For a centralized planning economy to transform itself into a market economy, one of the most difficult tasks is to convert state-owned enterprises into market-oriented, profit-pursuing firms that can contribute to output and productivity growth. While the number of new private enterprises in China is growing fast, that growth is not offsetting the inefficiency of the state-owned enterprises, which are contributing to rising inflation and eating away investment funds that might otherwise be effectively used. Moreover, many state-owned enterprises face possible bankruptcy, which threatens to put workers out in the streets and create accompanying social problems.

Developing mergers and acquisitions is one measure China has adopted to solve this problem, an approach that differs from those of East European countries and the former Soviet Union in many aspects. Consider, for example, Russia's voucher program for revitalizing state-owned enterprises. In November 1992 the Russian government decided to privatize its state-owned enterprises by distributing vouchers to its citizens, who would use the vouchers to bid, directly or through investment funds, for a "share of the state-owned enterprises when they were put up for auction. The voucher program offered several promising characteristics: (1) It was implemented swiftly, and that swiftness was thought to be a virtue by its promoters following the idea of Poland's "big bang". In about one year, 7,000 Russian state-owned enterprises were privatized through the voucher auction. (2) The program by design aimed at equity, with every citizen given an equal number of vouchers. (3) The program's single purpose was to achieve privatization of state-owned enterprises, with efficiency enhancement expected to follow as a natural result, at least in the long run. However, the voucher program has failed both to revitalize the state-owned enterprises and to achieve and maintain equity, according to some economists. Because the voucher auctions have injected neither capital nor better management skills and technologies into the state-owned enterprises, privatization has not improved productivity as expected. The program's failure to maintain equity among the people is, despite all its good intentions, one of its most significant shortcomings. Enterprise insiders and voucher speculators have eaten away the lion's share of the state-owned enterprises while common people are left at a great disadvantage. Such a result should perhaps not be surprising in a country lacking established institutions-visible and invisible--essential for a successful market environment.

Unlike the Russian government, which apparently chose the voucher program as a means of achieving radical political goals by demolishing the old economic system swiftly, the Chinese government seems to have more pragmatic considerations. China seeks to combine economic growth with the transformation of slate-owned enterprises and has adopted a policy of reforming them gradually, one by one. The idea behind the mergers and acquisitions approach, as well as other measures, is to let the state-owned enterprises be voluntarily acquired by or merged with other, better state enterprises, collective enterprises, private enterprises, and foreign business interests. Such an approach has combined ownership transfer with management adjustments, technology upgrading, and capital injections. While the one-by-one approach may privatize ownership more slowly, it may help avoid the painful shock of finding the economic environment and reformed enterprises abruptly mismatched. The government has more time to rectify problems that arise during the process and to establish a compatible market environment. The disadvantage of this approach may be that the solution will not keep pace with the fast deterioration of the state-owned enterprises. It is too early yet to evaluate the virtues and vices of China's approach. Given the unsatisfactory results of other, speedier approaches in Russia and some other Eastern European countries--for example, Poland--it will be interesting to see whether China's gradualism will succeed in reforming the state-owned enterprises.

The discussion that follows focuses primarily on China's mergers and acquisitions market itself—how it has come into existence, what its characteristics are, and how it may develop in the future. The privatization issue will be considered again as appropriate.

Economic Reform: 1978-95.

The mergers and acquisitions market in China has emerged as a logical outgrowth of the country's economic reform, which began in 1978 in the agriculture sector. The centralized planning economy was on the verge of collapse, and the key idea behind reformation was to replace the existing commune system with the family farming network. The result was dramatically improved agricultural output. In 1984 the government began reforming industrial enterprises as well, with a goal of converting them into profit-seeking units. Unfortunately, high inflation following the political upheaval in 1989 stalled the reform. In early 1992 when Deng Xiao Ping launched a campaign to revitalize the economic reform program, it picked up again and began to extend to other parts of the economy such as the financial sector and the tax system.

