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October 14, 2004

Special Report - China - Northeast

Revitalisation of Northeast China through SOE Reform - Hong Kong's Position and Strategy
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Executive Summary

  • The Chinese government is determined to revitalise the old industry base of Northeast China -- Liaoning, Jilin and Heilongjiang. In this connection, foreign investment is welcomed to restructure the state-owned enterprises (SOEs), even the large and profitable SOEs that were kept out from foreign participation in previous reforms.

  • To facilitate merger and acquisition (M&A) of SOEs, the Chinese government has issued three new regulations since 2002. Under these regulations, foreign investors can purchase both "state-owned shares" and "legal person shares" of SOEs. No limit is imposed on the amount of shareholdings that foreign investors may acquire except some as subject to the Catalogue Guiding Foreign Investment in Industries.

  • Hong Kong has been the largest investor in the Northeast. Hong Kong companies, including New World Development, Cheung Kong and Wharf, have invested billions of dollars-worth of projects in the Northeast, mostly in the hotel, tourism, retail and manufacturing sectors to take advantage of the market potential of the region. Capitalising on the latest SOE reform measures, Hong Kong companies can consider acquiring full or partial stakes in good quality SOEs in the Northeast to expand the scope and geographic spread of their business in China.

  • Investing in SOEs is a quick way to expand production capacity and obtain the required critical mass of customers to start a profitable business in China. For example, Shui On Group has successfully acquired and turned ailing SOEs around to build up its own cement production empire. It is now one of China's top three cement producers. According to Shui On, the costs of acquiring an existing plant is significantly lower than building a new plant, and the old plant can start production much faster than building a new plant.

  • By contributing capital, management and technical expertise, Hong Kong companies can benefit from the good quality assets, real estates, local sales network and readily available production capacities of the SOEs. Hong Kong companies can model on the successful experience of their counterparts in formulating development strategies in the Northeast. Given the strengths of the Northeast in heavy industries and natural resources, a number of multinational corporations like Sony, LG, General Electric and Volkswagen have been very active in expanding their presence in the Northeast.

  • Besides, Hong Kong will continue to be the most preferred financial market for capital raising and a platform for attracting foreign investment and matching foreign investors with mainland SOEs. Hong Kong, with a pool of professional services providers including accountants, bankers, management consultants and lawyers, can play the role of a service centre to complement the Northeast's industrial development and SOE restructuring. Moreover, Hong Kong can utilise its sales network, international connections and readily accessible market intelligence and act as a springboard for SOEs to develop international markets.

I. Revitalising the Northeast Rust Belt


Northeast China, which consists of Heilongjiang, Liaoning and Jilin, is the country's old industrial base. However, dragged by the legacy of a planned economy1 , the region's contribution of industrial output value to the national total decreased from a remarkable 17% in 1978 to 9% in 2002.






Major Economic Indicators of Northeast Provinces (2003)





Northeast Total

Land Area* (sq. km)




(8% of national total)

Population (million)




(8% of national total)

GDP (RMB billion)




(11% of national total)

GDP per capita (RMB)




(national average: 9,073)

Gross Industrial Output* (RMB billion)




(9% of national total)

FDI (US$ million)




(6% of national total)

Exports (US$ billion)




(4% of national total)

Source: Statistical Yearbooks of China and Various Provinces, 2003
* 2002 figures

Major Industries of Northeast China


Major Industries

Liaoning Petroleum processing, Smelting & pressing of ferrous metals, Electronic & telecommunications equipment, Chemical raw materials & chemical products
Heilongjiang Petroleum processing, Food processing, Machinery, Transport equipment
Jilin Automobile, Chemical raw materials & chemical products, Medical & pharmaceutical products
Source: Statistical Yearbooks of China and Various Provinces, 2003

State-owned enterprise (SOE) reform has taken a relatively slow pace in Northeast China due to is its high concentration of large enterprises, particularly heavy and resources-based industries that were kept under state management and control in previous reforms. A large number of large SOEs in the Northeast are now facing problems of outdated facilities, technology and management. Many of them are operating in loss and some are even near bankruptcy. In 2002, about 40% (371 out of 900) of the large SOEs and their subsidiaries in Northeast China recorded losses. In addition, the liability-asset ratio of SOEs in Liaoning, Jilin and Heilongjiang was 81.8%, 90.6% and 92.5% respectively, far above the national average of 64.8%.

