Report No. PIC5164 Project Name China-Wuhan/Huangshi Enterprise Reform Project (+) Region East Asia and Pacific Sector Industry Project ID CNPE3576 Public Disclosure Authorized Borrower Government of the People's Republic of China Beneficiaries Non-State and Transformed State-Owned Enterprises, Municipalities Tentative Financing Plan IBRD US$100 m Enterprise Self-Generated Funds US$ 15 m Domestic Banks US$ 42 m Municipal Governments US$ 3 m Total US$ 160 m Contact Mr. Zhang Weixian Public Disclosure Authorized Hubei Provincial Government Shui Guo Hu Wuhan, Hubei 86-27-7811487 (Fax) Board Date May 19, 1998 Background 1. The Hubei Provincial Government has proposed a project to finance state-owned enterprise (SOE) reform in the province's two largest cities, Wuhan and Huangshi. Wuhan, with a population of about 7 million in 1995, is the capital of Hubei Province and one Public Disclosure Authorized of the 18 cities designated for "comprehensive reform" by the Central Government. Its location on the banks of the Yangtze River and its road and railroad connections to the major cities of the north, the east, the west and the south, make it a potential hub of commerce and industry in central China. Huangshi, with a population of about 1.4 million in 1995, is also located on the banks of the Yangtze River about 100 kms south-east of Wuhan. Having been declared an open city by the Central Government, Huangshi has established access to international business through its developed ports and customs. Inclusion of Huangshi, a medium-size dynamic city, in the project is expected to create a healthy competition between the two cities in project preparation and implementation. 2. Between 1980-1994, the average annual GDP growth rates in China, Hubei, Wuhan and Huangshi were 9.94%, 9.95%, 9.40% and Public Disclosure Authorized 7.10%, respectively. The pattern of the economic development in Hubei and its two cities reflects the changes in the Central Government's economic policies. From 1978 through 1991, the Central Government's policy favored the economic development in the coastal provinces and cities. However, as of 1992, these liberal and reform-oriented policies were extended to inland provinces in order to achieve a more regionally balanced development. Accordingly, while Hubei's average annual GDP growth rate lagged behind the national average by 1.5% during 1980-1991, it exceeded the national average by almost 1.7% during 1992-1994. Wuhan and Huangshi's GDP growth rates exhibited a similar pattern during this period, with Wuhan changing from -1.2% to +3.1% and Huangshi changing from -4.7% to about -2% as compared to the national average. 3. As elsewhere in China, the economic development resulted in a dramatic change in the economic structure of Hubei and the two cities. The following table depicts these changes. Economic Structure of China, Hubei, Wuhan and Huangshi Shares of GDP by Sector (in percent) Agriculture Industry Trade & Services 1980 1994 1980 1994 1980 1994 China 30.1 21.0 48.5 47.3 21.4 31.7 Hubei 35.7 26.7 46.0 43.2 18.3 30.1 Wuhan 10.9 9.1 64.6 49.9 24.5 41.0 Huangshi 13.0 10.7 66.6 55.5 20.4 33.8 Despite the rapid growth of the trade and services sector in Wuhan and Huangshi, the industry sector remains dominant in both cities, reflecting both cities' traditional industrial development which has been based on their human and natural resources. However, because of the municipal governments' recent policies, the ownership structure of industry is rapidly changing as a result of a faster growth rate of the industrial enterprises in the non-state sector than that of those in the state sector. In 1992, the shares of the state, collectives and non-state sectors in Wuhan's industrial output were 73.1%, 21.3% and 5.6%, respectively. In 1994, while the state sector's share had decreased to 61.19, that of the collectives and non-state sector had increased to 25.6% and 13.3%, respectively. A more dramatic change took place in Huangshi, with the state sector's share dropping from 73.7% to 49.9%, the collectives' share decreasing marginally (from 20.9% to 19.8%), and the non-state sector's share increasing from 5.4% to 30.3%. 