Historical Developments. Of the factors contributing to the economic motivation for opening up the mergers and acquisitions market, the severe problems of the state-owned enterprises have done the most to tilt the political balance toward government acceptance of mergers and acquisitions. The inefficiency of the state-owned enterprises is a long-standing problem, and in the context of the market-oriented reform the survival of many of these has become an imminent issue as they hinder further economic development and reform. Nearly half of them are incurring losses, and many if left to their own resources would have already gone bankrupt. In recent years, the government has allocated 60 percent to 70 percent of annual fixed-assets investments from banks—all are state banks---to state-owned enterprises, largely to bail out those suffering losses. Such nonproductive fiscal expenditures account for the major portion of the fiscal deficit and contribute to the country's recurrent high inflation, which in 1994 was 24.1 percent for the nation and much higher for some major cities.

Early government attempts in the mid-1980s to reform the state-owned enterprises included measures to arrange mergers and acquisitions. The result, however, was less than satisfactory if not in fact a failure. Among the arranged mergers only a few generated some synergy, which usually dissipated very quickly, and many turned out to be disastrous because of conflicts of interests that materialized. Little efficiency enhancement should have been expected, though, given that the mergers and acquisitions essentially involved management adjustments and production re-planning without consideration of ownership issues, capital injection, or technology up-grading and given that, being arranged by the government, the activities lacked the motivation for success of profit-seeking enterprises.

Since the late 1980s, the government has been experimenting with other reforms for state-owned enterprises-for example, letting incurable firms go bankrupt and transferring the ownership of some other firms to the public through flee-market-style mergers and acquisitions. The bankruptcy experiment has progressed slowly because there is no social safety net for absorbing released workers, and private job growth is not fast enough to absorb the workers either. The mergers and acquisitions market has gained vitality, though, in the 1990s. State-owned enterprises may merge among themselves, and enterprises and private enterprises are also allowed to join the game on equal footing. In contrast to the mergers and acquisitions of the mid-1980s, the activities in this round are voluntary, and they may cross kinds of ownership, industries, and regions. In 1993 alone, more than 2,900 enterprises, most of them small and medium-sized, were merged or sold in the sixteen major cities of China, including Tianjin, Shanghai, Guangzhou, Wuhan, and Shenzhen; 6 billion yuan ($1 = 8 yuan) of assets changed hands, and 400,000 employees were reassigned. In addition, the role of the securities market in mergers and acquisitions has been exploited. In October 1992, the first acquisition of a public company through the secondary securities market was accomplished, and several other companies have followed the example.3

Foreign investors are participating in the current mergers and acquisitions market and are at least half-heartedly welcomed. Their participation injects more capital into China, which is good news, especially to the local governments. On the other hand, the central government is concerned about the loss, or the possible loss, of control over certain industries to foreign investors. The official policy has swung back and forth, reflecting the government's ambivalence. Foreign investors in this arena must maneuver without a complete set of guiding laws, and the lack of such a framework may work for or against their activities. For example, because the policy area is gray, some mergers and acquisitions transactions by foreign companies are structured as joint ventures while others are plain vanilla mergers and acquisitions.

The Chinese government finds the results of merger and acquisition activities largely encouraging. As expected, these activities have revitalized some state-owned enterprises and relieved some of the government's financial burden. One result has been more efficient allocation of production resources as-assets have been enlivened by transfer from the low efficiency state-owned enterprises to the new owners. International investors are also reacting positively, clearly attracted by the additional investment channel China offers.

Privatization.

Privatization of many state-owned enterprises is likely to be the most long-lasting type of merger and acquisition activity. For example, Vantone Company, one of the largest private enterpri~e~ that has prospered from the booming real estate business in Hainan Istand, has made inroads into retail and pharmaceutical businesses by acquiring state-owned enterprises. The company started with initial capital of 60,000 yuan in 1990 and by 1993 had become a profitable conglomerate with assets of 3.5 billion yuan. Another well-publicized example is the Wuhan Dadi Science and Technology Company, a private enterprise that acquired the medium-sized state-owned Wuhan Matches Plant at the end of 1993 at a price of about 70 million yuan.

Along with privatization has come significant growth in the number of entrepreneurs as the mergers and acquisitions market has provided opportunities for people to start and expand their own businesses. In recent years, many small firms have been bought out by independent entrepreneurs or the firms' employees.

Merger and Acquisition Targets.

The Chinese government has several criteria for deciding which enterprises can be allowed to enter the mergers and acquisitions market: First, the merger or acquisition should be carried out gradually so that the economy will not be subject to a shock. Second, control of the crucial outputs important to national security and economic health should be maintained. Third, the mergers and acquisitions market should move forward on an experimental basis (preferably embracing first those enterprises facing the most difficulties) as the government keeps some flexibility in adjusting its policy. In this spirit, the government has stipulated that (l) the mergers and acquisitions of state-owned enterprises should be compatible with the government's industrial strategy; (2) state-owned enterprises related to national security, military defense, advanced proprietary technologies, scarce mineral mining, and other specified areas cannot be sold to private or foreign investors; (3) a state-owned enterprise in a pillar industry such as energy, transportation, or communications may be partially sold, but a majority share must be retained by the government; and (4) any merger or acquisition deal of a large state-owned enterprise that is the backbone of an industry must be reviewed individually.

Most state-owned enterprises that are put on the market for sale or merger by the government are small or medium-sized, have a long history of operating losses or a lack of promising products, and are subject to a high level of debts. Selecting enterprises with these characteristics is consistent with the central government's motivation to revitalize the money-losing state-owned enterprises and to test and start the mergers and acquisitions market with small and medium-sized enterprises.

