This paper argues that Chinese state enterprise reform has been relatively successful in solving the short-term managerial incentive problem through both its formal, explicit incentive mechanism and its informal, implicit incentive mechanism. However, it has failed to solve the long-term managerial incentive problem and the management selection problem. An incumbent manager may have incentives to make short-term (but hidden) profits, but at present there is no mechanism to ensure that only qualified people will be selected for management. The fundamental reason is that managers of SOEs are selected by bureaucrats rather than capitalists. Since bureaucrats have the authority to select managers but do not need bear the consequences of their selection, they have no proper incentives to find and appoint high ability people. Since good performance does not guarantee that the incumbent manager will stay long, the manager does not have long-term incentives. The paper also argues that these built-in problems of state ownership cannot be solved by state-dominated corporatization. Bankruptcy has not played a role in disciplining managers because the state-owned banks have neither the incentive nor the ability to enforce debt contracts. To ensure that only high ability people will be professional managers and that managers can be well disciplined, the authority of selecting management must be transferred from bureaucrats to capitalists. This calls for privatization of both state enterprises and state banks. China is well on its way to privatization of state enterprises, but privatization of state banks is yet to come
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