Monday, June 02, 2014

Michael Komesaroff on "Politicians or Businessmen? --Decisionmaking in Chinese SOEs"

Michael Komesaroff, principal of Urandaline Investments, a consultancy specializing in China’s capital intensive industries, and a former executive in residence at the School of International Affairs, Pennsylvania State University, whose insights on Chinese economic activity has been featured here in prior posts.  See Here, here, here, and here.

He has recently produced an excellent analysis of China's political economy of the leadership of state owned enterprises.  His presentation, "Politicians or Businessmen" discusses the processes used by state owned enterprises when they seek approval for overseas investments. This post considers some of the more interesting points made.

(Pix (c) Larry Catá Backer 2014)

Komesaroff is interested in the nature of decision making by executives of China's state owned enterprises. And in a sense, that interest drives his examination of the ways in which Chinese sovereign investing is grounded in premises, and is assessed in accordance with standards, that may be different from those of developed Western states.  Those differences, in turn, might explain why, to some extent, what appear to be measures of inefficiency or failure by Western measures, may not e read that way when the value premises of Chinese SOEs are factored in. Indeed, Komesaroff starts his exploration by acknowledging that by whatever measure one uses, China does not fit a standard model of a foreign investor possessing superior skills to local players.  Indeed, while Chinese SOEs may be good performers at home (and there is reasonable debate about this, but not with respect to project delivery), their project delivery outside of China is reputedly poor.  Komesaroff also wonders why so few Chinese overseas mineral projects were successful.  And indeed, and quite tellingly, Komesaroff wonders why, when China could act directly, did the State Council change its strategy and approve Chinalco's share raid on Rio Tinto.  If that is the case, then it is necessary to try to figure out what calculus the Chinese use for their overseas development investments, and indeed whether commercial or national objectives predominate in Chinese overseas investment.

These questions arise, Komesaroff explains, because SOE leaders have to advance two sets of incentives, objectives that to the Western construct grounded in the formal split between public and private spheres (each with its own incompatible welfare maximization premises) may be irreconcilable. He uses the term "incentives" because these incentive objectives are driven by concrete state policies.  On the one hand the State-owned Assets Supervision and Administration Commission (SASAC, 国资委 provides concrete financial rewards to SOE leaders based on their financial performance.  On the other hand,  OD determines career paths based on how well SOE leaders carry out Chine Communist Party policy (e.g., Larry Catá Backer, On the Role of the Chinese Communist Party in Overseas Chinese Companies--A Preliminary Examination, Law at the End of the Day, July 7, 2013; for a very critical assessment see Christopher A. McNally, Strange Bedfellows: Communist Party Institutions and New Governance Mechanisms in Chinese State Holding Corporations, Business and Policitcs 4(1):91-115 (2002)).

To flesh this tension out, and its effects on SOE performance and corporate culture, Komesaroff proposes to (1) identify the institutions that regulate and approve China’s overseas direct investment, (2) explain the processes and techniques used to evaluate China’s foreign mineral resource investments, and (3) comment on the commercial effectiveness of the evaluation and approval process. His conclusion is upbeat but cautious: (1) SOEs have difficulty replicating their successful project management policies outside of China, (2) inadequate due diligence, hubris and a dysfunctional approval process are key reasons for high failure rate, and (3) while nominally objective, the evaluation process incorporates strong external subjective influences.  Ironically, these are the sort of conclusions one would have expected to read a generation ago with respect to U.S. overseas efforts, and several generations before that on European ventures.  The issues, then, is basic to extraterritorial business--to what extent are the factors that make economies successful in a home state exportable to host states, and to what extent might these serve as a drag on successful transnational operation.  The Chinese will appear to have to learn a lesson only partially absorbed by the economic enterprises of prior powerful economic states--that myopia can lead to disaster ad that it is sometimes not productive to assume that what makes for a superior internal economic culture will have the same effects abroad. (See Larry Catá Backer, “The Problems of Being a great Power: China and Neo-Colonialism in Africa, Law at the End of the Day, Nov. 22, 2006).

