China's New Capitalism

As the state sector crumbles, dynamic private companies are taking up some of the slack

Zhang Yue, the normally taciturn chief executive of privately owned Broad Air Conditioning, jumps up from his desk and rushes to his office window. It is a grey, drizzly August afternoon on the outskirts of Changsha, a sprawling central Chinese city in Hunan province dotted with the smokestacks of ailing state-owned industries and the rice fields of disgruntled, overtaxed farmers. But Zhang, 38, isn't focusing on this bleak scene. Instead, he watches eagerly as his company's Bell 206 helicopter takes off in a whir from the helipad just outside his window. "It's very useful for company business--and helps to stimulate one's imagination," Zhang says enthusiastically of his chopper.

A decade after Zhang and his brother founded the company, Broad now boasts $192 million in sales, 1,200 workers, and a reputation as one of China's top producers of large air- conditioning systems for office buildings. Hunan's largest taxpayer, Broad is so vital to the struggling local economy that a grateful provincial official describes Zhang as "a god."

As China prepares to celebrate the 50th anniversary of the Communists' Oct. 1, 1949, victory over the Nationalist army of Chiang Kai-shek, the pageantry will have a predictable look. A triumphant military parade through Beijing's Tiananmen Square is in the works. Also likely are long speeches by President Jiang Zemin and other top brass extolling the glorious accomplishments of the Chinese Communist Party.

But as the Party bathes itself in the sentimental imagery of past socialist achievements, the unstated irony is that a different sort of revolution is sweeping the nation. Quietly but steadily, private companies such as Broad are becoming the backbone of China's economy. While thousands of state-owned factories still languish with massive debts, red ink, and bloated workforces, maverick entrepreneurs are picking up the slack, generating badly needed jobs and helping Chinese industry approach world standards in sectors ranging from electronics manufacturing to Internet services. The private sector won't solve all of the serious problems left by the old socialist system, which will hang over China's economy for years. But it is starting to offer glimpses of a more dynamic, globally competitive economy that may lie in China's future, provided leaders don't again try to roll back the clock.

The private companies now emerging are a major step forward from the tiny private firms that started sprouting in China after late paramount leader Deng Xiaoping launched his economic reforms in 1979. Most of these were mom-and-pop eateries, small factories, and repair shops; the new generation of private companies are large, complex enterprises often engaged in sophisticated manufacturing and services.

These firms are also openly independent of the state, run by owner-operators who cherish their freedom. That's an advance from the murky front-companies for military and provincial governments that have long characterized Red Capitalism: For example, the "red chip" corporations traded on the Hong Kong exchange are all state-controlled conglomerates. It is only in the past few years, in fact, that Beijing has conceded private enterprise a legitimate role in the national economy. Thus, capitalists lived in an ideological netherworld. Many companies that presented themselves as independent, such as Beijing's Legend Computer or appliance-maker Haier, are in fact hybrid ventures in which government bodies were heavily involved. And many companies that classified themselves as village enterprises or foreign ventures were actually privately owned but disguised themselves to avoid taxes and official meddling.

From those embryonic early years of private capital formation, however, China is starting to produce substantial, fully formed private corporations. Their founders and senior executives come from a broad sector of society, from peasants' sons to managers who cut their teeth in foreign ventures to academics who are abandoning government institutes and young engineers who studied and worked in California's Silicon Valley.

These entrepreneurs have all struggled to raise capital for their ventures, and some of their fund-raising techniques remain obscure. They have often relied on family funds, or underground lending syndicates that charge scarily high rates for loans. But as they become more established, some entrepreneurs are starting to secure capital from sources long reserved for state enterprises---such as government-owned banks and the stock market. And they are pushing into more economically important and politically sensitive sectors, often with Beijing's tacit approval. These firms are convincing Beijing that China's best hope of producing new engines of growth rests on the country's ability to nurture startups, rather than on blueprints drawn up by government planners. The leadership "has seen evidence of the vitality and dynamism of the emerging private sector," says Goldman Sachs (Asia) economist Fred Hu. The shift "is irreversible."