4. The Bank's relationship with the Hubei Province began in the early 1980s, when the province and Wuhan City cooperated with the Bank in its economic and sector work on China by providing valuable data and information. More recently, Wuhan was selected as one of the five cities included in the Bank's 1995 study on SOE reform (See 1/). By providing detailed information on 28 enterprises, Wuhan participated in this study. The Bank's recent lending operations to the province comprise two projects: (i) the Medium-Sized Cities Development Project (See 2/) that supported three cities (including Shashi, -2 - a small city in Hubei with a population of about 0.3 million) in improving their capabilities in sector management and planning, and in municipal services; and (ii) the Hubei Urban Environmental Project (See 3/) . The latter is relevant to and supports the proposed project since it finances improvements in the environmental conditions of Hubei's four major cities, namely, Wuhan, Huangshi, Xiangfan, and Yichang. Enterprise Sector Issues and Government Strategy 5. In 1978, the non-financial service sector was very small and the industry sector, accounting for 48.2% of GDP, was highly dominated by SOEs which accounted for over 80% of the industrial output. The liberalization of the economy and the concurrent emergence and rapid growth of the non-state sector has dramatically changed the structure of the enterprise sector. For instance, while the industry sector grew at an average rate of 15% (1978-1994) and accounted for 47.3% of GDP in 1994, the share of SOEs in the industrial output declined to 34%. Ever since the start of the economic reforms, the poor performance of a large number of industrial SOEs (44% of the total in 1995) has been a major concern to the Government. As a result of the gradual reform measures implemented by the Government during 1978-1994, the combined budget and financial sector subsidies to SOEs declined from a peak of 10.2% of GDP in 1987 to 4.0% in 1994. Nevertheless, the Government continues to emphasize SOE reform by making it the focal point of its structural reform program during the Ninth Five-Year-Plan (1996-2000). 6. The existing policy and legal framework enables the development and implementation of reasonable SOE reform programs. It allows, inter alia: (i) divestiture (See 4/) (privatization) of all small SOEs and some medium SOEs; (ii) conversion of medium and large SOEs into companies under the Company Law, and equity participation of the non-state sector in such conversions, except for the core SOEs; (iii) separation of the government from the enterprises either through divestiture or conversion; (iv) imposition of hard budget constraints on all but strategic enterprises; and (v) reduction of social burdens of enterprises, including detachment of social services and facilities from SOEs. 7. In 1994, there were approximately 87,000 industrial SOEs in China with a total employment of about 53 million people. Excluding the construction industry SOEs (about 7,250) for which break-down data are not available, the balance of the industrial SOE sector comprised about 4,000 large, 10,500 medium and 65,200 small enterprises. Given the extensive size of the SOE sector and the social and political implications of enterprise reform, the major strategic issue facing the Government is how, where, and when to implement its reform agenda. In 1993, the Government announced its 10,000-1,000-100-10 program for SOE reform. But in 1995, in a bolder move, the Government announced that it would retain the largest 1,000 or so enterprises and "throw [the rest] out to sea," by which was meant ownership diversification, divestiture, mergers, leasing, joint venture arrangements, and conversion to collectives. - 3 - The 10 (now 18) cities designated for comprehensive reform and the 100 large-size SOEs to be restructured under the 1993 program have been identified. The progress made in the implementation of the reforms in some of the cities and enterprises has been modest. As far as the 1995 program is concerned, the Government has not yet formulated the necessary strategic plans to implement this program, but intends to do so by first developing appropriate selection criteria and implementation methodologies through experimentation. The proposed project fits this objective and, thus, is supported by the Government. Project Objectives 8. The principal objective of the proposed project is to increase the efficiency of the manufacturing and service sectors in Wuhan and Huangshi. Specifically, the project would focus on: (a) addressing the unfinished agenda in SOE reform through: (i) divestiture of all small and some medium municipally-owned state enterprises (MCEs); (ii) conversion of medium/large MCEs into companies under the Company Law, and introduction of non-state shareholdings; (iii) programs and policies to reduce SOE losses, including liquidation of value-subtracting medium/large MCEs; (iv) establishing in Huangshi and restructuring and developing in Wuhan the state assets management system and improved governance and management of SOEs; and (v) preparing for the transfer of pension, education and housing responsibilities to government authorities; and (b) improving access of private and privatized enterprises and reformed MCEs to long-term credit through : (i) a line of credit to local banks; and (ii) improvements in banks' capacities in project Project Design 9.