Komesaroof starts by suggesting that China cultivates  roughly four distinct types of investment. These include (1) natural resource projects that compensate for what China lacks; (2) projects that require Chinese technology, products, equipment or people, (3) projects that provide access to international markets, and (4) projects that use advanced technology ormanagement Of these only the first stands out. That might explain the tolerance for the string of heavy losses Chinese SOEs have sustained since 2007. Komesaroff explains that 
in 2007, 65% of overseas investments were under water. In 2008, SOEs lost $11 billion on overseas investments. Between 2008 and 2010, 90% of 300 overseas M&As were unsuccessful, with companies losing 40–50%. In 2012, 30% of ODI were loss making and 40% break even. Between 2004 and 2010, 14 companies with combined losses from overseas investments of ¥95.05 b. Over next 5 to 10 years, half of China’s ODI will earn no return or incur losses.
These recent failures, Komesaroff notes, stand in contrast to earlier successes by Chinese SOEs. These also appeared to meet national objectives. Komesaroff characterizes these as "far sighted, courageous investments made (seemingly) without sophisticated decision making processes and at a time China had no money."  These were undertaken in partnership with Western firms, at a time when market power was still tilted toward consumers, and involved an established global player, so thgere was no vertical integration across project delivery chain.  The lesson Komesaroff draws is that "Chinese partners did not seem to internalise the learning experience: 'Paid the school fees but did not go to class.'”

The response, Komesaroff notes, has been institutional.  In an effort to prtotect against further loses and the erosion of the China "brand," a number of steps were taken:
SOE leadership are now personally more accountable for overseas investment decisions Investors must now present detailed risk management strategies and contingency plans Investment from China is already starting to tighten But larger SOEs still jockey for endorsement as product or national champions.
In addition China's ODI policies have begun to tighten as well. This affects both the scope and completion of the now well established Go-Out (走出去战略) policy (cf. Joel Backaler, Why Do Chinese Companies Want to Go West?, Forbes, Dec. 11, 2013).  Komesaroff noted that due to limited experience and small financial reserves, overseas investment approvals were essentially subjective, personal and informal processes.  The initial relaxation of approval standards in the 1990s appeared to encourage poor investments.  In response, the approval and monitoring processes were strengthened and by 2004 the approval process was simplified and formalized following the failure of Minmetals’ effort acquire Noranda (e.g., Noranda Ends Exclusive Talks With China Minmetals (Update5),  Bloomberg, Nov. 16, 2004).

Komesaroff also noted that the approval process continues to evolve. He notes that the changes are designed to close loop-holes, and to simplify and liberalise the approval process.
Bureaucracy required to evaluate proposals <30 accountability="" and="" apply="" br="" cover="" days.="" exceeding="" for="" investments.="" management="" million="" more="" nbsp="" non-performing="" non-resource="" now="" projects.="" projects="" recent="" resource="" revisions="" risk="" to="" us="" working="">
The current process consists of four stages--registration, feasibility study, approval and progress reporting (assessment and monitoring).  But the formal simplicity of the process masks a complex process of stakeholder engagement from a number of different sectors. Most of this engagement and consultation process occurs at the stage of "feasibility", a term that now acquires a substantially more protean dimension.

Komesaroff described the process as follows: The SASAC review process is relatively passive.  The core of the analysis touches on whether the project conforms to the SOE’s business scope and whether it has a a good performance record. The review process by the National Development and Reform Commission (NDRC), China's top economic planning agency, is a bit more intense and touches on the national political policy elements of Chinese sovereign investing. As such the approval stakes are higher for both the state and the SOE. NDRC review includes assessment of project consistency with national industry policy, whether the SOE presenting the project is the best choice for representing China, and whether the project is consistent with China’s foreign policy. Beyond SASAC and NDRC, the feasibility stage of the review process includes consultation with the other state actors listed in the graphic above. As a consequence, what at the start of the 21st century has been a simple technical document, has now become substantially more sophisticated. China now has substantially increased the number of staff available for sophisticated financial evaluation, though, Komesaroff notes, consultants (especially foreign banks) are also used.

