Malcolm Riddell: Okay. Ed, we were talking earlier about SOE reform, state-ownedenterprise reform. I was wondering if you could tell me what's happening now with that.

Ed Tse: As you know, Malcolm, the SOE was somewhat of a double-edged sword for the Chinese government for a long time. The SOEs have helped theChinese government drive a lot of changes in China, because as you know the SOEs are directly owned by the Chinese government.Essentially, each enterprise can carry out the orders from the Chinese government. For a long time, they have actually in a way created a lot of progress for China.

At the same time, the SOEs also have developed a number of major problems, all related to the governance or the lack of proper governance of these enterprises.Malcolm Riddell: What do you mean?

Ed Tse: What I mean is, in a "modern" enterprise, the governance usually carried out through a properly designed board of directors. That board, as you know, provides the checks and balance for the management, and to make sure that things are done in a proper way.

For many SOEs, certainly in the old days, there's no such concept.There's no such concept of a public board of directors, because the SOEs were directly owned by the state, either at the central level or at the local government level. Therefore, a lot of the directors were given directly from the SASAC, which is the state organization which is the caretaker of all the state assets. They could directly or command directions for theSOEs through the chairman, or the so-called general manager, or the CEOof the companies. From a governance standpoint, it took a long time for the SOEs to build proper governance.

Malcolm Riddell: If I understand correctly, the SOEs are also pretty independent of government orders. They're not quite as lockstep with government directives as they might be. Is that right?

Ed Tse: It depends on the sectors that the SOEs are in. If they're in more opensectors, open meaning less regulated, more competition, and so on, theSOEs need to compete with the competitors, and the competitors usually come from either the private sector and/or the multinationals. For those companies, they need to be very agile and to be very market-oriented. By definition, they are less interfered with the government.

On the other hand, as you know, in some other sectors where perhaps it's much more protected, much more monopolized, and in some casesSOEs are in sectors that are considered as national security sectors. In those sectors, certainly there is quite a bit of alignment, in fact in some cases significant alignment, between the enterprise behavior and the government policies.

Malcolm Riddell: I can certainly see that with national security, but let me give you an example. The local government officials don't always listen to the directives from Beijing. They go their own way a lot of times. My understanding is that an awful lot of SOEs do the same thing.

Ed Tse: That's true at the local levels. Certainly very true. In fact, as you know,Malcolm, that is a good cause for much of the overcapacity that we see across many sectors in China, is because many of the locally owned and locally controlled SOEs are trying to do their own things, and therefore there's a lot of repeated investment.

Malcolm Riddell: One of my favorite directives I ever saw from the NDRC was about copper smelting. I forget in which county. It was a directive to shut down a couple of underperforming copper smelters. The directive said specifically, "You can't just shut them down and then move them to another place and open them up again." I thought that gave the idea.

I understand at the local, but at the national level, can we really say that the heads of a lot of these SOEs, the ones that fall in between, not the ones that are competing hard and not the ones that are obviously a matter of national security, but do the ones that are in between sometimes thumb their noses at the directions from the center?

Ed Tse: Yeah, as you know, there's always the check and balance. How do you actually create the balance? On the one hand, the enterprise executives from these SOEs need to deliver value, deliver themselves, because they're measured by SASAC on commercial performance. At the sametime, in many cases, the government would also like them to deliver missions or certain things that is perhaps not entirely conversant.

Let's take, for example, companies in the construction industry. Ofcourse, companies need to create value by doing construction projects on a profitable basis, but nonetheless, as you also know, in some cases some of these infrastructure construction projects can be at least partially motivated by national priorities, for example, building a high speed rail. Does it make sense economically?

If you analyze this from a pure project-based feasibility standpoint, a lot 3of the high-speed rail links are not economically feasible, yet the Chinese government, in particular the SOEs who are involved in this effort,continue to build, and China is still building. It has high-speed rail across the entire country because the Chinese government think that actually beyond some simple analysis of the economic feasibility, there's a multiplier effect on the economic ramifications of having an expansive network of high-speed across all of China and even perhaps beyondChina. That's a state-level or government initiative together with some economic analysis. That's how some of the SOEs needed help.

Malcolm Riddell: We needed the same thing. President Eisenhower created the national highway system for the same kind of multiplier effect. I'm talking about something a little bit different. What I'm saying is, when you talk about governance, and if we consider that if we take the premise that SOEs just follow the directions from whatever area of central government they report to, then how and why is governance a problem at all?

Ed Tse: Governance is critical because on one hand the executives need to have a clear check and balance on the decisions that they make. Some of that has to be with respect to whether or not a certain investment is justified and is to the benefit of the enterprises. That's one function of the board.

The other function of the board is to make sure that there is enough,what's the word, transparency in the decision-making, because you don't want to end up with inappropriate behavior, and therefore inappropriate benefits for individuals, in particular for the senior people in the company. As you know, Malcolm, some of the SOEs are now known as a hotbed for corruption for the senior people. That's why [inaudible00:13:59] corporate governance are coming.

Malcolm Riddell: This is the point I'm getting at. This is the contradiction that I see. If we start with the idea that SOEs are controlled by the government, then we would assume that that means the executives in there take orders from the government and act accordingly. I don't think that's the way it works.We see resistance. We see corruption. We see all kinds of activities that are going on there. How can you put a system of governance in place if you're still taking orders from the central government?

Ed Tse: Right. When I said the government, the SOEs taking their orders from the government meaning if the government wanted to direct an enterprise ora bunch of enterprises in a certain direction, in theory the executives from the SOEs would need to follow or should follow. Indeed, I would say most if not all of them do follow, but in the process of these executives doing their everyday decisions, and perhaps in some cases if they need to make a couple of investments or engage in a certain kind of project and so on, at least in the past, many of the executives would probably get 4their hands into the [inaudible 00:15:35] and perhaps try to benefit through much of the incoming investment. All things happens. Following the direction of the government, from a policy standpoint, that happens.At the same time, corruption also happens.

Malcolm Riddell: Let me take this from a different point of view. Quite often, the CEO of a major state-owned enterprise will do that for a few years, and switch out to a ministry post, and then maybe do some provincial post, and back toan SOE. Really we've got the same crowd managing the SOEs as are in the government. They're all in the same pool. Is that accurate?

Ed Tse: That's pretty accurate, you're right. In a way, the people in government and the people who lead the SOEs are from the same pool, in a way theelites in the Communist Party. These are people who considered as pretty capable and actually have a way to manage their career through the Communist Party. Essentially, it's more or less the same pool of people, but as you know, there are some 800,000 members of the Communist Party, so it's a pretty big pool.

Malcolm Riddell: I'm not disagreeing with that. What I'm trying to clarify for our viewers is that what we have here is a very different system, very different structure,than what we have say in the West, where you have an independent enterprise that, if it's a public company, has public stock holders. It has responsibilities to them. It has a board that is meant to make independent decisions based on the best interest of the companies and the shareholders. Executives are beholden to the board, and when one of them leaves, he probably goes on to be an executive in another company,whereas in the system in China, we have a very deep pool of people,perhaps, who take on various roles in their careers both in government and in industry. It's a very different system than what we're used to here,and I think it's one of the things that makes the governance question particularly hard to understand.

Ed Tse: It is certainly very different than the so-called Western system. That's why the SOEs need to reform, because on one hand, many of them have achieved a lot for China. On the other hand, they've actually created quite a lot of harm, in particular in the areas of overcapacity but also in the areas of corruption we've talked about.