We're often asked how we can own factories in China - isn't China a Communist country? Doesn't the State run everything?

Not any more. In fact, China's private sector is booming and is one of the fastest-growing economic engines in the world economy. This growth received an official "seal of approval" in the speech by Jiang Zemin, China's former President and party general secretary at the 16th Communist Party Congress held late last year, in which he stressed the importance of the private sector (including foreign company investors) to China's economic development. Jiang also promised vigorous legal protection of private property and vowed to overhaul regulations that discriminate against foreign companies.

This welcoming attitude contrasts sharply with the "party line" of the 1970s, when private businesses were viewed as "capitalist tails that must be cut off" and entrepreneurs were condemned. Before 1978, China had a centrally planned economy: around 75% of its industrial output was produced by state-owned enterprises (SOEs). Everyone belonged to state or publicly owned danwei (working units). Private enterprises and foreign-invested companies were basically non-existent. Foreign trade was restricted to importing goods that could not be produced domestically and exports were used to earn hard currency to pay for those imports.

In the late 1970s, a wave of economic reform changed all this. Today, around two-thirds of China's GDP is generated by the non-state sector, around half of it contributed by domestic private enterprises. Across China, registered private businesses surged from 90,000 in 1998 to 2.03 million in 2001.

Today, although SOEs still employ more than half the national work force, fewer people rely on the state for jobs and social benefits. More than 70 million Chinese currently work in foreign-related businesses; of these, 23 million work directly for enterprises backed by foreign investments, which contributed 53.2% of China's import-and-export value in 2002.

China is now a major player in the world economy. By 2002, its foreign trade exploded to US$620.8 billion, making it the world's sixth largest trading nation. During the 1990s, China was the world's second largest recipient of direct foreign investment. By 2002, direct foreign investment in China was growing 12.5% annually and reached a record high of US$52.7 billion. As a result, for the first time, China surpassed the United States as the world's number one destination for foreign dollars. By the end of 2002, 424,196 foreign companies were doing business in China, bringing total stock of direct foreign investment to US$447.9 billion.

Why the Shift Toward Capitalism?

Certainly, there are sound economic reasons for this policy shift. First, after years of industrial restructuring, China's (SOEs) are languishing and its four state-owned banks have been directed to channel some 80% of their loans into keeping them afloat. Not surprisingly, this policy has forced China's banks to accumulate a mountain of debt (totalling close to US$500 billion, according to Nicholas Lardy of the Brookings Institute).

While its SOEs struggled to survive, China's private sector developed rapidly, despite a harsh regulatory environment and serious discrimination.

By mid-2002, private sector profits surged 38% year-on-year and foreign-invested enterprises rose by 23%, while profits from SOEs fell by 11%. In 2002, the private sector (including foreign-invested enterprise) generated around 60% of China's industrial output using 20% of its total resources, while the state sector produced 40% of industrial output and consumed 80% of total resources. Today, the private sector employs close to 200 million workers, including over 100 million peasants. Eight out of ten new job opportunities are created by private small-and-medium enterprises.

Beyond this, the current Chinese leadership has committed itself to building a xiaokang or "well-off society" over the next two decades. To achieve this, China's GDP must quadruple by 2020 by attaining average growth rates of 8%. Employment must also rise. The World Bank recently estimated the need for 100 million new jobs by 2013. Work force growth will put enormous cash pressure on China's fledgling social security and pension systems. Clearly, its moribund SOEs are not up to these challenges. The government's solution to creating jobs and igniting economic growth involves two-pronged action: Expanding China's private sector and encouraging foreign investment.

Paving the Way for Growth and Reform

To spur new growth, the government took an important first step: "rehabilitating" the reputation of the private sector. In 1982, the 12th party congress recognised the legitimacy of private business. By 1997, the private sector had become "an important component of China's socialist market economy." At the 16th party congress, not only were the "red capitalists" invited to join the Communist Party, some private entrepreneurs were even made delegates. The party also vowed to "promote the healthy development of the non-public sector" and "better safeguard private property."

This was a major breakthrough. The lack of strong protection for private property has been a major stumbling block in China's modernisation drive. The recent confiscation of Yang Rong's Brilliance China Holdings Company—a privately owned automobile manufacturer—by the Liaoning provincial government is typical of the problems faced by China's private entrepreneurs. In response, many secretly moved their assets abroad, causing severe capital flight (estimated losses: US$50 billion annually, roughly equivalent to the FDI that China attracted in 2002). Lack of private property protection has also led to rampant "fake" product manufacturing.

Now, the central government starts to confront this issue, vowing to protect personal deposits, investments and the profits they generate. According to a new draft Civil Code, "all the basic principles and provisions on the protection of property apply to the possessions of citizens and other non-public property." In 2003, the "inviolable sanctity" of private property is expected to become a principle in China's Constitution.

While reform is moving in the right direction, three fundamental issues remain unresolved. One is addressing the "institutional sins" of China's newly rich, most of whom have accumulated their wealth illegally. A recent official study suggests that 90% of China's richest men became wealthy by using their power or family influence and most have evaded taxes. The recent arrest of China's famous actress, Liu Xiaoqing, is a case in point. Public resentment is high and the government is under pressure to respond vigorously.

Effectively enforcing new property protection law poses a second problem. Here, China's record is mixed, at best. Free speech and assembly, and the right to demonstrate, for instance, are integral to the existing Chinese Constitution, but these rights have never been properly implemented. Also, China claims to offer legal protection for Intellectual Property Rights, but piracy of software and brand names remain a severe headache for multinationals.

A third concern: Is the Chinese government fully prepared for the consequences of private property protection? As rights in this area grow, people will naturally seek to safeguard them from possible violation by individuals or the government. Property protection is also likely to fuel public demands for other types of political and economic change.

Reforming SOEs

The Chinese government is also pushing to reform SOEs. At the core of its new plan: A proposed State-Owned Assets Supervisory Commission (SOASC) that will exercise control at the central level. The new SOASC is designed to consolidate all finance, management, and personnel planning into a single, market-driven unit. This is a key step in "separating the party from the government," although a lack of professional administrators may make this goal difficult to achieve.

Reducing government bureaucracy and streamlining decision-making are also priorities. Now in development: a new Ministry of Commerce charged with overseeing both domestic and international commerce. Central supervisory agencies like a banking regulatory committee and an electricity regulatory committee have also been formed. A new State Development and Reform Commission has replaced the old Stalinist planning agency .

Great Opportunities, Great Risks

In this new round of changes, foreign investors and the domestic private sector (which has been promised treatment "equal" to that of foreign partners) are expected to reap handsome rewards from improved market access and new business opportunities. For example, private companies and foreign investors are now eligible to be involved in SOE restructuring. Exciting new market-access opportunities include direct investment, mergers and acquisitions (M&A) of SOEs or their assets, purchases of equity stakes in listed companies, portfolio investment in B shares, and indirect portfolio investment in A shares via qualified foreign institutional investors (QFIIs). China's capital markets will allow more foreign institutional investors.

The new SOE restructuring scheme has given disposal rights over state shares to local governments, many of which have developed their own plans to attract investors. For example, foreign tenders are now eligible to acquire 25% of Shenzhen Energy Group, 45% of Shenzhen Water (Group), 24% of Shenzhen Gas Group and 45% of Shenzhen Public Transportation (Group) Ltd. In Hunan, the provincial government just opened its entire mining market (except for the exploration of radiological minerals) to foreign companies.

Despite definite progress, the road to economic liberalisation is unlikely to be a smooth one. State ownership will still play the "dominant role" in the "socialist market economy." The state will retain a controlling interest in key strategic—and lucrative—sectors such as telecoms, petrochemicals, banking, and automobiles. Ultimately, the private sector may have to play only a minor role in China's SOE restructuring. Meanwhile, problems inherent in the SOE model, such as the lack of clearly defined property ownership, opaque financial situations, and unreliable valuations, pose potential risks to interested private and foreign investors.

Ahead: A Long and Winding Road

There are still several market impediments that could seriously hinder the development of China's private sector. Major obstacles include:

Limited financing sources: Obtaining loans from state banks has been extremely difficult for the private sector, partly because of its lack of a credit record and poor accounting practices. Other sources of financing are also limited. Among the six financing vehicles: credit, bonds, stocks, funds, project financing, and fiscal support available in China's capital markets, the private sector can only access two—credit and stock listing of large enterprises. By the end of 2002, there were only 139 private companies listed in China's public-sector dominated stock markets. They accounted for 11.8% of all listed companies and 6.7% of their total value. As a result, many private businesses resort to high-interest loans from the black market.

Limited market access: Among the 80 business sectors open to SOEs, FIEs may access 75% while China's private sector can access less than half of these. This is not in conformity with the WTO's principle of "national treatment."

Double taxation: In addition to paying 33% corporate tax, private entrepreneurs are also subject to personal income tax of 20%.

Legal vulnerabilities: Lack of effective legal protection is a major problem in making deals on mergers & acquisitions, retaining land-usage rights, and protecting both private property and intellectual rights.

While these obstacles are serious, they are not insurmountable. The importance of China's latest round of reforms cannot be overestimated. The Chinese government has cast off its ideological shackles and begun to address economic issues in accordance with accepted international norms. As President Jiang's "Three Priorities" strategy (economic development, cultural advancement, and support of the public's fundamental interests) indicates, the Communist Party is willing to transform itself to "move with the times."

In the coming decade, China's future will largely depend on how the Chinese government responds to a growing private sector and its demands for economic and political rights. This challenge will be left in the hands of the fourth generation of Chinese leadership headed by the new president and party secretary-general, Hu Jintao and his new team, which will be selected this spring. Whatever happens, an exciting future lies on the horizon for China's domestic private sector and for foreign companies with the staying power to handle the "growing pains" of a dynamic, but undeveloped, economy.

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