The reform of the approval process, and especially the disclosures now required on the feasibility study phase, Komesaroff argues, are consistent with state efforts to make SOEs more efficient.  These efficiency moves are in turn evidenced by recent modifications of the legal structures within which SOEs operate. 
Under China’s Company Law, SOE leadership is empowered to make their own operational and business decisions. SASAC, as the owner’s representative appoints, removes and rewards enterprise leadership for their commercial performance.
Komesaroff explains that SASAC's evaluation of SOEs might contribute to their effectiveness.  Especially effective, by Kamesaroff, are new systems in pace for rewarding SOE managers for their commercial performance.
Individuals complete a self‐assessment and colleagues fill out anonymous ratings. Annual and 3 yearly. With 3 years of mediocre ratings supposed to be removed. Managers with an A rating awarded triple standard bonus while those ranked E (?) receive no bonus.  Base salary one-third and standard bonus two-thirds. 60% of bonus paid immediately and 40% on retirement from role SASAC identifies future talent by rating ~10 mid‐to‐upper level SOE managers. Annually ~60 SOE managers seconded to SASAC and vice versa.
But these incentives and systems must be operationalized within the political framework within which these corporations must operate to further national policy as well as commercial performance. This is also built into the structures of SOEs. It is this aspect of SOE operations, and the baseline presumptions that structure their operations, that westerners sometimes forget when analyzing and evaluating these enterprises as against their Western competitors.  Central to these differences is the fundamental role played by the Chinese Communist Party within the structures of the SOE.  These operate under the core principle--党管干部-- the Party controls its cadres. To understand this one has to be sensitive to the position and role of the Chinese Communist Party as a vanguard element fo Chinese politics, society and economic activities (e.g., Backer, Larry Catá, The Rule of Law, the Chinese Communist Party, and Ideological Campaigns: Sange Daibiao (the 'Three Represents'), Socialist Rule of Law, and Modern Chinese Constitutionalism. Journal of Transnational Law and Contemporary Problems, Vol. 16(1):21-102 (2006)). The CCP's Organization Department
manages a list of the positions which are controlled by Beijing and a list of candidates for these positions. Ministerial and vice‐ministerial positions, provincial governors, first Party secretaries, heads of universities, Academies etc. Talent rotated between industry, government and Party. OD’s decision making processes are opaque. Interim Provisions on Management of Executives in Central SOEs, issued by Central Committee and State Council confirms that the Party maintains absolute control over SOE leadership.
The roel of the CCP in the approval process, therefore, cannot be underestimated. Anmd the importance of aligning the political, macro economic and commercial objectives of sovereign economic activity cannot be lightly dismissed.  To that end, the CCP oversees internal SOE operations and reward structures, the outbound investment approval process, and the financial support available through the banking sector.

