Report No. PIC5164

Project Name China-/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 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 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 .

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. The agreed project, blessed by the Central Government, will have two major components: (a) the municipal reform component; and (b) the enterprise reform component. The project would provide financial support to the former through a technical assistance loan and to the latter through a line of credit.

10 Municipal Reform Component. Reorganization and reorientation of the economic departments of the municipal governments are essential to the success of the project. In each municipality, the project will develop a program and a time-bound action plan for this purpose. The program would first articulate the municipal government's market-oriented economic policy and strategy in the medium-term, including investment policies and imposition of hard budget constraint on municipally-controlled state-owned enterprises (MCEs). The program would then specify a number of measures for implementation in the enterprise sector, including: (i) equal treatment of all types of ownership; (ii) removal of obstacles to entry and exit; (iii) facilitation of voluntary mergers and acquisitions; and (iv) rationalization of the management of the state assets to meet the requirements of the reforms specified under the Enterprise Reform Component. Reorientation of the governments necessitates systemic changes, staff training and acquisition of modern technologies in a number of areas.

- 4 - 11. Enterprise Reform Component. The Municipal Governments of Wuhan and Huangshi will implement the following reform measures in MCEs that operate in the manufacturing and service sectors:

- Divestiture of all small MCEs and a number of medium MCEs, and allocation of the net proceeds from such divestitures primarily to the social aspects of enterprise reform;

- Conversion of a number of medium/large MCEs into companies, under the Company Law and with the participation of the non-state sector;

- Liquidation of value-subtracting medium/large MCEs and conversion of the rest into companies under the Company Law;

- Establishment of local support institutions for divested/converted MCEs and non-state enterprises, on the basis of their needs;

- Development and implementation of a sound social security system at municipal level, with emphasis on retirement and unemployment benefits;

- Development of alternative mechanisms for the detachment of social facilities and services from medium/large MCEs and the design of an implementation program; and

- Development of alternative mechanisms for the reduction of redundant labor.

12. As of the end of 1995, the small MCEs in the manufacturing and service sectors of Wuhan and Huangshi numbered 968 and 194, respectively. An ongoing enterprise review of some 120 medium/large MCEs, in Wuhan and Huangshi's manufacturing sector, will classify these enterprises into viable, non-viable but potentially viable, and value-subtracting categories. Upon the completion of this review, the municipal governments will develop a time-bound action plan for the divestiture of small and some medium MCEs, conversion of viable and potentially viable medium/large MCEs, and liquidation of value-subtracting medium/large MCEs. This program will be implemented during the Ninth Five-Year-Plan. Concurrent with the implementation of this program, local support institutions for divested/converted MCEs will be established, a sound social security system will be put in place, and alternative mechanisms for the detachment of social facilities/services and the reduction of redundant labor will be developed and tested.

13. Under the project, a line of credit [in the amount of US$ 85 million] will be established to finance restructuring and/or expansion of divested/converted MCEs and non-state enterprises, in the manufacturing and service sectors, on a competitive basis. At least three commercial banks will be identified by the Bank, in consultation with the local authorities, to play the full financial intermediation role that would include bearing full credit risks on subprojects financed under the credit line. The identified banks

- 5 - should have the resources and capabilities to meet the Bank's requirements for sub-lending. The eligibility criteria for selection of subprojects and the appraisal methodology to be applied by the participating banks will be agreed upon by these banks and the Bank during project preparation. The local branches of six national commercial banks, with varying degrees of autonomy, have met collectively and individually with the identification mission. Having been fully informed of the project objectives and design, all six banks have shown interest in the project and have expressed their willingness to be appraised by the Bank.

14. The International Finance Corporation (IFC) has shown interest in participating in this project. IFC will probably select a few municipally-controlled enterprises for transformation into companies with the participation of domestic non-state sector and/or foreign investors (para 20, second item). It will then help develop and implement a full restructuring program for each of the selected companies.

Project Financing

15. A Bank loan of US$100 million is envisaged in the China lending program, of which up to US$ 15 million will be used to support the technical assistance program. The balance will be onlent to eligible enterprises through the PFIs under the line of credit component. Assuming a foreign/domestic cost ratio of 3/2 for restructuring subprojects, this amount could support a total investment of about US$ 145 million.

Project Implementation

16. At the provincial level, a project management office, headed by the Provincial Deputy General Secretary, will have the overall responsibility for project coordination and liaison with the Central Government and the Bank. In each municipality, a project management office, headed by a vice mayor will be responsible for project preparation and implementation. The project management offices have been established and staffed. Since the province and the two municipalities are involved in the Bank's Hubei Urban Environmental Project, the staff of the project management offices are already familiar with the Bank's processes and procedures. To increase the awareness and knowledge of the governments' senior officials and the managers of participating financial institutions in enterprise reform issues, an international workshop on "Effective Enterprise Reform at Municipal Level in China" will be held in Wuhan during April/May, 1997. The Central Government, the Hubei Authorities and the Bank have agreed on the workshop's objectives and program.

17. For effective project preparation, provision of external technical assistance services and modern office equipment to the project management offices is a necessity. Under a grant made available to the Bank by the Government of Japan (the PHRD Fund), the sum of 71,400,000 yen has been approved for financing the foreign exchange requirements of the preparatory work for the

- 6 - project. The Central Government and the Bank have agreed that the project entities would execute 60% of the grant and the Bank would execute the remaining 40%.

