Accounting in China

["Ian Murray" <seamus2001@xxxxxxxx>]

Legacy of Socialism Keeps China's State Firms in Red
Reform of Large Industrial Giants Slowing

By John Pomfret
Washington Post Foreign Service
Wednesday, June 20, 2001; Page A01


CHONGQING, China -- The Chongqing Iron and Steel Group, a massive
steel mill complex on the banks of the Yangtze River, has become a
monument to the sad march of China's industrial revolution and a
worrisome portent of the obstacles China faces on the road to
capitalism.

The immense factory group, with 25 subsidiaries, 52,000 employees and
a history dating back more than a century, last year reported a profit
for the first time in years. On paper, at least, the gain was $24
million.

But the claimed profit was the result of artful accounting and
government protectionism that masked the still formidable losses at
the state-owned behemoth, according to knowledgeable businessmen,
government officials and analysts. Rather than turn a profit,
Chongqing Iron and Steel has become a metaphor for the continuing
crisis of China's state-owned enterprises, still mired in the legacy
of socialism.

Only four years ago, Premier Zhu Rongji announced that China would
retool thousands of these factories. Last December, the government
declared victory. Hailing "remarkable progress," Sheng Huaren, then
head of the State Economic and Trade Commission, said more than 60
percent of state-owned firms had become profitable.


But an examination of the troubles of this factory and others paints a
different picture. Reform of China's industrial giants has slowed to a
snail's pace, and there are signs of retrenchment as conservative
Chinese thinkers have begun to block any movement toward reform,
according to the businessmen, officials and analysts who spoke about
the issue in recent interviews.

The stakes are enormous for China. Along with banking reform,
restructuring the state-owned enterprises is key to the health of the
Chinese economy, the success of the government and the status of the
Communist Party. Even after two decades of economic reforms,
state-owned enterprises still employ 41 percent of China's urban labor
force and account for a third of the $1 trillion gross domestic
product. The livelihood of millions of Chinese is wrapped up in their
fate, along with social protections such as health insurance and
housing that often accompany state-sector jobs.

The history of Chongqing Iron and Steel, built in this steamy
metropolis at the center of the country, goes a long way toward
explaining why such giant state-owned factories are difficult to
change.

Growth of Monoliths
Originally established with the help of the British in the late 19th
and early 20th centuries, the firm was built in the city of Wuhan,
downriver from Chongqing. In 1938, to escape the Japanese, the
Nationalist government moved the mill to Chongqing, then known as
Chungking, China's wartime capital. In the 1960s, Mao Zedong ordered
heavy industry from coastal areas and the northeast to move to
Chongqing and other inland regions, preparing for what he believed was
an imminent war with the Soviet Union. Chongqing Iron and Steel
received whole production lines from such places as the massive Anshan
steel works, in northeastern Liaoning province near the Russian
border.

For decades, the mill was emblematic of many other socialist
industrial monoliths that survived despite their enormous
inefficiencies.

The economic reforms inaugurated in 1978, which marked the beginning
of China's turn toward capitalism, initially did not touch Chongqing
and other aging state-owned enterprises. One reason was that Chinese
leaders were still committed to socialism. Also, the sheer challenge
of overhauling these colossal enterprises was so complex that many
were discouraged from trying even if they did not share the ideology.

But the drag on China's economy became starkly apparent by the
mid-1990s.

About 63 percent of China's 110,000 state-owned firms were losing
money. Moreover, the factories suffered from immense social burdens.
Each was a world unto itself, an almost self-sufficient economic
community that provided workers with cradle-to-grave security.
Nationwide, state-owned enterprises ran 18,000 schools, 19,000
nurseries and 224,000 hospitals, not to mention restaurants, plumbing
and transportation companies, florists and small police departments.

In 1997, when Zhu committed to solving the mess in three years, one
technique was to allow some state businesses to list on foreign stock
exchanges. The idea was that an infusion of capital would help foster
restructuring of the aging plants.

Tens of thousands of small- and medium-size firms were also sold off
to local managers, businessmen and governments. Billions of
state-owned assets were privatized in an often shady process almost
overnight.

Chongqing rode the wave in the late 1990s and listed a subsidiary on
the Hong Kong stock exchange. The listing was engineered by Guo Daiyi,
then general manager. Guo was a crusading businessman and won praise
in Chongqing and among investment bankers for creative solutions to
some of the firm's biggest problems.

One of his most important innovations was to make each of the firm's
subsidiaries responsible for its own profit and loss, a revolutionary
concept at the time. Under his leadership, the mill's construction
company won part of a city contract to construct a bridge in this
mountainous metropolis. And its hospitals took patients from outside
the factory gates.