In view of this, revitalising the old industrial base of Northeast China was put on top of the central government's agenda at the 16th Communist Party Congress in November 2002. By speeding up the restructuring of SOEs and attracting investment by foreign companies, China aims to rebuild the Northeast region into a competitive industrial base of essential equipments and raw materials. In April 2004, four major cities - Harbin, Changchun, Shenyang, Dalian - in the Northeast held their first meeting to push forward coordination and cooperation in their development to be a corridor of modern essential equipment industries like automobile, ship, aero engine, robot, military equipment, electric generator, etc. It is hoped that the Northeast will once again become an important regional economic powerhouse of China, along with the Pearl River Delta, the Yangtze River Delta and the Bohai Region.

II. SOE Reform in the Northeast

Given the overwhelming significance of SOEs in Northeast China's economy, success in revitalising the old industrial base will to a large extent rely on how far the SOEs are being reformed. The recent switch of the SOE reform focus from restructuring small- and medium-sized SOEs to larger ones is going to give a positive impact and new impetus to the Northeast region.

According to the State-owned Assets Supervision and Administration Commission (SASAC), along with the national SOE reform process, SOEs in the Northeast should in general adopt a more market-oriented development approach. These market-oriented approaches include speeding up the privatisation process by encouraging foreign investment, modernising internal management structure to make it compatible with modern business operation, introducing a social security system etc.

1. Foreign Investment in SOEs

One of the latest and most important initiatives of the current phase of SOE reform is that most of the state-monopolised sectors, except for some backbone industries or those concerning national security, will be opened to private investors (both domestic or overseas) via mergers and acquisitions (M&A). The major purpose of this policy is not only to facilitate foreign capital inflow to the country, but also to facilitate the transfer of advanced technology and management know-how from foreign investors, thus helping the country's large and competitive SOEs, including Daqing Oilfield Company Limited, Anshan Iron and Steel Group Corporation and China First Automobile Group of the Northeast, to become internationally competitive.

The regulatory framework for using foreign capital in restructuring SOEs is encompassed in three new regulations introduced since 2002:

  • Provisional Regulation on the Use of Foreign Capital Restructuring SOEs (利用外資改組國有企業暫行規定) jointly issued by the State Economic and Trade Commission (SETC), Ministry of Finance, State Administration for Industry and Commerce and State Administration of Foreign Exchange;
  • The Management Rules on Acquisition of Listed Companies (上市公司收購管理辦法) issued by the Ministry of Finance and the China Securities Regulatory Commission (CSRC);
  • Circular on Issues Concerning the Transfer of State-owned Shares and Legal Person Shares of Listed Companies to Foreign Investor (關於向外商轉讓上市公司國有股和法人股有關問題通知) promulgated by SETC and CSRC.

With reference to these regulations, foreign investors can purchase both "state-owned shares" (i.e. shares held by the state itself) and "legal person shares" (i.e. shares held indirectly by other Chinese entities typically controlled by the state) in SOEs, and there is no limit on the size of the shareholdings that foreign investors may acquire except for those industries of key importance to national or economic security as subject to the Catalogue Guiding Foreign Investment in Industries (外商投資產業指導目錄).

In response to the new rules on allowing foreign acquisition of SOEs, in July 2003, Grandtour Tire (China) Investment Company Limited, a unit of Singapore's Grandtour Tire Group, acquired a 44.3% stake, or 151.07 million state-owned legal person shares, in Heilongjiang's Hualin Tire Company Limited for RMB 97.89 million (US$11.84 million). This was the first M&A of an SOE by a foreign investor in China.

To attract M&A of SOEs, local governments in the Northeast region have introduced incentives such as exemption of value-added tax (VAT) for equipment in eight heavy industries, namely equipment manufacturing, petrochemical, smelting and pressing of metals, ship building, automobile manufacturing, agricultural products processing, military equipment and high-tech industry. Apart from the VAT exemption, different preferential tax treatments are also given by different provinces and cities. For example, those foreign-funded enterprises that are engaging in the construction of infrastructure facilities such as transportation, energy and communications in Shenyang, and are planning to operate for a period of more than 15 years will be granted preferential treatment in enterprise profit tax.

2. Management Reforms

Recently, the Chinese government has put its focus of SOE reform on the issue of management reform and business leadership so as to make the management structure of SOEs more compatible with those of modern corporations. Gone is the iron rice bowl for SOE leaders. In January 2004, a comprehensive set of performance standards was introduced to ensure high performance of the executives of China's 189 central SOEs. Executives of these SOEs must sign contracts with SASAC guaranteeing financial performance and those who fail to achieve the target will face pay cuts or dismissal.