Without question, China's business class has come a long way since the Deng era. Although the hybrid firms were a big break from socialism, authorities were more willing to shower favors like cheap loans and land on companies in which the state had a stake. That largesse often prevented companies from becoming truly competitive--and fed enormous waste.

Government-owned companies that all but monopolized business a decade ago make up only 47% of the economy today. Meanwhile, the private sector--not counting farms and the operations of foreign investors--accounts for as much as 40%, according to the China Economic Quarterly, an independent journal. In Shanghai, the number of private enterprises exceeds 111,000, according to the Shanghai Private Enterprise Assn.

If those numbers are accurate, then the private sector is making enormous strides--especially since government companies still monopolize such key industries as banking, telecom services, and wholesaling. One factor boosting these numbers is that many companies have ceased to disguise their truly private nature. Until recently, many "foreign joint ventures" were controlled by domestic entrepreneurs through Hong Kong shells. Other entrepreneurs felt they had to register their companies as collectives just so local clients would do business with them. "Now I have thrown away my `red cap,"' says Zhou Fusheng, founder of $1.2 million signmaker Shanghai Dasheng Industry & Trade Co., who termed his company a "collective" in its early years. "I'm not afraid to be a private businessman anymore." Also, a wave of privatizations by cash-hungry provincial and municipal governments has placed thousands of factories and service companies in private hands.

BEST HOPE. The implications for China, where the claim that the state is the core of the economy remains embedded in Communist Party dogma, are earthshaking. Not only does raw capitalism raise new questions about the legitimacy of the party's monopoly--it also underscores the desperation the leadership now faces over the economy. Simply put, President Jiang Zemin, Premier Zhu Rongji, and others recognize that the private sector offers the best hope as an engine of growth. As state firms shed workers and shut plants, new businesses are urgently needed to generate millions of new jobs.

Indeed, the largely hidden role of a vibrant, efficient private sector may help explain why Chinese growth continues to be as high as it is, despite the losses at state factories. In five years, more than 60% of the economy will be in private hands and employ some 75% of China's workforce, says Zhong Jiyin, an associate professor at the Chinese Academy of Social Sciences.

China's leadership is reacting in a confused way to the private sector's surge. At the party's upcoming plenary session, more plans to privatize state firms are expected. But at the same time, Beijing is propping up other big state firms with fresh money. Despite these zigzags in policy, Beijing now for the first time is actively helping the private sector. A recent Shanghai seminar sponsored by the state Bank of China on private enterprises drew 150 companies from as far away as Tibet. Cheap government loans, subsidies, and tax holidays are funding high-tech ventures. Government institutes are transferring knowhow and technology to hot startups and more established private companies.

More importantly, private enterprise is gaining the legal standing it has long lacked in China. Early this year, the country's constitution was amended to acknowledge the private sector's important role. The Aug. 30 passage of a law spelling out such legal rights as private-property ownership was another green light for private companies to accelerate. One reason: The government has a much better chance of collecting taxes from private companies than from loss-making state enterprises, which can use their political influence to secure breaks.

But Beijing is also merely catching up with reality. In such progressive coastal provinces as Zhejiang and Jiangsu, the local economy is almost entirely in nonstate hands. And even in backward inland provinces, major changes are afoot.

Take inland Hunan, once known only for its depressed economy. Now, besides Broad Air Conditioning, Hunan also boasts private companies such as Yada Chemicals and software developer Powerise. China Construction Bank, which is only now tackling its bad debt, is eager to lend more to such private enterprises. "For many private companies, our risk is very low," says Peng Maowu, general manager of the Hunan branch of China Construction Bank. Private enterprise in Hunan is growing at a booming 20%, compared with 4% for state enterprises. Vice-Governor Zheng Maoqing says the nonstate sector, which employs 2.3 million people, plays a crucial role in re-employing laid-off state workers. "In the future, state enterprises will only play a role in strategic industries," he predicts.

For a look at a sector no longer deemed strategic, travel to the private factories of booming Zhejiang. There, in the coastal city of Wenzhou, home to China's earliest private entrepreneurs, a purely private electronic parts industry has sprung up. Much like the Taiwan of two decades ago, countless factories pump out midtech goods such as adapters, circuit breakers, and converters for domestic consumption and export.