China's economic reform has obtained some positive results. In the last seventeen years, China has kept a near double-digit real (inflation-adjusted) growth rate. Per capita gross domestic product (GDP) for 1994 was only $431, but actual purchasing power was much higher because of low price levels (The State Administration of Statistics of the People's Republic of China [SAS] 1995b). Foreign direct investments increased at an average annual rate of 40.7 percent between 1983 and 1993 (Knight-Ridder 1994); at the end of 1994, 206,000 joint ventures and foreign subsidiaries had investments of $291.43 billion (SAS 1995b). Total exports had reached $120 billion by the end of 1994, total imports were $115 billion, and the foreign currency reserve reached $51.6 billion (SAS 1995b), which was ranked one of the largest in the world. In December 1990, Shanghai Securities Exchange (SHSE) was established, and in April 1991, Shenzhen Stock Exchange (SZSE) followed suit, both growing rapidly in the last couple of years.Given the Chinese economy's rapid growth and its enormous potential, the emergence and development of its mergers and acquisitions market are likely to be significant in the international economic community. As will be discussed, one difference the market will make is in opening up an additional channel for foreign investors to participate in the Chinese economy.

Table 1: Industrial Output by Enterprise Type (Percent)

Source: SAS (1995a)

A Taxonomy of Enterprise Ownership.

As the essence of mergers and acquisitions is restructuring the ownership of enterprises, a taxonomy of the current ownership of industrial enterprises in China might be informative as background for the discussion. It is important to remember, of course, that the ownership structure of these enterprises has been changing constantly and any simple classification such as the one presented here can serve only as a reference point for further understanding.

Ownership of enterprises in China may be sorted into three categories: state ownership, collective ownership, and a combination of private and foreign ownership. The state-owned enterprises vary in size, and their production scope covers heavy industry, light industry, and the service sector. They contributed 34.1 percent of China's total industrial output in 1994, a much lower share than that of sixteen years earlier (SAS 1995a; see Table 1). The collective enterprises are usually small and are concentrated in light industry, agriculture-support industry, and the service sector. Their total capacity, however, has expanded rapidly since 1978, and these enterprises contributed 40.9 percent of the total industrial output in 1994. The private enterprises are mostly in the service sector, and foreign enterprises cover a broad spectrum of manufacturing. They together contributed 25 percent of the total industrial output in 1994; most of these enterprises did not exist in 1978. A subcategory of the private industrial enterprises is 8 million so-called sole proprietors (see Table 2), which are not merger or acquisition targets given that their average number of employees is small.

Table 2: Number of Industrial Enterprises by Ownership (Thousands)

Source: SAS (1995a)

State-owned Enterprises. A state-owned enterprise is one established by the government, owned nominally by "all the people of China," and managed by government-appointed bureaucrats. Before 1980, no state-owned enterprise pursued profits but instead served as a government agency carrying out directives from its superiors. These directives specified the goods to be produced or distributed and the compensation to be received by workers. The raw materials and bank credits needed for the operation were allocated to the enterprise directly or indirectly by the State Planning Commission and the Ministry of Finance. The administrative superior of a state-owned enterprise was one or a few of the following bodies: the ministry in charge of the industry in which the enterprise was categorized, the provincial government, or the city government. The managers' goal was solely to fulfill the government plan, without having to consider business decisions, such as input and output prices, which were fixed by the government.

Entering the 1980s, the government began experimenting with reform measures aimed at enhancing the efficiency of state-owned enterprises. The reform advanced along two lines, one being to devolve decision rights to the enterprise managers and the other, to reform the price system, the tax system, and the financing system so that the economic environment would be more like a market and state-owned enterprises would respond to market signals. The results have been mixed, and many problems remain unsolved: unsuccessful alignment of incentives for labor, management, and the government; lack of management experience and skills needed in a new environment undergoing market-oriented transitions; aggressive competition from collective enterprises and foreign enterprises; and high operation costs owing to material wastes, shirking, redundant workers, and backbreaking welt-are burdens.