A related initiative is the open recruitment for professional managers from a worldwide scope. In so doing, managers of SOEs will no longer be appointed, but will be recruited from the public (both local or overseas) on a fair basis to attract professional management talents. In line with this policy, China United Telecommunications Corporation has made 27 senior management posts available to the public (both local and overseas), accounting for 12.5% of the total number of senior management staff. Reportedly, more than 1,300 management posts in central SOEs and 25,000 management posts at the subsidiary level will be recruited openly in future.

To speed up the personnel reform process, SASAC hosted a large-scale recruitment campaign in 2003 to help six big SOEs in recruiting seven senior executive posts, including deputy general managers and chief accountants. In the first round of the open recruitment campaign, 463 applicants competed for the seven positions, including 17 foreign residents, although none of them won out finally. However, SASAC confirmed that this process is going to expand in 2004 to include more major SOEs.

3. Social Safety Net for SOE Workers

Since China began restructuring the SOEs on a large scale in the 1990s, as many as 45 million workers have lost their jobs. According to the Labour & Social Security Ministry, reforms are expected to cost some three million jobs a year until 2006. The situation is even worse in Northeast China, where from 1997 to 2002, one-in-four of the 34 million redundant SOE workers in China were laid off in the region.

In view of the above, the Chinese government has planned to improve the social security system in parallel with the SOE reform. In particular, the State Council has chosen the Northeast provinces of Liaoning, Heilongjiang and Jilin as pilots in the social security system reform. These pilot projects include improving the basic old-age insurance system, speeding up development of workers' compensation insurance and maternity insurance, exploring ways to reform the social security system for state organisations and institutions, and setting up a system of subsistence allowances for rural residents where conditions permit.

4. Unloading SOEs' Social Services Obligations

Traditionally, large SOEs operate like a self-contained society with all sorts of social services provided to their employees (企業辦社會). For example, it is estimated that there are in total about 11,000 primary schools and 6,100 hospitals owned and run by SOEs, creating a tremendous cost burden of about RMB 45.6 billion a year to SOEs around the country.

By the end of 2002, SOEs in the Northeast still had 7,183 social services units including schools, nurseries and hospitals, with a total number of 491,000 employees and annual subsidies of RMB 15.8 billion, accounting for 26%, 28.4% and 33.7% of the national total respectively.

In view of the above, the Chinese government kicked off a pilot reform in Northeast China in 2001 which aimed at separating SOEs from those social services units (主輔分離), so that SOEs can discard and transfer unessential social services responsibilities to local governments and focus on their core businesses.

III. Direct Investment Opportunities for Hong Kong Companies

Hong Kong is the largest investor in Northeast China. Hong Kong companies including Cheung Kong (Holdings) Limited, The Wharf (Holdings) Limited and New World Development Company Limited have invested extensively in the Northeast region, mostly in the hotel, tourism, retail and manufacturing sectors. Under the latest government policy of revitalising the old industrial base of the Northeast, Hong Kong companies will benefit from new investment opportunities in sectors that were controlled or monopolised by the state, in particular those that have arisen from the accelerated restructuring of SOEs in the Northeast.

With a view to improving competitiveness and efficiency of the SOEs, foreign investment is encouraged even in the large and profitable SOEs. Capitalising on this new development, Hong Kong companies may choose to acquire full or partial stake of SOEs to take advantage of their assets for immediate production and further growth.

Drawing upon the successful experience of Hong Kong companies that have invested in SOEs, acquiring an existing SOE is a good option if sufficient due diligence is made in assessing the assets and liabilities position of the SOE, and liaising the terms of investment contract.

For example, Hong Kong's Shui On Group has been actively investing in cement production facilities in Chonqing, Guizhou and Nanjing to grasp opportunities that have arisen from the mainland's infrastructure boom. Instead of building new cement production plants from scratch, Shui On chose to acquire existing production capacity of SOEs. Shui On's strategy has proved successful. By now, it has acquired a total of 12 state-owned cement plants. With revenues of more than US$100 million generated from these cement plants in 2002, Shui On is now one of the top three cement producers in China, with a total production capacity of around 7.5 million tonnes per year.

