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For China, Two Steps Forward...


China's entry into the modern industrial world is an eternal balancing act. The country's leaders must restructure and close down unproductive state-owned enterprises while at the same time providing a social safety net for tens of millions of laid-off and retired workers. It must open up its markets to foreign competition without putting its own fledgling companies in jeopardy. As political pressure ebbs and flows, so does Beijing's reform policy.

Never have the contradictions been more apparent than in recent weeks. On Oct. 22, Beijing startled China watchers by announcing that state-owned enterprises (SOEs) would stop selling government-owned shares to the public through local stock exchanges. That signaled an abrupt halt to the further privatization of these industrial dinosaurs, which are a drag on state coffers and need to be restructured into for-profit companies.

JUGGLING. At the same time, however, China's economic managers were sending a contrary message. They allowed two foreign companies, the U.S.'s Emerson (EMR) and France's Alcatel (ALA), to buy local corporate assets in a long-protected sector of the Chinese economy, telecom equipment. The deals made it clear that China is ready to throw open its doors to the outside world as the country prepares for entry into the World Trade Organization.

There's an easy explanation for the split personality on economic reform. China's leaders are pinning their hopes for expansion on more foreign investment. But they are also desperate to ensure stability in their local enterprises and bourses. So it's two steps forward, one step back. "This is the whole nature of a transitional economy," says David Sito, an economist at HSBC in Beijing. "You're going forward juggling 14 balls, and sometimes you drop a ball, but still you've got 13 in the air."

To understand why Premier Zhu Rongji hasn't kept every ball aloft, look no further than the perilous state of China's economy. Overall profits of state enterprises rose last year because several big state-controlled energy companies got a lift from higher oil prices, while other companies got to shift bad loans off their books. But now, the sector's profit growth is slowing (charts). At the same time, China's exports have been hard hit by the global downturn. They grew only 7% in the first nine months of this year, compared with 27.8% for all of last year.

To raise cash for restructuring and to provide funding for the national pension system, state companies had begun to peddle new shares in their operations on the Shenzhen and Shanghai exchanges. But the share issues have glutted the markets. In the three months since Beijing announced the government sell-off, China's local-currency A-share markets had shed more than 30% of their value, triggering howls from increasingly hard-pressed banks and securities houses.

"A REAL SETBACK." Hence the sudden end to the sale of state-owned shares. The trouble is, while the ban may stabilize the bourses, it is a blow to the movement to privatize state companies. "This is a real setback in the SOE reform," says Shawn Xu, managing director for research at China International Capital Corp., a joint-venture investment bank between Morgan Stanley Dean Witter & Co. (MWD) and China Construction Bank. "With the state controlling 60% to 70% of listed companies, how can you build up corporate governance?"

The decision to suspend the state share sell-off hurts all the more because proceeds were also earmarked to fund pensions for those workers in defunct state-run factories who are nearing retirement age. With ailing state enterprises expected to account for some 20 million new unemployed workers annually in coming years, establishing a social safety net is crucial to China's overall social stability.

But even as Beijing backpedals on some reforms, it is pushing forward on others. Foreign investors were shocked by the announcement that Emerson had won permission from Beijing to buy 100% of Avansys, a subsidiary of Shenzhen-based Huawei Technologies Co., China's most successful private telecom-equipment maker. The $750 million purchase of Avansys, which makes power conversion products, will give Emerson much greater access to China's booming telecom market, long sheltered by regulators. "The transfer of 100% of a private Chinese company to a foreign company is truly unprecedented in China," says a banker for Morgan Stanley, which advised Huawei on the deal. Adds a Huawei official: "This is a win-win deal. It benefits us and it benefits Emerson. It also helps the government show it is opening to foreign capital."

Beijing hasn't stopped there. Just one day after the Emerson deal, the usually protectionist Information Industry Ministry announced it was selling Alcatel its stake in a joint venture that holds one-third of China's telephone switch market. The $312 million acquisition will give Alcatel a majority stake in Shanghai Bell, which is expected to generate $2 billion in sales this year.

REFORMS. In another victory for reform, Beijing on Oct. 29 announced that it would allow the asset-management companies that have taken over some $169 billion in bad bank debt to sell the distressed assets behind the debt at a steep discount to face value. The first auction will be held in mid-November. Huarong Asset Management, one of the largest holders of NPLs, has already lined up 12 international bidders, including Morgan Stanley, Merrill Lynch (MER), and Goldman Sachs (GS).

Finally, Beijing is aggressively pushing China's overseas-listed companies, which generally are the best-run on the mainland, to list on local exchanges. New York-listed oil producer Sinopec Corp. was one of the first to issue A-shares, raising $1.4 billion on the Shanghai bourse in August. Telecom players China Mobile (CHL) and China Unicom (CHU) are planning listings. Chinese punters can hardly wait. "Locals still can't get their hands on some of the best companies," says Laura Cha Shih May-lung, deputy chair of the China Securities Regulatory Commission.

So which way is China's great economic balancing act tilting? The suspension of the latest privatization program is a setback, analysts say. But in almost every other area, the drumbeat of reform continues as loud as ever. By Dexter Roberts in Beijing, with Alysha Webb in Shanghai


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