Collective Enterprises. A collective enterprise is nominally owned by its "guardian" or "sponsor," usually another company, a social organization, or a government agency, but it is usually quite independently operated by its management team. More often than not, the initial capital of a collective enterprise is contributed by the guardian or borrowed from the state banks or other institutions using the guardian's influence and connections. In the first case, the guardian may be entitled to a portion of the enterprise's profits; and in the latter, the guardian is usually entitled to an annual fee from the enterprise. The management team, which acts like a de facto owner, cannot claim the residual profits but has discretion about how to reinvest the profits and whether to disburse them as bonuses within the explicit or implicit limits set by the company charter and government regulations. Production by a collective enterprise is not planned by the government. Its managers decide what goods to produce or what services to provide, but they do so, of course, within the parameters of having to obtain raw materials and credits in the marketplace. Prior to 1978, a collective enterprise often found itself ignored by the economic planning system. During the 1980s, they benefited from economic reforms and, with their competitive advantage of management flexibility, low labor costs, and autonomy regarding the retained after-tax profits, they began to thrive in the more market like environment. Their success may partly explain why more and more collective enterprises have been set up under the encouragement of rural townships and urban municipalities since economic reform started.

Private and Foreign-owned Enterprises. For ideological reasons, private enterprises were all but nonexistent before 1978. They were allowed to come into existence then under the explosive pressure of mass unemployment manifested in the homecoming flood of city youths, who had been coaxed and coerced to the countryside during the cultural revolution (1966-76). The first such enterprises were usually small businesses in the service sector, most of them operated by an individual or a family. While a small portion of them have subsequently grown into bigger operations and forayed into manufacturing, most have remained small in both scale and scope. The number of firms that are wholly or partly owned by foreigners, in the form of joint ventures or independent companies, has mushroomed throughout the nation since 1978, thanks to the open-door policy to attract foreign capital. The role of both private and foreign-owned enterprises is expected to grow quickly.

Joint-Stock Companies. In the late 1980s, the Chinese government began implementing ownership reform for state-owned and collective enterprises. The ultimate goal is to limit the government's role in a state-owned enterprise to that of a shareholder with limited liabilities. For collective enterprises, reform involves redefining or clarifying the ownership shares of the involved parties, after which the enterprise is called a joint-stock company. A joint-stock company may have several classes of shares: those held by individual investors, those held by institutions, and those held by the government. The individual shares, which are listed on the stock exchanges, include A-shares, which are traded among domestic investors, and B-shares, which are traded among foreign investors; the institutional shares, called C-shares, are traded on the Stock Trading and Quotation System (STAQ) or the National Electronic Trading System (NETS). The state shares may be purchased only through negotiation with the government. In 1994, the number of state-owned enterprises converted into joint-stock companies increased to 25,800 from 13,000 in 1993 and 9,440 in 1992. Over the same period, about 3 million collective enterprises converted to joint-stock companies. Current policy makes it likely that most state-owned enterprises and collective enterprises will follow suit.

The conversion of enterprises into joint-stock companies is significant in the development of the mergers and acquisitions market in a couple of important ways. One is that it lays a rudimentary foundation for ownership transfer through public offerings and merger and acquisition activities because after the conversion it is easier to transfer ownership from one ~art}~ to another. Well before the stock market came into existence in China, some joint-stock companies began to exploit the operational advantage of restructuring their ownership by selling stocks to their own employees as well as other institutions. Another significance is more profound: without unlimited financial backing from the government, a joint-stock company converted from a state-owned enterprise is expected to compete in the market like a collective or private enterprise. A natural consequence is that some state-owned enterprises may come out alive and well while others will end up facing bankruptcy, a result that expedites the development of the mergers and acquisitions market because the last hope for some of these enterprises may lie in being acquired or merged.