Beijing Gets Cold Feet--and Freezes a Key Reform

To placate investors, it cancels a stock issue in state companies

Wang Shumei is back. The laid-off factory worker used to spend her days at the downtown Beijing branch of Xinda Securities, making bets on China's emerging companies to try to maximize her savings. She stopped coming about a year ago, when the markets began a long plunge: From June, 2001, to mid-June of this year, China's Shanghai and Shenzhen stock exchanges both fell 30%. Now, Wang has returned to Xinda to make her stock plays. She has the government to thank: On June 23, the State Council, China's Cabinet, decided to shelve a controversial plan to sell millions of shares in hundreds of state-controlled companies. Both markets are up about 10% since the announcement. Investors are ecstatic that no flood of new stock will drive down prices.

But what's good for Wang Shumei isn't necessarily good for China. To reformers, the decision to back off on selling state-owned shares is a major setback. Not only were they hoping that the privatization of state enterprises would improve often-slipshod corporate governance, but the proceeds from the sales were earmarked to bolster the struggling state pension system. "By stopping the share reform, they are going backwards," says Vincent Chan, head of China economics and strategy at UBS Warburg in Hong Kong. "They are giving in to short-term considerations."

It's patently clear why officials are dragging their feet. Some 60 million urban stock traders, many of them retired or laid-off workers like Wang, have proved themselves a noisy group when riled up. China's top leaders don't want to risk getting them angry--not with a key Party Congress coming in September that will install new leadership. "The Shanghai A-share index is [now considered] an indicator of the government's performance," says an economist with an investment bank in Beijing. "They are likely to keep the markets up until the new government takes over."

Before their latest move, Beijing policymakers had already tried several measures to boost the markets. On Feb. 21, the central bank cut interest rates for the first time in almost three years. In April, the China Securities Regulatory Commission announced a 3% ceiling on brokerage commissions--a bid to make trading cheaper for individual investors. "Even though the government tried all of this, the markets still would not improve," says Chen Siru, an analyst at Minzu Securities in Beijing. "So they decided to cancel the state share sell-off."

The most serious repercussion of the canceled sales, say analysts, is the impact on the pension system. Beijing is now meeting its obligations to retired workers, but on a strictly pay-as-you-go basis. Without reserves, Beijing over the next 20 years will face a $400 billion shortfall in making payments to its rapidly aging population, according to the World Bank. And with protests by retired and laid-off workers already a big political issue, the need to build a stronger social safety net is an urgent matter. China now has 33 million retirees receiving pensions, many of them ex-public sector workers. That number is expected to rise rapidly in coming decades. If the state sold all its shares in listed companies at current prices, the pension system would net $300 billion.

Another casualty of the pullback on privatization is improvement in the management of 1,200 listed companies. Some 60% of their shares are now held by the state. Many are in need of major restructuring. "As long as these companies are majority government-owned, senior executives will only be responsible to their political bosses," says the Beijing economist. If executives were responsible only to shareholders, analysts say, big listed companies like Baoshan Iron & Steel Co. would be better able to fend off pressure to buy up failing smaller companies in order to save jobs.

Some observers are convinced that the government pullback is temporary. "This represents only a tactical retreat rather than a permanent freeze," says Fred Hu, Goldman, Sachs & Co.'s Hong Kong-based managing director. That may be true. But for now, even as investors like Wang start buying stocks again, Beijing's policymakers have stalled out in a crucial area of reform. If the result is a depleted pension program and uncompetitive companies, Beijing will be buying trouble in double doses.

By Dexter Roberts in Beijing, with Mark L. Clifford in Hong Kong

— With assistance by Mark L Clifford

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