A study of Chinese companies challenges Western arguments that full privatization is the panacea

Economic instability caused by the financial crisis in Western economies raises concerns for policymakers in developing countries. In particular, there is concern about the free market development model proposed by the Washington consensus. Policymakers in developing countries are therefore beginning to see China as a role model with respect to economic development.

The free market model calls for the liberalization of markets with less regulation and state interference. This creates an economic environment where business success is financially rewarded and financial reward motivates business decision-making. Full privatization is a key feature of the state reducing its role in the economy. China, however, has stubbornly followed its own, different path to economic development, with both full and partial privatization being a feature. Given China's status as a role model, it is well worth reflecting on its privatization program.

China's privatization program originally formed part of the authorities' decentralization initiatives in the 1980s. It was a key component of a broader corporatization agenda that required the nation's State-owned enterprises to establish more Western-style governance structures that included shareholders, CEO positions and boards of directors. Under the popular slogan "retain the large, release the small", many State-owned enterprises (SOEs) were converted in an attempt to turn them into profitable businesses.

Partial privatization was allowed from 1993. This involved selling a minority stake in SOEs to private individuals, although the sale of a majority controlling stake to private investors was prohibited on ideological grounds.

Calls for restructuring grew as non-performing loans accumulated, and the pressure was magnified by the 1997 Southeast Asian financial crisis, which exposed the unwillingness of State-owned banks to impose budget constraints on SOEs. The central government was further spurred into action by its desire to join the World Trade Organization.

The corporate restructuring of SOEs was a key part of Premier Zhu Rongji's three-year program, beginning in 1998, to transform the fortunes of some of the country's largest enterprises. This shift towards the corporatization and privatization of SOEs provided clear incentives for managers to improve the performance of their companies.

Advocates of full privatization for China's SOEs argue that they are less efficient than private firms for two reasons. First, the "political view" contends that the state promotes social and political objectives that enter into direct conflict with the objective of maximizing profits. Second, the "managerial view" emphasises the absence of any effective incentives that would drive SOE managers to seek the greatest possible profits. Both views claim aggregate welfare would be maximized if ownership and control rights in SOEs are privatized and firms' decision processes are wholly depoliticized.

However, proponents of privatization often fail to appreciate the context in which privatization is to be applied. Attracting private investment into an economy is problematic where there are weak property rights laws and/or a weak judicial system to protect property rights. A private investor will be concerned that, after privatization, a government might make policies that devalue the investor's financial stake. If a degree of state ownership is maintained, via partial privatization, this might give a private investor confidence that a government would not undertake policies that would do both parties financial harm.

Workers are often concerned about the impact of privatization on their jobs and pay. Such concerns have the potential to create social instability. A degree of state ownership provides the means by which the government can provide a helping hand to protect workers' rights. A government that partially privatizes SOEs to expose them to private incentives while simultaneously protecting workers has the potential to create a "win-win" for both investors and workers.

A major study of Chinese firms by Nottingham University Business School sheds a useful light on this debate. Crucially, the results challenge the adopted Western-centric wisdom that full privatization is the panacea for the ills of China's SOEs.

The research analyzed data from the National Bureau of Statistics of China's annual report of industrial enterprise statistics for the period from 1999 to 2005, concentrating on more than 2,000 domestic firms that started as wholly State-owned - some of them subsequently registering the involvement of private capital.

China's western regions, where economic development is less accelerated than in the east and SOEs are still relatively dominant, provided the focus. As part of its western development strategy, the Chinese government has sought to establish a modern corporate governance system and reduce its share of state capital in SOEs, which has involved a program of both full and partial privatization of SOEs.

The results suggest full privatization is likely to result in more labor productivity and better training but does nothing for wages and costs jobs. By contrast, partial privatization also delivers in terms of productivity and training but, crucially, not at the expense of jobs losses or wages. Indeed, partial privatization might even create jobs and increase wages.

This has clear implications not just for China's ongoing economic development but for the country's social stability. It shows that exposing SOEs to the full force of market discipline and incentives via full privatization creates both winners and losers, while partial privatization provides a potential "win-win" scenario where investors and workers can share in its benefits.

By way of further illustration, let us consider some specifics. According to our research, a year after being fully privatized a Chinese SOE employs an average of 10 percent less people than equivalent firms that remain State-owned. Potentially, minority privatization leads to an average 12 percent job increase in the first year and majority privatization to an average 22 percent increase within two years.

In addition, although full privatization does not appear to benefit workers in terms of wages, partial privatization potentially leads to pay rises - 14 percent for minority privatization and 16 percent for majority privatization. Finally, both full and partial privatization tend to bring about additional labor productivity and slight improvements in workforce training.

The most striking aspect of these results, of course, is that in the case of partial privatization there are no obvious losers. Market discipline and incentives drive labor productivity improvements, while a government "helping hand" protects labor welfare via job creation and higher wages.

It should therefore be reasonable to expect that government would gain wider endorsement for a program of partial privatization than for a program of full privatization. Indeed, China's leaders have learned that hasty privatization measures can arouse often violent unrest among workers.

In 2009 the general manager of SOE giant Tonghua Steel was murdered by angry workers in reaction to a planned takeover that could have slashed the workforce from 30,000 to 5,000. Some weeks later the government was forced to cancel the privatization of State-owned Linzhou Steel in Henan province after militant workers held an official hostage for four days.

Social stability is paramount for China, and there are already clear signs that the leadership, attuned to the risks that full-scale privatization carries, is adopting a more tentative approach to reforms. The state sector is thriving at present, with the Ministry of Finance announcing in January that profits were up 38 percent on the previous year at 1.99 trillion yuan (209.5 billion euros). Profits and business revenue were double those of five years earlier, it said.

The official line is one of caution and was set out in March this year in a parliamentary address by China's top legislator Wu Bangguo. He announced the leadership had made a "solemn declaration" not to carry out privatization - although state media reports the number of private registered enterprises topped 8.4 million last year, accounting for 74 percent of the country's total.

Considering all of the above, policymakers and business leaders alike would do well to consider a wide-ranging program of partial privatization if China is truly to sustain its remarkable economic development and safely navigate the various obstacles in its path. After all, ensuring a "win-win" situation - which, among other positives, should help assuage worker resistance to the privatization phenomenon - is important for any government wanting to create vested interests that support an agenda of reform.

Kevin Amess is an associate professor of industrial economics at Nottingham University Business School, which has campuses in the United Kingdom, China (Ningbo) and Malaysia. Jun Du is a senior lecturer at Aston Business School. Sourafel Girma is professor of industrial economics at Nottingham University Business School.