When a large or profitable state-owned enterprise needs outside capital, the central government seems to prefer to let it go public rather than to sell it. The securities market, however, is still in its developmental stage China seeks to combine economic growth with the transformation of state-owned enterprises and has adopted a policy of reforming them gradually, one by one. and each year stingy quotas, explicit or implicit, are issued to the local governments for initial public offerings. To list in the securities markets in foreign countries (such as on the New York Stock Exchange or the Hong Kong Stock Exchange), a Chinese company has to get approval directly from the central government, and getting such approval is next to impossible for most state-owned enterprises. This situation has forced some large or profitable state companies, which need capital injections and technology upgrading, to venture into the mergers and acquisitions market and sell themselves. They are able to do so because of the consent or support of the local governments, which are eager to attract capital to the local economy. Some cities have thus stepped ahead of the rubric policies of', the central government and become pioneers in the so-called ownership revolution.

As mentioned above, the government also puts many collective enterprises, profitable or unprofitable, on the market for sale. They are usually small or medium-sized, and the government has fewer restrictions on their merger and acquisition deals. Private enterprises have had such a brief development history that they do not figure as merger and acquisition targets; their ownership transfer, if any, usually occurs within a circle of friends and relatives. Private-to-private merger and acquisition deals are uncommon not because of government discouragement but because these enterprises arc not developed fully enough to be attractive merger or acquisition targets.

As discussed above, many merger and acquisition deals for state-owned and collective enterprises are executed after they have been converted into joint-stock companies. A mergers and acquisitions transaction for a joint-stock company target is technically easier because of the company's clearer ownership definition.

The Institutional Environment.

Committed to making its transitions gradually, the government has been conservative in institutionalizing procedures for addressing issues in the mergers and acquisitions market. Because existing economic institutions are not designed for a free market operation, rules must be drafted as the game is being played, with the frequent result that they may be both vague and redundant. Existing institutions are intended to address the specific issues of the legality of deals, valuation of assets, and facilitation of transaction. The complicated and often confusing nature of government control over merger and acquisition activity has evolved somewhat out of rational consideration of the issues but also simply out of the bureaucratic machine.

Which regulatory agencies are involved in a merger and acquisition case depends on the ownership of the target and the type of acquirer, among other things. When the target is a state-owned enterprise, at least five government branches will be consulted: the Economic Planning Commission, the Administration for State Assets, the Administration for Industry and Commerce, the department in charge of the industry of which the target company is part, and the Commission for Restructuring Economic Systems. If the acquirer is a foreign investor, the Ministry for Foreign Trade and Economic Cooperation will also be included. For a publicly traded company, the Securities Regulatory Commission of China has a role.

The size and importance of the target company usually determines which level of the government is involved. A deal involving a small state-owned enterprise probably controlled by the local government can usually be approved locally. A medium-sized state-owned enterprise is likely to be jointly supervised by both the local and the central government, and the negotiations have to be carried out on both fronts. Most large state-owned enterprises are under the direct control of the central government, and any merger or acquisition deal involving these companies would be carefully reviewed by the central government.

The question of who represents a state-owned enterprise being targeted for merger or acquisition is often a point of contention between local governments and the central government as well as between the government and the company's management. The central government recently tried to reassert its control in the matter by stipulating that (1) the management of a state-owned enterprise has no right to sell the company without authorization; (2) only the designated agent, in most cases the Administration for State Assets, can represent a state-owned enterprise in a merger and acquisition deal if the enterprise has not already been converted into a joint-stock company; (3) a joint-stock company is the property of its shareholders, who have decision weights according to their shares, and the rights of the state shares are to be exercised by the Administration for State Assets; and (4) the acquirer of a state-owned enterprise may be an individual or an institution.

When the merger and acquisition target is a collective enterprise, the matter is simpler. As discussed earlier, a collective company, whose ownership is often vague, is usually controlled by the company's management while another company, a government agency, or a social institution acts as its guardian. Because collective enterprises tend to have a looser relationship with the government and their production focus is mostly on consumer products, the government has less interest in their merger and acquisition deals. In most cases, a deal is negotiated exclusively between the acquirer and the management of the target company, with final approval obtained from the guardian and a formal application filed with the government.

To acquire a joint-stock company, all an investor needs to do is to amass a controlling stake through stock purchase in the secondary market or negotiation with the shareholders, a practice similar to that in most western countries. Acquiring a public company through, the secondary market requires careful observation of securities laws and regulations: Foreign investors are not allowed to buy A-shares or take more than 5 percent of the ownership by holding B-shares. They may, in principle, purchase C-shares and state shares by dealing directly with the holders.

There are 174 property exchanges, established by the local governments and major financial institutions in recent years, that serve to facilitate merger and acquisition transactions and enforce government regulations. Specifically, the exchanges collect and disclose information about merger and acquisition prospects, assist both sides in procedures, and provide other consulting services. They also furnish information and experience to the government in formulating merger and acquisition policies on issues such as asset evaluation, debt settlement, and employee placement. Fourteen of the exchanges operate at the provincial level, 104 at the city level, and 56 at the lower municipal levels. While a few exchanges are active and developing quickly, the rest are not ready to function properly. In all likelihood, many of the city and lower municipal exchanges will be consolidated to the provincial level and networked nationwide.

Because the mergers and acquisitions market is in an experimental stage, most related regulations are in the form of provisional rules, which will be revised into permanent laws over time. Continual changes in the regulations should therefore be expected, and they will be open for interpretation as they are evolving. Such a legal environment offers investors both opportunities and risks: while investors may find more freedom in structuring and negotiating deals, they may also lack solid legal protection. China is speeding up the process of establishing a legal system in line with international standards. Each year sees progress in the passing of laws and in the clarifying of legal issues. However, full establishment of properly functioning legal institutions is a long-term goal.