literature. The paper provides the history of legal and administrative reforms of the SOEs that led to ever increasing levels of autonomy. Legal reforms brought in separation of government and enterprises, government and management, ownership and management rights as far as the responsibility for investment decisions’ outcomes are concerned.

Entrepreneurship is the required element in any business entity. The essence of business entity is to take a calculated risk in order make profits and the spirit of innovation, seeking new competitive areas to do business are inseparable from the nature of business enterprise. Obvious question is if the SOEs’ leaders are bureaucrats within the party-state, how the system ensures entrepreneurial nature of the companies and their leaders? Are they autonomous enough to enterprise which means not only possible increase in the shareholder value but also a risk of failure? Without this spirit it is not business but just another government agency.

The paper shows that industrial policy documents such as the Five Year Plans create the mandated boundaries within which the SOEs are operating as entrepreneurial units. Industrial policy is a collectively developed mechanism that describes the borders of what is allowed and encouraged. As the public pension funds are allowed to invest in triple “A” companies, the SOEs in China are allowed to play and enterprise within the broadly defined goals of the industrial policy. Within these boundaries it is safe to take business risks.

There are, however, very tangible limits to such entrepreneurship. The current drive to root out corruption has limited the entrepreneurial drive significantly as any loss, inadvertent as it may be, could be interpreted as either made out of ulterior corrupt motives or negligence of duty to care and grow state assets. The SOEs are just very reluctant to make any large investment decisions. The party-state system is built around selective and severe punishment and at times of heightened fight with corruption any unsuccessful investment decision could very realistically mean not only early retirement or disciplinary punishment but jail sentence.

Autonomy is the one of the corner stones of the corporate governance of the SOEs. Fighting corruption to ensure that this autonomy is genuinely utilized for the benefit of the company and ultimate shareholder, the state, is crucial to the success of this system. Corruption undermines autonomy as it puts the leadership of the SOEs and administrative agencies at the service of special interest and self-enriching interests.

At the same time, if the fight with the corruption undermines the autonomy then it would threaten the very system of corporate governance of the SOEs. If the leadership of the SOEs, out of fear making even an honest mistake, is demoralized to make any significant decisions and they all are made with the prior approval of the state administrative bodies that would mean effectively no autonomy of the SOEs.

In recent years, party’s Central Committee for Discipline Inspection (CCDI) has stepped in as a major anti-corruption agency with broad powers to investigate and detain. It seeks to prevent and punish corrupt behavior in the party, including the SOEs. While occasionally it has a clearly observable tendency to punish political foes of the current leadership, thus consolidating the power of the party leader, the disciplining impact on the whole bureaucracy has been very significant and visible. Punishments for wrong-doing of all sorts are very severe and public. The fear is quite tangible, especially at the higher decision-making levels. At this point, the anti-corruption effort is highly visible and to some extent effective, while it seems too early to come to the conclusion that the autonomy is being threatened.          

       

The third mechanism discussed here is embeddedness of the SOEs and its bureaucracy. SOEs are not fully autonomous companies free to enterprise in the way they desire and the fear of reprisal is not the only mechanism of control. The external and internal mechanisms of check and balance are there to monitor and control.  

Peculiar party-state organizational structure introduces specific checks and balances at the decision-making level. Despite very top-down outwardly impression, the decision-making process is rather collegial and consensus-based. It is required by the laws and regulations that make sure all important decisions are made, initially, by the company’s party committee based on the principle of thorough and collegial discussion.

The committee comprises all the stakeholders, including directors of important departments. Any major disagreement, especially by a head of the department in charge, postpones the decision or elevates it for consideration to the upper level. It rarely happens and decisions are made by consensus at the company’s party committee. Heads of departments are personally in charge of the outcomes of the decisions they are in charge and, therefore, are incentivized to make a responsible decision. Presidents of the board, CEOs and deputy CEOs in charge of vital departments cannot dismiss each other and are appointed by the state property agencies of the same level, thus are incentivized to consult.

This consensus-based and collegial decision-making process inserts a degree of professionalism that resembles Japanese corporate decision-making that usually requires “stamps” from all involved stakeholders inside the company. In this paper major regulations that introduced this corporate structure are described.

In addition to internal mechanisms, outside controlling mechanisms are placed before and after the decision-making process. The State-owned Asset Administration and Supervision Commission (SASAC) undertakes regular by-yearly audits as well as post-departure audits after senior management change.

