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Farewell, Red Hats

Though privately-invested, they are registered as collectively or state-owned. In the past, they sought government sponsorship. Now, more and more are moving back to private-ownership status. All the rage during the eighties and nineties, they are quickly and quietly disappearing...

They are the Red Hats, companies whose curious ambiguity is a product of China's gear-changing economic system. The State Council is now pushing for a special re-registration program for just such businesses, and if all goes as planned, dusk will soon fall on their historical era.

In the last week of October, You Pingzhou, vice president of the Ministry of Industry and Commerce (MIC), divulged that a new registration system was being developed in order to level the playing field for businesses of all ownership status. The Economic Observer has learned that as early as the end of 2005, senior officials at the highest levels of the State Council were concerned about privately-invested firms obfuscating their ownership status. Ultimately, they left the task for developing a new registration system to the MIC.

In the beginning of this year, teams led by You fanned out across various major Chinese cities to conduct research on Red Hat businesses. The investigation revealed that during the past five years in Shandong Province alone, approximately 10,000 businesses "hung up" their Red Hats.

This past May, the MIC presented the results of their inquiry in a report that was distributed widely among various government organs including the Development and Reform Commission, the Ministry of Finance, and the Ministry of Agriculture. The MIC asked for feedback, but neither the report nor the feedback has yet been made public.

According to insiders, this document includes minute details for a new registration process. Businesses must first go to their local MIC branch to obtain an application and provide all proof of property rights. They then must wait for approval from the concerned administrating body before finally applying for a change in status.

The document is silent on who will arbitrate the property rights disputes that will be inevitable in such cases. According to one property rights lawyer interviewed for this article, this is possibly why the document has not been made public yet, and that in actual practice the Ministry of Finance, the National Asset Management and Supervision Council, industry supervisors, and local courts will all play roles in the process.

In principle, when defining property rights, whoever invested is considered the owner. But anyone with controlling interests will unlikely be willing to forfeit control of their share in rapidly developing industries. In China, neutral arbitration in property rights disputes has historically been nearly impossible.

According to the MIC registrar, statistics show that China's collectively-owned businesses reached a peak in 1995 at 5,340,000. By 2005, there were only one million.

Today, no one can say for certain how many Red Hats are left. But as early as 2003, survey by the Academy of Science's Private Industry Research Center and the National Industry and Commerce Association revealed that 50-80 percent of collectively-owned businesses were actually Red Hats. And in 1994, an MIC survey claimed that 83 percent of registered township-owned businesses were actually privately owned. 
A Page in History 
In the 1980's, "township-owned" businesses were blooming, numbering in the millions. "According to convention, a township-owned business is classified as collectively-owned. But in actuality, at that time many were owned by a single person or were opened by families with zero investment by the collective." Says Zhang Wenkui, assistant director at the State Council Development Research Center.

Why would a business wear a Red Hat? Recalls Zhang, "There's the example of one business that ran restaurants in Henan province: after registering as collective-owned, they saved 2,800 yuan in administrative expenses, were exempt from 6,300 yuan worth of taxes, and saved 3,530 yuan in adjusted personal taxes.

In Hebei province, a shoe and hat factory needed more financial backing due to financial difficulties. By becoming a subordinate branch to another collective-owned firm, they were able to apply for collective-ownership and receive a bank loan of 180,000 yuan.

In Liaoning province, a factory that produced high-quality thermal blankets in large amounts was prohibited from joining a distribution network of state-owned businesses. Instead, it first had to sell its products to an intermediary that could then directly sell to department stores.

The second wave of Red Hat companies occurred in the years before Deng Xiaoping's 1992 southern tour. Zhang explains, "They were afraid that there would be another round of "stomping out capitalism", so private businesses lined up to register as collective-owned." In Guangdong province during the early nineties, approximately 80 percent of proprietors sought to change their ownership status from private to collective.

Deng Xiaoping's southern lecture tour was indeed a turning point. By the mid-nineties, businesses all over China were hanging up their Red Hats. According to an official with the Zhejiang Private Industry Economic Associations, due to changes to Zhejiang province's economic system in the last half of 1999, over 3,000 businesses changed their status to private-ownership as part of a scheme to have all businesses own up to their status within three years. Today, 80 percent of Zhejiang's collectives have already done so.

Simultaneously however, businesses began to re-register as collective-owned. According to Zhang, at that time the political environment had improved enormously, and few private businesses worried about property rights. But in real economic terms private businesses still faced many obstacles.

After the mid-nineties, the new flood of private businesses went to work. But foreign trading rights were not completely opened to them and government rules for requisitioning land was also unfavorable. Furthermore, there were still difficulties obtaining loans that state-owned and collectively-owned businesses did not have.

"People were overjoyed to hang up their hats when Deng Xiaoping visited. Everyone felt that it was perfectly justifiable; what they earned was theirs. There was no longer a need to masquerade. But after they changed status, they realized that the difficulties of private-ownership were still there. Thus, the new wave of Red Hats began again." says Zhang. "Many of these businesses had very little but highly diversified capital when they first formed. As they developed and increased their assets under one manager, it became more and more difficult to concretely distinguish ownership over the firm’s assets. Knowing that a difficult dispute would arise, many still have held off deciding.

According to IMC research, in 2005 only 0.24 percent of collectively-owned businesses changed their status. This is likely because of difficulty regarding property rights.

During the nineties, especially in Jiangsu province, many property rights disputes were settled through Management Buyouts (MBO). Jiangsu's Sha Steel is a classic example. But other times it only came after protracted lawsuits that ultimately led to the collapse of the business, with the initial investors forced out.

Zhang explains why: "It's simple: If the original investor leaves with profits and the business is ruled as a collective-owned, then that investor will be accountable for the embezzlement of public funds. Only if it is ruled as a privately-owned business will have the right to have done so... If during the process the initial investor does not properly compensate interested parties, it will end tragically." Ma Guangyuan, an attorney from Shanghai Tongli Law Firm, adds, "This kind of company can be found everywhere."

Thus, businesses are now looking for flexibility. Ma recently represented a junior branch of a publishing house. At that time it was not possible for a private investor to run a publishing company so they used the larger publishing house as an umbrella. As a result of the restructuring process, the original investor only retained a 30 percent share in the firm while the publishing house retained 40 percent.

Ma predicts that Red Hats won't be around for long. "Many people have gone through difficult times. The current Thirty-six Conditions are not good, with many markets impenetrable for private businesses. Investors will not be able to avoid problems with murky ownership status, and will thus choose to invest in state-owned companies instead.'

But just because the Red Hats are becoming history doesn't mean that Chinese firms won't wear another kind of hat instead. More and more companies are registering abroad in places like the Isle. of Man while simultaneously managing their firm domestically. "They're looking for protection and favorable policy." says Zhang.

Perhaps this is not so strange after all. But if companies start wearing "Sea Hats", when will they start taking them off?

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