Guo caught the eye of the city government. What happened next
underscores the problems many state-owned enterprises face when trying
to become more independent and market-oriented -- pressure from local
governments and the party.

The city government here did something incomprehensible to many
Western economists but in keeping with the practices and thinking of
socialism. Just as Chongqing Iron and Steel was shaking off the
shackles of its troubled history, the city government forced the firm
to buy another ailing steel mill, Chongqing Special Steel. The second
mill was home to 10,000 workers. It was hundreds of millions of
dollars in debt and almost bankrupt.

A key element of the state enterprise reforms involves establishing
effective, market-oriented corporate governance: allowing firms to run
themselves, rather than letting the state do it. But in this case, the
Special Steel transaction did not go through the Chongqing board of
directors, as it would have if good corporate governance procedures
had been followed. Rather, it was an administrative decision of the
Chongqing city government. And Chongqing Iron and Steel was given no
power to close Special Steel or reorganize it.

"It basically wasn't a forced merger, it was a bailout," said Edward
S. Steinfeld, a professor at MIT who has studied China's reforms and
done research in Chongqing.

Guo opposed the sale and left the firm, taking a job in the city's
legislature.

The plant's problems have deepened. Although the factory claimed
profits of $24 million, separately $448 million of debt was turned
into equity and handed over to several asset management firms set up
last year by the Chinese government to handle such debt. The transfer
made it much easier for the steel mill to claim a profit because it no
longer had to pay tens of millions of dollars in interest to China's
banks.

In addition, the government took special measures to protect the steel
industry, limiting production so prices would rise.

But even the protectionism has not healed the troubles of the steel
industry and Chongqing, a Chinese steel market analyst said. Once the
price of steel started to rise last year, many smaller steel mills
increased production to take advantage of the jump. Now the price has
fallen again, threatening profits for 2001.

Cooking the Books
Throughout China, the pressure on factory managers to show results to
Beijing is intense, making accounting tricks and outright fabrication
commonplace. Just 10 days after Sheng announced the reforms' success,
for example, the Finance Ministry released a report saying that a
random check of 276 state-owned firms revealed that almost all had
somehow cooked their books.

The experience at Chongqing also suggests why Beijing has treated the
problems of state-owned monoliths so gingerly. For one thing, the
Communist Party's top leaders still believe in public ownership, and
they worry that further privatization will spell the end of the
party's monopoly on power.

A second reason is that the party defines a successful state
enterprise as one that employs a lot of people, not one that makes a
profit. It fears worker unrest if too many people are laid off, said a
former senior manager at Chongqing who spoke on condition he not be
identified.

Nationwide, the government has laid off 15 million workers over the
last three years as part of the reform program. But of the remaining
140 million, up to 60 percent are considered surplus.

Tang Minwei, who took over from Guo as general manager at Chongqing
Iron and Steel, said he would like to cut his workforce in half. But,
for example, Chongqing Iron and Steel is required each year to employ
a group of demobilized soldiers whom it cannot fire. It now has 6,000
of them, company sources said.

"We'd like to move things along quickly," Tang said in an interview,
"but the priority is to help the workers manage a switch in their way
of thinking. In the past, we said our workers would live a
state-enterprise life and come back as a state-enterprise ghost. That
has started to change."

Even with Tang's go-slow approach, labor unrest is a problem at the
firm. Last December, 500 Special Steel workers protested, demanding
that their pensions be paid as promised, witnesses said.

Short-Term Perspective
Finally, the orientation of a manager of a state-owned firm is not
focused on long-term investment in plant, research and development,
and productivity. Instead, it is toward quick-hit profit or projects
favored by local governments.

When Tsingtao Beer listed on the Hong Kong stock exchange in 1993, for
example, the Qingdao city government commandeered a portion of the
money to build a road through part of the new city. Other state-owned
firms speculate on the stock market and invest in real estate. Or they
use the money for workers' pensions and back pay.

In the case of Chongqing Iron and Steel, some of the capital raised
from the listing in Hong Kong went into real estate, according to the
former senior manager. Loans from Chinese banks also went into
property and several other "dubious deals that have nothing to do with
steel," he said.

"We have had no serious capital investment in the firm in years," he
said. "Workers still shovel coal into furnaces," an observation borne
out during a trip to the firm's factory No. 7.

The reason managers use capital this way, he said, is that they are
government officials, appointed for terms of three or four years. They
are under enormous pressure to show an immediate profit, so
speculative investments are preferred. And because of their paltry
salaries -- Tang is paid less than $1,000 a month -- they must enable
themselves and their associates to make money from the firm, which
again makes risky investments more attractive.

"This is not the way to run a business in the West," the former
manager said. "The tragedy in China, however, is that the serious
mistakes being made seem completely rational from the perspective of a
factory boss."