Let East Europe be the guide, China
Private firms are generally more efficient than state-owned ones. Economists, a fractious lot, generally agree about that. Unsurprisingly then, in the early 1990s, when the former Soviet bloc countries wanted advice on what to do with their awful state firms, economists told them to privatise them. 'How?' the governments asked. 'As fast as you can,' replied the economists.
One can understand why. Policy advisers, as well as the reformers themselves, feared the return of their communist opponents and so wanted their market reforms locked in. Privatising as much industry as quickly as possible was one way of doing this.
A second reason was that the economic theory at the time assumed that the way you privatised did not really matter. This goes back to the great economist Ronald Coase and his theory of property rights. He argued that as long as ownership rights over a group of assets (a firm, for instance) were well-defined and secure, then the market would ensure that they ended up in the hands of the most productive user. Therefore, it did not matter how public assets were initially sold - or to whom.
Some 10 years on, we are older and a little wiser. We now know that it matters how one privatises. Coase's logic still stands - the problem lay in the premise that there is always a functioning secondary market in ownership rights. This entails a stock market, a decent mergers and acquisitions regime, courts able to make under-performing firms bankrupt - all the things we take for granted in the United States, parts of Europe and Hong Kong.
It was not so in the former Soviet bloc in the 1990s - and they are not yet properly present in the mainland. So, it matters how one privatises and who one sells to, since there is no secondary market to correct a mistake if the firm lands in the wrong hands. Bad things happened in the former Soviet bloc because of this error. Small firms were sold to their employees. This might seem fair, but it was not particularly efficient. No one 'owner' had the ability to make a decision at these firms.
Another problem was that many large firms were sold to outsider investors, often friends of government officials, at knock-down prices. With little incentive to restructure the firm (and little experience in running one) the new owners sat on their hands. Unsurprisingly, the privatised firms did not improve. The problem here was that the sale method was open to abuse.
There are lessons to learn. First, it is critical to note that, overall, privatisation in the former Soviet bloc was a success. Privatised firms have done better, on average, than those which remained state-owned. Countries that got on with privatisation, like the Czech Republic and Poland, have performed better than those, Ukraine for instance, which decided to persist with state ownership. Beijing might take note of this and support more sales.
Second, the best way to privatise a large firm is with an initial public offering (IPO) or an open auction. Both are open and transparent, and encourage competition. This minimises the chances that the sales will be open to corruption, and maximises revenues. Of course, the way China has done them so far, IPOs have not been so good. State-owned enterprises have listed their shares, but state entities usually retain a large chunk - and control. We are now being flooded with studies that show the performance of firms listed in Shanghai and Shenzhen generally declines after listing.
A better IPO method would involve selling a large chunk of shares to a private investor (a private placement) and selling a smaller slice to the public. Control would then be put into private hands (good for efficiency), but the public would also get a chance to profit from the sale. Employees might also get some shares, to encourage them to support the sale. China is uniquely placed to do IPO-privatisation properly - nowhere in the former Soviet bloc had as good a capital market infrastructure as China now has.
For companies not lucky enough to get a listing, an auction is a good alternative. Tender offers (where people are invited to submit secret bids) are much less transparent and encourage insiders to skew the terms of the deal to favour their friends.
Privatisation of large firms is now already taking place in China. While the central government is still ambitious to retain its large firms, the provinces are selling theirs. This is really exciting, since it shows enterprise reform is finally getting serious. However, there is no over-arching plan. Shenzhen has sold large minority stakes in five utility and food companies this year via international tender offers. Shandong and Hunan provinces have tried auctioning off their stakes in listed firms, although the central government stopped this, fearful of the stock market reacting negatively. Property-rights transaction centres, organs dotted around the country, are acting as sites for other transactions to be organised. Some are already informally offering basic trading facilities. Some are organising auctions.
But the main method - and one that seems likely to dominate if nothing is done - is direct transactions. Provincial officials are negotiating sales without any form of open or competitive sales process. One-to-one deals are not transparent and will often be facilitated by under-the-table payments.
The central government has yet to lay down a credible framework for large state-owned enterprise sales. In much of the former Soviet bloc and Latin American, there is now huge public resentment at the elite who enriched themselves via privatisation. In many areas, this has turned into a backlash against the whole market-reform agenda.
Beijing risks the same if it does not now lay down clear rules that ensure state-owned enterprise sales are open and competitive. It would be a good idea to set up a national agency to enforce this framework. In short, China needs a ministry of privatisation.
Stephen Green is the author of China's Stockmarket: A Guide to its Progress, Participants and Prospects, and head of the Asia Programme at the Royal Institute of International Affairs in London