According to Shui On, the advantages of acquiring existing state-owned cement plants include: (1) Lower costs. For example, when Shui On acquired Diwei Cement in Chongqing in 2001, the acquisition cost was only US$20 per ton of production capacity, or just about a third of the cost of building a new cement plant in China. Even after the cost of bank loans and guarantees, the costs involved in acquiring an old plant are still significantly cheaper than building a new one. (2) Shorter operation lead time. By buying an existing plant, even if it needs renovation and installation of new equipment, the old plant can start producing and sell cement faster than a newly built plant.

In another example, Towngas is able to participate in gas supply projects in China by forming joint ventures with SOEs. In 2002, Towngas formed a joint venture with the state-owned Wuhan Gas & Heat Group. The joint venture, which initially involved a capital outlay of RMB 240 million for pipeline construction, will enjoy 50 years of exclusive rights for piped-gas supply for Wuhan's urban population of more than four million. Under the joint venture agreement, Towngas will invest a total of RMB1.2 billion in the project and own the management rights to the project. With the management rights, Towngas is able to apply its management and technical expertise to the project.

While foreign investors are only allowed to participate in natural gas projects through joint ventures with Chinese partners, Towngas has been using a similar partnership model of the Wuhan project in expanding its business ventures in the Pearl River Delta, Jiangsu and Shandong. So far, all its partnership arrangements are satisfactory and Towngas has plans to increase investment in 20-30 projects in China, each has exclusive rights of operation for 50 years. One of these projects will be investing RMB 2 billion in Harbin Fuel Gas & Chemical Industry Co. in consideration of the high level of energy demand in Heilongjiang.

In general, investing in SOEs is a quick way to expand production capacity and obtain the required critical mass of customers to start a profitable business. It is especially true for utilities companies. Since both the service supply infrastructure like pipe and telephone lines network as well as the minimum threshold of customers will need years to become established, it is advantageous to partner up with an existing supplier. By contributing their capital, management and technical expertise, Hong Kong companies can benefit from the market entry licence, good quality assets, real estates, readily available production capacities, local sales network and government connections of the SOE partners.

Even though there is sometimes resistance to change from existing staff and workers of the SOE, in order to provide sufficient incentives and motivation to the SOE partner to help push through the restructuring measures and business development initiatives, it is suggested by veteran investors to let the Chinese partner to have sufficiently large shareholdings in the joint venture, while the foreign partner should have a controlling share to ensure its management autonomy.

Given the strengths of the Northeast, especially in heavy industries and natural resources, a number of multinational corporations, including Sony, Toshiba and Canon from Japan; LG from Korea; General Electric from the US; and Volkswagen from Germany, have already set up production plants in the region. Other multinationals such as Toshiba, Sanyo, Siemens and Pfizer have set up different types of cooperative relations with SOEs to fund the old industrial base in Northeast China.

Although Hong Kong does not have much heavy industry, which is the key feature of the Northeast region, it is not short of knowledgeable investors in businesses such as aluminum and auto making. In addition, there are other sectors in the Northeast that fall within the interests of Hong Kong companies such as retail and wholesale, entertainment, tourism, real estate and infrastructure projects which are expanding rapidly in the region. Hong Kong companies can model themselves on the successful experience of other companies in formulating their development strategies in the Northeast. Investing in the Northeast, Hong Kong companies can diversify the scope and geographic spread of their business, can expand vertically to include raw materials to increase their production efficiency and tap into the huge regional domestic market as well as neighbouring markets in Russia, Korea and Japan.

IV. Demand of Service Supports in the Revitalisation Process and the Position of Hong Kong

At present, services account for only 37% of the GDP of Northeast China. However, in the course of restructuring of the SOEs and speeding up development of the Northeast region, there will be strong demand for supportive services including commerce, logistics, financial, accounting, legal and other professional services. In view of this, the Chinese government has included development of service industries as one of the implementation strategies to revitalise the old industrial base of Northeast China.

Demand for Hong Kong's Professional Services

With services accounting for 87.5% of Hong Kong's GDP, Hong Kong can play the role of a service centre to complement the development needs and SOE reforms of the Northeast.

For example, SOEs in the Northeast in general have inadequate knowledge and understanding of market-oriented business practices. To push forward the SOE structural reforms, it is necessary to strengthen the SOEs' ability in business management, financial management, procurement and marketing, human resources management, etc. Hong Kong service providers can undertake consultancy projects to help SOEs to improve in these aspects, and to improve their overall efficiency and competitiveness.