18. The Bank will use the funds at its disposal for engaging international consultants to: (i) review the enterprise sector, with particular emphasis on medium/large MCEs in the manufacturing sector, and identify the sector's strengths and weaknesses; (ii) assist the municipalities in the development of their respective reform agenda and action plan; (iii) develop eligibility criteria and appraisal methodology for processing subprojects by the participating financial institutions; and (iv) assist in the establishment of local support institutions for the divested/converted MCEs and non-state enterprises. The funds available to the project entities will support: (i) the development of procedures and programs for the divestiture of small MCEs, and the development of valuation methodologies and organizational models for converting medium/large MCEs into companies; (ii) the preparatory work for the international workshops; and (iii) the introduction of office technologies and the training of staff involved in project preparation. The project entities are expected to engage an international management consulting firm to carry out items (i) of their part under a single contract and on the basis of the terms-of-reference agreed with the Bank. The attached bar chart shows the tentative program for project preparation.

Project Benefits, Sustainability and Risks

19. Benefits. Implementation of the project's municipal reform component will result in a market-oriented approach to the management of the economy by the municipal governments in Wuhan and Huangshi. In particular, rationalization of the management of state assets would entail separating the governments' ownership functions from their policy and regulatory function. Further, the authority and responsibility for the management of an enterprise will be transferred to the governing body of that enterprise, and the respective government's ownership functions in such an enterprise will be similar to those of shareholders in western corporations.

20. Divestiture (privatization) of a relatively large number of small MCEs would not only result in efficiency gains, but would also greatly reduce the municipal responsibilities for MCE management. Participation of the non-state sector in the conversion of a number of medium/large MCEs (partial privatization) would make the transformed companies more efficient and profit-oriented, and would demonstrate how the non-state capital could be used for the enhancement of medium/large MCEs without the disposal of state assets--a very sensitive issue in the Chinese context. Successful results, expected from IFC's participation in the partial privatization process (para 23), would provide concrete evidence on the merits of this process.

21. The processes and procedures, developed and implemented for the above-mentioned divestitures and conversions, could be readily adopted by other Chinese municipalities interested in enterprise

-7 - reform. Liquidation of value-subtracting medium/large MCEs and the conversion of the remainder into corporations, with modern governance systems and effective organizational structures, is expected to result in a healthier state-owned sector. Concurrent implementation of the other reform measures, listed under the project's enterprise reform component, is a condition for the realization of the above benefits.

22. Finally, the exclusion of the non-reformed MCEs from the line of credit and the establishment of a competitive base for the use of Bank funds send a clear signal that pre-identified traditional industrial restructuring projects for SOEs are no more supported by the Bank. The participating financial institutions, which have been largely financing SOE restructuring/expansion project, will benefit from the introduction of appraisal techniques, including risk assessment, for financing divested/converted MCEs and non-state enterprises.

23. Sustainability. The reforms undertaken under the project are expected to be sustainable because: the provincial and municipal governments are fully committed to these reforms; and the Central Government, with the SOE reform as a priority in its structural reform program, is seeking pragmatic approaches for the implementation of its reform policies. Realization of the expected benefits is the best assurance for sustainability.

24. Risks. The major, but improbable, risk is the Central Government's reversal of its enterprise reform policy. At the local level, resistance to the reforms by the municipal bureaus whose authorities will diminish is likely. Such a resistance may delay project implementation but, in view of the full commitment of the local governments' leaders to the reforms, the risk of project derailment is minimal. While, on the basis of experience in , effective opposition to divestitures and conversions by MCE managers and government officials is not expected, liquidation of a value-subtracting large MCE, involving the dismissal of a large number of workers, may be problematic for both the management and the respective government. Establishment of a sound social security system would alleviate this problem and reduce the risk of the emergence of a related problem, namely, the dismissal of redundant workers in converted MCEs. Although policy lending has been separated from commercial lending and the financial institutions have been granted full autonomy in their commercial operations, there is always the risk that the governments may influence the participating financial institutions in the use of the line of credit. Involvement of these institutions in project preparation and their full understanding of the reform program would reduce this risk.

1/ World Bank, China - Reform of State-Owned Enterprises, 1995, Report No. 14924-CHA

2/ World Bank, China - Medium-Sized Cities Development Project, 1990, Report No. 7705-CHA

-8- 3/ World Bank. China - Hubei Urban Environmental Project, 1995, Report No. 14879-CHA

4/ In line with Decision 6 of the Third Plenum of the Communist Party Congress (November 1993), divestiture of small SOEs can be carried out through sale, leasing or management contracting.

Contact Point: Public Information Center The World Bank 1818 H Street N.W. Washington, D.C. 20433 Telephone No.: (202) 458-5454 Fax No.: (202) 522-1500

Note: This is information on an evolving project. Certain components may not necessarily be included in the final project.

Processed by the Public Information Center week ending May 23, 1997.

-9- Annex Environmental

The subprojects to be financed under the line of credit would be identified only during project implementation. The project has a Category B rating, as the line of credit might finance some subprojects with potentially adverse social and environmental impacts. Under the policy and administrative requirements for environmental assessment of development projects in China, EIAa, EAPs, and EAs are carried out by project sponsors. These are submitted to relevant level environmental protection bureaus for review and approval. Financial institutions are prohibited from extending loans for projects that do not have the approval certificate of the EPBs. Financial institutions participating in the project will be required to ensure that the mitigation measures recommended in the approval EAs have been adequately incorporated into the subproject feasibility studies and investment approval and loan documentation. Qualified environmental consultants would carry out annual environmental quality assurance checks of selected samples of subprojects financed under the project to assess the implementation from an environmental standpoint.

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