The National Development and Reform Commission (NDRC) gives a “non-objection” resolution on major foreign and local investment projects beyond a certain level. It also has licensing and planning powers. Therefore, these two agencies have pre- and post-decision audit powers.

The big banks and provincial leaders also serve as enablers in large investment projects. Through loans they provide and permits granted they become stakeholders in the SOEs decision-making process.  

The paper suggests that these dynamic mechanisms, i.e. meritocratic bureaucracy, autonomy and organizational structure of checks and balances, determine the success or failure of the PRC’s SOEs. The case study of one of the centrally managed SOEs, China National Gold, shows how these dynamic mechanisms work on the example of an individual SOE.

Drawing on a broader legal debate, in the case of the PRC’s SOEs legal transplants do take their own content. Boards are intertwined with party committees. Internal and external audits are intertwined with party-state controlling mechanisms. Meritocratic selection and promotion is intertwined with party-state cadre system of seniority and loyalty. Managerial entrepreneurship is intertwined with obligatory FYPs legislated by the party-state.

As is in many cases of legal transplants, the PRC takes what is the generally accepted corporate governance mechanism and re-makes it into something its very own. Hence, the corporate form and the corporate law is much wider and includes many non-traditional aspects. Corporate form includes such non-traditional items as the state and the party. Corporate law includes not only laws, by-laws, regulations issued by the state and the company but also the party and other entities. This model of corporate governance is specific to PRC’s East Asian (Confucian) past and communist present.

One may suggest that this paper deviates from the discussion of core elements of corporate governance such as the boards, independent directors, external market mechanisms, etc. However, as the Part One seeks to show, the studies of traditional core elements reveal their weakness in the SOEs of the PRC. The situation leads some authors to conclude that corporate law is less important in the PRC then corporate form.

This paper, however, through the depiction of various actors such as the SOEs’ party committees, CCDI, NDRC, etc., seeks to show that corporate law in the PRC’s context is broader and the focus should go beyond traditional core elements. If the analysis of the corporate form is broadened to include elements such as networked hierarchies then corporate law should definitely follow the trail of regulatory documents issued by these various types of party-state agencies. For this precise reason, the discussion in this paper, while highlighting the research on traditional core elements, devotes much of its space to other, less traditional mechanisms. Corporate law in the PRC does not make much sense without them.

A more general, speculative, conclusion that could be derived from this paper is that SOEs in the PRC function as they do now, probably, mainly due to their dynamic features. They have been able to become the central-pillars of the post-reform PRC’s economy because of the features described above. There are plenty of state-owned and politically motivated companies around the world that perform miserably, however, at the moment the PRC’s SOEs stand out from among their developing countries’ peers.

At a more hypothetical level, it is also possible to suggest that for any other developing state well-endowed meritocratic bureaucracy, autonomy of decision-making and bounded entrepreneurial nature of the SOEs, checks and balances (occasionally ruthless) at the organizational level could at least benefit the performance of the SOEs. However, even if one puts aside hugely important normative disputes about the desirability of such party-state system, it would be hard, or probably impossible, to emulate those structures because they are very specific to the PRC’s East Asian (Confucian) and communist context, as mentioned earlier.

The remaining alternative is more market-based governance of the SOEs that follows the examples of more developed countries which require transparent democratic government institutions. However, it seems that in the absence of democratic institutions underpinning the whole social order, developing states are left with no other choice than to privatize fully the existing SOEs to resolve their governance issues. As this discussion remains outside of the scope of this paper, it is only a passing and speculative remark, though it surely deserves much deeper and thorough debate. 

In terms of content, Part One of this thesis will deal with a theoretical background, providing brief overview of mainstream theories dominating the thinking in the field and Part Two continues the theoretical debate by bringing in political economic theories based on the experiences of the East Asian economies. Part Three deals with mechanisms of corporate government derived from the latter approach distinct from more traditional ones based on more law and economy theories. Part Four seeks to undertake a case study of China National Gold, one of the centrally-managed SOEs.

To sum up the contribution of this paper, at a theoretical level, the research seeks to develop a novel approach towards the PRC’s SOEs by bringing a political economy approach of the “developmental state”. Politics and law approach (emphasis on fist word “politics”), possibly is more suitable in the PRC’s context of party-state and a logical outcome of following the developmental state theory. At an instrumental level, critical elements of corporate governance generalized for the SOEs could possibly serve as a useful tool for investment analysis. At a more normative level, study of the PRC’s SOEs and their corporate governance would strive to be a minor contribution to the debate over the durability and impact of “state capitalism” model.