These outfits have grown beyond backyard factories. Take companies such as $240 million Chint Group Corp. and $245 million Delixi Group Corp. Both were started by local farmers' sons who dropped out of elementary school and who broke into the business by selling components. After starting their own factories 15 years ago, both recently got permission to take over ailing state enterprises around the country. These companies each export more than 10% of their products and have dominant market shares at home.

Beijing now realizes that domestic companies such as Chint and Delixi are the only hope against the many multinationals like Siemens, ABB, and Rockwell now pushing into the China market. "In some areas like electronic parts, state enterprises will be sold to private companies like us, and the government can withdraw," says Chen Jianke, vice-president at Chint Group. His company has taken over three state companies, all with strong technology and products but with management problems and debts. Chint turned them around by trimming their payrolls and cleaning up their finances. Capital is flowing more freely now to these private superachievers. "We're now one of the best customers of Agricultural Bank of China in this province," says Delixi Vice-President Hu Wei.

Entire high-growth sectors such as software, biotech, and the Internet are up for grabs, and private companies are likely to take most of the spoils. Shanghai-based Fortune Group started in 1992 with a $480 investment by five graduates of prestigious Fudan University. The quintet, most of them biology graduates, started by selling a pharmaceutical product that tests for hepatitis, a major health problem in China. Now the group's seven companies are involved in everything from biotech to real estate. Fortune's pharmaceuticals group, with $60 million in sales and $7 million in profits, became one of China's first private companies to go public last August. "We were a test case to see whether private companies could really succeed in the stock market," says Chairman Guo Guangchang, 31. Its shares have leapt fivefold since the listing.

HARD KNOCKS. The private sector may even succeed at encroaching in industries once under the strict control of the state--like the mass media. Hunan Television & Broadcast Industry Co. became the first media company to secure a stock-market listing earlier this year when executives convinced securities regulators that it needed to raise private capital to meet the new challenges of the broadcast and print industries. The company plans to expand into cable television and the Internet. "It is a breakthrough," says Hunan Television chief Long Qiuyun. Already his company has taken over a cash-strapped economics newspaper from the Central Party School, and plans are afoot to acquire other publications.

Succeeding as a private company in China is far from easy. Already, companies like those in Wenzhou's electronic parts industry are struggling to make the transition from small, family-run outfits to larger corporations with sophisticated production, technology, and management. With that in mind, Delixi is starting to outsource production of some components to other companies. "If we want to perfect our product, it's impossible for us to do everything," says Vice-President Hu. Chint and Delixi are even establishing outside boards of directors.

Both companies also have had their share of hard-knock lessons. Like countless state and private enterprises, Chint and Delixi in the early 1990s expanded into everything from coal-mining machinery to clothing and real estate. After several tough years, Delixi was forced to sell off most of its new businesses and focus anew on electronic components. "Private companies must be very, very careful," says Hu. "There are many enterprises that have failed because of too-rapid diversification."

It's also hard to know how far some of the most outlandish firms can go as they bounce from one venture to the next. Chen Rong, president of Zhonglu Group, started out with a small-scale apparel factory, switched to stock speculation in the early 1990s, then went into bowling equipment. "Since state enterprises didn't care to enter the bowling business, it was a blank slate," says Chen. Now he wants to branch out into investment banking, filmmaking, biotech, even the Internet. So far, he's been successful. But playing the field this way is a tough formula for the long term.

Finally, there is always the danger that Beijing will once again swing back to conservatism. With much of the leadership formed in the Soviet mold of stodgy state bureaucracy, much resistance remains to letting go of key strategic sectors, such as telecom. Nervous about too much exposure, companies like private, Shenzhen-based telecom-switch manufacturer Huawei try to avoid the limelight. In the absence of a strong legal system, entrepreneurs still risk being squeezed by rapacious local officials.

Despite such worries, entrepreneurialism is now looking like China's best hope. As the top leadership prepares to herald 50 years of running China at the celebration in Beijing, the real party may be starting elsewhere, as private enterprise triumphs in the cities and provinces across the country.

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