In addition, Hong Kong has developed a strong pool of sophisticated professional service providers, including accountants, bankers and lawyers, who are able to advise and serve prospective investors in matters arising from M&A of SOEs. In order to grasp this opportunity, Deloitte Touche Tohmatsu, one of the world's largest accounting firms, has decided to invest US$1.5-2 billion in mainland China in the next five years and send knowledgeable experts to help the government in SOE restructuring and international mergers.

Hong Kong as a Springboard for SOEs to Develop International Markets

For some SOEs that would like to expand overseas and become internationally competitive, Hong Kong with its international network and professional business supports can act as a springboard for them. Sales network, international connections and ready access to market intelligence are the biggest advantages of Hong Kong, which can help potential SOEs to expand overseas or to serve international customers. By collaborating with Hong Kong companies, SOEs can collect information on the latest product trends, consumer trends and needs, and movements of their competitors in the international market.

In addition, Hong Kong is a trade fair capital and trading hub. Mainland SOEs not only can gain access to effective sourcing channels in Hong Kong, they may also set up marketing and sales operations or participate in trade fairs in Hong Kong as a means to meet overseas buyers directly and develop world markets.

Hong Kong as a Platform for Attracting Foreign Investment in SOEs

For those SOEs that are seeking listing and capital injection in international financial markets, the investment bankers, audit and accounting firms, lawyers and public relations companies in Hong Kong can provide a comprehensive package of services. In order to increase their attractiveness to international investors and leading institutions, an increasing number of SOEs have employed international investment bankers to advise on their asset restructuring and capital raising. Moreover, international business consultants are hired to conduct management training and process re-engineering, and advise on corporate image building.

On the other hand, Hong Kong companies may also capitalise on their business networks in both overseas countries and the mainland to act as an intermediary to facilitate international investors to acquire SOEs' assets. With its excellent network of connections and understanding of practices in the mainland, Hong Kong companies are in an advantageous position to act as an intermediary for foreign investors to invest in SOEs in China.

Hong Kong as a Financial Centre for SOEs to Raise Capital

In order to obtain capital, a number of companies from the Northeast have already listed in Hong Kong, including Shenyang Public Utility Holdings Company Limited, Angang New Steel Company Limited, Jilin Chemical Industrial Company Limited, Northeast Electric Development Company Limited and Harbin Power Equipment Company Limited; while some others are keen to raise funds through other means in Hong Kong's financial market.

Given the level of internationalisation of Hong Kong's financial market, and the effectiveness of Hong Kong in raising capital for the Chinese mainland, Hong Kong will continue to be the most preferred market for listings and initial public offerings of shares. At present, 98 Chinese enterprises had completed their H-shares listings on the Hong Kong Stock Exchange, with a market capitalisation of HK$312 billion. Among them, the majority are SOEs. In addition, SASAC is intending to groom 30-50 SOEs to become international giants by 2010. This, combined with the corporatisation of SOEs and the need for capital to finance M&A, would bring about a further rise in the number of listings and floatations of SOEs in Hong Kong.

Employment of Hong Kong Business Managers and Professionals by SOEs

While there is a lack of management talents in SOEs, China is now seeking world-class business leaders to turn the ailing SOEs around. To achieve this, foreigners and overseas professionals are now offered opportunities to fill up the posts of board directors and senior managerial staff, and a fair and equal competition will be guaranteed. Given the extensive international exposure that Hong Kong managers and executives have, SOEs are interested in getting Hong Kong people to take up senior positions in mainland SOEs.

Following the success of the first round of open recruitment for senior officials of SOEs in 2003, the second round started in June 2004. A total of 23 senior positions (including the posts of deputy executive directors and chief accountants) at 22 large SOEs (including Sinochem Corporation, China Shipping Group and China Chengtong Group) are open for overseas application. In particular, the chairman of SASAC has mentioned that Hong Kong, as an international financial centre, has a pool of high-quality accounting professionals who are capable of taking up the position of chief accountant in large SOEs.

In all, prospects of collaboration between Hong Kong and the Northeast in revitalising the old industrial base are bright. This is best concluded by Chinese Vice-President Zeng Qinghong's remark made during his meeting with a business delegation from Hong Kong and Macau in June 2004: "Hong Kong is always the most preferred partner for the Northeast, no matter in capital, technology, human resources or in management exchanges."

1. The shares of state-owned enterprises in industrial output in Liaoning, Jilin and Heilongjiang were among the highest in all Chinese provinces, which were 62.4%, 77.9% and 79.6% respectively in 2002 as compared to a national average of 40.8%.

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