Komesaroff, thus argues that it is necessary to understand SOE leaders as both commercial actors and political agents. He concludes:
Most Chinese ODI is undertaken by SOEs where approval is determined by politicians and others outside the enterprise. By setting the rules and approving projects and investors, Beijing exerts considerable influence over ODI. Most senior SOE leadership serve at the pleasure of the CCP, and rotate between government, Party and industry. Beijing has directed its SOEs in ways which seem contrary to the enterprises own commercial interests.
The result, Komesaroff suggests, is irreconcilable tension when national and commercial interests do not intersect.  Of course, in Western states, that usually results  either in the triumph of the political interests of the state, or more likely in the movement of capital and operations (at least to the extent of the conflict) out of the state and its establishment elsewhere. Capital and operaitonal flight is less available to SOEs and the conflicts are resolved usually in favor of the state and the naitonal interest. That produces a secondary set of effects that are important for the evaluation fo the economic viability of SOEs and the ability of financial markets to compare performance among Chinese SOEs and other enterprises int he same sector. KJomesaroff divides these into three categories.  First assessment of performance is harder, both across enterprises and internally.  There are no conse4nsus measures for meeting political objectives and these remain subjective and contextual. Second, corporate governance is harder to discipline along objective or trans-cultural principles.  It also makes it harder for SOEs operating abroad to conform effectively to the normative systems in place where they may invest.  If good enterprise governance is a subjective and moving target then it is harder to evaluate abnd discpline SOEs either as political actors or as commercial agents. Lastly, the structures to protect against corruption, both systemic and personal, must be heightened,  That requires a substantial expenditure of resources and constant vigilance.  On the one hand this siphons resources from other activities, on the other this may be necessary as a base cost for operating under the political framework on which the state is founded.

Komesaroff worries, and rightly so, that the great political reforms of Deng Xiaoping, and his setting of the current framework of Chinese political economy may be eroding in the face of pressure form both the left and right in China. That would be both lamentable and contrary to the principles on which the CCP currently operates it might seem.
“The key lies in building a high-quality cadre contingent that includes Party and government cadres, cadres in management functions in enterprises, cadres in the areas of science and technology.”  The slogan of “separating Party from government” has all but disappeared from political discourse. Talk about merging Party and government departments with similar functions.
Kpmesaroff illustrates these problems by looking at the economics and political factors in Chinalso's share raid on Rio Tinto.
Acquisition of 9% in 2008 at a time China was complaining about iron ore monopoly and BHP were moving on Rio. Combined BHP Rio would have controlled >50% of seaborne iron ore market which was seen to be to China’s disadvantage. Beauty parade of national champions decided who would represent China. Chinalco probably over paid, but they did block BHP. National objective achieved but probably not commercial basis
Of course, rather than show a weakness, this example may suggest the difference in the metrics used to gauge success when dealing with issues of welfare maximization in state owned enterprises.  Thus, Komesaroff is absolutely correct to point out that from a purely private perspective, Chinalco overpaid for Rio Tinto.  But Chinalco is not a purely private enterprise.  And it may be possible to define that difference between the price paid and the "private transaction price" as something like a "national interest premium".  If that is the case, then one would have to assume, and I think quite reasonably, that national interest can be valued.  If that is the case, then whether Chinalco overpaid would have to be based on the sum of the estimate of the reasonable range of private market price and a reasonable range of national interest pricing.  I leave the details to economists and accountants.  But I think the theory is sound.  In order to assess the value of Chinese sovereign investing, one has to be able to calculate the value -against price paid) for the national interest premium, and to assume that such a national interest has value, and value that can be measured (if only roughly). If that is the case, then the project of assessing the efficiency and utility of SOEs may more closely match their raality (and we can stop pretending that these enterprises are private and must be assessed accordingly). Once one can distinguish a national interest premium, assessment of SOEs will be easier and also more sophisticated.

Komesaroff concludes that SOEs fail because they believe their successful domestic model is universal and can be replicated overseas without change. They seek to vertically integrate across the project delivery chain on this basis while expecting foreign governments to broker social relations (exporting internal Chinese notions of government cultures abroad to weak non-Socialist governance zones).  And most importantly, because of the magnitude of their own internal success Chinese SOEs do not work to capture foreign learning experiences.  These are lessons Chinese SOEs ought to take to heart.  More importantly, these are lessons that the CCP ought to consider carefully.  Indeed, the profound insight that led to the current campaign of socialism with Chinese characteristics ought to remind CCP leaders that the same insight applies with equal force within the territories of other states where the Chinese way and its presumptions and values may be as awkwardly applied as Western notions of governance within China. 

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