Chinese state enterprises produce items no one wants. And managers rarely suffer the consequences. But across the country, that's about to change. Cities such as Shanghai and Guangzhou are key testing grounds for what is shaping up as one of the Chinese leadership's biggest assaults yet on the problems of the woebegone state sector. Overall losses last year increased by 38%. So since the February death of Deng Xiaoping, President Jiang Zemin has made state-enterprise reform a top priority as he bids to consolidate his power (table).

Jiang's campaign is likely to fall far short of mass privatization, a step that might make economic sense but would spell political suicide. For example, the latest reforms will leave the 1,000 largest state enterprises under Beijing's control. That said, cities are experimenting with ways to shake up management, close the biggest money-losers, retrain laid-off workers, and reduce the social welfare burdens carried by state companies. In many cases, small factories are being sold to foreigners. "The central government is clearly aware that the problem cannot be bypassed," says Weijian Shan, a managing director of J.P. Morgan (Hong Kong) Ltd.

DISCIPLINE. The government, after years of dragging its feet, is willing to take all this action because the Chinese economy is increasingly stable, many analysts believe. In 1994, the economy overheated as inflation skyrocketed to 21%. But last year, the consumer price index rose a modest 8.3%, and it is likely to rise 7% for the next two years, predicts Salomon Brothers Inc. economist Kevin Chan. That's largely due to tight credit controls that have been in place for three years, forcing discipline on state companies. If Beijing can sustain healthy but stable growth, absorbing laid-off workers will be easier.

Another reason may lie in politics. With Deng gone, there is pressure on Jiang to distinguish himself as the new top leader. Reform of the state-owned economy is one issue where there is widespread agreement on the need for change. And with a key National Party Congress that will set broad economic goals for the next five years coming up this fall, says a Beijing economist, "this is Jiang's chance." What's more, Jiang knows that reducing the state's role in industry is important to China's bid for World Trade Organization membership.

A pillar of Jiang's plan is to let small and midsize state companies sink or swim, while focusing state assistance on turning around the largest enterprises involved in everything from textiles to heavy machinery and metallurgy. As Jiang says: "Grasp the big, release the small." Sichuan province hopes to privatize all small and midsize enterprises owned by county governments by next year. The unprofitable ones are likely to disappear or be merged into larger companies over the next few years. In a recent interview in the China Daily, State Commission for Economic Restructuring researcher Wu Hongguang called small enterprises "a losing proposition for the state."

Persuading profitable state enterprises to assume the huge debt burdens and swollen workforces of the laggards won't be easy. So in January, economic czar Zhu Rongji revealed that Beijing would budget $3.7 billion to write off bad debts of companies that are taken over or go bankrupt.

Many local governments also are looking at new ways to provide for worker welfare. Rather than have companies pay all medical, retirement, and housing expenses as they occur, they are being urged to contribute to provident funds managed by cities. In Guangzhou, officials are using these funds to create a mortgage market to enable citizens to purchase their apartments from state companies. Local banks are allowed to lend half of the provident funds they manage for home loans. With the proceeds, the companies can upgrade their operations. In Yantai, a city in Shandong province, and Bengbu, in Anhui province, special banks have been created to provide mortgages. Some cities are also tapping corporate provident funds to set up health-care, pension, and savings programs to which both workers and employers contribute.

The leadership also is trying out management reforms. Shanghai is setting up a "human resource center" that will monitor the performance of senior executives at local state enterprises. For managers who are regarded as talented but frustrated with current employers, the center will offer retraining and help in landing a top job at another enterprise. The center also will keep tabs on poor managers and may even recommend their removal.

Jiang wants these innovations to spread beyond pacesetting cities such as Shanghai. Many of the boldest reforms are advancing furthest in the south, where problems with state enterprises aren't as acute. The southern province of Hainan island, for example, has been among the most thorough in implementing new worker welfare systems. That has been easier to accomplish because the workforce is young and the pension burden light. The real test will come with reforms in the industrial north, China's Rust Belt.

"WHY BUY?" In other areas, the plans are proceeding with mixed results. State workers in Beijing and Shanghai are buying their company-provided apartments. But in other cities, poorly paid workers are unwilling to spend the money. "Usually, they have all the rights [of ownership] and aren't going to be thrown out," says a Beijing-based Western economist. "So why buy?" As a result, most companies have had to sell their housing at below market prices, usually restricting workers' rights to resell. Still, the enterprises can get out of the housing business--and get some cash as well.

The other concern is the scale of the effort by Jiang and his policymakers. Strategic sectors such as telecommunications, high-tech electronics, and services such as banking and publishing are likely to remain firmly under state control for the foreseeable future. "The baseline is still to make these enterprises more efficient," says Hai Wen, deputy director of the China Center for Economic Research Center at Beijing University.

As long as the government retains ownership of these large companies, though, many analysts believe reform will be elusive. "The state has the power to take money from a wealthy child to subsidize a poor child," says J.P. Morgan's Shan. That runs counter to the hard logic of the market, but few expect Jiang to evolve into a free-market purist. Instead, expect gradual moves to dismantle the small and medium-size money-losers and make the economy less dependent on the large state enterprises. It may not be the ideal plan, and it's certainly not bold. But in China as elsewhere, politics is the art of the possible. Jiang is trying to make more things possible than ever.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE