The Revival of Private Enterprise in China (The Chinese Trade and Industry Series)

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THE REVIVAL OF PRIVATE ENTERPRISE IN CHINA

The Chinese Trade and Industry Series This series examines the immense importance of China within the global economy. Books in the series view the Chinese economy in many ways, such as: a transition economy; a bridge between the developing and developed nations; a vital member of the WTO; and even as a potential rival to the US. Providing readers with high quality monographs and edited volumes by authors from East and West, this series is a truly global forum on one of the world’s key economies. Series Editors Aimin Chen, Indiana State University, USA Shunfeng Song, University of Nevada, USA Recent Titles in the Series Assessing the Extent of China’s Marketization Edited by Xiaoxi Li ISBN 978-0-7546-4878-9 The Chinese Economy after WTO Accession Edited by Shuming Bao, Shuanglin Lin and Changwen Zhao ISBN 978-0-7546-4482-8 China’s Agricultural Development Challenges and Prospects Edited by Xiao-yuan Dong, Shunfeng Song and Xiaobo Zhang ISBN 978-0-7546-4696-9 China’s Rural Economy after WTO Problems and Strategies Edited by Shunfeng Song and Aimin Chen ISBN 978-0-7546-4695-2 Chinese Youth in Transition Edited by Jieying Xi, Yunxiao Sun and Jing Jian Xiao ISBN 978-0-7546-4369-2 Grains in China Foodgrain, Feedgrain and World Trade Edited by Zhang-Yue Zhou and Wei-Ming Tian ISBN 978-0-7546-4280-0

The Revival of Private Enterprise in China

Edited by SHUANGLIN LIN University of Nebraska, USA and Peking University, China and SHUNFENG SONG University of Nevada, USA

© Shuanglin Lin and Shunfeng Song 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the publisher. Shuanglin Lin and Shunfeng Song have asserted their moral right under the Copyright, Designs and Patents Act, 1988, to be identiﬁed as the editors of this work. Published by Ashgate Publishing Limited Gower House Croft Road Aldershot Hampshire GU11 3HR England

Ashgate Publishing Company Suite 420 101 Cherry Street Burlington, VT 05401-4405 USA

Ashgate website: http://www.ashgate.com British Library Cataloguing in Publication Data The revival of private enterprise in China. - (The Chinese trade and industry series) 1. Free enterprise - China 2. China - Economic conditions 1976-2000 3. China - Economic conditions - 2000- 4. China Economic policy - 1976-2000 5. China - Economic policy 2000I. Lin, Shuanglin II. Song, Shunfeng 330.1'22'0951 Library of Congress Cataloging-in-Publication Data The revival of private enterprise in China / edited by Shuanglin Lin and Shunfeng Song. p. cm. -- (The Chinese trade and industry series) Includes index. ISBN 978-0-7546-4892-5 1. Privatization--China. 2. Free enterprise--China. 3. Industrial policy--China. 4. China--Economic policy. I. Lin, Shuanglin. II. Song, Shunfeng. HD4318.R48 2007 338.6'10951--dc22 2006036919 ISBN: 978-0-7546-4892-5

Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire.

Contents List of Figures List of Tables Acknowledgements

vii viii xi

Chapter 1

Introduction Shuanglin Lin, Shunfeng Song

PART I

PRIVATE ENTERPRISES AND ECONOMIC DEVELOPMENT

Chapter 2

Higher Efﬁciencies or Resource Reallocation? Li Gan, Shunfeng Song, Chiu Tan

11

Chapter 3

Size of the State-Owned Sector and Regional Growth in China Kerk L. Phillips, Shen Kunrong

19

Chapter 4

Resource Allocation and Economic Growth in China Shuanglin Lin

33

PART II

GOVERNMENT AND PRIVATE ENTERPRISES

Chapter 5

Government and Private Enterprises: Wenzhou Experiences Wenbo Wu

Chapter 6

Property Rights Developments and Productivity Gains in China: A Law and Economics Perspective Xiaowen Tian, Vai Io Lo

69

Evolution of Economic Development: Entrepreneurs, Market, and the State Jack W. Hou

89

Chapter 7

Chapter 8

Private Enterprise Development and Governmental Functions Jian He

1

53

107

vi

The Revival of Private Enterprise in China

PART III

FINANCIAL REFORMS, OPENNESS, AND PRIVATE ENTERPRISE DEVELOPMENT

Chapter 9

Causes of the Non-Performing Loan Piling-Up in the Late 1990s: A Research Note Ding Lu, Sandre M. Thangavelu, Qing Hu

127

Public Venture Capital: Understanding the US and Chinese Experiences Changwen Zhao, Shuming Bao, Chunfa Chen

143

Chapter 10

Chapter 11

The Challenges China’s Private Enterprises Face in the WTO Shaomin Huang, Dongxia Wu, Grant D. Forsyth

PART IV

OWNERSHIP REFORMS AND PRIVATIZATION

Chapter 12

The Privatization of Russian State Industry: Some Lessons for China Marshall I. Goldman

185

Politician Control, Agency Problems, and Ownership Reform: Evidence from China Lixin Colin Xu, Tian Zhu, Yi-min Lin

199

Hospital Ownership: What can China Learn from the US Experience? Wei Yu

223

Chaper 13

Chapter 14

169

PART V

CORPORATE GOVERNANCE AND EFFICIENCY

Chapter 15

Corporate Governance and the Development of Private Enterprise in China Aimin Chen, Ping Li

237

The Productivity Efﬁciency of State-Owned Enterprises in China Chun-Chien Kuo

257

Chapter 16

Chapter 17

Index

The Prospect of Private Economy in China Xiaowen Tian

271

285

List of Figures

Figure 2.1

Gross Industrial Output Values by Ownership

12

Figure 3.1

Regional Output, 1978–1998 (Logarithmic Scale)

21

Figure 6.1

Output of Industry by Ownership (%)

74

Figure 9.1 Figure 9.2

Asymmetric Risk Taking Towards SOEs and Non-SOEs Asymmetric Risk Taking Over Time

135 137

Figure 11.1

US Trade with China, 2001–2003

178

List of Tables

Table 2.1 Table 2.2 Table 2.3 Table 2.4 Table 2.5 Table 2.6 Table 2.7

Distribution of Rural and Urban Participants in the Survey 12 Regression of Monthly Income on Education and Experience 13 Regression of Subsidy on Education and Experience 14 Regression of Total Annual Bonuses on Education and Experience 15 Regression of Choice of SOE or Non-SOE over Current Working Population 16 Regression of Choice of SOE or Non-SOE over Incoming Workforce 17 Impact of Education on Non-SOE Wage Premium and Choice Probability 17

Table 3.1 Table 3.2 Table 3.3 Table 3.4 Table 3.5

Per Capita GDP by Province, 1998 (1995 RMB) Adjusted Data used in Regressions, 30 provinces, 1978–1999 Results of Regressions using GRGDPPC as Dependent Variable Results of Regressions using GTFP as Dependent Variable Results of Regressions using GRSOEIO as Dependent Variable

Table 4.1

Investment Shares in 1996 and Growth Rates of Per Capita GDP, 1983–1996 Summary Statistics of the Major Variables, 1983–1996 Pearson Correlation Coefﬁcients/Pro>lRl under Ho: Rho=0/N=30 The Growth of Gross Domestic Product, 1983–1996 The Growth of Gross Domestic Product, 1983–1990 and 1990–1996

46

Table 6.1 Table 6.2 Table 6.3

Regression on Equation 7, 1980–1998 Regression on Equation 7, 1985–1998 Null Hypothesis Test

82 83 84

Table 9.1 Table 9.2 Table 9.3 Table 9.4 Table 9.5 Table 9.6

Variable Description Estimation Results of Borrowing Ratio Model (4) Evidence of Structural Change in Period, 1998–1999 Evidence of Asymmetric Risk Taking Evidence of Aggravation of Asymmetric Risk Taking, 1998–1999 Estimation Results of Logit Model for Default Probability Prediction

Table 4.2 Table 4.3 Table 4.4 Table 4.5

20 22 26 27 29

37 40 41 42

132 133 134 135 136 139

List of Tables

Table 10.1 Table 10.2 Table 10.3 Table 10.4 Table 10.5 Table 10.6 Table 10.7 Table 10.8

Table 11.1 Table 11.2

All SBIC Program Licensees: Financing to Small Businesses (in millions US$) All SBIC Program Licensees: Financing to Small Businesses by Age of Business (in millions US$) Financing to Start-up Businesses (Aged 2 Years or Less) All SBIC Program Licensees: Industry Distribution of Financing by Major NAICS Sector Group Venture Capital Pools and Disbursements in China by Year (in millions US$) IFSTF Supported Fields, 1999–2002 (in thousands RMB) Stages of IFSTF Supported Projects, 1999–2002 Provincial and Municipal Venture Capital Funds in China (in millions US$)

ix

146 147 149 150 153 154 156 158

Percentage of Gross Industrial Output, 1990–1993 Number of Designated Size Industrial Enterprises and their Gross Output, 2001 Number of Designated Size Industrial Enterprises and their Gross Output, 2002 Number of Designated Size Enterprises in Wholesale by Types of Registration, 2001 Number of Designated Size Enterprises in Retail Trade by Types of Registration, 2001 Number of Designated Size Enterprises in Catering Services by Types of Registration, 2001 Factor Endowments in China and Selected Other Countries, 1995 Predicted Export Gains for the US after China’s Entry into the WTO

179

Table 12.1 Table 12.2 Table 12.3 Table 12.4

Forbes Richest Russians, 2004 Siloviki in Business Forbes Top 25 Richest Chinese Renationalization and Control by Siloviki

186 189 193 197

Table 13.1 Table 13.2 Table 13.3 Table 13.4 Table 13.5 Table 13.6

Variable Deﬁnitions and Descriptive Statistics Correlation Matrix of Explanatory Variables Determinants of Reform Outcomes: Pooled Sample Determinants of Reform Outcomes: LLSC Determinants of Reform Outcomes: LLC Determinants of Reform Outcomes: EOSC

206 211 213 215 217 218

Table 15.1 Table 15.2 Table 15.3

Institutions and Employment of China’s Banking Sector, 2001 Investment in Fixed Assets by Sources and Uses of Funds Financing Investment: The Role of Financial Institutions and Capital Markets, 1996

240 241

Table 11.3 Table 11.4 Table 11.5 Table 11.6 Table 11.7 Table 11.8

172 173 174 175 175 176 177

242

x

Table 15.4 Table 15.5 Table 15.6 Table 15.7 Table 15.8

Table 16.1 Table 16.2

The Revival of Private Enterprise in China

Sources of Investment Funds (in 100 million yuan) by Ownership (% in parentheses) Stock Market Capitalization: International Comparison, 1996 Mutual Fund Investment in Stock Market Distribution of Companies by Types of Largest Shareholders, at IPO and 1999 (%) The Role of Company Board in Financial and Investment Decision (% of Listed Companies) Variable Statistics The MLE Estimation

243 245 246 248 249 260 261

Acknowledgements We thank all participants of the International Symposium on Private Enterprises and China’s Economic Development, held in Beijing on June 18–20, 2004, for contributing their quality research. We acknowledge the generous ﬁnancial support from the Ford Foundation, the Center for International Private Enterprises, The First Data Corporation, The LG Electronics, the Huaxia Yingcai Foundation, the Chinese Academy of Social Sciences, Northwestern University in China, and other institutes. We thank Miaomiao Yu, Xiangrong Yu, Alicia Tan, and Jing Wu for their excellent assistance in editing the book. We greatly appreciate the anonymous book reviewers for their helpful comments and the editorial staff of Ashgate for their efﬁcient editorial work.

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Chapter 1

Introduction Shuanglin Lin, Shunfeng Song1

The reemergence of private enterprises is the most important event in China’s recent economic development. In 1957 China completed socialist reform on the ownership of production means, eliminating all private enterprises. In the following year, China established people’s communes in rural areas and collectivized all farm households. For 20 years, while its neighboring countries were making economic strides, China was still a low-income country. In 1978, a new reform started to bring market mechanics into the economy. The government implemented the household responsibility system in the rural areas, encouraged township-village collective enterprises to develop, and allowed foreign enterprises to establish joint ventures in China. At the end of 1980s, private enterprises were legalized. In his 1992 South China tour, Deng Xiaoping, the architect of China’s economic reforms, called for deepening economic reforms and establishing socialist market economy. Since then, private enterprises have grown rapidly and China has experienced the highest economic growth in the world. There are ofﬁcially seven different types of enterprises based on ownership: individual ownership, private ownership, foreign ownership, joint ownership, shareholding corporations, collective ownership, and state ownership. The ﬁrst ﬁve ownerships consist of China’s private sector. Since 1985, the private sector has been the most dynamic source of industrial output growth. In the past 15 years, private enterprises outpaced the state-owned sector and the collectively owned town and village enterprises (TVEs). The persistent growth differentials have translated into a signiﬁcant shift in the composition of industrial output by ownership types. Until 1990, state-owned and collectively owned ﬁrms produced more than 90% of gross industrial output. Since then, the share of output produced by private ﬁrms has risen rapidly. In 2000, industrial value-added of state-owned enterprises above designated size accounted for 47% of total industrial value-added, while other types of enterprises produced 53%. In 2004, industrial value-added of state-owned

1 Lin: Noddle Distinguished Professor, Department of Economics, CBA 512, University of Nebraska at Omaha, Omaha, NE 68182, USA. Phone: 402-554-2815, Fax: 402-554-2853, E-mail: [email protected]; Professor and Chair, Department of Public Finance, School of Economics, Peking University, Beijing, China 100871. Phone: 10-6276-0620; Fax: 106275-1460. Song: Professor and Chair, Department of Economics, University of Nevada, Reno, NV 89557-0207, USA. Phone: 775-784-6860, Fax: 775-784-4728, Email: [email protected].

2

The Revival of Private Enterprise in China

enterprises above designated size declined to 35% of total industrial value-added, while other types of enterprises produced 65%. The private sector plays a more important role in creating new jobs. In 1990, state-owned and collectively owned enterprises employed 70 and 24% of urban labor force, respectively, while individual enterprises employed only 4.6% of urban labor force. In 2000, state-owned and collectively owned enterprises employed 35 and 6% of urban labor force, respectively, while other enterprises employed 59% of urban labor force. In 2004, state-owned and collectively owned enterprises employed 25 and 3% of urban labor force, respectively, while other enterprises employed 72% of urban labor force. Although private enterprises have taken a strong hold in the Chinese economy, they face many obstacles to further grow. Private enterprises are not treated equally, as they are discriminated against by state-monopolized banks in borrowing and are subject to numerous taxes, fees, and levies from local governments. In many aspects, private property ownership is not effectively protected by laws. Private enterprises in China also face many other challenges, such as lack of technical and information support, management experience, international trade and investment experience, and long-run planning. In addition, they must deal with the competition from the state enterprises and government ofﬁcials’ corruption. The faster development of the private sector is crucial to the successful handling of the internal and external challenges faced by the Chinese economy. First, unemployment rate remains high. Many state-owned enterprises (SOEs) and collectively owned enterprises (COEs) are losing money and have to lay off workers. Rural disguised and hidden unemployment problem could be much worse. As China further opens markets to foreign competition, there will be more unemployment in SOEs and in rural areas. Second, the income inequality is widening. Income gaps between the rich and the poor and between the rural and city residents are growing. Third, the banking sector is burdened with large non-performing loans and the non-banking ﬁnancial sectors are underdeveloped. It is difﬁcult to channel large amounts of savings to investment, and the threat of a potential ﬁnancial crisis still exists. Fourth, China faces a challenge of maintaining a healthy economic growth. The ofﬁcial Chinese statistics show that the growth rate is still as high as 10%. The high growth rate was achieved with large investment in state enterprises and government deﬁcit spending. The inﬂuence of government command-and-control on the economy is still strong, and economy has periodically experienced the cycle of decontrol-overheating-control-slump. Fifth, China has entered the WTO and must honor its commitments, including the opening of a number of crucial markets. Stateowned enterprises in these markets lack competitiveness. The economic achievements of the developed countries rely on the development of private enterprises. China is no exception. Private enterprises have contributed signiﬁcantly to China’s recent economic growth and will play a key role in achieving China’s goal of building a comprehensively well-off society. What are the main obstacles to private enterprise development in China? What measures should be taken to promote private enterprise development? How can private enterprises help China mitigate its macroeconomic problems such as unemployment, income inequality, ﬁnancial disintermediation, and unhealthy economic cycle? What lessons

Introduction

3

can China learn from other countries in promoting private enterprise development and privatization? This book attempts to answer the above questions. Most of the articles in this book are selected from the chapters presented at the three-day international symposium, “Private Enterprises and China’s Economic Development,” which was organized by the Chinese Economists Society and the Chinese Academy of Social Sciences in Beijing, China on June 18–20, 2004. The book is divided into ﬁve parts. The ﬁrst part, “Private Enterprises and Economic Development,” discusses private enterprises’ efﬁciency and their contributions to China’s economic development in the past 20 years. The second part, “Government and Private Enterprises,” examines the role of the Chinese government in promoting and protecting private enterprises. The third part, “Financial Reforms, Openness, and Private Enterprise Development,” investigates relationship between private economy and China’s ﬁnancial reforms and WTO accession. The fourth part, “Ownership Reforms and Privatization,” analyzes the challenges China faces in reforming the state ownership. The last part, “Corporate Governance and Efﬁciency,” focuses on governance issues related to private enterprises. The content of each chapter is brieﬂy reviewed below. Part I begins with a chapter contributed by Li Gan, Shunfeng Song, and Chiu Tan “Higher Efﬁciencies or Resource Reallocation?” In this chapter, Li Gan, Shunfeng Song, and Chiu Tan analyze the differences in quality of labor between public and private ﬁrms in China. Using panel data from different provinces, the chapter ﬁnds that more educated workers are better off in non-SOEs while more experienced ones in SOEs. In spite of this, more educated workers are more likely to be found in SOEs, as are more experienced ones. For people leaving school for the work force, the more educated people are more likely to choose to work for an SOE. This trend continues despite an increasing difference in nonSOE compensation. This result suggests that the decline in output for SOEs is not due to less able human capital inputs, but more to inefﬁciencies in the sector, implying that the slide in SOEs output is likely to continue. Simply matching non-SOEs compensation is unlikely to solve the problem because more able workers are already found in SOEs. Chapter 3, “Size of the State-Owned Sector and Regional Growth in China,” is contributed by Kerk Phillips and Kunrong Shen. The chapter tests the contributions made by SOEs to China’s economic growth. The authors estimate regressions with various measures of real output growth as the dependent variable and a variety of other factors, including measures of the size of the state-run sector, as regressors. Controlling for a variety of other factors, they ﬁnd the greater the size of SOEs, as measured by their share of total industrial production, the lower the provincial growth rate. The estimates indicate that a decrease in the SOE share of industrial production by 10 percentage points increases real GDP growth the following year by between 0.7 and 1.2%. The average impact of a reduction in the SOE share in employment by 10 percentage points is between 1.6 and 2.3%. Chapter 4, “Resource Allocation and Economic Growth in China,” is written by Shuanglin Lin. This chapter shows that the allocation of resources among enterprises of different types of ownership is important to economic growth. The data on 30 Chinese provinces indicate that the investment share of SOEs is negatively related to

4

The Revival of Private Enterprise in China

the growth rate of per capita GDP, while the investment share of private enterprises is positively related to the growth rate, i.e. the provinces which invested more in private enterprises grew faster than the provinces which invested more in state enterprises. Meanwhile the effect of total investment on the growth rate of per capita GDP appears to be insigniﬁcant. The share of trade in GDP was positively related to the growth rate of per capita GDP, indicating that openness is beneﬁcial to economic growth. Also, illiteracy rate of employees seems negatively related to the growth rate of per capita GDP, implying human capital is important for economic growth. The second part of the book starts with Chapter 5, “Government and Private Enterprises: Wenzhou Experiences” by Wenbo Wu. The chapter presents an analytical narrative on the relationship between government and private enterprises in Wenzhou. In particular, the chapter focuses on the role played by the central and local governments in the evolution of private property rights in Wenzhou’s private enterprises. Since their birth in the late 1970s, private enterprises in Wenzhou have been growing rapidly and developed different guises for their ownership and private identity. The author argues that intergovernmental ﬁscal relations and private enterprises’ expansion are two critical factors in shaping the development of private property rights. He observes two favorable conditions for the establishment of a secure system of private property rights. Firstly, radical ﬁscal reforms in 1994 have restricted local expropriation to some degree. Local governments found it less meaningful to directly control operations of private enterprises. Secondly, the private sector’s demand for a well-deﬁned property rights system has been increasing. Under these two conditions, local governments ﬁnd it in their own interests to collaborate with the central government to protect private property rights. In Chapter 6, “Property Rights Developments and Productivity Gains in China: A Law and Economics Perspective,” Xiaowen Tian and Vai Io Lo examine the issue of property rights developments from a law and economics perspective to refute an established view in favor of collective rather than private property rights developments in China. The authors ﬁnd that the Chinese experience cannot, as some have claimed, pose a challenge to the property rights theory. The unsatisfactory economic performance of the Chinese private sector in the 1980s was attributed to the discriminatory legal environment within which private property rights developed. Private property rights had to develop, to a large degree, under the disguise of collectives. Once the political and legal environments improved in the 1990s, the private sector achieved signiﬁcantly greater productivity gains and contributed more to economic growth than all other sectors, which is shown in a growth model based on an aggregate production function, employing a large set of data that covers 30 Chinese provinces from 1980 to 2000. Chapter 7, “Evolution of Economic Development: Entrepreneurs, Market, and the State,” contributed by Jack W. Hou, compares the experiences of China and Russia. Though the Russian economy has shown improvement, the current performance still lags behind China, and when one examines the time series of the past decade and a half, the disparity is even more profound. If 1989 is used as the starting point, China’s GDP has nearly doubled, while Russia’s GDP has shrunk more than 40%. Comparing and contrasting the experience of the two dominating former socialist economies in the transition is both inevitable and necessary. Both are waging a great battle for the survival and prosperity of its people. This chapter attempts to address

Introduction

5

why China’s reform succeeded while Russia’s didn’t and indirectly tries to ﬁnd out the reasons why Russia may not be able to replicate China’s reform lies in culture, history, and other “invisible” traits, rather than the erroneous shock therapy. In Chapter 8, “Private Enterprise Development and Governmental Functions,” Jian He provides a theoretical and systematical deﬁnition or explanation of the western governments and gives a detailed discrimination of the central and local governments of the United States. The Chinese economy is experiencing a period of development of private enterprises. However, many obstacles hinder the further growth of the private sector. How can private enterprises overcome those problems? What governmental actions should be taken to promote the development of private enterprises? What lessons can China learn from other countries in promoting private enterprise development and privatization? The chapter attempts to answer the above questions by capturing the nature and ﬂavor of the public manager’s job in western countries and by discussing how the US government promotes private enterprise development by using many different cases. The chapter gives some ideas and views that could be employed by the Chinese administrators in their effort to promote private enterprise. Part III focuses on ﬁnancial reforms, openness and private enterprise development. In Chapter 9, “Causes of the Non-Performing Loan Piling-Up in the Late 1990s: A Research Note,” Ding Lu, Sandre Thangavelu, and Qing Hu argue that banks were systematically more risk-taking in giving loans to SOE borrowers because they “gambled for resurrection” in hoping for ex post bailout. The piling up of non-performing loans in China’s banking sector in the late 1990s coincided with the government’s bolstered efforts to restructure SOEs and the banking sector. It is not apparent whether the rise of non-performing loans was mainly caused by the government’s ex ante intervention in banking business or banks’ own rational choice upon the expectation for government’s ex post bailout. Chapter 10, “Public Venture Capital: Understanding the US and Chinese Experiences,” is contributed by Changwen Zhao, Shuming Bao, and Chunfa Chen. The authors conduct a comparative study of the public venture programs in the United States and China by comparing those differences between public and private venture capitals in terms of their objectives, functions, performance and their policy implications. They try to answer questions such as: why and where should the public venture capital be invested and what is their relationship with private venture capital; how can the public venture capital be more efﬁcient for funding hi-tech start-ups; and what are the strategies to integrate public venture capital and private venture capital? The authors conclude that the hi-tech development in China suffers from the lack of both public venture capital and private venture capital. The government should take a more active role in developing venture capital, fostering a good investment environment for the venture capital industry, and integrating public venture capital with private venture capital for better performance. In Chapter 11, “The Challenges China’s Private Enterprises Face in the WTO,” Shaomin Huang, Dongxia Wu, and Grant Forsyth argue that China’s accession to the World Trade Organization (WTO) will bring new challenges for many private enterprises. The typical private enterprise is small, family owned and operated, and located in the light manufacturing, agricultural, retail, or service sectors, and it uses

6

The Revival of Private Enterprise in China

a limited amount of physical capital. Within China, private enterprises have been relatively successful in competing with large SOEs. However, in China’s post-WTO economy, foreign corporations are increasingly encroaching on the private enterprises’ traditional markets. As the competitive pressure increases, it will be crucial for the survival of many private enterprises to update their managerial methods, increase their use of capital, and look for strategies that will grow their businesses. However, this will be difﬁcult given the hurdles associated with obtaining sufﬁcient levels of human and ﬁnancial capital. Part IV of the book has three chapters. Chapter 12, “The Privatization of Russian State Industry: Some Lessons for China,” by Marshall I. Goldman, discusses how the results of privatization have been affected by the differences in the way communism in Russia and China evolved. It also attempts to provide insights into what pitfalls China must avoid if it wants to implement a successful program of privatization. In this chapter, the author argues that if Russian reforms had been successful, then neither Soviet-era factory directors nor members of the Soviet nomenklatura would have automatically become owners of the state factories they had been administrating. All those who become owners of state property should have had to compete to obtain that ownership on an equal footing and should pay a fair value for it. The author believes that China should emulate Poland’s model, in which the factory directors do not automatically take over as the owners and the public at large derive some real material beneﬁt from the privatization process, not just in the beginning but on a continuing basis. Chapter 13, “Politician Control, Agency Problems and Ownership Reform: Evidence from China,” is a permitted reprint of an article in Economics of Transition, Volume 13 (1) 2005, 1–24. In this chapter, Lixin Colin Xu, Tian Zhu and Yi-min Lin study the effects of reducing politician control and agency problems on the ﬁnancial performance of the reformed ﬁrms by using data from a recent national survey on the ownership reform of SOEs in China. Taking into account the endogenous nature of the reforms, the authors ﬁnd that ﬁrm performance is positively affected by the lessening of politician control by increasing the ﬁrm’s ﬂexibility in labor deployment and mitigating the agency costs through the introduction of more effective corporate governance mechanisms such as one-share one-vote and shareholding-based board structure composition. Ownership structure also affects performance. Relative to shareholding by the state, foreign ownership has a positive effect on ﬁrm performance; individual (mostly employee) shareholding has a negative effect; and the effect of collective and legal person shareholding is indistinguishable from that of state shareholding. Somewhat surprisingly, operating autonomy (excluding labor deployment ﬂexibility) has a negative effect on ﬁrm performance, suggesting serious agency problems in the reformed enterprises. In Chapter 14, Wei Yu addresses the issue, “Hospital Ownership: What can China Learn from the US Experience?” He shows that the inﬂuence of private for-proﬁt hospitals on China’s hospital market depends largely on the market environment. At the moment, private for-proﬁt hospitals cater to China’s rich patients who are willing to pay for improved quality of services and quality of care. The competition from these hospitals has limited effects on state hospitals. If the private for-proﬁt hospitals begin to serve the general public, the effects on state hospital will be substantial.

Introduction

7

He suggests that, due to the special features of medical-care services, such as moral hazards and asymmetric information, the government should be actively involved in quality assessment and regulation, information dissemination, and price management. Many guidelines for these interventions can be gleaned from the US experience. Part V of the book concerns Corporate Governance and Efﬁciency. Chapter 15, “Corporate Governance and the Development of Private Enterprise in China,” by Aimin Chen and Ping Li, examines the basic aspects relevant to corporate governance of Chinese ﬁrms by evaluating four important relationships concerning ownership structure and corporate control: ﬁrm’s relationship with banks, the stock market, the government, and the relationship between managers and employees within the ﬁrm. The chapter also tries to answer what type of governance structure is more suitable to help private ﬁrms become future modern corporations and what must they consider in seeking a corporate governance model for their future development. The authors conclude that China’s corporate governance structure is neither the JapaneseGerman style, in which banks have signiﬁcant control over corporations, nor the Anglo-American style, in which stock and managerial markets function to alleviate principal-agent problems in modern corporations. While Chinese banks remain the major ﬁnancier of investments in corporative SOEs, they exert little supervising role over the corporations. Meanwhile, stock markets in China are still at its infancy in terms of its capitalization as percentages of total investment ﬁnanced and of GDP, of the limited number of ﬁrms publicly listed, as well as of the irregular operations of corporative ﬁrms. There also lacks the managerial market as the government still has considerable control over who to become managers and chairpersons of the boards. China’s enterprise reform, however, is striving to build a modern enterprise system that resembles the Anglo-American mode of corporate governance. In Chapter 16, “The Productivity Efﬁciency of State-Owned Enterprises in China,” Chun-Chien Kuo examines the efﬁciency of SOEs to see if they have improved after the 1997 full-scale share-holding conversion. A stochastic frontier model is adopted to estimate the productivity efﬁciency of SOEs during 1994–2001. Thirty-seven industry groups during 1994–2001 are included in this study. The primary ﬁnding is that the production efﬁciency of China’s SOEs does not seem to improve after the conversion to the 1997 state share-holding type. The production efﬁciency of the heavy-industry groups is less efﬁcient compared to other industry group during 1994–2001. This ﬁnding indicates an unsatisfactory improvement in the SOEs, suggesting the promotion of the private sector is the most important task that should be given ﬁrst priority in China’s economic development. In Chapter 17, Xiaowen Tian discusses “The Prospect of Private Economy in China”. The author talks about how the Chinese government has gradually changed its policy toward the private economy from 1978 onwards, and the economic necessity for the change. He argues that the driving force behind the policy change had been the advantages of private-owned enterprises (POEs) in competitive markets. The author also describes how the private economy arose in China after 1978 and the speciﬁc compositions of the private sector. He divides the development of the private economy into three stages. The ﬁrst stage covered the period of 1978–1988, which was characterized by the rise of individual-owned enterprises and the hidden development of POEs. The second stage covered the period of 1989–1992, in which

8

The Revival of Private Enterprise in China

the private economy experienced a crisis due to the Tiananmen Square Incident. The third stage is after 1992 when Deng Xiaoping reconﬁrmed the friendly policy to the private economy in his tour to Southern China. The author analyzes the limitations to the policy change and the discriminations against the private economy, in areas of legislation, ﬁnance and taxation, and business entry and market access. He also explains, from both theoretical and empirical perspectives, why the private economy will become a full-grown swan in the process of China’s transition to a market-based economic system. In summary, the articles included in the book study a wide range of issues concerning China’s private enterprise development and examine problems and strategies faced by China’s private sectors after its accession into the WTO. Therefore, this book contributes to advancing our knowledge of China’s private enterprises and economic development. We hope this book will help readers better understand China’s private enterprises and the potentials of China’s economic growth.

PART I Private Enterprises and Economic Development

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Chapter 2

Higher Efﬁciencies or Resource Reallocation? Li Gan, Shunfeng Song, Chiu Tan1

1 Introduction In the mid 1980s, China’s economic reforms shifted from the agricultural sector to the industrial sector. One by-product of these reforms is the falling share of the economy by state owned enterprises (SOEs) as compared to non-state owned enterprises (non-SOEs). Figure 2.1 shows the gross industrial output values between SOEs, collectives and private industries since the beginning of economic reforms. The SOEs output dropped from 76% in 1980 to 28% in 1999. The collective’s share increased from 23 to 35% during the same time period. Private industries had the most dramatic increase, rising from 0.5% in 1980 to 44% in 1999. External factors such as state-imposed policy burdens have been suggested as a cause of SOE’s poor performance (Lin, Cai and Li, 1998). In this chapter, we examine whether there is a relationship between the SOE’s poor performance and the quality of their labor force composition. The ﬁrst hypothesis is that SOE’s are less efﬁcient in utilizing human capital. With similar quality human capital input, SOEs do not perform as well as non-SOEs. The second hypothesis is an issue of resource reallocation. SOEs are losing more able people to non-SOEs. Thus with less able human capital, the SOEs performance worsens. Education attainment and experience are used to proxy for ability. 2 The Data Data for this chapter were obtained from the China Health and Nutrition Survey (CHNS) conducted jointly by the Carolina Population Center at University of North Carolina at Chapel Hill, Institute of Nutrition and Food Hygiene and the Chinese Academy of Preventive Medicine. The survey covers nine provinces in China. The province of Liaoning was included in survey years 1989, 1991 and 1993. Heilongjiang

1 Gan and Tan: Department of Economics, University of Texas at Austin, Austin, TX 78712, USA. Phone: 512-475-8540, Email: [email protected]. Song: Professor, Department of Economics, University of Nevada, Reno, NV 895570207, USA. Phone: 775-784-6860, Fax: 775-784-4728, Email: [email protected].

The Revival of Private Enterprise in China

12 80

% of Total Industry

70 60 50 □ % State % Collective  % Private

40 30 20 10 0 1980

1985

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

Year

Figure 2.1

Gross Industrial Output Values by Ownership

Table 2.1

Distribution of Rural and Urban Participants in the Survey

Rural Urban

1989 8977 3995

1991 8397 3617

1993 8398 3288

1997 7349 2525

was chosen to replace Liaoning in 1997. Both provinces are excluded in this chapter. The rural and urban distribution of participants can be found in Table 2.1. Participants are grouped into SOE or non-SOE category based on the kind of work unit reported. People who reported as working in a state enterprise or institute were considered as working for an SOE. Participants who reported themselves as working in a “joint venture”, “individual or private enterprise”, “family contract farming”, “three-capital enterprise”, “household business” are all considered to be working for a non-SOE.2 Participants who worked in either large (county, city or province owned) or small (township owned) collectives are excluded from our sample. We believe that large collectives behave more similarly like SOEs, while small collectives are closer to private enterprises. 3 Wage Differentials Between SOEs and Non-SOEs There have been several studies done on the returns to education in China with a range of reported results.3 Using a Mincer type model, we ﬁrst estimate how returns to education differ between SOEs and non-SOEs. The results are found in Table 2.2.

2 Not all categories were used in each survey year. Three-capital enterprise refers to enterprises owned by foreigners, overseas Chinese and joint ventures. 3 See Zhang and Zhao (2002) for a summary of ﬁndings from various authors. Heckman and Li (2003) and Li and Urmanbetova (undated) for dealing with heterogeneity and attenuation bias.

Higher Efﬁciencies or Resource Reallocation?

Table 2.2

13

Regression of Monthly Income on Education and Experience

Variables Intercept

1989 1991 1993 1997 3.2550 2.7200 3.5016 3.8540 (20.29) (26.76) (23.75) (24.56) Log(hours) 0.3748 0.6042 0.4044 0.6816 (5.73) (13.95) (6.79) (10.19) Experience 0.0277 0.0289 0.0270 0.0268 (6.21) (10.75) (6.31) (6.95) Experience2 -0.0004 -0.0003 -0.0004 -0.0004 (-4.77) (-6.46) (-4.27) (-5.39) Male 0.1429 0.1392 0.0899 0.1385 (3.49) (6.29) (2.68) (4.24) Years of School -0.0044 0.0085 0.0066 0.0251 (-0.72) (2.53) (1.28) (4.61) Pri * Years of 0.0448 0.0461 0.0650 0.0346 School (6.67) (11.80) (10.90) (6.95) Pri * Experience -0.0068 0.0001 -0.0000 0.0019 (-3.14) (0.11) (-0.01) (0.96) Urban 0.0243 0.1011 0.1557 0.0090 (0.60) (4.59) (4.64) (0.26) Observations 1965 1657 1434 1204 Notes: Dependent variable is log(monthly income), with income excluding bonuses and subsidies. log(hours) refers to the number of hours worked per day. Parentheses contain t-values.

Holding all other factors constant, the returns for an additional year of school at a non-SOE is 4.5% higher compared to an SOE. This difference increased marginally in 1991 to 4.6% and sharply in 1993 to 6.5%. In 1997, the difference narrowed to 3.4%. A possible reason for the shrinking difference between non-SOEs and SOEs is that the non-salary beneﬁts (bonuses and subsidies) for more educated workers at non-SOEs have begun to catch up with those found in SOEs, in effect, substituting higher salaries with higher beneﬁts. This can be inferred from rerunning the model, with subsidies and bonuses instead of monthly salary.4 The results are found in Tables 2.3 and 2.4. While the ﬁndings are not always statistically signiﬁcant across all survey years, they do suggest that the return in terms of subsidies and bonuses for more educated workers at non-SOEs are rising compared to SOEs. The second determinant of higher quality human capital is experience. Here, we estimated experience using age and years spent in school. The difference in returns for experience salary wise between SOEs and non-SOEs is not statistically signiﬁcant across survey years. However, when considering the returns in terms of subsidies, SOEs pay more than non-SOEs for every additional year of experience, with a difference of 2.3% in 1989, 2.7% in 1991, and 3.95% in 1997, respectively. 4 In 1989 survey, the categories were food, one-child subsidy, health, bathing and haircut, books and others. The reminding survey categories were grocery, health, haircut, books, house and others. Subsidies are recorded monthly while bonuses are recorded on an annual basis.

14

Table 2.3

The Revival of Private Enterprise in China

Regression of Subsidy on Education and Experience

Variables Intercept

1989 1991 1993 1997 2.5600 2.9800 3.4900 3.6072 (7.61) (8.05) (8.39) (4.92) Log(hours) -0.2440 -0.1558 -0.3172 -0.2500 (-1.59) (-0.91) (-1.67) (0.75) Experience 0.1741 0.0176 0.0178 -0.0069 (3.19) (3.00) (2.05) (-0.35) Experience2 -0.0002 -0.0003 -0.0002 0.0002 (-2.18) (-2.16) (-1.10) (0.4) Male 0.0514 0.0939 0.0022 0.1440 (1.08) (1.96) (0.03) (1.01) Years of School 0.0451 0.0329 0.0531 0.0575 (6.31) (4.48) (5.54) (2.37) Pri * Years of -0.1282 -0.0110 -0.0213 0.0191 School (-7.17) (-0.81) (-0.81) (0.44) Pri * Experience -0.0231 -0.0274 -0.0053 -0.0395 (-4.49) (-6.44) (-0.62) (-2.02) Urban 0.1907 0.1950 0.2000 0.5178 (4.04) (4.15) (3.20) (3.59) Observations 1312 1233 819 276 Notes: Dependent variable is log(monthly subsidy). Parentheses contain t-values.

This suggests that SOEs pay more for experience than non-SOEs in beneﬁts rather than in salary. Other results are expected. Working longer generates more income. More senior workers receive higher salaries, although this relationship is not proportional. It is interesting to note that male workers are paid signiﬁcantly higher than their counterpart, likely suggesting there is a gender discrimination against female workers. Education plays a more important role with the economic reforms, as it is evidenced by the increasing positive and signiﬁcant returns on education over the years. The results on urban status show that workers with urban residence receive higher salaries, at least in 1991 and 1993. Some points are to be noted regarding bonuses and subsidies. In general it is difﬁcult to estimate the value of non-wage beneﬁts. Here, we restrict the subsidies to actual cash each participant reported and ignored other forms of non-monetary beneﬁts such as housing or coupons since their value is difﬁcult to estimate. In general, one can assume that such beneﬁts are likely to be higher in SOEs than in non-SOEs (Zhao, 2001). Thus, it is likely that the non-monetary beneﬁts for working at an SOE are underestimated in the model. Similarly, we only considered cash bonuses that are estimated from previous year amounts, thus susceptible to measurement error in general.

Higher Efﬁciencies or Resource Reallocation?

Table 2.4

15

Regression of Total Annual Bonuses on Education and Experience

Variable Intercept

1989 1991 1993 1997 4.8200 4.7500 5.2655 5.7809 (16.26) (9.86) (12.67) (11.44) Log(hours) 0.1310 0.2200 0.1407 -0.0424 (0.98) (0.97) (0.76) (-0.20) Experience 0.0069 0.0139 0.0219 0.0097 (0.98) (1.87) (2.07) (0.55) Experience2 -0.0000 -0.0002 -0.0004 0.0000 (-0.28) (-1.31) (-1.66) (0.06) Male 0.0227 0.1316 0.0224 0.0177 (0.45) (2.38) (0.32) (0.16 ) Years of School 0.0206 0.0192 0.0300 0.0635 (2.76) (2.31) (2.85) (3.60) Pri * Years of -0.0632 0.0176 0.0113 0.0466 School (-1.15) (0.92) (0.42) (1.75) Pri * Experience -0.0182 -0.0018 0.0232 -0.0093 (-2.23) (-0.22) (2.23) (-0.87) Urban 0.1099 0.1297 0.1943 0.1992 (2.14) (2.36) (2.70) (1.85) Observations 995 1005 776 431 Notes: Dependent variable is log(annual bonus). Parentheses contain t-values.

4 Human Capital Composition of SOEs and Non-SOEs From the previous section, the results suggest that non-state sectors pay more for more educated workers while state sectors pay more for experienced workers. In this research, we apply a linear probability model to the general working population to examine the composition of educated and experienced workers in SOEs and nonSOEs. Table 2.5 shows the results. Looking at experience, workers with more experience are more likely to be found working for an SOE. This probability increases across survey years from 0.004 in 1989 to 0.006 in 1997. This is not surprising since SOEs reward seniority more than non-SOEs, people working in SOEs are less likely to leave once they decide to work for a state ﬁrm. Despite the non-state ﬁrm paying more for more educated workers, people with more years of education are more likely to be found working for an SOE. This trend continues even though some evidence suggests that beneﬁts in non-SOEs have begun to improve. In 1989, a worker with an additional year of school lowers the chances of working for a non-SOE by 0.035. This is despite non-SOEs paying about 4.4% more during that same period (Table 2.2). The largest gap in salary for educated workers between SOEs and non-SOEs is in 1993 at 6.5% (Table 2.2). Yet in that same year, the probability of not working for an SOE actually increased to 0.04. In 1997, with the gap between SOEs and non-SOEs narrowing to 3.4% and some evidence suggesting that beneﬁts for more educated workers have improved at non-

16

Table 2.5

The Revival of Private Enterprise in China

Regression of Choice of SOE or Non-SOE over Current Working Population

Variable Intercept

1989 1991 1993 1997 0.78876 0.62771 0.84603 1.16346 (20.14) (16.03) (19.98) (23.62) Years of School -0.03579 -0.03575 -0.04083 -0.05529 (-12.18) (-12.39) (-12.85) (-14.37) Male 0.04417 0.01177 0.04991 0.00065 (2.20) (0.60) (2.29) (0.03 ) Experience -0.00431 -0.00532 -0.00519 -0.00676 (-5.34) (-6.38) (-5.59) (-6.43) Monthly Income 0.00001972 0.00134 0.00003857 0.00009129 (1.05) (12.64) (2.49) (5.26) Urban -0.25031 -0.22200 -0.22402 -0.26473 (-13.11) (-11.80) (-10.55) (-10.51) Observations 1972 1687 1592 1323 Notes: Dependent variable is a binary variable of non-SOE. Parentheses contain t-values.

SOEs, the probability for working at a non-SOE continued to drop to 0.05. Thus, the general overview presented between SOEs and non-SOEs indicates that the labor force found in SOEs is actually more able than those found in non-SOEs. 5 First Time Entrants into Labor Force

The choice of working in an SOE or a non-SOE presented in the previous section remains endogenous since the accrued beneﬁts workers receive through seniority is indistinguishable from beneﬁts in general. For example, a worker may choose to remain working for an SOE because seniority beneﬁts like housing or pension may not be transferable to a non-SOE. Thus, even if a non-SOE offered both higher monetary and non-monetary beneﬁts, the worker will still continue to work for the SOE. Furthermore, it is also unclear if the current workers were aware of the differences in beneﬁts between SOEs and non-SOEs when they started their careers. To have a more accurate picture, we then consider a similar model, this time consisting only of ﬁrst time workers. This group is restricted to participants who were students in the one survey year and who moved into the work force in the next immediate survey year. For example, someone who is a student in 1989 and is working in 1991 will be in the population of “Entry 1991” and so on. This category of ﬁrst time workers will be less constrained by accrued beneﬁts discussed above. Furthermore, this category will also suggest whether SOEs remain attractive to a newer generation of workers. The results of the model restricted to this group of participants are found in Table 2.6. Since the changes in compensation between SOEs and non-SOEs for more educated workers will eventually be known to entering workers, we can assume that entry workers in the nth period will be aware of the compensation offered between

Higher Efﬁciencies or Resource Reallocation?

Table 2.6

17

Regression of Choice of SOE or Non-SOE over Incoming Workforce

Entry 1991 Entry 1993 Entry 1997 1.57829 1.71680 1.60864 (17.06) (12.27) (16.90) Years of School -0.04566 -0.05647 -0.04899 (-5.82) (-5.42) (-6.61) Age -0.01788 -0.01965 -0.01461 (-3.65 ) (-2.31) (-4.13) Male 0.01422 -0.01625 -0.00166 (0.33) (-0.34) (-0.04) Urban -0.32485 -0.23920 -0.15133 (-6.26) (-3.51) (-3.15) Observations 227 204 322 Notes: Dependent variable is a binary variable of non-SOE. Parentheses contain t-values. Intercept

SOEs and non-SOEs in the n-1th period. Therefore, a student in 1993 who is working in 1997 will be aware that non-SOEs pay 6.5% more than SOEs for an additional year of school in 1993. Table 2.7 summarizes these results, for convenience. The more education a person has, the more likely he will choose to work for an SOE coming out of school. This is done (surprisingly) even with prior knowledge of the salary differential between SOEs and non-SOEs. This suggests that ﬁrst time entrants continue to view SOEs as attractive places to work. 6 Concluding Remarks Since the start of China’s economic reforms, the output of SOEs has fallen continuously. The results from this chapter suggests that more educated workers are better off at non-SOEs while more experienced ones at SOEs. In spite of this, more educated workers are more likely to be found in SOEs, as are more experienced ones. For people leaving school for the work force, the more educated people are more likely to choose to work for an SOE. This trend continues despite increase difference in non-SOE compensation. This suggests that the decline in output for SOEs is not due to less able human capital inputs, but more to inefﬁciencies in the organization. The implication of this is that the slide in SOEs output is likely to Table 2.7

Year 1991 1993 1997

Impact of Education on Non-SOE Wage Premium and Choice Probability Prior year non-SOE premium for an additional year of school 4.5% 4.6% 6.5%

Impact on current year student choice between SOE and non-SOE -0.0456 -0.0564 -0.0490

18

The Revival of Private Enterprise in China

continue. Simply matching non-SOEs compensation is unlikely to solve the problem since the evidence suggests that more able workers are already found in SOEs. Two cautions are worth mentioning. Firstly, the data does not allow us to make the distinction between foreign-owned, local-owned or SOE spin offs in classifying non-SOEs. Further research is needed to better understand these differences in order to make better comparisons between SOEs and non-SOEs. Secondly, our use of education and experience as proxies for ability still presents heterogeneity bias. The dataset does not account for how different experience or academic training are relevant to their respective jobs. References Heckman, J. and Li, X, “Selection Bias, Comparative Advantage and Heterogeneous Returns to Education: Evidence from China in 2000,” NBER working paper 9877 (2003). Li, H. and Urmanbetova, A., “The causal effect of Education on Wages: Evidence from China’s Rural Industry,” working paper, School of Economics, Georgia Institute of Technology, Atlanta, Georgia, USA, undated. Lin, J.Y., Cai, F. and Li, Z., “Competition, Policy Burdens, and State-Owned Enterprise Reform,” American Economic Review, 88, 2 (1988): 422–427. Zhang, J. and Zhao, Y., “Economic Returns to Schooling in Urban China, 1988– 1999,” presented at the Annual Meetings of the Allied Social Science Associations, Washington, DC, January (2002). Zhao, Y., “Earnings Differentials between State and Non-State Enterprises in Urban China,” China Center for Economic Research (CCER) Working Paper Series, No. E2001001(2001).

Chapter 3

Size of the State-Owned Sector and Regional Growth in China Kerk L. Phillips, Shen Kunrong1

1 Introduction China has recently experienced episodes of very rapid growth. From an empirical and theoretical standpoint, this phenomenon cries out to be understood, especially since it contrasts so sharply with the experience in other parts of the world. The welfare implications from understanding growth in a country that accounts for a ﬁfth of the world’s population are very large indeed. When one begins to grasp the potential size of the Chinese economy if it were more fully developed and the numbers of people that would be affected, it is difﬁcult to think of other areas of economics where a clearer understanding yields greater potential beneﬁts. One potential way to gain a better understanding of the growth process in China is to look at differences across provinces in China. In the past two decades of double digit annual growth, much of China’s growth has occurred in the coastal provinces, of Jiangsu, Zhejiang, Fujian, and Guangdong. Growth in other parts of China has been respectable, but nowhere near as strong. The disparities between provinces are almost as striking as the high growth rates. Table 3.1 shows real GDP per capita in 1998 by province/administrative area. The highest per capita GDP was Shanghai with 23,844 RMB (measured in constant 1995 RMB).2 Guizhou’s per capita GDP was a mere 2168 RMB. Even allowing for substantial deviations from purchasing power parity, this difference by a factor of eleven is huge. Not only is there a great disparity in the levels of GDP per capita, but the growth rates vary substantially as well. Figure 3.1 plots the log-levels of GDP by region. It clearly shows that the East and South Central regions grew at a faster rate than the rest of the country over this period. All of this raises many interesting questions. Why are the regional differences in per capita GDP so large? Why are the regional differences in growth rates so large? Undoubtedly there are many causes and the answers are not likely to be simple. This chapter focuses narrowly on just one question: what role has the persistence of

1 Phillips: Professor, Brigham Young University. Shen: Professor, Department of economics, Nanjing University, School of Business. 2 The exchange rate was approximately 8.35 RMB per US dollar in 1995.

20

Table 3.1 Province Shanghai Beijing Tianjin Zhejiang Guangdong Fujian Jiangsu Liaoning Shandong Heilongjiang Hebei Xinjiang Hubei Jilin Hainan

The Revival of Private Enterprise in China

Per Capita GDP by Province, 1998 (1995 RMB) Per Capita GDP 23,884 15,266 13,163 10,541 10,518 9506 9448 8795 7637 7068 6102 6044 5906 5549 5493

Province Inner Mongolia Shanxi Hunan Henan Anhui Jiangxi Qinghai Sichuan Yunnan Ningxia Guangxi Shaanxi Tibet Gansu Guizhou

Per Capita GDP 4788 4754 4654 4405 4273 4162 4121 4081 4078 3990 3834 3619 3409 3252 2168

state-owned enterprises played in accentuating or reducing this regional disparity in economic growth? State owned enterprises (SOEs) have been and remain major actors on China’s economic stage. Though their role has lessened somewhat as economic liberalization has taken place, they remain important employers and users of resources, especially in the northwest and some interior provinces. Nationwide, well over half of all employees classiﬁed as “staff and workers” are employed by SOEs. SOE shares in industrial production vary widely across provinces. In the interior, where growth has been slower and per capita GDP is still relatively low, SOE shares are close to 50%. In contrast the faster growing, higher GDP southern costal provinces have much lower SOE shares. In 1998, for example, less that 7% of industrial production in Zhejiang province was attributed to SOEs. While these correlations are of interest, they do not, by themselves, prove anything. The correlation may be spurious, or related to other important factors, such as the location of resources or transportation infrastructure. In this chapter we examine the correlation while controlling for many other potential factors driving the growth process. 2 Data Set Our dataset consists of various data taken from Chinese statistical publications complied at the provincial level every year. Our sample runs from 1978 to 1997 and includes 30 provinces, autonomous regions and independently administered cities. The city of Chongqing was made independent from Sichuan province in 1996. We aggregate these two regions for 1996–1997 making it consistent with earlier observations. We are able to gather a reasonably complete set of data for the variables listed in Table 3.2. We have double checked this data for accuracy and in cases where there

Size of the State-Owned Sector and Regional Growth in China

21

North Northeast East South Central Southwest West

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Figure 3.1

Regional Output, 1978–1998 (Logarithmic Scale)

are obvious, yet uncorrectable errors, we have omitted the observations. With 19 years3 and 30 provinces we have potentially 570 observations, though we often have fewer usable observations in practice due to missing data. Our major sources of data are all ultimately traceable to the National Bureau of Statistics, though they have come to us through a variety of routes. Some are from yearbooks published in China and available at the Nanjing University library. Others come from Hsueh et al (1993); an excellent source of provincial data up to 1989. Additional sources include the English/Chinese language China Statistical Yearbook in various printed and CD-ROM editions. Finally, the CD-ROM on Fifty Years of Chinese Statistical Data was also a useful source. We gathered as many data series as we could ﬁnd that are important for economic growth and development. There are, of course, literally thousands of types of data that ﬁt this criterion. However, the need for consistently reported data from all or most provinces for the bulk of the sample period turns out to be a great winnower of data. We end up with the series reported in Table 3.2. 2.1 Dependent Variables We are attempting to explain economic growth across provinces and include as our ﬁrst dependent variable, the growth of real per capita GDP (GRGDPPC). However, we realize that the data contains not only measurement errors, but biases as well. For example, it is well-known that provincial level data tend to overstate the importance and growth of the private sector. This biases the data because provinces with large 3

Calculating growth rates and lagging our regressors results in the loss of a year.

22

Table 3.2 RGDPPC GRGDPPC TFP GTFP RINVPC RFINVPC SOEEMPP SOEPRODP SOECONP SOERETP SOEINVP GPOP MPOPP AGPOPP GOVTGDPP IISGDPP NEXGDPP CAPINVP INNINVP RFCAUPC RFLONPC RFDIPC LGRGOVP LGEGOVP LTAXLGRP LGCCLGEP LGINLGEP LGAGLGEP LGOTLGEP LGADLGEP DEPGDPP EDEPGDPP PSEPC SSEPC RSEPC HEEPC PSTPC SSTPC RSTPC HETPC HINSPC HOSPPC HIBEDPC HOBEDPC MEDPC DOCPC RRDDEN HWYDEN TELPC RSOEIO GRSOEIO MIGRATE MRATE

The Revival of Private Enterprise in China

Adjusted Data used in Regressions, 30 provinces, 1978–1999 real GDP per capita annual growth of real GDP per capita total factor productivity growth of total factor productivity real investment per capita real ﬁxed investment per capita SOE staff and workers as percent of total employment SOE industrial output as percent of total industrial output Value of SOE construction as percent of total construction value SOE retail sales as percent of total retail sales SOE investment as percent of total ﬁxed capital investment annual growth of population percent of population that is male percent of population classiﬁed as “agricultural” govt consumption as percent of GDP change in inventories as percent of GDP net exports as percent of GDP percent of ﬁxed capital investment classiﬁed as “construction of ﬁxed capital” percent of ﬁxed capital investment classiﬁed as “innovation capital” real value of “foreign capital” actually utilized per capita real value of foreign loans real value of foreign direct investment local gov’t revenue as percent of gov’t consumption local gov’t expenses as percent of gov’t consumption local gov’t taxes revenue as percent of local gov’t revenue local gov’t capital consumption as percent of local gov’t expenditures local gov’t innovation investment as percent of local gov’t expenditures local gov’t agricultural supports as percent of local gov’t expenditures local gov’t other expenses as percent of local gov’t expenditures local gov’t administrative expenses as percent of local gov’t expenditures national bank deposits as percent of GDP enterprise bank deposits as percent of GDP primary school students enrolled as percent of population secondary school students enrolled as percent of population regular secondary school students enrolled as percent of population higher education students enrolled as percent of population primary school teachers as percent of population secondary school teachers as percent of population regular secondary school teachers as percent of population higher education teachers as percent of population health institutions per capita hospitals per capita health institution beds per capita hospital beds per capita medical technicians per capita doctors per capita km of railroad per sq km of area km of highway per sq km of area telephones per capita real SOE industrial output growth of real SOE industrial output implied population migrating into a province percent implied population migrating into a province

Size of the State-Owned Sector and Regional Growth in China

23

state-owned sectors will have smaller reported growth rates simply because the GDP ﬁgures put less weight on the inﬂated private sector.4 For this reason we also examine other measures that should be highly correlated with real GDP growth, but hopefully, less susceptible to this bias. We consider the growth of total factor productivity (GTFP). This controls for variations in capital usage and labor market participation, but is still subject to the bias mentioned above. This variable was calculated by using these real GDP ﬁgures, the reported employment ﬁgures, and a rough measure of the capital stock, calculated by using the perpetual inventory method. The initial capital stock for each province and the depreciation rate were chosen such that the sum of the provincial stocks followed a path as similar as possible to the national capital stock reported by Chow (1993). We calculated TFP using capital shares in output of one-fourth. Other formulations we tried did not produce capital stock series that were very different from this method. We also use growth of industrial output in the state-owned sector only (GRSOEIO). This should eliminate the bias, but may also overcorrect, by ignoring important real gains in the private sector. 2.2 Independent Variables Our independent variables are grouped into the following categories: Baseline Regressors We choose these to match as closely as possible the baseline regressors used in Levine and Renelt (1992). These are real GDP per capita in the previous year,5 real investment per capita in the previous year, and the growth rate of the population from the previous year. These are variables which have been found to be robust in explaining growth in cross-country studies. Measures of the Size of State Owned Enterprises We use ﬁve measures. First is the percent of total employment accounted for by SOEs within the province (SOEEMPP). The second is the SOE share in industrial output (SOEPRODP). This measure may have a downward bias as mentioned previously. The last three are conceptually less accurate measures of total size, but are included because the data were available and they should be positively correlated with overall size. They are the share of SOEs in construction (SOECONP), the share of SOEs in total retail sales (SOERETP), and the share of SOEs in total investment (SOEINVP). Other Regressors As a check for robustness we also include other variables which could inﬂuence economic growth. These include measures of education and human capital, demographics, infrastructure, government spending and taxation, etc. The full list of regressors is given in Table 3.2. 4 We are grateful to Thomas Rawski for this insight. 5 Most cross-country studies use initial GDP level, but in a panel regression this is multicolinear with provincial ﬁxed effects. Hence, we use the lagged value of GDP to control for convergence.

The Revival of Private Enterprise in China

24

There are serious problems with measurement in provincial level data from China. Unfamiliarity with necessary reports, inadequate base year adjustment and bureaucratic incentives all play a role in inﬂating or distorting output statistics.6 However, this inaccuracy does not mean it is impossible to extract information from these ofﬁcial statistics without major data revision. For example, if the output ﬁgures are always inﬂated by a ﬁxed amount, the growth rates will be unaffected. Even if growth rates are overstated, if the overstatement is a constant percent regression analysis will subsume this distortion into the estimated constant term without any adverse effects on estimates of how growth responds to SOE size. If growth rates are distorted differently over time, but in the same way over all provinces, or if the distortions are province-speciﬁc but remain the same over time, then a set of ﬁxed-effect dummies will also subsume these errors. Even if there are systematic distortions that cannot be picked up by ﬁxed-effects, they will not impact on SOE coefﬁcients unless the errors are correlated with SOE size. In some cases, this may well be true, particularly for overall GDP growth as mentioned above. 3 Methodology In the past two decades, there has been a blossoming of research in economics concentrating on economic growth. Much of this work has been empirical in nature, and the bulk of it has used data from cross-country regression analysis. Advances in statistical analysis computing power have made it possible to move away from crosssectional studies which use long-run (30-year averages) growth across a sample of several dozen countries. Instead, focus has begun to shift to panel regressions that utilize data from several countries observed at several points in time. Results from cross-country regressions like those reported by Levine and Renelt (1992) and Sala-i-Martin (1997) show a great deal of multicolinearity in the independent variables. This makes it very difﬁcult to distinguish between the effects of various potential explanatory variables. In our case, however, it turns out that the results of SOE size are robust to the inclusion of other regressors, hence we do not present a full set of permutations. We test contributions to economic growth by estimating regressions of the form shown in (4.1): git = yit–1βy + xit–1βy + εit

(1)

with git as the dependent variable and yit and xit as vectors of regressors. git is the per capita growth rate in province i over time period t, yit is the set baseline regressors introduced in the previous section and xit is a set of SOE size variables. Note that lagged values of the right-hand variables are used to minimize problems of joint determination. To test for robustness we vary the number of elements in xit. The two cases we use are a single SOE regressor in xit and all ﬁve regressors. 6

See Woo (1997) for an excellent discussion.

Size of the State-Owned Sector and Regional Growth in China

25

We also estimate a regression of the following form: git = yit–1βy + xit–1βy + zit–1βz + εit

(2)

where zit is the whole set of other regressors listed in Table 3.2. We run these regressions using OLS and include both time-period and province dummies to control for ﬁxed effects in our panel regression. We also allow for greater weight on large provinces by estimating using weighted least-squares. Given the limited data we have many missing observations for some variables. We treat these missing variables two different ways. The ﬁrst is to drop all observations where one of the regressors in (4.2) is missing. This gives us a ﬁxed sample across all regressions we run, but greatly reduces the number of observations. It also ignores potential information from the regressors that are not missing. Hence, we also estimate using proxies for missing observations. We do so by including missing/ not missing dummy for each regressor and setting the value of missing observations to zero. This has the effect of using an estimate of the missing regressor conditional on the other observable regressors whenever it is missing. Hence for each choice of dependent variable, SOE vector, and inclusion of other regressors, we run four different regressions: OLS with missing observations omitted, OLS with proxies for missing observations, WLS with missing observations omitted, and WLS with proxies for missing observations. We now discuss the results of this estimation. 4 Results of Estimation Tables 3.3 through 3.5 present the results of our estimation. In Table 3.3 we estimate ﬁve permutations of eq. (1) with real per capita GDP is the dependent variable for each SOE variable included alone. Second, we estimate using all ﬁve SOE measures. Finally, we estimate using all ﬁve measures and all additional regressors. Several robust results are apparent. First, the SOE measures are generally not signiﬁcant when OLS is used. WLS, however, tends to give highly signiﬁcant results. Second, the SOE shares in employment and industrial production both have robustly negative coefﬁcients, while the SOE share in construction and retail sales are robustly positive. SOE share in investment does not have a robust relation. Third, the effects are generally larger when missing observations are ignored than when they are proxied. The sizes of the effects are rather large. For example, the coefﬁcient on SOEEMPP is approximately -.35 indicating that a drop in the share of SOEs in employment from 80% to 70% would be associated with a rise in real GDP per capita of 3.5% the following year. Table 3.4 gives the results when the growth of total factor productivity is the dependent variable. The results are very similar to Table 3.3. We ﬁnd a robust negative correlation between SOE shares in industrial output and employment and growth of total factor productivity the following year. We ﬁnd a robust negative relation for SOE shares in construction and retail sales. And we ﬁnd no consistent correlation for the SOE share in investment.

The Revival of Private Enterprise in China

26

Table 3.3

Results of Regressions using GRGDPPC as Dependent Variable OLS omit 236

OLS proxy 600

WLS omit 236

WLS proxy 600

0.5341 -0.2695 -1.5310

0.3524 -0.1865 -1.6445

0.6046 -0.2326 c -9.3666

0.4745 -0.1555 c -10.4360

R2 SOEPRODP t-stat

0.5407 -0.1270 c -2.6024

0.3509 -0.0474 -1.2235

0.6108 -0.1177 c -20.2879

0.4768 -0.0723 c -15.3183

R2 SOECONP t-stat

0.5302 0.0059 0.1795

0.3490 0.0024 0.0945

0.6027 0.0166 c 4.2798

0.4727 0.0002 0.0615

R2 SOERETP t-stat

0.5345 0.1198 1.3925

0.3489 -0.0062 -0.2161

0.6050 0.0960 c 9.1501

0.4729 0.0072 c 1.8404

R2 SOEINVP t-stat

0.5337 0.0671 1.1450

0.3497 0.0008 0.0269

0.6066 0.0772 c 11.2135

0.4732 0.0051 1.4324

All ﬁve regressors R2 SOEEMPP t-stat

0.5639 -0.3892 a -1.9511

0.3556 -0.1920 -1.5759

0.6287 -0.3477 c -12.0022

0.4804 -0.1728 c -10.4184

SOEPRODP t-stat

-0.1911 c -3.3092

-0.0553 -1.3512

-0.1751 c -25.5597

-0.0865 c -17.4266

SOECONP t-stat

0.0229 0.7338

0.0083 0.3219

0.0253 c 6.9720

0.0063 c 2.0947

SOERETP t-stat

0.2229 b 2.2724

-0.0003 -0.0110

0.1824 c 15.4043

0.0157 c 3.9414

SOEINVP t-stat

0.0736 1.2465

0.0037 0.1155

0.0910 c 13.0559

0.0149 c 3.9182

All regressors R2 SOEEMPP t-stat

0.7367 -0.4916 -1.4332

0.5253 -0.4300 b -2.3913

0.7675 -0.3494 c -7.3963

0.6002 -0.41198 c -17.1246

SOEPRODP t-stat

-0.0778 -1.3614

0.0305 0.6271

-0.1056 c -15.5115

-0.0211 c -3.5455

SOECONP t-stat

0.0120 0.3079

0.0187 0.7081

0.0390 c 8.0066

0.0272 c 7.8773

SOERETP t-stat

0.0687 0.6063

0.0340 1.0134

0.0480 c 3.6072

0.0420 c 8.6286

SOEINVP t-stat

-0.0767 -0.9453

-0.0218 -0.3786

-0.0956 c -8.9396

-0.0568 c -7.6497

usable observations One SOE regressor R2 SOEEMPP t-stat

a signiﬁcant at 90% conﬁdence b signiﬁcant at 90% conﬁdence c signiﬁcant at 90% conﬁdence

Size of the State-Owned Sector and Regional Growth in China

Table 3.4

Results of Regressions using GTFP as Dependent Variable OLS omit 236

OLS proxy 600

WLS omit 236

WLS proxy 600

0.4877 -0.7106 c -3.5381

0.3027 -0.4251 c -2.7655

0.5570 -0.6768 c -24.0754

0.3817 -0.4063 c -18.8397

R2 SOEPRODP t-stat

0.4679 -0.0639 -1.1434

0.2933 -0.0267 -0.5488

0.5422 -0.0596 c -9.3723

0.3760 -0.0559c -8.6874

R2 SOECONP t-stat

0.4659 -0.0137 -0.3227

0.2946 0.0322 1.0970

0.5403 0.0068 1.3455

0.3765 0.0365c 9.9347

R2 SOERETP t-stat

0.4672 0.0769 0.8121

0.2937 -0.0329 -0.9120

0.5409 0.0518 c 4.5267

0.3744 -0.0144 c -2.8478

R2 SOEINVP t-stat

0.4672 0.0476 0.7852

0.2930 0.0123 0.3469

0.5430 0.0664 c 9.3614

0.3761 0.0214 c 5.0331

All ﬁve regressors R2 SOEEMPP t-stat

0.5005 -0.8436 c -3.8750

0.3067 -0.4485 c -2.7404

0.5699 -0.8448 c -26.8666

0.3900 -0.4757 c -19.4193

SOEPRODP t-stat

-0.0948 -1.5301

-0.0440 -0.8912

-0.0771 c -10.8957

-0.0809 c -12.4899

SOECONP t-stat

0.0053 0.1409

0.0332 1.1255

0.0149 c 3.4219

0.0345 c 8.9443

SOERETP t-stat

0.1914 c 1.7718

-0.0107 -0.2826

0.1414 c 10.9377

0.0174 c 3.2645

SOEINVP t-stat

0.0642 1.0553

0.0033 0.0958

0.0995 c 13.8746

0.0200 c 4.7109

All regressors R2 SOEEMPP t-stat

0.7001 -1.4963 c -3.0867

0.5057 -0.8417 c -3.9573

0.7275 -1.2924 c -20.0455

0.5631 -0.8436c -28.2089

SOEPRODP t-stat

-0.0110 -0.1723

-0.0025 -0.0450

-0.0403 c -5.2996

-0.0542 c -7.5633

SOECONP t-stat

-0.0150 -0.3737

0.0208 0.6847

0.0033 0.6553

0.0330 c 8.2025

SOERETP t-stat

-0.0421 -0.3057

-0.0106 -0.2390

-0.0566 c -3.4504

-0.0029 -0.4459

SOEINVP t-stat

-0.0954 -1.1013

-0.0011 -0.0156

-0.0959 c -8.1990

-0.0202 c -2.2410

usable observations One SOE regressor R2 SOEEMPP t-stat

c

27

Signiﬁcant at 90% conﬁdence

28

The Revival of Private Enterprise in China

To check for the bias we discussed above, Table 3.5 uses growth of industrial production in SOEs only. If the data for private enterprises is inﬂated our SOE shares are biased downward, but presumably the reported growth of the state-owned sector is not biased in the same way. It is problematic, at best, to interpret the results here as applying to the whole economy. The most accurate interpretation is to view them as the correlation of state-owned performance with the relative size of the state-owned sector. Here as well, we ﬁnd results that are very similar to Table 3.3. SOE shares in employment and industrial production are robustly negatively correlated with the following year’s growth of SOE industrial output. The other three measures of SOE size: construction, retail, and investment, all have robust positive correlations. The sizes of the effects are generally much higher than is the case for real GDP growth. For example, the coefﬁcient on SOEEMPP in WLS regressions is -0.54 to -1.58 rather than the -0.17 to -0.41 reported in Table 3.3. To summarize, we ﬁnd that for a variety of measures that one might expect to be highly correlated with actual real per capita GDP growth, there is a largely negative correlation of these measures with the SOE share in employment. 5 Conclusions We realize there are problems with data at the provincial level in China. The process for gathering the data is not as transparent as one would wish and there are real concerns about political manipulation of the data, particularly since 1998. Random inaccuracies that are uncorrelated are, at least conceptually, not a problem as these errors can be subsumed into our regressions’ error terms. More problematic are biases created by the distortions in both our dependent and independent variables simultaneously. We know of no way to adequately control for such biases, but we do look at a variety of measures of economic “well-being” in hopes that not all of these are plagued by the same biases. Given the above caveat, our results show a strong negative correlation between the size of the state-owned sector and local economic growth rates the following year. These effects are in addition to any ﬁxed effects associated with each province and time period. The most robust effects are found for the SOE share in provincial employment and in industrial production. For 1978 these shares averaged 24% and 79%, respectively, across all 30 provinces. By the end of our sample in 1997, these shares had fallen to 21% and 38%. The estimated coefﬁcients are higher for employment than for industrial production, but SOE employment has changed little since the mid-1970s, while SOE industrial production shares have fallen dramatically. Using the values from our WLS regressions with missing observations proxied this translates into average local growth rates being higher in 1997 than they would have been had the SOE shares remain unchanged. The estimated impacts are between 0.46% and 1.10% higher due to the drop in SOE employment and between 0.86% and 3.53% higher due to the large drop in SOE industrial production share. We ﬁnd our results are not due to changes in factor allocation since we ﬁnd almost identical results using total factor productivity growth instead of real GDP growth. However, our measures of provincial capital stocks are very imprecise and

Size of the State-Owned Sector and Regional Growth in China

Table 3.5

29

Results of Regressions using GRSOEIO as Dependent Variable OLS omit 236

OLS proxy 600

WLS omit 236

WLS proxy 600

0.4710 -0.8993 a -1.7965

0.4729 -0.5054 b -1.9933

0.5007 -1.0620 c -15.1563

0.4729 -0.4568 c -11.5423

R2 SOEPRODP t-stat

0.4667 -0.2027 -1.6370

0.4644 -0.0158 -0.2229

0.4951 -0.2082 c -13.9275

0.4714 -0.1277 c -12.4273

R2 SOECONP t-stat

0.4637 0.0975 1.1983

0.4662 0.0445 1.2806

0.4910 0.0705 c 7.7888

0.4693 0.0422 c 8.9051

R2 SOERETP t-stat

0.4613 -0.0013 -0.0065

0.4648 0.0278 0.7086

0.4896 0.0008 0.0358

0.4692 0.0402 c 7.3230

R2 SOEINVP t-stat

0.4615 -0.0348 -0.2633

0.4650 -0.0254 -0.6175

0.4896 -0.0119 -0.7531

0.4679 -0.0172 c -3.3986

All ﬁve regressors R2 SOEEMPP t-stat

0.4809 -0.9773 a -1.8529

0.4772 -0.537 b -2.1165

0.5095 -1.1590 c -15.3290

0.4832 -0.5389 c -13.5196

SOEPRODP t-stat

-0.2396 -1.5284

-0.0327 -0.4397

-0.2366 c -12.3704

-0.1586 c -14.6883

SOECONP t-stat

0.1147 1.4164

0.0536 1.5049

0.0759 c 8.4065

0.0587 c 12.0069

SOERETP t-stat

0.2319 1.0043

0.0413 1.0443

0.2353 c 8.2931

0.0651 c 11.5234

SOEINVP t-stat

-0.0063 -0.0472

-0.0318 -0.7543

0.0406 c 2.5118

-0.0051 -0.9604

All regressors R2 SOEEMPP t-stat

0.5922 -1.7377 -1.5898

0.5694 -0.7574 -2.4858

0.6058 -1.5843 c -11.0794

0.5805 -0.7571 c -16.6090

SOEPRODP t-stat

-0.4815 b -2.3617

-0.4980 c -20.1838

-0.0128 -1.1631

SOECONP t-stat

0.3333 c 2.8825

0.0958 c 2.6916

0.2866 c 21.3540

0.1123 c 23.1647

SOERETP t-stat

0.5273 a 1.9699

0.0651 1.4919

0.5238 c 16.7757

0.0563 c 8.6113

SOEINVP t-stat

0.2776 1.0927

0.1300 1.1868

0.2663 c 8.0387

0.0934 c 6.0829

usable observations One SOE regressor R2 SOEEMPP t-stat

a signiﬁcant at 90% conﬁdence b signiﬁcant at 90% conﬁdence c signiﬁcant at 90% conﬁdence

0.0488826 0.6030

30

The Revival of Private Enterprise in China

our TFP measures do not include adjustments for capital utilization or changes in hours per worker. To address the bias introduced by over-reporting of private sector production we also estimated regressions using only the growth of SOE production. We ﬁnd the same negative correlations here as above. Less-precise measures of economic well-being such as net migration, and investment growth do not yield a consistent picture. We are reluctant to make any policy recommendations based solely on this chapter. However, our results indicate that the responsiveness of growth to changes in SOE employment is higher than the responsiveness to changes in SOE industrial production. Since SOE employment shares have fallen very little in the past 20 years, it would seem that relaxation of policies which hold SOE employment steady might be a fruitful way to further stimulate growth. References Cashin, P. and Sahay, R., “Internal Migration, Center-State Grants and Economic Growth in the States of India,” International Monetary Fund Staff Papers, 43, 1 (1996). Chow, G., “Capital Formation and Economic Growth in China,” Quarterly Journal of Economics, 108 (1993): 809–42. Coulombe, S., “New Evidence of Convergence across Canadian Provinces: The Role of Urbanization,” Regional Studies, 34, 8 (2000): 713–25. Hsueh, T., Oiang, L. and Shucheng, L., China’s Provincial Statistics: 1949–1989, (Westview Press, 1993). Knight, M., Norman L., and Villanueva, D., “Testing the Neoclassical Theory of Economic Growth: A Panel Data Approach,” International Monetary Fund Staff Papers, 40, 3 (1993). Johnson, P., “A Nonparametric Analysis of Income Convergence across the US States,” Economics Letters, 69, 2 (2000): 219–23. Lamo, A., “On Convergence Empirics: Some Evidence for Spanish Regions,” Investigaciones Economicas, 24, 3 (2000): 681–707. Leamer, E., “Let’s Take the Con out of Econometrics,” American Economic Review, 73, 1 (1983): 31–43 Leamer, E., “Sensitivity Analyses Would Help,” American Economic Review, 75, 3 (1985): 308–13. Liu, T. and Li, K., “Impact of Liberalization of Financial Resources in China’s Economic Growth: Evidence from Provinces,” Journal of Asian Economics, 12, 2 (2001): 245–62. Levine, R. and Renelt, D., “A Sensitivity Analysis of Cross-Country Growth Regressions,” American Economic Review, 82, 4 (1992): 942–63. National Bureau of Statistics, People’s Republic of China, China Statistical Yearbook, var. eds. and CD-ROMs, (China Statistics Press). Pekkala, S., “Regional Convergence across the Finnish Provinces and Subregions, 1960–94,” Finnish Economic Papers, 12, 1 (1999): 28–40.

Size of the State-Owned Sector and Regional Growth in China

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Quah, D., “Empirics for Economic Growth and Convergence,” European Economic Review, 40, 6 (1996): 1353–75. Sala-i-Martin, X., “I Just Ran Two Million Regressions,” American Economic Review, 87, 2 (1997): 178–83. Woo, W., “Chinese Economic Growth: Sources and Prospects,” mimeo (1997).

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Chapter 4

Resource Allocation and Economic Growth in China Shuanglin Lin1

1 Introduction In 1957 China completed socialist reform on the ownership of production means. For 20 years, while her neighboring countries were making economic strides, China was still a low-income country. In 1978, another reform started which intended to bring market mechanics into the economy. Since then, the Chinese economy has been growing at an astonishing rate, with an average annual growth rate of GDP of around 10%. What are the ultimate forces (if any) which caused the rapid Chinese economic growth? This chapter intends to address this issue by examining the effects of the allocation of resources among enterprises of different types of ownership, along with other factors, on economic growth. Based on the theory of endogenous economic growth, allocation of resources between public sector and private sector matters for economic growth. Romer (1989), King and Rebelo (1990), Rebelo (1991), and Jones and Manueli (1990) showed that if more resources are allocated to the government sector (through an increase in taxes) economic growth will be slow. By considering productive services which the government provides for private ﬁrms, Barro (1990) showed that theoretically government spending (measured by government spending-output ratio) may be either positively or negatively related to the growth rate of output, but empirically government consumption expenditures were negatively related and government investment expenditures were insigniﬁcantly related to economic growth. In many countries, particularly the centrally-planned socialist countries, government not only collects taxes to ﬁnance its spending, but also directly runs state-owned enterprises. The Chinese economy is characterized by a large state production sector. In China, the output share of state enterprises in total output was 76% in 1980. The private production sector has been growing rapidly since early 1 Noddle Distinguished Professor, Department of Economics, CBA 512, University of Nebraska at Omaha, Omaha, NE 68182, USA. Phone: 402-554-2815, Fax: 402-554-2853, Email: [email protected]; Department of Public Finance, School of Economics, Peking University, Beijing, China 100871. Phone: 10-6276-0620; Fax: 10-6275-1460. This chapter was published in Economic Inquiry, Volume 38, Number 3, 2000, 515–26. The author thanks the Western Economic Association International for granting permission to reprint the paper in this book. Minor revisions have been made.

34

The Revival of Private Enterprise in China

1980. In 1996, the industrial output share of state enterprises declined to 28.5%. Chow (1993) analyzed how physical capital formation in the national economy and the ﬁve productive sectors of agriculture, industry, construction, transportation, and commerce contributed to economic growth. He found that capital formation played an important role and technical change was absent in the growth of Chinese economy from 1952–1980. So far the relationship between the allocation of resources between private and state sectors on economic growth has not been studied. It has long been argued that the private sector is more efﬁcient than the public sector (see, for example, Hayek (1935) and Friedman (1980)). In this chapter, we will test the hypothesis that an increase in the investment share of private enterprises can increase the growth rate of per capita GDP by using data from thirty Chinese provinces. The data are mainly from the recently published statistics book, Seventeen Years’ Regional Statistics after Reforms and Opening-Up (1997), and the various issues of Statistical Yearbook of China.2 It is found that the investment share of state enterprises is negatively related to the growth rate of per capita GDP, while the investment share of private enterprises is positively related to the rate of growth, i.e., the provinces with a larger share of investment in state enterprises grow slower than the provinces with a smaller share of investment in state enterprises. The remainder of the chapter is organized as follows. Section 2 describes the state and private enterprises in China from a historical perspective. Section 3 discusses the hypotheses to be tested, with an emphasis on the share of resources allocated to state and private enterprises on economic growth. Section 4 describes data and deﬁnes variables. Section 5 presents the empirical results concerning the relationship between resource allocations and the rate of economic growth. Section 6 concludes the chapter. 2 State and Private Enterprise in China Chinese enterprises have been ofﬁcially classiﬁed by ownership into the following categories:3 State enterprises, collective enterprises, private individual enterprises, and other enterprises. The state enterprises are afﬁliated with various levels of government, such as central government, provincial government, city government, and county government. Government at different levels delegates the supervision of the afﬁliated state enterprises. Managers act according to the commands of supervisory bureaucracies in the government. Two key problems have plagued the state enterprises, the lack of incentives for the managers and workers and unsuccessful planning by the planning authorities. Collective enterprises include those afﬁliated to a district government under a municipality or a county, a neighborhood under a district, a township government, and villages. These enterprises are not directly under the central government planning. They produce in response to market demand and are responsible for their losses. Thus, collective enterprises act like the ﬁrms in the market economy. 2 Chow (1993, p. 810) argued that Chinese statistics, by and large, were internally consistent and accurate enough for empirical work. 3 See Statistical Yearbook of China, 1993.

Resource Allocation and Economic Growth in China

35

Individual enterprises are owned by individuals or a group of individuals and are not afﬁliated to any government organizations. They can determine what and how to produce, and sell their products in the market. These enterprises are clearly private enterprises. Other enterprises include foreign enterprises and joint ventures between domestic ﬁrms and foreign ﬁrms, and joint ventures between state enterprises and private enterprises.4 Since these enterprises are market-oriented and pursue proﬁts, we put them in the same category as private enterprises. In 1949 the government seized all large enterprises and turned them into state enterprises. The initial government policy toward the medium and small private enterprises was to turn them into state or collective enterprises gradually (through buying their shares). The process was called “socialist reform”. It was planned to be completed by 1967. However, as the economy recovered and became stronger, the government lost its patience. Using administrative power, the government completed the “socialist reform” by the end of 1957. Since then, for more than 20 years, private enterprises had not been legal in China. The Chinese planning system before reform might be the most rigid one, compared to the systems in other centrally-planned economies. In fact, the Eastern European Countries and the former Soviet Union started economic reform in the 1950s after the death of Stalin. They raised agricultural product prices to stimulate agriculture, and introduced material incentives to motivate workers in industry. These reforms had been strongly criticized as “revisionism” leading to capitalism by the Chinese authorities until the Chinese government started its own reform in 1978. Private enterprises reemerged in 1980. Since then, both the number of private enterprises and the output produced by them had increased gradually. The bankruptcies of state enterprises also contributed to the decrease in the resource allocation toward state enterprises. On November 1, 1988, the government passed the “Bankruptcy Law,” allowing the state enterprises with long suffering losses to go bankrupt.5 The number of enterprises declaring bankruptcy has been increasing.6 4 According to the ofﬁcial deﬁnition, other enterprises “include the enterprises of private economy, joint-owned economy, share-holding (companies limited with liabilities), foreign funded economy (Sino-foreign joint ventures, Sino-foreign cooperative enterprises and foreign ventures exclusively with their own investment), economy funded by the entrepreneurs from Hong Kong, Macao and Taiwan (joint ventures and cooperatives enterprises with the mainland as well as ventures exclusively with their own investment) and other types of ownership [see Statistical Yearbook of China, 1998, p. 487].” The data on investment for joint ventures were available only after 1993. In 1997, ﬁxed investment was 342.9 billion yuan by individual enterprises, 138.7 billion yuan by stock sharing enterprises, 195.6 billion yuan by foreign enterprises, 93.7 billion yuan by enterprises of Hong Kong, Taiwan, and Macao, but was only 12.3 billion yuan for joint ventures [see Statistical Yearbook of China, 1998, pp. 188–9].” 5 In many western countries, government usually nationalizes the enterprises, which are losing money. Shleifer and Vishny [1994] showed that “potentially proﬁtable ﬁrms are the best candidates for privatization, because they are restructured after privatization.” 6 The number of bankruptcy case received by courts was 98 in 1989, 32 in 1990, 117 in 1991, 428 in 1993, and 710 in 1993 (see Wang [1994]). More than 30% of state enterprises are losing money and the government policy in recently years has been “holding the big

36

The Revival of Private Enterprise in China

The rapid expansion of non-state enterprises, particularly private enterprises, greatly changed industrial output composition by ownership. In 1980, the output share of state-owned enterprises was 75.97%. Since 1980, the share to state enterprises in industrial output has been steadily declining, while the share of non-state enterprises is increasing. In 1996, the output share of state-owned enterprises decreased to 28.48%. Clearly, there is a trend of privatization in the Chinese industry.7 Private enterprises have not been treated the same as state enterprises. Until recently, private enterprises were considered supplements of the state enterprises. In China, most banks and other ﬁnancial institutions are owned and controlled by the government. The government has adopted a biased lending policy in favor of the state enterprises. About 70% of loans have been given to state enterprises. For example, in 1995, the government banks made 2800 billion yuan out of total lending of 4000 billion yuan to state enterprises. Also, government loans to state enterprises were at much lower than the market interest rate. Sometimes the real interest rates on loans to state enterprises were even negative. For example, in 1994, the government loans to state enterprises were at an interest rate less than 11%, but the inﬂation rate was over 20%.8 All state enterprises have been interested in pursuing loans from the government. Some did not use the loans to improve technology and to raise productivity, instead they re-lent the loans out at a higher interest rate to make money (see Yi (1996)). On the other hand, loans to non-state enterprises, especially private enterprises, have been subjected to higher interest rates and other conditions. Government policy is a key determinant of the allocation of investment between state and non-state enterprises. The government policies towards private enterprises in different provinces were quite different. Since 1979, the Chinese government established the Special Economic Zones, the Economic and Technological Development Zones, and the New and High-Tech Industrial Development Zones. These economic zones enjoyed many privileges, such as low taxes and tariffs, and easier credit loans. As a result, more non-state enterprises were established in these special economic zones. The provincial and local governments played an increasingly important role in the allocation of resources. The reform-oriented provincial and local ofﬁcials would be more favorable towards private enterprises, while the ofﬁcials who are not reformoriented would be more hostile to private enterprises.9 enterprises and letting go the small enterprises.” As the number of loss-making state enterprises and the number of bankruptcy increases, many workers have left the state enterprises. In 1994, 5 million workers left the state enterprises (see Fan [1996]). 7 In 1985, the industrial output share was 64.86% for state enterprises, 32.08% for collective enterprises, 1.85% for individual enterprises, and 1.21% for other enterprises. In 1996, the industrial output share was 28.48% for state enterprises, 39.39% for collective enterprises, 15.48% for individual enterprises, and 16.65% for other enterprises [see Attachment II]. From 1985 to 1996, the annual growth rate of real industrial output was 3.8% for state enterprises, 13.2% for collective enterprises, and 30.6% for individual enterprises, and 35.2% for other enterprises [calculated based on the data from Statistical Yearbook of China, 1998]. 8 See Li and Li [1996]. 9 In China, provincial ofﬁcials are appointed by the central government, and the local government ofﬁcials are appointed by the provincial ofﬁcials.

Resource Allocation and Economic Growth in China

Table 4.1

37

Investment Shares in 1996 and Growth Rates of Per Capita GDP, 1983–1996

. . . y/y y/y y/y 1983–1996 1983–1990 1990–1996 1 Beijing 0.609 0.064 0.327 0.054 0.040 0.071 2 Tianjing 0.588 0.152 0.259 0.062 0.033 0.096 3 Hebei 0.429 0.304 0.265 0.087 0.061 0.117 4 Shanxi 0.745 0.059 0.187 0.058 0.044 0.074 5 Inner Mongolia 0.755 0.040 0.205 0.068 0.060 0.077 6 Liaoning 0.618 0.117 0.264 0.065 0.057 0.074 7 Jilin 0.700 0.069 0.222 0.066 0.053 0.080 8 Heilongjiang 0.752 0.057 0.182 0.065 0.041 0.094 9 Shanghai 0.521 0.120 0.307 0.057 0.014 0.108 10 Jiangsu 0.355 0.293 0.349 0.098 0.069 0.133 11 Zhejiang 0.328 0.251 0.416 0.115 0.085 0.151 12 Anhui 0.484 0.213 0.301 0.077 0.058 0.100 13 Fujian 0.414 0.108 0.470 0.124 0.098 0.154 14 Jiangxi 0.557 0.048 0.394 0.075 0.054 0.099 15 Shandong 0.446 0.304 0.247 0.094 0.068 0.124 16 Henan 0.480 0.179 0.340 0.080 0.047 0.119 17 Hubei 0.597 0.099 0.293 0.081 0.062 0.103 18 Hunan 0.519 0.116 0.364 0.076 0.052 0.103 19 Guangdong 0.462 0.144 0.391 0.113 0.097 0.133 20 Guangxi 0.496 0.129 0.373 0.095 0.069 0.125 21 Hainan 0.455 0.030 0.496 0.085 0.068 0.104 22 Sichuan 0.521 0.163 0.313 0.076 0.053 0.102 23 Guizhou 0.680 0.076 0.242 0.055 0.055 0.054 24 Yunnan 0.613 0.104 0.280 0.087 0.088 0.086 25 Tibet 0.959 0.000 0.029 0.032 0.039 0.023 26 Shaanxi 0.650 0.064 0.285 0.067 0.055 0.080 27 Gansu 0.698 0.061 0.239 0.050 0.037 0.065 28 Qinghai 0.829 0.066 0.102 0.053 0.059 0.047 29 Ningxia 0.767 0.055 0.178 0.059 0.055 0.064 30 Xinjiang 0.804 0.057 0.139 0.079 0.074 0.084 Sources: China’s Bureau of Statistics, Statistical Yearbook of China, Various Issues; China’s Bureau of Statistics, Seventeen Years’ Regional Statistics after Reforms and Opening-Up, 1997. Code

Province

θs 1996

θc 1996

θp 1996

As a result, the development of private enterprises was quite uneven across provinces. Table 4.1 shows investment shares in state, collective, and private enterprises in 1996. In 1996, the investment share in state enterprises was 82.9% in Qinghai and 80.4% in Xinjiang; while it was only 32.8% for Zhejiang and 35.5% for Jiangsu. The next two sections will analyze the effect of allocation of resources between state and non-state enterprises on economic growth.

38

The Revival of Private Enterprise in China

3 The Hypothesis and Regression Model It has been long argued that public ownership is inefﬁcient in production. Hayek (1935, p. 204) predicted that output, where the use of available resources was determined by some central authority, would be lower than if the price mechanism of a market operated freely under otherwise similar circumstances. He believed that, without private ownership of capital, there would be no effective entrepreneurship. Friedman (1980, p. 24 and p. 57) argued that when physical resources are owned by government, nobody has a direct interest in maintaining or improving their conditions, and economic progress will be slow if private property is narrowly limited. However, some economists and policy makers still doubt that ownership really matters. We can show that in a simple growth model with a private and a public production sector, if the private sector being more efﬁcient than the state sector, an increase in the investment share of the private sector will increase the growth rate, or equivalently, an increase in the investment share of the public sector will decrease the growth rate.10 Our main hypothesis here is that provinces with higher investment share of state enterprises in total investment grow slower than provinces with lower investment share of state enterprises. The basic regression model includes the investment share in state private enterprises as well as other variables commonly used in growth analyses. The initial per capita GDP is used to examine whether there exists a convergence or not in per capita GDP. Many empirical studies of growth include initial per capita GDP in the regression equation (see, for example, Barro (1991) and Romer (1990)). Since there is a growing concern over regional income inequality in China, it is useful to include this variable in the regression. The investment share in GDP has been used by most studies of growth (see, for example, Barro (1991), Romer (1990), and Levine and Renelt (1992)). Government spending share in GDP is used to measure government size, as in Landau (1983), Barro (1991) and Romer (1990). The growth of population has been also a commonly used variable in empirical studies on growth. The share of trade in GDP represents openness in our analysis. Many prior studies have used either the growth rate of exports, the growth rate of imports, or the growth rate of the volume of trade to represent the degree of openness, and have found a positive relationship between the growth rate of trade and the growth rate of output. Most recent works on endogenous growth have measured openness as exports share or imports share in output (see, for example, Romer (1989)). But as Edwards (1993) mentioned, exports and imports shares depend heavily on the size of a country. A small country may have a larger share of exports and imports in GDP, while a large country may have a relatively smaller ratio of international trade in output even though it might be free-trade oriented. The current study is a cross-province study, and within one country, the problem mentioned by Edwards (1993) might be less severe. Many theoretical and empirical studies have shown that human capital is important in economic growth (for example, Lucas (1988) and Barro (1991)). Generally, it’s difﬁcult to ﬁnd a good measure of human capital. We will use the illiteracy rate of employees as a measure of human capital in each province. We believe that provinces with a higher illiteracy rate grow slower. 10 The derivation of this result is available from the author on request.

Resource Allocation and Economic Growth in China

39

Our basic empirical framework involves the following cross-sectional speciﬁcation: . y/y=a+βx+u . where y / y is the growth rate of per capita GDP, x is a vector of explanatory variables, β is a coefﬁcient vector conformable to x, and u is a stochastic error term. 4 Data and the Deﬁnitions of Variables The provincial data on the allocation of investment are available only after 1983. Thus, the data for the period 1983–1996 for thirty provinces are used. The variables are deﬁned as follows. y0: Real gross domestic product (GDP) in the initial year. The data are taken from Seventeen Years’ Regional Statistics after Reforms and Opening-Up (1997). The data were given in current price originally, and it was deﬂated by the overall retail price index, which are obtained from the Statistical Yearbook of China (1997). . . y / y: Growth rate of real GDP. It is calculated as follows: y / y = [ln(yT) – ln(y0)]/T, where yT is the end-period GDP, and T is the time span. The data are from Seventeen Years’ Regional Statistics after Reforms and Opening-Up (1997). i: Average of the ratios of total investment in ﬁxed assets to GDP from 1983 to 1996. The data are from the Statistical Yearbook of China. θs: Average of the share of investment in total investment for the state enterprises from 1983 to 1996. The data are from various issues of Statistical Yearbook of China. θc: Average of the share of investment in total investment for the collective enterprises from 1983 to 1996. The data are from various issues of Statistical Yearbook of China. θp: Average of the share of investment in total investment for private enterprises from 1983 to 1996. The data are from various issues of Statistical Yearbook of China. . . p: Growth rate of population, which is calculated as follows: p = [ln(pT) - ln(p0)]/T, where pT and p0 are the population for the end year and the initial year, respectively; and T is the time span. The data are from various issues of Statistical Yearbook of China. x: Average of the ratio of the volume of imports and exports to GDP. The data are from a data set compiled by the Information Center of the National Bureau of Statistics. The volume of trade is initially given in US dollars. We converted the ﬁgures into Chinese yuan based on ofﬁcial exchange rates, which are from Statistical Yearbook of China. h: Average illiteracy rates of employees from the fourth population census. In the fourth population census in 1990, the illiteracy rate is deﬁned as the ratio of illiterate and semi-illiterate employees to the total employment (see Statistical Yearbook of China, 1992). Illiteracy rates of employees in other years are not available. g: Average of the ratio of government expenditures to GDP. The data are from Seventeen Years’ Regional Statistics after Reforms and Opening-Up (1997) and the Statistical Yearbook of China (1997).

The Revival of Private Enterprise in China

40

Table 4.2

Summary Statistics of the Major Variables, 1983–1996a

Variable N Mean Std Dev Minimum Maximum . 30 0.075 0.021 0.032 0.124 y/y y0 30 613.2 475.1 263.0 2573.3 . p 30 0.014 0.003 0.007 0.022 30 0.147 0.092 0.066 0.564 g 30 0.304 0.066 0.220 0.425 i x 30 0.216 0.216 0.047 1.035 30 0.670 0.133 0.345 0.875 θs θc 30 0.115 0.065 0.044 0.283 30 0.215 0.086 0.080 0.375 θp h 30 0.227 0.119 0.107 0.704 a All the variables are deﬁned in Section 3, where y0 is real gross domestic product (GDP) in the initial year. y. / y is the growth rate of real GDP. i is the average of the ratios of total investment in ﬁxed assets to GDP. θs is the average of the share of investment in ﬁxed assets for the state enterprises. θc is the average of the share of investment in ﬁxed assets for the collective enterprises. θp is the average of the share of investment in ﬁxed assets for . private enterprises, p is the growth rate of population year, x is the average of the ratio of the volume of imports and exports to GDP, h is the illiteracy rate, and g is the government expenditure share in GDP.

Table 4.2 shows summary statistics of major variables. The mean of GDP in 1983 for all provinces was 613.2 Chinese yuan, with 263.0 yuan (Quizhou province) and 2573.3 yuan (Shanghai) as the minimum and maximum. The mean of the population growth rate was 1.4% over the period of 1983–1996. The mean of the share of government spending in GDP from 1983 to 1996 was 14.7%. The mean of the investment share in GDP was 30.4%, which was rather high compared with the world average. The mean of the investment share of state enterprises was about 70%, with 34.5% (Zhejiang province) and 87.5% (Qinghai province) being minimum and maximum. The mean of the investment share in collective enterprises and private enterprises was 11.5% and 21.5%, respectively. Finally, the mean of the illiteracy rate was 22.7%. Table 4.3 shows the correlation coefﬁcients of the independent variables. It can be seen that the investment shares in state, collective, and private enterprises are strongly correlated, with coefﬁcients -0.84 and -0.92. Also, government spending, g, and illiteracy rate, h, are strongly correlated, with a correlation coefﬁcient 0.85. To avoid the problem of multi-collinearity, the strongly correlated variables will not be used in the same regression equation. 5 Empirical Results This section analyzes how the allocation of investment between private and state sectors affects the growth rate of per capita GDP. Table 4.4 shows the cross-sectional regression results of per capita GDP on the variables of the share of investment in state enterprises, θs, the share of investment in private enterprises, θp, total investment, i, illiteracy rate, h, government size, g, the share of trade in GDP, x, initial GDP, y0, . and population growth, p, from 1983 to 1996.

Table 4.3

Pearson Correlation Coefﬁcients/Pro>lRl under Ho: Rho=0/N=30

. y0 θs θc θp i x h g p 1.000 0.237 0.064 -0.433 0.485 0.516 -0.357 -0.157 0.048 y0 0.000 0.207 0.736 0.017 0.007 0.004 0.053 0.406 0.800 0.237 1.000 -0.837 -0.917 0.462 0.066 0.211 0.528 0.450 θs 0.207 0.000 0.000 0.000 0.010 0.730 0.264 0.003 0.013 θc 0.064 -0.837 1.000 0.569 -0.133 0.217 -0.264 -0.507 -0.390 0.736 0.000 0.000 0.001 0.482 0.250 0.159 0.004 0.033 -0.433 -0.917 0.569 1.000 -0.595 -0.153 -0.134 -0.438 -0.362 θp 0.017 0.000 0.001 0.000 0.001 0.418 0.479 0.016 0.050 0.485 0.462 -0.133 -0.595 1.000 0.491 0.145 0.393 0.527 i 0.007 0.010 0.482 0.001 0.000 0.006 0.444 0.032 0.003 x 0.516 0.066 0.217 -0.153 0.491 1.000 -0.174 -0.006 0.239 0.004 0.730 0.250 0.418 0.006 0.000 0.357 0.975 0.203 h -0.357 0.211 -0.264 -0.134 0.145 -0.174 1.000 0.848 0.306 0.053 0.264 0.159 0.479 0.444 0.357 0.000 0.000 0.100 -0.157 0.528 -0.507 -0.438 0.393 -0.006 0.848 1.000 0.424 g 0.406 0.003 0.004 0.016 0.032 0.975 0.000 0.000 0.020 . p 0.408 0.450 -0.390 -0.362 0.527 0.239 0.306 0.424 1.000 0.800 0.013 0.033 0.050 0.003 0.203 0.100 0.020 0.000 . Note: y0 is real gross domestic product (GDP) in the initial year. y / y is the growth rate of real GDP. i is the average of the ratios of total investment in ﬁxed assets to GDP, θs is the average of the share of investment in ﬁxed assets for the state enterprises, θc is the average of the share of investment . in ﬁxed assets for the collective enterprises, θp is the average of the share of investment in ﬁxed assets for private enterprises, p is the growth rate of population year, x is the average of the ratio of the volume of imports and exports to GDP, h is the illiteracy rate, and g is the government expenditure share in GDP.

Table 4.4 Reg. (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)

The Growth of Gross Domestic Product, 1983–1996a

Intercept 0.103 (6.51)** 0.121 (9.12)** 0.105 (9.47)** 0.153 (12.95)** 0.039 (5.93)** 0.147 (8.75)** 0.149 (8.33)** 0.15 (12.24)** 0.15 (12.37)** 0.132 (9.44)** 0.014 (0.80) 0.033 (1.99)+ 0.046 (2.98)**

y0

θs

θp

-0.00003 (-4.22)** -0.00003 (-4.82)**

i -0.09 (-1.74)+ -0.032 (-0.46) 0.025 (0.35)

x

0.052 (3.98)** 0.051 (3.67)**

h

-0.8 (-3.02)

. p

-0.87 (-0.57) -0.62 (-0.52)

g

-0.145 (-7.29)**

-0.116 (-6.84)** 0.169 (5.28)** -0.000006 (-1.33) -0.00001 (-2.2)* -0.00002 (-4.15)** -0.00002 (-3.9)** 0.00002 (-4.72)** -0.000003 (-0.05) -0.000007 (-1.04) -0.00002 (-3.57)**

-0.121 (-7.13)** -0.107 (-7.34)** -0.097 (-8.49)** -0.1 (-6.99)** -0.079 (-4.57)** 0.197 (5.81)** 0.169 (5.07)** 0.152 (4.96)**

0.042 (0.80) -0.011 (-0.21) 0.032 (0.80) 0.023 (0.49) 0.038 (0.71) 0.062 (1.11) 0.005 (0.09) 0.048 (1.08)

0.04 (3.39)** 0.037 (3.38)** 0.036 (3.44)** 0.04 (3.82)**

0.037 (3.09)** 0.034 (3.04)**

-0.065 (-2.87)** -0.066 (-2.93)**

-0.069 (-2.88)**

0.365 (0.50) 0.161 (0.22)

-0.094 (-3.37)**

R2 0.083

obs 30

0.509

30

0.63

30

0.55

30

0.49

30

0.57

30

0.68

30

0.77

30

0.78

30

0.77

30

0.52

30

0.6

30

0.71

30

Table 4.4

Continued

. Intercept y0 θs θp i x h p g R2 obs 0.049 -0.00002 0.149 0.057 0.035 -0.067 -0.357 0.72 30 (3.67)** (-3.87)** (5.30)** (1.06) (3.23)** (-2.61)* (-0.47) (15) 0.053 -0.00002 0.116 0.072 0.039 -0.359 -0.107 0.74 30 (4.12)** (-4.27)** (3.84)** (1.24) (3.54)** (-0.5) (-4.32)** a All the variables are deﬁned in Section 3, where y0 is real gross domestic product (GDP) in the initial year of the period under study, i is the average of the ratios of total investment in ﬁxed assets to GDP, θs is the average of the share of investment in ﬁxed assets for the state enterprises, θc is the average of the share of investment in ﬁxed assets for the collective enterprises, θp is the average of the share of investment in ﬁxed assets for private enterprises, . p is the growth rate of population year, x is the average of the ratio of the volume of imports and exports to GDP, h is the illiteracy rate, g is the government expenditure share in GDP, and obs is the number of observations. t-values are given in the parentheses, which are based on White (1980) heteroskedasticity robust covariance estimator. + Statistically signiﬁcant at the 10% level. * Statistically signiﬁcant at the 5% level. ** Statistically signiﬁcant at the 1% level. Reg. (14)

44

The Revival of Private Enterprise in China

In regressions (1), (2), and (3), the growth rate of per capita GDP is regressed on total investment (the share of investment in GDP) and other variables. The coefﬁcient for total investment is negative and statistically signiﬁcant at the 10% level in regression (1) where only total investment is used as a regressor. It is negative and insigniﬁcant in regression (2) when the illiteracy rate and other commonly-used variables are included along with total investment, and it is positive but insigniﬁcant in regression (3) when government spending is included. This result is surprising since many empirical studies have shown that investment is signiﬁcantly positively related to the growth rate of per capita GDP.11 The key characteristic of the Chinese economy is that a large part of the investment is controlled by the government and is allocated to the stateowned enterprises. For most provinces the investment share of state enterprises was higher than 60%. The state-owned enterprises are not using resources efﬁciently. For many years, state enterprises overly initiated many investment projects, resulting in extra production capacity. A recent survey of more than 900 major industrial products producers by the National Statistical Bureau showed that, in half of these enterprises, the capacity utilization rate is less than 60%.12 This may explain why total investment did not have a signiﬁcant impact on economic growth. In regressions (4) and (5), the growth rate of per capita GDP is regressed on the share of investment in state enterprises and private enterprises, respectively. From regression (4), the share of investment in state enterprises is negatively related to the growth rate of per capita GDP. The coefﬁcient is highly signiﬁcant with a R2 of 0.55, implying that the investment share in state enterprises alone can explain 55% of the variation in the growth rate of per capita GDP. Thus, provinces with a larger share of investment in state owned enterprises grew slower than provinces with a smaller share of investment in state enterprises. From regression (5), the share of investment in private enterprises is positively related to the growth rate of per capita GDP growth, i.e., provinces with a larger share of investment in private enterprises grew faster than provinces with a smaller share of investment in private enterprises.13 In regressions (6) to (10), more explanatory variables are used along with the investment share of state enterprises, including total investment, i, the share of trade in GDP, x, illiteracy rate of employees, h, initial GDP, y0, government size, g, and . population growth rate, p. In all these regressions, the share of investment in state enterprises, θs, is signiﬁcantly negatively related to the growth rate of per capita GDP. This result appears to be robust. In regressions (11) to (15), more explanatory variables are used along with the other variables. In all these regressions, the coefﬁcient of θp is positive and highly signiﬁcant, indicating that the share of investment in private enterprises is positively related to the growth rate of per capita GDP. 11 See Levine and Renelt (1992), where they found that the investment variable is signiﬁcantly positively related to the growth rate of GDP and is not sensitive to the changes of the speciﬁcations of the regression equation. 12 See Economic Daily (Jingji Ribao, an ofﬁcial newspaper in China), January 21, 1999. 13 Note that since there exist collective enterprises and other enterprises, θs and θp are not added up to 1 (see means of θs and θp in Table 3.2).

Resource Allocation and Economic Growth in China

45

The share of international trade (exports plus imports) in GDP, x, is positively related to the growth rate of per capita real GDP. The effect of international trade on economic growth has been an important subject of debate since the 1980s. Many studies have demonstrated that export growth is positively related to the growth rate of output.14 This study shows that the provinces with a higher ratio of international trade to GDP grew faster. So far, no empirical studies (either cross-sectional or time-series) have shown that the share of exports, imports, and the volume of trade (exports plus imports) in output positively affect the rate of output growth. Illiteracy rate of employees, h, is negatively related to the growth rate of per capita GDP. The coefﬁcient of h is negative and statistically signiﬁcant in all the regressions where h is included, indicating human capital is important to economic growth. This ﬁnding supports Lucas’s (1988) argument on the importance of human capital in economic growth and is consistent with most empirical ﬁndings. The share of government spending in GDP, g, seems negatively related to economic growth [see regressions (3), (10), and (15)]. This ﬁnding is consistent with Barro (1990) where he showed that government spending is negatively related to growth based on a large international data set. Population growth is not signiﬁcantly related to the growth rate of output, contrary to the notion that population is negatively related to economic growth.15 There is some evidence of convergence in real per capita GDP among provinces during the period of 1983 to 1996. In all of the regressions, except for regressions (6), (11), and (12), the coefﬁcients of the initial GDP are negative and statistically signiﬁcant. Table 4.5 shows the cross-sectional regression results of per capita GDP on the variables of the share of investment in state enterprises, θs, the share of investment in private enterprises, θp, total investment, i, the share of trade in GDP, x, illiteracy . rate of employees, h, initial GDP, y0, government size, g, and population growth, p, 16 in two sub-periods, 1983 to 1990 and 1990 to 1996. In all the regressions in Table 4.5, except regressions (4) and (9), the coefﬁcient of total investment (the share of total investment in GDP) is insigniﬁcant. In all the regressions for both sub-periods, the share of investment in state enterprises is negatively related to the growth rate of per capita GDP, and the share of investment in private enterprises is positively related to the growth rate of per capita GDP growth. These ﬁndings are consistent with the ﬁndings for the whole period (1983–1996). The share of international trade (exports plus imports) in GDP is positively related to the growth rate of per capita real GDP in both sub-periods. Thus the provinces with a higher ratio of international trade to GDP grew faster. Illiteracy rate

14 Edwards [1992] provided a review of the recent literature on trade policy and economic growth in developing countries. 15 See Johnson [1996] for a discussion of population and economic development in China. 16 In explaining the growth rate for the sub-period of 1983 to 1990, the illiteracy rate of employees in 1990 is not used. It is not plausible to use the illiteracy rate in 1990 to explain economic growth during the period of 1983 to 1990. Also, since some data for Tibet and Shanxi were only available at the end of the 1980s, the two observations were not used in regressions.

Table 4.5

The Growth of Gross Domestic Product, 1983–1990 and 1990–1996

Reg. Intercept 1983–1990 0.1 (1) (7.54)** 0.043 (2) (5.87)** 0.088 (3) (6.55)** 0.078 (4) (6.24)** 0.092 (5) (4.84)** 1990–1996 0.218 (6) (13.34)** 0.3 (7) (3.04)** 0.219 (8) (12.23)** 0.22 (9) (14.4)** (10) 0.226 (17.74)** (11) 0.225 (16.33)**

y0

θs

θp

i

x

h

. p

g

-0.06 (-3.17)** 0.07 (2.41)* -0.00002 (-6.70)** -0.00003 (-6.86)** -0.00003 (-4.16)**

-0.058 (-3.02)** -0.048 (-2.63)* -0.088 (-3.29)**

0.072 (1.54) 0.082 (2.30)* 0.039 (0.75)

0.073 (3.30)** 0.098 (3.25)**

-0.221 -0.26

-0.186 (-7.70)** 0.298 (7.06)** 0.00001 (1.81)+ 0.000004 (0.63) -0.000009 (-1.36) -0.00001 (-1.34)

-0.181 (-7.32)** -0.174 (-8.13)** -0.16 (-9.05)** -0.16 (-7.43)**

-0.05 (-0.99) -0.083 (-1.87)+ -0.011 (-0.26) -0.007 (-0.15)

0.031 (3.15)** 0.028 (3.39)** 0.028 (3.30)**

-0.09 (-3.62)** -0.089 (-3.48)**

-0.16 -0.20

0.149 (1.71)+

R2

obs

0.21

30

0.14

30

0.43

30

0.62

28

0.67

28

0.68

30

0.64

30

0.72

30

0.8

30

0.87

30

0.87

30

Table 4.5

Continued

. Intercept y0 θs θp i x h p g R2 obs 0.2 -0.000008 -0.134 0.014 0.032 -0.518 -0.124 0.86 30 (12.95)** (-1.09) (-5.59)** (0.27) (3.66)** -0.63 (-3.22)** All the variables are deﬁned in Section 3, where y0 is real gross domestic product (GDP) in the initial year of the period under study, i is the average of the ratios of total investment in ﬁxed assets to GDP, θs is the average of the share of investment in ﬁxed assets for the state enterprises, θc is the average of the share of investment in ﬁxed assets for the collective enterprises, θp is the average of the share of investment in ﬁxed assets for private enterprises, . p is the growth rate of population year, x is the average of the ratio of the volume of imports and exports to GDP, h is the illiteracy rate, g is the government expenditure share in GDP, and obs is the number of observations. t-values are given in the parentheses, which are based on White [1980] heteroskedasticity robust covariance estimator. + Statistically signiﬁcant at the 10% level. * Statistically signiﬁcant at the 5% level. ** Statistically signiﬁcant at the 1% level. Reg. (12)

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of employees is negatively related to economic growth, with high t-values for the period of 1990 to 1996. The results on the share of government spending in GDP are interesting. The share of government spending in GDP, g, has a negative coefﬁcient and is statistically signiﬁcant during the period of 1990 to 1996, while it has a positive coefﬁcient and is statistically signiﬁcant at 10% during the period of 1983 to 1990 [see regression (5)]. These results may be affected by dropping two observations (some data for two provinces were missing for this period). Tibet has a high government spending ratio to GDP and a low growth rate. Population growth is not signiﬁcantly related to the growth rate in both sub-periods. There is convergence in real per capita GDP among provinces during the period of 1983 to 1990, since the coefﬁcient of the initial GDP is negative and statistically signiﬁcant in regressions (3)–(5). However, the coefﬁcient of the initial GDP is not statistically signiﬁcant in regressions (8)–(12). Thus, there is no convergence in real per capita GDP among provinces during the period of 1990 to 1996. Regional inequality indeed became an important issue. 6 Concluding Remarks Evidence from thirty Chinese provinces indicate that the investment share of private enterprises is positively related to the growth rate of per capita real GDP, i.e., the provinces which invested more in private enterprises grew faster than the provinces which invested more in the state enterprises. Meanwhile the relationship between total investment and the growth rate of per capita GDP appears insigniﬁcant. Thus, the allocation of resources between the private and state enterprises is crucial for economic development in China. It is also found that the share of trade in GDP was positively related to the growth rate of per capita GDP, indicating that openness is beneﬁcial to growth. In addition, illiteracy rate seems negatively related to the growth rate of per capita GDP, implying human capital is important for economic growth. References Barro, R., “Government Spending in a Simple Model of Endogenous Growth,” Journal of Political Economy, 98, October (1990), 103–25. Barro, R., “Economic Growth in a Cross Section of Countries,” Quarterly Journal of Economics, May (1991), 407–43. China’s Bureau of Statistics, Statistical Yearbook of China, Various Issues, (Beijing: Publishing House of China’s Bureau of Statistics). China’s Bureau of Statistics, Seventeen Years’ Regional Statistics after Reforms and Opening-Up, (Beijing: Publishing House of China’s Bureau of Statistics, 1997). Chow, G.C. “Capital Formation and Economic Growth in China,” Quarterly Journal of Economics, 108, August (1993), 809–42. Edwards, S., “Openness, Trade Liberalization, and Growth in Developing Countries,” Journal of Economic Literature, 31, September (1993), 1358–93.

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Fan, G., “Gradually Reforming the State Enterprises,” in Dianqing Xu and James Wen eds. Chinese State Enterprises Reforms, (Beijing: Economics Publication House, 1996), 40–48. Friedman, M. and R. Friedman, Free to Choose, (New York and London: Harcourt Brace and Jovanovich, 1980). Hayek, F.A., “The Present State of the Debate,” in Collectivist Economic Planning: Critical Studies on Possibilities of Socialism, edited with an Introduction and a Concluding Essay by F.A. Hayek. New York: Augustus M. Kelley, 1935, 201-43. Kormendi, R.C. and P.G. Meguire, “Macroeconomic Determinants of Growth: Cross-country Evidence,” Journal of Monetary Economics, 16, September (1985), 141–63. King, R.G. and S. Rebelo, “Public Policy and Economic Growth: Developing Neoclassical Implications,” Journal of Political Economy, 98, October (1990), 126–51. Johnson, D.G., “Can There Be Too Much Human Capital—Is There a Population Problem?” in Sisay Asefa and Wei-Chiao Huang eds Human Capital and Economic Development, (Kalamazoo, Michigan: W.E. up John Institute for Employment Research, 1996), Reprinted in John M. Antle and Daniel A. Sumner, eds The Economics of Agriculture: Volume 1, Selected Papers of D. Gale Johnson, (University of Chicago Press, 1996), 295–318. Jones, L.E. and R. Manuelli, “A Convex Model of Equilibrium Growth: Theory and Policy Implications,” Journal of Political Economy, 98, October (1990), 1008–38. Levine, R. and D. Renelt, “A Sensitivity Analysis of Cross Country Growth Regressions,” American Economic Review, 82, September (1992), 942–63. Li, D. and S. Li “The Debt Crisis of the Chinese State Enterprises: Theoretical Analysis and Policy Suggestions,” in Dianqing Xu and James Wen eds. Chinese State Enterprises Reforms, (Beijing: Economics Publication House, 1998), 362– 82. Lucas, R.E., “On the Mechanics of Economic Development,” Journal of Monetary Economics 22, July (1988), 3–42. Rebelo, S., “Long-Run Policy Analysis and Long-Run Growth,” Journal of Political Economy, June (1991), 500–21. Romer, P.M., “Capital Accumulation in the Theory of Long-Run Growth,” in Robert Barro ed. Modern Business Cycle Theory, (Cambridge, Massachusetts: Harvard University Press, 1989), 51–127. Romer, P.M., “What Determines the Rate of Growth and Technological Change?” World Bank Working Papers #279, (1989). Romer, P.M., “Capital, Labor, and Productivity,” Brookings Papers on Economic Activity: Microeconomics, (1990), 337–67. Shleifer, A., and R.W. Vishny, “Politicians and Firms,” Quarterly Journal of Economics, 109, November (1994), 995–1025. Wang, W., “Factors Affecting the Bankruptcy of State Enterprises (guanyu woguo guoyou qiye puochan qingkang de yingsu fenxi),” Economic Research Journal (Jingji Yanjiu), 6, June (1994), 41–7. White, H., “A Heteroskedasticity Consistent Covariance Matrix Estimator and A Direct Test of Heteroscedaticity,” Econometrica, 48, May (1980), 817–38.

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Yi, G., “Analyses of Chinese Financial Assets and Some Policy Implications,” China Center for Economic Research (CCER) Working Paper Series, No. 1996004(1996).

PART II Government and Private Enterprises

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Chapter 5

Government and Private Enterprises: Wenzhou Experiences Wenbo Wu1

1 Introduction On March 14, 2004, the National People’s Congress in China approved a constitutional amendment with a provision that “a citizen’s lawful private property is inviolable.” That is a landmark event in the evolution of relations between the government and private enterprises. A commonly accepted tenet in economics is that secure private property rights are the precondition for a genuine market economy. It is argued that agents respond to incentives as structured by the penalty and reward system, which is deﬁned by the property rights system (Furubotn and Pejovich 1974). Monopolizing the use of coercive forces, the government is the enforcer of the property rights system. The government’s roles in granting and maintaining property rights are the most important aspect of relations between the government and private enterprises, especially in developing and transition countries. Many scholars rightly put property rights at the center of studies on economic reforms and transitions (e.g., Weimer 1997). Most transition economies in Eastern Europe attempted to dismantle the public ownership systems and establish formal private property rights systems overnight. The shock therapy is an experiment of institutional designs of grand scale. China, however, follows a “gradualist” path. The evolution of China’s property rights system during the reform period is characterized by the spontaneous emergence of various forms of formal and informal property rights and the gradual convergence toward a formal system of property rights. Before the reform program was launched in China in the late 1970s, the economy was operated based on direct administrative control and plans. All properties were publicly owned. The transition of Chinese economy initiated by the reform program and open-door policy is essentially the transformation of its property rights system. There exist three different ways in which de facto private property rights emerge in China during the reform period: 1 Lee Kuan Yew School of Public Policy, National University of Singapore. Email: [email protected]. This chapter was written and revised when the author visited the Department of Social and Decision Sciences, Carnegie Mellon University. The author would like to express his gratitude to their hospitality. The author also wishes thank participants at the International Symposium on Private Enterprises and China’s Economic Development (June 2004, Beijing) for their valuable comments.

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decentralization of the public ownership; inﬂow of direct foreign investment; and emergence of native private businesses. To be consistent with the open door policy, foreign owned enterprises or Sino-foreign joint-venture ﬁrms are well protected by China’s legal system.2 Domestically, the public ownership of state-owned enterprises in China is gradually decentralized from the central government to local governments, from governments to non-governmental entities, and from entities to individuals (Wu 1994, Oi and Walder 1999, and Peng 2001).3 Together with the top-down process of decentralizing the management of public assets is a bottom-up process in which numerous business entities are created by aspiring private entrepreneurs. The domestic private sector is recognized and protected by the government with clarity and a certain degree of credibility. China has established regulations and laws to protect private business interests with a variety of deﬁnitions.4 More importantly, the polity has made signiﬁcant changes to accommodate the rise of private business interests and formally grant and protect private property rights, as signiﬁed by the constitutional amendment in March 2004. Why does a socialist government, which supposedly champions the public ownership of properties, grant and protect private property rights? This is the core question asked in this chapter. We seek to answer these questions by doing a case study on Wenzhou, in an attempt to analytically describe the evolution of relations between the government and private enterprises. Wenzhou is a fertile land for a genuine market economy and a remarkable success story of economic freedom. During the period from 1978 to 2002, Wenzhou’s GDP grows from RMB 1.32 billion to RMB 10.6 billion. GDP per capita grows at a remarkable average annual rate of 18.6% over 24 years (Wenzhou Statistics Yearbook 2003). The rapid economic growth is deﬁnitely attributed to the striving private sector in Wenzhou. In 1978, Wenzhou’s state-owned enterprises (SOEs) accounted for 35.7% of the total industrial outputs, collective enterprises 55.1%, individual businesses 0.01%, and “others” (essentially private enterprises) 9.2%. In 2002, Wenzhou’s SOEs accounted for 2.5% of the total industrial outputs, collective enterprises 1.4%, individual businesses 30.6%, and “others” 65.5%. Wenzhou’s economy is overwhelmingly dominated by the private sector. In this chapter, we investigate the emergence and rapid development of private businesses in Wenzhou during the reform period and how the government responds 2 Since the late 1970s, China has established a well-rounded system of laws and regulations protecting private property rights in foreign invested enterprises. Main laws include Sino-foreign Joint Venture Law (enacted in 1979, and revised in 1990 and 2001), Wholly Foreign Owned Enterprise Law (enacted in 1986, and revised in 2000), and Sinoforeign Cooperative Enterprise Law (enacted in 1988, and revised in 2000). 3 This gradual process of decentralization is a trial and error approach adopted by the central government to improve the efﬁciency of public assets including state-owned enterprises, collective enterprises, state-owned urban lands and natural resources, and collectively owned rural lands. 4 For example, the 1986 General Principles of Civil Law recognizes “individual industrial and commercial household” and individual partnership which is also more extensively protected by Partnership Enterprise Law (enacted in 1997). Private enterprises are covered by Private Enterprise Administration Act (enacted in 1988) and Sole Proprietorship Enterprise Law (enacted in 1999).

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to the development. A major purpose of this chapter is to treat the development of economic freedom enjoyed by private entrepreneurs as a consequence of strategic interactions among rational government players at the central and local levels. The chapter proceeds as follows. In Section I, we present a general framework for understanding why and how intergovernmental ﬁscal relations in China are critical in determining the course of economic reform. Applying the general framework, we analyze the evolution of economic freedom, and particularly property rights in Wenzhou in Section II. Section III concludes. 2 Fiscal Federalism as a Market-Preserving Institution Before going further to explore the unique government structure in China as an institutional foundation for rapid economic growth, we need to address the fundamental “collective choice” problem in China’s reform game in order to understand why the government is the key institution in shaping the reform program. 2.1 The Logic of Collective Action in China’s Reform The main objective of economic reform is to establish a genuine market economy, which improves the overall economic efﬁciency. The process of economic reform, however, is fundamentally political in the sense that various interest groups struggle to advance their own objectives in the distributional game. Reform programs in China since the late 1970s are a grand-scale societal transformation characterized by remarkable economic growth and dramatic redistribution among different social groups. The dividend from economic reform is unevenly shared among different groups. Some groups are even strictly worse off. By deﬁnition, reform does harm to the interests of certain social groups. The painful adjustment process leaves some groups behind. Why would these potential opposition groups not raise to effectively resist the reform process or change the course? To answer these questions, we need to identify various interest groups in the reform game and analyze their group formation. At the broadest level, we consider three main groups: the state, private entrepreneurs, and “disadvantaged groups.” Disadvantaged groups emerge in China because economic reform has disrupted the old social order of a centrally planned economy and a relatively egalitarian society. In urban areas, reform of SOEs, which employed a majority of Chinese workers, has resulted in large-scale job losses. The “Iron rice bowl” system, which guaranteed workers with life-long employment security, is cracked. Displaced workers and those more fortunate, who are usually employed on short-term contracts, face uncertain future. The most disadvantaged group emerged during the reform era is the rural poor, especially those in inland regions. The collapse of collective farming has fundamentally corrected the incentive problems and resulted in great improvements in agricultural production. However, a majority of rural people (approximately 800 million people) lost the protection of the collectives and are exposed to greater vulnerabilities in generating income and receiving basic social services. These disadvantaged groups consist of a great majority of the Chinese population, and

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their main interest would be in redistributing the dividend of economic reform or changing the course to their own advantages by placing more weights on the fairness principle of any reform measures. During the past several decades, however, no effective and large-scale resistance to economic reform has emerged in China. The fundamental reasons for the almost non-existing anti-reform camp are prohibitively high transaction costs and free-riding problems in group formation and collective action present in any potentially large groups. The size of disadvantaged groups in China is enormous and the groups are very diverse. Even though it is possible to identify and articulate common interests for these groups in the reform game, it is inconceivable to have a solution for the problem of coordinating such large and diffuse groups to act in concert for their common goals. To begin with, it is extremely unlikely for involved parties to reach an agreement on their common goals. Let us suppose that there exist solutions for the coordination problem. Strong political entrepreneurs emerge and all transactions costs are somehow paid for so that participating groups incur no costs whatsoever. According to Olson (1965), when the number of involved parties is large, all supposed solutions are not implementable because of free-riding. It is in their common interests for these disadvantaged groups to organize themselves to advance their welfare, since the total beneﬁts would be likely to be much larger than the total costs. However, it is individually rational for each group member not to invest in organizing. As a large group in Olson’s terms, the disadvantaged groups are not able to form an effective interest group to lobby and win the economic struggle in the reform game. As a group, private entrepreneurs represent major beneﬁciaries of economic reform. These entrepreneurs emerge and develop as the private sector is created by three major driving forces: the inﬂow of foreign direct investments; the privatization of public enterprises; and the growth of domestic private businesses. Counting millions of “individual businesses” (getihu), “private enterprises” (siren qiye), “private technological enterprises” (minying keji qiye), and Sino-foreign jointventure enterprises, we see a large and diverse group of private entrepreneurs.5 The main common interest of this group is to secure their properties and investments by deepening market-oriented reform and reducing redistribution. The same logic of collective action applies to this group. It is unlikely for private entrepreneurs to effectively organize themselves as an independent interest group.6 In the reform game, the state is the sole effective group and can pursue its collective objectives. As a self-interested player, the state attempts to maximize its revenue and political support from its citizens. Playing with two non-effective groups, the state is at a powerful position to direct the game. However, it does not mean that the state 5 In 2002, there are 181,557 enterprises in China (China Statistics Yearbook 2003). Among them, only 29,449 are SOEs. 6 Private entrepreneurs in China have set up various industrial associations and chambers of commerce. However, these organizations are under strict government regulations and mostly used as a self-regulating mechanism. Recently, some private entrepreneurs took up high-ranking positions in local People’s Congresses and local branches of Chinese Peoples Political Consultative Conference. As demonstrated later in this chapter, it is an indication of political recognition and approval from the Communist Party of China (CPC) and the central government.

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can arbitrarily use its power. It is motivated to protect citizens’ rights because it needs political support. If the state hinders citizens’ freedom and violates their rights to a high degree, citizens may withdraw their support and the coordination problems as mentioned above may be solved somehow. As the rationality of fear model (de Figueiredo and Weingast 1997) shows, citizens may take extra-constitutional actions if the probability of their rights being threatened by the state is higher than a threshold value. Moreover, the objective of maximizing revenue provides the state with a strong incentive to protect citizens’ rights and provide public goods, since the state and citizens have a common interest in economic growth resulting from the state’s protections of citizens’ rights (Olson 1993). The state, however, is not a unitary player. In a sizable country like China, the central and local governments have non-overlapping interests, and their strategic interactions greatly affect the course of reform. 2.2 How Does Fiscal Federalism Preserve Markets in China? In models of “market-preserving ﬁscal federalism” in China (Montinola, Qian, and Weingast 1995 and Jin, Qian, and Weingast 2001), the revenue-sharing system between the central and local governments is regarded as the institutional foundation for China’s economic performance during the high reform period (1982–1993). Under the ﬁscal arrangements negotiated between the central and local governments, local governments in China were able to retain a high portion of tax collection at the margin. Local governments and ofﬁcials, who are interested in increasing local revenue, independence from the center, power, and personal gains, were motivated to pursue local economic prosperity. The main means for developing local economies was township-village enterprises (TVEs). Essentially, local governments directly control TVEs’ ownership to secure their revenue. This form of government ownership was an effective mechanism for preserving economic incentives during the period (Che and Qian 1998 and Che 2002). After 1993, however, situations in China dramatically changed. A large quantity of TVEs failed, and many surviving ones started to change their ownership structure. The central government implemented radical ﬁscal reforms to strengthen the central government’s ﬁscal power. Therefore, it seemed that major elements in the institutional foundation were largely absent after 1993. However, the Chinese economy continued to grow at a high rate and economic freedom enjoyed by private entrepreneurs increased instead of decreasing. We posit that conditions favoring government ownership in local enterprises have changed dramatically since the mid-1990s. Local governments might ﬁnd that it is in their own interests to loose their direct control on local ﬁrms. We posit that ownership relations between local governments and local ﬁrms not only structure local governments’ incentives for economic growth, but also have serious implications in the ﬁscal system. Our analyses are based on this premise. A local government has two options to achieve its objectives: enforcing private property rights locally and local expropriation. A local government could be an ideal limited government by having the minimum level of local expropriation, an ultimate Leviathan by having the maximum level of local expropriation, or something in between. In terms of protecting private property rights, the local government could completely fade out local private enterprises, totally control these enterprises, or

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something in between. A local government chooses a combination of these two options as its strategy in dealing with the central government. TVEs can be regarded as a strategy in these two dimensions. A local government directly controls TVEs as a channel of local expropriation and the government ownership means that the private property rights are interfered. As many have shown, the government ownership in TVEs is effective during a certain period. However, it violates private property rights. In models of “market-preserving ﬁscal federalism”, local governments’ helping hands as motivated by ﬁscal incentives are visible hands since governments directly control the operations of these enterprises. To achieve their objectives, local governments are able to use both helping hands and grabbing hands at the same time. Helping hands promote local economic growth and hence, enlarge the total surpluses which are available for redistributions. To enhance its revenues, a local government is also motivated to use its grabbing hand to seize a larger portion of the surpluses. China’s decentralized ﬁscal system not only motivates local governments to use their helping hands, but also provides them with more room to use their grabbing hands since the central controls become much weaker. Models of “market-preserving ﬁscal federalism” largely ignore the “dark side” of ﬁscal decentralization in China. Like local governments, the central government is also mainly motivated to maximize its revenues. In a decentralized economy, the central government does not directly control local economies. Its revenues are remitted by local governments as its agents. It is in the common interest for both the central and local governments to promote economic growth, since total surpluses available for redistribution between different levels of governments become larger. In contrast to local governments, however, the central government wants to reduce local expropriation to enhance its own revenues. To restrict local expropriation, the central government can use its political and administrative authority over local governments. For example, it can use the authority in personnel matters to punish those local government ofﬁcials who grab too much (Blanchard and Shleifer 2000). The central government can also strengthen its tax collection efforts and control channels for local expropriation. To promote economic growth, the central government can commit itself to protecting private property rights. However, assistance and cooperation from local governments are needed for effectively protecting property rights since local governments can directly affect the implementation of national policies. Under certain conditions, the local government has the incentive to make efforts in protecting private property rights and induce the central government to do the same. When local expropriation is more costly, the local government is more likely to commit to protecting private property rights and economic freedom. Essentially, a local government could retain a certain portion of total surplus from the private sector through two substitutable ways: local expropriation which increases its share in the total ﬁscal revenue, or promoting local economic growth which increase the size of ﬁscal revenue. When the former ﬁrst option becomes more costly, a local government makes more efforts in the second option. Especially when a well-deﬁned formal property rights system is in higher demand by private enterprises, the local government is more likely to collaborate with the central government to establish secure private property rights because insecure private property rights then hinder economic growth.

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When private businesses are small, informal property rights (or more precisely, government ownership) are effective in preserving the incentives of both private entrepreneurs and local governments. This institutional arrangement leads to local prosperity and increased revenue for local governments because local governments can reap beneﬁts from both increased revenue bases and portions of local revenue. However, the central government might ﬁnd its revenue shrinking if the degree of local expropriation is too high. Therefore, the central government faces the tradeoff between preserving local governments’ incentives by allowing local government ownership in local ﬁrms and restricting local expropriation by restricting local governments’ direct control of local ﬁrms. When private businesses become sizable and need outside investment and human capital, this tradeoff for the central government becomes insigniﬁcant since local governments are motivated to fade out more mature local ﬁrms. They are more motivated to fade out private enterprises when the central government formalize the ﬁscal system and restrict off-budget activities. Without effective channels in local expropriation, local governments ﬁnd that the major way for them to secure their revenue ﬂow is to ensure the smooth development of local private ﬁrms. When these ﬁrms demand well-deﬁned ownership, local governments are committed to protecting private property rights. When local governments’ commitment is credible, the central government ﬁnds that it is in its interest to grant and protect private property rights, since it beneﬁts from enlarged revenue bases as well when local economies grow. Based on the insights, we analyze how local governments and private enterprises interact against the background of the evolving ﬁscal system in China during the reform period. 3 Government and Private Enterprises in Wenzhou Located on China’s east coastal line and close to Taiwan, Wenzhou was regarded as a potential war zone when the government was still prepared to engage a war with Taiwan since the late 1940s. Wenzhou is situated in a mountainous area. Arable land is scare and the transportation system was very backward. In 1978, arable land per capita was only 0.53 mu. In the same year, the national average was 1.6 mu. A railway is connected to Wenzhou only in 1992. Wenzhou was not a favorable place in a centrally planned economy. In 1978, total social ﬁxed investment was only RMB 37.62 million, including RMB 35.99 million in SOEs, and RMB 1.63 million in collective enterprises. During the period from 1949 to 1981, total public investment in Wenzhou was merely RMB 655 million in total. Because of all these disadvantageous geographical conditions, Wenzhou became a relatively isolated region. It was exactly in that backward and isolated region where a surest sign of entrepreneurship and a genuine free market economy started to develop in the late 1970s. 3.1 Entrepreneurs Selling Buttons In the late 1970s, farmers in some rural areas in China spontaneously launched various production responsibility systems. In 1979, the central government ofﬁcially

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endorsed the reform and introduced “household responsibility system” to more regions. The success of the contract system was immediate. Agricultural productivity increased dramatically. The productions means owned by collectives were sold to or distributed among the households which were also contracted for the sideline production for collectives. The autonomy enjoyed by households, surplus labor in the rural area, and accumulated funds promoted the emergence of “individual industrial and commercial households” or “individual businesses” (geti gongshang hu or getihu). In Wenzhou, villages are located in isolation from large cities and receive little technical and managerial assistance from urban industrial centers. In addition, there existed limited collective industrial enterprises in rural Wenzhou. Therefore, the ﬁrst form of industrial production emerged in rural Wenzhou was mere sideline productions in farming families. And there were a large quantity of such families. These families were also engaged in marketing and sales of their own products and buying their own supplies because the state-owned and collective commercial channels were not open to them. According to one study (Zhang and Li 1990), there are about 90% of farming families in one town in Wenzhou had sideline production in textile processing and related commercial activities before 1986. For many families, the sideline production became a major source of income and they set up family workshops or family factories. There were more than 80,000 family ﬁrms in 1984 and the number increased to 110,000 in 1986. These private enterprises employed about 300,000 workers and produced 50% of the total industrial outputs in Wenzhou (Li 2000). These family enterprises were small and mostly employed family members. Their production technologies were simple and relatively backward, and they required little capital investment. It was exactly these tiny family businesses that created most vibrant markets in China. The comparative advantage of these small-size low-tech family enterprises is to produce articles of everyday use, which are characterized by varieties and small production batches. The comparative advantage was fully explored in the late 1970s and 1980s when the demand for those everyday necessities were extremely high after many years of shortage under a command economy. Entrepreneurs from Wenzhou satisﬁed the consumer demand by setting up their own commercial and logistical channels. Salesmen from Wenzhou were all over China and roadside markets for industrial products emerged in Wenzhou’s villages. In 1985, there were 2874 markets in Wenzhou. Each village developed a specialized market. For example, there is a village market specializing in buttons. Buttons from this market reached department stores all over China. These vibrant trading villages symbolize the spontaneous order of a truly competitive market. The trading system operates outside of the state-owned commercial system, is an outcome of market activities of numerous entrepreneurs. These entrepreneurs are all autonomous, specialized and trades according to market conditions. Their economic freedom was created not because of ex ante government policies. As a matter of fact, these entrepreneurs could emerge and be free to choose what to do, exactly because of the absence of prior government actions. In these forgotten and remote villages, entrepreneurs seized market opportunities to realize their own objectives in a harsh environment. Later, local governments did attempt to take action to wipe out these markets operating outside of the formal system. By doing so, local government ofﬁcials tried to demonstrate their adherence to the policies of

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the central government. However, it appeared to be an impossible mission to depress market activities. Gradually, these governments found it better to promote rather than to hinder the development of markets, since markets provided them with dramatically increased revenues. It was a process for local governments in Wenzhou to discover their “encompassing interests” in the local economies.7 It is interesting to note that the local governments seemed to behave as limited governments in the sense that they provided public goods and a supportive environment for market exchanges. The local governments consolidated chaotic roadside markets into trade-fair-style wholesale markets at ﬁxed locations. By providing ﬁxed trading places, local governments could easily monitor market activities, collect taxes and charges and, hence, realize its own objectives of maximizing revenues. At the same time, however, these trade-fair-style wholesale markets beneﬁt the further development of market activities and hence, the whole local economies. Local governments provide public goods inside these markets, including security services, arbitration services, and preventing commercial fraud. In addition, local governments adjust their tax rates to a minimum level to attract more businesses, including those from other localities. These markets sanctioned by local government are open and a haven for economic freedom. The emergence of the limited local governments in Wenzhou was fundamentally attributed to the competitive market structure of the local economy. A family which wished to enter the trading system faced no natural barriers. If a local government sets up a barrier, those small ﬁrms could easily “vote by feet” and move to other localities. Local governments competed with each other for mobile small businesses. The disciplining force drove local governments in Wenzhou to provide better public goods. That these local governments could be very business-friendly was also due to the fact that potential “opposition” groups were very small. Employees in SOEs could feel threatened by the thriving private businesses. As mentioned above, SOEs were very small in Wenzhou. In 1978, there were only 294 (7%) SOEs among 4085 industrial enterprises. Though the size of SOEs was small, the free-rider problem in collective actions still presented. Therefore, oppositions to the emergence and further development of the private sector are almost non-existent in Wenzhou. To a large degree, interactions between local governments and private entrepreneurs determine the development of the private sector and the space for economic freedom. At the earlier stage, competing local governments provided a supportive external environment for family ﬁrms to development. When these family ﬁrms grew, local governments found themselves in shaping these ﬁrms’ internal structure. 3.2 Entrepreneurs Wearing “Red Hats” and Local Government Ofﬁcials “Eating in Separate Kitchens” In the early 1980s, there existed hundreds of thousands of family businesses that grew beyond the size of a getihu as deﬁned by the government. The State Councils regulations only recognized two types of non-farming entities in the rural area: 7 The reason why local governments “discovered” their “encompassing interests” was that they could share marginal increments of tax revenues after ﬁscal reforms in the early 1980s (see Section II.B).

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collective enterprises with more than ﬁve employees and individual industrial and commercial households (getihu) with ﬁve employees or less. In other words, family businesses with more than ﬁve employees had difﬁculties in maintaining their identities of private enterprises and protecting their economic freedom. The difﬁculties were not only in legal terms but also in political matters. Private entrepreneurs were still considered to belong to an “exploiting class.” Therefore, there was considerable political risk for being proﬁt-oriented private entrepreneurs.8 In business terms, private enterprises were also discriminated against. In contrast, TVEs were encouraged.9 Together with other state and collective enterprises, TVEs received favorable treatments in tax breaks, bank loans, and rights to use public land. Like their counterparts in other parts of China, private entrepreneurs in Wenzhou faced a daunting challenge to protect their newly acquired economic freedom and continuously expand their thriving businesses. These entrepreneurs came up with an innovative solution of “wearing red hats,” meaning that private entrepreneurs registered their essentially private businesses as collective enterprises. A related practice was to ﬁnd “hang-on” enterprises. Essentially, a private entrepreneur paid a SOE or a government agency for using its name and other business conveniences such as the rights to use their letters of introduction, contracts, and banking accounts. By disguising as collective enterprises, private ﬁrms with large sizes were better able to deal with economic and political difﬁculties faced by them. Wearing red hats, private entrepreneurs were able to maintain their effective control over their own ﬁrms and protect their economic freedom. Therefore, red hatting became a common practice. It was estimated that between 90% and 95% of registered collective enterprises wore red hats (Parris 1993). Red rats were an effective solution. When the majority of private enterprises were still of limited sizes, formal legal protection was not in a great demand. Personal relationships among private entrepreneurs and local bureaucrats serve as an informal mechanism for protecting private property rights. Local bureaucrats were willing partners. Otherwise, the red-hat phenomenon could never become popular that rapidly. At that time, local government ofﬁcials were encouraged to collude with private entrepreneurs because of a unique ﬁscal system that existed during the takeoff years of private enterprises in China. Before 1978, the ﬁscal system in China was highly centralized. Local governments were responsible for collecting taxes. However, they remitted most of their collection to the central government who then assigned expenditures to local governments through the national budget. The ﬁrst wave of ﬁscal reform was launched in 1980 when so-called ﬁscal contracting system was introduced (Wong,

8 Private entrepreneurs were one of the groups openly criticized during the national campaigns “against spiritual pollution” in 1983 and “against bourgeois liberalization” in 1987. 9 In 1984, the CPC Central Committee approved the “Report on the Exploration of New Prospects for Commune and Brigade Enterprises” drafted by the Ministry of Agriculture, Animal Husbandry and Fish Farming, and the State Council published “Some Regulations on Self-employed Industry and Commercial Individuals in Rural Areas.” These two documents for the ﬁrst time deﬁned the commune and brigade enterprises as Township and Village Enterprises (TVEs).

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Heady, and Woo 1995, and Ma 1997). The revenue-sharing system was aimed to make the provincial and central governments to eat in separate kitchens. Separate kitchens meant two different tax bases: central revenues and local revenues. The third category was shared revenues. The center negotiated with each province regarding the contractual terms of shared revenues. One major consequence of the reform was widening inequality of revenues among provinces. Reforms in 1985 attempted to change the situation by introducing a new scheme of revenue-sharing arrangements based on the budget balance in previous years. Provinces with ﬁscal surpluses were required to remit a portion of their surplus receipts to the central government. Poorer provinces with ﬁscal deﬁcits were allowed to retain a higher portion of their receipts. In 1988, six types of revenue-sharing contracts were introduced in an attempt to enhance wealthier provinces incentive to collect revenues. The 1988 system was extended until the end of 1993, largely unaltered. Prior to 1993, the revenue-sharing system created a strong incentive for local governments to promote local economic growth on one hand (Montinola, Qian, and Weingast 1995), to minimize the amount of revenues remitted to the center on the other hand. Speciﬁcally, the latter efforts were demonstrated in the fact that local governments worked hard to raise extra-budgetary and off-budget funds. Though the statutory tax rates and bases were decided through negotiations between the center and provinces, local governments effectively controlled the effective rates and bases by changing the level of local expropriation (i.e., the degree to which budgetary funds were shifted to extra-budgetary and off-budget funds). The main difference between extra-budgetary and off-budget funds is their technical legality. The former is allowed and regulated by the central or provincial governments while the latter are collected by lower-level governments without the authorization from the central or provincial governments. Off-budget funds are also known as “little money lockers”. By its very nature, the magnitude of off-budget funds is unknown. Nevertheless, policymakers in China and researchers have long recognized the seriousness of the problem (Fan 1998 and Bahl 1999). These off-budget funds are especially widespread among township governments and villages. A major source of off-budget funds for these governments is proﬁts and contributions from local enterprises. Under the ﬁscal system before 1993, local governments in China were motivated to control local private enterprises in order to secure their own revenue streams. Common interests shared by local governments and private enterprises led to a corporate structure with Chinese characteristics. Under such a structure, private entrepreneurs’ economic freedom was maintained at a price paid to local governments. The involvement of local governments in red-hat enterprises made them similar to TVEs in the sense that the ownership of these ﬁrms was unclear. Many studies indicate that an ambiguous property rights system (red-hat enterprises, or local government ownership of enterprises in TVEs) is a second-best institution under Chinas transitional context when free-market institutions (especially, an independent and well-functioning legal system) are not completely effective and when governments are not constrained and might be predatory (Weitzman and Xu 1994, Li 1996, Che and Qian 1998, and Che 2002). As we argue earlier, ﬁscal incentives drive local governments to control local enterprises. Stakes in these enterprises are the foundation for a commitment mechanism for local governments to

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adjust their own expropriation activities to a sustainable level. However, the level of local expropriation is too high from the perspective of the central government. While the second-best institution in the form of ambiguous property rights system arguably is the major contributor to China’s spectacular economic growth during the reform era, the collusion relationship between local governments and local enterprises has negatively affected the overall health of the ﬁscal system. In particular, the central governments revenue sources and abilities to manage the economy were greatly weakened. During the period from 1978 to 1993, the ratio of total (local and central) budgetary revenue-to-GDP declined from 29% in 1979 to 13% in 1993, and the central governments share of total budgetary revenue decreased from 51% to 28% (Ma and Norregaard 1998). The deteriorating ﬁscal position led the central government to implement radical ﬁscal reforms in 1994. The revenue-sharing system was replaced by a tax assignment system which redeﬁned the three categories of revenue sources. Reforms were mainly aimed to curb some of incentives and channels for local expropriation. One major reform measure was that the central government took over the VAT (Value-Added Tax). This measure greatly limited one of the key sources for local governments’ offbudget revenues. In addition, national tax services were set up in every province to collect central and shared taxes. A new central agency, the State Bureau of General Taxation, was established to supervise local national tax services. These institutional measures are essentially an option adopted by the central government to signal that the level of local expropriation was too high. By adopting these measures, the central government changed the dynamics between local governments and private enterprises, and set up a new stage for the evolution of economic freedom in China. 3.3 Farmers-Turned-Board Chairmen and Entrepreneurs-Turned-Politicians Under the new ﬁscal system, options for local government to hide and keep ﬁscal revenues locally were much more restricted. Local governments had to substitute local expropriation with other options in order to continuously enjoy stable ﬂows of revenues. A substitution option for local government is to commit to protecting property rights and hence, induce the center to formally grant and enforce private property rights. This option becomes more attractive when the private sector is more responsive to the property rights system. When private enterprises in Wenzhou including those with red hats expanded their operations and market conditions changed, the demand for formal legal protections of private properties dramatically increased. As a matter of fact, the demand for secure property rights from private enterprises existed much earlier than the 1994 ﬁscal reforms. In the mid-1980s, local experiments in joint-stock cooperative (JSC) were initiated in the Wenzhou region (Shi, Jin, Zhao, Luo, et al 2002). Ownership changes from individual enterprises and red-hat enterprises to JSCs accelerated in the early 1990s. JSC is a signiﬁcant institutional innovation in the sense that local governments fade out these enterprises. By adopting the politically acceptable form of JSC, private entrepreneurs are able to completely control their ownership without even wearing red hats. The development indicates that genuine private property rights emerge in China, and that economic freedom of private entrepreneurs becomes legally maintained and protected by the government.

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In their studies on the evolution of private enterprises in the Wenzhou region, Shi et al (2002) show that JSC ﬁrms in the region essentially were a response to less-developed factor markets and problems in red-hat enterprises. A major problem of red-hatting was that private enterprises had a strong incentive to overuse and abuse reputation associated the red-hats. Private entrepreneurs treated reputation resources of nominal collective enterprises as commons. As a consequence, too many low-quality and fake goods were produced. That promoted local governments in Wenzhou to take off red hats from many private enterprises in the mid-1980s. Local governments were motivated to limit the destructive behavior by private enterprises because they share a common interest in a healthy and growing local economy. As we argue earlier, local economies in Wenzhou are characterized by numerous smallsize family businesses. The big number of actors prevents an effective solution to the commons problem in optimal use of reputation resources. Local governments acted to provide the public good of a common reputation of products made in Wenzhou. Eventually, local governments as well as private entrepreneurs found JSC an attractive alternative. By transforming themselves into JSC ﬁrms, private enterprises were able to overcome problems in factor markets. In Wenzhou, most private enterprises were owned by members from individual families before JCS became a popular form of business organization. JCS ﬁrms were jointly owned by several families and essentially internalized enlarged factor markets. JCS ﬁrms were able to tap into much larger pools of funds and human capital. Local governments in Wenzhou started to actively promote JCS in the mid-1980s. Then they had to take certain political risks because the central government had not recognized JCS as a form of collective ﬁrms yet. Since the early 1990s, however, the national climate for the development of genuine private enterprises with secure property rights has signiﬁcantly improved. At that time, local governments in other regions started to fade out government-controlled or government-linked enterprises. Wenzhou was just one step ahead of the rest. The central government has been placing more and more emphasis on building up a genuine market economy with a rules-based framework (Qian 1999). The ﬁrst approval in principle for local experiments in granting and enforcing private property rights and other rules-based institutional reforms from the center came in the form of then paramount leader, Deng Xiaoping’s famous southern tour in September 1992. In October 1992, the Communist Party’s Fourteenth Congress ofﬁcially set a socialist market economy as its reform goal. In the following years, ofﬁcial reform programmes focused on free market rules and institutions, and reforming SOEs in terms of property rights and ownership. In September 1997, the Fifteenth Party Congress recognized private enterprises as an important component of the economy and emphasized the rule of law as a foundation for a market economy. In March 1999, private ownership was incorporated into a constitutional amendment. In November 2002, the 16th CPC National Congress made a historical gesture to China’s private enterprises. For the ﬁrst time, a few private entrepreneurs became delegates to the most important political event in China. Secretary-General Jiang Zemin’s report emphasized that the Central Government would ﬁrmly support the further development of the private sector in China. After the Congress, many private

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entrepreneurs were selected to take high positions in various political organizations. Economic freedom of these private entrepreneurs becomes politically supported. 4 Conclusion China still has a long way to go to establish an effective system of private property rights and maintain and further economic freedom enjoyed by private entrepreneurs. However, China is on the track. We argue that a secure system of private property rights is more likely to occur as an outcome when the private sector is more responsive to property rights protection, and local expropriation is more restricted. When local expropriation activities are restricted in an improved ﬁscal system, local governments, who has enormous stakes in local economic growth under China’s de facto ﬁscal federal system, make efforts in protecting private property rights. Provided that local governments credibly make the commitment, the central government ofﬁcially grants and enforces private property rights for its own interests in securing ﬁscal revenues. China’s evolving ﬁscal system has created one of the critical conditions for the emergence of private property rights in China. Another favorable condition is the rapid development of the private sector which increasingly demands welldeﬁned property rights system and government-business relations. After decades of evolution, native private enterprises need to develop beyond their limited sizes into larger companies with expanded business opportunities, management teams, and external ﬁnancing. China’s accession into WTO further pushes these enterprises into greater competition and opportunities internationally. Establishing limited-liability shareholding companies is inevitable. The transition to the modern corporate form demands a more formal and effective property rights system. Governments at all levels in China easily recognize the importance of the transition. A more dynamic private sector is critical for sustainable long-term economic growth which is in the very interests of both central and local governments in China. The ideological obstacle for a genuine private sector with secure property rights is largely broken down. Nevertheless, challenges for establishing and maintaining an effective system of private property rights and economic freedom are great. Costs are enormous. Governments at all levels need to collaborate to establish an independent judicial system. Moreover, governments need to take up a vast agenda of reform to level the playing ﬁeld among all types of enterprises (ADB 2003). Another signiﬁcant challenge is to continuously improve the ﬁscal system. A key insight from our analyses is that the evolution of the property rights system is closely related to the development of the ﬁscal system. The ﬁscal system determines the incentive structure for a local government. When the ﬁscal system is able to tie up the “grabbing hand,” the local government is motivated to take its hands off local private enterprises. The 1994 ﬁscal reforms has achieved partial success in terms of enhanced ﬁscal transparency and increased central revenues. However, the ﬁscal system is still not established through formal legislature, but affected by strategic interactions between the central and local governments. After 1994, local governments are able to continue to use extra-budgetary and off-budget funds. As we demonstrate, an effective system of

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private property rights can be fully established only when the “grabbing hand” is tied up somehow. References Asian Development Bank, The Development of Private Enterprise in the Peoples Republic of China (Manila, Philippines: Asian Development Bank, 2003). Bahl, R., Fiscal Policy in China: Taxation and Intergovernmental Fiscal Relations (Ann Arbor: University of Michigan Press, 1999). Blanchard, O. and Shleifer, A., “Federalism With and Without Political Centralization: China versus Russia,” NBER Working Paper, 7616 (2000). Che, J., “Rent Seeking and Government Ownership of Firms: An Application to China’s Township-Village Enterprises,” Journal of Comparative Economics, 30, 4 (2002): 787–811. Che, J. and Qian, Y., “Insecure Property Rights and Government Ownership of Firms,” Quarterly Journal of Economics, 113, 2 (1998): 467–96. China National Statistics Bureau, China Statistics Yearbook 2003 (Beijing, China: China Statistical Publishing House, 2003). De Figueiredo, R., and Weingast, B., “The Rationality of Fear: Political Opportunism and Ethnic Conﬂict,” in B. Walter and J. Snyder eds Civil Wars, Insecurity and Intervention (Columbia University Press, 1999), 261–302. Fan, G., “Market-oriented Economic Reform and the Growth of Off-budget Local Public Finance,” in D. Brean eds Taxation in Modern China (New York: Routeledge, 1998). Furubotn, E. and Pejovich, S., The Economics of Property Rights (Cambridge, MA: Ballinger, 1974). Hayek, F., The Road to Serfdom, (Chicago, IL: University of Chicago Press, 1944). Jin, H., Qian, Y. and Weingast, B., “Regional Decentralization and Fiscal Incentives: Federalism, Chinese Style,” Working Paper (Hoover Institution, Stanford University, 2001). Li, D., “A Theory of Ambiguous Property Rights in Transition Economies: The Case of the Chinese Non-State Sector,” Journal of Comparative Economics, 23, 1 (1996): 1–19. Li, D., The Wenzhou Mystery – A Successful Model of Poverty Alleviation in China (Wenzhou Zhi Mi - Zhongguo Tuopin Zhifu De Chenggong Moshi) (in Chinese) (Beijing, China: Guangming Daily Press, 2000). Ma, J., Intergovernmental Relations and Economic Management in China (England: Macmillan Press, 1997). Ma, J. and Norregaard, J., “China’s Fiscal Decentralization,” World Bank Working Paper, November (1998). Montinola, G., Qian, Y. and Weingast, B., “Federalism, Chinese Style: The Political Basis for Economic Success in China,” World Politics, 48, 1 (1995): 50–81. Olson, M., The Logic of Collective Action (Cambridge: Cambridge University Press, 1965).

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Olson, M., “Dictatorship, Democracy and Development,” American Political Science Review, 87, 3 (1993): 576–76. Parris, K., “Local Initiative and National Teform: The Wenzhou Model of Development,” The China Quarterly, 134 (1993): 242–63. Peng, Y., “Chinese Villages and Townships as Industrial Corporations: Ownership, Governance, and Market Discipline,” American Journal of Sociology, 106, 5 (1001): 1338–70. Qian, Y., “The Institutional Foundations of China’s Market Transition,” Stanford University Economics Department Working Paper, 99-011 (1999). Shi, J., Jin, X., Zhao, W. and Luo, W., et al, Institutional Changes and Economic Development: Studies on Wenzhou Model (Zhidu Bianqian Yu Jingji Fazhan: Wenzhou Moshi Yanjiu) (in Chinese) (Zhejiang, China: Zhejiang University Press, 2002). Weimer, D., The Political Economy of Property Rights: Institutional Change and Credibility in the Reform of Centrally Planned Economies. (New York, NY: Cambridge University Press, 1997). Weitzman, M. and Xu, C., “Chinese Township-Village Enterprises as Vaguely Deﬁned Cooperatives,” Journal of Comparative Economics, 18, 2 (1994): 121– 45. Wenzhou Municipal Statistics Bureau, Wenzhou Statistics Yearbook 2003 (Beijing, China: China Statistical Publishing House, 2003). Wong, C., Heady, C. and Woo, W., Fiscal Management and Economic Reform in the People’s Republic of China, (Hong Kong: Oxford University Press, 1995). Wu, Y., Comparative Economic Transformations: Mainland China, Hungary, the Soviet Union, and Taiwan (Stanford, CA: Stanford University Press, 1994). Zhang R. and Li, H., Studies on Wenzhou Model (Wenzhou Moshi Yanjiu) (in Chinese) (Beijing, China: China Academy of Social Sciences Press, 1990).

Chapter 6

Property Rights Developments and Productivity Gains in China: A Law and Economics Perspective Xiaowen Tian, Vai Io Lo1

1 Introduction Property rights developments have been taken as a major reform measure to improve efﬁciency in transition economies in recent years. The economic rationale was most clearly spelled out by the property rights theory. According to this theory, welldeﬁned property rights can serve as the basis for the proper functioning of markets because they provide incentive; stimulate competition; and engender the efﬁcient use of resources, technology innovation, and output growth in a world of scarcity (Furubotn and Pejovich, 1972).2 In other words, the more property rights move into private hands, the greater are efﬁciency gains, and the more rapid is output growth. The Chinese experience, however, appeared to be inconsistent with this theory. A number of empirical studies have found that private ﬁrms did not achieve as much productivity gains as collectives did (Svejna, 1990; McGuckin and Nguyen, 1993; Dong and Putterman, 1997). This seems to suggest that privatization did not materialize what the property rights theory had claimed, and that the rapid growth of the Chinese economy in the past twenty years resulted mainly from the productivity gains achieved in the intermediate forms of ownership—the collectives. To counter this challenge, this article argues that the poor performance of the private sector and the successes of the collective sector were attributed to the legal environment that favored collectives over private ﬁrms in the 1980s, not due to the assumed superiority of collectives over private ownership. In a discriminatory legal environment, private property rights progressively developed within, or under the disguise of, collectives in the 1980s, and thereby contributed to the successful performance of the collective sector in that period. Along with the changes in the legal environment to strengthen 1 Tian: University of Nottingham. Lo: International University of Japan. 2 With respect to property rights, Honore lists eleven standard incidents that comprise private property, including right to exclusive possession; right to personal use and enjoyment; right to manage use by others; right to income from use by others; right to capital value (alienation, consumption, waste, or destruction); right to security; and power to transmit by gift, devise, or descent. See Honore (1961).

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protection of private property rights, private ownership developed in a more open manner and began to outperform collectives in the 1990s. Accordingly, the Chinese experience cannot pose a challenge to property rights theory, but rather, demonstrates economic gains from progressive, albeit hidden in the beginning, privatization and the importance of legal protection of private property rights. In what follows, we ﬁrst explain the discriminatory legal environment that forced private property rights to develop within, or under the disguise of, collectives. Then in Section 3, we outline the major developments in legislation with respect to private property rights in the late 1980s and particularly after 1992, which enabled private ownership to develop openly and to outperform the collectives. In Section 4, we develop, based on an aggregate production function, an econometric model to compare the respective productivity gains of the openly private-owned and the collective sectors in the 1980s and 1990s, and describe the data used for the empirical investigation. In Section 5, we explain the results of the regression analysis. The ﬁnal section concludes. 2 Discriminatory Legal Environment in the 1980s China started economic reform in the rural areas, and carried it out in a trial-byerror manner. In the early period of the reform, the Chinese government encouraged limited development of private property rights within the framework of, or under the name of, public ownership that referred to, in the rural areas, collective ownership. In agriculture, the government promoted the household responsibility system, under which farmers obtained the rights to use a piece of land for a period of time by signing a contract with the collective authorities—the owner of the land. In industry and commerce, the government promoted the development of township and village enterprises (TVEs), in which elements of private property rights emerged and developed under the disguise of collective ownership.3 Due to ideological considerations, however, the Chinese government maintained a hostile attitude toward openly private-owned enterprises. In most of the 1980s, therefore, the legal and political environment was conducive to nominally collective-owned enterprises, but discriminatory against openly private-owned ﬁrms. Various preferential policy treatments were, for instance, granted to TVEs, particularly those with greater degree of collective ownership, namely, the commune and team enterprises (shedui qiye). Newly established commune or team enterprises initially were exempt from industry and commerce tax as well as income tax for two to three years.4 Starting from April of 1981, new commune or team enterprises could 3 In 1984 when the name of township and village enterprises was introduced, it ofﬁcially referred to commune and team enterprises (so-called entirely collectively owned), enterprises run by joint households, and enterprises run by individual household. In fact, the majority of TVEs were nominally owned by collectives, but they contained elements of private property rights to a more or less degree. 4 Guowuyuan Guanyu Tiaozheng Nongcun Shedui Qiye Gongshang Shuishou Fudan de Ruogan Guiding [The State Council’s Several Rules regarding the Adjustment of the Industry and Commerce Taxation Burden of Rural Commune or Team Enterprises] [hereinafter I/C Taxation

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receive cuts in industry and commerce taxation for one year if they had difﬁculty in paying taxes and their business or products did not belong to the high-tax category, including tobacco, wine, sugar, cotton yarn, and watch.5 Moreover, newly established commune or team enterprises were exempt from income taxation for one to two years if they did not compete with large advanced-industrial enterprises for raw materials.6 Among them, enterprises that had difﬁculty in paying taxes after the exemption period might be granted one more year of tax exemption.7 In 1984, commune or team enterprises that did not compete with large industries for raw materials continued to receive tax remission or reduction if they met certain criteria. For example, newly established commune or team enterprises were exempt from income taxes for one year if they experienced difﬁculties in business.8 Moreover, commune or team enterprises and basic-level supply and marketing cooperatives might pay lower income taxes at regular intervals if they had difﬁculty in paying taxes in accordance with the eight-grade above-quota progressive rate.9 Similarly, commune or Burden Rules], promulgated on January 30, 1981. In addition, taxation exemption was granted for enterprises doing certain types of business or enterprises located in particular geographical areas. For example, the sale revenues and proﬁts of small iron mines, electricity stations, coal pits, and cement plants run by commune or team enterprises were exempt from industry and commerce as well as income taxes from January 1, 1978 to December 31, 1980. Caizhengbu Guanyu dui Nongcun She Dui Ban de Xiao Tiekuang, Xiao Meiyao, Xiao Dianzhan, Xiao Shuinichang Mianzheng Gongshangshui he Suodeshui de Tongshi [The Ministry of Finance’s Notice concerning the Exemption of Industry and Commerce and Income Taxes for Small Iron Mines, Coal Pits, Electricity Stations, and Cement Plants Run by Communes or Teams], issued on February 13, 1978. Similarly, enterprises run by communes and teams located in revolutionary bases were exempt from income taxes for ﬁve years, starting from 1979, if the average income of their members in 1978 was lower than ﬁfty dollars. Guanyu Mianzheng Geming Laogenjudi Shedui Qiye Gongshang Suodeshui Wenti de Tongzhi [Notice concerning the Exemption of Industry and Commerce Income Taxes of Commune and Team Enterprises Located in Revolutionary Bases], issued by the Ministries of Civil Administration and Finance on June 24, 1979. 5 I/C Taxation Burden Rules, supra note 9, art.2. In 1982, the State Council promulgated a supplement to the I/C Taxation Burden Regulation, which was to be effective on April 1. The supplement provided a list of products manufactured by commune and team enterprises on which industry and commerce taxes would be levied. The list consisted of tobacco, watch, sugar, sewing machines, cosmetics, silk, plastics, electric appliances, leather goods, etc. However, commune or team enterprises that manufactured products other than those in the list and had difﬁculty in paying taxes might, as determined by provincial, municipal, and autonomous-regional governments, obtain tax exemption or reduction for the maximum period of one year. Guowuyuan Guanyu Tiaozheng Nongcun Shedui Qiye Gongshang Shuishou Fudan de Buchong Guiding [The State Council’s Supplemental Regulations regarding the Adjustment of the Industry and Commerce Taxation Burden of Rural Commune or Team Enterprises] promulgated on March 18, 1982. 6 I/C Taxation Burden Rules, supra note 9, art. 2. 7 Id. 8 Caizhengbu Guanyu Tiaozheng Nongcun Shedui Qiye he Jiceng Gongxiaoshe Jiaona Gongshang Suodeshui Shuilu de Guiding [The Ministry of Finance’s Rules regarding the Adjustment of the Rate of Industry and Commerce Income Taxes Paid by Rural Commune or Team Enterprises and Basic-Level Supply and Marketing Cooperatives], issued on September 3, 1983. 9 Id.

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team enterprises situated at the revolutionary bases in the war periods, areas of ethnic minorities, or the borders might receive reduction in income taxes at regular intervals.10 In fact, TVEs situated at the borders and autonomous regions were exempt from income taxes from 1984 to 1985 if the amount of their annual income was less than 3,000 yuan.11 Furthermore, the proﬁts of TVEs that used their own waste water, waste gas, and waste residue as main raw materials for production were exempt from income taxes for ﬁve years, starting from the date they went into operation.12 Accordingly, TVEs and their predecessors received preferential tax treatment during the 1980s. Apart from tax remission or reduction, the government provided rural collective enterprises with preferential loans. According to the Agricultural Bank of China, the balance of loans given by agricultural banks and credit cooperatives to rural industries amounted to 68 billion yuan by the end of 1986, which was more than ﬁve times the amount in 1980.13 Of these loans, TVEs borrowed more than 55 billion yuan, accounting for 81% of the total.14 Indeed, the Provisional Measures for Loans to Rural Industries were issued in 1985, providing guidelines in favor of TVEs with respect to the qualiﬁcations of borrowers, types of loan and duration, interest rate, loan agreement, and loan administration and supervision.15 On the other hand, openly private-owned enterprises were discriminated against legally and politically. Although the government encouraged rural surplus workers to become self-employed (getihu) in handicraft, repair, service, and food industries and would consider special treatment in terms of loan, price, and taxation, it maintained a hostile attitude toward larger-scale private enterprises (siying qiye).16 On legal terms, larger-scale private enterprises were not allowed to exist and develop both in rural areas and in cities until 1988. There emerged, nevertheless, some larger-scale private ﬁrms, such as the shazi guazi (dull man’s melon seeds) ﬁrm, that employed more than a hundred workers, but they did not have any legal protection from the government.

10 Id. 11 Caizhengbu Guanyu Dui Xiangzheng Qiye Jinyibu Jian, Mian Gongshang Suodeshui de Tongzhi [The Ministry of Finance’s Notice regarding the Further Reduction and Remission of Income Taxes of Township-and-Village Enterprises], issued on March 25, 1984. 12 Id. art. 3. 13 Zhongguo Nongye Yinhang Guanyu Gaijin Xindai Fuwu Jiaqiang Xindai Jiandu Zhichi Nongcun Gongye Wending Xietiao Fazhan de Ruogan Guiding [The Agricultural Bank of China’s Several Rules regarding the Improvement of Credit Services, Strengthening of Credit Supervision, and Support of the Stabilization, Coordination, and Development of Agricultural Industries], issued on March 16, 1987. 14 Id. 15 Zhongguo Nongye Yinhang Xiangcun Gongye Daikuan Zanxing Banfa [The Agricultural Bank of China’s Provisional Measures for Loans to Rural Industries], issued on December 9, 1985. 16 Guowuyuan Guanyu Nongcun Geti Gongshangye de Ruogan Guiding [The State Council’s Several Regulations concerning Rural Individual Industry and Commerce], promulgated on February 27, 1984. Generally speaking, geithu were run by one person or a family. If necessary, getihu might employ one to three assistants after obtaining approval from the government. Id. art. 7. If an enterprise had eight or more employees, it became a private enterprise (siying qiye).

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73

Even the getihu, which were ofﬁcially allowed to exist, operated in a discriminatory environment. For instance, they were (and are now still) not permitted to do business in many production areas, such as banking, telecommunications and post, electricity, ammunition, tobacco, steel, gold and silver products, cofﬁn-making, army uniform, police uniform, ﬁlm-recording, tea products from minority nationalities, emulation toy guns, dangerous chemicals, hunting riﬂes, explosive goods for civil use, and round spring scales.17 Moreover, getihu were banned from the wholesale of certain kinds of goods, including goods under state monopoly, goods under state planning, necessities closely related to people’s livelihood, books and periodicals, western medicines, and goods for labor protection.18 Similarly, they were banned from the retail sale of a variety of goods, such as imported books and periodicals, cotton, non-ferrous metal, discarded productive metal, color TVs, silk, fertilizers, farm chemicals, cultural relics, pearls, and crystals.19 Owing to the lack of legal protection of, and the discrimination against, private entrepreneurs, collectives provided a convenient, transitional form for private property rights to develop and exist. In the 1980s, as shown in Figure 6.1, the formal private sector was very weak, consisting mainly of small-scale, household-based individual producers (getihu).20 It could not compete with collectives in productivity. Private property rights developed actively, however, in collectives. Many collectives became “fake collectives” because they were de facto privately owned, but they used the collective label to counteract discrimination and secure economic beneﬁts in terms of loans and taxation. As a result, collectives that served as “disguise of private enterprises” were a common sight in China, particularly in the coastal region.21 In sum, Chinese collectives constituted a hybrid form of ownership, combining elements of public and private property, even though they were formally under the rubric of collective ownership. The success of the Chinese collective enterprises in the 1980s was, to a degree, attributed to this hybrid nature, that is, the private property rights that developed within the collectives. This process has been referred to as informal privatization or hidden privatization in the literature (Francis, 1999; Krug, 1997). 3 Legal Developments with respect to Private Property Rights A major change in the legal and political environments occurred in 1988. In that year, new provisions were added to article 11 of the 1982 Constitution, allowing a private economy to exist and develop within the conﬁnes of laws, and avowing that

17 See Guang Lang Wei, Zhongguo Zhengce [China’s Policies] (1999). 18 Id. 19 Id. 20 Up to 1989, small-scale, household-based individual producers (getihu) accounted for 80% of the registered assets and 85% of the output of the private sector. See Zhongguo Siying Qiye Fazhan Baogao [A Report of the Developments of Chinese Private Enterprises] (Houyi Zhang and Lizhi Ming eds, 1999). 21 See Property Rights and Economic Reforms in China (Oi and Walder, 1999).

The Revival of Private Enterprise in China

74 100% 90% 80%

Percent

70% 60% 50% 40% 30% 20% 10% 0% 1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

Year

State

Figure 6.1

Collective

Openly Private-Participated

Output of Industry by Ownership (%)

Sources: Statistical Yearbook of China 1999.

private economy was a complement to the socialist public economy.22 Accordingly, the State would protect the lawful rights and interests of the private economy.23 After private ownership had been legitimized in the Constitution, the State Council enacted the Provisional Regulations on Private Enterprises.24 This set of regulations established a basic legal framework within which private enterprises could operate. For instance, it provided the deﬁnition of a private enterprise,25 outlined the various types of private enterprise,26 and designated the areas in which private enterprises could do business.27 More importantly, it delineated the rights and obligations of private

22 Zhonghua Renmin Gongheguo Xianfa Xiuzhengan [Amendments to the Constitution of the People’s Republic of China] [hereinafter Amendments to the Constitution], adopted by the 1st Session of the 7th National People’s Congress on April 12, 1988. 23 Id. 24 Zhonghua Renmin Gongheguo Siying Qiye Zanxing Tiaoli [Provisional Regulations on Private Enterprises of the People’s Republic of China] [hereinafter Provisional Regulations on Private Enterprises], promulgated by the State Council on June 25, 1988, reprinted in Zhongguo Siying Jingji Nianjian 1978–1993 [hereinafter Siying Jingji Nianjian 78–93] 3 (Xuwu Zhang, Minggan Xie, and Ding Li, eds, 1994). 25 A private enterprise was a proﬁt-making economic organization, the property of which was privately owned, and which employed eight or more people. Id. art. 2. 26 A private enterprise could be a sole proprietorship, a partnership, or a limited liability company. Id. arts. 6–10. 27 Private enterprises could engage in production or business in the areas of industry, construction, communications and transportation, commerce, food and drink, service, repair, and scientiﬁc and technical consultation. However, private enterprises could not do business or production in war and ﬁnancial industries, and could not manufacture or trade products

Property Rights Developments and Productivity Gains in China

75

28

enterprises. Among various rights, private enterprises had right to own property, to pass property to successors, to apply for patents and trademarks, and to borrow loans.29 Thus, private enterprises began to enjoy legal protection of their property. Furthermore, the State Council and its subordinates promulgated a series of regulations and administrative rules on taxation and loan procurement relating to private enterprises. For example, there were the Provisional Regulations on Income Taxes of Private Enterprises,30 the Regulations regarding the Imposition of Individual Income Adjusted Taxes on Investors of Private Enterprises,31 the Provisional Measures on the Administration of Loans to Individual Industrial and Commercial Households and Private Enterprises,32 and Several Rules concerning the Tax Policy on Private Enterprises.33 Although most of these regulations and administrative rules were subsequently repealed, their enactment made the then-existing regulatory framework for private enterprises more complete. Notwithstanding these legislative moves, the Tiananmen Square Incident in 1989 restituted a hostile attitude toward private ownership because the conservatives subsequently gained more support than the reformers. As a result, the private economy did not rapidly expand. In 1992, Deng Xiaoping reafﬁrmed the friendly policy toward private ownership during his historic southern tour. Following this reafﬁrmation, the antagonism toward private ownership subsided, and many local legislatures enacted regulations to promote the development of private enterprises in their respective areas.34 Thus, the local environment became propitious for the expansion of private enterprises. prohibited by the State. Id. art. 12. The Implementation Rules for the Provisional Regulations on Private Enterprises also stated that private enterprises could engage in proﬁt-making cultural, artistic, traveling, sports, pharmaceuticals, and breeding and cultivation activities. Zhonghua Renmin Gongheguo Siying Qiye Zanxing Tiaoli Shixing Banfa [Implementation Rules for the Provisional Regulations on Private Enterprises of the People’s Republic of China], issued by the State Administration for Industy and commerce on January 16, 1989. 28 Provisional Regulations on Private Enterprises, supra note 33, arts. 20–26. 29 Id. arts. 20–21, 24. 30 Zhonghua Renmin Gongheguo Siying Qiye Suodeshui Zanxing Tiaoli [The People’s Republic of China’s Provisional Regulations on Income Taxes of Private Enterprises], promulgated by the State Council on June 25, 1988. 31 Guowuyuan Guanyu Zhengshou Siying Qiye Touzizhe Geren Shouru Tiaojieshui de Guiding [The State Council’s Regulations regarding the Imposition of Individual Income Adjusted Taxes of Investors of Private Enterprises], promulgated on June 25, 1988. 32 Geti Gongshanghu Siying Qiye Daikuan Guanli Zanxing Banfa [Provisional Measures on the Administration of Loans to Individual Industrial and Commercial Households and Private Enterprises], issued by the Agricultural Bank of China on August 24, 1988. 33 Guanyu Siying Qiye Shuishou Zhengce de Ruogan Guiding [Several Rules concerning the Tax Policy on Private Enterprises], promulgated by the State Tax Bureau on November 17, 1988. 34 See, e.g., Hebei Sheng Siying Qiye Tiaoli [Hebei Province’s Regulations on Private Enterprises], adopted by the 10th Session of the Standing Committee of the 8th Hebei People’s Congress on November 2, 1994; Shenzhen Jingji Tequ Siying Qiye Zanxing Guiding [Shenzhen Special Economic Zone’s Provisional Regulations on Private Enterprises], adopted by the 102nd General Session of the Shenzhen People’s Government on February 25, 1995, adopted by the 11th Session of the Standing Committee of the 8th Yunan People’s Congress on January 13, 1995.

76

The Revival of Private Enterprise in China

On the national scene, the Provisional Regulations on Private Enterprises still provided the governing rules, but more comprehensive laws on business associations were enacted in the 1990s. As mentioned above, a private enterprise could be a sole proprietorship, a partnership, or a limited liability company. These business entities were brieﬂy explained in the Provisional Regulations on Private Enterprises.35 Thus, more comprehensive laws or regulations on these subjects were necessary. In 1993, the Company Law36 was passed, followed by the Partnership Law37 in 1997. These two laws contained detailed provisions about the formation, corporate governance, dissolution, liquidation, etc. of limited liability companies, companies limited by shares, and partnership.38 Accordingly, these two laws facilitated not only the acquisition of capital for business operations, but also the development of private enterprises. In 1999, the Constitution was further amended.39 Article 6 now states that public ownership of the means of production is the principal body, and that together with the joint development of various forms of ownership, it comprises the basic economic system of the country.40 Moreover, article 11 now states that individual and private economies are important components of the socialist market economy, and that the State protects the lawful rights and interests of the individual and private economies.41 Hence, the private economy has become an integral part of the overall economy. Subsequent to the constitutional amendments, the Sole Proprietorship Law was passed.42 It provides that the investor of a sole proprietorship has the right to own and transfer its property.43 In addition, a sole proprietorship may apply for loans

35 See Provisional Regulations on Private Enterprises, supra note 33, arts. 7–10. 36 Zhonghua Renmin Gongheguo Gongsi Fa [Company Law of the People’s Republic of China] [hereinafter Company Law], adopted by the 5th Session of the Standing Committee of the 8th National People’s Congress on December 29, 1993 and amended by 13th Session of the Standing Committee of the 9th National People’s Congress on December 25, 1999. In 1998, the Securities Law was passed, providing a comprehensive regulatory framework for the issuance and trading of securities. Zhonghua Renmin Gongheguo Zhengquan Fa [Securities Law of the People’s Republic of China], adopted the 6th Session of the Standing Committee of 9th National People’s Congress on December 29, 1998. 37 Zhonghua Renmin Gongheguo Hehuo Qiye Fa [Partnership Law of the People’s Republic of China], adopted by the 24th Session of the Standing Committee of the 8th National People’s congress on February 23, 1997. 38 In a limited liability company, the liability of each investor is limited to his or her amount of investment. Moreover, the number of investors must be at least 2 and fewer than 50. Company Law, supra note 45, arts. 3 and 20. In a company limited by shares, the liability of each investor is limited to the number of shares he or she holds. Additionally, the minimum amount of registered capital must be 10 million yuan. Id. arts. 3 and 78. 39 Amendments to the Constitution, supra note 31, adopted by the 2nd Session of the 9th National People’s Congress on March 15, 1999. 40 Id. art. 14. 41 Id. art. 16. 42 Zhonghua Renmin Gongheguo Geren Duzi Qiye Fa [Sole Proprietorship Law of the People’s Republic of China], adopted by the 11th Session of the Standing Committee of the 9th National People’s Congress on August 30, 1999. 43 Id. art. 17.

Property Rights Developments and Productivity Gains in China

77

44

and obtain land use rights. This legislation, together with the Provisional Rules regarding the Granting of Self-Handling Import and Export Rights to Privately Owned Production Enterprises and Scientiﬁc Research Institutes45 and the State’s recent policy to promote small and medium-sized enterprises,46 further improved the environment for the development of the private economy. With a more developed legal framework and the abatement of discrimination, private enterprises began to develop more openly and more rapidly in the 1990s. At the same time, the government tried to reform state enterprises by allowing them to merge and to become share-holding companies, share-holding cooperatives, and jointly owned enterprises, where property rights were openly reassigned to individuals to varying degrees.47 As a result, privatization was accelerated, and the openly privateparticipated sector became an increasingly important player in the booming Chinese economy. From 1988 to 1998, as shown in Figure 6.1, the share of openly privateparticipated sector in the output of industry increased from 8% to 38%. 4 The Model and Data According to the property rights theory, as mentioned in the introduction, development of private property rights should lead to productivity gains and output growth. To test this theory against the Chinese experience, however, we need to take into account the change in legal and political environments. Based on the fore-going analysis, it is expected that private enterprises had different economic performance in the 1980s as compared with that in the 1990s. We should compare, therefore, the private sector with other sectors under public ownership in terms of economic performance in the two periods, respectively. For this purpose, we need to design an econometric model. The model is based on the aggregate production function: Yt = AtF(Kt, Lt)

(1)

where Y is the real aggregate output (GDP), L is the aggregate labor force, K is the aggregate capital stock, and A is aggregate production technology. In addition, t

44 Id. art. 24. 45 Guanyu Fuyu Siying Shengchan Qiye he Keyan Yuansuo Ziying Jinchukouquan de Zanxing Guiding [Provisional Rules regarding the Granting of Self-Handling Import and Export Rights to Privately Owned Production Enterprises and Scientiﬁc Research Institutes], promulgated by the Ministry of Foreign Trade and Economic Cooperation on October 1, 1998. 46 See Guojia Jingmaowei Guanyu Guli he Cujin Zhongxiao Qiye Fazhan de Ruogan Zhengce Yijian [The State Economic and Trade Commission’s Several Opinions regarding the Encouragement and Promotion of the Development Small and Medium-Sized Enterprises], issued on July 6, 2000. 47 Up to 1997, there were 36,000 share-holding companies and 4 million share-holding cooperatives in China. See Qi Guizhi, Zhongguo Suoyouzhi Gaige Ershinian (20 Years of Ownership Reform in China), (1998). Up to 1998, 90% of the accumulated foreign direct investments came to China after 1992.

The Revival of Private Enterprise in China

78

denotes year. The production function exhibits constant returns to scale in capital and labor. Let Pt be the total population, and yt = Yt/Pt, lt = Lt/Pt, and kt = Kt/Pt. Divided by Pt on both sides, equation (1) can be written as: yt = At f(kt, lt)

(2)

which relates GDP per capita to capital stock per capita, the ratio of labor force to the population and production technology. Totally differentiating equation (2), we obtain: ∂f ∂f dyt = fdAt + At — dkt + At — dlt) ∂kt ∂lt ∂f dK K dP = fdAt + At — —–t – —t —–t ∂kt Pt Pt Pt

(

)

∂f dL L dP + At — —–t – —t —–t ∂lt Pt Pt Pt

(

)

(3)

Dividing both sides of equation (3) by yt, we obtain:

(

)

dy f ∂fA dK ∂fA dL ∂fA K ∂fA L dP —–t = — dAt + —–t —–t + —–t —–t – —–t —t + –—t — —–t yt yt ∂kt Yt ∂lt ytPt ∂kt Yt ∂lt Yt Pt

(

)

dA ∂y dK ∂y dL 1 ∂y K ∂y L dP = —–t + —–t —–t + —–t —–t — lt – —–t —t + —–t — —–t At ∂kt Yt ∂lt Lt yt ∂kt Yt ∂lt Yt Pt

(4)

. . . Let yt = dyt / yt, At = dAt / At, It = dKt / Yt, Pt = dPt / Pt, and ∂yt ∂y dl 1 ∂y K ∂y L β = —–, δ = —–t —–t —, λ = —–t —t + —–t —t . ∂kt ∂lt lt yt ∂kt Yt ∂lt Yt Equation (4) can be written as:

(

. . . yt = At + βIt + δl + λPt

)

(5)

which relates the growth of GDP per capita to technology progress, the ratio of investment to GDP, the ratio of labor force to the population and the growth of population. It is important to note that here β indicates the marginal productivity of capital. . Technology progress, A, is generally assumed to be the total factor productivity (TFP) which captures any effect on output growth that is not attributable to aggregate labor force and aggregate physical capital and, therefore, has been identiﬁed with many different types of variables in empirical studies on growth. For example, it has been found that openness could increase competition and absorb advanced foreign technology (Balassa, 1978; Feder, 1983; Ram, 1985), and that human capital was crucial to the diffusion of knowledge and. economic growth (Lucas, 1988; Barro, 1991). In growth empiricism, therefore, A can be replaced with variables that are supposed to be closely related to TFP progress. For the time being, we tentatively use openness and human capital to capture the effect of technology progress and rewrite equation (5) as:

Property Rights Developments and Productivity Gains in China

. . y = a + φO + γE + βI + δl + λP + u

79

(6)

where O is the ratio of foreign trade to GDP to represent economic openness, E is the ratio of the literate to the population to represent the level of human capital, and u is a stochastic component. In addition, time scripts are ignored. On the basis of this growth regression equation, two approaches can be applied to examine the difference in productivity gains across three sectors. The ﬁrst approach is to decompose the aggregate investment ratio to GDP, I, into different components, as shown by rewriting equation (6) as: . . y = a + φO + γE + βsIs + βcIc + βpIp + δl + λP + u

(7)

where Is is the ratio of state investment to GDP, Ic is the ratio of collective investment to GDP, and Ip is the ratio of openly private-participated investment to GDP. Accordingly, βs is the marginal productivity of capital of the state sector, βc is the marginal productivity of capital of the collective sector, and βp is the marginal productivity of capital of the openly private-participated sector. The second approach is to leave the aggregate investment ratio to GDP, I, in equation (6) as it is, but add a new variable to represent the share of the state sector (Vs), the share of the collective sector (Vc), or the share of the openly privateparticipated sector (Vp) in total investment. We then rewrite equation (6) as: . y = a + φO + γE +

.

Σφ V + βI + δl + λP + u j

j

(8)

where j = s, c and p. As the effect of total investment has already been captured by I, Vs, Vc and Vp are each taken as a variable that affects TFP progress, just as O and E. They show the effect of the rearrangement of property among the three sectors on economy-wide TFP gains. As shown in the model, the data for investments by different forms of ownership are essential to this study. The best data available concern ﬁxed asset investments by ownership. As a result of China’s incremental privatization,48 these data do not include a category of investment by fully private-owned sector and are not consistent with respect to the classiﬁcation of ownership over time. The measurement of investments by the openly private-participated sector is thus a main challenge to this study. In the pre-1993 period, the data of ﬁxed asset investments were classiﬁed into four categories by ownership: “state-owned units,” “collective-owned units,” “individuals,” and “other types of ownership.” From 1993 onward, the data were classiﬁed into eight categories by ownership: “state-owned units,” “collective-owned units,” “individuals,” “joint-owned economic units,” “share-holding economic units,” “foreign-funded economic units,” “economic units funded by entrepreneurs

48 Unlike its Eastern European counterparts, China did not launch whole-scale privatization of its state sector. As discussed above, Chinese collectives have been a transitional form of ownership. Thus, privatization in China is incremental.

80

The Revival of Private Enterprise in China

from Hong Kong, Macao and Taiwan,” and “economic units of other types of ownership.”49 We group all these types of investments into three basic categories, i.e., state investments, collective investments, and the remainder. Included in the remainder are the last two categories for the pre-1993 period and the last six categories for the post-1993 period, which has a common feature: private investments are openly involved, either totally or partially.50 Thus, we call this category “openly privateinvolved investments” or “openly private-participated investments,” and view it as representing investments of the most private nature among the three categories. The most public are state investments, and collective investments lie somewhere in between. This classiﬁcation is in line with the process of China’s incremental privatization. The data of the investments are taken mainly from China Regional Economy: A Proﬁle of 17 Years of Reform and Opening-Up, Statistical Yearbook of China, Comprehensive Statistical Data and Materials on 50 Years of New China, and various issues of the statistical yearbooks of individual provinces and municipalities compiled by China Statistical Bureau. Output is measured by GDP. The growth rate of GDP per capita is calculated in real terms on the basis of the ofﬁcial GDP index. The data are from The Gross Domestic Product of China 1952–1995 and Statistical Yearbook of China. There are no data of disaggregate GDP by ownership. Labor force is measured by the total number of employed persons provided in China Regional Economy: A Proﬁle of 17 Years of Reform and Opening-Up and Statistical Yearbook of China. There are no data of disaggregate employment by ownership. Openness is measured by the ratio of foreign trade to GDP, and the data are obtained from Almanac of China’s Foreign Economic Relations and Trade compiled by the Ministry of Foreign Trade and Economic Cooperation of PRC (MOFTEC).51 The data for Population are obtained from China Statistical Yearbook of Population (1984–1999). It is very difﬁcult to ﬁnd a proper measure for human capital. The best data available are the ratios of the illiterate and semi-illiterate to the population at the age of 15 and above provided in Statistical Yearbook of China and China Statistical Yearbook of Population. Subtracting the ratio from 1, we obtain a measure of the literacy ratio. The data are available, however, only for the years 1982, 1987, 1990, and 1995 to 1998. We use the average literacy ratio of all the years covered by corresponding periods.52 A better measure of human capital might be the education 49 Share-holding companies with more than 50% of state-owned shares are in the category of “state-owned units.” 50 It is possible that there is no private participation at all in some “joint-owned economic units” that are jointly owned by state and collective units. Given that investments of the “joint-owned economic units” accounted for only 1% of the total investments of the “openly private-participated sector,” we decided to ignore this problem. Indeed, the regression results hardly change when we exclude the “joint-owned economic units” from the “openly privateparticipated sector.” 51 Ministry of Foreign Trade and Economic Cooperation of PRC (MOFTEC), issues from 1984 to 2000. 52 We use the average literacy ratio of 1982 and 1987 for the period 1980 to 1988; the average literacy ratio of 1987 and 1990 for the period 1985 to 1992; the average literacy ratio

Property Rights Developments and Productivity Gains in China

81

level of the labor force. The data of the education level of the employed persons are available only for the period after 1996 and, therefore, cannot be used in this study. The data for Chongqing City, which became a municipality in 1996, were included in the data of Sichuan Province in order to maintain consistency of data over the entire period. The GDP and investment data for Qinghai and Tibet Provinces were not available for the period before 1985. 5 Regression Analysis Equations (7) and (8) are estimated separately. For each equation, the data are divided into two periods roughly in accordance with the developments in legal protection of private property rights in China, and are averaged for the corresponding periods. The dataset is therefore cross-sectional. We ﬁrst estimate the period-speciﬁc effect by running a regression for each of the two periods separately, and then estimate the overall effect by running a pooled regression. At the end, we test the robustness of the regression results. In interpreting the results, we focus on the variables Ic, Ip, Vc, and Vp, which are the main concerns of this study, and test the hypotheses βp > βc and ψp > ψc, respectively. To begin with, we estimate equation (7) for the period 1980 to 1988. As shown in Column 1, Table 6.1, the coefﬁcient of Ic is positive and statistically signiﬁcant while the coefﬁcient of Ip is positive but statistically insigniﬁcant, indicating that the marginal productivity of the collective sector was greater than that of the openly private-participated sector. Thus, the hypothesis βp > βc is rejected. This ﬁnding is consistent with other empirical studies for the same period and can be explained by the absence of legal protection of private property rights in the 1980s (Svejna, 1990; Dong and Putterman, 1997). Without legal protection, private property rights developed primarily within the collectives. Moreover, the openly private-participated sector consisted mainly of household-based small businesses and, therefore, was quite weak. Column 2 contains the estimates for the period 1988 to 1998. The coefﬁcient of Ic remains signiﬁcantly positive, while the coefﬁcient of Ip not only turns signiﬁcantly positive but also has a larger value than the coefﬁcient of Ic. We then run a linearly restricted regression to test the null hypothesis βp – βc = 0. As shown in Table 6.3, the null hypothesis is rejected at the 5% signiﬁcance level. Hence, the hypothesis βp > βc cannot be rejected this time. In other words, the marginal productivity of capital of the openly private-participated sector became signiﬁcantly greater than that of the collective sector in the 1990s. This ﬁnding is consistent with the improved legal environment for private property rights after the Constitution was amended in 1988. Private property rights could then develop more openly, and the collective as a transitional form of ownership began to lose ground. Since the data for Qinghai and Tibet Provinces were available only after 1985, the two provinces were dropped in the estimation of column 1. Leaving out the

of 1990, 1995, 1996, 1997, and 1998 for the period 1988 to 1998; and the average literacy ratio of 1995, 1996, 1997, and 1998 for the period 1992 to 1998.

The Revival of Private Enterprise in China

82

Table 6.1 Variable

Constant O E . P l Is Ic Ip

Regression on Equation 7, 1980–1998 1980–1998 Sample 1980–1988 1988–1998 1 2 0.10** 0.17** (2.20) (4.73) 0.03 0.03** (0.81) (1.94) 0.01 0.04 (0.03) (1.25) -0.41 0.33 (-0.45) (0.46) -0.05 -0.15** (-0.91) (-2.86) -0.03* -0.13** (-1.89) (-3.20) 0.25** 0.16** (2.09) ( 2.37) 0.24 0.35** (1.16) ( 3.63)

1985–1998 Sample 1985–1992 1992–1998 3 4 0.09** 0.21** (2.35) (3.14) 0.04 0.04** (0.72) (2.04) 0.02 0.04 (0.08) (1.25) -0.11 0.28 (-0.63) (0.57) -0.06 -0.16** (-0.73) (-2.97) -0.05** -0.15** (-2.05) (-2.13) 0.22** 0.13** (2.14) (2.28) 0.25 0.37** (1.45) (2.54)

Adjusted R2 0.30 0.72 0.27 0.74 Observation 28 30 30 30 Note: ** signiﬁcant at the 5% signiﬁcance level; * signiﬁcant at the 10% signiﬁcance level.

two provinces may cause biases in the estimation. In addition, although 1988 was a benchmark year in which private property rights were legitimized by the Constitution, the protection of private property rights did not really materialize until 1992, that is, after Deng Xiaoping’s southern tour. Consequently, it is necessary to reorganize the data to test whether the ﬁndings are sensitive to the exclusion of the two provinces and to an alternative classiﬁcation of periods. We then estimate equation (7) using data after 1985, which are divided into two periods, with 1992 as the dividing year. As shown in columns 3 and 4, the estimated results hardly change. We then proceed to estimate equation (8). As Vs is highly correlated with Vp in all classiﬁcations of periods, with a correlation coefﬁcient of no less than 0.90, we do not include the two variables in the same regression to avoid the problem of multicollinearity. Columns 1 and 2 in Table 6.2 contain the estimates for the period 1980 to 1988. The coefﬁcient of Vp is positive and statistically signiﬁcant while the coefﬁcient of Vc is positive but statistically insigniﬁcant. This is to say, the increase in the capital of the collective sector resulted in greater TFP gains than the increase in the capital of the openly private-participated sector in the pre-1988 period. Accordingly, the hypothesis ψp > ψc is rejected. This ﬁnding is consistent with the previous ﬁnding about the marginal productivity of capital of the two sectors. Columns 3 and 4 display the estimates for the period 1988 to 1998. The coefﬁcients of Vc and Vp are signiﬁcantly positive, but the value of Vp is greater than that of Vc by a wide margin. With the null hypothesis ψp – ψc = 0 rejected at the 1% signiﬁcance

Table 6.2 Variable

Constant O E . P l I

Regression on Equation 7, 1985–1998 1980–1998 Sample 1980–1988 1 0.09* (1.93) 0.06 (1.02) -0.01 (-0.31) -0.62 (-0.59) -0.06 (-0.87) 0.02 (0.37)

Vs Vc Vp

0.09* (2.09) 0.10 (1.38)

2 0.18** (3.54) 0.06 (1.01) -0.01 (-0.26) -0.66 (-0.69) -0.06 (-0.85) 0.02 ( 0.44) -0.07** (-2.14) 0.7** (2.34)

1985–1998 Sample 1988–1998

3 0.10** (3.76) 0.03** (2.73) -0.02 (-0.69) 0.56 (1.06) -0.14** (-3.74) 0.01 (0.28)

0.08** (3.15) 0.15** (5.98)

4 0.25** (7.41) 0.03** (2.79) -0.01 (-0.60) 0.61 (1.28) -0.14** (-4.00) 0.01 (0.32) -0.15** (-9.27) 0.07** (3.78)

1985–1992 5 0.05* (1.69) 0.04 (0.87) -0.02 (-0.48) -0.41 (-0.35) -0.05 (-0.99) 0.01 (0.81)

0.08** (2.09) 0.13 (1.58)

Adjusted R2 0.20 0.21 0.81 0.82 0.25 Obser-vation 28 28 30 30 30 Note: ** signiﬁcant at the 5% signiﬁcance level; * signiﬁcant at the 10% signiﬁcance level.

6 0.11** (3.12) 0.05 (0.99) -0.02 (-0.58) -0.56 (-0.98) -0.05 (-0.59) 0.01 (0.66) -0.8** (-2.89) 0.07** (2.87)

0.26 30

1992–1998 7 8 0.13** 0.19** (3.88) (6.52) 0.06** 0.06** (2.98) (2.87) -0.03 -0.03 (-0.78) (-0.87) 0.62 0.56 (0.87) (1.10) -0.12** -0.11** (-2.87) (-2.98) 0.02 0.02 (0.35) (0.45) -0.12** (-7.54) 0.06** 0.04** (2.05) (2.06) 0.16** (4.62) 0.83 30

0.82 30

84

Table 6.3 Null Hypothesis βp – βc = 0 Table 6.1 Column 2 Column 4 ψp – ψc = 0 Table 6.2 Column 3 Column 7

The Revival of Private Enterprise in China

Null Hypothesis Test Calculated F Value

Degree of Freedom

Critical Value at 5%

Decision Rejected

11.57 12.62

(1, 22) (1, 22)

4.30 4.30

Rejected Rejected

8.76 5.66

(1, 22) (1, 22)

4.30 4.30

Rejected Rejected

level (Table 6.3), the hypothesis ψp > ψc cannot be rejected this time. That is to say, the increase in the capital of the openly private-participated sector resulted in greater TFP gains than the increase in the capital of the collective sector in the 1990s. This ﬁnding is also consistent with the previous ﬁnding about the marginal productivity of capital of the two sectors. To test whether the results are sensitive to the exclusion of Qinghai and Tibet Provinces and to an alternative classiﬁcation of periods, we estimate equation (8) by using the data after 1985, which are divided into two periods, with 1992 as the dividing year. As shown in columns 5–8, the estimates we obtained in columns 1–4 hardly change, even though we include the two provinces and use an alternative classiﬁcation of periods. Consequently, the results of the regressions suggest that the hypotheses βp > βc and ψp > ψc can be rejected only for the period 1980 to 1988 and the period 1985 to 1992. However, these hypotheses can be rejected neither for the period 1988 to1998 nor for the period 1992 to 1998. In other words, although the openly privateparticipated sector did not result in greater gains in marginal productivity and the TFP in the early years of economic reform than the collective sector, it did in the subsequent years of the reform. This regression result is consistent with our analysis of the different legal and political environment in the two periods. The regression results also shed light on the effect of other variables on growth. The coefﬁcients of Is and Vs are negative and statistically signiﬁcant in all of the regressions, indicating that the state sector has had a negative impact on economywide gains in marginal productivity of capital and total factor productivity throughout the reform period. This is consistent with most other empirical studies (Svejna, 1990; McGuckin and Nguyen, 1993; Ehrlich, Gallais-Hamonno, Liu and Lutter, 1994; Dong and Putterman, 1997). Given that the state sector accounted for more than 70% of the total investment, it does not come as a surprise when we ﬁnd that the

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coefﬁcient of the ratio of total investment to GDP, I, is statistically indifferent from zero in all regressions in Table 6.2. The coefﬁcient of foreign trade to GDP, O, is positive and statistically signiﬁcant in all of the regressions, indicating that openness has contributed signiﬁcantly to productivity progress and economic growth in China. The ﬁnding is consistent with the neoclassical theory and most of the empirical studies on growth (Svejna, 1990; McGuckin and Nguyen, 1993; Ehrlich, Gallais-Hamonno, Liu and . Lutter, 1994; Dong and Putterman, 1997). The coefﬁcient of population growth, P, is statistically indifferent from zero in all of the regressions, which is consistent with the established theory and most empirical ﬁndings (Johnson, 1994). The coefﬁcient of the ratio of labor force to population, l, is statistically indifferent from zero in the early periods; however, it turns signiﬁcantly negative in the subsequent periods (See Columns 2 and 4 in Table 6.1 and columns 3, 4, 7 and 8 in Table 6.2). This ﬁnding can be explained by the fact that China is a developing country and a transition economy with enormous underemployment in agriculture and numerous redundant workers in the state sector. The increase in the total labor force may have a negative effect on growth, even though the increase in labor force in certain sectors may have a positive effect.53 What is interesting is the coefﬁcient of the literacy ratio, E, a proxy for the effect of human capital. This coefﬁcient is not statistically signiﬁcant in all of the regressions. The ﬁnding appears to contradict the new growth theory and most crosscountry empirical studies (Barro and Sala-I-Martin, 1995), but it is consistent with cross-province studies of China (Lu and Xue, 1997). Nonetheless, the ﬁnding is not sufﬁcient to refute the new growth theory about the positive role of human capital because the literacy ratio of the population may not be a good proxy for human capital in this context; a better proxy has yet to be found. Since the insigniﬁcant variables of the population growth, the literacy ratio, and in some cases, the labor force ratio to population are included in the regressions, it is necessary to test whether or not the estimated effects of different forms of ownership on productivity gains and economic growth in Tables 6.1 and 6.2 are sensitive to the inclusion of these insigniﬁcant variables. Accordingly, we rerun the above regressions with these insigniﬁcant variables excluded. The estimates, however, hardly change.54 6 Concluding Remarks The argument against property rights theory is not, as some have claimed, supported empirically in China. The unsatisfactory economic performance of the private sector in the 1980s is attributed to the poor legal and political environments that favored the collective rather than the private sector. Without legal protection, the formal private sector was very weak, consisting mainly of small-scale, household-based individual producers, 53 It would be interesting to see if we decompose the total labor force into different components under different forms of ownership, such as the state, the collective, and the openly private-participated sectors. Unfortunately, the data for the composition of the labor force in the three sectors are not available at the provincial level. 54 The detailed results are available from the authors upon request.

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which could not compete with larger-scale collectives. Without legal protection, on the other hand, private property rights developed mainly under the disguise of collectives, and contributed to the successful story of the collectives over that period. The legal and political environment improved signiﬁcantly after 1988 when private economy was legitimized in the Amendment to the Constitution, particularly after 1992 when Dong Xiaoping reconﬁrmed this friendly policy toward private economy in his southern tour. A valid comparison of economic performance between the private sector and other sectors should be made based on data of the 1990s rather than the 1980s. Using Chinese provincial data, this study ﬁnds that the private sector led to signiﬁcantly greater productivity gains, and contributed more to economic growth, than all other sectors in the 1990s. This ﬁnding provides further evidence to support the property rights theory, and sheds light on the importance of legal and political environments to property rights development and, therefore, to economic performance in transition and developing economies. Appendix: List of Symbols A. A E I Ic Ip Is K k L l O P. P Vc Vp Vs Y y . y

Aggregate production technology Growth of aggregate production technology Ratio of the literate to population Ratio of total investment to GDP Ratio of collective investment to GDP Ratio of openly private-participated investment to GDP Ratio of state investment to GDP Aggregate capital stock Capital stock per capita Aggregate labor force Ratio of labor force to population Ratio of foreign trade to GDP Population Growth rate of population Share of collective investment in total investment Share of openly private-participated investment in total investment Share of state investment in total investment Output (GDP) GDP per capita Growth rate of GDP per capita

References Balassa, B., “Exports and Economic Growth: Further Evidence,” Journal of Development Economics, 39, 5 (1978): 181–9. Balassa, B., “Exports, Policy Choices, and Economic Growth in Developing Countries after the 1973 Oil Shock,” Journal of Development Economics, 18 (1985): 23–35.

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Barro, R., “Economic Growth in a Cross Section of Countries,” Quarterly Journal of Economics, 34, 4 (1991): 407–43. Barro, R. and Sala-I-Martin, X., Economic Growth (New York: McGraw-Hill Inc., 1995). Bowles, P. and Dong, X.Y., “Enterprise Ownership, Enterprise Organization, and Worker Attitudes in Chinese Rural Industry: Some New Evidence,” Cambridge Journal of Economics, 23, 1 (1999): 1–20. Chow, G.C., “Capital Formation and Economic Growth in China,” Quarterly Journal of Economics, 108, 8 (1993): 809–42. Dong, X.Y. and Putterman, L., “Productivity and Organization in China’s Rural Industries: A Stochastic Frontier Analysis,” Journal of Comparative Economics, 24, 2 (1997): 181–201. Edwards, S., “Trade Orientation, Distortions, and Growth in Developing Countries,” Journal of Development Economics, 39, 3 (1992): 31–57. Feder, G., “On Exports and Economic Growth,” Journal of Development Economics, 12, 2 (1983): 59–73. Furubotn, E.G. and Pejovich, S., “Property Rights and Economic Theory: A Survey of Recent Literature,” Journal of Economic Literature, 10, 4 (1972): 1137–62. Honore, A.M., Ownership in Oxford Essays in Jurisprudence, 107 (A.D. Guest ed., 1961) 112–28. Jefferson, G., “Are China’s Rural Enterprises Outperforming State-owned Enterprises?” Research Paper No. CH-RPS#24 (Washington DC: The World Bank, 1993). Johnson, D.G., “Can There be too much Human Capital – Is There a Population Problem,” in S. Asefa and W. Huang eds Human Capital and Economic Development. (Michigan: W.E. Upjohn Institute for Employment Research, 1994), 24–39. Kornai, J., “The Afﬁnity between Ownership Forms and Coordination Mechanisms: the Common Experience of Reform in Socialist Countries,” Journal of Economic Perspectives, 4, 3 (1990): 131–47. Krug, B., “Privatization in China: Something to Learn From,” in Giersch, H. ed. Privatization at the End of the Century (Berlin: Springer, 1997), 227–47. Lin, S., “Export Expansion and Economic Growth: Evidence from Chinese Provinces,” Paciﬁc Economic Review, 4, 1 (1999): 65–78. Lin, J.Y.F. and Liu, Zh.Q., “Fiscal Decentralization and Economic Growth in China,” Economic Development and Cultural Change, 2 (2000): 21–32. Lu, D.D. and Xue, F.X., China Regional Development Report 1997 (Beijing: Shangwu Press, 1997). Lucas, R., “On the Mechanics of Economic Development,” Journal of Monetary Economics, 22, 4 (1988): 3–42. Mark, K. and Engels, F., Communist Manifesto (London: Lawrence & Wishart). McGuckin, R.H. and Nguyen, S.V., “Post-reform Industrial Productivity Performance of China: New Evidence from the 1985 Industrial Census Data,” Economic Inquiry, 31, 3 (1993): 323–41. Oi, J.C. and Walder, A.G. eds, Property Rights and Economic Reform in China (Stanford: Stanford University Press, 1999).

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Pejovich, S., The Economics of Property Rights: Towards a Theory of Comparative Systems (Dordrecht: Kluwer, 1990). Putterman, L., “On the Past and Future of China’s Township and Village-owned Enterprises,” World Development, 25, 10 (1997): 1639–55. Qi, G., ed., 20 Years of Ownership Reform in China (Zhengzhou: Zhongzhou Guji Press, 1998). Ram, R., “Exports and Economic Growth: Some Additional Evidence,” Economic Development and Cultural Change, 33, 2 (1985): 415–25. Svejnar, J., “Productive Efﬁciency and Employment,” in W. Byrd and Q.S. Lin eds China’s Rural Industry: Structure Development and Reform (New York: Oxford University Press, 1990), 253–4. Wei, G.L., China Policies (Beijing: China Legal Press, 1999). Weitzman, M. and Xu, C., “Chinese Township-village Enterprises as Vaguely Deﬁned Cooperatives,” Journal of Comparative Economics, 18 (1994): 121–45. Woo, W.Th., “The Art of Reforming Centrally Planned Economies: Comparing China, Poland, and Russia,” Journal of Comparative Economics, 18 (1994): 276–308. Zhang, H.Y. and Ming, L.Z. eds, Report of Private Enterprises Development in China: 1978–1998 (Beijing: Social Sciences Literature Press, 1999).

Chapter 7

Evolution of Economic Development: Entrepreneurs, Market, and the State Jack W. Hou1

1 Pulp Fiction Though the Russian economy has shown improvement, the current performance still lags behind China, and when one examines the time series of the past decade and a half, the disparity is even more profound. If we use 1989 as the starting point,2 China’s GDP has nearly doubled, while Russia’s GDP has shrunk more than 40% (Stiglitz 1999). As the two dominating former socialist economies, comparing and contrasting their experience in the transition is both inevitable and necessary. Both are waging a great battle for the survival and prosperity of its people. “Great battles,” Winston Churchill remarked, “change the entire course of events, create new standards of values, new moods, in armies and in nations.” No two battles are the same; the same can be said regarding the reform attempts by the various former socialist nations. Their approaches, paths, and effectiveness differ due to many reasons, trying to develop a single model will be missing the main point, whereas history and evolution of events provide complex texture to understanding the transition process. The importance of history on formulating economic models (Arrow 1986, Solow 1986) or policies is never more evident than the question we are addressing here. There have been many reasons raised to explain the apparent success of China and the lack of success in Russia. They range from “gradualism” (the piecemeal approach) versus the “big bang” or a shock therapy approach (Lin 2002), sequencing of reform policies (Sachs and Woo 1997, Hou 2004), and as mentioned earlier, historical “initial condition” and/or cultural heritage (Hou and Hou 1996, 2002, 2003). This chapter attempts to address the question why China’s reform succeeded while Russia’s withered? And indirectly try and answer the tantalizing question: If the Russians mimicked China’s reform policy/strategy, would it have succeeded? This opening section is titled as “Pulp Fiction.” This may be strange, even for those that have seen the Quentin Tarantino movie. In Pulp Fiction, it started with a robbery in a diner, and then went backwards in time to show the events that led 1 Professor, Department of Economics, California State University, Long Beach. 2 “Glasnost and perestroika” was in vogue for Russia (or the USSR at that time), while China was reeling from the shock at Tiananmen.

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to this robbery. I chose this as the title of the opening section precisely with this in mind. At the end of the introduction, I posed the question: Would the Russians have been able to succeed if they mimicked China’s reform sequence/strategy. At the risk of being anticlimactic, I will answer this now: No. There were many reasons why the Russians failed, and just as many reasons why the Chinese succeeded. Some of these reasons contain a certain element of luck, but for the most part they are results of planning (intentional or accidental), government leadership, the history and cultural traits of the nation involved. Major events and consequences are never isolated events but an evolutionary culmination of a series of events. This already points out an obvious and most often raised “cause” of the success versus failures in the two reforms: the gradualism of China and the big bang of Russia. Nature has never looked fondly on mutations. Rather, as Darwin pointed out, it is a series of evolutions based on the principle of “survival of the ﬁttest.” The patience of China in its reform process and the series of pragmatic reforms that they undertook certainly exhibit the Darwinian evolution trait (Fei and Hou 1994), while the “big bang” can only be characterized by a mutation (deﬁned as a sudden and radical change), just as the original Leninism was to the existing social structure after the Bolsheviks. The rest of the chapter will be devoted to explaining how I came to the conclusion that China’s approach was natural, and the Russian result was just as inevitable. Changing roles or mimicking would not have made the result any different. The most often raised question was: what if the Russian leaders had been more patient and implemented a reform that was more gradual like that of China, would their economic performance be better? This is much like asking the question, what if Socrates had died at the Battle of Delium (424 BC) during the Peloponnesian War (431–404 BC), what would the Western civilization had evolved into (Hanson 2003)? It is a meaningless, but nevertheless, intriguing question; and it is where I will begin. 2 Is the Invisible Hand too “Invisible”? Most of us who went through neo-classical training in the West are lured into two misconceptions. One is that the “market” always exists, and the second is that adjustments are instantaneous. The latter is the direct result of mathematics and living in the ivory tower. One only needs to take a look at the real world and understand that any changes will take anywhere from months to a generation before it is fully imbedded into the system. Let us be generous for the time being. If the real world is indeed as characterized by neo-classical theory, then the big-bang (the immediate withdrawal of government intervention) approach should have allowed the full capacity of the invisible hand causing the non-performing or non-viable ﬁrms to be eliminated by competition, leading to an efﬁcient and viable economic system. In contrast, the gradualism approach of China should have led to inefﬁcient stagnation. This prognosis, of course, is utterly shattered by the actual performance of these two economies.

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As Lin (2002) correctly pointed out, the rigorous transition policies advocated by World Bank, the IMF, and noted economists at Harvard and MIT, failed because they emphasized the economic viability aspect. They concentrated on such issues as property rights, corporate governance, government intervention, and others related to the ﬁrm’s management. However, Lin argued, these are central to the viability of ﬁrms, but the existence of many ﬁrms in the transition economy was not based on comparative advantage but on other political or non-economic principles (in other words, they did not evolve in the Darwinian sense). Unless the policies address these real issues, they are bound to fail. I certainly agree with Lin’s assessment. The fact that both Russia and China overemphasized the development of “secondary” (heavy) industries, at the expense of primary (agriculture) and tertiary (light or consumer) industries, clearly demonstrate the guidance of the State rather than via traditional comparative advantage. This is not just prevalent in centrally planned economies, but also in the case of many contemporary LDCs. As the State has invested heavily in these “favored” sectors, the amount of ﬁxed capital and employment are usually very high. If one induces shock therapy and force the non-viable ﬁrms into bankruptcy, the waste of the ﬁxed investment will be considerable, but more traumatic is the massive unemployment this would potentially imply. Thus, unless the invisible hand works almost instantaneously, this reallocation of resources will most assuredly generate panic and chaos. To further compound the issue, what if the market mechanisms that the invisible hand relies on to efﬁciently reallocate resources is imperfect or even absent? Then we will have the destruction of the old (though admittedly inefﬁcient centrally planned resource allocation) with no other systematic and system-wide mechanism to take its place. What would we expect to ensue? The crisis of the Russian economy in the 1990s demonstrated this painfully clearly.3 To summarize, nature does not look fondly at mutations, but rather favors gradual evolution. The market system that the capitalistic West has been so accustomed to is the end result of two hundred plus years of continued evolution. In contrast, the central planning Soviet style can be interpreted as a mutation politically created by Lenin, while the big bang approach adopted by the Russians 70 plus years later paramount to a repeat of the mutation process. The gradualism approach that the Chinese followed allows for the market to develop and catch up with the changing economic mechanism. Whether this is by luck or by design (though I will make some conjectures in the next section) is really not important. The success of China and the painful experience of Russia and Eastern Europe clearly testify to the fact that if the market mechanism is imperfect or lacking and if adjustment is not instantaneous, the shock therapy or “big bang” will only deliver a painful lesson with less than substantial results. Though the government leaders are to blame, so are we, the Western trained economists, as we have fallen into the trap of believing the invisible hand exists universally and that adjustments are almost instantaneous. 3 Most of the Republics of the former USSR are suffering the same hardship. A recent book by Craig MacPhee (2005) has a detailed and in-depth look at the chronicles of the Georgia Republic.

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3 Gradualism by Design? As mentioned earlier, nature favors an evolutionary approach rather than sudden mutations. It we categorize Russia’s shock therapy as a mutation, then the gradualism of China should be classiﬁed as an evolution path. The next question to ask is whether it was a deliberate design by the Chinese leaders or a pleasant accident? And whether this can be attributed as the cause of China’s success and Russia’s failure? For the ﬁrst question, the opinion in the literature seems to suggest it was not a design in 1987 and appears likely to continue for some time. Where it will all end is not known to anyone either inside or outside of China.” True as this may be at the time when Perkins wrote his milestone paper,4 the epoch ending events of the last decade or so of the 20th century (Tiananmen, fall of the Berlin Wall, liberalization of Eastern Europe, and the disintegration of the Soviet Union) should leave no doubt in anyone’s mind as to where the reform will end.5 Though the question of whether China has a speciﬁc “plan” for its continued reform may still be debatable, two facts are clear. First, the direction of the reform is clearly determined, and China has most assuredly passed the point of no return. Second, such a direction and determination was most likely absent in the early stages of the reform. As Chow (2002) pointed out, the Chinese leaders were pragmatic and not subject to ideological restraints. There was no blueprint for the economic institutions to model after and policies were adopted through experimentation and learning-by-doing (or in Deng words, “crossing the river while feeling the rocks”). This pragmatic attitude followed the mode of experimenting at a smaller scale, if it is proven to work, then adopt at a larger scale. The responsibility system was the result of a series of experiments locally, and then adopted nationally because it had worked well. The 1984/85 reforms of the SOEs (State Owned Enterprises) began with allowing partial autonomy to a select group. With the success and the experience gained, it was extended to more SOEs and with a greater degree of autonomy as the experiment continued (to this day). The experiments with the SEZs (Special Economic Zones), stock markets, and the policy towards FDI (Hou and Zhang 2004), all followed the same pattern. This is very much in the same style as what sculptors and architects do, they start with a smallscale model before committing to a full-size production. In addition to this analogy, the experimental approach has its necessity in China’s case. The small-scale experiments verify what works and what doesn’t without causing too much disturbance to the establishment. Such experiments take time, and allow the reform-oriented party fraction time to reconcile the ideology of this experiment with socialism doctrine. Once the experiment proves viable, the reformists can then convince the broader based party to adopt and implement a larger scale program.

4 Documentary evidence shows that the Chinese reformers clearly had a “capitalistic” blueprint in mind, at the latest, in 1984. This is evident in the Central Committee (1984) document. 5 Indeed, some may be as so bold to predict the inevitability of the march towards a capitalistic market system, even if it is with Chinese characteristics and socialism bent (Hou and Hou 2002).

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This is a patient and cautious attitude, which is typical of Chinese. In contrast, the “shock therapy” adopted by Russia and Eastern Europe demonstrates their desire to change to a market economy immediately (hence suffering from the structural problems discussed in the previous section). This, too, is natural from their historical heritage: small nations (Eastern Europe) or a large but feudalistic country (Russia). The piecemeal experimental approach adopted by China is by deﬁnition slower going, and is imbedded into the Chinese culture over the past two millenniums. China has been a large uniﬁed country for almost 2,500 years.6 Though an all-powerful emperor that is the “son of heaven” rules it, the actual governance is done by a huge and complicated bureaucratic system that rules the nation with the appearance of the emperor’s will. These “appearances” and the operational governance of such a large country by such a large number of bureaucrats necessitates coordination and forming a consensus. Is this not a “Chinese characteristic”? In conclusion, this gradual approach of China can be viewed as by design due to the bureaucratic nature of China’s past; but it can also be viewed as a sign of a lack of consensus regarding what and how to do things. The two may be observational equivalent, and probably both true. But, just like putting together a thousand-piece puzzle, even if there were no idea (blueprint) of what to do next at the outset, after a certain point the big picture does emerge and an implicit agenda must be there. Most of us here believe that such a picture of China’s future has emerged, and there is no turning back. This does not mean that we are nearing completion. On the contrary, the road is harder and longer ahead, as the tougher reforms have yet to be done, including the reform on the ﬁnancial sector, and political reform that is needed to accommodate all the market reform that has been accomplished. Following the pattern of previous sectors, we are now ready to lead into the next section. We can take two routes: the liberalization/democratic reform or look at the origin of China’s reform and why gradualism was the trait. I choose to address the latter ﬁrst. 5 Reform Sequence Whether the cautious or piecemeal method is due to cultural traits and/or lack of consensus within the Party, the fact is that the Chinese leadership did not have a blueprint in mind, at least at the outset. Despite this, it is also obvious that the two nations took very different paths in terms of the sequence of their reforms. Russia concentrated on reforming the industrial sector, while seemingly abandoning the agricultural side, in contrast, China’s reform centered on the rural/agricultural sector exclusively for the ﬁrst six years, if not longer. This sequential decision of agriculture ﬁrst is consistent with the “dual development” theory of Fei and Ranis fame. The literature has mainly attributed this to the difference in the “initial conditions” between the two countries (Sachs and Woo 1997, Liu 2001). The most astounding statistics were the distribution of labor force between agricultural and non-agricultural 6 This is another reason why “patience” is a cultural trait. When time is measured in centuries rather than decades or mere years, patience seems to be as natural as the air we breathe.

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sectors at the beginning of their respective reforms. For the former Soviet Union, 85% of the labor force was working in the non-agricultural sector, while at the start of China’s reform, only 18% of labor were working for the non-agricultural sector. They argued that the fact that China was less industrialized, there was more space for them to mimic the Western experience. And, since agricultural population was so high, this released productivity is also much larger than that of Russia. This is a well-established and accepted theory, and perceived as “naturally” the reason why the initial reform was in the non-agricultural sector while China began with agriculture. The literature has not really addressed the more in depth cause of why the Chinese focused on agriculture, beside the obvious observed fact. One of the few exceptions is Hou, Mead, and Nagahashi (2004). We proposed that the origin of China’s reform can be traced directly to the food crisis resulting from the early years of the Cultural Revolution, Mao’s siding with the pragmatism of Chow Eng-lai, the failure of Lin Biao’s “coup” attempt at the Lu-shan conference, and the second food crisis as a result of the transfer of partial authority to the local governors and military leaders. Soon after, China formally abandoned the “self–reliant” policy on food. This can be further seen in many aspects of China’s policy towards the outside world. The ping-pong diplomacy (which was such a major event that it even made its way into the Oscar winning movie “Forest Gump”) focused on major agricultural exporting nations (the US, Canada, Australia, Argentina) or those with chemical fertilizer technology (Japan), and the fact that 19 of the ﬁrst 38 contracts for “imported” plants to China in the year following the US–China rapprochement (1972) were facilities for the production of chemical fertilizers.7 This clearly represented a much more pragmatic attitude and a signiﬁcant deviation from the earlier idealism. To further reinforce our belief, we took stock of China’s relationship with Latin America, especially in the 1970s. Here we see a dramatic piece of evidence that a dramatic shift in China’s central doctrine is underway. In addition to Cuba, China had signiﬁcant relations with four Latin America counties: Argentina, Chile, Mexico, and Peru. China started importing wheat and millet from Argentina to alleviate the effects of the Great Leap Forward’s “Three Bad Years.” Chile was under the Allende’s Marxian regime and was able to supply wool and fertilizer that China needed. Peru was the ﬁrst South American country to establish diplomatic relations with China and this relationship was further strengthened after the military coup of Juan Velasco Alvarado when the new government nationalized many US owned corporations, causing the US to cut aid and discourage investment and imports. China was able to absorb part of Peru’s exports and minimize the impact.8 Under 7 The statistics are even more lopsided than it appears. These 19 facilities represented 85% ($392 million out of $461 million) of the total contract, with the bulk coming from Kellogg Continental of the US and its subsidiary in the Netherlands. It is also worth mentioning that the nature of these early technology imports are not the same as the Foreign Direct Investment (FDI) currently ﬂowing into China, as they were “purchases” of entire plants, often with some technical advisors attached. 8 During 1960–1970, overall trade between China and Peru was less than $1 million. Yet, in 1971, the total trade reached $58 million. Peru voted for the admission of China into the UN in 1971.

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President Luis Echeverris, Mexico tried to reduce its dependence on the West in order to strengthen its own position in the world market and the political scene and looked towards socialist countries in an effort to better its bargaining position with its northern neighbor (the US). Trade between the two countries, Mexico and China, also increased signiﬁcantly from under $1 million in 1971 to $52 million in 1977.9 The above relations are natural and perfectly aligned with the original Chinese doctrine of “exporting” revolution. What followed in the late 1970s, however, is not consistent as the Latin American political landscape underwent major changes. Mexico became more aligned with the US, the Chilean Marxian government of Allende fell to the rabidly anti-Soviet regime of General Pinochet, and Argentina’s government was taken over by the anti-Communist regime of General Videla. Yet, China chose to maintain both political and economic ties with these nations in a total departure from its previous patterns. These changes clearly demonstrate China’s dramatic alteration of its foreign policy from ideological purity to economic pragmatism. This external aspect grew in tandem with China’s internal efforts to change the economic incentives for agricultural production (Fei and Hou 1994, Hou 2004), which led to the full ﬂedge economic reform by 1979. One can hence conjecture, China’s reform may not have started with a blueprint, but it was also not simply due to the “initial condition.” Furthermore, theory (e.g. Fei and Ranis model) has suggested that in the path towards industrialization, the productivity increase in agriculture was the prerequisite. This was seen in the fact that the 17th century “agricultural revolution” preceded that of the famed industrial revolution. Also that the success of the rebuilding of Japan, the industrialization of South Korea and Taiwan were all proceeded by land reform which led to dramatic increases in agricultural productivity. This allowed the agricultural sector to fulﬁll their “historical missions:” create agricultural surpluses to feed the non-agricultural population, to release surplus labor to be employed by the industrial sector, provide ﬁnances for industrialization and the market for industrial output. This is well documented for Taiwan (Kuo, Ranis and Fei 1981, Hou and Appleton 1996). This leads to another question: could and should have the Russians intentionally focused on the agricultural sector to achieve the needed agricultural “contribution”? I do not think so. Unlike China, the former Soviet Union is made up of many different Republics with different languages and different culture. There was also deliberate (perhaps based on comparative advantage) compartmentalization of production in the Soviet central planning. For example, as Russia is highly industrialized, Ukraine was made the “breadbasket” for Russia. This may be part of the reason for the aforementioned disparity between Russia and China’s “initial condition”. The “disadvantage” of the Russians runs deeper than this. Even if they had a large non-agricultural sector, and even if they took a lesson from China by being patience (gradualism) and started with the agricultural reform, it would not have mattered as they lacked the soft capital of history, cultural, and tradition. China has had a long history of market-oriented farmers, why the Russian peasants were effectively serfs to the manor before the 1917 revolution. 9 Echeverris not only supported China’s admission to the UN, he also gave a strong speech advocating the expulsion of Taiwan in 1971.

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6 Culture, Fistory, and the Invisible Side of Economics Economists, especially the younger generation of Western-trained scholars, have been mesmerized by the theoretical mathematical models. In such models, time is implicit, adjustment is almost instantaneous, and the existence of markets is accepted as given (hence the problem raised in Section 2). Furthermore, economists as a profession, even when we discuss our theory and models in the context of a speciﬁc economy, we have mostly ignored the history and cultural aspect of what we are studying. This is perhaps what prompted Solow (1986) to dismay that a universal “general” theory is a dead-end, and each case is “speciﬁc” in nature. Indeed, as a profession, we need to be acutely reminded that we are, after all, a social science. With this in mind, I pondered what are the major distinctions between China and Russia (historically and culturally) that would be relevant in explaining the difference in their current economic performance. One of the ﬁrst aspects that came to mind is the length of which a Communist State Economy was in place. The People’s Republic of China was established in 1949. During the initial transformation, public and private ownership coexisted till 1956. The Comprehensive Economic Reform was ofﬁcially adopted in 1979 (Central Committee 1979). Thus, the centrally planned communist economy was in place less than two and a half decades. The signiﬁcance of this is the industrialists and entrepreneurs that were present before the Revolution were still alive, and the market culture can thus be (relatively speaking) easily revived. In contrast, the Bolshevik revolution was in 1917 and lasted till the early 1990s, spanning more than seven decades. If the industrialists/entrepreneurs existed in Russia prior to the revolution, they would have been dead by the time Boris Yeltsin became the Russian President. If one takes a second look at Russia under the Czar, one has to doubt whether such industrialists/entrepreneurs ever existed, or existed in a large enough number to form a meaningful social class. In 1861, Czar Alexander II enacted the Emancipation Edict, which abolished personal serfdom (freeing one third of the population). The peasants were to receive land from the landlords, but with payment. The government advanced the payment to the landlords and was to recover it from the peasants via 49 annual payments. As a temporary arrangement (before the system was set up), the peasants paid “temporary obligation” directly to the landlord in terms of labor or monetary means. In many places, this “temporary obligation” dragged on for more than two decades. Many peasants were forced to accept “beggarly allotments” (i.e. 25% of the prescribed amount) in exchange for eliminating the monetary payments, while others were forced to pay more than the worth of the land. To make things worse, the Russian peasantry was organized into communes (mir), which controlled village life. The mir was responsible for redemption payments and periodically redistributed the land to meet the changing needs of the various households. Thus, though peasants could and do own private land, only 14 million hectares were truly privately owned while 151 million hectares of land in European Russia were owned and farmed collectively in 1910. Though there were nominally changes in terms of land ownership, it did little to improve productivity as peasants did not really “own” the land and hence had no incentive to improve land quality or try new methods/crops.

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Despite the disadvantages of the mir system, the peasants preferred it as they felt it guaranteed everyone a fair share of the land. But true to the Malthusian theory on population, this “improvement” caused a population explosion as it doubled between 1861 and 1910. Despite the size of Russia, only 2 million of its 15 million square kilometers of land (both European and Siberia) are suitable for farming. This population explosion meant that the average allotment dropped from 5.24 hectares in 1961 to 2.84 in 1910. The West experienced similar population explosions, which was absorbed by the rapid growing industrial sector, but this route was not available to the Russians.10 The peasants were in a permanent state of expectation (expecting the land promised to them would be given to them). When it became obvious that this was not going to happen, their allegiance (to the Czar) wavered. It was in this environment that the Socialist Revolutionary Party, and later the Bolsheviks, were able to win the popular support of the peasants in 1917. Despite this, it must be recognized that the peasants in Russia are extremely conservative. They simply switched from a feudalistic manor system to a commune run by the mir. They have never been able to dictate their own destiny, and perhaps never wanted to. In contrast, China has had a market-oriented entrepreneur peasant class for over a thousand years. China has had a well-structured farming structure based on variations of the “well ﬁeld” system for over two millennia. The land is “owned” by the State, and is given to the peasant family to cultivate. The peasants paid taxes in the form of grain (mostly rice), while others paid their taxes in kind (e.g. carpenters paid taxes in the form of services in building/maintaining government ofﬁces).11 This system depended on a large quantity of land and a meticulous record of land lots (hence the famous “ﬁsh scale” books). This all changed in the tenth century (Sung Dynasty, 960–1279AD), as the population outgrew the land. Land became private property and tax payment changed from rice to money. This freed up the peasants from single-mindedly planting rice to utilize comparative advantage and plant crops with maximum yield and proﬁt. The emergence of this market-oriented, entrepreneur peasant class was a major breakthrough in China’s economic development. Not only was this able to increase agriculture productivity, it had a far more profound impact on the Chinese Economy, which brought China to the brink of “commercial” capitalism. The root cause is the change in land ownership, and more importantly, the payment of taxes. As tax payments changed from rice to money, this stopped the “institutional” ﬂow of rice to the North. In its place, a class of long-range rice merchants arose. They would travel thousands of miles to the South, buy rice and transport it to the North. This had a tremendous multiplier effect both in terms of economic institutions and economic activities. To facilitate trade (for both safety and convenience), checks 10 The industrial sector was only able to absorb about one-third of the excess rural population, despite the costly efforts of the reform policy of Witte. 11 This is why in the Disney movie “Mulan”, the heroine’s father was called up for military duty when the barbarians invaded. He was paying his taxes. Mulan’s family was a military family, which received rice in peacetime, and goes to war to pay their taxes when the need comes.

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or money orders (ying-piao) and money houses (chien-zwun) emerged. These early forms of commercial banking greatly reduced the cost of transaction. The shipping of such large quantities of rice/grain was no simple task. Land/ water transportation industries blossomed, as well as security services. The surge of merchants and travelers brought about commerce, food, lodging, and a variety of business along the trading routes. Such radical changes lead to, or were facilitated by, changes in government. It is the Sung Dynasty that established political, social, economic, and cultural patterns that remained largely unaltered in China for a millennium. A new group—the scholar-gentry class, whose power came from landholding and long years of educational training, replaced the old aristocratic domination of government. Interestingly, it was the further weakening of the Sung Dynasty (the Southern Sung) that brought about even further advances. As Northern China fell to the invading barbarians, the Sung Court and many of the literary gentries ﬂed south. For the established gentry class, they were able to bring their wealth in the form of money and other precious material, but land was immobile. Without a stable and perpetual source of income (land rents), these gentries that ﬂed south were forced to engage in commerce. The importance of this event is the general upgrade of the human capital of the merchant class, and the total integration of Confucianism into the very fabric of society. Contrary to Weber (1930, 1964), I believe Confucianism is not a hindrance towards capitalism, but promotes hard work and discipline that is essential to the formation of entrepreneurship spirits. Indeed, Confucianism is much like the Protestant ethic that Weber saw as the prerequisite for the Industrial Revolution, and the reason that Weber came to a conclusion to the contrary is due to his misunderstanding of many of the Confucian teachings (Hou and Hou 2004). Indeed, if one looks at the success of Japan, the four small dragons, and China, one of the most important common threads is Confucianism or the Chinese culture.12 During the 10th and 11th centuries, in addition to the changes in land ownership and tax payments, agriculture also beneﬁted by the introduction of new, early-ripening strains of rice. Combined, food production was greatly increased, this released labor from the farming sector and the food surplus allowed the support of a growing nonagriculture city-dwelling social structure; much like the agriculture revolution of 17th century Europe that was the precursor to the Industrial Revolution. In China, these changes led to the rise of cities and enormous advances in commerce. Cities based on trade and industry multiplied rapidly, especially along the southeastern coast, the Yangtze River valley, and the Grand Canal that led north. Indeed, the specialization of agriculture propelled the nation into a semi-national market in many goods, combined with the fact that the gentry class was forced to engage in commerce, the capitalistic entrepreneurs had become part of Chinese culture. In addition, starting from the later stages of this period (Sung Dynasty), China’s seafaring also took on a grander scale. As well-stated in the labor literature (e.g. 12 For a more formal discussion of gentry, culture, and capitalism in China, refer to Yin (1987) and Yu (1987). The effect of Confucianism and Chinese Culture on neighboring nations, please refer to Hou and Hou (2004), and Liao (1983, 1985).

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Borjas 1987), those that chose to migrate such long distances are not your average people. They tend to be the more determined, industrious, and most certainly have an extremely strong entrepreneur spirit. The wide spread success of overseas Chinese industry is an extremely vital asset, which is something a semi land-locked nation like Russia cannot compare. The serfs had no right to move, and even with the communes (the mir) such mobility and entrepreneur spirits were certainly not easy to foster. Both China and Russia were not particularly strong in terms of industrial capitalists. Indeed, up till the early 20th century, both were dominated by foreignowned industries operating within their political borders. But here, China again held the advantage. The Bolshevik Revolution effectively ended any opportunity for the development of a Russian capitalist class. The turbulent years of the 1930s till the end of WWII were important to the emergence of the capitalist class in China. In an effort to prepare China to (inevitably) combat the Japanese, the Nationalist government intentionally fostered such industrialists. Unequivocally, these were the “privileged” class and were inevitably corrupt,13 but the eight year war against Japan, and the Western powers relinquishing their economic hold on China (as a way to “thank” the Chinese war effort), did create an industrial capitalist class. 7 Role of the State Until now, I have deliberately avoided a direct discussion of the role of the State, and the differences between the two reforms in this aspect. It is not because I do not deem it as important; rather it is precisely because of the pivotal role that the State plays which compelled me to place it at the end of my analysis. If one takes a short stroll through history, the active role of the State is everywhere; be it the living gods of Egyptian Pharoahs, the Athenian Empire through the Delian League, and the Caesars of Pax Roman. If we examine more recent history, the State intervention under Mercantilism is obvious, and its political residue (i.e. the effects of colonialism) continues to haunt us. Even for the model of modern democracy (the United States), it would not have survived except for the strong-willed central government (demonstrated by the action of Hamilton) in the early stages. The laissez faire ideal of the invisible hand requires numerous mature and functioning institutions, nevertheless, the belief that “Government is not the solution. Government is the problem” (President Reagan’s 1980 Inaugural Address) has had a profound inﬂuence politically and academically for over two decades. It is only reasonable to assume that this philosophy had its effect on the post–Soviet era Russia. The exact reason why this had no a major effect for China is unclear. The cautious nature of the Chinese reformers (see Section 3) is an explanation, but the fact is that when this Reagan saying was publicized, China was already many years into its reform attempts.14 Combined with the fact that the reform measures have shown concrete effect, there certainly was no reason to abandon the role of the State. 13 These, among other issues, gave the CCP (Chinese Communist Party) a platform that was very popular to the general public. 14 This is if you accept the argument made by Hou, Mead, and Nagahashi (2004) that China’s reform really began in the early 1970s.

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In contrast, when the Russian reform began in earnest, the Reagan quote was already part of popular language and a political ideology for over a decade. Furthermore, it is my belief that Boris Yeltsin really did not have any plan or strategy to deal with the post-Soviet Russia economy. Thus, when Sachs advised the Russian President on liberalizing the economy and letting the market take over, Yelstin eagerly agreed. In reality, rather than categorizing this as “liberalism”, it is perhaps better characterized as abandonment of responsibility of the State. This leads to a fundamental issue: what is the role of the State (both academically and from social populist point of view)? Most economists that believe in market mechanism will suggest that when faced with minor or even moderate economic disequilibrium, it is best to let the invisible hand take its course. However, with the exception of perhaps the most hardcore laissez faire economists, when faced with truly severe economic crisis we (just like the general public) turn to the State for guidance and assurance. As a metaphor, we liken the role of the State to that of a medical doctor. When one has a minor cold, we either let it take its course or use over-the-counter medication to relieve the symptoms and/or speed up the recovery. But, when we are severely ill, the doctor is looked upon as God or at least our savior. Perhaps an even stronger description (still using doctors as a metaphor for the State) is to relate to children. To ensure the safe birth of a new-born, the doctor’s role in prenatal care, pregnancy delivery, and the ensuing pediatric care are vital. These increase the odds of survival, and set the foundation for a longer and healthier life afterwards. If one adheres to this example of human life and draw parallels to economic development, the importance of the State in the early stages of development is inescapable. Without exception, all economies lack the market mechanism: low in efﬁciency, insufﬁcient funds, and have high risk in the early years. In this sense, there is an absolute need for the State to “supply” development capital. For both China and Russia, the logical route is to develop large business, as the existing SOEs are by nature such ﬁrms. This is perhaps best characterized as moving towards a “public capitalism” (in the Gailbraith tradition), where social structure is based on a complementary relationship between the State and big corporations, with the integration of social interest with market efﬁciency as the end objective. Typically, the State takes on the role of “giving birth” to large corporations, and when these companies are mature, they then take on the task of assuring the achievement of State objectives; similar to the ideal relationship between parent and children. Such “child rearing” can take on many forms. It could be a direct incorporation into the realm of government (Taiwan’s national monopolies), or direct public ﬁnancing (the chebols of South Korea). It could take the form of indirect public planning where the State determines the budget for public investment and then distributes it among different “national” industries (e.g. France), or via a semicompetitive auction where large companies receive public ﬁnancing for speciﬁc State related projects (the US and UK). Regardless of what form it takes, this relationship implies that the State and the large corporations jointly devise, manage, and implement long term strategies for both their domestic and external markets. A perfect example is the export subsidy and foreign exchange rebate that China used to encourage production and obtain

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hard currency in the mid/late 1980s (through the early 1990s). Prices were still “unreasonable” due to government control, and the over-valued RMB implied that SOEs lacked competitiveness in the international market. The State provided export subsidies to the SOEs to offset the high RMB, the foreign exchange earned (which was mandatory sold to the State) aided the State in acquiring needed imports, while the portion of foreign exchange the exporting SOEs are allowed to retain serve as economic incentive to become more efﬁcient. Under this Public Capitalism, the State and big business cooperate to achieve the main objectives, and in doing so provide a stable and rule-adhering environment, which is the desire of both State and business.15 Such an environment is in the interest of the State, ﬁrms, and the general population. The only people that would dislike such an arrangement would be illegal business. Illegal activities will always exist, but in an economy where the State is weak and rules are either lacking or inconsistent, it fosters such illegal business activities. That is perhaps why the unorganized semiillegal sector in Russia accounts for up to 50% of the economic activity.16 This is especially true in the ﬁnancial sector, as the Russian economy is notoriously under-monetized. In a properly funded economy, total bank deposits should be 15 to 20% of GDP (China is in excess of this), but this ﬁgure is merely 7% in Russia (Li 1997). This implies that the banks are unable to provide ﬁnancial services vital to business, and this is indeed one of the major problems plaguing the Russian economy since the 1990s. As a measure of how this has severely handicapped the performance and market values of the business sector, let us quote some numbers. The top 200 industrial ﬁrms in Russia had a total market value that is equivalent to 40% of the value of General Electrics. Or, another perhaps even more depressing ﬁgure, the top 7 ﬁrms in Taiwan has a market value that is 47.5% of the top 200 Russian ﬁrms. Not only has China not had this problem, it is further blessed with the huge source of capital inﬂow from overseas Chinese industry. The fact that Hong Kong and Taiwan are the largest and fourth largest FDI into China (Hou and Zhang 2001ab, 2004), respectively, is testament to this. Russia does not even come close in this aspect. If one looks at the broader picture and examines the issue of FDI, the difference between Russia and China could not be more different. According to Ksenia Yudaeva (Centre for Financial and Economic Research, Russian Federation), Russia has few legal limits on FDI, but public policy creates a climate effectively hostile to such investment. “We want foreign donors to come to Russia,” lamented Yudaeva, “not foreign investors.” While limits on FDI do exist in China, they have welcomed it in practice, reaping tremendous beneﬁts. Since the 1990s, China has been the largets FDI destination among developing nations, and the second largest overall (behind the US). But since 2003, China has surpassed the US and is the largest recipient of FDI, and the growth is only going to be more impressive as China’s FDI

15 This is exactly what Hou and Hou (2003) meant by a “negative” institution cost as it reduces the cost of production. 16 It is generally acknowledge that the “organized” illegal activity (i.e. the Russian mob) has a signiﬁcant hand in many aspects of the economy, but actual numbers are hard to come by.

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related laws continue to become more liberalized (Hou and Zhang 2004) and the markets more accessible (per WTO rules). Returning to my metaphor of the State being a doctor bringing a new child into this world, China certainly had this, while Russia is woefully lacking. Using yet another metaphor, China’s economy grew under the paternalistic (Gailbraith, again) and watchful eye of Deng, Jiang/Zhu, and the current leadership. In contrast, the Russian “child” was effectively abandoned by Yeltsin. Though a nurtured and loved child may not grow up to be a productive adult, the odds are astronomically better than a child left to fend for itself in the wild. However, as I stated in my opening statement, at the Conference on Reform and Development in Deng’s China (Miller Center for Government, University of Virginia, 1992), In the early stages of the reform, it is vital to have a strong central government. The State has to play the role of a trafﬁc policeman, directing who to stay and who to move. Otherwise, the impatience of those involved will inevitably result in chaos and trafﬁc gridlock. However, it is equally important for political reform to gather momentum and not lag too much behind. Otherwise, much like a person leaning forward (progress in economic reform), if the legs or political reform do not catch up, one will eventually fall down.

This, perhaps, is the only dark cloud hanging in the horizon. Ironically, this is precisely the edge that Russia may enjoy if it can ride through the current turmoil. Another more pressing issue is foreign exchange and the ﬁnancial sector. Russia had liberated State banks and implemented currency convertibility. China, on the other hand, facing the WTO imposed deadline of 2007 for the ﬁnancial liberalization has a tough road ahead. This also points to, perhaps, the only positive result to come from the shock therapy for Russia. By liberalizing the prices, they are (theoretically) freed from the threat of “structural” inﬂation (due to price-rigidity in the downward direction, plus needed changes in relative prices), which was perhaps the cause of China’s 1994 inﬂation (Chang and Hou 1997), and may be repeating itself right now. Ten years ago, it took the determination of the then Premier Zhu Rongji to bring it under control. Will the current leaders have the same determination and power? 8 Concluding Remarks The comparative performance of the Chinese and Russian economy is for the whole world to see. Indeed, with the emergence of China, the “ﬂying geese” development pattern of Asia is now a thing of the past (Hou et al 1995). While the economic effect of Russia on Asia and Europe is still relatively minor by contrast. This apparent success of China and the lack of it in Russia have constantly raised the question of why and whether the Russians could learn from China. This chapter attempts to address this issue. It is the opinion of this author that the Russian failure is more than just the initial condition and shock therapy, though they are major catalysts for sure. The liberalization of government control in Russia (the shock therapy) was a mistake

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as it depended on the invisible hand of market that did not exist. The gradualism (or piece meal approach) of China allowed all sides to adjust, learn, and grow. The disastrous Cultural Revolution had an unexpected beneﬁt (though at tremendous cost), as it led to China’s reform following the natural sequence of agriculture ﬁrst and industry second. The most important reason why Russia may not be able to replicate China’s reform lies in culture, history, and other “invisible” traits. China was under central planning for only twenty years, which meant that when reform began, the entrepreneurs were older but still alive. In contrast, Russia was under communism for 70 years, even if the capitalistic entrepreneurs existed, they would have died before the reform was initiated. Whether a large entrepreneur class ever existed in Russia is of considerable doubt. China has had a proﬁt-seeking peasant and merchant class for over a millennium. It is in the very fabric of Chinese Culture. In contrast, the Russians evolved from serfdom to a commune collective (the mir) in the second half of the 19th century, only to see it transform into a people’s commune under communism. It is my contention that the proﬁt-seeking entrepreneur “class” never existed for the Russians. Finally, I examined the role of the State in the early stages of all economic development. A strong State involvement is key to all the successful civilizations in history. China was fortunate to have a strong central government under the leadership of cautious but open-minded leaders. The lack of a coordinated State role was the ﬁnal blow to the Russian reform. Though I am by no means writing off Russia (indeed, I see it as having a potential advantage in the longer-run), its current failure is no surprise. Reference Arrow, K.J., “History: the View from Economics,” in William N. Parker ed. Economic History and the Modern Economist (New York: Basil Blackwell, 1986), 13–20. Borjas, G.J., “Self–Selection and the Earnings of Immigrants,” American Economic Review, 77, 4(1987): 531–53. Central Committee, “Regulations on the Work in Rural People’s Communes,” reprinted (in English) in two parts in Issues and Studies, August (1979): 100–112 and September (1979): 104–15. Central Committee, “Decision of the Central Committee of the CCP on Reform of the Economic Structure,” reprinted (in English) in the Beijing Review, 29, October (1984): 27–44. Chang, G. and J.W. Hou, “Structural Inﬂation and the 1994 Monetary Crisis in China,” Contemporary Economic Policy, 15, 2 (1997): 73–81. Chow, G., China’s Economic Transformation (Blackwell Publishers, January 2002). Fei, J. and J.W. Hou, “The Comprehensive Economic Reform of The PRC (1978-),” in Shao-chuan Leng ed. Reform and Development in Deng’s China, Volume IV, The Miller Center Series on Asian Political Leadership (University Press of America: New York,1994), 19–64.

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Hanson, V.D., Ripples of War, (Doubleday & Company, 2003). Hou, C.-C. and J.W. Hou, “China’s Economic Reform: Lessons from History,” Soochow Journal of Economics and Business, 17 (1996): 1–18. Hou, C.-C. and J.W. Hou, “Evolution of Economic Institutions and China’s Economic Reform,” The Social Science Journal, 39, 2 (2002): 363–79. Hou, C.-C. and J.W. Hou, “Evolution Rules of Economic History,” presented at the Western Economic Association International 77th Annual Conference (Denver, July 2003). Hou, C.-C. and J.W. Hou, “Confucianism, Entrepreneurship, and Economic Development,” Working Paper (California State University, Long Beach, 2006). Hou, J.W., “Rural Reform and the Welfare Impact on Urban Workers: An Analytical Approach,” in Aimin Cheng, Gordon G. Liu, and Kevin H. Zhang eds Urbanization and Social Welfare in China (Aldershot: Ashgate, 2004), 107–37. Hou, J.W. and J. Appleton, “The ‘Engine’ of Taiwan’s Economic Growth: A Path Analysis Approach,” Singapore Economic Review, 41, 1 (1996): 25–46. Hou, J.W., S. Ichimura, S. Naya, L. Werin, and L. Young, “Paciﬁc Rim Trade and Development: Historical Environment and Future Prospects,” Contemporary Economic Policy, 13, 4 (1995): 1–25. Hou, J.W., R.W. Mead and H. Nagahashi, “Evolution of China’s US Policy (1965– 72): Prelude to the Economic Reform?” The American Journal of Chinese Studies, 12(1) (2005): 1–24. Hou, J.W. and K.H. Zhang, “A Location Analysis of Taiwanese Manufacturing Branch-Plants in mainland China,” International Journal of Business, 6, 2 (2001a): 53–66. Hou, J.W. and K.H. Zhang, “Taiwan’s Outward Investment in Mainland China,” in Hung-Gay Fung and Kevin H. Zhang eds Financial Markets and Foreign Investment in Greater China (New York: M.E. Sharpe, 2001b), 182–203. Hou, J.W. and K.H. Zhang, “China’s FDI Policy and Taiwanese Direct Investment (TDI) in China,” presented at the American Society of Business and Behavioral Sciences 11th Annual Meeting (Las Vegas, February 19–22, 2004). Kuo, S.W.Y., G. Ranis and J.C.H. Fei, The Taiwan Success Story: Rapid Growth with Improved Distribution in the Republic of China, 1952–1979 (Boulder: Westview Press, 1981). Li, K.–W., “Money and Monetization in China’s Economic Reform,” Applied Economics, 29 (1997): 1139–1145. Liao, C.–C., Confucian Spirit in Japanese Business Management (Taipei: Lian Jing Publishing, 1983). Liao, C.–C., Managerial Strategy of Japanese Enterprisest (Taipei: Lian Jing Publishing, 1985). Lin, J.Y., “Viability, Economic Transition, and Reﬂections on Neo-classical Economics,” Kyklos, 58(2) (2005): 239–264. Liu, Y., “Russia’s Fall, China’s Rise? Comparing Transitions of Russia and China (Parts I and II),” Perspectives, (an on-line publication of the Overseas Young Chinese Forum), Vol. 2, No. 5 (http://www.oycf.org/perspectives/11_043001/ russia.htm) and No. 6 (http://www.oycf.org/Perspectives/12_063001/Russia_fall. htm) (2001).

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MacPhee, C.R., Roll Over Joe Stalin: Struggling with Post–Soviet Reform in the Caucasus, (iUniverse: New York, 2005) Perkins, D.H., “Reforming China’s Economic System,” Journal of Economic Literature, 26, 2 (1988): 601–45. Sachs, J., and W.T. Woo, “Understanding China’s Economic Performance,” NBER Working Paper, W5935 (1997). Solow, R.E., “Economics: Is Something Missing?” in William N. Parker ed. Economic History and the Modern Economist (New York: Basil Blackwell, 1986), 21–9. Stiglitz, J.E., “Whither Reform? Ten Years of the Transition,” Keynote address at the 1999 Annual Bank Conference for Development Economics (1999). Sylla, R., R. Tilly, and G. Tortella, eds, The State, the Financial System and Economic Modernizatio (New York: Cambridge University Press,1999). Weber, M., The Protestant Ethic and the Spirit of Capitalism, translated by T. Parson (London: Allen & Irwin, 1930). Weber, M., The Religion of China: Confucianism and Taoism, translated by H.H. Gerth (London: Collier Macmillan, 1964). Yin, C., “The Issues of the Emergence of Capitalism in China’s Feudalistic Society,” in Sun Chien ed. Collected Works on China’s Economic History (Beijing: China People’s University Press, 1987), 36–59. Yu, Y.–S., Gentry and the Chinese Culture (Shanghai: People’s Publishing Co., 1987).

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Chapter 8

Private Enterprise Development and Governmental Functions Jian He1

The Chinese economy is experiencing a period of private enterprise development. Private and other non-state owned enterprises are growing yearly and have taken a strong hold in the Chinese economy. It is clear the private enterprise is playing the most active role in China’s economic society and is becoming more important for China’s economic development. However, there are many obstacles to further grow for the private sector. For example, now private enterprises are allowed to exist but are not treated equally. Private enterprises are discriminated against by statemonopolized banks in borrowing and are subject to numerous taxes, fees, and levies from local governments. The legal system to protect private property is very weak. Private enterprises in China also face many other challenges, such as lack of credit, technical and information support, management experience, international trade and investment experience, and long run planning. In addition, they must deal with the competition from state enterprises, enterprise management disputes, contract violations, and government ofﬁcials’ corruption. The private enterprise sector is crucial to the successful handling of the above challenges. How can private enterprises overcome those problems? What are the main obstacles to private enterprise development in China? What governmental functions should be taken to promote private enterprise development? What lessons can China learn from other countries in promoting private enterprise development and privatization? It is the Chinese government’s responsibility to help private enterprise recover the difﬁculties they are facing. However, after managing the state-owned economy for over ﬁfty years, the China’s government needs to learn how to handle this new side of their function. In fact, in many Northern America and European counties, one major governmental function is providing support and service to private enterprises. The purpose of this chapter is not to provide a theoretical and systematical deﬁnition or explanation of the western government, nor give detailed discriminations of America’s central and local governments. Rather, the chapter seeks to capture the nature and ﬂavour of the public manager’s job in western countries. It particularly intends to discuss how American government promotes private enterprise development by using 1 Economic Development Specialist and State Demographer, State Government of Ohio.

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different cases. This chapter may give some ideas and views that could be employed by the Chinese administrators for their effort of promoting private enterprise. Public management in the United States is an extremely diverse enterprise. It is a part of all three branches of government—executive, legislative, and judicial. It is a part of all levels of government—national, state, and local. Beyond these traditional categories, public management is a part of newer governmental categories that have emerged in recent years—special districts, councils of governments, regional planning commissions, among others. All these categories of public agencies, both traditional and contemporary, provide the means through which society pursues its goals. Therefore, public management of the US must be seen as the link between government goals and accomplishments. Goals translate into actions only through the coordinated application of human effort and economic resources. This process of translation is the central purpose of the public manager’s job. For government’s work to be accomplished: • • • •

Policies, plans, and organizations must be created. Money must be obtained, budgeted, and expended. People must be hired, trained, assigned, and supervised. Programs must be monitored, evaluated, and guided.

Generally speaking, there are three major functions which government of the US use when dealing with the development of private enterprises. Those functions are: Service function, Community Development function, and Management function. Those functions will be discussing below and be described by Cases. Service function The most important function of America government is service. The agencies of the government provide services to the public. The legal foundation of this function is the money supporting the exit of the government coming from the public. In other words, taxpayers are the bosses of government and not vice versa. For example, the mission of the Department of Development is working with communities and businesses. The Department promotes economic opportunities to improve the proﬁts and prosperity of the state’s citizens. The Department acts in a supporting role and provides ﬁnancial, informational, and technical assistance to those making investments in the state’s future. The following are some cases showing the services fount ions of the government. Case One The Department of Developments’ Ofﬁces of Communications/Special Projects and Strategic Research work to provide information, reports, news, and research data to the business community, media and general public. Both ofﬁces utilize electronic and print media to distribute news and promotional information. They execute comprehensive media and marketing strategies promoting State’s business climate

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and available business resources. The Ofﬁce of Special Projects and Strategic Research provides census and statistical data including: demographic, economic, speciﬁc trade, industry and labor analyses. The ofﬁce also develops and disseminates population estimates and projections. They provide tools for better-coordinated decision-making in public and private sectors. These kinds of services are eligible and available everyone, including companies. The information is available in the ofﬁce’s Columbus headquarters and its forty-two afﬁliate centers. The ofﬁce also has placed extensive web-based reports such as County Proﬁles on its web page. All of the above services and information are available for free to the public. The ofﬁce only charges on a cost-reimbursable basis for few special requests that need addition time and effort. Case Two The Department of Development’s Economic Development Division works to create, retain and expand job opportunities for all state residents. The Division focuses on issues affecting state’s economy and provides a variety of business development resources to help the state remain at the forefront of economic development. The Division offers companies direct ﬁnancial assistance in the form of low-interest loans, grants, bonds, and state and local tax incentives. The Division also offers assistance with employee training and infrastructure development. For example, the Economic Development Division provides state businesses with access to technical assistance, counseling and training programs. Programs such as the 1st Stop Business Connection offer comprehensive information designed to assist small start-up ﬁrms with business development. The ﬁrst in the country to offer electronic site selection information, Ohio’s electronic site location proposals drastically cut response time while enhancing the quality of information available. From new entrepreneurs starting small businesses to large corporations, the Economic Development Division provides business owners and executives with the information and support they need. This information helps them make informed, critical decisions on location, infrastructure, job creation and retention, training and ﬁnancial assistance. Case Three The Ofﬁce of Business Development provides assistance to companies considering expanding or locating in the State. They provide professional services to companies by structuring responsible economic incentive packages, providing information on the state’s business assistance programs, and conducting site and/or building searches and tours. The Ofﬁce reviews loans, tax credits, tax exemptions, training, and infrastructure programs to make recommendations on appropriate programs for each individual project. They also work closely with state’s communities to retain and attract businesses in their area. The ofﬁce’s Business Development Representatives walk companies and communities through all phases of the application and approval process for incentives

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offered to induce a project to move forward in Ohio. The Ofﬁce also includes specialists for the European, Canadian and Paciﬁc Rim along with specialists in agribusiness, transportation, and environmental programs. The Ofﬁce of Business Development works with clients from their ﬁrst inquiry to the Department through the life of the project, providing competitive economic development services. Case Four The International Trade Division promotes the export of state products and services to strengthen state’s economy and advance its leadership position in the global market place. The division provides companies with market research; performs agent and distributor searches; participates in trade shows; organizes trade missions; and assists with export ﬁnance. The division also works with the Economic Development Division to promote the State and attract foreign investments. State’s international trade ofﬁces are located in different countries and regions throughout the world, such as Brussels, Belgium; Tokyo, Japan; Hong Kong, People’s Republic of China; Toronto, Canada; Tel Aviv, Israel; Mexico City, Mexico; Sao Paulo, Brazil; Santiago, Chile; Buenos Aires, Argentina; and Johannesburg, South Africa. The division and its international trade ofﬁces provide various services for Exporters. One service is called “Export Counseling”. One of the division’s trade advisors will visit the private company to consult with them about their export goals and objectives. The trade advisor will answer questions, provide research regarding the company’s target markets and work with the company to assess the viability of their product or service in those markets. There is no fee for this service. The other service is called “Agent and Distributor Search”. The key to success in international markets can be ﬁnding the right agent or distributor. Working through the state’s network of international ofﬁces, or with the division’s many international contacts, the trade advisor will coordinate searches for prospective agents and distributors who can effectively sell the private company’s products. This initiates relationships that will pay dividends for the company long into the future. There is no fee for this service. The International Trade Division also organizes business missions. The business missions are often led by the Governor of the state, to initiate and nurture relationships with potential international business partners. Participating in a business mission can provide private companies with an opportunity to meet high-level businesses and government executives face-to-face, greatly enhancing their potential for future business opportunities. Catalog Show is another service provided by The International Trade Division. Catalog Shows provide a low-cost way for state’s companies to gain exposure and develop leads in a new market. The division’s staff will represent those companies or organizations to interested buyers or representatives, distributing their literature and providing them with leads upon their return. The International Trade Division organizes trade Shows also. The right trade show can provide the companies with invaluable ﬁrst-hand market research, facilitate the company’s entry into a new market or help them increase their sales in an existing market. The Division’s trade advisors and international ofﬁces work with companies

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to identify the right trade show for their products and services. In some cases, they will organize a state pavilion to secure prime space at a reduced price. To make a company’s trip worthwhile, the state’s international ofﬁces can also arrange prequaliﬁed meetings with interested buyers and assist with translators and in-country transportation. The International Trade Division encourages all state’s companies to participate in catalog show, trade shows, seminars, workshops and business missions. The following is an example of these events trying to create opportunities to enhance company’s export efforts: Ohio–China Wood Products Mission 2003—The Ohio Department of Agriculture organized a wood products trade mission to southern China and the Furniwood Guangzhou (FWG) 2003 trade fair in Guangzhou, China. The mission ran March 11–26, 2003 and included activities in Dongguan, Guangzhou and Hubei, China. Activities included pre-arranged business meetings, site visits and exhibitions at FWG 2003. Case Five The Ohio Export Finance Initiative (OEFI) assists Ohio companies in meeting their export ﬁnance needs by working with the following organizations and programs: Export-Import Bank of the United States (Ex-Im Bank) (Ex-Im Bank) is a US Government agency that ﬁnances export sales of American goods and services through guarantees, loans, and export credit insurance. As a participant in the City/State Partnership Program, the OEFI markets programs offered by Ex-Im Bank, and packages applications for these programs. The OEFI’s relationship with Ex-Im Bank provides Ohio companies a direct line to export ﬁnance. US Small Business Administration (SBA); The OEFI also works with the US Small Business Administration (SBA), which provides guarantees on loans made by lenders to support the production of goods and services for export. Ohio Banks; The OEFI maintains close contact with all Ohio banks whom actively participate in ﬁnancing international trade. Government Sources; In addition to Ex-Im Bank and the SBA, the OEFI helps Ohio companies evaluate their options with other US Government agencies that provide ﬁnancing for international ventures. These agencies include the Overseas Private Investment Corporation (OPIC), the US Agency for International Development (USAID), and the US Trade and Development Agency (TDA). Alternative Finance; when traditional sources of export ﬁnance are unavailable to Ohio companies, the OEFI helps them explore alternatives including factoring and forfeiting. Case Six The Division of Minority Business Affairs (DMBA) aids in the creation of a business environment in State sensitive to the particular needs of minority business enterprises and assists in their growth and development. The realization of this objective will

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strengthen the minority business community and will contribute to the general economic health of the State. The Division also provides services to non-minority, small and disadvantaged businesses. The following are some programs provided by The Division of Minority Business Affairs: 1. The Minority Contractors and Business Assistance Program (MCBAP) provides outreach for the Division of Minority Business Affairs (DMBA) into the minority business community. The MCBAP ofﬁces assist minority entrepreneurs with loan and bond packaging services, management, technical, ﬁnancial and contract procurement assistance. The MCBAP ofﬁces are located in 8 regional areas including Akron, Cincinnati, Cleveland, Columbus, Dayton, Portsmouth, Toledo and Youngstown. These ofﬁces provide one-onone counseling to new and existing business owners. MCBAP ofﬁces help minority ﬁrms with the following: • Accessing various state and local government programs; • Completing federal, state and local certiﬁcation applications; • Identifying local resources; Referrals to ﬁnancial assistance programs; • Providing access to a Plan/Bid room, which includes on-line Dodge Reports. 2. MCBAP also provides direct professional services, contributing to the growth and stability of state’s underutilized businesses: • Accounting assistance; • Loan packaging assistance; • Marketing plan development; • Estimating/Bidding assistance; • Plan rooms/Dodge Reports; • Contract procurement assistance; • Business management counseling; • Community Development Function. Healthy communities are vital to a state’s social and economic well-being. The Department of Community Development establish and expand upon successful and meaningful partnerships, working to make the state a better place for people and businesses to call home. The Department administers a variety of state and federally funded programs that beneﬁt individuals and families of the state. The Department coordinates its programs to form a comprehensive strategy to build stronger, healthier communities throughout the state. Through partnerships with local governments, community action agencies, other community-based nonproﬁt service providers and private-sector funding sources, The Department helps to: Support local economic development activities to create and retain jobs; Rehabilitate communities and neighborhoods through affordable housing and infrastructure improvements; Provide weatherization services, energy efﬁciency incentives and assistance with home heating bills; Provide emergency shelter, transitional and permanent housing for the homeless; and provide job training, emergency food, shelter and medical services.

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Case One: Community Services Block Grant The Community Services Block Grant (CSBG) remains one of the major initiatives of the War on Poverty. Beginning in FY 1982, Congress delegated the responsibility for program administration to states. In Ohio, the program is administered by the Ohio Department of Development, Ofﬁce of Community Services (OCS). The mission of the block grant is to provide ﬂexible dollars for local communities to implement service programs, lessening the causes and conditions of poverty. CAAs, governed by nonproﬁt boards of directors, annually submit work programs and budgets for the use of CSBG funds. The applications are available for public inspection prior to submission for the state’s review. Case Two: Home Energy Assistance Program (HEAP) The Home Energy Assistance Program (HEAP) is a federally funded program administered by the Ohio Department of Development, Ofﬁce of Community Services (OCS). It is designed to help low-income Ohio residents meet the high costs of home heating. The program pays a one-time payment for most Public Utilities Commission of Ohio (PUCO) regulated utility customers reﬂecting their usage for the winter heating season. Vouchers are issued to non-regulated utility customers, mastermetered and other applicants not having utility bills in their name. For eligibility, an applicant’s total household income must be at or below 150% of the federal poverty guidelines. A household applying for HEAP must report household income for the past 12 months for all persons 18 years of age or older. Both homeowners and renters are eligible for assistance. Applications are mailed to households found eligible for assistance the previous winter heating season. Applications are available at local libraries, community action agencies, county Department of Job and Family Services ofﬁces, Area Agencies on Aging, and local utility ofﬁces. Case Three: Travel and Tourism The Division of Travel and Tourism promotes the state’s many travel and vacation attractions. Promoting the state’s heritage is a top priority. In 1997, the Division created the National Heritage Tourism Research Forum, which developed a national deﬁnition for heritage tourism and is currently working on a national strategy for data collection on heritage tourism visitor spending. In addition, the Heritage of Ohio Tourism Task Force (HOTT), established in 1995, is a collective group of state agencies committed to the development of state’s historical, cultural, and natural resources. The Division of Travel and Tourism provides business beneﬁt to the state’s tourism industry. It offers partnerships with statewide tourist attractions and local convention and visitors bureaus. It also provides information on Ohio travel destinations. Direct visitor spending in Ohio totaled $27.1 billion in 1999. The industry supports the jobs of 657,000 Ohio residents. The 1-800-BUCKEYE and OhioTourism.com programs work with local travel destinations and events by assisting in marketing their information nationwide and

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beyond. This information reaches over 3 million travelers annually. For eligibility, participation in 1-800-BUCKEYE and OhioTourism.com is free to everyone who successfully completes a data submission form with a minimum requirement of attracting travelers from a radius of at least 50 miles. The Division of Travel and Tourism house the most frequently called state tourism hotline in the country. The call system responds to approximately 1.5 million inquiries annually. The Division of Travel and Tourism was responsible for mailing nearly 600,000 Ohio tourist information packets in 2000. OhioTourism.com is a valuable source of information allowing potential travelers access to the Ohio tourism database via the Internet. More than 4,000 entities are included. Statistics show nearly one million people “visited” Ohio through the website in 1998. The Division of Travel and Tourism created the National Heritage Tourism Research Forum in 1997. The forum developed a national deﬁnition for heritage tourism and is currently working on a national strategy for data collection on heritage tourism visitor spending. The national deﬁnition for heritage tourism established in 1997 is: “Traveling to experience the places and activities that authentically represent the people and stories of the past.” The Division sponsors an annual heritage tourism research breakfast to report on progress. Case Four: Urban Development The mission of the Ofﬁce of Urban Development is to assist communities in creating wealth from personal, business and community successes. The goals of the Ofﬁce are to identify the necessary resources and ﬁnancing to enhance the economic viability of local communities. The Ofﬁce’s objective is to improve the economic climate in some of the state’s older communities by encouraging new investment, innovative land use, and job retention and/or creation. The Clean Ohio Revitalization Fund, a key ﬁnancial component to help a community build economic capacity, provides funding for Brownﬁeld redevelopment. Brownﬁeld redevelopment allows a community to reclaim and improve its lands, making property viable for new development. The Clean Ohio Revitalization Fund is a portion of the $400 million Clean Ohio Fund approved by Ohio voters in November 2000. Voters gave the state the ability to issue $200 million for brown ﬁeld redevelopment activities and another $200 million for preservation of green space. The Ohio Department of Development, through its Ofﬁce of Urban Development, is implementing the brown ﬁeld portion of the bond in consultation with the Ohio Environmental Protection Agency. The Ohio Department of Development (ODOD) is responsible for supporting the newly legislated Clean Ohio Council. The Clean Ohio Council was created to select projects that will receive grants and low-interest loans from the Clean Ohio Fund. The council is chaired by the director of the Ohio Department of Development. The director of the Ohio Environmental Protection Agency (EPA) is also a voting member, along with two state senators and two state representatives. In addition, the Governor of the state appoints seven members to represent local governments,

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business and development interests and environmental advocacy organizations. The director of the Ohio Public Works Commission serves as a nonvoting member. Case Five: Housing and Community Partnerships The Ofﬁce of Housing and Community Partnerships (OHCP) provides ﬁnancial and technical assistance to units of local government and nonproﬁt organizations in the state for project activities, which beneﬁt low- and moderate-income citizens. The overall objectives of OHCP are to: Conserve and expand the affordable housing stock to provide decent homes and a suitable living environments; Attract, expand and retain business and industry to create and retain long-term jobs in the private sector; Improve and expand public works and facilities in order to prevent deterioration of property and neighborhoods; Provide long-term solutions to the need for jobs and affordable housing; Address the issue of homelessness in Ohio; Provide short-term, emergency assistance, social and other public services for low-income Ohio residents. To accomplish these objectives, OHCP administers several federal and statefunded programs. • • •

Housing, Shelter and Supportive Services Programs; Community Development Programs; Economic Development Programs.

Case Six: Investment in Training The Ohio Investment Training Program (OITP) provides ﬁnancial assistance and technical resources for customized training involving employees of new and expanding Ohio businesses. OITP provides up to 50% reimbursement to fund instructional costs, materials and training-related activities. There is an emphasis on manufacturing and selected employment sectors that have signiﬁcant training and capital investment related to creating and retaining jobs. OITP also supports community economic development efforts through job creation and retention. The result is increased employee productivity, improved labor/management relations and a highly skilled labor pool. The regional OITP Coordinators walk companies through all phases of the application and approval process, at no cost to the business. Case Seven: Housing Finance Agency Housing Finance Agency (OHFA) offers affordable housing opportunities from rental assistance to homeownership for the residents of the state. OHFA also provides access to ﬁnancial resources for the development and management of safe, sanitary and affordable housing. The Agency’s programs serve ﬁrst-time homebuyers, renters, senior citizens and other populations with special needs who otherwise might not be able to afford quality housing.

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The Agency’s continued success results from the solid partnerships it has established with investment banking ﬁrms, developers, private investors, lenders, Realtors, nonproﬁt organizations and homebuyers. Controlled by a board appointed by the Governor, OHFA is a division of the Ohio Department of Development (ODOD). OHFA administers its programs through four ofﬁces: Finance and Administration; Homeownership Programs; Planning, Preservation and Development; and Housing Management. The programs the agency handles include: Mortgage Revenue Bond Program (First-Time Homebuyer Program) provides low-interest, 30-year ﬁxed-rate mortgage ﬁnancing to qualiﬁed homebuyers, enabling more working families in Ohio to purchase homes. The beneﬁts for homebuyers are: lower ﬁxed mortgage rates, monthly payments and down payments. The beneﬁts for businesses are: a more stable workforce having a ﬁnancial investment in the community. All residents of the state with low- and moderate-income who are ﬁrst-time homebuyers (have not owned a home in the last three years), or are purchasing homes in targeted (economically distressed) areas. Proceeds from the sale of tax-free mortgage revenue bonds are used to offer mortgages at rates below conventional market rates. Maximum family income eligibility limits and home purchase price limits are set geographically by the US Department of Housing and Urban Development. Housing Credit Program creates tax incentives to develop affordable, family rental housing by providing equity ﬁnancing. This program helps ﬁnance the purchase, construction and rehabilitation of affordable housing units and maintain units at lower rent levels for minimum periods of affordability. Serves low- and moderate-income residents. All nonproﬁt or for-proﬁt organizations are eligible to apply. Applicants may either apply the credit towards their federal income tax liability, or syndicate the credit to generate equity for the project. Tax credits are awarded in a highly competitive funding round each year. Multifamily Bond Program creates incentives to develop affordable, family rental housing by providing lower-cost debt ﬁnancing. This program helps ﬁnance the purchase, construction and rehabilitation of affordable housing through the issuance of tax-exempt bonds. All nonproﬁt or for-proﬁt organizations are eligible to apply. Applications are accepted throughout the year. If the issuance is to utilize volume cap, a separate application to ODOD is necessary. Project applicants engage in a two-step process: inducement and ﬁnal approval. All projects must meet OHFA criteria and obtain ﬁnal approval of the OHFA board. Affordable Housing Loan Program used to lower acquisition, pre-development and development costs associated with the production of affordable housing. This program helps lower affordable housing ﬁnancing costs associated with site acquisition and pre-development, construction interest, and interim ﬁnancing for deferred equity resulting from the sale of Housing Credits. Projects must serve lowand moderate-income residents. All nonproﬁt or for-proﬁt organizations are eligible to apply. Applications are accepted throughout the year. Funds are provided through

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Ohio’s unclaimed funds. All loans must meet OHFA criteria and be approved by the OHFA board. Housing Development Assistance Program provides funding for housing activities beneﬁting low-and moderate-income Ohio residents. The program helps community-based, nonproﬁt housing development organizations and for-proﬁt housing developers provide housing for low-income citizens. It also provides “gap” ﬁnancing for eligible housing projects to expand the supply of decent, safe, and affordable housing. Certain nonproﬁt and community-based organizations and forproﬁt developers are eligible to apply. Management Function Management is a “people” process and all organizations are, by deﬁnition, conglomerations of people. The organization may be public or private, large or small, centralized or decentralized. Its goal may be proﬁt, service, control, religion, or other. Whatever the distinction, the manager’s concern in every instance is to foster cooperative interactions and contributions toward organizational concern. In each case the manager must develop people skills, such as communication, analysis, motivation, persuasion, and strategy. While the central concern of public managers is to achieve public goals, action in relation to goals can be achieved in different ways. The president, mayor, governor, Congress, city council, or other pertinent person can take a range of choices. This range can be depicted on the following scale, with each point representing an increase in the amount of government involvement: • • • •

•

Level one—Government acts to inform private company it may or may not take appropriate action. Level two—Government provides ﬁnancial assistance to inﬂuence private company. For example, a small business loan. Level three—Government regulates the behavior of private organizations, such as inspections of restaurants. Level four—Government at one level ﬁnancially supports a government agency at another level. For example, the Federal government provides support to state and local government housing agencies. Level ﬁve—Government creates an agency to pursue a particular goal or goals such as the US Department of Energy.

The following are some cases, which give examples of above ranges of government management: Case One: Commercial Industrial Services The Commercial and Industrial Unit facilitates programs and partnerships to inform, coordinate and integrate opportunities for energy efﬁciency in the commercial, institutional, industrial and transportation sectors. Partnerships provide the foundation for most of the C&I unit’s activities. Only by working together can we develop the

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capacity to sustain efforts to save energy and improve environmental quality while serving the needs of the community. The C&I Unit maintains a portfolio of technical and ﬁnancial resources for energy efﬁciency. The available Programs are: • • • • • • • • • • • • • • • • • •

Clean Cities Motor Challenge; Conversion Facilities Tax Exemption; Energy Efﬁciency Revolving Loan Fund; Ohio Public Facilities Maintenance Association; Federal Energy Management Program (FEMP); Ohio’s Materials Exchange; FIRST; Plant wide Industrial Assessments; Industrial Best Practices; Rebuild America; Industries of the Future; Inventions and Innovation; Energy Smart Community Challenge; Energy Star; Distributed Energy Generation (DG); Electric Partnership Program (EPP); Governor’s Awards for Excellence in Energy Efﬁciency; Home Weatherization Assistance Program.

Case Two: Tax Incentives The Ofﬁce of Tax Incentives (OTI) is responsible for managing the state’s business development tax incentive programs and overseeing the administrative performance of various local property tax incentive programs. Ofﬁce staff also provides support to members of the Tax Credit Authority, who review and approve tax credits for job creation and retention projects throughout the state. The Authority consists of ﬁve members appointed by the Governor, Speaker of the state House of Representatives, and President of the state Senate. OTI staff also provides technical support to communities and local elected ofﬁcials that establish and administer real and personal property tax incentive programs. Such programs require the involvement of OTI in establishing areas eligible for property tax incentives and the execution of select agreements involving the movement of assets within the state. Businesses receiving property tax incentives are required to ﬁle an annual progress report with OTI, which generates an annual program report for the General Assembly on the performance of such incentives. Case Three: Governor’s Excellence in Exporting Award Each year, the Governor of the State of Ohio presents “E” Awards to companies and organizations of all sizes that have increased the number of export-related jobs in Ohio or helped Ohio companies achieve success internationally. In addition, the Governor presents the Exporter of the Year award to one Ohio Company whom

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exempliﬁes the state’s commitment to international trade. Winning companies are honored at a luncheon ceremony held in Columbus, Ohio. Small, medium, and large Ohio-based (for-proﬁt) manufacturers or service businesses can apply for this award, which honors excellence in veriﬁable international exports, direct or indirect, from the state. Ohio agribusiness companies that export the following types of products are also eligible: processed foods, industrial ingredients, specialty foods, commodities, livestock and related technology, and hardwoods. Non-proﬁt corporations and associations that provide trade promotion and assistance services are also eligible. Recognition is based upon new program development and customer success stories with veriﬁcation of the organization’s role in generating export sales. Companies that received the “E” Award in the previous three years are not eligible to apply. Sales ﬁgures may be used by only one corporate entity every three years. Applicants must illustrate and explain trends from one year to the next, as they relate to the following criteria: Total dollar volume of exports; Percentage of export sales to total sales in relation to industry standard; Growth of percentage of export sales to total sales; Job retention, creation, or expansion resulting from export activity; Applicants are encouraged to provide the following elements as supplemental material to support the criteria mentioned above: Demonstrated aggressive international marketing of product line or service, including research activities; Traveled to target markets to meet representatives/agents and study the market(s); Developed foreign language promotional materials and general promotional activities; Developed network of distributors or international ofﬁces or subsidiaries; Developed and marketed a new export product or service; Accomplished breakthrough in a closed or difﬁcult market; Overcame unique obstacles/barriers to successfully export product line or service; Developed training programs for overseas employees; Participated in trade shows; Participated in volunteer or mentor programs for new-to-export companies in the local area; Participated in seminars and training for new-to-export companies; Encouraged other Ohio companies to export; Educated employees on the importance of international trade to their jobs and the company’s overall success. Case Four: CAP Capital Access Program CAP Capital Access Program encourages ﬁnancial institutions to make loans to small businesses having difﬁculty obtaining loans. This program includes different sub-programs: •

• •

MCBAP Minority Contractors Business Assistance Program—sits minority entrepreneurs with loan and bond packaging services, management, technical, ﬁnancial and contract procurement assistance. OMFI Ofﬁce of Minority Business Financial Incentives—provides ﬁnancial assistance to minority and small businesses. OMTS Ofﬁce of Management and Technical Services—provides technical expertise and support to the Minority Contractors Business Assistance

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Program (MCBAP) regional ofﬁces by assisting in providing management and technical services and facilitating conferences, workshops and seminars. PTAC Procurement Technical Assistance Center program—helps state’s small, disadvantaged, and minority businesses sell goods and services to local, state and federal governments. DMBA provides assistance through the Minority Contractors Business Assistance Program (MCBAP), Ofﬁce of Management and Technical Services (OMTS), and the Procurement Technical Assistance Center program (PTAC).

Case Five: Minority Business Financial Incentives In addition, the Division provides ﬁnancial assistance to minority and small business enterprises through the Ofﬁce of Minority Business Financial Incentives (OMFI) and Capital Access Program. OMFI assists minority and small business enterprises through the Minority Direct Loan, Ohio Mini-Loan Guarantee and Minority Bonding Business Programs. The Mission of both programs is to assist socially and economically disadvantaged Ohio businesses in creating wealth and expanding global economic opportunities. A minority business in the State is deﬁned as a business whose ownership is at least 51% owned and controlled by a minority; that is African-American, Asian, Hispanic or Native American. Case Six: Ofﬁce of Management and Technical Services (OMTS) Management and Technical Services provides technical expertise and support to the Minority Contractors Business Assistance Program (MCBAP) regional ofﬁces by assisting in providing management and technical services and facilitating conferences, workshops and seminars. OMTS services are available to existing and start-up minority business enterprises. Management and Technical Services is also responsible for administering the Management and Technical Services Grant Program and fostering and developing partnerships with other state agencies, private organizations, and federal and local governments to facilitate the growth of minority business. Case Seven: Technology Division Making the state boasts a technological excellence. The Ohio Department of Development’s Technology Division is helping advance the tradition through programs designed to provide a sustainable competitive advantage for technologybased businesses within the state. Through strategic partnerships among government, industry, and academia, the Technology Division’s coordinated programs focus on four goals: 1. Fostering an entrepreneurial climate that accelerates the creation and expansion of high-tech, high-growth businesses in the state.

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2. Ensuring that a complete and effective commercialization infrastructure is in place to capitalize upon major areas of research excellence in the state. 3. Advancing the global competitive position of manufacturing and technologybased businesses in the state. 4. Improving the agility and operational efﬁciency of the Technology Division to better serve customers and maximize technology-related opportunities. Three major programs are used by the Technology Division to reach its goals: Edison Technology Centers Each of the ten Edison Incubators provides a comprehensive package of entrepreneurial support to incubator tenants, including expert advice and assistance, links to qualiﬁed funding sources, access to multiple educational opportunities, access to highly qualiﬁed students, technology identiﬁcation and location, a menu of networking events, the availability of specialized ofﬁce and laboratory facilities at attractive terms, and the use of shared business equipment and facilities. The Edison Technology Incubators facilitate the startup and growth of inevitable, scaleable technology-based businesses in the State. These businesses typically employ highly skilled and paid employees. They are generally regarded as the primary drivers of economic growth. In the last 3 years alone, the tenant companies of the Edison Incubators have generated over $160 million in sales revenue, attracted almost $80 million in investment capital, have been awarded 90 SBIR/STTR grants with a value of over $22 million, and have applied for almost 240 patents with almost 90 issued to-date. Through state matching grants and other federal, community, and industry support and partnerships, many of the services, rents and fees are offered at attractive levels; Incubators provide access to funding through a variety of angel, seed, and venture capital networks. All state and technology-based businesses with the potential for signiﬁcant revenue and creation of high quality, high paying jobs are eligible to apply the Edison grants. Edison Technology Incubators Edison Technology Incubators provide low-cost space to reduce operating costs during the start-up phase for technology-based businesses; access to business, technical, and professional services, including legal, accounting, marketing, and ﬁnancial counseling. This program facilitates the start-up and continued growth of new technology-based businesses at reduced costs. Through state matching grants and other federal, community, and industry support, rents and fees are at or below market rates; some incubators provide access to separate seed capital funds. Only new small technology-based state businesses are eligible to apply Edison Technology Incubators. Edison Federal Technology Commercialization Centers The two “gateway” organizations provide companies easier access to the resources of the federal laboratory system, including intellectual property, scientiﬁc and engineering expertise, facilities and equipment. The centers help state’s industry access technology and resources to

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keep companies globally competitive. The Technology Transfer Centers also help the state’s labs, which are signiﬁcant employers in their local economies, to meet federally mandated technology transfer goals. Funding from the National Aeronautics supports the Great Lakes Industrial Technology Center (GLITeC) and Space Administration (NASA) and the Ohio Department of Development primarily to support technology transfer for NASA Glenn Research Center in Cleveland. The Wright Technology Network (WTN) is supported by funding from the Ohio Department of Development and the Air Force Research Laboratory (AFRL) to support technology transfer from the AFRL Technical Directorates in Dayton. Most center services are free. However, in-depth technical assistance from laboratory personnel may require some form of cost reimbursement, and the licensing of proprietary technology will likely entail royalty payments to federal labs. The companies, primarily geared toward technology-based businesses and manufacturers, are eligible to apply. The federal government requires ﬁrms be USbased in order to beneﬁt from federal laboratory technology. Case Eight: Small Business Innovation Research Program The Small Business Innovation Research Program assists companies applying for research funds through the federal Small Business Innovation Research (SBIR) Program. SBIR awards are granted to small businesses in amounts of up to $100,000 (Phase I) and up to $750,000 (Phase II). Ohio’s SBIR Ofﬁce assists businesses in identifying topics for research and development projects, educational services, workshops and conferences. The ofﬁce increases awareness of ﬁnancial opportunities available to Ohio’s research community through the federal government. It also helps Ohio’s research community obtain federal dollars and commercialize successful SBIR-developed products in Ohio. No charge for technical assistance and winners’ support activities; fees may be charged for workshops and conferences. Additional support services are available. For-proﬁt Ohio companies with 500 or fewer employees are eligible to apply. Case Nine: Technology Action Fund Business Beneﬁt: In 2000 and 2001 the Technology Action Board focused Technology Action Fund grants on programs supporting entrepreneurial activity in various technology sectors across the state, contributing to economic development in the state. The fund supports growth and expansion of Ohio’s technology-oriented companies and encourages the creation of quality job opportunities in technologyrelated industry. Technology Action Fund grants are made on a competitive basis. Proposals should be focused on programs supporting entrepreneurial activity in technology sectors across the state which contribute to economic development. Technology Action Fund awards is made on a competitive basis. Proposals are sought at least once a year in focus areas set by the Technology Action Board. The State Controlling Board makes the awards subject to approval by the Technology

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Action Board. The preferred minimum grant request is $100,000. Proposed initiatives should have the capacity for generating substantial economic growth in the state and creating and/or retaining sustainable jobs. References Baxter, N., Opportunities in State and Local Government Careers, Revised by Hope M. Rajala, Published by VGM Career Horizons, (1995). Bingham, R.D. and W.M. Bowen, Managing Local Government: Public Administration in Practice, (Newbury Park, London: Sage Publications, 1992). Cohen, S., The effective public manager: achieving success in a changing government, 1953-, Third Edition (San Francisco: Jossey-Bass, 2002.) Crane, D.P. and W.A. Jones, The Public Manager: Contemporary Challenges and Responsibilities, Jr. (Georgia State University Business Press, 1991). Denhardt, J.V. and R.B. Denhardt, The New Public Service: Serving, Not Steering (NY: M.E. Sharpe, 2003). Gordon, G.J., Public Administration in America, Third Edition (New York: St. Martin’s Press, 1986). Hughes, O.E., Public Management and Administration: An Introduction, Third Edition (New York: Palgrave Macmillan, 2003). Nutt, P.C, Strategic Management of Public and Third Sector Organizations: A Handbook for Leaders, First Edition (San Francisco: Jossey-Bass Publishers, 1992). Osborne, D.E., Reinventing Government: How the Entrepreneurial Spirit is Transforming the Public Sector (New York, NY: Plume, 1992).

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PART III Financial Reforms, Openness, and Private Enterprise Development

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Chapter 9

Causes of the Non-Performing Loan Piling-Up in the Late 1990s: A Research Note1 Ding Lu, Sandre M. Thangavelu, Qing Hu2

1 Introduction The aim of this research note is to provide a correct diagnosis of the non-performingloan (NPL) piling up in China’s banking sector in the late 1990s. The scale of this piling up was unprecedented. With NPL-ratio ofﬁcially amounting to over onefourth of bank loans, the four major state banks, namely the Bank of China (BOC), the Agricultural Bank of China (ABC), the China Construction Bank (CCB), and the Industrial and Commercial Bank of China (ICBC), became technically insolvent [Xu (1998) and Lardy (1998)]. The severity of the issue prompted the government to the Ministry of Finance issued bank restructuring bonds worth RMB 270 billion (US$ 33 billion) to re-capitalize the four state commercial banks by doubling their capital base in 1998. A year later, the government established four state-sponsored asset management companies to take over RMB 1.4 trillion (US$ 169 billion) of bad debts from the banks’ balance sheets.3 Despite these rescue efforts, by 2003 the NPL’s of these four banks still amounted to RMB 2.4 trillion (US$ 290 billion), or 23% of total loans, according to ofﬁcial estimates.4 The timing of the NPL piling up coincided with major strides in banking reforms. The promulgation of a central bank law and a commercial bank law in 1995 marked 1 Translated and reprinted from China Journal of Finance 2(2) (2004): 40–55, with permission from the journal’s editorial board. 2 Lu: Professor, Department of economics, Sophia University and adjunct professor at Fudan University (China). Thangavelu: Associate Professor, Department of economics, assistant dean of Faculty of Arts and Social Sciences, and Director of Singapore Centre for Applied and Policy Economics at National University of Singapore. Hu: Executive Ofﬁcer, the branch in charge of ﬁnancial economics analysis and research. 3 “NPL reduction move on the way”, China Daily, 2 December 2003. 4 Unofﬁcial estimate from some credit-rating agencies even suggests the ﬁgure to be close to RMB 3.5 trillion [“Reforming China’s banks: Don’t bank on a bail-out”, The Economist, 4 December 2003].

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a watershed between a centrally planned mono-bank system and a post-reform modern central banking system based on fractional reserves. Guided by these laws, the four major state-owned banks were restructured and commercialized, with their burdens of providing “policy loans” taken over by three newly established policyloan banks.5 Within the state banks, the “asset-liability management method” was introduced into the accounting system to ensure ﬁnancial independence. A nationwide, inter-bank market started operation in 1996. The emergence and growth of banks and ﬁnancial institutions with plural ownership structures substantially reduced the four major state-owned commercial banks’ share of total bank credits (from over 75% in the early 1990s to below 60% in recent years).6 As a major step to beef up its surveillance over lending risks, the central bank, the People’s Bank of China (PBOC), introduced an accounting standard by the end of 1998 to classify banking loans into ﬁve categories according to their ﬁnancial risks.7 On top of that, a series of regulatory measures were enacted to improve bank governance. Starting in 1998, the PBOC abandoned the credit quota plan to allow state-owned commercial banks to make their own lending decisions. To ameliorate provincial governments’ interference in bank lending, the PBOC consolidated its 30 provincial branches into nine regional centers (Zeng et al, 1999; Standard Chartered, 2001). The late 1990s also witnessed government’s bolstered efforts to restructure the state-owned enterprises (SOEs). When he was designated Premier in 1997, Zhu Rongji vowed to solve the SOE problem in three years. Under his leadership, great efforts were made to harden budget constraints of SOEs in 1997–2000, highlighted by the ofﬁcial policies of “encouraging mergers and consolidation, standardizing and streamlining bankruptcy procedures, downsizing SOEs to raise efﬁciency, replacement and reemployment projects for laid-off workers”. The number of laidoff SOE employees amounted to 6.10 million in 1998 and nearly doubled to 11.74 million in 1999 (Zeng et al, 1999, 2000). With all these developments in banking and SOE reforms, the real cause of the NPL piling up in the late 1990s appears to be a puzzle. On the one hand, the reckless lending of state banks could be a result of government’s ex ante intervention in banking business. Until 1994, the Chinese banks were obliged to make policy-loans, which were granted out of policy or political considerations. Chinese Academy of Social Sciences (CASS) (1998) estimated that policy loans accounted for 35% of total loans made by the state banks in the ﬁrst half of the 1990s, and policy loans are well known for their lower quality compared to commercial loans (CASS, 1999; Xu and Lu, 2001). Due to the discretionary nature of the intervention, ex ante government intervention makes it difﬁcult to measure the banks’ performance. As a result, the Chinese state banks constantly use policy lending as an excuse for their poor records of lending decisions (Zhang, 1999; Xie, 1994). It is quite plausible that 5 The three policy-loan banks are: the National Development Bank, the Agriculture Development Bank of China, and the Export and Import Bank of China. 6 CCER (2000, p. 12) and remarks by Liu Mingkang, PBOC governor, at a news conference on 1 December 2003 (xinhuanet.com, 2003-12-02). 7 These categories are “passed”, “special mention”, “substandard”, “doubtful”, and “loss” (CCER, 2000, p. 10).

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the NPL crisis of the late 1990s was a legacy of the past, in particular the aftermath of the “macroeconomic adjustment” in 1993–1994 when the then vice-premier Zhu Rongji ordered a total credit freeze that forced termination of thousands of projects. It is equally plausible that, in the late 1990s, the state-owned commercial banks did not enjoy real business autonomy and continued to be pressed by governments at various levels to extend low-quality loans to unproﬁtable projects and ﬁrms. On the other hand, the Chinese government has also intervened in the credit market ex post by bailing out troubled SOEs or state-owned ﬁnancial institutions (including banks). The government bailout can take various forms, such as injecting funds to restructure the ailing SOEs, the takeover of non-performing loans, and deliberately delaying the closure of insolvent ﬁnancial institutions. It may also be in the form of government’s implicit guarantee of loan security. Such bailout activities may reduce the banks’ incentive to improve lending efﬁciency, leading to moral-hazard type of risky lending (Xu and Lu, 2001; Xie, 2001). According to Mitchell (1997) and Roland (2000), with expectation for repeated bailouts, banks may “gamble for resurrection” by lending even more recklessly to government-sponsored borrowers. This kind of behavior may occur even when banks have full business autonomy and are able to make lending decisions on their own based on commercial considerations. A correct diagnosis of the main causes of the NPL piling up in the late 1990s has important policy implications. If the main cause of this piling up was the accumulation of low-quality loans due to ex ante government intervention, the rectiﬁcation should be focused on improving bank autonomy and ﬁnancial independence to minimize ex ante government intervention. If the main cause of this crisis was moral hazard lending due to banks’ expectation for government’s ex post bailout, the rectiﬁcation should then be a ﬁrm government commitment to letting the market decide the fate of ﬁnancial institutions. This research note is based on the ﬁndings of a recent study by the authors (Lu, Thangavelu and Hu, 2005). With ﬁnancial data collected from the public listing companies in China’s stock market, we have found evidence that Chinese banks were systematically more risk-taking in giving loans to SOE borrowers and projects favored by government’s industrial policies in the 1990s. Such asymmetric risktaking in lending became more manifest as banking and SOEs reforms intensiﬁed in 1998–1999. The evidence lends support to the diagnosis that moral-hazard lending in hoping for ex post bailout was the main cause of the NPL piling up in the late 1990s. 2 Data and Methodology This study uses a sample of 268 public listing companies in China for the period 1994–1999.8 Using this data for the research has the following beneﬁts: First, the data covers the period 1994–1999, after the setting up of the three policy-loan banks. This removes a major part of policy-lending inﬂuence on bank behavior. Second, the ﬁrm8 Data is collected from Genius Database maintained by Genius Information Technology Co. Ltd., which specializes in the production and distribution of Chinese stock market information. The total number of listed companies in China increased from 275 in 1994 to 815 in 1999. A total of 268 companies had full data for the period 1994–1999.

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level data enable us to identify the degree of state ownership of the listed companies so that a robust analysis on differences in bank ﬁnancing for SOEs and non-SOEs is possible. This allows us to empirically observe the impact of ownership structure on bank lending. Finally, the study is exclusively focused on the part of the banks’ lending that was least distorted by government-orchestrated policy lending. To become a public listing company, a ﬁrm must meet minimum proﬁtability qualiﬁcations and accounting standards set by the stock exchange regulators. These companies are thus perceived as one of the best borrowers and credit worthy groups. The lending to the public listing companies therefore most likely reﬂects banks’ rational business choices. To examine factors that affect banks’ lending decisions, we developed a borrowing ratio model in the following way. Demand for bank loans is mainly a function of the borrower’s ﬁnancial needs and borrowing cost (interest rate) while supply of bank loans is mainly a function of lending risk (or lending safeguard) and lending returns (interest rate). More speciﬁcally, suppose that ﬁrm i’s demand for bank loans at time t is: Litd = f(GEAit, REAit, GSit, PDPit, It)

(1)

Or (by assuming a linear function): Litd = β0 +β1GEAit +β2REAit+β3GSit +β4PDPit + β5It

(1’)

The dependent variable is the borrowing ratio (Lit), deﬁned as the ratio of a company’s corporate borrowing over its total assets. Corporate borrowing is the sum of (current-year) short-term and long-term bank loans and long-term debt with a remaining maturity of no more than one year. On the right-hand-side of the equation, It is interest rate while gross earnings/total assets (GEAit), retained earnings/total assets (REAit), and growth rate of sales (GSit) are proxies for the ﬁrm’s needs for borrowing.9 A ﬁrm with a high earning to asset ratio should be rich in cash and hence has lower needs for borrowing, other things being equal. We therefore expect their coefﬁcients of GEAit and REAit, β1 and β2, to be negative. For a similar reason, higher sales growth implies faster revenue increase and hence may reduce the ﬁrm’s needs for borrowing so we expect the sign for the coefﬁcient of GSit, β3, to be negative. PDPit refers to “Projected Default Probability” (deﬁned in the appendix), a proxy for the ﬁrm’s default risk. A low-risk borrower usually needs less credit than a high-risk borrower because the former would have more avenues to raise funds. Therefore, β4 is expected to be positive. Borrowing cost should have negative incentive for borrowing so the coefﬁcient of interest rate (It), β5, should be negative. On the supply side, the amount of loans the bank is willing to lend to ﬁrm i at time period t is: Lits = f(FAit, SIZit, SO it, TAXit, GSit, PDPit, It

(2)

Or: 9 The correlation between GEA and REA varies from 0.0619 (in 1999) to 0.4114 (in 1996).

Causes of the Non-Performing Loan Piling-Up in the Late 1990s s

2 it

Lit =γ0+γ1FAit+γ2SIZit+γ3 GSit+γ4 SOit+γ5TAXit+γ6PDPit+γ7PDP +γ8It

131

(2’)

where all variables on the right-hand-side except for interest rate (It) are about bank’s lending risk (or lending safeguards). The ratio of ﬁxed assets over total assets (FAit) is a proxy for collateral. Since collateral reduces loan risk, we expect the coefﬁcient of FAit, γ1, to be positive. The value of ﬁrms’ total assets (SIZit), a proxy for ﬁrm size, and growth rate of sales (GSit), a proxy for ﬁrm’s business prospect, all increase loan security so their coefﬁcients, γ2, and γ3, are both expected to be positive. The ratio of state-owned shares in total shares is given as SOit and its coefﬁcient, γ4, would be positive if there exists lending bias to SOEs. State-owned shares are deﬁned as the sum of government shares and legal entity shares.10 The sales-related tax rate (TAXit) is a proxy for government’s industrial policy.11 Firms prioritized by government’s industrial policy may enjoy government’s implicit guarantee or support for their borrowing, so the banks should be more willing to lend to them. Hence we expect the coefﬁcient of TAXit, γ4, to be negative. We presume a non-linear relationship between lending and the default risk (PDPit) for the following reasons: given an interest-rate level, usually the bank would be willing to meet a borrower’s demand for credit if its default risk is within an acceptable range. Beyond that range, higher borrower’s risk must be compensated by interest premiums.12 It is therefore possible to observe a nonlinear relationship between the borrower’s risk and loan amount: the borrowing ratio rises with the borrower’s risk to a certain level and begins to drop after the borrower’s risk exceeds some critical value. Finally, higher lending returns (It) encourages lending, so γ8 should be positive. At equilibrium, market clears when interest rate equates quantity demanded (Litd) and quantity supplied (Lits). For the period under investigation, however, interest rates were uniformly set by the Central Bank.13 Therefore, the amount of loans was either bounded by quantity supplied (when interest rate was below equilibrium level and there existed excess demand) or bounded by quantity demanded (when interest was above equilibrium level and there existed excess supply). Suppose that, of the total ﬁrm population, there were a proportion, ω ∈ [0, 1], of ﬁrms that could borrow the 10 In China’s stock exchange regime, there are ﬁve types of shares: (1) government shares, which are retained in the state institutions and government departments, are not tradable; (2) legal entity shares, which can only be held by other state-owned enterprises, are not listed in the two ofﬁcial exchanges; (3) employee shares are non-tradable until the ﬁrm allows their convertibility; (4) ordinary domestic individual shares, or A shares, can only be purchased and traded by private Chinese citizens in the two ofﬁcial exchanges; and (5) foreign individual shares, which are denominated in foreign currencies, can be purchased and traded in exchanges in China (B shares), in Hong Kong (H shares) or in NYSE (N shares). 11 See Lu (2002) for detailed discussions on the sales-related taxes as one of the major means adopted by China government to support the prioritized industries designated by industrial policy. 12 By using Germany credit ﬁle data, Machauer and Weber (1998) show empirically that the credit line increase with borrowers’ risk, indicating that banks tend to meet the borrowing needs that increase with the borrower’s risk within a certain range. 13 It was not until 2000–2003 when China’s central bank gradually deregulated commercial banks’ lending rates.

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Table 9.1

Variable Description

Variable Description name L Borrowing ratio = (Current-year loan from banks + debt about to mature within one year) / total assets S1 SOE dummy=1 if state-owned share/total share > 0.5, 0 otherwise SO State ownership ratio=State-owned share/total share PDP Projected Default Probability FA Fix asset ratio=Fixed assets/total assets TAX Tax burden=Sales-related tax payment/sales SIZ Firm size =log (Total assets) GEA Gross earning ratio=Gross earnings/Total assets REA Retained earning ratio=Retained earnings/Total assets GS Growth rate of sales

Expected sign of coefﬁcient

>0 α6= (1-ω)γ4 > 0 α8 > 0, α9 <0 α3=(1-ω)γ1>0 α7=(1-ω)γ5<0 α4=(1-ω)γ2>0 α1=ωβ1<0 α2= ωβ2<0 ωβ3+(1-ω)γ3 uncertain

amount of loans they wanted at the ofﬁcial interest rate while the rest of the ﬁrms could not. A randomly selected ﬁrm would have the following expected borrowing ratio: Lˆ it = ω (β0 + β1GEAit + β2REAit+ β3GSit + β4PDPit + β5It) + (1 – ω)(γ0 + γ1FAit + γ2SIZit + γ3GSit + γ4SOit + γ5TAXit + γ6PDPit + γ7PDPit2 + γ8It) = [ω(β0 + β5It) + (1 – ω)(γ0 + γ8It)] + ωβ1GEAit + ωβ2REAit + (1 – ω)(γ1FAit + γ2SIZit) + [ωβ3 + (1 – ω)γ3]GSit + (1 – ω)γ4SOit + (1 – ω)γ5TAXit + [ωβ4 + (1 – ω)γ6]PDPit + γ7PDPit2 (3) Deﬁning α0 = [ω(β0 + β5It) + (1 – ω)(γ0 + γ8It)], in which It is exogenously given, α1=ωβ1, α2= ωβ2, α3=(1 – ω)γ1, α4=(1 – ω)γ2, α5=ωβ3 + (1 – ω)γ3, α6= (1 – ω)γ4, α7=(1 – ω)γ5, α8=[ωβ4 +(1 – ω)γ6], and α9=γ7, we can simplify (3) to a testable model: Lˆ it = α0 + α1GEAit+ α2REAit + α3FAit + α4SIZit + α5GSit + α6SOit+ α7TAXit + α8PDPit + α9PDPit2 + φi + vit

(4)

where φi represents a random effect that is varying over cross section units and invariant over time for a given cross section unit and vit is residual. Table 9.1 lists the variable used in our empirical analysis. 3 Findings of Lending Bias and Asymmetric Risk Taking 3.1 Evidence of Lending Bias The estimation results for the borrowing ratio model (4) are shown in Table 9.2. All coefﬁcients are highly signiﬁcant. The estimation reveals that sales growth has a negative impact on ﬁrms’ borrowing and the impact is the smallest among the

Causes of the Non-Performing Loan Piling-Up in the Late 1990s

Table 9.2

Estimation Results of Borrowing Ratio Model (4)

Dependent variable = Borrowing ratio Fixed asset ratio Tax burden State ownership ratio Size Retained earning ratio Gross earning ratio Sales growth rate Projected default prob. Squared PDP Constant R-square within 0.1684 between 0.3269 overall 0.2998 Baltagi-Wu LBI

Coefﬁcient 0.0420 -0.6081 0.0978 0.0419 -0.6296 -0.2967 -0.0150 0.9301 -2.0965 -0.6510

1.9331

133

14

Std. Err. z 0.0263 1.59 0.1829 -3.32 0.0364 2.69 0.0059 7.14 0.1051 -5.99 0.0278 -10.67 0.0080 -1.87 0.1617 5.75 0.4619 -4.54 0.1269 -5.13 No. of obs No. of groups Wald chi2 Prob > chi2 Durbin-Watson

P>|z| 0.1110 0.0010 0.0070 0.0000 0.0000 0.0000 0.0610 0.0000 0.0000 0.0000 1123 262 254.31 0.0000 1.3100

variables. The signs of the other coefﬁcients meet our hypotheses reasonably well. The signs of coefﬁcients for projected default probability (PDP) and its squared value are in line with the ﬁndings of Machauer and Weber (1998), indicating a nonlinear curve as mentioned earlier.14 These results provide strong support to the hypothesis that bank lending was biased to SOEs. In particular, the positive and signiﬁcant coefﬁcient for state ownership ratio indicates that for every percentage point rise in state ownership ratio there is nearly 0.1 percentage point increase of borrowing ratio. This impact is even greater than that of the proxy for collateral (0.0420 for ﬁxed asset ratio). Meanwhile the estimated coefﬁcient for tax burden, which reﬂects government’s industrial policy, has a signiﬁcantly negative impact (-0.6081) which is greater than that of state ownership in absolute value. This supports the hypothesis that government implicitly guarantees positively inﬂuence banks’ lending decision.15 It is worthwhile to highlight that we obtained robustness of state-owned share impact despite the fact that most public listing non-SOEs were transformed from former SOEs. It exactly testiﬁes that banks’ lending bias was unfavorable even to 14 A GLS random-effect model regression process is applied with a two-step procedure described in Greene (2000) to rectify autocorrelation and heteroscedasticity in panel data. A GLS ﬁxed-effect regression was run for comparison and the resulted ﬁtness is not as good as that of a GLS random-effect regression. 15 To test robustness, we estimated the regressions leaving out one of the independent variables each time and found the estimates of the remaining variables stable and signiﬁcant. We then re-estimated the regression for model (4) by replacing PDP and PDP2 with the ﬁve independent variables in the Logit model, the results conﬁrmed the signs and signiﬁcances of the estimated coefﬁcients in the model. All the estimates of the redeﬁned model remain signiﬁcant with pretty similar values with their counterparts in initial estimated model. The results of these robustness tests are available upon request.

134

Table 9.3

The Revival of Private Enterprise in China

Evidence of Structural Change in Period, 1998–1999

Dependent variable = Borrowing ratio Coefﬁcient Std. Err. z Fixed asset ratio 0.0441 0.0262 1.68 Tax burden -0.6274 0.1823 -3.44 State ownership ratio 0.0986 0.0363 2.72 Size 0.0371 0.0060 6.22 Retained earning ratio -0.6278 0.1044 -6.01 Gross earning ratio -0.2768 0.0281 -9.86 1998–99 dummy × State ownership ratio 0.0316 0.0081 3.91 Sales growth rate -0.0150 0.0080 -1.89 Projected default prob. 1.0496 0.1631 6.43 Squared PDP -2.2955 0.4608 -4.98 Constant -0.5690 0.1283 -4.44 R-square No. of obs Within 0.1906 No. of groups Between 0.3376 Wald chi2 Overall 0.3095 Prob > chi2 Baltagi-Wu LBI 1.9557 Durbin-Watson

P>|z| 0.0920 0.0010 0.0070 0.0000 0.0000 0.0000 0.0000 0.0590 0.0000 0.0000 0.0000 1123 262 274.06 0.0000 1.3449

the SOEs-transformed ﬁrms, which had lowered shares of state ownership in their restructuring process. 3.2 Trends of Lending Bias To test whether banks’ lending bias towards SOEs had any change after China accelerated SOE and banking reforms in 1998, we estimated the above model with a year-dummy assigned to years 1998 and 1999. The results are displayed in Table 9.3. The estimated coefﬁcient for “1998–99-dummy × State ownership ratio” is 0.0316 and statistically signiﬁcant at 1% level of signiﬁcance, suggesting a structural change for 1998–1999 that made bank lending more biased to SOEs. 3.3 Asymmetric Risk Taking Next, we want to check whether banks’ risk taking behavior varied with the ownership status of their clients. For this purpose, we replaced the variable of state ownership ratio in model (4) with two independent variables, “SOE dummy × PDP” and “SOE dummy × squared PDP” and the estimated results are reported in Table 9.4. Here we observe that the estimated coefﬁcient for “SOE dummy × PDP” is statistically signiﬁcant at 1%, while that for “SOE dummy × squared PDP” is not statistically signiﬁcant. Figure 9.1 displays the different impacts of PDP on borrowing ratio for SOEs and non-SOEs. The much higher curve for SOEs suggests that banks were willing to take higher risks for loans lent to SOEs. It is also worth noting that the insigniﬁcance of the coefﬁcient for “SOE dummy × squared PDP” indicates that the curve for SOEs is more likely to be straight and linear—evidence that SOEs at the higher-risk end are likely to get more loans.

Causes of the Non-Performing Loan Piling-Up in the Late 1990s

Table 9.4

135

Evidence of Asymmetric Risk Taking

Dependent variable = Borrowing ratio Coefﬁcient Std. Err. z Fixed asset ratio 0.0439 0.0260 1.69 Tax burden -0.5885 0.1828 -3.22 Size 0.0445 0.0058 7.69 Retained earning ratio -0.6461 0.1052 -6.14 Gross earning ratio -0.2998 0.0281 -10.69 Sales growth rate -0.0117 0.0079 -1.48 PDP 0.4457 0.2581 1.73 Squared PDP -1.2416 0.9215 -1.35 SOE dummy × PDP 0.6559 0.2394 2.74 SOE dummy × squared PDP -1.1233 0.9273 -1.21 Constant -0.6465 0.1222 -5.29 R-square No. of obs Within 0.1744 No. of groups Between 0.3291 Wald chi2 overall 0.3060 Prob > chi2 Baltagi-Wu LBI 1.8955 Durbin-Watson

P>|z| 0.0920 0.0010 0.0000 0.0000 0.0000 0.1390 0.0840 0.1780 0.0060 0.2260 0.0000 1149 264 265.99 0.0000 1.2771

0.14 Impact on SOEs

0.12 0.10 0.08

Average impact 0.06 0.04 0.02

Impact on non-SOEs

0.00 0%

5%

10%

15%

20%

25%

30%

Projected Default Probability

Figure 9.1

Asymmetric Risk Taking Towards SOEs and Non-SOEs

Note: PDP is over 30% for only 14 out of 846 observations. This accounts for less than 2% of all observations. We thus cut off the PDP axis at 30%.

3.4 The Changing Pattern of Asymmetric Risk Taking Finally, we want to know whether the asymmetric risk-taking as regarding clients’ ownership status has changed over time with the progress of China’s banking reforms

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Table 9.5

Evidence of Aggravation of Asymmetric Risk Taking, 1998–1999

Dependent variable = Borrowing ratio Fixed asset ratio Tax burden Size Retained earning ratio Gross earning ratio Sales growth rate PDP Squared PDP SOE dummy × PDP SOE dummy × PDP2 98–99-dummy × SOE dummy × PDP 98–99-dummy×SOE dummy × PDP2 Constant R-square Within 0.1744 Between 0.3291 Overall 0.3060 Baltagi-Wu LBI

Coefﬁcient Std. Err. z 0.0443 0.0258 1.71 -0.5763 0.1821 -3.16 0.0432 0.0058 7.48 -0.6260 0.1044 -6.00 -0.2789 0.0282 -9.89 -0.0119 0.0079 -1.50 0.5427 0.2593 2.09 -1.5042 0.9232 -1.63 0.5273 0.2390 2.21 -0.6962 0.9288 -0.75 0.4063 0.1715 2.37 0.0729 1.1975 0.06 -0.6297 0.1217 -5.17 No. of obs No. of groups Wald chi2 Prob > chi2 1.8955 Durbin-Watson

P>|z| 0.0860 0.0020 0.0000 0.0000 0.0000 0.1330 0.0360 0.1030 0.0270 0.4540 0.0180 0.9510 0.0000 1149 264 265.99 0.0000 1.2771

and SOE reforms. For this purpose, we added in two more independent variables, “98–99-dummy × SOE dummy × PDP” and “98–99-dummy × SOE dummy × squared PDP” to the model. The results are reported in Table 9.5. Now we observe that both the estimated coefﬁcients for “SOE dummy × PDP” and “98–99 dummy × SOE dummy × PDP” are statistically signiﬁcant within 5%. Based on the results in Table 9.5, we can identify the differences in risk taking overtime and across clients’ ownership types, as displayed in Figure 9.2. The curves in the diagram manifest that banks were not only willing to take higher risks when lending to SOEs, but also became much more risk taking in lending to SOEs during the last two years of the 1990s. Meanwhile, they appeared to be quite cautious in lending to non-SOEs. 4 Implications The implications of our empirical results can be summarized as follows: 1. The Chinese banks had a systematic lending bias in favor of SOEs during the period 1994–1999. 2. The high-risk SOEs were able to borrow more bank loans than low-risk SOEs and non-SOEs. In other words, banks were willing to take higher default risks when lending to SOEs. 3. Bank lending became more biased to SOEs in years 1998–1999, as compared to 1994–1997.

Causes of the Non-Performing Loan Piling-Up in the Late 1990s

137

0.30 Impact on SOEs 98–99

0.25

Impact on SOEs 94–97

0.20 0.15 0.10 Average impact

0.05 0.00 0%

5%

10%

15%

20%

Projected Default Probability

Figure 9.2

25%

30%

Impact on non-SOEs

Asymmetric Risk Taking Over Time

4. Banks became more willing to lend to high-risk SOEs during 1998–1999 as compared to 1994–1997. The ﬁrst two results may have been driven by two competing hypothetical explanations as mentioned earlier. One assumes that government has ex ante the banks bailed out intervention to direct bank lending in favor of high-risk SOEs. Or in other words, high-risk SOEs mainly at government request. The other proposes that lending in favor of high-risk SOEs was banks’ rational business choice upon the expectation for implicit government guarantees for those loans—a moral-hazard behavior induced by ex post government bailout for banks. With the expectation, the banks were willing to provide liquidity to keep aﬂoat the ﬁrms in ﬁnancial distress despite that the latter’s cash ﬂow was already trickling to zero, or even had become negative. By keeping these ﬁrms from going bankrupt, the banks could avoid a straightforward default of the debts owed by these ﬁrms, holding on to the hope for a government-sponsored ex post bailout or takeover (Mitchell, 1997; Roland, 2000, pp. 308–9). The third and fourth results lend strong support to the hypothesis of moral-hazard behavior in banks’ lending. A series of banking reforms were carried out after 1994 to restructure the major state banks to be more like full-ﬂedged commercial banks, especially by substantially reducing their burdens of providing “policy loans” and granting greater business autonomy to these banks. The government also stepped up efforts to restructure SOEs in the late 1990s by hardening their budget constraints. All these developments should have reduced the overall degree of government’s ex ante intervention in banks’ lending to SOEs. If the hypothesis of an ex-ante interventiondriven lending were true, we would have not observed an escalation of lending bias and asymmetric risk-taking in the later years of the period under study. It is therefore more comprehensible that the banks’ reckless lending to high-risk SOEs was driven by moral-hazard behavior, especially in the backdrop of the RMB 1.7-trillion (ex post) bailout for the four big banks in the period 1998–1999. The aggravation of the banks’ lending bias and asymmetric risk-taking in favor of SOEs in the later years of the 1990s could best be explained by the hypothesis

The Revival of Private Enterprise in China

138

of rational lending inspired by possible future ex post bailout plans. Such ex post bailout did happen again when the PBOC injected US$ 45 billion of China’s foreign reserves in January 2004 to boost the capital-adequacy ratios of China Construction Bank (CCB) and Bank of China (BOC), two of the four big state-owned commercial banks.16 Our results offer a diagnosis of the real causes of the NPL piling up in the late 1990s. This diagnosis may shed light into the recent round of credit expansion in China’s banking sector since 2002 and the policy measures to prevent the formation of another piling up of non-performing loans. Appendix: Projected Default Probability Ideally, a bank’s perspective for a ﬁrm’s default risk should be the bank’s credit rating of ﬁrms, which is not available to the public. To construct a proxy for the ﬁrm’s (bank-perceived) default risk, we construct a binary logistic model (Logit model) to produce a predicted default probability (PDP) for each ﬁrm and for each year. This type of model is quite popular in the literature of predicting ﬁnancial distress, bankruptcy or default.17 A binary logistic model of predicted default probability can be described as follows: Let Xi denote a vector of predictors for the ith observation; let θ be a vector of unknown parameters. A logistic probability function of default for any given Xi and θ is given by: P(Xi, θ) = [1 + exp(–θ'Xi)]-1

(5)

The unknown parameters θ are estimated by the maximum likelihood method. The logarithm of the likelihood function is given by: l(θ) =

ΣlogP(X , θ) + Σlog(1 – P(X , θ)) i∈F1

i

i∈F2

i

(6)

where F1 is the set of default ﬁrms and F2 is the set of non-default ﬁrms. Once the estimators for θ are obtained, the predicted default probability can be computed. The performance of a Logit model can be evaluated by the prediction accuracy given a cutoff value of P ∈ (0, 1). In this study, a default event is identiﬁed if a ﬁrm loses money two years in a row. Let Eit be the event of default or non-default for ﬁrm i at time t. Eit equals 1 if ﬁrm i suffers a loss in time t−1 and t−2. We assume that a ﬁrm has difﬁculties in making

16 A major purpose of this “indirect bailout” was to refresh the banks’ balance sheet with the injected funds so that they could soon list their shares on the stock market and be able to make new, supposedly more proﬁtable, lending [“Recapitalising China’s banks”, The Economist (UK), 8 January 2004]. 17 See Altman and Saunders (1998) for a review of credit risk measurement and prediction. Although other popular credit risk measurement schemes are available, such as the discriminant analysis model, the probit model and VAR (Value at risk) model (e.g. KMV model), we chose logit model mainly because of its well-known convenience.

Causes of the Non-Performing Loan Piling-Up in the Late 1990s

Table 9.6

Variable DE DMC WCA LS LEQ Constant

139

Estimation Results of Logit Model for Default Probability Prediction Coefﬁcient 0.0031 4.7789 1.0701 -1.4258 0.7233 1.7098

Std. Err. 0.0021 1.2985 1.1667 0.4136 0.5525 4.1414

Z 1.51 3.68 0.92 -3.45 1.31 0.41

P>|z| 0.1320 0.0000 0.3590 0.0010 0.1900 0.6800

repayment when two consecutive years of losses are incurred.18 Thus in our model, if a ﬁrm never makes a loss in two consecutive years during the sample period, Eit equals 0 for any given i and t.19 In fact, most of the defaulted ﬁrms deﬁned in our study lost money in a successive three-year period. China’s stock market watchdog, China Security Regulatory Commission, deﬁnes a ﬁrm as an “ST ﬁrm”20 if it has experienced three-year losses in a row. In this case, the daily price ﬂuctuation of an “ST” stock is restricted to a special limit of 5% rather than a normal limit of 10%. In most of the applications of the default probability model, the predictors Xi include accounting ratios, such as returns on capital, current ratio, etc. However, the predictors vary considerably in different studies (Altman, 1968; Altman, Haleman and Narayanan, 1977; Ohlson, 1980; Platt and Platt, 1991). For our purpose, we used 20 variables, among which 15 variables are key ratios or supplemental ratios used in S&P corporate bond rating. By using backward stepwise regression technique, we identiﬁed ﬁve variables that are of the best predictive power. These ﬁve variables are: total debt/EBITDA (DE),21 total debt/market value of capitalization (DMC), working capital/total assets (WCA), log sales (LS), and log equity (LEQ).22 We use the average value of t–1 and t–2 years’ data of these variables to estimate the Logit model that projects the default probability in year t. In Table 9.6, the estimation results of the Logit model with default probability are given. The signs of most coefﬁcients are as expected: high debt burdens (DE and DMC) raise the likelihood of default; high working capital ratio may be a sign

18 Of the 846 observations used in Logit model estimation, there are 43 occurrences of a ﬁrm with two consecutive years of losses. None of the ﬁrms in the sample involves more than one occurrence of such events. 19 The notion of ﬁnancial distress if a ﬁrm suffers two-year losses is also used in Coats and Fant (1993). 20 ST means “specially treated”. 21 EBITDA represents earnings from continuing operations before interest, taxes, depreciation, and amortization. 22 The “total debt” in DE and DMC refers to total unpaid debt owed by the bank while the “borrowing” in L refers to current year bank loans and debt about to mature within one year. For years 1994–1999, the correlation between L and DE varies from –0.02 to 0.27 while that between L and DMC varies from 0.60 to 0.69.

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of operational inefﬁciency or pileup of inventory; and large sales revenue increases cash ﬂows. Only that of LEQ is not of the expected sign and somewhat puzzling.23 The model-projected default probability varies from 0 to 0.5885 for the sample, with a mean of 0.0540, a median of 0.0396, and a standard deviation of 0.0502. With a cutoff value of 0.045, our model classiﬁes correctly 28 out of 43 default cases and 535 out of 803 non-default cases. The classiﬁcation accuracy is 65.1% for the nondefault cases, 66.6% for default cases. The overall prediction accuracy is 66.5%. References Altman, E.I. “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance, 23, 4 (1968): 589–609. Altman, E.I. and Saunders, A., “Credit Risk Measurement: Developments over the Last 20 Years,” Journal of Banking and Finance, 21 (1998): 1721–42. Altman, E.I. and Haleman, R.G. and Narayanan, P., “ZETA Analysis: A New Model to Identify Bankruptcy Risk of Corporations,” Journal of Banking and Finance, 1 (1977): 29–54. China Center for Economic Research (CCER), “China’s Financial System Reform: Retrospect and Prospect,” CCER Working Paper Series, No.C2000005 (2000). Chinese Academy of Social Sciences (CASS), “Macro Situations, Financial Risk and External Shock,” Economics Research Journal (Jingji Yanjiu), 3 (1998): 3–14. Chinese Academy of Social Sciences (CASS), “Investment, Cyclic Fluctuation and Institutional Retrenchment Effect,” Economic Research Journal (Jingji Yanjiu), 3 (1999): 16–25. Coats, P. and Fant, K., “Recognizing Financial Distress Patterns Using a Neural Network Tool,” Financial Management 22, 3 (1993): 142–55. Greene, W.H., Econometric Analysis, (New York: Prentice Hall, 2000). Lardy, N.R., “China and the Asia Financial Contagion,” Foreign Affairs, 77 (4) July/ August (1998): 78–89. Lu, D., “Revamping the Industrial Policies,” in Shang-Jin Wei, G.J. Wen, and H. Zhou eds. The Globalization of the Chinese Economy (Cheltenham, UK: Edward Elgar, 2002), 13–33. Lu, D., Thangavelu, S.M. and Hu, Q., “Biased Lending and Non-performing Loans in China’s Banking Sector,” Journal of Development Studies, 41, 6 (2005): 1071– 91. Machauer, A. and Weber, M., “Bank Behavior Based on Internal Credit Ratings of Borrowers,” Journal of Banking and Finance, 22 (1998): 1355–83. Mitchell, J., “Strategic creditor passivity, regulation, and bank bailouts,” LSE/Center for Economic Performance Discussion Paper 1780 (London: 1997). Ohlson, J.A., “Financial Ratios and the Probabilistic Prediction of Bankruptcy,” Journal of Accounting Research, 18, 1 (1980): 109–30.

23 It is possible that companies with larger equity may be less cautious in using their funds. Since this issue is beyond the scope of this research project, we leave this puzzle for future research.

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Platt, H.D. and Platt, M., “A Note on the Use of Industry-relative Ratios in Bankruptcy Prediction,” Journal of Banking and Finance, 15, 1 (1991): 183–94. Roland, G., Transition and Economics: Politics, Markets, and Reforms, (Cambridge and Massachusetts: The MIT Press, 2000). Standard Chartered, “China’s Banking System in Transition, Business Intelligence No. 6 – China,” (2001) www.tdctrade.com/econforum. Xie, P., “On state Specialized Banks Reform” (in Chinese), Economic Research Journal (Jingji Yanjiu), 2 (1994): 643–65. Xie, P., “The Debate on the Reform of China’s Rural Credit Cooperatives System” (in Chinese), Journal of Financial Research (Jinrong Yanjiu), 1 (2001): 1–13. Xu, G. and Lu, L., “Incomplete contract and moral hazard: China’s ﬁnancial reform in 1990s” (in Chinese), Journal of Financial Research (Jinrong Yanjiu) 2 (2001): 28–41. Xu, X., “Bank Crises: Possibility and Prevention” (in Chinese), Reform (Gai Ge) 2 (1998): 19–23. Zhang, J., “Non-performing Loans of Sate-owned Banks in Transition Economy” (in Chinese), Journal of Financial Research (Jinrong Yanjiu), 5 (1999): 35–40. Zeng, P. et al eds, Report on China’s National Economic and Social Development for 1998 (Beijing: China Planning Publisher, 1999). Zeng, P. et al eds, Report on China’s National Economic and Social Development for 1999 (Beijing: China Planning Publisher, 2000).

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Chapter 10

Public Venture Capital: Understanding the US and Chinese Experiences Changwen Zhao, Shuming Bao, Chunfa Chen1

1 Introduction It has been well recognized that venture capital has made signiﬁcant contribution to the development of start-ups and economic growth of many countries, especially the United States in the last two decades. Venture capital has been known to facilitate innovation, characterized by the introduction of new products, processes or services on the market that directly contribute to improve economic performances. Besides, it also helps in developing an absorptive capability. An increased VC intensity makes it easier to absorb the knowledge generated by the universities and ﬁrms, and therefore improves aggregate economic performance (Romain and Potterie 2003). So it has been embraced as a key tool for economic and technological development by policymakers, academics and business community. During its development, the government has played a signiﬁcant role in facilitating the development of venture capital industry by establishing programs which are referred to as public venture capital. Public venture capital has been a very important ﬁnancing alternative, and a considerable proportion of capital is publicly ﬁnanced (see OECD 1996). The US Small Business Administration provides ﬁnancing to start-up businesses. The governments of Great Britain, France, Belgium, and the Netherlands also have ﬁnancial programs, to assist unemployed workers who start businesses (Bendick and Egan 1987, OECD 1996 and 1997). Germany, Japan, Israel, China and a group of other nations have also adopted various programs to assist start-ups with publicly ﬁnanced venture capital. Vaillancourt (1997) shows that 44% of the stock of venture capital in Canada in 1994 was in the form of public funds (funds ﬁnanced by the government, or funds that beneﬁted from tax incentives). 1.1 The Deﬁnition of Venture Capital and Public Venture Capital Venture capital has been deﬁned in various ways, one of which recognizes it as a professionally managed pool of money raised for the sole purpose of making actively1 Zhao: Business School, Sichuan University, PRC, [email protected]. Bao: Jiangxi Normal University and China Data Center, University of Michigan Chen: Business School, Sichuan University, PRC, [email protected]..

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managed direct equity investments in rapidly-growing hi-tech companies, and with a well-deﬁned exit strategy. It is always closely related with the entrepreneurship, the ability to marshal resources to seize new business opportunities (Organization for Economic Cooperation and Development, 2000). Venture capital can be divided into private venture capital and public venture capital by the source of funds and the performer. Private venture capital funds are professionally managed, and have risk-equity capital invested primarily in innovative and/or rapidly expanding enterprises (US National Venture Capital Association, 2000). Along with providing funds by purchasing equity securities, these funds also add value by actively participating in the development of the company. Public venture capital is a subset of “public investment,” and it is a variety of the mechanisms that have been created by the governments to encourage knowledge-based economic development. These programs have in common the commitment of public funds to support the entrepreneurial development of technology in situations where private venture capital ﬁnds it too risky to venture (Henry Etzkowitz et al, 2002). We deﬁne public venture capital as a typical government ﬁnancial program that supports the new technology R&D and commercialization of small businesses, and it is a complex, consisting of a variety of grants, loans, subsidies, even equity investment, at the central or local levels of the government. 1.2 Public Venture Capital: Its Role and Characteristics Despite of the important role public venture capital has played, academic attention in this respect has remained limited. This contrasts with the theoretical and empirical ﬁnance literature on venture capital in general. David L. Barkley et al (1999) suggested that the state-backed venture capital programs serve one or more of the following goals: to encourage general economic development; to enhance economic opportunities for geographically isolated regions or economically disadvantaged populations; to enhance availability of early stage or seed capital investments; and to create venture capital infrastructure and management capacity within the state and so on. Lerner (1999) documents that one of the most important and visible federal programs, the Small Business Innovation Research (SBIR) grant program, which provides grants to small businesses for feasibility and development research in hi-tech areas, designed to correct a perceived market gap in the equity ﬁnancing of young, technology-based companies, has proven very successful at fostering technological innovation and corporate growth. Public venture capital funds generally expect lower rates of return than those sought by private venture capitalists and they often operate with a geographic or community focus. The funds may operate with a dual bottom line, considering both social and ﬁnancial returns on investments (Barkley et al, 2001). David L. Barkley et al (2001) propose that the industrial focus and geographic concentration of venture capital activity contributed to the view that certain industries and regions of the country are underserved by private venture capital ﬁrms. Private venture capitalists are not willing to seek aggressively investment opportunities in small metropolitan areas and non-metro communities because deal ﬂow is sparse, costs

Public Venture Capital

145

per investment are relatively high, exit opportunities are limited, and local business environments are less supportive. Public venture capital programs can play a role in certifying new ﬁrms to outside investors (Lerner 2002). This is one way to overcome the informational asymmetries. The idea is that government programs can identify and support the creation of new ﬁrms in industries that do not attract private venture capital (for example, technologyintensive industries). In recent years, government interest in ﬁnancing new ﬁrms has surged, particularly in many European and Asian nations. While these efforts have proliferated, a consensus as to how to structure these “public venture capital” programs remains elusive. Josh Lerner (2002) points out that government ofﬁcials must seek to understand the business environment in which young, hi-tech ﬁrms operate. Yet some scholars propose a limited role by the government and regard government as a supplement, not the substitution for market. After examining the success factors of Silicon Valley, Gary S. Becker (2000) have concluded that dynamic industrial clusters require a ﬂexible economic environment, not government industrial policy. Oana Secrieru1 and Marianne Vigneault (2004) have proposed that governments should not interfere in business decisions beyond the provision of capital, unless they have enough expertise to provide the right level of advice. Public venture capital distinguishes itself from private venture capital primarily in several ways. First of all, public VC is funded by the central or local governments while private VC is funded by private sector. Secondly, private venture capitalists are always willing to invest in those ﬁrms with higher expected economic returns while public VC programs are more concerned about social returns: growth of hitech ﬁrms, development of technology and local economy. Besides, private VC is basically more attracted to the hi-tech companies sitting on the expansion stage while public VC usually ﬁnances the start-ups, because entrepreneurs have been least successful with raising appropriate ﬁnance for initial operations. Fourthly, public VC ﬁnances small businesses with a variety of ﬁnancial instruments in the form of grants, loans, loan guarantee, direct subsidies and so on. Meanwhile, private VC is involved in equity investment and requires equity in exchange. Last, private VC funds, in general, are organized as limited partnerships with a predetermined life of ten years. However, the organization structure of public VC varies by the level, country and objectives. It has been recognized that the public VC is important for many new start-ups at their early stage of development, especially in those countries under a transition from centrally planned economy to market economy with a bank-based ﬁnancial system, although public VC and private VC may function in different ways. 1.3 Objectives and Organization With a comparison of public venture capital and private venture capital in both China and the Unites States, this chapter will explore the issues as: Why and where should the public VC be invested and their relationship with private venture capital? How can the public VC be more efﬁcient for funding hi-tech start-ups? And what are the strategies to integrate public and private public VC?

Table 10.1

All SBIC Program Licensees: Financing to Small Businesses (in millions US$)

Initial Financing Follow-on Financing FY ended # $ # $ Sep 1993 1,086 $442.70 906 $363.60 Sep 1994 1,241 $517.00 1,107 $483.60 Sep 1995 1,322 $724.70 899 $524.30 Sep 1996 1,081 $1,021.90 1,026 $594.10 Sep 1997 1,360 $1,658.30 1,371 $710.70 Sep 1998 1,721 $2,037.10 1,735 $1,202.30 Sep 1999 1,379 $2,925.80 1,717 $1,295.10 Sep 2000 2,251 $3,859.70 2,388 $1,606.60 Sep 2001 1,477 $2,497.10 2,800 $1,958.20 Sep 2002 1,060 $1,273.80 2,944 $1,385.80 Sep 2003 1,624 $1,455.80 3,209 $1,015.40 Source: SBA Website at http://www.sba.gov.

Total Financing # $ 1,992 $806.30 2,348 $1,000.60 2,221 $1,249.00 2,107 $1,616.00 2,731 $2,369.00 3,456 $3,239.40 3,096 $4,220.90 4,639 $5,466.30 4,277 $4,455.30 4,004 $2,659.60 4,833 $2,471.20

Straight Debt # $ 1,361 $192.80 1,608 $215.60 1,508 $259.20 1,145 $187.90 1,380 $240.10 1,890 $363.40 1,061 $276.50 1,713 $392.70 1,066 $289.70 1,118 $320.30 2,223 $506.30

Debt with Equity # $ 293 $237.50 350 $330.50 275 $348.60 411 $534.60 640 $756.00 631 $705.30 846 $887.40 960 $1,052.30 1,349 $903.40 1,430 $688.50 1,364 $598.30

Equity Only # $ 338 $376.00 390 $454.50 438 $641.20 551 $893.50 711 $1,372.90 935 $2,170.70 1,189 $3,057.00 1,966 $4,021.30 1,862 $3,262.20 1,456 $1,650.80 1,246 $1,366.60

Table 10.2

All SBIC Program Licensees: Financing to Small Businesses by Age of Business (in millions US$)

Under 3 Years 3 to 6 Years Fiscal Year Funds % Funds % 1993 440.3 54.6 138.2 17.1 1994 582.1 58.2 178.4 17.8 1995 699.3 56.0 177.0 14.2 1996 878.2 54.3 246.0 15.2 1997 1,174.7 49.6 441.1 18.6 1998 1,790.5 55.3 492.8 15.2 1999 2,243.2 53.1 750.5 17.8 2000 3,427.4 62.7 963.2 17.6 2001 2,568.3 57.6 970.0 21.8 2002 1,281.7 48.2 588.5 22.1 2003 1,065.5 43.1 642.6 26.0 Source: SBA Website at http://www.sba.gov.

6 to 10 Years Funds % 85.0 10.6 101.2 10.1 140.6 11.3 195.2 12.1 334.0 14.1 350.2 10.8 328.0 7.8 323.9 7.2 285.4 6.4 312.8 11.8 334.3 13.5

Over 10 Years Funds % 142.8 17.7 138.9 13.9 232.1 18.6 296.6 18.4 419.1 17.7 606.0 18.7 899.2 21.3 681.8 12.5 631.6 14.2 476.6 17.9 428.7 17.4

Total Funds 806.3 1,000.6 1,249.0 1,616.0 2,369.0 3,239.4 4,220.9 5,466.3 4,455.3 2,659.6 2,471.2

% 100 100 100 100 100 100 100 100 100 100 100

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The Revival of Private Enterprise in China

This rest of the chapter is organized as follows. Section II examines the public VC programs at Federal and State Levels in the United States. Then in section III, we offer the current situation of Chinese venture capital development and the present public venture capital program—IFSTF at the central government level and matching funds at the provincial and municipal level. Section IV focuses on the models that integrate public and private venture capital both in the US and China. And in the last section we present some discussion and suggestions on government policies. 2 A Review of the US Public Venture Capital Programs In the US, both the federal and local governments have initiated polices aimed at establishing VC industry and encouraging the development of venture capital, though more so in the early years of VC and indirect in most cases. 2.1 SBIC The most important direct US government involvement in venture capital was the passage of the Small Business Investment Act of 1958 authorizing the Small Business Administration (SBA) to license Small Business Investment Corporations (SBICs). The SBICs partner with the federal government to provide venture capital for startups or business expansions. They could borrow leverage equal to 300% of its private capital up to US$300,000 at a favorable 5% rate through the Federal Government. Using a combination of private funds and funds borrowed from the federal government, the SBICs provide equity capital, long-term loans (up to 20 years, with a possible 10-year extension), and management assistance to eligible small businesses. SBICs provided small businesses with either loans or a loan with debentures convertible to common stock (Avnimelech et al, 2004 working paper). Public VC investments are usually substantial compared to contemporaneous private investments in new ﬁrms. For instance, the SBIC program led to the provision of more than $3 billion to young ﬁrms between 1958 and 1969, more than three times the total private VC investment during the same period. In 1995, the sum of the ﬁnancing provided through and guaranteed by public VC programs in the United States was at least $2.4 billion, a substantial amount relative to the $3.9 billion disbursed by traditional venture funds in that year. Perhaps more signiﬁcantly, the bulk of the public funds were for early-stage ﬁrms, which in the past decade have only accounted for about 30% of the disbursements by traditional venture funds. These programs offered support to some of the most dynamic technology companies, such as Apple Computer, Chiron, Compaq, Federal Express, and Intel when they were still private entities. Particularly in Silicon Valley, a number of individuals used their SBICs to leverage their personal capital, and some were so successful that they were able to reimburse the program and raise institutional money to become venture capitalists themselves (see Tables 10.1–10.4). However, the practice once deviated from its original intention due to the illdeﬁned criteria for approving the licenses. It attracted licensees from a wide variety of industries including real estate, product distributors, and simply unscrupulous

Public Venture Capital

Table 10.3

149

Financing to Start-up Businesses (Aged 2 Years or Less)

Number of Financings Fiscal Year # % 1993 871 43.7 1994 1,091 46.5 1995 1,049 47.2 1996 970 46.0 1997 1,016 37.2 1998 1,456 42.1 1999 1,171 37.8 2000 2,149 46.3 2001 1,719 40.2 2002 1,178 29.4 2003 1,352 28.0 Source: SBA Website at http://www.sba.gov.

Amount of Financing $ % 383.8 47.6 484.6 48.4 583.9 46.8 744.8 46.1 999.8 42.2 1,566.90 48.4 1,874.20 44.4 2,733.30 50.0 2,012.40 45.2 849.10 31.9 839.80 34.0

individuals apart from the young venture capitalists. Besides, some SBICs tried to do arbitrage business by lending to mature enterprises due to most favored interest from federal government and repayment pressure, instead of ﬁnancing start-ups and new ﬁrms. In addition, some SBICs, especially corporations with publicly traded stocks put a lot of money in M&A, because individual investors were always reluctant to take high risk with the equity portfolio, even when it is possible to get high premium. Thirdly, it is hard to attract and train professional capitalists due to lack of incentive mechanism (Fenn, Liang, and Prowse, 1995). Finally, as a government agency it was very bureaucratic for its constantly changing rules and regulations. 2.2 SBIR The Small Business Innovation Research (SBIR) program encourages small businesses to explore their technological potential and provides incentive to proﬁt from its commercialization. SBIR targets the entrepreneurial sector because that is where most innovation and innovators thrive. Usually the risk and expenses of conducting serious R&D efforts are often beyond the means of many small businesses. By reserving a speciﬁc percentage of federal R&D funds for small business, SBIR protects the small businesses and enables it to compete on the same level with larger businesses. SBIR funds the critical startup and development stages and it encourages the commercialization of the technology, product, or service, which, in turn, stimulates the US economy. By providing over $7 billion since its formation for R&D to small businesses that lack the budgets of large science and technology corporations, SBIR essentially plays a vital role in stimulating the technology economy, functioning similarly as seed VC. Yet, companies do not have to give up any equity or intellectual property rights to the technology developed in SBIR; but they must grant a “no fee license” to the Federal Government for its use. SBIR grants have a clear value for high tech startups as they are focused solely on small, hi-tech ﬁrms. SBIR has proven itself to

150

Table 10.4

The Revival of Private Enterprise in China

All SBIC Program Licensees: Industry Distribution of Financing by Major NAICS Sector Group

Major NAICS Sector Group Agriculture, Forestry, Fishing and Hunting Mining Utilities Construction Manufacturing Wholesale Trade Retail Trade Transportation and Warehousing Information Finance and Insurance Real Estate and Rental and Leasing Professional, Scientiﬁc and Technical Serv. Management of Companies and Enterprises Administrative and Support and Waste Mgt. Educational Services Health Care and Social Assistance Arts, Entertainment and Recreation Accommodation and Food Services Other Services (except Public Admin.) Unclassiﬁed Total Source: SBA Website at http://www.sba.gov.

1999 0.3 1.7 0.1 2.3 38.1 8.5 2.4 5.3 17.9 1.6 0.5 7.7 1.6 3.2 1.2 2.5 2.1 0.1 1.3 1.7 100%

2000 0.3 1.3 0.3 2.2 33.5 3.8 4.3 6.4 21.8 1.1 0.7 12.9 1.8 1.0 0.5 1.4 3.1 0.3 0.5 2.8 100%

2001 0.0 0.1 0.2 1.3 25.6 4.2 2.4 1.6 26.9 1.5 0.2 27.2 0.1 3.0 1.4 1.1 0.4 1.1 1.4 0.4 100%

2002 0.1 1.0 0.2 1.3 27.7 3.4 2.6 2.3 23.5 1.4 0.4 22.5 0.1 2.9 1.6 2.7 0.2 3.8 1.1 1.2 100%

2003 0.1 0.2 0.5 3.1 28.2 2.8 2.5 9.2 16.9 3.9 0.7 15.2 1.8 3.8 1.0 4.0 0.6 2.4 1.3 1.8 100%

be consistently successful in funding technologies with real commercial prospects. However, the pool for SBIRs is still relatively small, and therefore the impact they can produce is limited, and the process may be slower than a competitive market may permit in the fast-paced world of technology. Josh Lerner’s study shows that SBIR program has provided over US$6 billion to small hi-technology ﬁrms between 1983 and 1995, and 32 ﬁrms which received SBIR grants grew signiﬁcantly faster than a matched set of non-awardees over a ten-year period and suggests that these grants allowed ﬁrms to overcome ﬁnancing constraints which otherwise would have proven binding. 2.3 STTR The Small Business Technology Transfer Program (STTR) is one under which awards are made to small business concerns for cooperative research and development, conducted jointly by a small business and a research institution. STTR, although modeled substantially on the Small Business Innovation Research (SBIR) Program, is a separate program and is separately ﬁnanced. Subject to availability of funds, Department of Defense Components will support high quality cooperative research and development proposals of innovative concepts to solve the listed defense-related

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scientiﬁc or engineering problems, especially those concepts that also have high potential for commercialization in the private sector. The STTR Program is designed to provide a strong incentive for small companies and researchers at research institutions, i.e., non-proﬁt research institutions, contractoroperated federally funded research and development centers, and universities, to work together as a team to move ideas from the research institution to the marketplace, to foster hi-tech economic development, and to address the technological needs of the armed forces. The technologies and products are transferred from the laboratory to the marketplace by reserving a speciﬁc percentage of federal R&D funding for award to such partnership. 2.4 NMVC Low-income communities usually face barriers to sustainable growth. A common obstacle for virtually all such communities is that they are unable to attract sufﬁcient equity capital and technical assistance for starting and expanding businesses due to lack of infrastructure supply, longer investment cycle, and limited return. The supply of venture capital is concentrated geographically, and venture capital investments are focused in a small number of regions and industries. According to the 2000 Price Water house Coopers survey, 71% of US venture capital investments were in ﬁve States—California, Colorado, Massachusetts, New York, and Texas, and 91% of the investments were in technology and Internet-related companies. The New Markets Venture Capital (NMVC) Program, established in December 2000, is a developmental VC program designed to promote economic development of, intensive technology assistance to, and the creation of wealth and job opportunities in, low-income (LI) geographic areas and among individuals living in such areas, through public-private partnerships between SBA and newly formed NMVC Companies (NMVCCs) and existing Specialized Small Business Investment Companies (SSBICs). Therefore, Congress appropriated FY2001 funding of $150 million for debenture guarantees and $30 million for operational assistance grants to supplement the private capital that is raised by NMVC companies(Recipients), which are required to use the grant funds to provide speciﬁc, no cost Operational Assistance (OA), directly or indirectly, through third parties and afﬁliates, to small enterprises, in which it has made or expects to make equity capital investments (actual or prospective portfolio concerns). Grant funds include both the Federal funds obligated by SBA under the grant award for use by Recipient, and the non-Federal share of the grant award (Recipient’s grant matching resources). 2.5 Federalism Federalism distributes authority and ﬁscal resources between the national government and ﬁfty individual state governments (Osborne, 1988), thus the state has played some role in the development of VC and hi-tech industry. State governments have developed a range of programs to support the innovative activities of small ﬁrms. Many of these programs still remain in existence, making a positive impact on the

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local economy and providing a strong demonstration of the potential for VC activity in the area. During 1990s, many states are sponsoring the formation of new VC ﬁrms to spur the creation and growth of new businesses. These programs typically bring together a state’s academic, private sector, and public partners for the purpose of technology development and transfer. One key beneﬁt of these venture funds is the coordination of private and public sector resources and objectives that lead to a more focused approach to technology transfer and regional economic development. Where a venture fund is used, loans are made to promising private sector offshoots of the programs, with the capital re-paid by successful ventures. Thus, the venture funds are both revenue generating and can be self-perpetuating (OECD, 2001). In addition to research support and access to university facilities and scientists, states provide a myriad of specialized programs ranging from business plan services to marketing and personnel training assistance (Schachtel and Feldman 2001). Together, states spent more than $400 million on these programs in 1995 (SSTI 1998). In 1999, $2 to $4 billion of equity ﬁnancing was provided to startups by public small business ﬁnancing programs in the US. The bulk of this money went to early stage ﬁrms. These smaller funds are generally focused on companies that will improve the local economy. However, there are some limitations on the effects of state-funded VC. First, these funds often struggle to generate private funds for current or later rounds. Second, the number of publicly funded investments is still small and therefore, has a limited impact. Finally, research has not been conclusive as to the effectiveness of publicly funded VC. In fact, some nontraditional VC institutions have been failures both in terms of ﬁnancial returns and economic development impacts. 3 Public Venture Capital in China 3.1 The Status Quo of VC Industry in China The current situation of VC industry in China proves to be extremely difﬁcult to evaluate and measure. The initial development of the VC industry in China was essentially done through direct government participation in the market. In the mid-1980s central and regional governments started to establish VC companies. Moreover, the governments have also made the establishment of venture capital communities a top priority. On the whole, China has enormous potential to develop the venture capital industry while it faces many pitfalls and challenges. The venture capital industry in China is remarkably volatile. As can be seen in Table 10.5, the amount of funds raised increased dramatically until 1995 when it ﬂattened out. From 1998, it shot up dramatically until the highest in 2002. Similarly, the investments have oscillated violently, reaching between $50–700 million per year from 1992 through 1997. But then investment plummeted in 1998, before increasing once again in 1999, and reaching the peak in 2000. In 2001 and 2002, there was ample or even excess venture capital in China, but a lack of promising investments. This is illustrated by the low-level of investment versus the total pool of funds.

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Table 10.5

Venture Capital Pools and Disbursements in China by Year (in millions US$)

Year

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Numbers

N/A

Pools

N/A 878 1,422 2,384 3,458 3,612 3,500 3,112 3,735 5,647 7,899 8,200

8

15

28

36

38

66

128

202

236

246

269

Disbursements N/A 65 242 645 678 609 662 411 728 806 565 418 Source: Asian Venture Capital Journal various years and Authors’ calculating based on the China Annual Report of venture capital in 2002 published by Zero2ipo Company and the other publication.

There is no established pattern of investment in China and thus far much of the investing continues to be experimental and ranges from hi-tech to infrastructure and consumer goods. The biggest investments have gone into infrastructure, consumer products, and transportation / distribution, areas which are not normally considered for VC investment. But given the growth of the domestic market these may be the signiﬁcant opportunities. From 1998 to 1999, there was a signiﬁcant increase in information technology investing, probably manifesting the Internet bubble in China. The amount of investment in IT industry continued to grow from 2000 to 2002, but with a declining growth rate. Meanwhile, investment in Biomedicine, Telecommunications, Utilities infrastructure keep on increasing due to the increasingly open policy. The venture capital industry is geographically clustered, with 150 VC company ofﬁces located in Beijing, Shanghai and Shenzhen, accounting for 60% of the total VC companies and 70% of total funds. Foreign VC has played an important role in helping create a good climate for VC investment as well as VC industry. Moreover, the government has shown support for foreign VC investment. Statistics show that among the 73 VC companies that invested in China with the total amount of US$418 million, there are 34 foreign companies, accounting for 49.8% (from China Venture Capital Forum in 2003, Beijing). There is consensus that China is the most important location for venture investing in the future, and there appears to be a large number of strategies for investing in China—a situation suggesting either many opportunities or uncertainty about what will work. The Chinese environment is not yet sufﬁciently mature or stable to present a “favorable” climate for venture investing which is still a new practice with a few examples of successful exits with returns of 10 times or greater. To improve the situation, the government must undertake to sweep away the barriers that are amenable to government action. 3.2 Public Venture Capital in China Chinese government has recognized the signiﬁcant contribution of hi-tech to economic development, and within the past few years, government efforts to ﬁnance small hi-tech ﬁrms have increased. Actually, Chinese VC has been supported and

Table 10.6

IFSTF Supported Fields, 1999–2002 (in thousands RMB)

1999 2000 2001 # of # of # of Disbursement % Disbursement % Disbursement % projects projects projects Elec. and IT 331 244,830 29.99 418 184,210 27.9 358 272,170 34.7 Bio-tech 212 160,730 19.69 282 152,850 23.2 157 123,400 15.8 Material 216 166,090 20.35 266 120,460 18.3 168 128,850 16.4 Automation 219 159,760 19.57 290 149,720 22.7 207 164,620 21.0 55 42,540 5.21 69 29,000 4.4 66 54,330 6.9 Environment 42 31,030 3.8 48 23,420 3.6 40 31,130 4.0 Energy Other 14 11,370 1.39 10 12 8,800 1.2 Total 1,089 816,350 1,383 659,660 1,008 783,300 Source: IFSTF Management Center, the Ministry of Science and Technology, PRC. http://www.innofund.gov.cn.

2002 # of Disbursement projects 291 190,850 116 81,320 118 84,350 141 101,820 66 46,400 48 35,500 780

540,240

% 35.3 15.1 15.6 18.8 8.6 6.6

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promoted by the government at the national, provincial, and municipal levels from the start. Many government entities in China have been actively involved in VC investing. The situation is complex and difﬁcult to fully comprehend. Today most VC companies are those founded by the government. By one estimate, government capital makes up over 80% of the total VC investment (UltraChina.com). 3.2.1 Innovation Fund for Small Technology-based Firms (IFSTF) IFSTF is a special government fund set up on June 25, 1999 upon the approval of the State Council, with an initial capital of RMB 1 billion (US$ 120 million) through budgetary allocations by the central government. It aims at promoting the development of new and high technology industries by encouraging the technology innovation activities and facilitating commercialization of R&D achievements of STFs. It also attempts to attract more investment to STFs from local governments, corporations and ﬁnancial institutions. The fund does not aim at proﬁt-making in its own right, but it takes revenue increase and job creations as the reward, therefore contributing to the national economic structure adjustment and the general health and growth of the economy. IFSTF takes three different forms depending on the speciﬁc characteristics of the projects. First of all, appropriation is applied primarily as start-up capital to small ﬁrms founded by research personnel bearing their own research achievements. It also provides partial subsidies to STFs for new product development and pilotproduction. The total volume of appropriation to each project will generally not exceed US$120,000 (RMB 1 million) with a maximum of US$250,000 (RMB 2 million) for key projects. Secondly, loan interest subsidy is adopted to provide interest for STFs requiring loans from commercial banks to expand the production scale of the innovation project. The total subsidy amount of each project is generally within US$120,000 (RMB 1 million) and US$250,000 (RMB 2 million) for key projects. The loan support is different from the loan of policy-oriented banks which generally can be used in many ﬁelds while the loan from IFSTF is limited to use in technology innovation. Thirdly, equity investment is targeted at a small number of projects with a high level of technology starting point, greater innovation capacity and market potential in emerging industries. Generally the investment will not exceed 20% of the registered capital of the invested company and will be redeemed within a time limit in accordance with law. IFSTF primarily supported the hi-tech projects in the ﬁelds of Electronics and IT, Biotechnology and Medicine, Advanced Materials, Automation Technology, Resources and Environment as well as New Energy and Energy Saving Technology (see Table 10.6). This contrasts sharply with private venture capital, the majority of which have gone into traditional industries like infrastructure, consumer products, and transportation/distribution. A big share of IFSTF went into pilot production, the rest was divided between mass production and R&D (see Table 10.7). For the ownership structure, limited liability company is the most popular form, accounting for almost a half. In terms of the company size, 35% of the companies were small, with the rest as medium-sized.

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Table 10.7

The Revival of Private Enterprise in China

Stages of IFSTF Supported Projects, 1999–2002

Year 1999

R&D Pilot Production Mass Production Total Applications # 25 121 263 409 % 6.11% 29.58% 64.31% 100% 2000 # 23 196 271 490 % 4.70% 40.00% 55.30% 100% 2001 # 86 440 372 898 % 9.58% 49.00% 41.42% 100% 2002 # 17 118 52 187 % 9.09% 63.10% 27.81% 100% Total # 151 875 958 1984 % 7.61% 44.10% 48.29% 100% Source: IFSTF Management Center, the Ministry of Science and Technology, PRC. http:// www.innofund.gov.cn.

The performance of the Fund has demonstrated the signiﬁcance of the strategy of the central government to increase the ﬁnancial support for STFs through direct government funding. It is well believed that, by supporting the development of STFs, IFSTF will produce a profound impact upon pulling the domestic demand, promoting investment, upgrading and optimizing the industrial structure. However, the volume of total investment and the number of projects are still limited. Besides, appropriation and interest-free loans are a little too big, yet the return on capital is low, which tends to push the “rent-seeking” action of the government department involved. 3.2.2 Provincial and Municipal Public Venture Capital Fund IFSTF has not only provided direct funding for STFs, but has also successfully attracted investment from ﬁnancial institutions. Four major commercial banks signed cooperation agreements with IFSTF in 1999 to give preferred support by way of interest subsidies to the IFSTF projects. More importantly, it has facilitated the establishment of various local funds. The IFSTF Management Center Statistics (see Table 10.8) reveal that 28 provincial and municipal governments promote venture capital as an economic development strategy, and have set up their own innovation funds, S&T achievement commercialization funds or STF development funds. From 1999 to 2002, the central government has appropriated RMB 3.3 billion (approximately US$400 million), funding 4946 projects, and attracting more than RMB 30 billion (approximately US$365 million) of investment from the local governments, ﬁnancial institutions and enterprises, with local government matching funds and independent innovation funds accounting for 16.7%. The local innovation funds have not only made joint efforts with IFSTF in supporting projects, they have also chosen some hi-tech projects themselves in the forms of appropriation, loan interest subsidy, guarantee, equity investment and so on. The case of Jiangsu Provincial Venture Capital Fund exempliﬁes the operation of Provincial Venture Capital Fund in China. It works on three levels: Firstly, as

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an owner of the fund, the managerial committee, including the related government departments, undertakes to make decisions on investment and dividend policy, yet it is never involved in, or intervenes with, its operation. Meanwhile, it has set up the Board of Supervisors. Secondly, Jiangsu Hi-tech Venture Capital Investment Company operates the fund, but they couldn’t use any extra money except for commission, in order to separate Investment Company from the Fund. Moreover, the investment company does not operate speciﬁc project, instead it only transfers money to start-ups selected by project management company so as to separate fund investment from fund management. Jiangsu Hi-tech Venture Capital Company is one of the public venture capital pioneers in China. It has established the cooperative relationship with eight venture capital companies, attracted more than US$243 million venture capital portfolio investment through an amount of US$79 million government capital and has become the ﬁrst partner of IDG in 2002. We carried out a questionnaire survey in 2001, with about 200 hi-tech companies regarding driving forces, obstacles and things that need to be done by public authorities to promote innovation and local economic growth. Of the companies receiving the questionnaire, 82–90% responded. The most interested issue is investment climate, such as high quality academic research, human capital and legal system. There is also a strong need for more public seed ﬁnancing and support to start-ups and SMEs. Among the most frequently occurring issues brought up by the respondents is the lack of capital for different phases in a company’s development and the limited support offered to SMEs by public authorities. It is especially pointed out that there is an increasing need of public seed ﬁnancing since private venture capital companies rarely invest in early development phases. Our questionnaire results show that most entrepreneurs appreciated public ﬁnancial support, especially those that characterized the milestones of the company, such as, introducing new technologies, developing new products, attracting new markets. In most cases the support was provided as grants, either at the beginning of the investment or as reimbursement after the investment was accomplished. It was also indicated, however, that such plan should be widely available and easier to access. Some entrepreneurs proposed a complete change of the policy of ﬁnancing SMEs due to the fact that small companies have little chance to attract appropriate funds regardless of their growth potential. Therefore, adequate forms of ﬁnancing should be more easily accessible, including seed capital, speciﬁc funds for developing new products, guarantees that would enable sharing of risks between the entrepreneurs and the providers of capital. Public VC should greatly facilitate accomplishment of development tasks in early stages of growth. Standardized procedures were valued by other entrepreneurs. 4 Integration of public VC with private VC What is the relationship between public venture capital and private venture capital? How do they affect each other? Is there any possibility for them to partner with each other?

Table 10.8 No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Provincial and Municipal Venture Capital Funds in China (in millions US$)

Management Department Commission of S&T, Beijing City Dept. of S&T, Hebei Province Dept. of S&T, Inner Mongolia Municipality Department of S&T, Liaoning Prov Bureau of S&T, Shengyang City Department of S&T, Jiling Prov Commission of S&T, Shanghai City Department of S&T, Jiangsu Prov Bureau of S&T, Nanjing City Department of S&T, Zhejiang Prov Bureau of S&T, Ningbo City Department of S&T, Fujian Prov Bureau of S&T, Xiamen City Department of S&T, Jiangxi Prov Dept. of S&T, Shandong Prov Dept. of S&T, Henan Prov Dept. of S&T, Hubei Prov Bureau of S&T, Wuhan City Bureau of S&T, Guanzhou City Dept. of S&T, Guangxi Dept. of S&T, Hainan Prov Dept. of S&T, Sichuan Prov Bureau of S&T, Chengdu City Dept. of S&T, Guizhou Province Dept. of S&T, Yunnan Prov

Fund/Setting up Time Innovation Fund/2001 Innovation Fund /2001 Innovation Fund /2000 Innovation Fund /2002 Innovation Fund /2000 Innovation Fund /2000 Innovation Fund /2002 Innovation Fund /2002 Innovation Fund /2000 Innovation Fund /2002 Innovation Fund /2001 Innovation Fund /2002 Innovation Fund /2001 Innovation Fund /2000 Innovation Fund /2001 Innovation Fund /2002 Innovation Fund /1999 Innovation Fund /2002 Innovation Fund /2002 Innovation Fund /2002 Innovation Fund /2002 Innovation Fund /2002 Seed Fund/2001 Innovation Fund /2000 Innovation Fund /2000

Amount/year 6.10 1.22 0.98 7.31 0.61 3.05 12.2 24.4 2.44 13.42 0.37–0.61 14.63 3.17 0.61 1.83 1.83 12.2 12.20/5 7.32 2.44 0.06 2.44 1.22 1.22 2.44

Source “three-item expenditure” Financial Appropriation Financial Appropriation Financial Appropriation Financial Appropriation Financial Appropriation Financial Appropriation “three-item expenditure” Financial Appropriation “three-item expenditure” Financial Appropriation Financial Appropriation Financial Appropriation Financial Appropriation Financial Appropriation “three-item expenditure” Financial Appropriation Financial Appropriation “three-item expenditure” Financial Appropriation “three-item expenditure” Jointly by Finance and S&C “three-item expenditure” Financial Appropriation Financial Appropriation

Table 10.8

Continued

No.

Management Department

Fund/Setting up Time

Amount/year

Source Commercializing Fund for 26 Dept. of S&T, Gansu Prov Innovation Fund /2001 0.73 research achievements 27 Dept. of S&T, Xingjiang Innovation Fund /2002 0.61 Jointly by Finance and S&C 28 Dept. of S&T, Qinghai Prov Innovation Fund /2000 0.61 Financial Appropriation 29 Commission of S&T, Tianjing City Special Complementary Fund /2001 0.61 “three-item expenditure” 30 Dept. of S&T, Shanxi Prov Special Complementary Fund /2001 0.61 “three-item expenditure” 31 Bureau of S&T, Dalian City Special Complementary Fund /2001 0.37 “three-item expenditure” 32 Bureau of S&T, Changchun City Special Complementary Fund /2001 30% complementary “three-item expenditure” 33 Dept. of S&T, Heilongjiang Prov Special Complementary Fund /2001 50% complementary Financial Appropriation 34 Bureau of S&T, Haerbin City Special Complementary Fund /1999 1.22/per year Financial Appropriation 35 Dept. of S&T, Anhui Prov Special Complementary Fund /2001 0.61 “three-item expenditure” 36 Bureau of S&T, Qingdao City Special Complementary Fund /2001 0.73 Financial Appropriation 37 Dept. of S&T, Hunan Prov Special complementary Fund /2001 complementary “three-item expenditure” 38 Dept. of S&T, Guandong Prov Special Complementary Fund /2001 50–150% complementary “three-item expenditure” 39 Commission of S&T, Chongqing City Special Complementary Fund /2001 2.44 “three-item expenditure” Notes: 1. The “three-item expenditure” on science and technology is a special fund which is limited to R&D of science and technology and managed jointly by Ministry of S&T and Ministry of Finance. It refers to the expenditure on trial-producing new products, the expenditure on the middle stage tests, and the expenditure on subsidies for major scientiﬁc research projects. 2. Financial appropriation is the special ﬁnancial account which is in line with the local government budget and is only used for the innovation of science and technology. Source: Management Center of IFSTF, the Ministry of Science and Technology.

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Public–private partnerships are at the top of many issues in hi-tech industry development. When the market fails to distribute ﬁnancial resources to small hi-tech enterprises that much more need them and less-advantages development areas— especially in developing and transitional countries, partnerships between public and private organizations are often seen as offering an innovative method with a good chance of producing the desired results. A good working deﬁnition for public-private partnership would include three points. First, these partnerships involve at least one private for-proﬁt organization and at least one non-proﬁt or public organization. Second, the partners have some shared objectives for the creation of social value, often for disadvantaged small businesses and local economic development. Finally, the core partners agree to share efforts, risks and beneﬁts. Partnerships can involve a range of partners with different rights and responsibilities, including core partners, who assume key responsibilities for the joint enterprise, and in-country partners, whose participation is necessary for successful implementation. Some partnerships play prominent roles in the governance structures of the recipients while others do not. In practice, many public VC companies or funds have established partnerships with private VC companies. Recent estimates suggest that close to 40% of venture or venture-like disbursements in the United States and more than half of early-stage investments came from “social” sources in 2001: those whose primary goal was not a high economic return. This partnership activity has not been limited to the United States. Governments in dozens of countries have established signiﬁcant public venture capital programs. Yet little is known about the conditions that foster partnership success, and the precise structures of these programs vary, although partnerships can produce innovative strategies and positive consequences for public goals, and they can create powerful mechanisms for addressing difﬁcult problems by leveraging the ideas, resources of different partners. Though different with cultures and social circumstances, public and private VC partnerships that provide a sustainable mechanism share some characteristics. The following will focus on the experiences in both the United States and China. 4.1 American Models An examination is given in Section III about the US public venture capital programs, which reveal the government’s active role in encouraging the development of venture capital. In this part the business models are examined. David L. Barkley suggested three types of public VC in term of organization structure and business models: 1. publicly funded and publicly managed VC funds; 2. publicly funded and privately managed VC funds; 3. certiﬁed capital companies. Publicly funded and managed programs are usually capitalized with state money made available through appropriations or sale of bonds. Fund management is provided by a public or quasi-public agency (for example, State Department of Commerce). Institutional objectives generally are promoting economic development and/or improving state VC markets.

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In terms of privately managed programs with public funding or incentives, state capital generally is placed in private VC institutions, and/or public incentives such as tax credits are employed to encourage the placement of private capital in the funds. A private party manages the fund, though government representatives may serve on the institution’s board. Investment objectives generally are to maximize the fund’s internal rate of return (IRR) subject to state restrictions on the location and type of investments. Certiﬁed capital companies (CAPCOs) are privately funded, privately managed institutions created by state enabling legislation. Capitalization of CAPCOs is provided by insurance companies in exchange for 100% state tax credits over 10 years on premium taxes paid by insurance companies. CAPCOs place approximately 40% of the raised capital in zero coupon bonds as collateral on the insurance companies’ investments, thus not all certiﬁed capital raised from insurance companies is available for investments in qualiﬁed businesses. CAPCOs must invest the certiﬁed capital in speciﬁc types of qualiﬁed in-state businesses according to a speciﬁc investment schedule, for example, 50% of certiﬁed capital invested in qualiﬁed businesses within 5 years. CAPCO investment goals are to maximize IRR from fund investments, while meeting the state’s regulatory requirements (David L. Barkley, 2001). Each structure above has both advantages and disadvantages, so how to choose an effective organization structure still remains a vital issue. 4.2 Chinese Models 4.2.1 Government Capital, Government Management The overwhelming model of public VC in China is Government Capital, Government Management model of which the IFSTF is a typical case in point. Firstly, all of its initial and follow-up capital comes from the Ministry of Finance and the State Policy-oriented Banks; Secondly, the Management Center of IFSTF is an institution under the Ministry of Science and Technology. Besides, municipal and provincial governments also provide VC programs. As an advantage, this model can be so designed as to meet the objectives of developing hi-technology and economy. Its performance and efﬁciency depend heavily on the operating and managerial mechanism, the staff’s dedication. As a matter of fact, IFSTF has been playing a very active role since its establishment. The government has made substantial efforts to design a new operational model for the government fund, continuously improving the administration mechanism and strengthening the post supervision of the awarded projects. Political consideration and pressure, however, can lead to investments in certain industry, provinces or ﬁrms, rather than areas that can bring more proﬁt. That also makes it very difﬁcult to attract most talented fund managers, or to co-invest with private VC, it can even result in bureaucracy and political corruption. A study shows that many SBICs made investments in ineffective or corrupt ﬁrms, and SBIC managers’ incentives to screen or monitor portfolio ﬁrms were greatly reduced by the presence of government guarantees that limited their exposures to unsuccessful investments. So the government still faces the dilemma: stimulating development in certain areas, regions, industries, or encouraging economic proﬁts. For IFSTF, their

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hard work lies in how to balance the different objectives and keep on improving managerial mechanism. 4.2.2 Owned and Operated by State Owned Enterprises A large proportion of Chinese VC companies are state-owned or state-holding companies. This is very important in terms of organization form and quite different from that of the US. For instance, the main shareholders of Tsinghua Venture Capital Co., Ltd. are Hi-tech Group of Tsinghua University, Capital Steel Group, accounting for about 50% share. The rest share-holders are national ﬁnancial institutions, VC funds and some industrial or commercial enterprises. With another VC company, Tsinghua Unisplendour HiTech Venture Capita, most of shareholders are state-owned enterprises or stateholding listed companies, such as Tsinghua Unisplendour Corporation, Sichuan Investment Group, Beike Medical Industry Corporation, China Shipping Haisheng Co., Ltd. Beijing Yanjing Beer Co., Ltd, with average of 8% share, except for Tsinghua Unisplendour Corporation holding 16% of the share. It must be recognized that this is common VC organization form, since venture capital is still young in China, and basically, the VC investment companies have been set up by following the state trust investment company model. On the other hand, it was hard for state-owned VC institutions to take a favorable form, because “Investment Company” is the only legal form for venture capital, especially limited liability company. However, the nature of venture capital lies in the high return due to the high risk, and the investors expect to get the return as soon as possible. These two things keep the private investors reluctant to co-invest with state owned enterprises. Therefore, the “Investment Company” form may not be rule of thumb, though presently adopted. 4.2.3 Owned and Operated by Private Company There are a quite limited number of private VC companies in China. Wanxiang Venture Capital Company is a representative. It was established jointly by Wanxiang Group Corporation with the shares of 70.28%, Zhejiang Province Department of Finance with the shares of 10%, ShenZhen Wanxiang Investment Company with the shares of 9.33%, Zhejian Oriental Communication Company with the shares of 3.33%, Shanghai Linyu Automobile EBusiness Ltd. with the shares of 3.33%, Hang Zhou City Financial Development Company with the shares of 1.67%, Xiao Shan State Assets Management company with the shares of 1.67%, Venture Equities Management Inc. (US) with the shares of 0.84%, Power drive Europe Ltd. (UK) with the shares of 0.84% in November 2000, the registered capital was 300 million RMB (36.58 million U.S Dollar). So it is a really private holding VC company with the government participation, private partner plays main role in the decision-making. However, this kind of model is not prevailing, because except for some listed companies held by private groups, most individual investors always worry about the high risk of venture capital, and they also lack adequate knowledge about VC. 4.2.4 Reﬁnancing Model The young ﬁrms may need to resort to the capital market for the second round of ﬁnancing for their expansion. There is the need and pressure

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to grow on the one hand, but there is also the constraint of capital resources and channels on the other. The government then may provide a springboard for the ﬁrms to have easier access to the needed capital resources by equity investment, loan guarantee and loan subsidies. 4.2.5 Co-investment Model The role of the government to provide matching funds or to co-invest has been quite popular in China. The government attracts private capital resources to sectors where capital is needed most, and it also sets up matching funds with private venture capital to ﬁnance the small businesses. Is so doing, the government share the risk with private VC and have reduced the risk of the projects. Meanwhile, the governments have also achieved the objective and strategy of using a certain amount of capital to encourage more activity of private venture capital and therefore guiding and orienting the private capital. 5 Policy Implications for Chinese Public Venture Capital 5.1 Chinese Government Should Use More Initiative to Encourage VC Development The role of the government always arouses controversy and the government always faces a dilemma in its involvement in VC development. On the one hand, some entrepreneurs acclaim the government’s involvement, especially in making VC more locally accessible. The most common model was guarantee similar to SBA loans, where government mitigates some of the ﬁnancial risk associated with equity investment. Besides, public VC programs can help change the local entrepreneurial culture and attract more investment talent to a region. On the other hand, many entrepreneurs still favor a hands-off approach: they prefer less government involvement in the VC development and less restrictions with as few roadblocks as possible. However, the role of the government has become more prominent in China in terms of VC development. From the historical perspective, government policy has produced an extraordinarily strong effect on the general health of VC business. Further, China is still in the process of transition from planned economy to market economy, and the distribution of resources depends on both government department and market mechanism. In other words, the market has not been fully established in China. Therefore, the government should undertake to nurture the market. Chinese government faces the issue of how to improve the capital market. Modern comparative ﬁnancial theory suggests that capital market is more favorable than bank system to VC development. But China is a bank-based ﬁnancial system with the capital market still in its primitive stage of development. The share of market capitalization in GDP is only 37.43%, still very low compared with developed countries. By contrast, the ratio of total loans to GDP in 2002 was 125.62%, suggesting the primary roles of banks and other ﬁnancial institutions in ﬁnancing for small hi-tech businesses. The relationship between ﬁnancial development and VC development, and the presence of signiﬁcant differences in the organization of ﬁnancial systems raise a

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series of important questions. For instance, how do the ﬁnancial institutions and markets play their roles in VC investment? What are the differences between the development patterns followed by China and the United States respectively? Is it possible to determine the types of institutions that are more conducive to VC development? How much can the investment boom be accounted for by the ability of efﬁcient and well-organized ﬁnancial markets to channel funds toward the most innovative and high returning projects in United States? These issues have attracted great academic interest in recent years, since, ﬁrst of all, the ﬁnancial markets have played a critical role in supporting and stimulating the economic growth of the US in the recent years, and secondly, important transformation has been taking place in Chinese ﬁnancial markets. Therefore, it is safe to conclude that Chinese government should play a more important role and assume a greater responsibility than that in United States in the development of VC industry and in nurturing entrepreneurship. Indeed, the central and local governments in China have become intimately involved with economic development. 5.2 The Government Should Try to Foster the Investment Climate for VC The role of the US government in the development of the VC industry should not be underestimated, though indirect. The US government helped greatly by generally practicing sound monetary and ﬁscal policies ensuring relatively low inﬂation with a stable ﬁnancial environment. The tax policy, though it evolved, has been favorable to capital gains, and a number of decreases in capital gains taxes may have had some positive effect on the availability of venture capital (Gompers, 1994). With the exception of a short period in the 1970s, US pension funds have been allowed to invest prudent amounts in VC funds. The NASDAQ stock market, the preferred choice of exit channel for venture capitalists, is strictly regulated and characterized by increasing openness thus eliminating investors’ fear of fraud and deception. This created a general macroeconomic environment of transparency and predictability, reducing risks for investors. In fact, any government committed to sustained economic progress must ensure that all aspects of its economic system are conducive to and supportive of increased levels of entrepreneurial activity. This includes minimizing taxation, ensuring access to labor, lowering non-wage labor costs, deregulating and making it easier to do business with the government. Attempting to learn from the US experience like other nations, the Chinese government has made great efforts to encourage VC development, and an environment with a good innovative climate for the commercialization has been evolving. However, many of its laws discourage small ﬁrm formation. These include regulations on the minimum required capital of RMBҰ10 million to be considered a company with the exception of technology-based ﬁrms for which only RMBҰ100,000 is required. There are other legal provisions that by commission or omission retard entrepreneurship and thereby formation of an active VC industry. One of the most signiﬁcant of these is the prohibition or restrictions on disposal of shares in the open market after an IPO by the investors and founders. In addition, many regulations negatively affect venture capital in China. For example, Company Law Article 24

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provides that, when a company invests in other limited liability companies or limited companies, the aggregate amount of investment shall not exceed 50% of the net assets of the company, not including any capital increase of the other limited liability companies or limited companies arising from any conversion of proﬁts into capital following such investment, except for investment companies and holding companies speciﬁed by the State Council. Article 147 states that shares of a company held by a promoter of that company shall not be transferred within three years of the company’s establishment. Directors, supervisors and the managers shall report all the shares that they hold in the company, and shall not transfer them during their term of ofﬁce. Improving the environment for VC development requires re-considering some of the central tenets of the way the central government controls the economic environment. For example, simplifying the environment for foreign venture capitalists would also be part and parcel of simplifying the environment for foreign investors in general. Besides, allowing stock option plans for start-ups would likely be part of a more general creation of stock option plans. Similarly, removing restrictions on share sales by insiders would almost surely require an improved and more transparent stock regulatory system modeled after the US SEC. Thus, improving the environment for VC also implies decisions about the future direction of the economy and the industrial structure. There are many non-governmental concerns apart from the issues in government policies and regulations. Some entrepreneurs tend to be shortsighted and treat the venture capitalists’ investments as a “gift,” thereby exposing the investors to a classic “principal-agent” problem. This is not entirely surprising, as it will require some time before Chinese entrepreneurs are educated to the behavior patterns of a “bankable” entrepreneur — but for investors this is an immediate problem. China is also in bad need of experienced professional managers, which contributes a lot to the difﬁculty in organizing a good management team. 5.3 Strategy to Integrates Public VC and Private VC in China The public VC and private VC have been seesawing in different periods as can be seen from the US case. For instance, the experiences of the United States before 1970s show that, in contrast to the poor performance of private VC, public VC did well. It is clear that increasing the support system to start-up companies would promote growth of the hi-tech industry. But since then, private VC has developed dramatically. So both private and public venture capitals have been playing important roles in ﬁnancing hi-tech businesses with different strengths and limitations. So the point is how to keep the appropriate balance between the free market and intervention by public authorities. The current public venture programs have been set up to cultivate a mechanism to distribute the limited source of capital, but a more important issue is how to establish a fund-raising mechanism. Statistics show that the non-government investment account for about 60% in total R&D expenditure of $14.16 million, suggesting that private capitalists are willing to invest more in hi-tech R&D.

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Therefore, it is our recommendation that there be different business models integrating public VC with private VC following a three-step process. As the ﬁrst step, public VC plays the principal part of VC industry. As discussed, no individual or private companies would like to invest without a sound environment, which includes law and regulations, professional managers, exit channel and so forth. Therefore, public VC should play its roles in ﬁlling the capital gap, attracting foreign investments, training professional investors, promoting managerial system and improving legal environment. After that, an integration of public and private VC in different forms should be encouraged. The key issue is to design an efﬁcient governance structure, regardless of the model. Public VC may focus on the professional manager training while private VC may involve in strategy and management. There is a long way for Chinese VC industry, because government investments always are limited while the private companies and social capital have enough room to expand with an outstanding amount of savings deposit in urban and rural areas close to US$ 900 billion. With the improvement of investment environment and more professional manager with richer experiences and even great achievement, an increasing number of individuals and private companies will join the VC fund, and public-private relationship will be expected to deepen. Finally, public VC takes more or less a back seat and functions as a tool for supplement and adjustment. Meanwhile private VC takes over and becomes the principal part of VC industry and thus plays a leading role in the capital market and development of hi-tech industry in China. References Abbott, C.C. and E.M. Zuckert, “Venture Capital and Taxation,” Quarterly Journal of Economics, 55, 4(1941): 667–82, Commision Staff Working Paper, Trends in European Innovation Policy and the Climate for Innovation in the Union Brussels, SEC(2000) 1564. Barkley, D.L., D.M. Markley and J.S. Rubin, Public Involvement in Venture Capital Funds: Lessons from Three Program Alternatives, (Rural Policy Research Institute, PB99-2, November 1999). Barkley, D.L., D.M. Markley and J.. Rubin, “Certiﬁed Capital Companies: Strengths and Shortcomings of the Latest Wave of State-Assisted Venture Capital Programs”. Economic Development Quarterly, 15(4) (November 2001), 350-66. Bergemann, D. and U. Hege, “Dynamic Venture Capital Financing, Learning and Moral Harzard,” Journal of Banking and Finance, 22(1998), 703–35. Casper, S., “High Technology Governance and Institutional Adaptiveness. Do Technology Policies Usefully Promote Commercial Innovation Within The German Biotechnology Industry?” working paper, The Netherlands Institute for Advanced Studies, Wassenaar, The Netherlands, June(1999). Etzkowitz, H., “Science Policy Institute, The Triple Helix of University – Industry – Government Implications for Policy and Evaluation,” Working Paper 11 (2002).

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Feldman, M.P. and M.R. Kelley, “How States Augment the Capabilities of Technology-Pioneering Firms,” Growth and Change, 33(2) (2002), 173–195. Freshwater, D., D.L. Barkley, D.M. Markley, J.S. Rubin, and R. Shaffer, Study of Nontraditional Venture Capital Institutions: Filling A Financial Market Gap, Part 2 of 4 of the Final Report of RUPRI Rural Equity Capital Initiative’s Study of Nontraditional Venture Capital Institutions, P2001-11B (2001). Galante, S.P., An Overview of the Venture Capital Industry and Emerging Changes, (The Private Equity Analyst, newsletter, Wellesley, MA 2001). Gentry, W.M. and R.G. Hubbard, “Tax Policy and Entrepreneurial Entry,” American Economic Review, 90, 2(2000): 283–7. Gompers, P.A. and J. Lerner, The Venture Capital Cycle (Cambridge, MIT Press, 1999). Hall, W., L. Foster and R. Shukla, “Public Venture, Public Gain?” November 9 (2002), Larta University’s course on winning federal R&D funds. Hao, K.Y. and A.B. Jaffe, “Effect of Liquidity on Firms’ R&D Spending,” Economics of Innovation and New Technology, 2(1993): 275–82. Himmelberg, C.P. and B.C. Peterson, “R&D and Internal Finance: A Panel Study of Small Firms in Hi-tech Industries,” Review of Economics and Statistics, 76(1994): 38–51. Horvath, M., “US Venture Capital Flows: Empirical Evidence and Implications,” Stanford University, November(1999). Hubbard, R.G., “Capital-Market Imperfections and Investment,” Journal of Economic Literature, 36(1998), 193–225. Keuschnigg, C. and S. Nielsen, “Tax Policy, Venture Capital, and Entrepreneurship,” NBER Working Paper No. 7976, October (2000) (also: CEPR Discussion Paper No. 2626, November 2000). Keuschnigg, C. and S. Nielsen, “Start-ups, Venture Capitalists and the Capital Gains Tax,” Journal of Public Economics, 88(2002), 1011–42. Leazer, R. and S.Z. Royko, “Seed and Venture Capital Formulation: Essential to Hitech Business Job Growth,” A White Paper for the Wisconsin Economic Summit held November 29–December 1, Milwaukee, Wisconsin, (2001). Lerner, J., “When Bureaucrats Meet Entrepreneurs: The Design of Effective ‘Public Venture Capital’ Programs,” working paper. Lerner, J., “The Government as Venture Capitalist: The Long-run Effects of the SBIR Program,” Journal of Business, 72(1999): 285–318. Megginson, W.L., “Towards a Global Model of Venture capital?” Working Paper, Price College of Business, The University of Oklahoma, (2002). Poterba, J.M., “Venture Capital and Capital Gains Taxation,” NBER Working Paper No. 2832, July(1989). Repillo, R. and J. Suarez, Venture Capital Finance: A Security Design Approach (CEMFT, Madrid, Mimeo, 1998). Sandström, A., Backlund, A., Häggblad, H., Markusson, N., Norgren, L. and Westerlund, L. “The Swedish Biotechnology Innovation System,” Working Paper May (2000). Secrierul, O. and M. Vigneault, “Public Venture Capital and Entrepreneurship”, Working Paper, Bank of Canada, WP04-10, (2004).

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Stillman, R.D., “Government Support for Venture Capital,” Beijing Forum on SME Financing, May 14 (2002). Willmott, H., “New Control Modes and Emergent Organizational Forms: Private– Public Contracting in Public Administration,” Administrative Theory and Praxis, 23, 3(1991): 407–430, (with D.Grimshaw and S. Vincent).

Chapter 11

The Challenges China’s Private Enterprises Face in the WTO Shaomin Huang, Dongxia Wu, Grant D. Forsyth1

1

Introduction

China became a member of the World Trade Organization (WTO) in December 2001. This was an important step for China’s economy and it opens the door for it to play a major role in the world economy. At the same time, however, business ﬁrms in China will face new challenges, especially the newly established private enterprises (PEs). The typical PE is small, uses a limited amount of physical capital, is family owned and operated, and is typically located in the light manufacturing, agricultural, retail, or service sectors. These enterprises are similar to sole-proprietorships in the United States. The challenges facing China’s PEs include choosing the best strategies to grow and how to meet increased foreign competition. That is, although international markets offer signiﬁcant growth opportunities, they also bring increased competition into China’s domestic market. This competition will inevitably force difﬁcult structural changes on the economy. As a result, there is growing interest in how PEs will survive and grow in the post-WTO economy. China’s PEs have been studied using many different perspectives. For example, Parker (1995) used the Schumpeterian creative destruction model to explain the high growth of China’s rural township and village enterprises, as compared to more mature state-owned enterprises. Parker suggested that inefﬁcient ﬁrms in mature industries are large due to past growth, but immature industries in rural areas grow faster because small, relatively inefﬁcient ﬁrms will not grow in the absence of stateprotection. In other words, rural growth rates are going to disproportionately reﬂect the impact of small rural ﬁrms that are operated more efﬁciently. Chen and Feng (2000) investigated the source of cross-provincial variation of economic growth in China. Their empirical analyses found evidence that private ownership, higher education, and international trade have all contributed to an increase China’s economic growth over the last two decades. They also showed that PEs are increasingly important to China’s economy.

1 Huang: professor of economics, Lewis-Clark State College, Idaho, USA. Wu: associate professor of economics, Guangxi University, PR China. Forsyth: associate professor of economics, Eastern Washington University, Washington, USA.

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Wen (2000) noted that given China’s enormous population and limited fertile land, domestic food production, historically, has been the primary concern, where the level of concern was directly related to the country’s degree of isolation. Under this food pressure, China developed an institutionalized segregation between rural and urban residents to avoid food shortages in urban areas. Wen pointed out that its accession to the WTO will provide institutionalized food security to China. Wen suggested that instead of struggling with food production, the bulk of China’s labor force can focus on the manufacture of labor-intensive products and exchange these products for food imports. Therefore, China has the chance to reduce rural poverty, assuming that the traditional rural labor force can ﬁnd work in the new sectors of the economy. Liu, Liu, Wang, and Woo (2001) discussed issues concerning China’s accession to the WTO. They develop a market-share-testing principle to assess how WTO accession would impact the evolution of ownership in different industrial sectors. They concluded that joint ventures will weaken state ownership, resulting in a more diversiﬁed ownership structure in the post-WTO economy. In other words, nonstate-owned enterprises will ultimately have more weight in the post-WTO economy. However, empirical data supporting this conclusion is missing in their study. Yao (2002) focused on China’s rural economy after entry to the WTO. He studied China’s rural surplus labor and the constraints on township and village enterprise development. Yao noted that the agricultural sector may have to bear the burden of WTO accession more unfairly compared to the rest of the economy, because as China becomes more industrialized, agriculture will offer lower returns without government subsidies. Many economists in China are concerned about this problem and are seeking a governmental solution. However, if the government focuses on policies oriented towards subsidies, rather than polices oriented towards establishing a more efﬁcient agricultural market, then the agricultural sector will continue to be much less competitive than other countries. China’s WTO accession will likely accelerate the privatization process. Therefore, it is reasonable to assume, as suggested by current research, that China’s PEs will play an increasingly important role in the domestic economy. As a result, how well PEs perform in the post-WTO economy will certainly attract more academic attention. In this context, Section II discusses the characteristics of China’s PEs; Section III discusses China’s accession to the WTO and the challenges PEs will face; and Section IV will present some policy considerations. 2 The Characteristics of China’s Private Enterprises As China’s economy has developed over the last two decades, its PEs have been developing even faster under the pressure of the market mechanism. The following are the key characteristics of China’s PEs. 2.1 High Growth with a Large Supply of Rural Labor To alleviate rural poverty and improve educational opportunities, the last two decades have seen formal efforts by the Chinese government to develop small towns in the

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countryside. The number of registered towns (i.e., towns ofﬁcially recognized by the government’s organizational system) has increased substantially. In 1981 there were only 2,678 registered towns; however, by 2000 there were 19,692—over 7 times the 1981 count. On a growth basis, that represents an average annualized increase of just over 11%. Migration from the countryside into these towns was 58.4 million in 1981, and 367.3 million in 1998—over an 11% increase on an annualized basis. In the last decade, approximately 60 million rural surplus labors migrated into rural towns, which accounts for about 50% of the total laborers who moved from farming jobs to non-farming jobs.2 In these small towns, most of the business enterprises are privately owned. As a result, these ﬁrms have been providing crucial goods, services, and jobs that have aided rural economic development. 2.2 Relatively Young and Closely Held Firms China’s economic reforms started in earnest in the mid-1980s. Since then, the centrally planned economy has quickly transformed into the market oriented economy visible today. Firm privatization started at end of the 1980s and accelerated through the 1990s. This means the oldest PEs have existed slightly less than 18 years and, with China’s economic transformation still in progress, private ownership is still a relatively new concept in a legal and legislative sense. Therefore, the deﬁnition of a “private enterprise” is not always clear. Many companies registered as “limited liability corporations,” “share-holding corporations,” or “joint ownerships” are typically closely held companies in that they are controlled and managed by a very small number of individuals. In the case of state-owned companies, many of these may be slowly converted to some form of private ownership; however, the exact conversion approach remains unclear. Here, however, the focus is on PEs without share-based ownership forms. 2.3 Self-trained Entrepreneurs One of the important factors behind China’s surprising economic progress is the emergence of a large number of self-trained entrepreneurs. Without these new entrepreneurs, it would be impossible to establish a market based system in such a large country, especially where production was formally based on large and relatively inefﬁcient state enterprises. The willingness of so many ordinary Chinese citizens to assume the ﬁnancial risk of running a ﬁrm reﬂects the new policies that allow individuals to keep the proﬁts associated with their risk-taking. Clearly, even in the absence of a formal business education, many in China are responding to the new ﬁnancial incentives. 2.4 Small but Growing Output Contributions In 1990, after more than a decade of economic reforms, the output of China’s traditional state-owned enterprises was still 54.6% of gross industrial output (see 2 China’s Monetary Policy Executive Report in 2002 First Quarter by People’s Bank of China, Monetary Policy Analysis Team.

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Table 11.1

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Percentage of Gross Industrial Output, 1990–1993

Enterprise Form 1990 1991 1992 State-owned 54.60% 52.94% 48.09% Collective-owned 32.08% 35.70% 38.04% Private ownership 5.39% 5.70% 6.76% Others 4.38% 5.66% 7.11% Source: National Bureau of Statistics of China, Statistical Report in 1994.

1993 43.13% 38.36% 8.35% 10.16%

Table 11.1). In contrast, the output value of the collective-owned enterprises accounted for 32.1% of gross industrial output, while PEs’ only accounted for 5.4%. However, PEs experienced steady gains in output shares following 1990. Following another decade of economic reforms, PEs have also signiﬁcantly increased in numbers, relative to all industrial ﬁrms. Tables 11.2 and 11.3 show the distribution of enterprises and their gross industrial output in 2001 and 2002. In 2001, among designated size3 industrial enterprises, registered private ownership enterprises (i.e., PEs) were the most common, accounting for over 21% of ﬁrms.4 State-owned and collective-owned enterprises were the next largest, accounting for over 20% and 18% of ﬁrms, respectively. In 2002, among designated size industrial enterprises, registered private ownership enterprises (i.e., PEs) accounted for over 27% of ﬁrms. In contrast, state-owned and collective-owned enterprises accounted for just over 15% and 16% of ﬁrms, respectively. Again, this data suggests that small entrepreneurs have been quick to respond to the new incentives of the market reforms (see Point 2–3). However, in terms of gross revenues, their contribution is quite small—they produced only about 9% of gross output in 2001 and just over 11% of output in 2002. Nevertheless, the PEs’ small contribution to output is perfectly consistent with industrialized countries like the United States. The United States Census Bureau ﬁnds that sole-proprietorships without employees account for approximately 75% of the ﬁrms in the United States, but they only generate about 3% of total gross revenues.5 2.5 Over Reliance on Outdate Production Methods Since China’s economy is still developing, PEs are operating in a sometimes difﬁcult and chaotic environment. As a result, small ﬁrms face many operational problems. These problems include obtaining sufﬁcient quantities of modern physical capital, ﬁnding experienced managers and workers, and how to market their products. The adoption of modern capital is complicated by an underdeveloped banking system. Park and Seht (2001) concluded that, “…ﬁnancial intermediation in China is far from efﬁcient and that ﬁnancial reforms in the mid-1990s have not reversed the trend of worsening banking performance” (p. 636). (Other authors, for example, Lai and 3 Designated size industrial enterprises refer to those enterprises with an annual income over ¥5 million. 4 If non-designated size enterprises are included, the number will be much higher. 5 United States Census Bureau, web site at http://www.census.gov/epcd/nonemployer/ index.html.

The Challenges China’s Private Enterprises Face in the WTO

Table 11.2

Number of Designated Size Industrial Enterprises and their Gross Output, 2001

Enterprise Form National Total

173

Number of Enterprises in 2001 171,256

Percent of Enterprises in 2001

Gross Industrial Percent of Output in 2001 Gross Industrial (¥, Billions) Output in 2001 9,544.9

State-owned 34,530 20.16% 1,722.9 18.05% Collective-owned 31,018 18.11% 1,005.3 10.53% Cooperative 10,864 6.34% 299.5 3.14% Joint ownership 2,234 1.30% 85.1 0.89% Limited liability 18,956 11.07% 1,553.5 16.28% Share holding 5,692 3.32% 1,269.8 13.30% Private ownership 36,218 21.15% 876.1 9.18% Others 321 0.20% 10.6 0.11% Funds from Hong Kong, Macao and 18,257 10.66% 1,184.7 12.41% Taiwan Foreign funded 13,166 7.69% 1,537.4 16.11% Source: National Bureau of Statistics of China, Statistical Report in 2001. Notes: 1) Designated Size Industrial Enterprises refer to those enterprises with an annual income over ¥5 million. 2) The gross industrial output value is calculated at current prices. 3) “Joint ownership” enterprises include state joint ownership, collective joint ownership, joint state-collective, and other joint ownership within domestic funded enterprises. 4) “Limited liability” corporations includes state sole funded corporations and other limited liability corporations. 5) “Private ownership” enterprises include privately funded enterprises, private partnership enterprises, private limited liability corporations, and private share-holding corporations. 6) “Funded from Hong Kong, Macao and Taiwan” includes joint-ventures, sole investment enterprises, share-holding corporations, limited liability enterprises, and corporations. 7) “Foreign funded” includes private-funded enterprises, private partnership enterprises, private limited liability corporations, and private share-holding corporations.

Yau, 2001; Laurenceson and Chai, 2001; Wong and Wong, 2001; and Woo, 2000 also discussed the challenges facing China’s banking system and its various statecontrolled banks.) In the case of production, start-up ﬁrms often rely on outdated technologies to manufacture light industrial products or process agricultural products. Although these production technologies are well established and affordable, they are not the most efﬁcient from the perspectives of costs and externalities. For example, Yao (2002) noted older production methods often generate heavy pollution in rural areas. Of course, the problem of industrial and agricultural pollution extends to urban areas as well. Finally, the lack of a modern educational system will hinder the ability of successful PEs to obtain more ﬂexible and productive workers.

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Table 11.3

Number of Designated Size Industrial Enterprises and their Gross Output, 2002

Enterprise Form

Number of Enterprises in 2002 181,557 29,449 27,477 10,193 1,964 22,486 5,998 49,176 348

Percent of Enterprises in 2002

Gross Industrial Percent of Output in 2002 Gross Industrial (¥, Billions) Output in 2002 11,077.6 1,727.1 15.59% 961.9 8.68% 320.3 2.89% 94.2 0.85% 2,007.0 18.12% 1,411.9 12.75% 1,295.1 11.69% 14.3 0.13%

National Total State-owned 16.22% Collective-owned 15.13% Cooperative 5.61% Joint ownership 1.08% Limited liability 12.39% Share holding 3.30% Private ownership 27.09% Others 0.19% Funds from Hong Kong, Macao and 19,546 10.77% 13,668.81 12.34% Taiwan 14,920 8.22% 18,790.47 16.96% Foreign funded Source: National Bureau of Statistics of China, China Statistical Yearbook 2003. Note: See Table 11.2 for deﬁnitions.

2.6 Heavy Orientation towards the Wholesale, Retail, and Service Sectors Although PEs play an important role in the industrial sector, they also play important roles in other sectors too. Tables 11.4, 11.5, and 11.6 show the distributions of the designated size6 enterprises in the wholesale, retail, and catering service sectors by types of registration in 2001. From these tables it is clear that private ownership enterprises are smaller than other types of enterprises. In the wholesale sector as a whole, the average number of employees per ﬁrm was 130 in 2001. In contrast, however, PEs averaged only 37 employees, which is the lowest in this sector. In the retail trade sector, the average number of employees was 201. Again, similar to the wholesale sector, PEs averaged only 36 employees, which is the lowest in this sector. Finally, in the catering services sector, the average was 187 employees, while PEs averaged 123 employees—the second lowest among this group. (The lowest is collective-owned enterprises with 121.) Most of the un-designated size enterprises are also privately owned. If these ﬁrms are accounted for, it is likely that PEs have a very large, and possibly increasing, share of the wholesale, retail, and service sectors. Given the lack of ofﬁcial support given to small ﬁrms in China, it is encouraging that they continue to thrive. That is, unlike the larger state-owned enterprises, PEs have received little support in the way of government funding, technological support, or favorable business regulations. As a result, PEs often struggle to compete with the large domestic ﬁrms. Nevertheless, like many small ﬁrms in developed counties, their continued survival is likely due to their ability to focus on small niche markets 6 Designated size enterprises in the service sector refer to relatively large and stable ﬁrms.

The Challenges China’s Private Enterprises Face in the WTO

Table 11.4

Number of Designated Size Enterprises in Wholesale by Types of Registration, 2001

Number of Enterprises Total wholesale trade 15,258

Enterprise Form

Percent of Percent of Employment Employ. Enter. 1,982,927

State-owned 7,736 50.70% 1,124,343 56.70% Collective-owned 1,859 12.18% 274,613 13.85% Cooperative 363 2.38% 28,830 1.45% Joint ownership 206 1.35% 19,449 0.98% Limited liability 2,671 17.51% 270,770 13.66% Share-holding 949 6.22% 197,366 9.95% corporation Private ownership 1,262 8.27% 47,116 2.38% Others 12 0.08% 677 0.03% Funded from Hong Kong, Macao and 84 0.55% 7,212 0.36% Taiwan 116 0.76% 12,551 0.63% Foreign funded Source: National Bureau of Statistics of China, Statistical Report in 2001. Note: See Table 11.2 for deﬁnitions.

Table 11.5

175

Average Employ. 130 145 148 79 94 101 208 37 56 86 108

Number of Designated Size Enterprises in Retail Trade by Types of Registration, 2001

Enterprise Form

Number of Enterprises 13,285 3,839 2,041 449 139 1,691

Percent of Percent of Employment Enter. Employ. 2,063,028 28.90% 707,606 34.30% 15.36% 218,322 10.58% 3.38% 62,627 3.04% 1.05% 17,028 0.83% 12.73% 377,403 18.29%

Total retail trade State-owned Collective-owned Cooperative Joint ownership Limited liability Share-holding 742 5.59% 427,033 20.70% corporation Private ownership 4,161 31.32% 149,972 7.27% Others 13 0.10% 3,375 0.16% Funded from Hong Kong, Macao and 100 0.75% 44,054 2.14% Taiwan 110 0.83% 55,608 2.70% Foreign funded Source: National Bureau of Statistics of China, Statistical Report in 2001. Note: See Table 11.2 for deﬁnitions.

Average Employ. 201 184 107 139 123 223 576 36 260 441 506

while being more ﬂexible and less bureaucratic than the state-supported ﬁrms. As a result, PEs do have some competitive advantages against larger domestic ﬁrms.

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Table 11.6

Number of Designated Size Enterprises in Catering Services by Types of Registration, 2001

Enterprise Form

Number of Enterprises 4,132

Percent of Percent of Employment Employ. Enter. 779,370

Total catering services 772 18.68% 182,412 23.41% State-owned Collective-owned 570 13.79% 69,224 8.88% Cooperative 243 5.88% 33,048 4.24% Joint ownership 38 0.92% 6,845 0.88% Limited liability 489 11.83% 97,652 12.53% Share-holding 127 3.07% 35,294 4.53% corporation Private ownership 1,272 30.78% 156,607 20.09% Others 7 0.17% 1,741 0.22% Funded from Hong 373 9.03% 104,206 13.37% Kong, Macao and Taiwan Foreign funded 241 5.83% 92,341 11.85% Source: National Bureau of Statistics of China, Statistical Report in 2001. Note: See Table 11.2 for deﬁnitions.

Average Employ. 189 236 121 136 180 200 278 123 249 279

383

2.7 Chinese Cultural Inﬂuences China’s PEs have been strongly inﬂuenced by Chinese culture. Wang and Chu (2002) noted that many PEs in China are family business, which means they are directly controlled and managed by their owners. Most business is conducted through relationships related to the immediate family, relatives, friends, or other similar networks. These networks ﬁt perfectly into a closed, traditional Chinese market, and allow for the kind of niche marketing that improves the chances for ﬁrm survival. The moral hazard problems associated with the owners and mangers of the large stateowned ﬁrms are also lessened since the welfare of the entire family is directly linked to the proﬁtability of the ﬁrm. Likewise, a small ﬁrm based on a family network reduces the information asymmetries between decision makers. However, because these networks often function outside of traditional legal and tax systems, it is unclear how the implementation of the WTO rules, which inﬂuence the enforcement of international business laws—for example, copyright and patent laws—will impact this system. If the WTO rules are vigorously enforced, then many family-owned PEs may ﬁnd it difﬁcult to operate under more traditional family networks. 3 Comparative Advantages and the Challenges from the WTO Before China became a member of the WTO, the large Chinese producers, both in the manufacturing and agricultural sectors, were protected by high tariffs and other import restrictions. As a member of the WTO, China will follow the WTO rules and treat

The Challenges China’s Private Enterprises Face in the WTO

Table 11.7

177

Factor Endowments in China and Selected Other Countries, 1995

Labor Force Cropland (Hectares Physical Capital Tertiary Education (Millions) per Worker) ($1,000 per Worker) (Years per Capita) China 808.3 0.12 1.6 0.2 Indonesia 119.7 0.19 2.7 0.5 South Korea 31.8 0.07 21.5 3.0 Singapore 2.1 0.00 62.7 0.5 Brazil 101.4 0.61 9.6 1.1 India 561.3 0.30 1.7 0.5 Japan 87.0 0.05 131.4 0.8 United States 172.3 1.09 73.0 2.1 Source: The World Bank, China Engaged: Integration with the Global Economy, Washington D.C. 1997, p. 34. Country

other member nations as “Most-Favored-Nations.” As a result, China has promised the following: (1) To reduce tariff rates on industrial and agricultural products by an average of 8.9% and 15%, respectively; (2) to reduce its agricultural subsides; (3) end its doublepricing policy7 on domestic and export products and gradually eliminate other pricing protections; and (4) open its service sector, especially the domestic ﬁnancial sector, to foreign companies. If fully implemented, all of these changes have the potential to drastically increase the level of competition and complexity in China’s domestic market, even for small ﬁrms. Of course, the impact of these changes will differ across ﬁrms, with those ﬁrms reﬂecting China’s comparative advantages likely to be thriving. 3.1 Analysis of China’s Resource Endowment According to the Heckscher-Ohlin factor-endowment theory (HOT), a nation’s endowments, such as labor, land, and capital, are the key determinants of its comparative advantage. Therefore, according to HOT, under the pressure of the market, developing countries will see their economic institutions develop around their most plentiful endowments. In the post-WTO economy, what comparative advantages does China have? Table 11.7 shows the factor endowments in China and selected countries based on 1995 data. First, China has a large supply of unskilled labor, which is shown in Table 11.7. Among the comparison countries in 1995, China had the largest number of laborers (808.3 million), but the lowest level of tertiary education per capita (0.2 years). By comparison, the United States’ tertiary education per capita (2.1 years) was nearly 11 times higher, while Japan’s tertiary education per capita (0.8 years) was four times higher. For the newly industrialized South Korea, its tertiary education per capita (3 years) was than 15 times higher. In terms of natural resources focused on food production, China had a relatively low ratio of cropland per worker (0.12 hectares) in 1995 (see Table 11.7). By 7 The domestic price is not the same as the exporting price under a ﬁxed foreign exchange rate regime.

The Revival of Private Enterprise in China

178 70% 60%

40% 30% 20%

Jan-03

Nov-02

Sep-02

Jul-02

May-02

Mar-02

Jan-02

Nov-01

Sep-01

May-01

-20%

Mar-01

0% -10%

Jul-01

10% Jan-01

Year-on-Year % Change

50%

-30% Month % Change in U.S. Exports to China

% Change in U.S. Imports from China

Figure 11.1 US Trade with China, 2001–2003 Source: United States Census Bureau and United States Bureau of Labor Statistics.

comparison, the United States had nine times more hectares per worker (1.09) and Brazil had ﬁve times more hectares per worker (0.61). These relative differences reﬂect the comparative advantages that the United States and Brazil enjoy in agricultural production. Nevertheless, China’s ratio of cropland per worker is higher than those in Japan, South Korea, and Singapore; as a result, some traditional Chinese agricultural products, such as vegetables and spices, will have ready markets in many Asian countries. Finally, considering physical capital, China again had the lowest ratio of physical capital per worker ($1,600) in 1995 (see Table 11.7). This ratio is even below that of India, the second most populace developing country. Compared to industrialized countries, Japan’s capital per worker ratio ($131,400) was 82 times higher, and the United States’ ratio ($73,000) was nearly 46 times higher. These statistics indicate that, China, relative to industrialized countries, and some developing countries, does not have a comparative advantage in capital-intensive production. 3.2 China’s Advantages in the WTO The above resource endowment analysis suggests that China will focus on producing labor-intensive products and import capital- and natural resource intensive products, as well as high skill services such as ﬁnancial services. Assuming China’s low real wages are not offset by substantially lower labor productivity, China’s labor-intensive products should have a cost advantage in the international market. In particular, textile products will likely continue to be one of China’s primary exports. A 1999 United States International Trade Commission (ITC) study assessing the potential impact of China’s entry into the WTO noted: China is the world’s largest single country exporter of textiles and apparel products… Although the majority of apparel from China continues to be of low- to medium-quality,

The Challenges China’s Private Enterprises Face in the WTO

Table 11.8

179

Predicted Export Gains for the US after China’s Entry into the WTO

Product Amount ($ Change, Millions) Percentage Increase* Wheat 33.0 15.5% Vegetable oil 288.5 145.8% Cotton 230.1 59.2% Beverages and tobacco 222.9 124.5% Footwear and leather 126.7 21.3% Chemicals and plastics 102.2 2.8% Iron and steel 10.0 3.0% Electronic equipment 283.6 14.1% Other machinery 515.6 11.0% Other manufacturing 205.6 114.0% Source: United States International Trade Commission, Assessment of the Economic Effects on the United States of China’s Accession to the WTO, August 1999, p. xxii, Table ES-7. Note: * Estimates compared to base year 1998. the Chinese apparel industry is becoming more quality oriented and is beginning to produce higher-valued goods, particularly in those operations being guided in Hong Kong. The potential for growth is greater in China’s apparel industry because apparel production is highly labor-intensive and China has an abundance of skilled, low-cost labor (ITC, 1999, p. xxii).

Interestingly however, Figure 11.1 shows that although Chinese imports surged into the United States early in 2002, US exports to China also continued at a healthy pace. Table 11.8 shows conservative ITC predictions of near-term export gains for the United States given reductions in China’s tariffs.8 These predictions come from the same 1999 ITC study noted previously, and they are broadly consistent with China’s endowments. In the agricultural sector, US wheat, vegetable oil, and cotton products will see signiﬁcant growth through Chinese trade. In the light industrial sector, US exports of beverages, tobacco, and leather products will increase, as will some products associated with the heavy industrial sector—for example, chemicals, plastics, electronic equipment, and high-tech machinery. This suggests that Chinese PEs in parts of the agricultural and industrial sectors are likely to see downward pressure on their returns to capital over the next decade. 3.3 China’s Challenges in the WTO Unfortunately, it is not clear that China and its more successful PEs, at least initially, will be allowed to realize all the potential gains from trade. In a recent edition of Foreign Policy, Cuddy (2003) noted that China’s WTO accession protocol, “… 8 The ITC study found when China’s potential post-WTO productivity growth and capital accumulation was incorporated into the model, the predicted gains increased. These values are not shown in Table 11.8.

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contains provisions that could give the WTO’s other 143 members a freer hand to restrict Chinese imports” (p.74). One provision that Cuddy highlighted speciﬁcally singles out Chinese imports; it stipulates that in situations where Chinese imports are causing disruptions to a WTO member’s domestic market, that member can request direct mediation with China. Cuddy noted, “This provision represents a departure for the WTO’s rules on nondiscrimination, as it only applies to imports from China— even if imports from other countries also increase [in the domestic market]” (p. 74). Directly or indirectly, the WTO bias against China could hinder the development of small and medium sized PEs. Other challenges related to entry into WTO revolve around the management of China’s PEs. Since most PEs are family oriented business (see Point 2–7), the owners and managers are not necessarily familiar with modern managerial and marketing techniques or international law. In other words, the managerial approaches that have made these enterprises so successful against the state-owned enterprises, may not serve them as well in a more global marketplace. This means to survive, many of China’s PEs are going to have to suffer through a great deal of “learning by doing.” As a result, multinational corporations with modern operating strategies and, in some cases, long histories of operating in developing markets, will be formidable competitors. Similarly, if multinational companies are able to purchase or become major shareholders in China’s state-supported companies, as they have done in places like Central and Eastern Europe, then many small PEs could see their economic fortunes signiﬁcantly diminish. 5 Policy Considerations As the ﬁrst decade of the twenty-ﬁrst century progresses, there will be increasing attention paid to the performance of PEs in China’s post-WTO economy. Even though the domestic market represents the PEs’ primary focus, entry into the WTO will ensure a gradual increase in competition. This raises the question: How can China’s PEs survive and develop in the post-WTO economy? Several obvious policy considerations come to mind. The ﬁrst consideration concerns China’s education system and the development of human capital. As China continues to emphasize the market mechanism, the nation’s educational system will have to adapt so it can provide individuals with skill sets compatible with a dynamic market economy. Emerging PEs will increasingly need specialized personnel (e.g., lawyers, accountants, production managers) familiar with modern managerial techniques and tools. They will also need workers capable of multitasking and adjusting to technological change. The second consideration is to accelerate reforms targeted at the domestic banking sector; of course, this includes accelerating the reforms designed to increase foreign bank access to the domestic market. As time passes, many small ﬁrms will face the classic market based dilemma: grow or go. The ability of any ﬁrm to grow (i.e., move down its long-run average cost curve) depends heavily on its ability to obtain ﬁnancing. Similarly, a ﬁrm’s ability to increase and modernize physical capital depends heavily on its access to debt markets. If ﬁnancial sector reforms are handled

The Challenges China’s Private Enterprises Face in the WTO

181

properly, China’s new enterprises will have unprecedented access to new ﬁnancial and physical capital—a condition historically reserved for state-owned enterprises. In short, it seems unlikely that the current state-owned banks, by themselves, represent a sufﬁcient foundation for China’s emerging PEs. The third and ﬁnal consideration is to make sure that the legal code is modernized to establish the rules under which mergers of PEs, both horizontal and vertical, can take place. If individual ﬁrms lack the ﬁnancial capital to expand, mergers with other ﬁrms offer an alternative to debt ﬁnanced expansions. Besides increasing economies of scale, mergers would allow ﬁrms to diversify their product offerings and, therefore, their ability to sell outside of local markets. The ability to sell outside of local markets would increase production volume, thereby lowering average costs. References Chen, B. and Feng, Y., “Determinants of Economic Growth in China: Private Enterprise, Education, and Openness,” China Economic Review, 11, 1 (2000): 1–15. Cuddy, K.J., “Crouching Tariffs, Hidden Protectionism,” Foreign Policy, January/ February (2003): 74–5. Laurenceson, J. and Chai, J.C.H., “State Banks and Economic Development in China,” Journal of International Development, 13 (2001), 211–25. Li, J. and Yau, J., “China’s Banking Reform: A Single Step in a Thousand-mile Journey,” International Journal of Business, 6, 2 (2001): 87–110. Liu, G.S., Liu, X., Wang, L. and Woo, W.T., “China’s New Horizon: Challenges and Opportunities from WTO Membership,” China Economic Review, 12, 2–3 (2001): 103–6. National Bureau of Statistics of China, Statistical Report in 1993, (China Statistics Press, 1994). National Bureau of Statistics of China, Statistical Report in 2001, (China Statistics Press 2002). National Bureau of Statistics of China, Statistical Report in 2002, (China Statistics Press 2003). Park, A. and Sehrt, K., “Tests of Intermediation and Banking Reform in China,” Journal of Comparative Economics, 29 (2001): 608–44. Parker, E., “Schumpeterian Creative Destruction and the Growth of Chinese Enterprises,” China Economic Review, 6, 2 (1995): 201–23. People’s Bank of China, Monetary Policy Analysis Team, China’s Monetary Policy Executive Report in 2002 First Quarter (2002). Statistics Department of the People’s Bank of China. The People’s Bank of China Quarterly Statistical Bulletin, 23, 3 (2001). The World Bank, China Engaged: Integration with the Global Economy, (Washington. DC, 1997). United States International Trade Commission, Assessment of the Economic Effects on the United States of China’s Accession to the WTO Investigation, No.332–403. (Washington, DC, 1999).

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Wang, X. and Xiaoping, C., “Studies of Private Enterprise Corporate Governance Structure Evolution Model,” Economic Science, 130, 3 (2002): 89–93. Wen, G.J., “New Frontier of Economic Globalization: The Signiﬁcance of China’s Accession to WTO,” China Economic Review, 11, 4 (2001): 432–6. Wong, Y.C.R. and Wong, M.L.S., “Competition in China’s Domestic Banking Industry,” Cato Journal, 21, 1 (2001): 19–41. Woo, W.T., “Improving Access to Credit in Rural China,” in T.D. Willett (Series ed.), B. Chen, J.K. Dietrich, Y. Fang (Vol. eds), Financial market reform in China: Progress, Problems, and Prospects (Oxford: Westview Press, 2000), 322–45. Yao, S., “China’s Rural Economy in the First Decade of the 21st Century: Problems and Growth Constraints.” China Economic Review, 13, 4(2002): 354–60.

PART IV Ownership Reforms and Privatization

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Chapter 12

The Privatization of Russian State Industry: Some Lessons for China Marshall I. Goldman1

1 Introduction After the Bolsheviks seized power in 1917, the Russian Communist Party did everything it could to insure that there would be no counter-revolution and a return to capitalism. Thereafter, for over 70 years, the Soviet authorities sought to destroy any surviving remnants of capitalism. Through atrophy and decree, the Soviet authorities set about ridding themselves of all capitalist era law as well as the institutional checks and balances that are an essential supplement to the former system of capitalist law. In effect, the Soviets burnt their capitalist bridges behind them. Ridding the country of most of its lawyers and accountants was not entirely a tragedy, but it did all but guarantee that if an effort was made to bring back capitalism, there would be some serious problems. While the Soviet purge of capitalist institutions was not entirely successful, it was successful enough so that any effort to reintroduce capitalism was bound to bring with it an enormous distortion as well as social and economic upheaval. It was an environment that invited devious dealers and economic chaos. As a measure of how disruptive the reinstitution of the market system was, in 1991 after Boris Yeltsin introduced his reforms, the Russian GDP shrank by 40–50%. But the impact was not shared equally. While in 1998 almost 30% of the Russian population suddenly found themselves below the poverty line for the ﬁrst time, seven Russians made it into the ranks of Forbes Magazine’s list of the world’s richest billionaires. By 2004, there were 36 (see Table 12.1). Prior to 1991, there were none. After 1998, economic conditions in Russia improved signiﬁcantly but almost 20% of the Russian population today still remain below the poverty line. The challenge is to avoid such an extreme redistribution of wealth in China. Although as yet China may have only a dozen or so billionaires, there are a growing number of extremely rich Chinese businessmen who have built up a net worth exceeding several hundred million dollars (see Table 12.3). In what follows, we shall see how the results of privatization have been affected by the differences in 1 Kathryn W. Davis Professor of Russian Economics, Emeritus, at Wellesley College and the Associate Director of the Davis Center for Russian and Eurasian Studies at Harvard University.

186

Table 12.1

The Revival of Private Enterprise in China

Forbes Richest Russians, 2004

1. Mikhail B Khodorkovsky*† $15.2 billion Yukos – Oil 2. Roman A Abramovich* $12.5 billion Millhouse Capital – Sibneft Aluminum 3. Viktor Vekselberg* $5.9 billion TNK – BP, Sual 4. Mikhail Prokhorov* $5.4 billion Norilsk Nickel 5. Vladimir O Potanin*† $5.4 billion Norilsk Nickel 6. Mikhail M Fridman* $5.2 billion Alfa Group/TNK – Oil 7. Vladimir Lisin $4.8 billion Novolipetsk – Steel 8. Oleg V Deripaska* $4.5 billion Rusal, Basic Element – Aluminum, Auto 9. Alexei A Mordashov* $4.5 billion Severstal – Steel 10. Vagit Y Alekperov*† $3.9 billion Lukoil – Oil 11. German Khan $2.9 billion Alfa Group/TNK – Oil 12. Alexander Abramov $2.4 billion EvrazHolding – Metals 13. Vladimir Bogdanov* $2.2 billion Surgutneftegaz AFK Sistema – Telecommunications, 14. Vladimir P Yevtushenkov* $2.1 billion Microelectronics, Real Estate, Retail 15. Iskander Makhmudov $2.1 billion Uralsky GMK 16. Pyotr Aven $2.1 billion Alfa Group 17. Nikolai Tsvetkov $2.0 billion Nikoil 18. Leonid Nevzlin* $2.0 billion Menatep/Yukos 19. Alexei Kuzmitchev $1.9 billion Alfa Group 20. Mikhail Brudno* $1.8 billion Menatep/Yukos 21. Vladimir Dubov* $1.8 billion Menatep/Yukos 22. Platon Lebedev* $1.8 billion Menatep/Yukos 23. Vasily Shakhnovsky* $1.8 billion Menatep/Yukos 24. Leonid Fedun $1.7 billion Lukoil – Oil 25. Alexander Lebedev $1.4 billion National Reserve Group 26. Viktor Rashnikov $1.3 billion Magnitogorsk Steel 27. David Davidovich $1.3 billion Sibneft 28. Rem Vyakhirev† $1.3 billion Former CEO of Gazprom 29. Vyacheslav Sheremet $1.2 billion Gazprom – Natural gas 30. Andrei Melnichenko $1.2 billion MDM Bank 31. Sergei Popov $1.2 billion MDM Group – Metals 32. Igor Zyuzin $1.1 billion Mechel Steel 33. Andrei Gorodilov $1.1 billion Sibneft 34. Valery Oif $1.1 billion Sibneft 35. Yelena Baturina $1.1 billion Inteko 36. Alisher Usmanov $1.0 billion Gazprominvestholding Source: Forbes Russia. *Forbes 2003. †Forbes 1998.

the way communism in Russia and China evolved. This will also provide insights into what pitfalls China must avoid if it wants to implement a successful program of privatization.

The Privatization of Russian State Industry

187

2 Goals of Privatization In order to understand the challenges facing China, it is necessary to consider what the goals of a good privatization program should be. One of the highest priorities should be to insure that the privatization process itself does not immediately create a small group of rich new oligarchs who become rich solely because they have connections (guanxi) or in some way bribe or intimidate government ofﬁcials. It may well be that in a decade or so, an oligarchic class will emerge in China but that should be because these oligarchs added value to what they had, not because they inherited or seized what had been state assets. Inevitably, the process of privatization creates inequality, but an effort should be made to ensure that such inequality is a result of value added and not coercion or manipulation. If Russian reforms had been successful, then neither Soviet-era factory directors nor members of the Soviet nomenklatura would have automatically become owners of the state factories they had been administrating. The same should be the goal in China. All those who become owners of state property should have had to compete to obtain that ownership on an equal footing and should pay a fair value for it. It is also important that while state enterprises are being privatized, simultaneously everything should be done by the state to facilitate the creation of new start-up businesses. Only in this way can a competitive infrastructure be created. Without such a foundation, what were state industries will continue to operate as monopolies even if they become privatized. They will just be private monopolies. This has been particularly important in Russia where even in the czarist era, large state monopolies dominated the economy. Initially, after the collapse of the Soviet Union in December 1991, small business start-ups ﬂourished. However after a year or so, Russian authorities had second thoughts about the chaos they saw and they reversed course. Instead of encouraging start-ups, they instituted more restrictive controls. Reacting in December 1992 to what he saw as the chaos and sprawl of the market, Viktor Chernomyrdin, the then Prime Minister, declared that “Russia will not become a bazaar economy.”2 Soon after, the police closed down what had been ﬂourishing kiosks and sidewalk stalls that had only just begun to appear on corners throughout Russia’s larger cities. Despite an effort now to facilitate the opening of new businesses, that underlying attitude remains. For example, Mayor Yuri Luzhkov of Moscow will periodically order street-corner kiosks closed because he regards them as unsightly.3 As a result, in Russia today only 10–15% of the GDP originates from among small businesses. This compares to 50% or more in most western economies. A well-designed reform should also lead to substantial restructuring of the former state sector which in turn should bring with it an increase in productivity. This may well necessitate the search for new managers able to operate outside the bounds of the traditional centrally planned economic system. Basing their arguments on the Coase Theorem, economists Maxim Boycko, Andrei Shleifer and Robert Vishny assumed that because new owners would seek to maximize the return on their 2 Nezavisimaia Gazeta, December 16, 1992, p. 2. 3 Johnson’s Russia List, October 19, 2004, #8417, item 10; Moscow Times, September 24, 2004.

188

The Revival of Private Enterprise in China

investment, such restructuring would happen automatically.4 What they neglected however, is that for all this to happen there must ﬁrst be proper laws in place as well as supportive institutions. Only then will it be possible to institute a proxy ﬁght with impartial courts and judges. They are needed to guarantee an honest contest. Even now in Russia there are no such guarantees. Not only is it essential that new managers attuned to a market system be put in control, it is also important that the proﬁts from such a takeover be shared at large with the public on an ongoing basis. This means that it is necessary to report the proﬁts of these newly privatized businesses in an honest way and that dividends and taxes be paid to the shareholders and to the state. Moreover, at least a portion of the proﬁts should be shared by the country’s pension funds. In this way, the public can share in the ongoing beneﬁts generated by what used to be the publicly owned entities. A share of the taxes and dividends collected by the state should also be set aside to pay for the retraining of employees ﬁred in the process of restructuring. In the same way, some of those funds should also be used to underwrite the startup of new businesses; a sort of venture capital fund to underwrite not only ﬁrms with advanced technology, but individuals seeking to open smaller service and retail operations. In addition to such important ﬁnancial measures, efforts must also be made to shrink the existing state bureaucracy and contain and curb corruption. Reducing the bureaucracy should facilitate that goal. Not only that but commercial and legal codes must be adopted to replace the communist era codes which had governed the state ownership of the means of production. Based on the experiences in Russia to date, none of this is an easy or automatic procedure. If anything, the Russian bureaucracy seems to be larger than ever.5 Even more ominous, a few select members of the Kremlin bureaucracy (the siloviki) are appointing themselves to positions of authority and control in some of the country’s largest and most proﬁtable companies, both state and private (see Table 12.2). At the same time, neither the existing courts nor their judges have had any experience dealing with private businesses. Finding judges experienced in dealing with the private sector is a time consuming and educational process and ﬁnding the funds to ensure that such judges will be ﬁnancially independent and thus less likely to be affected by bribes is an even more time consuming task. To put it in economic terminology, the challenge is to design a system that ensures that in any transformation, the state and society at large capture whatever economic rent may result from the privatization process and the turn to the market. (Economic rent for an oil producer, for example, can be deﬁned as the value of the oil company on a well-functioning stock market minus the price the oligarch paid the state for that oil company.) In the Communist Party era, the state captured the rent but more often than not, a relatively small share of the proceeds were shared by the public. All too often, however, the state used the rent to ﬁnance grandiose schemes such as major public works, military adventures and space activities. It is essential 4 See Boycko, Shleifer and Vishny (1995, p. 21). 5 The Independent, January 18, 2006; Johnson’s Russia List, May 26, 2005, No. 9160, item 9.

The Privatization of Russian State Industry

Table 12.2

189

Siloviki in Business

Name Title Andrei Belianinov CEO Sergei Chemezov* Chairman Viktor Ivanov* Member of Board/ former KGB Dmitry Medvedev Chairman

Gazprom

Natural gas

Sergei Prikhodko

Tvel Rosneft Transneft

Nuclear fuel trading Oil Oil pipeline

Russia Railways

Railway

Chairman

Igor Sechin* Chairman Yevgeny Shkolov Board of Directors Board of Igor Shuvalov Directors Vladislav Surkov Chairman Vladimir Yakunin* President * member of KGB.

Business Concentration Rosoboronexport Arms exports Rosoboronexport Arms exports Aeroﬂot Airline

Day job

Putin aide

Putin Chief of Staff Foreign affairs adviser to Putin Kremlin staff Presidential aide

Presidential economic adviser Transnefteprodukt Pipeline hardware Kremlin staff Russia Railways

that in any future restructuring, the funds be reserved primarily for reinvestment and consumption. Most important of all, the bulk of economic rent should not go exclusively to the newly emerged class of oligarchs as happened in Russia. 3 Russia’s Privatization Experience The privatization process in Russia is a perfect example of how NOT to do it. With so much wealth to privatize, it was almost inevitable that Russia would make a mess of it. Had Russia been poorer, there would have been less to steal. Instead there was enormous pressure for those alert to the opportunities to seize the country’s most valuable assets before someone else did. While it was nice not to have to import such resources, the presence of such “easy” wealth was an enormous temptation in Russia. It was almost a guarantee that Russian society would be corrupted—if not individual corruption than systemic corruption; that is, Russia would come to rely too much on its oil and less on hard work and manufacturing, the so-called Dutch Disease. Russia’s energy properties were among the ﬁrst entities to be privatized. Thus the Ministry of the Gas Industry was one of the ﬁrst state institutions to be transformed into a private corporation. In August 1989, the then Minister of the Gas Industry, Viktor Chernomyrdin, converted almost the entire gas ministry into a hybrid state-corporate enterprise which he called Gazprom. Initially the state retained sole ownership and held all the stock (it now owns one share more than 50%) but gradually shares were sold to public individuals, ﬁrst of all to the then private company’s senior executives, especially Rem Vyakerev, Chernomyrdin’s successor. The Ministry of the Petroleum Industry was similarly transformed. But instead of creating one massive entity as they did with Gazprom, the reformers broke the

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petroleum ministry into several separate entities. The acting minister at the time, Vagit Alekperov, set aside three choice producing ﬁelds, Langerpaz, Urengoi and Kogalym, for himself and called his new company LUKoil. In the same way, Vladimir Bogdanov, who was also a senior petroleum ministry executive in charge of some producing ﬁelds in Surgut, ensured that he ended up as the principle shareholder of what he came to call Surgutneftegaz. While neither man owned all the shares of their companies, they did acquire enough so that not only did they gain effective control of their companies, they also made it into Forbes Magazine’s list of the world’s richest billionaires. All three, Vyakerev, Alekperov and Bogdanov had been members of the Soviet nomenklatura before the breakup of the country in 1991. They simply seized for themselves some of the same properties they had managed for the state. But it was not only the elite nomenklatura who enriched themselves in the process. With the collapse of the Soviet Union, a small group, almost all of whom had no standing in the Soviet nomenklatura, gradually emerged from the shadows of the black market and the underground economy. These social misﬁts, as they were regarded in the Soviet era, began as traders of goods and providers of services. Prior to 1987, their activities were treated as economic crimes. However, once Mikhail Gorbachev decided to legitimize private and cooperative activities in 1987, what had traditionally been an illegal act became legitimate. More than that, these individuals who had heretofore been regarded as somewhat shady, suddenly became wealthy and prominent. They knew where and how to obtain goods in short supply. This was important because with so many empty shelves throughout Russia in 1992, an ability to search out goods in short supply gave traders an enormous advantage over the state ofﬁcials who had previously run the economy. Not surprisingly, many of these traders became very wealthy very quickly. The oligarchs, as they came to call themselves, then used their new wealth to open private commercial banks which Gorbachev also authorized in 1987. In this new world of private business and banking, the state by itself no longer could dictate economic policy without considering how the private sector and the oligarchs might respond. For example, if these new oligarchs who were said (incorrectly) to control as much as 50% of the country’s industrial wealth refused to pay their taxes, the state in turn would ﬁnd it difﬁcult to pay its bills. As the state’s ﬁscal crisis worsened, Vladimir Potanin, one of the new bankers, declared he was eager to help the government pay its bills. More than that, he would mobilize the other major bankers for that purpose. In what came to be called “Loans for Shares” Potanin and the other large private bankers offered to lend the government the money it needed. In return, the government would have to provide collateral in the form of shares of stock in companies that had not yet been privatized. This sounded fair enough but in the process, the Loans for Shares initiative enabled the oligarchs to gain control of Russia’s richest raw material enterprises. Such a scheme was attractive to the bankers because the state had not yet privatized some of its most valuable raw material entities. In theory, it was also attractive to the governmental authorities, because once enough in the way of taxes had been collected the stock would be returned. As a safeguard, if for some reason tax collection did not increase, then the bankers committed themselves to auctioning

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off the stock. In this way, the ultimate proceeds for the state would substantially exceed the size of the loan. Since it was the oligarchs who were not paying their taxes, they knew better than anyone else that it was unrealistic to expect that the state tax revenue would increase enough to pay back the loans. What was not as widely anticipated however, was that almost all the bankers would also rig their auctions. By disqualifying anyone who might make a serious competitive bid, the bankers conducting the auction made sure that they themselves would end up as the winners. In this way, Mikhail Khodorkovsky was able to gain control of Yukos (a $15 billion company) for some $300 million. Similarly, Boris Berezovsky paid a mere hundred million dollars for what is now a $10 billion Sibneft. Potanin won control of Norilsk Nickel in the same way. The Loans for Shares scheme led to the most criticized acquisitions by private holders of what had been some of the states most valuable assets. Given the enormity of what could be called a quasi-theft, sooner or later there was bound to be a backlash. It was only a matter of time before the public and various political leaders became sensitized to what at best was an unfair and unearned seizure of state resources. The reform process was further tainted by the fact that so much of the focus was on the privatization of state monopolies. Few seemed interested in fostering the startup of new small businesses. To the contrary, shortly after his appointment as prime minister, Viktor Chernomyrdin, as we saw, criticized the mess and rubbish which were an inevitable by-product associated with the street markets. Yet street markets and bazaars are an important starting point for many small businesses. Chernomyrdin’s reaction was in part a legacy of both the czarist and Soviet eras when the emphasis was traditionally on large scale operations, “gigantimania” as they called it. Nor were business startups facilitated by the bureaucratic stranglehold that faced anyone foolish enough to attempt to start a new business. The chinovnik (bureaucrat) so prominent in Gogol’s and Tolstoy’s novels was as ubiquitous a presence a century ago as he is today. This disdain for the small businessman is another reason why small businesses today, as we saw, account for only 10–15% of Russia’s GDP. If all this were not enough, the reforms were further ﬂawed by the massive outpouring of capital that characterized the ﬁrst decade of the reform. The estimate was that the net capital ﬂight exceeded a billion dollars per month. Those with money feared the maﬁa, the bureaucrats and each other. It was only prudent to ship as much money as possible out of the country for safekeeping. It was as if there were a race to see who could strip the most assets from the one-time state enterprises and anything else the oligarchs could put their hands on. Only in early 2003 and again in 2005 did the net ﬂow of capital turn positive. This asset stripping of necessity also had an impact on production. For example, production of natural gas began to fall in 1992 and continued to decline through the remainder of the decade. Petroleum output fell even more precipitously. Whereas crude oil production was 452 million tons in 1991, by 1996 it had dropped 35% to 293 million tons. By the time of the Duma elections in December 2003, the public at large had come to regard the reform process, particularly the privatization effort, as highly ﬂawed. Depending on how the question was asked, from 70–90% of those polled favored the renationalization or at least a revisiting of the privatization process.

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The reformers must take the blame for drawing up an unsuitable blueprint. Their initial claims of success notwithstanding, the arbitrary behavior of Putin and other state authorities have left investors and entrepreneurs, present and past, with the enormous uncertainty. There is now the fear that at any time, just as they did with Yukos and the arrest of its CEO Mikhail Khodorkovsky, state authorities can call a company’s legitimacy into question. Recognizing this, Vladimir Putin tried to restore calm with the reassurance that “if 5, 7 or 10 people broke the law, that doesn’t mean that the others did.”6 The only problem is that he did not identify who those 5, 7 or 10 were. The $60–70 price of oil in 2005 served to offset some of that anxiety among those seeking shares in Russian oil and gas companies, but investing in Russia is still accompanied by an abnormal degree of uncertainty. 4 China’s Privatization Experience The situation in China is very different; at least on the surface. China lacks the resource wealth that so inﬂuenced the process in Russia. Nor did China embrace privatization in the all-encompassing, almost instantaneous way adopted by the Russians. In contrast to Russia, China moved very slowly and cautiously toward privatization, in large part because of fear that privatizing state industry might result in massive worker layoffs and subsequent labor unrest. (Chinese workers are much less passive than their Russian counterparts, who almost always seem resigned to a life of abuse and struggle.) Instead the Chinese have put much more emphasis on fostering startups and new business formation. And because of their signiﬁcantly lower labor costs, the Chinese seem better able to foster local manufacturing businesses that with time often result in products that are more sophisticated and competitive. Of course there are many similarities. The ﬁrst is that corruption is a major presence in business life in both countries. In China, government guanxi, corruption and payoffs play a proportionately bigger role than maﬁa crime whereas in Russia while government corruption has become a serious concern to private Russian operators, the maﬁa initially in the early 1990s was the major obstacle. Finally, courts in both countries still selectively choose which laws they want to have enforced. In China, the ostentatious display of wealth, even the appearance of a name in the upper echelons of the Forbes list of the richest oligarchs, sharply increases the risk of a visit from the local and national tax police. For example, businessmen such as Zhou Zhengyi, Li Haiching, Liu Han, Yang Bin, Yang Rong, Chau Ching-Ngai and Zuao Jinling, who were once included on the Forbes list were either visited by the tax authorities, murdered or found themselves in prison.7 Some of the Russian oligarchs now ﬁnd a listing in Forbes Magazine invites the same kind of danger. Perhaps the biggest difference between those on the Russian list of the rich and a similar Chinese list is the number of Chinese on the Forbes list who are self made (see Table 12.3). 6 Moscow Times, December 24, 2003. 7 New York Times, October 29, 2003, p. A5: International Herald Tribune, October 16, 2003; South China Morning Post, October 22, 2003.

Table 12.3

RE RE RE SM SM SM RE SM RE RE SM RE SM

SM SM, RE

SM SM

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Forbes Top 25 Richest Chinese Worth ($US, mill.) 1,640 1,600 1,430 1,270 1,250 1,160 1,200 1,100 1,100 1,000 1,000 810 800 680 620 620 610 530 530 490 490 470 450 444 420 410

Source: Forbes Magazine SM—Self made RE—Real estate

Name Larry Rong Zhijian Yan Jiehe Zhu Mengyi William Ding Lei Wong Kwong Yu Liu Yongxing Liu Yonghao Guo Guangchang Xu Ming Hui Wing Mau Chen Tianqiao Zhang Li Lu Guanqiu Wu Guodi Du Sha Zhou Zerong Zhang Rongkun Robin Li Shen Wenrong Chen Lihua Liu Fang Lou Zhongfu Jin Fuyin Zhou Furen Zhu Yicai Liang Xinjun

Company CITIC Paciﬁc Group China Paciﬁc Construction Group Hopson Development, Guangdong Zhujiang Invest Net Lease.com Gome Appliances East Hope Group New Hope Group Fosun High-Tech Group Shide Group Shimao Group Shanda Interactive Entertainment R & F Properties Group Wanxiang Group Alison Group Home World Group Kingold Group Fuxi Investments and Feidian Investments Baidu Jiangsu Shagang Group Fu Wah International HK Group Ping An Insurance Guangsha Holdings Shanghai People enterprise group Xiyang Group Jiangsu Yurun Food Fosun High-Tech Group

Business activity electricity, telecom, steel conglomerate construction manufacturing mobile phones retail agribusiness ﬁnance, banking drugs, steel, retailing, manufacturing building materials, real estate real estate computer games real estate auto parts

computer games furniture, real estate

food drugs, steel, retailing, manufacturing

The Revival of Private Enterprise in China

194

This is a by-product of the availability of cheap labor and as we saw, the absence of major deposits of raw materials. There was no meaningful struggle to gain control of raw materials in China since there were so few that were privatized that were worth struggling over. But that in no way means that inﬂuence, connections or bribes were not important in the Chinese privatization effort. It turns out that gaining control over Chinese government property has also led to abuse in China. However, the struggle was not over raw material deposits, but something that is in equally short supply, and that is land. Given China’s massive population, control of well-located parcels of land in many ways brings with it the access to wealth we normally associate in Russia with control of raw material deposits such as oil and gas. At least the Chinese practice does present such possibilities if the land is acquired at a price far below that which it would bring in a fair and competitive auction. This is equivalent to Khodorkovsky’s acquisition of the multi-billion dollar Yukos for $300 million. What is important in such cases is not what the new owner has done to enhance the value, productivity or attractiveness of the product. The value is already there. The only difference is that the act of privatization combined with non market considerations allow the new private owner to acquire this asset for reasons that have nothing to do with innovation or improvement. Thereby the new landlord becomes the recipient of this new economic rent. Winning control of the block opposite the Beijing Hotel in Beijing is not worth as much as Khodorkovsky’s oil ﬁelds, but whenever a Chinese real estate developer manages to gain operational control of centrally located land at a token price or rent, the principle is the same. In other words, in China there are oligarchs on the Chinese Forbes list who are there because the state or local government authorities turned over operational control of some of China’s most valuable, scarce resource, its land. In China, it is not only petroleum that is scarce, but land. The point is that China has not entirely escaped the phenomenon of oligarchs deriving their wealth purely from their success in gathering control of what under communism had been state-owned assets. This happens when the new oligarchs seize such control without paying full value for their acquisitions. The difference between the value and what is paid for this purchase (the economic rent) is almost always substantial. That is in part because under communism almost no one was able to accumulate much in the way of net worth and in part because the transfer of ownership is usually the result of bribes, kickbacks or guanxi. But it speaks well for China that while about a third of the Chinese oligarchs derived their wealth from real estate, i.e. economic rent, this makes up a smaller percentage of the new Chinese rich than is the case in Russia.8 While ten of the Forbes list of the 50 richest Chinese have reached the one billion dollar level, slightly more than half of those who do appear on the list appear to be self made, that is they made their money by manufacturing and adding value, not by extracting rents either from tenants or taking resources out of the ground. Admittedly there are probably very few of these rich Chinese who operate completely independent of the state. Just as in Russia, it is essential that erstwhile 8

Forbes, February 27, 2006.

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195

oligarchs have a patron in higher places or a krisha (a roof) as the Russians call it. Moreover, some of the manufacturing operations in China started out as state or even communal enterprises. But there are some purely private startups as well whose origin is due solely to the entrepreneurial efforts of a few or even a single individual who have managed to create something out of nothing. The point is, the acquisition of their wealth involved more than simply taking over the operations of an already existing enterprise or a piece of land that was overdue for development. The difference in the way the Chinese and Russians treat small businesses and startups is striking. According to ofﬁcial Russian statistics, the number of ofﬁcially registered small and medium businesses as of January 1, 2002, was 843,000. This was a substantial decline from two years earlier when 891,000 small businesses were registered.9 It was only in 2004 that the number of small businesses in Russia again rose to the 2000 level of 891,000.10 According to Jorgen Delman, a Danish specialist on private business in China, the number of individual businesses in China exceeds 24 million. As Delman sees it, the Russian problem is that Russian authorities do all they can to extort entrepreneurs before they begin to operate. That explains why small business accounts for only 10–15% of the GDP. Not many want or are able to make their way through the maze of regulations necessary to win operating approval. By contrast in China, the bureaucrats are eager to facilitate entry so that they then have something to extort on a regular basis, not just one time. If a company never makes it through the permission process, then there is only one opportunity. 5 Lessons for China Since China began the process of privatization so much later and so much more modestly, it is not too late to learn from Russia’s mistakes. But the model that China should seek to emulate is Poland.11 Seeking to avoid many of Russia’s mistakes, the Poles realized from the beginning that if they wanted their reforms to be successful, not just for a time in the beginning but in the long run, they would have to head off recriminations of the sort that have led to the arrest or exile of some of the original oligarchs and now also threaten to undo or reverse at least some of the privatization work in Russia. It is essential therefore to design a system where the factory directors do not automatically take over as the owners. It is also important that the public at large derive some real material beneﬁt from the privatization process, not just in the beginning but on a continuing basis. The Poles did this by turning over 60% of the stock of their newly-privatized enterprises to 15 mutual funds that were set up for this purpose. However, recognizing that if the stock were divided up equally among these 15 mutual funds, no one would have effective control, the reform was designed so that 33% of each company’s stock was given to one of the mutual funds while 27% was divided up among the other 14. Finally while the directors and the other members of the work force were also allocated 15% of the stock (enough to make 9 Goskomstat, Russia, Rossiiskii Statisticheskii Ezhegodnik, Moscow 2003, p. 318. 10 Goskomstat, Russia, Rossiiskii Statisticheskii Ezhegodnik, Moscow 2005, Table 13.5. 11 See Goldman (2005).

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them feel that they had a stake in the ﬁrms’ success, but not enough to cause the managers to disregard the instructions of the dominant mutual fund) the remaining 25% of the stock was set aside for state pension funds. Thus in addition to receiving shares of stock of each of the 15 mutual funds, a one-time beneﬁt of privatization, each Polish citizen could look forward to sharing the proﬁts of these privatized ﬁrms as some of their dividends were sent to the state pension fund. Unlike what happened in Russia, the public at large in Poland ended up not only with a large share of the wealth from the initial privatization effort, but with a share of the ongoing proﬁts. In this way, there was relatively little in the way of economic rent that went only to the factory directors or the oligarchs of the newly-privatized companies. That explains why on Poland’s list of its richest citizens, the number of self-made entrepreneurs is impressively high while there are relatively few whose wealth stems primarily from the acquisition of large holdings of stock in what were formerly state industries. 6 Conclusions and Discussion There is much to learn from this experience for both Russia and China. In the case of Russia, it is clear that unless voluntary efforts are made retroactively by the oligarchs to provide the state with a substantially large share of the economic rent they acquired initially and continue to enjoy, there will be continuing pressure from politicians and bureaucrats to harass such ﬁrms. This will bring with it continuing uncertainty. No one will know who might be called in and arrested or which private companies will be seized by state authorities (see Table 12.4). This has to have a negative impact on investment and economic growth, particularly in more sensitive areas such as manufacturing where investors require a stable long term horizon. China should learn from Russia’s mistakes and seek to do all it can to ensure that as in Poland, the economic rent that arises from privatization should be designed so that such rent is held to a minimum and that as much as possible of that rent is shared by the state and the public at large. It is impossible to prevent some operators from beneﬁting more than others when privatization occurs. But everything possible should be done to keep the distribution as equal as possible. Vouchers alone are not enough. The urgency of providing the public with equal shares in the now-privatized state industries should bring with it an insistence on equal wealth for all. Simultaneously with the process of privatization, even more effort should be made to encourage startups and new business formation. This means increasing credit and ﬁnancial opportunities while reducing bureaucracy. Creating a shrunken and user-friendly bureaucracy which seeks to enhance the stature of the businessmen will not be easy. This is true in both China and Russia. At least in China, being a merchant was historically socially acceptable. Admittedly, whenever possible, a Chinese merchant would seek to convert some of his wealth into land and then do everything he could to make sure that his son became a scholar or ofﬁcial. But being a merchant was not an antisocial act. In Russia, the attitude toward businessmen was and is much more negative. As in the days of the czars,

The Privatization of Russian State Industry

Table 12.4

197

Renationalization and Control by Siloviki Renationalized Dec. 2004

New owner Rosneft

Sibneft Oil AvtoVaz Automobile

Oct. 2005 Nov. 2005

Gazprom Rosoboronexport

Kamaz Diesel Trucks VSMPO-Avisma Titanium Gorbunov -Kazan Aircraft MIG Aircraft Sukhoi Aviation Ilyushin Aviation Gagarin Komsomolsk on Amur Aircraft Sokol Aircraft Chkalov Aircraft Tupolev OMZ Heavy Machinery Kamov Helicopter Transneft Pipeline Svyazinvest Telecom Rostelcom Telecom Aeroﬂot Airline United Energy Systems Electricity Alrosa Diamonds

Mar. 2006 Feb. 2006

Rosoboronexport Rosoboronexport

Feb. 2006

United Aircraft

75.0%

Feb. 2006 Feb. 2006 Feb. 2006 Feb. 2006

United Aircraft United Aircraft United Aircraft United Aircraft

100.0% 51.0% 25.5%

Feb. 2006 Feb. 2006 Feb. 2006

United Aircraft United Aircraft United Aircraft

Yugansneftegaz

State’s share (%) 100% (will be reduced to 70% after IPO) 51 2% shares (effective control) Already 100% Under pressure

38.0% 25.5% 65.8% 100.0% 100.0% 100.0% 75.0% 38.1% 51.0% 52.7% 32.0%

there is a real disdain for business and businessmen. The more favorable attitude toward business in China is illustrated by the willingness of so many children of Chinese leaders (the princes) to go into business. It is a much rarer occurrence in Russia. The children of Viktor Chernomyrdin, the prime minister under Boris Yeltsin, but earlier the CEO of Gazprom, did become ofﬁcials of some of Gazprom’s subsidiaries and spinoffs, but as often as not, these were perfunctory or ﬁgurehead roles more important for their prestige and access to proﬁts than for their day to day work. Given the dominance of the bureaucratic mentality in both countries, diminishing the importance of the bureaucracy and its inﬂuence is essential but it will not be easy. As powerful as the bureaucrats were in the pre-revolutionary period in both China and Russia, they became even more entrenched in the communist era where almost everything was bureaucratically determined. Undoubtedly, present day bureaucrats in both countries fully expect that they will endure as well. Fadish campaigns to reduce the size and inﬂuence of the bureaucrats will pass as they always have. This is

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reﬂected in a subtle story the Russians tell to highlight how a good bureaucrat thinks only of the long run and cares little for what the demands of the moment might be: A customer walked into a restaurant as another customer began to shout loudly at the waiter. “Turn on the air conditioner, you idiot. Can’t you see how hot it is here?” “Yes sir,” replied the waiter. However a few moments later the waiter was called over again and this time told, “What’s wrong with you! Are you a penguin or something? It’s freezing here. Turn off the air conditioner.” “Yes sir. Sorry.” After several sets of this “turn on the air conditioner, turn off the air conditioner,” the quiet customer called the waiter and asked how he could stand such abuse and vulgarity. “It’s no problem,” he responded. “We don’t have an air conditioner!” References Boycko, M., A. Shleifer and R. Vishny, Privatizing Russia (Cambridge: MIT Press, 1995). Goldman, M.I., The Piratization of Russia: Russian Reform Goes Awry (New York: Routledge, 2005).

Chaper 13

Politician Control, Agency Problems, and Ownership Reform: Evidence from China1 Lixin Colin Xu, Tian Zhu, Yi-min Lin2

1 Introduction The performance of state-owned enterprises (SOEs) suffers from both political costs (i.e. the costs associated with control of ﬁrms by politicians who have political goals that differ from economic efﬁciency) and agency costs (i.e. the costs resulting from managerial pursuit of private beneﬁts at the expense of the ﬁrm) (Shleifer and Vishny, 1994; Qian, 1996). Whether these costs can be contained is the key to the success of SOE reforms. The large-scale ownership and organizational reform of Chinese SOEs during the second half of the 1990s represents the Chinese government’s attempts to address the issues of politician control and agency problems. Since the early 1990s, China has shifted the focus of its SOE reform from delegation of decision-making authority to the reform of ownership and corporate governance. Two strategies have been adopted: privatization and corporatization.3 The reforms were propelled by the fact that SOEs’ ﬁnancial performance steadily 1 This chapter is a permitted reprint of an article in Economics of Transition, Volume 13 (1) 2005, 1–24. The research for this chapter was funded by the Hong Kong Research Grants Council and the World Bank Research Committee. We thank George Clarke, Chun Chang, Robert Cull, Yingyi Qian, Mary Shirley, T.J. Wong and two anonymous referees for their very helpful comments on an early version of the chapter. The ﬁndings, interpretations and conclusions in the chapter are entirely those of the authors and do not necessarily reﬂect the views of the World Bank, its Executive Directors, or the countries they represent. 2 Xu: The World Bank and Guanghua School of Management, Peking University. MC 3-420, Development Research Group, The World Bank, 1818 H Street, N.W., Washington, DC 20433. Phone: (202) 473-4664. Fax: (202) 522-1155. Email: [email protected]. Zhu: Division of Social Science, Hong Kong University of Science and Technology. Lin: Division of Social Science, Hong Kong University of Science and Technology. 3 Researchers appear to have different deﬁnitions of privatization and corporatization. Sometimes any divestiture of state shares is taken to imply privatization. Here, we follow the World Bank (1995) and Shirley (1999) who deﬁne privatization as “the sale of state-owned assets” such that “management control (measured as the right to appoint the managers and board of directors) passes to private investors”. Corporatization, on the other hand, is deﬁned as diversiﬁcation of ownership structure, especially through inclusion of non-state parties as

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deteriorated during the 1990s, following a period of improved productivity in the 1980s (Lardy, 1998).4 Privatization is mostly used to sell small SOEs to private entrepreneurs (Cao, Qian and Weingast, 1999). The main strategy, however, is corporatization (Zhu, 1999). This aims to turn SOEs from sole state proprietorships controlled by industry-speciﬁc government agencies at various administrative levels to modern-form corporations with a Western-style corporate governance structure without serious erosion of dominant public, but not necessarily state, ownership. Corporatization transforms most SOEs into three types of shareholding companies: limited liability companies (LLCs), limited liability stock companies (LLSCs), and employee-owned stock cooperatives (EOSCs) (Lin and Zhu, 2001).5 The shares of reformed ﬁrms are classiﬁed into ﬁve categories: state-owned, individual-owned (mostly shares issued to employees individually), legal-person-owned (i.e. shares owned by any institution that has a legal person status such as an investment company), collective-owned (i.e. shares issued to employees as a collective) and foreign-owned. In most corporatized enterprises, the majority of the shares are held by the state, business entities controlled by or afﬁliated with the government or other SOEs, and employees. In this research, we use data from a recent national survey of the ownership reform of state-owned industrial enterprises in China to study the effects of reducing politician control and agency problems on a number of measures of the reform outcomes. Taking into account the endogenous nature of the reform, we ﬁnd that these outcome measures of the reform’s success are positively affected by the lessening of politician control through increasing the ﬁrm’s ﬂexibility in labor deployment and by the mitigation of agency costs through the introduction of more effective corporate shareholders, “to make SOEs operate as if they were private ﬁrms facing a competitive market or, if monopolies, efﬁcient regulation” (Shirley 1999, p. 115). 4 Small-scale ownership reform of SOEs, which is often referred to as shareholding reform in China, began in the mid-1980s; systematic experimentation with the shareholding system began in 1992 (SCESR 1997). In December 1993, the Company Law was passed, and SOE reforms entered a stage in which privatization or corporatization of SOEs could, in principle, be guided by law. Large-scale ownership reform started in the mid-1990s. By the end of 1998, some 24,000 or 10.1% of SOEs had either been privatized or corporatized (People’s Daily, August 7, 1999). 5 As reported in Lin and Zhu (2001), the vast majority of reformed SOEs were converted into these organizational forms, and only 7% were turned into pure private ﬁrms. Yet there are also a number of corporatized enterprises where non-state owners held the majority of shares. According to the Company Law, the main differences between limited liability companies and limited liability stock companies lie in the following: (i) the equity capital threshold (0.5 million vs. 10 million yuan), (ii) the level of approving authority (sub-provincial vs. provincial government or an authority designated by the State Council), (iii) the number of shareholders (2–49 vs. 5 or above), and (iv) the liquidity of shares—only shares in limited liability stock companies can be traded on a stock exchange, and only companies with equity capital of over 50 million yuan are eligible for listing. Employee-owned stock cooperatives are limited liability entities owned wholly or predominantly by the employees, individually (through shares issued to individuals) or collectively (through “collective shares”). There is no minimum equity capital requirement. The shares for individual holdings can only be issued to enterprise employees, who may receive dividends in addition to their regular wages.

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201

governance mechanisms such as one-share one-vote and shareholding-based board structure composition. Ownership structure also matters: relative to shareholding by the state, foreign ownership has a positive effect on reform outcomes; individual (mostly employee) shareholding has a negative or insigniﬁcant effect. Somewhat surprisingly, operating autonomy (excluding labor deployment ﬂexibility) has a negative effect on ﬁrm performance, suggesting serious agency problems in the reformed enterprises. Our study contributes to the literature on comparative economic transition. Chinese reform of SOEs contrasts with the reform strategy adopted in many Central and Eastern European countries. In these countries, outright privatization is the dominant measure of enterprise reform, whereas in China, privatization is limited only to small SOEs. The reform in China also contrasts with corporatization in these countries, where it was used to convert SOEs into wholly state-owned joint stock or limited liability companies and was pursued as a prelude to privatization (Frydman et al, 1993). In China, corporatization has been pursued as a lasting measure of SOE reforms, and in most cases corporatized enterprises have non-governmental shareholders. Previous empirical studies of the effects of enterprise reform in China mostly focus on the effect of decentralization of decision-making authority and incentive contracting on the performance of SOEs (Groves et al, 1994; Jefferson, Rawski and Zheng, 1996; Li, 1997; Xu, 2000; Shirley and Xu, 2001), or compare differences in performance between state and non-state ﬁrms (Woo et al, 1994; Xu, 1995; Jefferson, Rawski and Zheng, 1996; Zhang, Zhang and Zhao, 2001). This research is one of the ﬁrst few systematic empirical studies on the impact of the more recent SOE ownership reforms. Yao and Song (2003) also study the impact of ownership reform on ﬁrm performance in China, but they use a different dataset with a few hundred ﬁrms. Our study also adds empirical material to the literature on corporatization. While there is a large body of literature on privatization (Megginson and Netter, 2001), there has been only limited empirical research to systematically evaluate corporatization, in China or elsewhere. Lin and Zhu (2001) use the same survey data set mainly to examine organizational forms, ownership and the corporate governance structure of reformed enterprises, and the determinants of the pace of the reform. In this chapter, we focus on the determinants of post-reform operating performance. Lee (1999) ﬁnds that reforms with corporatization elements undertaken in China between 1980– 1994 lowered wages and improved productivity. Our study complements his in focusing on a different time period with different reform content as well as in using a different conceptual framework. Finally, Shirley (1999) provides empirical evidence that corporatization works better when combined with ownership and other reforms. The evidence she provides is based on case studies of 12 developing countries. In this chapter, we use a large sample of ﬁrms from a national survey in China to examine the short-run impact of ownership reform on performance. In particular, we focus on the role of decision-making autonomy, ownership structure and corporate governance in explaining the performance of reformed ﬁrms. In Section 2, we present a conceptual framework that will be used to guide our analysis and to interpret our empirical ﬁndings. In Section 3, we describe the data and deﬁne the dependent and explanatory variables. Section 4 presents the econometric

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methods. The ﬁndings are reported in Section 5. The concluding section summarizes the main results and discusses their implications as well as limitations. 2 Politician Control, Agency Problems, and Corporate Governance Our empirical investigation is guided by some of the recent economic theories of organization and corporate governance, where authority relations are a central issue. Aghion and Tirole (1997) distinguish between formal and real authority in economic organizations. They show that real authority, i.e. the effective control over decisions, is determined by the structure of information, which in turn depends on the allocation of formal authority (i.e. the rights to decide). In other words, with more formal authority, an agent will have incentives to acquire more productive information and hence enjoy more real authority. However, agency costs increase as more formal authority is delegated to the agent. Before enterprise reforms started in the early 1980s, Chinese SOEs were controlled by politicians6 who exercised almost all the formal authority over operating and personnel decisions. Such an allocation of authority led to a lack of managerial initiative on the one hand, and politically-motivated or misinformed business decisions on the other. Politicians have incentives to control or/and subsidize SOEs to achieve economically inefﬁcient objectives for political purposes. In particular, politicians may require an SOE to hire more workers than needed or to maintain excess employment at the expense of ﬁrm performance (Shleifer and Vishny, 1994). Politicians do so in order to win political support, or to avoid “social instability” that may arise as a result of high unemployment. Politicians may also ask an SOE to meet output growth targets that they can tout as their policy achievement even if the enterprise cannot sell all of its output at a proﬁt. These considerations led to many problems among Chinese SOEs under the command system. Chinese reforms that delegated many of the decision-making rights to SOE managers in the 1980s (Naughton, 1995) can be viewed as allocating some of the formal authority to the managers. As implied by Aghion and Tirole’s theory, managerial autonomy then motivated SOE managers to become more informative about business decisions; as a result, they enjoyed more real authority. However, as agents of the state, SOE managers had a strong incentive to use (i.e. abuse) their newly acquired power in their own self-interest. On the other hand, politicians often maintained formal authority over key personnel and investment decisions and, in particular, over labor deployment. In an insightful application of organization theories to Chinese enterprise reform, Qian (1996) characterizes the plight of Chinese SOEs in the 1990s as being caused 6 We follow Shleifer and Vishny (1994) in using the term “politicians” instead of “bureaucrats”, the term used by, e.g. Bai and Wang (1998), Li (1998) and Shirley (1999), to refer to government ofﬁcials in charge of enterprises in a socialist or transition economy. This terminology is consistent with our using the term “political costs” rather than “bureaucracy costs” to refer to inefﬁciencies associated with politician control. In organizational economics, the term “bureaucracy costs” is often used to refer to the costs of using hierarchies rather than markets in organizing transactions (Williamson, 1985).

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by a combination of agency problems and politician control. Agency problems arise as managers enjoy more authority, formal as well as real, over business decisions, thanks to delegation reforms. While politician control may be a mechanism of checks-and-balances to mitigate agency costs, it also causes the loss of information, inefﬁcient interference in management, use of incompetent but obedient managers, bad investment decisions, and soft budget constraints.7 Qian (1996) argues that SOE reforms should aim at reducing both political and agency costs by establishing a new corporate governance system through a variety of measures such as depoliticization, privatization, and corporatization. China’s recent SOE ownership reform is indeed intended to deal with both of these costs through the establishment of a Western-style corporate system. It is hoped that political costs and agency costs will be simultaneously reduced by separating government from enterprises, introducing non-government corporate/institutional shareholders as well as employee and private shareholders, and establishing a more effective corporate governance structure. However, as state ownership is still signiﬁcant in the majority of reformed enterprises, and social institutions such as a social safety net that may be necessary for the complete separation of the government from enterprises have just begun to develop in China, some degree of politician control, particularly over labor deployment, should still linger in the reformed ﬁrms. Moreover, it takes time to establish market-oriented economic and legal institutions conducive to effective corporate governance in a transitional economy (Shleifer and Vishny, 1997). Therefore, corporate governance in reformed enterprises often deviates from what is stipulated in the law and may be quite ineffective in containing agency costs. Consequently, both politician control and managerial moral hazard continue to pose problems in reformed enterprises. Chinese managers in general enjoy more decision-making autonomy after ownership reform. This reduces political costs but may possibly increase agency costs when other mechanisms normally used to counter managerial moral hazard are weak or simply not present. The net effect of operating autonomy on ﬁrm performance is thus an open empirical issue. Managerial control over labor decisions, which have been signiﬁcantly conditioned by political considerations, should however improve ﬁrm performance. According to Shleifer and Vishny (1994), politician control tends to create labor redundancy in ﬁrms. In fact, there is strong evidence that Chinese SOEs demonstrate excess employment (Dong and Putterman, 2003). Unlike politicians, managers are not concerned about general employment situations. When given control over labor deployment, managers have stronger incentives to cut excess employment than politicians do. Politician control also manifests itself in the selection and replacement mechanism of CEOs. If CEOs are appointed by the government, they are more likely 7 Politician control is sometimes viewed as a form of agency problem because politicians enjoy the control rights but are not the residual claimants, and thus can be viewed as agents of the citizens (Bai and Wang, 1998). In this chapter, we follow Qian (1996) in using the term “agency problems” in a narrow sense to refer to the managerial moral hazard problem.

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to be subject to politicians’ inﬂuence. On the other hand, government-appointed CEOs are accountable to politicians and hence their ability to abuse their power is possibly curtailed. The net effect of government appointment of CEOs on ﬁrm performance is, therefore, subject to empirical investigation. Moreover, replacing the incumbent management during the reform is found in the literature to result in better ﬁrm performance (Denis and Denis, 1995) and more restructuring in transition economies (Barberis et al, 1996). It is of some interest to see whether this is also the case in the Chinese reforms. Ownership structure should impact on performance.8 Greater ownership stakes by non-state shareholders such as private individuals or foreign investors may imply relatively lower political costs, closer monitoring and more pressure for proﬁts on self-interested mangers. However, not all private shareholders exert equal efforts on monitoring. Since the beneﬁts of monitoring are shared by all shareholders while the costs are borne completely by the monitoring party, large shareholders internalize the costs and beneﬁts of monitoring to a greater extent, and therefore exert more monitoring efforts (Shleifer and Vishny, 1986). Indeed, Morck, Shleifer and Vishny (1988), McConnels and Servaes (1990), and Wruck (1989) ﬁnd evidence of the positive effects of appropriate levels of ownership concentration, whereas Anderson, Lee and Murrel (2000) ﬁnd that dispersed private ownership leads to worse performance than that exhibited by state ownership in Mongolia. In the current context, foreign and legal person shareholding may be characterized as representing relatively more concentrated ownership. It is thus possible that foreign ownership and legal person ownership may lead to better performance than state ownership. On the other hand, if shareholding by domestic private individuals (mostly employees in the Chinese case) is more of a dispersed ownership, then the comparison between state ownership and private ownership can only be settled empirically. Theories of corporate governance imply that the degree of alignment of ﬁrm ownership and control, as reﬂected in the voting mechanism and the board structure, affects performance.9 One-share-one-vote is generally believed and theoretically shown to be a more efﬁcient voting mechanism in corporate governance (Grossman and Hart, 1988; Harris and Raviv, 1988). One-share-one-vote helps to reduce the likelihood that the manager would respond to shareholders that have greater control than that which their proportion of the total shares implies. Another mechanism used to protect shareholder interests is a shareholding-based board of directors. If a ﬁrm’s board structure is characterized by a divergence between ownership shares and board representation, the manager and the shareholders who are disproportionately represented on the board may collude to pursue private or parochial interests at the expense of the under-represented shareholders. We thus expect, ceteris paribus, ﬁrms observing the one-share-one-vote rule and ﬁrms with a shareholding-based board structure to demonstrate better performance. 8 See Shleifer (1998) and Megginson and Netter (2001) for excellent summaries of theories and evidence on the performance effect of ownership structure. 9 See Shleifer and Vishny (1997) for a survey of the corporate governance literature and Hermalin and Weisbach (2001) for a survey of a new literature on how the structure of the board of directors affects company performance.

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3 Data and Variables The data we analyze are drawn from a national survey of the ownership reform of industrial SOEs in China. The survey was conducted by the National Statistical Bureau in the summer of 1998. Its aim was to examine how ownership reform had proceeded among industrial SOEs during all of 1997 and the ﬁrst quarter of 1998. The survey took the form of a three-part questionnaire. The ﬁrst part contains: (1) questions about the enterprise’s basic proﬁle (i.e. enterprise code, sector, location, and size); (2) the status of ownership reform (e.g. whether and when ownership reform was completed and what new organizational form was adopted, etc.); and (3) a personal proﬁle of the top manager (e.g. age, gender, education, etc.). The second part of the questionnaire contains a set of questions about ownership structure and accounting information for the period under review. The third part of the questionnaire contains questions about various aspects of the reform, including questions on corporate governance structure, enterprise autonomy and in particular the manager’s assessment of the effect of the reform. A total of 40,246 industrial enterprises responded to the survey, equivalent to 62% of the total number of industrial SOEs that were in operation during that year.10 All the enterprises in the survey were required to answer the ﬁrst part of the questionnaire. 6,872 of the enterprises that responded to the survey (i.e. 17% of the enterprises surveyed) indicated they had completed their reform by the time of the survey. Only the reformed enterprises were required to answer the second part of the questionnaire (i.e. on ownership and accounting information). A selected group of reformed enterprises was also asked to answer the third part of the questionnaire, and 2,632 ﬁrms responded.11 Out of the 2,632 selected enterprises that responded to all three parts of the questionnaire, 1,634 completed their reform in 1997. We generate a data set based on the survey results of these 1,634 enterprises. We only select ﬁrms that completed their reform in 1997 because we will use the accounting data in the ﬁrst quarter of 1998 to examine the performance effect of the resulting ownership structure, corporate governance mechanisms and enterprise autonomy. The data set thus includes accounting and ownership information for all of 1997 and the ﬁrst quarter of 1998, information on the proﬁles of selected enterprises and their managers, as well as information on certain aspects of corporate governance and the manager’s subjective assessment of the effects of the reform. Because some values were missing, the numbers of valid observations for our regressions are between 900 and 1000. The variables used in our analysis are deﬁned in Table 13.1. We have three dependent variables. The ﬁrst is the conventional operating performance measure, 10 According to China Statistical Yearbook (1999, p. 421), there were about 64,900 industrial SOEs in 1998. 11 The number of enterprises selected by each province (or centrally administered municipality) to answer part III of the questionnaire was assigned by the National Statistical Bureau, and ranged from 60 to 150. The provincial statistical bureau’s survey teams were responsible for selecting these enterprises. While selection at the provincial level was supposed to be random, we do not know how quality control was achieved in terms of random and representative sampling.

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Table 13.1 Variable ROAt

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Variable Definitions and Descriptive Statistics Deﬁnition

Returns on assets, deﬁned as before-tax proﬁts over the book value of total assets for the ﬁrst quarter of 1998. Since the top and bottom 1 percentages represent signiﬁcant outliers, we winsorized the data at the 1st and 99th percentiles. That is, the top and bottom 1 percentages are replaced with the 99th and 1st percentile values respectively. Returns on assets for 1997, also winsorized at the 1st and ROAt-1 99th percentiles. The difference in the returns on assets for 1998 and ROAt -ROAt-1 1997. A dummy variable that is one when the manager IMPROV believes the restructuring has improved or will improve performance. Debt-equity ratio in 1997. Winsorized at the 1st and 99 th leveraget-1 percentiles. The logarithm of the number of employees in 1997. lnLt-1 A dummy variable that is one when the manager of the Autonomy reformed ﬁrm has complete or basic autonomy over operating decisions (excluding issues related to labor deployment) and zero otherwise. A dummy variable that is one when the manager feels l_ﬂex that he or she has reasonable ﬂexibility and discretion in labor deployment. A measure of the divergence between ownership structure DO-B j and board structure, constructed as, DO – B = √Σ j=1 (SjB – SjO)2 B where Sj is the share of membership on the board of directors by each type of shareholders, SjO is the percentage share of ownership, and j = state, legal person, collective, individual, and foreign. A dummy variable that is one when the pre-reform CEO staying_CEO stays on as the CEO after reform. CEO_ by_ govt A dummy variable that is one when the post-reform CEO is appointed by the government. A dummy variable that is one when the one-share-one1share_1vote vote principle is adopted for the shareholder meetings. share_individual The share of individual ownership in total outstanding shares in 1998. The share of foreign ownership in total outstanding shares share_foreign in 1998. The share of legal-person and collective ownership in share_other_ total outstanding shares in 1998. ownership

Mean

S.D.

0.012 0.118

0.028 0.098 -0.017 0.108 0.726 0.446

0.842 1.260 5.511 1.515 0.914 0.209

0.722 0.447

0.524 0.362

0.631 0.483 0.163 0.370 0.327 0.469 0.322 0.379 0.014 0.080 0.196 0.334

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returns on assets (ROA), deﬁned as the ratio of before-tax proﬁts over the book value of total assets in the ﬁrst quarter of 1998. This ﬁgure is annualized by multiplying it by four. As the ﬁrms in our sample completed their reform in 1997, this ROA regression only reﬂects the reform’s short-term impact on performance with the underlying assumption that operating performance in the ﬁrst quarter of 1998 can be explained by organizational changes brought about by the reform before 1998. We justify this assumption by noting that there were several stages to the reform process including planning, proposal, approval and implementation, and the entire process normally lasted more than one year. The reform blueprint took shape well before completion of the actual reform. The affected parties should therefore react to the proposed reform well before it actually took place.12 The ROA regression measures how the level of operating performance is affected by ownership reform. To examine how the change in performance is affected by the reform, we also run another regression in which the dependent variable is ROA1998, i – ROA1997, i here we include ROA1997, i on the right-hand side. The lagged performance is controlled because ﬁrms that have performed better in the past tend to show smaller performance changes. Given that it may take time for ownership reform to have its full impact on a ﬁrm’s performance, we use another measure of the reform outcome as our dependent variable: the subjective assessment of the reform by ﬁrm managers, assuming that their assessments are forward-looking. Speciﬁcally, the measure is a dummy variable (IMPROV) that takes the value of one when a ﬁrm’s manager believes that the reform has improved or will improve performance. Clearly all three measures of performance outcomes have shortcomings: the ﬁrst two are based on short-run performance, and the third is subjective. But if we obtain similar ﬁndings from all three sets of regressions, the credibility of the ﬁndings is greatly strengthened. It turns out that the regression results using the three outcome measures are largely consistent.13 12 There is perhaps another issue: given that 1998 is considered by many as a particularly bad year for Chinese economy, does it make sense to use 1998 performance as the dependent variable? We believe this is not an issue. Our focus is not to identify the aggregate effects of ownership reform on ﬁrm performance; rather, we aim to investigate how ﬁrms with different reform patterns (in ownership structure, corporate governance, etc.) were affected differently. Thus, even if all ﬁrms suffered from decreased ROA, ﬁrms with good reforms would be expected to experience a smaller fall (or even an increase) in ROA. A referee points out that 1998 witnessed the worst irregularity in Chinese statistics in a long time. This should not affect our conclusions, however. The Chinese data can have problems when they are related to GDP growth, other aggregate data, and sensitive questions such as corruption. In the case of ﬁrm-level survey data, neither the ﬁrms and the surveyors have great incentives to abuse numbers. For instance, the average annual pre-tax ROA in our sample is only 1.2%, which does not strike us as particularly high. 13 In the data set, the answers for the manager’s assessment of the effect of restructuring on performance are slightly more nuanced than as can be represented by a binary variable, ranging from “signiﬁcant improvement”, “some improvement”, and “no improvement” to “worsening performance”. We collapse “some improvement” and “signiﬁcant improvement” into “improvement”, and “no improvement” and “worsening performance” into “no

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Many studies on Chinese enterprise reforms have used total factor productivity (TFP) as the performance measure. We use ROA as our performance measure for two reasons. The ﬁrst is a practical reason: our data set does not allow us to construct the TFP measure. Second, many Chinese SOEs experienced rising productivity but declining ﬁnancial performance during the 1990s (Bai, Li and Wang, 1997). This situation arose when SOEs failed to sell all of their output or adjust their output in a sub-optimal way (for instance, not reducing quantity when output prices fell) while their technical efﬁciency may have improved. Using the industrial census data in the 1990s, Bai, Du and Tao (2002) ﬁnd that ﬁnancial performance is a robust measure of ﬁrm performance for ﬁrms of various ownership types, while productivity tends to be a fragile measure. In particular, for private ﬁrms, both productivity and ﬁnancial performance are positively correlated and tend to have similar determinants; but for SOEs, productivity and ﬁnancial performance are sometimes negatively correlated and have somewhat different determinants. Therefore, in a study of ﬁrms with different ownership structures, it seems more appropriate to use ﬁnancial performance as the performance measure. In our analysis, the effectiveness of the protection of shareholders’ interest is proxied by two variables. The ﬁrst is a dummy variable (1share_1vote) that takes the value of one when one-share-one-vote is adopted for shareholder meetings and zero otherwise. The second is a new measure we introduce in this chapter to proxy the extent of deviation of ownership from control. Speciﬁcally, we deﬁne a variable DO-B that measures the divergence between the ownership structure and the structure of the board of directors: j DO – B = √Σ j=1 (SjB – SjO)2

(1)

where SjB is the share of membership on the board of directors by each type of shareholder (including state, legal person, collective, individual and foreign),14 and SjO is the ownership share by each type of shareholder. DO – B is bound between 0 and √2. Based on earlier discussions, we expect DO – B to be negatively related to performance and 1share_1vote to be positively related to performance. 4 Methods The regressions we run are the following: ROAi = Xi β1 + Aiα1 + Oiγ1 + DO – B, iδ1 + Ciθ1 + εi ROAt, i – ROAt – 1, i = ROAt – 1, i ρ + Xi β2 + Aiα2 + Oiγ2 + DO – B, iδ2 + Ciθ2 + ε P(IMPROVi = 1) = Φ(Xi β3 + Aiα3 + Oiγ3 + DO – B, iδ3 + Ciθ3)

(2)

improvement”. We believe that collapsing the outcomes into fewer categories will probably reduce the extent of measurement errors in the subjective performance indicator. Moreover, the endogeneity issue is very difﬁcult to deal with under the ordered probit framework. 14 In the board of directors’ data, there is no information on the representation of the “collective” shares, which seem to be included in the vague category “others”. We thus treat “others” as an approximate measure for the “collective” shares.

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The right-hand side of the third regression is the normal cumulative density. X includes such conventional controls as leverage (lagged by one period), and log of the number of employees (lagged by one period) as a measure of size. We have also tried including the logarithm of capital (lagged by one period) in X. The results are very similar to those obtained without including it, while the adjusted R square is roughly the same. We thus decide not to include it. The other explanatory variables will be called the reform variables. A includes two dummies. The ﬁrst is a dummy variable (autonomy) indicating whether the CEO has complete or at least basic decision-making autonomy (the default is that the CEO has limited autonomy) over operating decisions (but not labor deployment). The second is a dummy variable (l_ﬂex) indicating whether the CEO has ﬂexibility in deploying labor after the reform. O includes the percentage ownership share by legal persons, collectives, individuals, and foreigners, respectively, with the omitted category being the state share. Finally, C includes a dummy (staying_CEO) indicating whether the incumbent CEO stays on after the reform, and a dummy (CEO_by_govt) that takes the value of one if the post-reform CEO is appointed by the government, and zero otherwise (when the CEO is appointed by the ﬁrm, board of directors or shareholder meetings). We ﬁrst estimate equations in (2) using the ordinary least squares method. However, we recognize that the reform variables (i.e., A, O, D and C) could be endogenous in several ways. First, there could be reverse causality. That is, instead of reform variables affecting performance, it could be performance that causes the ﬁrms to choose systematically different reform measures. Second, there could be selection bias, that is, certain types of ﬁrms choose particular packages of reform measures. In other words, ﬁrm heterogeneity could be correlated with both performance and reform variables. Finally, there is the classical omitted-variable bias. Omitted variables could be correlated with both performance and the reform variables. When examining the effects of reforms on performance, transition literature has paid attention to the endogeneity issue (Li, 1997; Frydman, Gray, Hessel, and Rapaczynski, 1999; Anderson, Lee and Murrell, 2000; Shirley and Xu, 2001). To deal with the issue in the current study, we identify instrumental variables by noting some of the special features characterizing the Chinese ownership reform. First, one ingredient of the latest wave of Chinese SOE reforms is to “grab the big and let go of the small”. Chinese SOEs are classiﬁed as large, medium and small, with the classiﬁcation often based on historical heritage rather than current size. The government adopts different reform policies for ﬁrms of different historicallydetermined sizes. Reform measures based on these size categories should not directly affect performance, especially since we have controlled for the number of employees in the ﬁrm. Therefore, these three historically determined size categories offer useful identifying information. Second, the government may receive different control beneﬁts associated with different industries (Demsetz and Lehn, 1985). The line ministries may face different incentives to reform SOEs. As a result, a ﬁrm’s reform measures should be inﬂuenced by its industry afﬁliation. Third, reform measures may also depend on the authorities approving the reform. These include the State Economic and Trade Commission (ETC), provincial ETCs, local ETCs, State System Reform Committee (SRC), provincial SRCs, local SRCs, other governing

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authorities, multiple government agencies (for joint decisions), and the ad hoc agencies in charge of ownership reform. The difference in the approving authority appears to affect the reform measures, yet it is unlikely to be directly related to ﬁrm performance. In our implementation, for each potentially endogenous variable, say A, we ﬁrst obtain two variables representing the target reforms at the level of the government or the reform-implementing agency. In particular, we obtain the ﬁtted values of A on: (a) the size-industry dummies (we call the ﬁtted value Asize, industry), and (b) the reform’s approving agency dummies (Aagency). Asize, industry can be interpreted as the target reform outcome from the central government and line ministries, while Aagency approximates the reform’s approving agency’s speciﬁc reform target. These two variables therefore reﬂect the reform policies of the policy suppliers (i.e., the government) and should be correlated with ﬁrm-speciﬁc reform variables, but are likely to be un-correlated with ﬁrm-speciﬁc performance. We shall present estimations based on the generalized methods of moments that treat all the reform variables as endogenous and use Aagency, Asize, industry to identify the effects of these variables.15 It is important to consider the possibility that these instruments may also be correlated with ﬁrm performance, in which case they may not serve as good instruments. To examine the validity of our identifying assumptions, we use the overidentifying restrictions test developed by Hansen (1982). That paper shows that if an equation is overidentiﬁed by an abundance of instruments, a test of overidentifying restrictions—Hansen’s “J” statistic—can be used to evaluate the validity of the model. If this statistic (distributed Chi-squared in the number of overidentifying restrictions) leads to the rejection of the null hypothesis that the additional moment conditions are approximately satisﬁed, the validity of the model is called into question. As will be seen, the statistical tests suggest that these instruments serve as valid instruments. Another important condition for good instrumental variables is that they have good explanatory power for the endogenous variables (Bound, Jager and Baker, 1995; Staiger and Stock, 1997). This condition is also satisﬁed in our case. Indeed, the F statistics of the excluded instruments in the ﬁrst-stage regressions are almost always greater than 10, and the marginal R squares of these excluded instruments range from 2% to 11%, quite high in comparison with the marginal R squares that are required for a reasonable instrumental variable estimation (Bound, Jager and Baker, 1995). 5 Results Descriptive Statistics Descriptive statistics of the dependent and explanatory variables used in our regression analysis are presented in Table 13.1. Some interesting facts stand out. The ROA in the ﬁrst quarter of 1998 was on average only 1.2%, reﬂecting the troubles still faced 15 For an application of the GMM method with a similar strategy of selecting instruments, see Svensson (2003). In particular, he uses the region-industry mean of bribes as the instrument for ﬁrm-level bribes to identify the effects of ﬁrm-level corruption on ﬁrm performance.

Table 13.2

Correlation Matrix of Explanatory Variables

Panel A lnLt-1 autonomy l_ﬂex DO-B staying_CEO CEO_by_govt 1share_1vote share_other_ownership share_individual share_foreign

leveraget-1 0.042 -0.017 -0.031 -0.090 0.023 -0.035 0.040 -0.064 0.196 -0.106

Panel B CEO_by_govt 1share_1vote share_other_ownership share_individual share_foreign

staying_CEO -0.073 0.103 -0.094 0.096 -0.079

lnLt-1

autonomy

l_ﬂex

DO-B

0.015 0.022 -0.087 0.002 0.151 -0.038 -0.059 -0.169 0.058

0.202 -0.062 -0.048 0.016 0.018 0.077 -0.014 0.065

-0.010 0.019 -0.064 0.050 0.086 -0.046 0.079

-0.019 0.214 -0.170 0.024 -0.556 -0.113

CEO_by_govt

1share_1vote

share_other_ownership

share_individual

-0.321 -0.026 -0.438 -0.038

-0.059 0.378 -0.107

-0.266 -0.028

-0.126

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by many of the ﬁrms after ownership reform, and perhaps also the adverse macro shocks felt during 1998. Also reﬂecting the macro shocks, there was an average –1.7% decline in ROA between 1998 and 1997. 72% of the managers thought that the reform had improved or would improve performance. The vast majority of ﬁrms appear to have operating decision-making autonomy after the reform (91%), but the grant of control over labor deployment to managers lags behind (72%), reﬂecting the government’s concerns over the unemployment of SOE workers. The measure of the divergence between ownership and board control is fairly large (0.52), as the perfect alignment of ownership and control implies a value of zero for the variable. It appears that the majority of incumbent CEOs stay on after reform (63%) and 16% of the CEOs are appointed directly by the government. The one-share-one-vote principle is observed by only one-third of the ﬁrms. On average, the state remains the largest shareholder, accounting for roughly 47% of the total shares in reformed enterprises. Legal-person and collective shares account for 20%. There is also substantial private involvement: 32% of the total shares of these former SOEs are in the hands of private citizens, and 1.3% is owned by foreigners. Interested readers may also refer to Table 13.2 for the correlation matrix of the explanatory variables. Base Results Table 13.3 presents the base results with odd columns for the OLS results and even columns for the GMM results. The ﬁrst two columns focus on the level of ROA, the second two columns on the change in ROA, and the ﬁnal two columns on the likelihood of a favorable judgment by ﬁrm managers of the impact of ownership reform. Before getting to the results of our main interest, we ﬁrst examine how some conventional factors affect our dependent variables. Without considering endogeneity, larger ﬁrms do not exhibit signiﬁcantly worse performance (except in the IMPROV regression). Once endogeneity is considered, however, larger ﬁrms are shown to have both a lower level of and lower change in ROA, and their managers have a less favorable assessment of the reform (t=1.41). Before considering the issue of endogeneity, there appears to be a negative correlation between debt burden and reform outcomes. But the correlation proves to be spurious and disappears once endogeneity is tackled with the GMM method. We now examine how business autonomy, ownership structure and corporate governance affect performance outcomes. Autonomy is not signiﬁcantly correlated with performance in the OLS regression. Taking into account the endogeneity of the reform changes the result. In the GMM regressions, autonomy is associated with signiﬁcant drops both in ROA level and in ROA changes, whereas the sign in IMPROV is negative but highly insigniﬁcant. Recall that the decrease in political costs as a result of more business autonomy would imply a positive effect of autonomy on performance, while a possible increase in agency costs would imply a negative effect. Therefore, the negative effect of autonomy on performance appears to suggest that there are serious agency problems in reformed enterprises. Consistent with our conjecture, a ﬁrm’s ﬂexibility in labor deployment (l_ﬂex) has a signiﬁcant positive effect on all three measures of reform outcomes whether

Table 13.3

Determinants of Reform Outcomes: Pooled Sample

leveraget-1 lnLt-1 autonomy l_ﬂex DO-B staying_CEO CEO_by_govt 1share_1vote share_individual share_foreign share_other_ownership

(1) OLS ROAt -0.009 (2.92)*** 0.001 (0.36) 0.016 (1.23) 0.028 (3.48)*** -0.027 (2.97)*** 0.017 (2.27)** -0.038 (3.53)*** 0.011 (1.47) -0.003 (0.21) -0.014 (0.32) 0.017 (1.49)

(2) GMM ROAt -0.004 (1.49) -0.004 (1.97)** -0.230 (2.86)*** 0.108 (2.80)*** -0.089 (2.31)** -0.074 (1.74)* 0.031 (0.63) 0.179 (4.34)*** -0.090 (2.32)** 0.280 (1.76)* -0.029 (0.54)

931 0.07

927

ROA t-1 Observations R-squared P-value for Hansen’s J

0.649

(3) OLS ROAt - ROAt-1 (4) GMM ROAt - ROAt-1 -0.002 0.001 (0.62) (0.45) 0.000 -0.004 (0.03) (2.08)** 0.015 -0.129 (1.27) (2.14)** 0.018 0.073 (2.60)*** (2.28)** -0.019 -0.035 (2.36)** (1.07) -0.002 -0.041 (0.23) (1.25) -0.018 -0.010 (1.90)* (0.27) -0.002 0.092 (0.31) (2.84)*** -0.009 -0.052 (0.90) (1.62) -0.024 0.311 (0.63) (2.33)** 0.018 -0.004 (1.78)* (0.10) -0.338 -0.362 (9.32)*** (7.77)*** 922 918 0.91 0.773

(5) probit IMPROV -0.023 (1.93)* -0.017 (1.75)* 0.060 (1.17) 0.285 (9.63)*** -0.038 (1.06) 0.012 (0.39) -0.069 (1.63) 0.043 (1.41) 0.019 (0.39) -0.064 (0.39) 0.040 (0.88)

(6) GMM IMPROV -0.013 (0.61) -0.024 (1.41) -0.031 (0.12) 0.268 (1.71)* -0.155 (1.17) -0.130 (0.78) 0.099 (0.53) 0.164 (1.17) 0.131 (0.51) 1.499 (1.66)* 0.419 (1.29)

991 0.115

987 0.582

Note. Throughout the tables, *, ** and *** represent statistical signiﬁcance at the 10, 5 and 1% levels. In parentheses are t-statistics. In column (5), we report , and the R square refers to the pseudo R square. Hansen’s J refers to the J test statistics for the null hypothesis that the instruments are orthogonal to the residual. All variables except for lnLt-1 and leveraget-1 are considered endogenous in the GMM speciﬁcations. For each endogenous variable (say R), the instruments are the size-industry mean of R, and the mean of R for particular type of government agency in charge of the ownership reform. Industry dummies are not included in both speciﬁcations because they were tested to be jointly insigniﬁcant.

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we consider endogeneity or not. But note that the magnitude of the effects on both the level and the change in ROA tends to be greater when endogeneity is taken into consideration. This suggests that l_ﬂex is negatively correlated with the error terms of the regressions, implying that ﬁrms with worse ﬁnancial performance are granted more ﬂexibility in labor deployment, and correcting for such selection effects raises our estimates of the effects of l_ﬂex. The coefﬁcients in the GMM regressions suggest that granting managerial control over labor deployment would increase annualized ROA by 10.8% instead of 2.8% as found in the OLS regression, and a change in ROA by 7.3% rather than 1.8%. This result suggests that political costs associated with labor issues are especially large, and ﬂexibility in labor deployment is especially important for ﬁrm performance. Ownership structure is found to have important effects on reform outcomes, and the contrast between considering and not considering endogeneity is striking. When ownership variables are treated as being exogenous, then relative to state ownership, the correlations of performance with individual, foreign, or other ownership are insigniﬁcant—the one exception is that other ownership may be positively correlated with the change in ﬁnancial performance between the two years. When ownership variables and other reform variables are considered endogenous, however, the results change completely. In the GMM regressions, the effect of individual ownership (predominantly by employees) is negative and statistically signiﬁcant for the level of ROA, and is negative and close to being signiﬁcant for the change in ROA (t=1.62). These results are consistent with the notion that private ownership by itself is not sufﬁcient to counter agency costs; some kind of concentrated private ownership is needed to achieve effective monitoring (Shleifer and Vishny, 1986). State ownership represents nominally the ownership of all the people, but at least some delegated agency is to some extent accountable for the performance. Yet in the case of dispersed private ownership, there is still nominal ownership by many people but without the beneﬁts of some accountability. Our ﬁnding on the negative effect on performance of dispersed private ownership is also consistent with evidence from Mongolia given in Anderson, Lee and Murrell (2000), who ﬁnd similar evidence after considering the endogeneity of the ownership structure. Another interesting ﬁnding is that the effect of foreign ownership becomes positive and statistically signiﬁcant in all three regressions. The magnitude of the effect is large: an increase of foreign ownership share by 1% raises annualized ROA by more than 0.28% and changes ROA by 0.31%. The effect of other ownership is statistically indistinguishable from state ownership. This result is intuitive since much of the legal-person and collective ownership in China tends to be essentially another form of state ownership. The results on CEO appointment and turnover also change dramatically after considering endogeneity. Without considering endogeneity, ﬁrms whose CEOs are appointed by the government exhibit worse performance, and ﬁrms with the same CEO after reform are more likely to exhibit a better level of ﬁnancial performance. Once we take endogeneity into consideration, however, CEO appointment by the government no longer has any systematic relationship with performance. Moreover, incumbent CEOs staying on after reform are associated with a negative level of ROA. This suggests a positive nature of the selection bias: incumbent CEOs choose

Table 13.4

Determinants of Reform Outcomes: LLSC

leveraget-1 lnLt-1 autonomy l_ﬂex DO-B staying_CEO CEO_by_govt 1share_1vote share_individual share_foreign share_other_ownership

(1) OLS ROAt -0.009 (1.51) 0.007 (1.25) -0.050 (1.56) 0.022 (1.23) -0.038 (1.88)* 0.015 (0.98) -0.062 (1.70)* 0.009 (0.68) -0.024 (0.87) 0.104 (1.57) 0.034 (1.27)

(2) GMM ROAt -0.004 (1.45) -0.004 (1.92)* -0.252 (3.09)*** 0.118 (3.03)*** -0.082 (2.12)** -0.065 (1.52) 0.046 (0.93) 0.174 (4.18)*** -0.082 (2.10)** 0.301 (1.88)* -0.021 (0.39)

130 0.23

129

ROA t-1 Observations R-squared P-value for Hansen’s J

0.631

(3) OLS ROAt - ROAt-1 (4) GMM ROAt - ROAt-1 0.003 0.001 (0.45) (0.48) -0.000 -0.003 (0.03) (1.91)* -0.027 -0.143 (0.95) (2.36)** 0.021 0.081 (1.37) (2.51)** -0.032 -0.025 (1.84)* (0.77) 0.013 -0.031 (1.01) (0.95) -0.018 0.001 (0.57) (0.01) 0.006 0.085 (0.51) (2.64)*** -0.036 -0.045 (1.51) (1.40) 0.064 0.323 (1.12) (2.40)** 0.024 0.008 (1.04) (0.17) -0.417 -0.358 (4.66)*** (7.64)*** 130 129 0.94 0.759

(5) probit IMPROV 0.018 (0.47) -0.028 (0.85)

0.489 (4.17)*** -0.069 (0.56) -0.073 (0.85) -0.058 (0.30) 0.144 (1.73)* -0.072 (0.41) 0.550 (1.29) -0.012 (0.07)

133 0.17

(6) GMM IMPROV -0.011 (0.54) -0.026 (1.51) 0.002 (0.01) 0.253 (1.60) -0.181 (1.36) -0.123 (0.74) 0.111 (0.59) 0.185 (1.31) 0.115 (0.45) 1.445 (1.60) 0.416 (1.27)

132 0.568

216

The Revival of Private Enterprise in China

or are chosen to stay on in ﬁrms with better performance. The negative effect of CEOs staying on is weakly consistent with the ﬁnding in the literature that changing CEOs after reform results in better performance (Denis and Denis, 1995) and more restructuring (Barberis et al, 1996) in transition economies. The voting mechanism for shareholder meetings also matters. The one-shareone-vote dummy has no signiﬁcant effect on performance when not considering endogeneity, but has positive and signiﬁcant effects on both the level of and the change in ROA. Finally, consistent with our hypothesis, the deviation of board structure from share ownership has a signiﬁcant and negative effect on ROA level; and the signs are also correct for the change in ROA and IMPROV. The effects (in terms of magnitude) that take endogeneity into account are stronger than in the OLS regression. The magnitude of the effect is very large. For example, compared with ﬁrms in which there is hypothetically no such deviation (i.e. DO – B = 0), ﬁrms with the maximum divergence between ownership and control (DO – B = √2) would have an annualized ROA that is 13.5 percentage points lower, and the change in ROA 4.9 percentage points lower. Do the Effects Differ by Organization Types? It is possible that the effects of decision-making autonomy, ownership structure and corporate governance mechanisms differ qualitatively among the three main organizational types, i.e., limited liability stock companies (LLSCs), limited liability companies (LLCs) and employee-owned stock cooperatives (EOSCs). It would be re-assuring to ﬁnd that most of our key ﬁndings stay intact for each of these organizational types. Tables 13.4, 13.5 and 13.6 present the results separately for each of the three organization types. We present both the OLS (or probit in the case of IMPROV) and GMM results. Indeed, the signs for our important variables remain intact across the three sub-samples. 6 Conclusions Using a large sample of Chinese ﬁrms undertaking ownership reform in 1997, our study of the recent experience of Chinese enterprise reform suggests that differences in authority allocation, ownership structure, and corporate governance mechanisms hold important clues to explaining performance variation in reformed ﬁrms. Speciﬁcally, we ﬁnd evidence that ﬁrms tend to perform better when managers have ﬂexibility in labor deployment, when corporate governance mechanisms lead to better alignment between ownership and control, and when foreign ownership is higher. Interestingly, dispersed individual ownership and operating autonomy lead to worse performance, suggesting the seriousness of agency problems in reformed ﬁrms. Our analysis suggests that it is important to take into account the endogenous nature of the ownership reform. Indeed, many of the results change directions when endogeneity is considered in the empirical implementation.

Table 13.5

Determinants of Reform Outcomes: LLC

leveraget-1 lnLt-1 autonomy l_ﬂex DO-B staying_CEO CEO_by_govt 1share_1vote share_individual share_foreign share_other_ownership

(1) OLS ROAt -0.004 (1.08) -0.000 (0.12) 0.025 (1.56) 0.030 (2.85)*** -0.026 (2.21)** 0.023 (2.32)** -0.036 (2.57)** 0.015 (1.42) -0.004 (0.21) -0.052 (0.86) 0.021 (1.45)

(2) GMM ROAt -0.004 (1.53) -0.004 (1.94)* -0.231 (2.87)*** 0.107 (2.79)*** -0.090 (2.33)** -0.075 (1.75)* 0.032 (0.64) 0.179 (4.33)*** -0.089 (2.31)** 0.278 (1.76)* -0.028 (0.53)

530 0.07

527

ROA t-1 Observations R-squared P-value for Hansen’s J

0.649

(3) OLS ROAt - ROAt-1 (4) GMM ROAt - ROAt-1 0.001 0.001 (0.26) (0.39) 0.000 -0.004 (0.07) (2.06)** 0.021 -0.134 (1.52) (2.22)** 0.017 0.075 (1.87)* (2.32)** -0.011 -0.034 (1.15) (1.06) -0.003 -0.043 (0.35) (1.32) -0.011 -0.010 (0.90) (0.25) -0.006 0.091 (0.68) (2.81)*** 0.005 -0.051 (0.34) (1.60) -0.044 0.300 (0.87) (2.26)** 0.026 -0.003 (2.08)** (0.08) -0.314 -0.362 (6.68)*** (7.77)*** 524 521 0.92 0.777

(5) probit IMPROV -0.021 (1.32) -0.008 (0.61) 0.076 (1.18) 0.271 (6.99)*** 0.017 (0.38) 0.007 (0.18) -0.105 (1.91)* 0.053 (1.33) 0.099 (1.49) 0.509 (1.39) 0.076 (1.31)

(6) GMM IMPROV -0.016 (0.79) -0.022 (1.29) -0.069 (0.27) 0.280 (1.79)* -0.140 (1.05) -0.120 (0.72) 0.126 (0.67) 0.146 (1.04) 0.166 (0.64) 1.530 (1.69)* 0.425 (1.31)

561 0.139

558 0.575

Table 13.6

Determinants of Reform Outcomes: EOSC

leveraget-1 lnLt-1 autonomy l_ﬂex DO-B staying_CEO CEO_by_govt 1share_1vote share_individual share_foreign share_other_ownership

(1) OLS ROAt -0.030 (4.30)*** 0.007 (0.83) 0.022 (0.74) 0.019 (1.10) -0.016 (0.78) 0.021 (1.12) 0.040 (0.73) 0.018 (1.05) 0.051 (1.70)* -0.008 (0.03) 0.024 (0.72)

(2) GMM ROAt -0.004 (1.37) -0.004 (1.96)** -0.225 (2.83)*** 0.108 (2.83)*** -0.085 (2.23)** -0.070 (1.66)* 0.030 (0.62) 0.175 (4.28)*** -0.093 (2.43)** 0.262 (1.67)* -0.028 (0.53)

166 0.17

166

ROA t-1 Observations R-squared P-value for Hansen’s J

0.622

(3) OLS ROAt - ROAt-1 (4) GMM ROAt - ROAt-1 -0.026 0.001 (4.18)*** (0.50) 0.003 -0.004 (0.46) (2.10)** 0.022 -0.131 (0.82) (2.18)** 0.016 0.076 (1.02) (2.35)** -0.015 -0.033 (0.84) (1.01) 0.004 -0.035 (0.24) (1.07) -0.004 -0.010 (0.08) (0.26) 0.008 0.093 (0.53) (2.90)*** 0.005 -0.057 (0.17) (1.80)* 0.175 0.294 (0.80) (2.22)** 0.000 -0.010 (0.01) (0.23) -0.317 -0.370 (3.17)*** (7.95)*** 164 164 0.90 0.759

(5) probit IMPROV -0.082 (2.51)** 0.024 (0.64) 0.025 (0.21) 0.283 (3.66)*** -0.188 (2.09)** 0.074 (0.91) -0.036 (0.16) -0.019 (0.25) 0.031 (0.24)

-0.000 (0.00)

174 0.135

(6) GMM IMPROV -0.021 (1.04) -0.023 (1.36) -0.062 (0.25) 0.304 (1.97)** -0.181 (1.40) -0.135 (0.83) 0.144 (0.78) 0.138 (1.00) 0.176 (0.70) 1.234 (1.42) 0.314 (1.00)

174 0.481

Politician Control, Agency Problems, and Ownership Reform

219

The ﬁndings in this chapter, however, are subject to important caveats. First, short-term ROA and managerial subjective assessments are not ideal measures of reform outcomes. The long-term effects of the ownership reform need to be explored in future research. Second, the data is cross-sectional, and hence we have no means of controlling for ﬁrm heterogeneity. Since both ﬂaws are due to limitations of the data set, the collection of better quality data is needed to improve our understanding of the issue. These limitations notwithstanding, the empirical regularities found in our analysis should not be taken too lightly, especially as we have been able to ﬁnd reasonably good instruments (judged both by a priori reasoning and by statistical tests) for the reform variables, and given that the results from all three sets of regressions are similar. Moreover, most of our ﬁndings are consistent with what is implied by theory and with ﬁndings in related empirical studies (Megginson and Netter, 2001), and thus should be given some credence. References Aghion, P. and J. Tirole, “Formal and Real Authority,” Journal of Political Economy, 105, 1 (1997): 1–29. Anderson, J.H., Y. Lee, and P. Murrell, “Competition and Privatization Amidst Weak Institutions: Evidence from Mongolia,” Economic Inquiry, 38, 4 (2000): 27–49. Bai, C.-E., M. Du and Z. Tao, “What Is Up Is Really Down: Evidence about Technical and Economic Efﬁciencies from China,” mimeo, University of Hong Kong (2002). Bai, C.-E., D.D. Li and Y. Wang, “Enterprise Productivity and Efﬁciency: When is Up Really Down?” Journal of Comparative Economics, 23, 3 (1997): 265–80. Bai, C.-E. and Y. Wang, “Bureaucratic Control and the Soft Budget Constraint,” Journal of Comparative Economics, 26, 1 (1998): 41–61. Barberis, N., M. Boycko, A. Shleifer and N. Tsukanova, “How does Privatization Work? Evidence from the Russian Shops,” Journal of Political Economy, 104 (1996): 764–90. Bound, J., D.A. Jaeger and R.M. Baker, “Problems with Instrumental Variables Estimation When the Correlation between the Instruments and the Endogenous Variable is Weak,” Journal of the American Statistical Association, 90, 430 (1995): 443–50. Cao, Y., Y. Qian and B.R. Weingast, “From Federalism, Chinese Style to Privatization, Chinese Style,” Economics of Transition, 7, 1 (1999): 103–31. China Statistical Yearbooks, (Beijing: China Statistics Press, 1999). Demsetz, H., and K. Lehn, “The Structure of Corporate Ownership,” Journal of Political Economy, 93 (1985): 1155–77. Denis, D.J. and D.K. Denis, “Performance Changes Following Top Management Dismissal,” Journal of Finance, 50 (1995): 1029–57. Dong, X.Y., and L. Putterman, “Soft Budget Constraints, Social Burdens, and Labor Redundancy in China’s State Industry,” Journal of Comparative Economics, 31, 1 (2003): 110–33.

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Chapter 14

Hospital Ownership: What Can China Learn From the US Experience? Wei Yu1

1 Introduction In China, medical care is one of the few industries that is still dominantly owned and managed by government. In 2001, privately owned for-proﬁt hospitals accounted for only less than 1% of total hospitals; the number of beds, doctors, and nurses in private hospitals accounted for 1.4, 9.4, and 0.8%, respectively. As it did for other state-owned enterprises, the economic reform brought market competition to state hospitals. Under the current policy, hospitals must be ﬁnancially independent; funding from the government is ﬁxed and accounts for less than 20% of total revenue for most hospitals. Market competition has forced some hospitals into ﬁnancial insolvency. Competition has also induced behaviors leading to inefﬁcient resource allocation from societal perspective. Because a hospital’s accounting proﬁt can be used directly for employees’ compensation, state hospital managers have the same incentives as that in private for-proﬁt hospitals. For example, physician-induced demand for proﬁtable services and treatments is common in state hospitals. Inconsistency in government-controlled prices for hospital services often results in different proﬁt margins across services and treatments. In 2000, the diagnosis fee for a senior doctor in a big hospital was only about 10 RMB (US $1.2), according to the government’s ﬁxed prices. Thus, physicians are inclined to prescribe more proﬁtable (often expensive) drugs and order more proﬁtable diagnostic procedures than clinically necessary. Patients often complain that it is cheap to see a doctor, but too expensive to pay for prescribed medicines and diagnostic tests. Government statistics conﬁrmed such trends: In 2000, only 40% of the income of state hospitals came from their medical services, and more than 50% came from sales of medicines. Although government has gradually adjusted prices in recent years, proﬁt-seeking behavior still exists. Improving quality 1 Health Economist, Health Economics Resource Center, HSR&D Service and Cooperative Study Programs, US Department of Veterans Affairs, Fellow, Center for Health Policy, Center of Primary Care and Outcomes Research, Stanford University, April 2003. Mailing address: VA Palo Alto Health Care System, 795 Willow Road (152MPD), Menlo Park, CA 94025, Tel: (650) 493-5000 x23157, Fax: (650) 617-2639, Email: [email protected]. This chapter was published by Shanghai Academy of Social Science in a proceeding for the International Symposium on Health Policy in July 2004.

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of care and efﬁciency of resource use are the two main challenges in China’s medical care system. Market competition, especially competition from the private sector, brought dramatic improvement in productivity and innovation in other industries during the economic reform; thus, whether introducing private for-proﬁt hospitals can improve the performance of state hospitals has been an important policy question in recent years. This line of thinking has been reﬂected in government policies. In the past few years, the Chinese government has adjusted its policy on private investment in China’s hospital market, especially foreign investment. Starting in 2000, the government now allows privately owned hospitals to set their own prices. Since China joined the World Trade Organization in the end of 2001, foreign investors have been allowed to own up to 70% of the investment in a joint-venture hospital; they were permitted only 30% before the policy change. Foreign joint-venture hospitals are also exempt from proﬁt tax during their ﬁrst 3 years of operation. The policy change has increased foreign interest in China’s hospital market. In March 2004, the ﬁrst comprehensive joint-venture hospital that had a controlling foreign investor opened in Beijing: the SK Hospital Beijing. SK, the South Korean telecommunications and energy giant, provided 70% of the total 29 million RMB (US$3.5 million) in investment in the hospital. The remainder came from the Chinese Ministry of Health’s International Health Exchange and Co-operation Centre (IHECC) and a Fuzhou company. On March 17, 2004, Chindex International, Inc. (www.chindex.com), a leading American health-care provider, announced that it had signed a letter of intent (LOI) with Xiamen Zhongshan Hospital to establish its third hospital venture in the People’s Republic of China. The new hospital will be in the southern city of Xiamen. With such a rapid increase in private for-proﬁt hospitals, the potential inﬂuence of these hospitals, especially foreign-controlled hospitals, on state hospitals’ performance is a topic worthy of investigation. With majority of foreign ownership and pricing authority for services and products, foreign joint-venture hospitals are capable of operating under a production structure that maximizes proﬁt. The level of service quality and operating efﬁciency which foreign joint-venture hospitals can provide largely depend on the market environment and competition from state hospitals. Unlike other services and goods, competition for medical care may not necessarily lead to services with better quality and lower costs. The current competition among state hospitals has already induced many negative behaviors. With government control, the damage of those negative behaviors to the society has been restricted. When private for-proﬁt hospitals have more authority than state hospitals, they may have the advantage to compete with state hospitals. Therefore, it would be useful for policy makers to understand ﬁrst the unique features of medical-care services and second the potential effects of market competition across hospitals under different ownerships. This chapter reviews theories and empirical evidence on the performance of private for-proﬁt hospitals reported in the US literature. It also explores the potential effects of introducing private for-proﬁt hospitals on China’s medical-care market. There are three main reasons that the US experience is useful to China’s policy making. First, the medical-care market in the United States is much more diversiﬁed than that in China. In 2002, government, for-proﬁt, and not-for-proﬁt hospitals accounted for 16,

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13, and 71% of the total number of beds, respectively. Therefore, there is adequate evidence of the competition between for-proﬁt and not-for-proﬁt hospitals. Second, the payment structure in urban China is similar to that in the United Stated: medical care is paid through employment-based insurance. The payer has a strong inﬂuence on prices of medical services. China is currently converging its health-insurance programs into a single, government-managed insurance plan in urban cities; that plan will have a dominant power in price control. Although the US government does not control prices of medical care, health-insurance programs do strongly inﬂuence prices. Finally, there is a rich literature on hospital ownership in the United States. In Section 2, I introduce economic theories about hospital ownership. Section 3 reviews the US empirical evidence on the performances of hospitals across ownership types. Section 4 explores the potential effects of private for-proﬁt hospitals on China’s medical care services. My conclusions are presented in Section 5. 2 Theoretical Concepts Fiscal balance is obtained when revenue is equal to or exceeds cost; it is a necessary condition for any business organization, regardless of ownership. No business venture can survive if it continually spends more than it earns. The main difference between for-proﬁt and not-for-proﬁt hospitals lies in the distribution of accounting proﬁt. For-proﬁt hospitals must distribute the proﬁts to their owners or equity holders, whereas not-for-proﬁt hospitals do not distribute proﬁts at all. Thus, forproﬁt hospitals must operate under the principle of proﬁt maximization. Their proﬁtmaximization incentive leads to a concern about whether for-proﬁt hospitals are likely to provide the care that most satisﬁes the desire of the society. Several unique features of medical care form the basis for this concern. 2.1 Unique Features of Medical-care Industry Kenneth Arrow identiﬁed three unique features of the medical-care industry: asymmetric information, moral hazard, and externalities. These features signiﬁcantly affect the structure of medical-care industry. Asymmetric Information The information available to consumers and to providers for medical care is asymmetric. Consumers usually have little knowledge of what is or is not appropriate care. Because of the incentive to maximize proﬁts, providers in for-proﬁt hospitals may be inclined to provide more care than they would if consumers have the same knowledge as they do. This information asymmetry also extends to uncertainty about the outcomes of medical-care services. Assessing the quality of medical care is so complicated and uncertain that it is almost impossible for consumers to monitor quality. Therefore, hospitals that maximize proﬁts may not provide a level of quality of care as high as they would if patients and providers had the same knowledge. The difference in ownership, however, does not guarantee that managers in not-for-proﬁt hospitals will maximize the social welfare. They could maximize the accounting proﬁt for other purposes that are not consistent with societal desire.

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Moral Hazard The second unique feature of medical care is caused by payment structure. In many countries, especially developed countries, medical care is paid through either an insurance plan or a social program. Under this third-party payment structure, consumers’ direct payment is much less than the actual cost of care. As a result, consumers tend to consume more medical care than they would if they paid the full cost, a phenomenon dubbed “moral hazard.” Moral hazard from consumers matches the incentive of hospitals to sell more care than is necessary or than can be justiﬁably afforded by the society. Similar to behavior that results from asymmetric information, the behavior of moral hazard could occur in any type of hospitals; however, for-proﬁt hospitals have stronger incentives to accept such behavior than do not-for-proﬁt hospitals. Externalities The third unique feature of medical care is externalities, or external effects. Many medical-care services have positive externalities to the society. Preventive care of infectious diseases is a typical example. The value placed on immunization by individual consumers may not be as high as the overall value to the society. People thus are not necessarily willing to pay for a service based on its value of the society. Therefore, endeavors such as preventive care of infectious diseases may have to be subsidized by the government or through a health-care management organization (HMO)—entities that are inﬂuenced by the observation that preventive care usually is highly cost effective. Services that have positive external effects on the society are called public goods. Because maximizing proﬁt is the ultimate objective of a for-proﬁt hospital, it may not provide the same level of public goods as does a not-for-proﬁt hospital. 2.2 Theoretical Models Because of the special features outlined in Section 2.1, not-for-proﬁt hospitals, both private and government owned, have often been considered superior to for-proﬁt hospitals by policy makers and social scientists. Depending on the market structure and institutional environment (i.e., regulations and government monitoring) in a country, performance may not differ signiﬁcantly between not-for-proﬁt and forproﬁt hospitals. Economists have analyzed the behavior of not-for-proﬁt hospitals using different theoretical models. Two of those models could be useful to China’s market structure. Newhouse argues that, because not-for-proﬁt hospitals are exempt from paying any tax, and consumers are insensitive to price, not-for-proﬁt hospitals may try to maximize both quality and quantity of medical treatment under a constraint of zero proﬁt. Market competition between not-for-proﬁt and for-proﬁt hospitals could be focused on quality of care because of the payment structure, and/or focused on prices because of the power wielded by payers. Whether not-for-proﬁt hospitals under this model are superior to for-proﬁt hospitals in terms of value to society depends on whether that society’s marginal gain from health-care services is greater or less than their marginal cost. Pauly and Redisch examined the behavior of not-for-proﬁt hospitals from a different angle. They assumed that not-for-proﬁt hospitals could behave as

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cooperatives controlled by physicians, and, therefore, could make decisions based on maximizing physicians’ private beneﬁt. The fact that China’s hospitals can distribute the accounting proﬁt for compensation could be described by the cooperative model too. The social-welfare effect under this model may still be unclear, however, because we do not yet know whether physicians can monitor the efﬁciency of not-for-proﬁt hospitals as effectively as do shareholders of a for-proﬁt hospital. Overall, these theoretical models suggest that whether not-for-proﬁt hospitals provide more socially valuable service than do for-proﬁt hospitals depends heavily on institutional and market structure. The US medical-care market is much more mature than is China’s market. Large payers such as Medicare and Medicaid programs have developed various prospective-payment systems to contain cost increases. Given such a heavily regulated market, the effects of market competition from private forproﬁt hospitals on medical-care services in the United States provide a useful model to guide China in policy decisions that must be made in the near future. 3 US Empirical Evidence There is a rich literature in the United States that compares the performance of notfor-proﬁt and for-proﬁt hospitals. This section includes three factors that are most relevant to China: efﬁciency quality of care, and medical expenses. 3.1 Efﬁciency Theoretically, private for-proﬁt hospitals can be expected to be more efﬁcient than the not-for-proﬁt hospitals because residual claimant is not clearly deﬁned in notfor-proﬁt hospitals. Thus, a potential positive effect of market competition from private for-proﬁt hospitals is reduction of medical-care costs without sacriﬁce in quality of care (i.e., improvement in efﬁciency). Studies conducted over the past two decades in the United States have found no systematic differences in efﬁciency between private for-proﬁt and private not-for-proﬁt hospitals. For-proﬁt hospitals spend less on personnel, provide less charity care, and average shorter patient stays than do not-for-proﬁt hospitals; they spend more on administration and ancillary services than do not-for-proﬁt hospitals. The main reason that empirical studies do not reach a consistent conclusion is that cost is a function of many factors that are often difﬁcult to measure. For example, it is difﬁcult to control accurately for quality of care and patients’ health conditions. Notfor-proﬁt hospitals often provide services that beneﬁt the society, such as research and teaching. Physicians who undertake research and teaching often order more tests and spend a longer time with patients, resulting in costs for the services higher than those incurred by physicians who are concerned with only individual-patient care. Although researchers have used different methodologies, they have not been able to control sufﬁciently for these differences. Furthermore, measuring costs is difﬁcult because available cost data usually are recorded in accounting books that do not break down costs by classiﬁcations suitable for economic analysis.

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3.2 Quality of Care Given the third-party-payer insurance structure, patients are less sensitive to prices than they would be if they paid directly, so they may be more sensitive to other variables. Thus, hospitals could compete on the basis of quality of services. This effect could be strong in China’s medical-care market, foreign joint-venture hospitals commonly claim the advantage of an international (or best) standard of quality of care. In the US studies, a common measure of the quality of hospital services is riskadjusted mortality. Devereaux and colleagues recently conducted a systematic review and meta-analysis of studies comparing mortality rates of private for-proﬁt and private not-for-proﬁt hospitals. Their study suggested that patients in private for-proﬁt hospitals faced a higher risk of death compared with those in private not-for-proﬁt hospitals. Hartz and colleagues also found higher mortality rates in private for-proﬁt hospitals. However, McClellan and Staiger showed that, although for-proﬁt hospitals had higher mortality among the elderly with heart disease, most of the differences were associated with hospital location. Within speciﬁc locations, for-proﬁt hospitalization was associated with better outcomes. Studies by Sloan and co-authors on outcomes of medical care for speciﬁc medical conditions among the elderly, as well as several other studies, also found no signiﬁcant differences in quality of care between for-proﬁt and not-for-proﬁt private hospitals. Researchers in the United States also compared the inputs of medical-care services and process of care in not-for-proﬁt and for-proﬁt hospitals. Based on statistics published by the Institute of Medicine, for-proﬁt hospitals had a level of nursing stafﬁng lower than that of not-for-proﬁt hospitals, suggesting a corresponding lower quality of care. In terms of process, a large study by Keeler and colleagues calculated two process measures for quality of care for ﬁve medical diseases in ﬁve states. An explicit measure examined the diagnostic and therapeutic procedures in medical records; an implicit measure reﬂected an overall opinion about the quality of care obtained from a survey of physicians. The authors did not ﬁnd any difference in those measurements between private not-for-proﬁt and for-proﬁt hospitals. A study by Mark on psychiatric hospitals did ﬁnd that for-proﬁt hospitals, on average, had more violations recorded by and complaints reported to Medicare and Medicaid programs than did not-for-proﬁt hospitals. That study also found that violations increased in for-proﬁt hospitals when market competition increased. 3.4 Effects of Market Competition Competition from for-proﬁt hospitals can inﬂuence prices of medical-care services. Kessler and McClellan showed that areas served by both not-for-proﬁt and forproﬁt hospitals had 2.4% lower hospital expenditures than, and virtually the same outcomes as, areas served by only not-for-proﬁt hospitals, suggesting a pressure from competition by the for-proﬁt hospital on price. In contrast, a study by Silverman and colleagues indicated that, in areas served predominantly by for-proﬁt hospitals, Medicare paid more per eligible patient not only for hospital care, but also for home care and for care in other facilities. Sloan also reviewed studies on uncompensated care, technology diffusion, hospital-pricing patterns, and proﬁtability; he found no

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consistent differences between for-proﬁt and not-for-proﬁt hospitals reported by those studies. Empirical evidence in the United States does not indicate consistent differences in efﬁciency and outcomes between private for-proﬁt and not-for-proﬁt hospitals, although the two types of hospitals have different objectives. Market competition is probably the driving force for such similarities. Because prices of hospital services are determined primarily by what insurance and government agencies are willing to pay and hospitals are willing to accept, consumers are not sensitive to price competition. Hospitals must compete on the basis of quality of care and services, rather than of price. Pope analyzed non-price competition among hospitals and found that, if notfor-proﬁt hospitals had positive proﬁts, then increasing competition in quality of care increased costs and reduced proﬁt. If not-for-proﬁt hospitals had zero proﬁt, increasing competition increased operating efﬁciency. Another study also found that not-for-proﬁt hospitals reduced uncompensated care when they had to compete with other hospitals. 4 What can China learn from the US experience? It appears that, over a period of competition under a heavily regulated market, the levels of efﬁciency and quality of care offered by for-proﬁt and not-for-proﬁt hospitals in the United States are converging. The US experience suggests that, if the market environment is appropriately regulated, certain negative effects of proﬁtseeking behaviors can be controlled. The critical question is how to establish such a market environment. 4.1 Efﬁciency Efﬁciency in medical care can be further divided into two concepts: efﬁciency of operation and efﬁciency of medical care. Efﬁciency of operation can be measured by the cost of each speciﬁc service or procedure (e.g., a chest X-ray examination or an echosonography test), and the efﬁciency of medical care is usually related to the measure of cost-effectiveness of a treatment strategy. Because outcomes of medical care are difﬁcult to measure and often are not observable in a short time period, it is relatively easy to improve operating efﬁciency, but difﬁcult to improve the efﬁciency of medical care, 4.1.1 Operating Efﬁciency Although the incentive of proﬁt seeking from private forproﬁt hospitals can improve operating efﬁciency, competition may not lead to the most efﬁcient production of medical services. The major concern about market competition is its effects on quality of services and care. Since quality of care is not easily measured and monitored, hospitals may cut costs such that quality of service is harmed. Therefore, regulations on patient safety should be established and enforced to protect patients. Without an effective monitoring agency, competition in the medical-care market could lead to negative results. Such a monitoring system would still be urgently needed in China even if for-proﬁt hospitals did not enter the medical care market.

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With an appropriately regulated market, competition from private for-proﬁt hospitals may indeed improve the operating efﬁciency of state hospitals. There are three main barriers that prevent state hospitals from operating at their most efﬁcient structure. The ﬁrst barrier is the management policy on human resources. Hospital managers do not have the full authority to determine the number of physicians and nurses they can hire. It is extremely difﬁcult for hospital managers to lay off any employees. Therefore, the production structure in state hospitals is usually not efﬁciently organized. The second barrier is the pricing authority. State hospitals must follow the price caps set up by government agencies. Because of historical and political reasons, prices of many services do not reﬂect the costs. For example, prescribing old medications and diagnostic procedures generally is not proﬁtable, whereas offering new drugs and diagnostic tests does bring in proﬁts. When prices do not reﬂect costs, hospitals will be inclined to encourage use of more proﬁtable services. The prices of medical care in the United States are well established by government and private insurance programs such as Medicare and Medicaid, and are frequently adjusted to reﬂect changes in the market. Developing a reasonable pricing system is necessary in China’s medical-care market. The third barrier is the ﬁnancial burden of retired employees. State hospitals currently support pensions and health insurance for retired employees. In certain hospitals, retired employees account for more than 30% of total employees. In contrast, private hospitals are relatively young and do not have a large cadre of retired employees to support. Thus, state hospitals have associated costs much higher than those of private hospitals. This imbalance in social responsibility could be corrected by government through its ﬁnancing policy. 4.1.2. Cost-effective Treatment Establishing a market environment that encourages hospitals and health-care providers to focus on the cost-effectiveness of medical treatments is an extremely difﬁcult task. Even in the United States, where medical education and practice are in the leading position in the world, large variations in practice patterns are still observed across geographic regions [e.g., Wenberger et al]. A hospital or medical group has little incentive to focus on a long-term health-care strategy unless it bears the consequent costs of failing to provide such care. Thus, an organizational structure that can generate such incentives is necessary to improve the efﬁciency of medical care. From this perspective, the United States has not set a good example. Because of the employment-based insurance structure and the private insurance market in the United States, it is difﬁcult for patients and providers to maintain long-term relationships. On this measure an integrated and state-owned health-care system, such as the one in the United Kingdom, or a universal health-care ﬁnancing system such as the one in Canada, is probably a better choice. In the United States, insurance and government agencies develop various guidelines for payment schemes to encourage cost-effective treatment strategy. Another important method of encouraging cost-effective treatment is adopting a prospective-payment system for hospital care, such as the one developed for the Medicare program in the United States. The Medicare prospective payment system classiﬁes hospital stays into about 500 diagnosis-based categories, and sets the price prospectively for each. Under this payment system, hospitals have incentives to control costs. China has not developed

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a prospective-payment structure. With a market-oriented system, the prospectivepayment method could control rapid growth in health-care expenditures. 4.2 Quality of Care Quality of care can also be measured from two perspectives: the quality of service and the quality of medical care. The quality of services includes various ways a hospital serves a patient, such as number of patients served by a nurse, the privacy and convenience in a room, or the quality of food. The quality of medical care is determined by factors such as the skills of physicians and nurses, the availability of advanced medical equipments, and hospital management expertise. Because the quality of medical care is more difﬁcult to measure, more costly to improve, and less observable by patients compared to the quality of service, competition from private for-proﬁt hospitals is likely to improve the quality of services, but not necessarily to improve the quality of medical care. In the United States, information on hospital quality—especially on the quality of medical care—is still not transparent, although many projects have been initiated to decrease the asymmetry of information between patients and providers. In the US market, empirical studies found no systematic difference in risk-adjusted mortality between private for-proﬁt and not-for-proﬁt hospitals. However, the studies did ﬁnd differences in terms of inputs to hospital services, such as the patient-nurse ratio, which is more likely to affect the quality of services than the risk-adjusted mortality. Thus, the US experience suggests that, if the government can perform assessments of the quality of medical care and can make this information readily available to prospective patients, hospitals will be likely to compete through the quality of medical care. 4.3 Potential Effects of Private For-proﬁt Hospitals on Medical-care Market The current market share of private for-proﬁt hospitals in China is still trivial. It appears that the ﬁrst group of private for-proﬁt hospitals is courting the rich cohort by providing high quality of services and new technology. There is no evidence regarding whether those hospitals provide better quality of medical care. Because the government-managed insurance programs usually do not pay for services provided through those hospitals, the immediate effects of competition from private for-proﬁt hospitals are limited. The more challenging question is whether the government should allow forproﬁt hospitals to enter the market for the general population or even allow selling of state hospitals to private investors. For example, the government-managed healthinsurance programs could enroll private for-proﬁt hospitals as contracted hospitals. Once private for-proﬁt hospitals enter the market of the general population, competition will have the potential to improve both efﬁciency and quality of medical care. If certain state hospitals cannot compete with private for-proﬁt hospitals, the government could sell them to private investors. A potential problem arising from privatization of state hospitals is that for-proﬁt hospitals will focus on proﬁtable

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services and will leave the burden of public services and other unproﬁtable care to state hospitals—a trend that could bankrupt the remaining state hospitals if the government’s ﬁnancial support (including tax beneﬁts) cannot cover the cost of those services. Therefore, it is important for the government to identify public services clearly and to budget for them fully. This policy will support those hospitals that provide a large proportion of public services. A recent study examined conversions in ownership type between private forproﬁt and private not-for-proﬁt hospitals in the United States. The results indicate that conversions in both directions were common, and that the primary reason for either conversion was ﬁnancial difﬁculty. A private for-proﬁt hospital converted to either a private not-for-proﬁt or a government hospital because the government or a not-for-proﬁt organization believes that a local hospital was needed and is willing to subsidize it. A private not-for-proﬁt hospital that converted to a private for-proﬁt hospital was usually involved in a reorganization that resulted in proﬁtability. The US experience supports the theoretical concept that medical care cannot be run solely by the market forces. The government or a private not-for-proﬁt organization has to back up services that are not proﬁtable at the individual level but that are identiﬁed as providing an overall cost-effective beneﬁt to society. 5 Conclusions The inﬂuence of private for-proﬁt hospitals on China’s hospital market depends largely on the market environment. At the current level of market share, private forproﬁt hospitals cater to China’s rich patients who are willing to pay for improved quality of services and quality of care. The competition from these hospitals has limited effects on state hospitals. If the private for-proﬁt hospitals enter the market of the general population, however, the effects—both positive and negative—could be substantial. Because of the special features of medical-care services, such as moral hazards and asymmetric information, the government should be actively involved in quality assessment and regulation, information dissemination, and price management. Many guidelines for these interventions can be gleaned from the US experience. Without a healthy market environment, market competition from private for-proﬁt hospitals could lead to rapid increase in medical-care expenses without signiﬁcant improvement in the quality of care. References Arrow, K.J., “Uncertainty and the welfare economics of medical care”, American Economic Review, 53 (1963): 941–73. Devereaux, P.J., Schunemann, H.J., Ravindran, N.,Bhandari, M., Garg, A.X., Choi,P. T., Grant, B.J., Haines, T., Lacchetti, C., Weaver, B., Lavis, J.N., Cook, D.J., Haslam, D.R. Sullivan, T. and Guyatt, G.H., “Comparison of Mortality between Private For-proﬁt and Private Not-for-proﬁt Hemodialysis Centers: Asystematic Review and Meta-analysis”, Jama., 288, 19 (Nov 20, 2002): 2449–57.

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Devereaux, P.J., Choi, P.T., Lacchetti, C., Weaver, B., Schunemann, H.J., Haines, T., Lavis, J.N., Grant, B.J., Haslam, D.R., Bhandari, M., Sullivan, T., Cook, D.J., Walter, S.D., Meade, M., Khan, H., Bhatnagar, N. and Guyatt, G.H., “A Systematic Review and Meta-analysis of Studies Comparing Mortality Rates of Private For-proﬁt and Private Not-for-proﬁt Hospitals”, Cmaj., 166, 11 (May 28, 2002): 1399–406. Gray, B.H., “Conversion of HMOs and Hospitals: What’s at Stake?”, Health Aff (Millwood).16, 2 (Mar-Apr 1997): 29–47. Gray, B.H., McNerney, W.J., “For-proﬁt Enterprise in Health Care”, The Institute of Medicine Study. N Engl J Med., 314, 23(Jun 5 1986): 1523–8. Gruber, J., “The Effect of Competitive Pressure on Charity: Hospital Responses to Price Shopping in California”, J Health Econ.,13, 2(Jul 1994):183–212. Hartz, A.J., Krakauer, H., Kuhn, E.M., Young, M., Jacobsen, S.J., Gay, G., Muenz, L., Katzoff, M., Bailey, R.C. and Rimm, A.A., “Hospital Characteristics and Mortality Rates”, N Engl J Med., 321, 25(Dec 21 1989): 1720–25. Health, United States, with Chartbook on the Health of Americans, Table 107, National Center for Health Statistics (2002). Keeler, E.B., Rubenstein, L.V., Kahn, K.L., Draper, D. and Harrison, E.R., “Hospital Characteristics and Quality of Care”, Journal of the American Medical Association, 268, 13(Oct 7 1992): 1709–14. Kessler, D.P., McClellan, M.B., “The Effects of Hospital Ownership on Medical Productivity”, Rand J Econ., 33, 3(Autumn 2002): 488–506. Lewin, L.S., Eckels, T.J., Miller, L.B., “Setting the Record Straight. The Provision of Uncompensated Care by Not-for-proﬁt Hospitals”, N Engl J Med., 318, 18(May 1988): 1212–15. Liu, J., “Investors Lured by Call of Siren.” China Daily. (02/05/2004): 11. Mark, T., “Psychiatric Hosptial Ownership and Performance”, Journal of Human Resources, 1, 3(1996): 631–49. McClellan, M. and Staiger, D., “Comparing Hospital Quality at For-proﬁt and Notfor-proﬁt Hospitals”, National Bureau of Economic Research, Working paper 7324 (August 1999). Newhouse, J.P. “Toward a theory of nonproﬁt institutions”, American Economic Review, 60(1970): 64–74. Nursing Staff in Hospitals and Nursing Homes: Is It Adequate? (Washington: National Acedamy of Sciences Press, 1996). Pattison, R.V., Katz, H.M., “Investor-owned and Not-for-proﬁt Hospitals: A Comparison Based on California Data”, N Engl J Med., 309, 6 (Aug 1983): 347– 53. Pauly, M.V., “The Not-for-proﬁt Hospital as a Physicians’ Cooperative”, American Economic Review, 63 (1973): 87–99. Pope, G.C. “Hospital nonprice competition and Medicare reimbursement policy”, J Health Econ., 8, 2(Jun 1989): 147–72. Shen, Y.C. “Changes in Hospital Performance after Ownership Conversions”, Inquiry., 40, 3 (Fall 2003): 217–34.

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Shortell, S.M., Hughes, E.F., The Effects of Regulation, Competition, and Ownership on Mortality Rates among Hospital Inpatients”, N Engl J Med. Apr 28 1988; 318 (17): 1100–107. Silverman, E.M., Skinner, J.S., Fisher, E.S., “The Association Between For-proﬁt Hospital Ownership and Increased Medicare Spending”, N Engl J Med. Aug 5 1999; 341 (6): 420–26. Sloan, F.A., ed. Not-for-proﬁt Ownership and Hospital Behavior. 1st ed. San Diego: Elsevier B.V.; 2000. Arrow K.J., Intriligator MD, eds. Handbooks in Health Economics; No. 17. Sloan, F.A., Picone, G.A., Taylor, D.H., Chou, S.Y., “Hospital Ownership and Cost and Quality of Care: Is there a Dime’s Worth of Difference?”, J Health Econ. Jan 2001; 20 (1): 1–21. Sloan, F.A., Trogdon, J.G., Curtis, L.H. and Schulman, K.A., “Does the Ownership of the Admitting Hospital Make a Difference? Outcomes and Process of Care of Medicare Beneﬁciaries Admitted with Acute Myocardial Infarction”, Med Care., 41, 10(Oct 2003): 1193–205. Taylor, D.H., Jr., Whellan, D.J., Sloan, F.A., “Effects of Admission to a Teaching Hospital on the Cost and Quality of Care for Medicare Beneﬁciaries”, N Engl J Med., 340, 4(Jan 1999): 293–9. Watt, J.M., Derzon, R.A., Renn, S.C., Schramm, C.J., Hahn, J.S., Pillari, G.D., “The Comparative Rconomic Performance of Investor-owned Vhain and Not-for-proﬁt Hospitals”, N Engl J Med., 314, 2(1986): 89–96. Wei, S.Z., Wu, T.B., The Ministry of Health (2002.8). Woolhandler, S., Himmelstein, D.U., “Costs of Care and Administration at Forproﬁt and Other Hospitals in the United States”, N Engl J Med., 336, 11(Mar 1997): 769–74.

PART V Corporate Governance and Efﬁciency

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Chapter 15

Corporate Governance and the Development of Private Enterprise in China Aimin Chen, Ping Li1

1 Introduction Corporate governance did not exist in China before economic reforms because urban enterprises were not owned by shareholders, but by the state. The reform of stateowned enterprises (SOEs) through corporatization and ownership diversiﬁcation has made nearly all of them share system enterprises. Some large and medium enterprises have been listed on the Shanghai or Shenzhen Stock Exchange, and small and medium enterprises have been transformed to be share corporations, or limited liability companies. These changes in the structures of ownership and control gave rise to the issue of corporate governance of Chinese ﬁrms. At its Fifteenth National Congress of the Communist Party in 1997, the Chinese government concluded China would reform its SOEs by building a modern enterprise system, or corporatization. In the most recent Premier’s Work Report at the Second Session of the Tenth National People’s Congress (March 5–14, 2004), the government reiterated its determination to revive China’s state capital by strengthening corporate governance and turning state enterprises into share-holding companies. This was to be done through mergers between state and domestic private capital and between state and foreign capital. Can corporatization of Chinese ﬁrms make former SOEs more efﬁcient? Should such a process be considered silent and partial privatization? The authors argue while corporatization may enhance the efﬁciency, the principal-agent relationship in China between the principal (the government) and private agents (managers and employees) is more complex because of the widely noted soft penalty problem. The laxness in the enforcement of contracts, the many layers of government representatives, and a greater room for corruption are a few. While conditions may improve toward a more effective relationship in the future, some are intrinsically more costly to dealings between the two parties. Corporatization of Chinese ﬁrms, therefore, will not cure all problems of state-owned enterprises. China’s corporatization has been a process of 1 Chen: Professor and Vice President, Sichuan Univeristy, China; Distinguished Professor, Indiana State Unviersity, USA. Li: Professor, Liaoning University, China.

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partial privatization. The extent of privatization depends on the ease of participation by non-government outsiders, i.e. private citizens, private enterprises, foreign investors, etc. Letting private and foreign capital purchase shares of SOEs remains an important step toward greater privatization, greater outsider involvement, improved composition of shareholders, and improved governance of Chinese SOEs. Our study takes a fundamental approach to examine the basic aspects of relevance to corporate governance of Chinese ﬁrms. In detail, we evaluate four important relationships concerning ownership structure and corporate control: ﬁrm’s relationship with banks, the stock market, the government, and the relationship between managers and employees within the ﬁrm. By doing so, we show the operation of Chinese ﬁrms as well as the socio-economic and historical background of their move toward establishing modern corporations. Moreover, through a better understanding of the merits and problems of current corporations that are mostly state-owned, we wish to extend our thoughts to the corporate governance issue of China’s private enterprises and call for more research in this respect. Which type of governance structure is more suitable for private ﬁrms who will become future modern corporations? What must they consider in seeking a corporate governance model for their future development? Herein, we attempt to analyze these issues regarding China’s private enterprise development. We start Section 2 with a summary of the stylized models of corporate governance to set the foundation for our analysis of the four relationships. Section 3 examines the relationship between enterprises and banks; Section 4 investigates the relationship between ﬁrms and capital markets; Section 5 explores the connection between ﬁrms and the government; and Section 6 deals with the relationships within the ﬁrm. In Section 7, we conjecture features of corporate governance that are more effective for newly established Chinese private enterprises that will move toward becoming modern corporations. Finally, Section 8 concludes the chapter. 2 The Stylized Models of Corporate Governance Governance models of modern corporations often choose to efﬁciently solve the problems associated with the principal-agent relationship and minimize agency costs, such as costs arising from monitoring, bond posting, and residual losses. While models of corporate governance vary depending on an economy’s cultural, historical, economic, and institutional backgrounds, there are two stylized models of corporate governance. One is called the Anglo-American model that relies on the efﬁcient development of the equity market. The other, the Japanese-German model, is bank-centered. The former is practiced in countries such as the USA, the UK, Australia, and Canada. Japan, Germany, and continental European countries practice the latter. The Anglo-American model has these characteristics: 1) Shareholders elect a board of directors to run the company on their behalf, and the board is expected to provide direction and oversight to company managers. 2) Representation of shareholders on the board is generally held to be the means by which the interests of shareholders can be directly expressed. 3) This model requires competitive markets

Corporate Governance and the Development of Private Enterprise in China

239

for corporate control, managerial manpower, and product of the ﬁrm. A competitive product market rewards efﬁcient ﬁrms for their good ﬁnancial performances, which is in turn rewarded by the equity market through dividends and stock prices. An efﬁcient equity market signals to shareholders the worthiness of the ﬁrm’s stock and thus exercises its role of corporate control. An efﬁcient managerial market regulates the performance of managers to be in the best interest of shareholders. 4) More recent emphasis has included (Tam, 1999, p. 28) (a) increasing the number of outside independent directors on the board, (b) establishing a system of more independent board committees to oversee functions of auditing, executive and director compensation, and board nomination, (c) the separation of the board chairman’s position from the chief executive ofﬁcer, and (d) more stringent disclosure requirements and standards of ﬁduciary duties and liabilities, regulatory facilitation of shareholders’ activism and promotion of a competitive capital market environment. On the other hand, the Japanese-German model has these distinct characteristics. 1) Most shares are stable and cross-held by large-block shareholders who assume a more active management role. While individuals in Japan constitute more than 98% of shareholders, they own less than 17% of shares. Only about 20–30% of the outstanding shares are in general circulation (Tam, 1999, p. 29). 2) Despite the fact that banks normally have a modest share ownership in companies they lend money to, the banks exercise a signiﬁcantly greater degree of inﬂuence and control over them. This occurs because banks are alleged to have better information regarding corporations and ﬁnancial system, and be capable of efﬁciently monitoring and lending. 3) Employees are encouraged to develop ﬁrm-speciﬁc human capital when labor market turnover is low. 4) The stability of the organization and the labor market allegedly promotes long-term growth of the company and advancement of the interest of both shareholders and other stakeholders such as employees, suppliers and customers. Between the two models, the Anglo-American model has been deemed a better alternative because of problems arising from the bank-centered model of governance. 1) Banks are more inclined to protect their own interests as ﬁxed claimants rather than acting altruistically to protect the interests of shareholders. 2) The model relies on special knowledge of the banks on corporations and the ﬁnancial market, which may not exist. 3) Unlike the Anglo-American model where managers are constantly pressured to perform in a competitive market, the stability under the JapaneseGerman model is obtained at the expense of new blood and new ideas from outside the small circle. This is one reason for the dismal performance of Japanese-German economies in 1990s (Miller, 1996, Nakamura, 2002). The corporate failures in the US in recent years, like Enron, have revived the thinking of the Japanese-German model as a valid alternative. Banks have continued to play a signiﬁcant role in Japan’s corporate governance (Nakamura, 2002). There are more versions of corporate governance beyond the above two extremes. Russia and other East European countries, for example, have, in the processes of their privatization, developed into the insider-control model. In this model insider employees and managers have secured the majority of the shareholding. China intended to follow the Anglo-American model, but many of its practices have displayed characteristics of insider-control model. The special managerial power and the lack

240

Table 15.1

The Revival of Private Enterprise in China

Institutions and Employment of China’s Banking Sector, 2001

Institutions Total The People’s Bank of China Industrial and Commercial Bank of China Agriculture Bank of China Bank of China Construction Bank of China Agricultural Development Bank of China Bank of Communications Export-Import Bank of China Shanghai Pudong Development Bank National Development Bank CITIC Industrial Bank China Everbright Bank China Minsheng Banking Corp., Ltd. China Huaxia Bank China Merchants Bank Guangdong Development Bank Fujian Industrial Bank Shenzhen Development Bank Co., Ltd Yantai House Savings Bank Source: China Statistical Yearbook 2002, p.661.

Number 118,691 2,228 28,345 44,418 12,529 23,925 2,275 2,838 3 240 37 340 31 105 17 293 560 255 172 80

Employment 1,878,677 166,984 429,709 490,999 184,529 419,157 59,487 57,602 523 5,743 3,516 8,850 7,249 3,094 5,025 12,922 11,009 5,815 5,089 1,375

of an efﬁcient equity market, managerial market, as well as a legal infrastructure are examples. Regardless of the model concerned, corporate governance, especially in transition economies, associates closely with the relationships between the ﬁrm and banks, between the ﬁrm and the development of the capital market, between the ﬁrm and the government, and within the ﬁrm, between managers and employees. We will closely examine these relationships below. 3 State Enterprises and Banks 3.1 The Changing Role of Banks Prior to the reform, banks functioned as policy banks and performed book keeping for enterprises. One enterprise banked with a designated bank which kept the account for the ﬁrm’s working capital. Fixed investments came primarily from ﬁscal sources. Under reform, Chinese banks are striving to become commercial banks. Table 15.1 summarizes the types of banks and ﬁnancial institutions in China. 3.2 Banks Remaining the Major External Source of Corporate Finance Investments in enterprises come from four fund sources: government budget appropriations, loans from ﬁnancial institutions, self-raised funds, which include

Corporate Governance and the Development of Private Enterprise in China

Table 15.2

241

Investment in Fixed Assets by Sources and Uses of Funds

Sources of Funds (%) Year 1981 1991 2001

Uses of Funds (%) Purchase of State Construction Foreign Fundraising Equipment Budgetary Banks Loans and Investment and Others and Appropriation Installation Instrument 28.1 12.7 3.8 55.4 71.8 23.3 6.8 23.5 5.7 64.0 65.2 26.1 6.7 19.1 4.6 69.6 61.7 23.7

Others 4.9 8.7 14.6

Source: China Statistical Yearbook 2002, pp. 178–9 and the authors’ calculations.

retained earnings and funds raised through issuing bonds and shares, and foreign investments. Among the four sources, government budget appropriation has declined over time, contrastingly bank loans and fund-raising have increased (Table 15.2). Banks and ﬁnancial institutions remain the largest ﬁnancier among all nongovernment outside sources of investment (78% of total) (see Table 15.3). Since the 1980s, the composition of funds allocated to state enterprises changed rapidly from budget appropriations in 1978 (70%) to state bank loans in 1982 (80%) (Tong, 2002, p. 21). In 2001, budget appropriations constituted 12.29% of SOEs’ investment funds. State enterprises rely on budget appropriations and bank loans more than other types of ﬁrms. They have the lowest ratio among domestic ﬁrms of self-raised funds containing primarily retained earnings (Table 15.4). Bank loans to SOEs were issued under the “two track” system. Banks must see the approval of local state planning commission for an investment project before a loan can be issued. For production outside of state quota, the loan arrangements depended on negotiations between the bank and enterprises, i.e., the commercial part of the function of the banks. 3.3 Supervising Role and Entanglement with the SOEs Three major factors limit the supervising role of Chinese banks: • • •

Banks are not allowed to directly invest in enterprises, unlike in Japan and Germany. Chinese banks supervise their loan performance through the role of creditors (as in the US). Since many loans have been and continue to be made according to administrative instructions, loan making decisions can be loan-performance independent. Chinese banks, being SOEs themselves, had little incentive to efﬁciently supervise the performance of their loans.

As a result, Chinese banks have been plagued with non-performing loans. A bank, in the hope of recuperating its loan, often tries to prevent the ﬁrm from going under by inﬂuencing local government or by giving the ﬁrm more loans, creating a vicious circle. The indebtedness of state enterprises, including corporatized ones, directly affects the performance of state banks and their reform. When state banks are able to

The Revival of Private Enterprise in China

242

Table 15.3

Financing Investment: The Role of Financial Institutions and Capital Markets, 1996

Types of Financing

Value of Finance (billion yuan)

Loans by Financial Institutions, of which: Banks State Banks Other Banks Non-banks Capital Market Capitalization Stock Markets Bond Markets Total Source: Tong (2002), p. 79.

Value of Finance (percent of total)

Value of Finance (percent of GDP)

6,115.28

78.0

89.1

4,937.11 4,743.47 193.64 1,178.17

63.0 60.5 2.5 15.0

72.0 69.1 2.9 17.1

1,722.00

22.0

25.1

984.24 737.96 7,837.28

12.6 9.4 100.0

14.3 10.8 114.2

stop making loans to non-performing state enterprises and clear existing bad loans, China’s banking sector can be reformed to become commercial banks. 3.4 Debt-equity Swap In 1999, to clear the entanglement of state banks with poorly performed state enterprises, the government created four state asset management companies, China Cinda, China Oriental, China Great Wall, and China Huarong, to purchase, manage, and dispose bad loans of four state banks. Banks included: Industrial and Commercial Bank of China, Agriculture Bank of China, Bank of China, and Construction Bank of China, including their branches everywhere in the country.2 Instead of paying banks interest, the debtor enterprise pays dividends to the asset company. These loans are sold as initial public offerings or transfers of ownership. The debt-equity swap scheme allows enterprises in question a fresh start without the burden of heavy debts, and banks strengthen their balance sheets, on the other. On October 30, 2002, China Cinda carried out the ﬁrst transfer of ownership through auction by selling off 38% of the shares of Hebei Lingyun Industrial Group, Limited, at 68.37 million yuan, over the estimated value of 65.1 million yuan.3 The four state banks had reduced their bad debt ratio by more than 3 percentage points to 25% in early 2003 based on the ﬁve grade international classiﬁcation (CCTV, 2/8/02 and 3/17/03), and further to a little over 17% in March of 2004. Debt-equity Swaps and bond issuance by the government to inject capital into banks as equity to improve their balance sheets helped reduce this debt. This occurred as a result of an injection of USD45 billion into the China Construction Bank and Bank of China by the government preparing these two state banks to become share companies (CCTV, 3/11/04). 2 3

A ﬁfth one has been set up in August 2003 in Hainan Province. Data provided by the Shares Management Department of China Cinda.

Corporate Governance and the Development of Private Enterprise in China

Table 15.4

Total State Budgetary Appropriation

Sources of Investment Funds (in 100 million yuan) by Ownership (% in parentheses) Private Joint State Collective Enterprises Ownership Enterprises Enterprises and Units Proprietors

Taiwan, Foreign Hong Kong, Funded and Macao Units Units

17606.97

5278.57

5429.57

94.52

1415.4

2163.63

291.42

0.85

0.51

(-0.02)

(-0.54)

(-12.29)

(-5.52)

4073.12 Banks Loans Foreign Investment

243

586.27

(-23.13)

(-11.11)

346.14

176.1

(-1.97)

Fundraising and 10603.8 Others (-60.23)

(-3.34) 4308.34 (-81.52)

406.67 (-7.49)

2.19 (-0.15)

Others

1583.29

141.68

2.69

1.96

(-0.17)

(-1.38)

15.42

213.01

409.6

11.52

(-16.31)

(-15.05)

(-25.87)

(-8.13)

4.47

0.74

656.7

391.83

2.71

(-0.08)

(-0.78)

(-46.4)

(-24.75)

(-1.91)

88.2

688.19

(-93.31)

(-48.62)

5139.42 (-94.66)

1039.8 (-65.67)

127.19 (-89.77)

Source: China Statistical Yearbook 2002, pp. 178–9 and the authors’ calculations. Note: The four sources do not add up to the totals in the original data.

4 Enterprises and the Capital Market 4.1 A General Description Since 1984, SOEs have been able to issue corporate bonds, while the government resumed the systematic issuance of treasury bonds in 1981. Banks were permitted to issue ﬁnancial bonds in 1985 (Tong, 2002). Private enterprises, however, had been banned from issuing corporate bonds until recently. Bond issuance constitutes an insigniﬁcant portion (9.4%) of capital investment from ﬁnancial institutions and capital markets. Of the total bond issuance in 1996, corporate bonds accounted for less than 5%. Government bonds and ﬁnancial bonds constituted more than 95% of the total value of bonds (Table 15.3), making bond ﬁnancing of state enterprises investment a negligible part of total investment. Since 1990, total corporate bond issuances have valued 220 billion yuan (or 27 billion USD), primarily in industries such as energy, transportation, raw materials, and infrastructure. In March 2004, China General Technology Holding Ltd. became the ﬁrst SOE under the central government to issue a corporate bond of 1 billion RMB, or 120 million USD, to a foreign project. The government will encourage more of funding in the corporate bond market (CCTV, 3/30/04). Investment ﬁnancing through stock markets ofﬁcially began in 1992. By the end of January 2003, 1229 Chinese ﬁrms, almost all state owned, had become publicly listed stock companies. Chinese listed company shares are classiﬁed as A shares (issued by domestic companies and are held and traded in RMB by domestic investors only). B shares (issued by domestic companies registered on the mainland, but traded in hard currency by foreign investors), and H shares (issued and listed by domestic companies in Hong Kong). Each type accounts for about one-third of all shares.

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The Revival of Private Enterprise in China

On the types of investors, Chinese listed companies’ shares are also divided into: (1) Non-tradable state shares, held by central and local governments represented by local ﬁnancial bureaus, state asset management companies, or investment companies; (2) Non-tradable legal person shares, held by domestic institutions, such as industrial enterprises, securities companies, trust and investment companies, foundations and funds, banks, construction and real estate development companies, transportation and power companies, and technology and research institutes. Systemically, legal person shareholders include SOEs, state-owned nonproﬁt organizations, collectively owned enterprises, private enterprises, joint stock companies, and foreign-funded companies. Almost all the largest legal person shareholders are industrial SOEs Therefore the state is directly or indirectly in control of listed companies. Legal person shares are also not tradable; (3) Tradable A, B, and H shares, held by individuals and institutions. (4) Employee shares, held by management and employees of listed companies. In 1998, the regulatory authorities issued a circular to discontinue the issuance of employee shares (Tenev et al, 2002). 4.2 Limited Role of the Stock Markets The limited role of stock markets in China is manifested in the following ways: •

• • •

•

Out of the 181,557 total industrial SOEs and “scaled non-SOEs” that had greater than ﬁve million sales revenues in 2002 (China Statistical Yearbook 2003, p. 461), a limited number of ﬁrms are listed (1229 by Jan. 2003). Tradable shares comprise only about 1/3 of all shares among listed ﬁrms, providing an insigniﬁcant source of investment ﬁnancing. Stock capitalization relative to GDP is smaller than developing countries such as Indonesia, Thailand, and Mexico. See Table 15.5. Stock markets signal limited information to investors. Chinese investors are generally skeptical about information provided by and the accounting practices of listed ﬁrms. This is a consequence of both non-standard accounting practices of ﬁrms and the general lack of transparency. Institutions also keep ﬁrms’ practices ethical. Corruption, stock market manipulation, tax cheating, fraudulent dealing, and all manners of plundering of state assets and the lack protection of shareholders’ rights are some of the more conspicuous manifestations of the ethical issues (Tam, 2002). The state has remained the majority shareholder (not necessarily the tradable shares) of most listed ﬁrms, which makes political interference more likely and limits the inﬂuence of the stock market on ﬁrms’ incentive structure.

Intending to reduce the government’s stake in listed companies and bring up the meager social security budget, the Chinese government announced the policy of selling state-owned shares through IPOs in June 2001. It also declared that 10% of the proceeds would go into a new state welfare fund. The move, however, ﬂooded the market with liquidity that knocked 30% off the value of the A-share markets. The government then decided to shelve the sales of the state-owned shares in October 2001 (China New Digest, 10/25/01).

Corporate Governance and the Development of Private Enterprise in China

Table 15.5

245

Stock Market Capitalization: International Comparison, 1996

Country Market Capitalization as % of GDP Liquidity Ratio* (%) China 14.3 191.4 United States 115.6 83.3 Japan 67.2 28.5 Hong Kong 216.6 47.4 Taiwan 216.6 171.8 Korea 28.6 127.7 Singapore 159.7 17.3 Indonesia 40.3 35.3 Thailand 53.9 44.4 Mexico 31.8 40.4 Source: Tong (2002), p. 82. Note: Liquidity ratio is deﬁned as annual total trading value divided by market capitalization.

The stock market capitalization, as a ratio to GDP, and the small number of listed ﬁrms do not fully reﬂect the role of the Chinese stock market. This occurs although legal person shares and employee shares are not ofﬁcially tradable, they are nonetheless traded in the informal market, providing some impetus to the performance of stock ﬁrms. A new development in the equity market is the growing share of institutional investors such as managed funds. The number of mutual funds has grown from 33, totaling 56 billion yuan or 6.8 billion USD at the end of 2001 (Tam, 2002), to 125, totaling 28.75 billion USD in March 2004 (China State Statistical Bureau, CCTV, 3/8/04). Further growth of bond ﬁnancing has been encouraged and expected. As shown in Table 15.6, the share of investment in the stock market by mutual funds is currently 7.6% and is expected to nearly double in 2004. Such development is believed to be beneﬁcial. Not only will it provide a new vehicle of investment but also a catalyst for professionalism, sophistication, efﬁciency and increased stability in the market and industry. 5 The Firm and the Government: the Structure of Ownership and Control in Transition 5.1 An Overview State owned-enterprises (SOEs) in China are characterized by government ownership of different levels. Enterprises directly under the central government represent the highest level of government ownership, and the ranks decline to the provincial government, municipal government, and county level government. Technically, Chinese state-owned enterprises are also known as enterprises owned by the people (quan min suo you zhi). As such, the state, or government, serves on behalf of the people as the owner, or principal, and the ﬁrm’s managers are the agents.

246

Table 15.6 Period

The Revival of Private Enterprise in China

Mutual Fund Investment in Stock Market Investment Volume and (Share)

By March2004 12 billion USD (7.6%) By the end of 18–22 billion USD (12–15%) 2004 (estimate) Sources: China State Statistical Bureau and CCTV 3/8/04.

Number of Fund Management Companies 49 N/A

While our governance analysis applies primarily to the ﬁrms after reform was launched. Firms were owned and controlled by the government before the reform. A brief review of the relationship between the government and ﬁrms before the reform is beneﬁcial for a better understanding of the current and evolving structure. Prior to reforms, ﬁrms produced according to quotas and prices set and materials allotted by the government. The government appointed all major management staff of a state enterprise, usually having a factory director and a party secretary. The party secretary was in charge of a ﬁrm’s ideological matters and had the highest authority in the ﬁrm. The factory director would be in charge of production matters that were of secondary importance. Cadres of state enterprises carry standard ranking of government ofﬁcials4 and are remunerated accordingly in terms of salaries, housing, medical care, and retirement beneﬁts. Salary scales of the cadres and workers were set by the government with differences in job skills, job difﬁculties, and regional conditions. The management must exhibit politically correct behavior. As market opportunities for cadres became corrupt and pirate state assets were limited, the principal-agent relationship was simpler and reﬂected primarily in cadres’ quota fulﬁllment. Employees, who were called the masters of the ﬁrm, were given “iron rice bowls,” had strong incentives to shirk and disobey disciplines. Production plans were often carried out with poor quality, if at all. The government replaced the top management as a way of exercising the right of the principal. Model cadres and workers were often selected to boost morale and work incentives. Enterprise reform has signiﬁcantly changed the relationship between enterprises and the government. The government’s role in enterprises has remained not only as a regulatory role, but, more importantly, an ownership role, and a controlling ownership role in most cases. Meanwhile, ﬁrms have been given autonomies on what to produce, how to produce, and what prices to sell their products. As the macroeconomic priority has been switched to economic growth, the central government calls for limiting government interference in enterprises, but local governments and their branches may interfere more frequently depending on the proﬁtability situation of the ﬁrm and the need of speciﬁc government agencies. Top managers are still appointed, especially in large enterprises. The government also sets top manager’s maximum salary as according to a certain multiple of the lowest paid worker. Moreover, the Party Secretary is no longer the number one boss. The government lets the Factory Director make major decisions. The Party Secretary 4 The factory director of an important steel plant could have the same rank as a key ofﬁcial in the municipal government, for example.

Corporate Governance and the Development of Private Enterprise in China

247

is in charge of human resources and public relations. There is still a lack of managerial market due to government involvement. Turnovers of business executives are low. There lacks a market for corporate control. Mergers and acquisitions of ﬁrms are initialized primarily by local governments according to the basic sentiment of the central government and the local needs (Chen and Li, 2003). Managerial autonomies and emerging market opportunities have led to a more complex principal-agent relationship. The cadres of SOEs have considerable control over remunerations, in-kind beneﬁts, and dealings that maximize the management’s interest at the state’s expense. In addition to shirking, piracy of state assets has become a major problem in the new principal-agent relationship. The need to motivate better performance with greater enterprise autonomies has been confronted with effective control of enterprises by managers and massive plundering of state assets. This new form of governance relationship is the Chinese way of effective insider managerial control. To counter this insider-control effect and strengthen governance of state enterprises, the State Asset Management Commission (SAMC), for the ﬁrst time in history, acted formally as the principal, representing the interest of the state. They announced to implement a series of measures to hold agents responsible for the state assets through checking their fulﬁllment of ﬁnancial targets. It symbolizes a start of a new form of principal-agent relationship in China. The measures can be summarized as follows: 1. Share system and ownership diversiﬁcation with government, foreign, and private capitals will be implemented among nearly all of the 189 SOEs that are central government owned. Due to the nature of the product or service, it would be difﬁcult for the excepted ones, such as munitions producers, to have diversiﬁed ownerships (CCTV 4, 12/15/03). 2. China will start a property-rights or ownership-rights related incentive system in 2004, among state-owned high tech ﬁrms. Under the system, engineers, technicians, and managers with outstanding contributions, will be given shares of their companies (CCTV 4, 12/15/04). 3. Starting in 2004, the SAMC will implement and manage an annual salary system among top managers of central government SOEs. The ﬁrst phase of the new system, the taking-off phase, will emphasize promoting short run incentives, basing annual salaries on ﬁnancial performance standards, enforcing the standards more effectively and forcefully, and thus correcting the situation where managers set their own salaries. In a longer run, salaries will be determined by the demand and supply in the managerial market.5 5 20 of the central government level SOEs, among them, China Petroleum and Natural Gas Company (zhongguo shiyou yu tianranqi zonggongsi) and The Three Gorges Dam Project Developing Company of the Central Government (zhongyang changjiang sanxia gongcheng kaifa zonggongsi), had been selected by the SAMC by December 14, 2003 to experiment the new remuneration system. These ﬁrms, as agents, have signed an agreement with the SAMC, as the principal, to realize certain proﬁt targets. The targeted proﬁt level of 2004 for these 20 ﬁrms collectively is 36.77 billion yuan, or an increase of 7.8% over the estimated proﬁts this

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248

Table 15.7

Share Type

Distribution of Companies by Types of Largest Shareholders, at IPO and 1999 (%) First Largest At IPO 1999 47 42

State Shares Legal Person 49 Shares Employee Shares 0 A Shares 3 B Shares 0 H Shares 0 Foreign Legal Persons 0 Other 0 Source: Tenev et al (2002), p. 79.

Second Largest At IPO 1999 6 5

Third Largest At IPO 1999 1 4

54

64

58

17

53

0 2 0 0 1 0

4 22 3 0 0 0

1 26 5 1 0 4

4 28 3 1 1 0

1 31 6 1 0 4

5.2 The Relationship within Listed Companies An overwhelming feature of China’s listed companies is the state remains the controlling shareholder of either tradable shares or non-tradable legal person shares. This was indicated in a survey by the World Bank on 257 companies listed on Shanghai stock exchange in 1999 (Table 15.7). Companies with the state as the controlling shareholder tended to decrease over time. For instance, from 47% of listed companies at IPO to 42% in 1999, but companies with legal persons as the largest shareholder have tended to increases. For instance, from 42% of listed companies at IPO to 54% in 1999. If state shares and legal person shares are taken into consideration together, the ownership structure is relatively stable overall, and the state has remained controlling shareholder of the listed companies (see Table 15.7). Since almost all the largest legal person shareholders are industrial SOEs, the state is directly or indirectly in control of listed companies. Corresponding to the state’s controlling share status, Chinese boards, compared with practices in other markets, have relatively little decision-making power within the existing legislative framework. Government ministries and commission and securities regulatory authorities enjoy substantial decision-making power. •

•

As Table 15.8 shows, for about 20% of China’s listed companies, the board has full powers in matters regarding ﬁnance and investment. While in about half the companies the board has decisive inﬂuence over these matters. According to the survey by World Bank, the board exerts full powers in the appointment of general managers in about seventy percent of the companies.

year. Each ﬁrm will be responsible for its ﬁnancial performance according to its agreement signed with the SAMC. Those who meet the speciﬁed criteria of the Agreement will be paid their agreed upon annual salaries promptly, those who exceed the criteria will be rewarded with mid to long term bonuses, those who fail to meet the criteria will either incur reduced or delayed remuneration, or have their positions terminated (CCTV 4, 12/15/03).

Corporate Governance and the Development of Private Enterprise in China

Table 15.8

The Role of Company Board in Financial and Investment Decision (% of Listed Companies)

Company Action

Full power

Adjustment of Equity 10.5 Structure Dividends Distribution 10.9 NewCapital Investment 21.8 Sale of Assets 20.6 Borrowing for Fixed Assets 25.7 Investment Mergers and Acquisitions 10.9 Company’s Strategic 35.4 Planning Source: Tenev et al (2002), p. 96.

•

•

249

Decisive Power

Substantial Inﬂuence

Some Inﬂuence

No Inﬂuence

52.9

12.8

3.9

1.6

59.1 49.8 48.6

13.6 9.7 10.9

1.9 2.7 1.6

0.5 0.7 0.8

38.1

14.8

3.9

0.8

56.4

12.1

1.2

0.9

44.4

6.6

1.2

0.4

Large shareholders often overstep their boundaries and exercise effective control although Company Law states the relationship between shareholder’s meetings, boards of directors, and management relatively well. Board chairs usually have good government connections and exert genuine control over shareholder’s meetings as representatives of the largest shareholder.

The state’s dual role as owner and regulator has made the relationship more complex.6 On the one hand, the state as an owner needs to be properly represented on the boards. As the regulator, on the other hand, the involvement of the state easily becomes political intervention, especially when it oversteps its boundary as the largest shareholder. In the extreme cases, the state’s role of regulator directly mixes with that of owner. When the state considers itself the owner, it becomes the ultimate controller of listed companies through its ownership of the holding company by default. However, it may not own a single share of either the holding company or the listed company. Some call this structure pyramiding corporate hierarchy. At the bottom of the pyramid lies the listed company, in the middle, the holding company, owning the majority share. On the top, the state owns 100% of the holding company although no shares of the holding or the listed company (Watanabe 2002). The pyramiding corporate hierarchy produces a distortion of separating the income rights (from equity holding) and control rights. Instead of “one share one vote,” the ultimate equity holder (the state) can control the listed company with minor equity through pyramiding. When the ultimate controller’s interest differs from the company and its small shareholders, conﬂict of interests happens between the government and other shareholders. The holding company or the assets management 6 Although the state has always been the owner (representing the whole mass), the ownership role has never been as explicitly spelled out as in the case of a majority shareholder.

250

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company becomes the channel for the government and the distorted governance structure. This structure of interest conﬂict differs from developing economies such as Indonesia or Korea, where the conﬂict of interest usually occurs between owner families and small shareholders or banks (Watanabe 2002). While managers and boards of directors tend not to resist arbitrary government intrusion into all areas of business operations, there are also cases where the state’s shares are unattended and state’s interests are unrepresented (Chen, 1994). In fact, piracy of state assets has been a common phenomenon and become a major problem in the new principal-agent relationship. 6 Firms and Their Employees 6.1 A General Description Prior to economic reforms, a state enterprise functioned as a small society that provided employees with housing, medical care, daycare, retirement beneﬁt, and an “iron rice bowl.” The ﬁrm was the facilitator of the big rice pot which employees with their “iron rice bowls” fetch whatever could be taken from the pot. While employees were “masters” of the ﬁrm and little disciplinary actions such as being ﬁred, ﬁned, or laid off could be taken against them, they did not join decision making within the ﬁrm. Firms’ cadres were administratively superior to subordinate employees. Although there were too few market opportunities to breed massive corruption, unequal distribution of in-kind remunerations, such as housing, existed. Reforms have ended the “masters of the ﬁrm” status of employees and made them contract laborers. They can be laid off, ﬁred, or ﬁned. The “iron rice bowl” has melted. Firms no longer function as providers of the safety net and social welfare of housing, medical care, daycare, and retirement. In theory, workers have a number of legal rights to protect their interests. First, collective contracting and negotiations typically govern narrow employee interests related to compensation, ﬁring, social beneﬁts, working conditions, and so on. Second, the workers’ congress and trade unions have extensive rights to consultation and information regarding production plans, use of public welfare funds, and other matters affecting employees’ interests. Meanwhile, management now has more autonomies and greater control of the ﬁrm while possessing greater power over employees. While managers’ autonomies grow signiﬁcantly and they can legitimately remunerate themselves with company cars, better housing, etc., there is less democracy within the ﬁrm. Workers’ voice being heard, their involvement in decision making, and the atmosphere of camaraderie, are a few examples. 6.2 Among Listed Companies Employees can be represented on boards of directors and supervisors. By the Company Law, boards of directors and of supervisors in limited liability companies should contain a proper proportion of workers’ representatives. A 2000 survey of 1,229 enterprises in Henan province recalled 48% of enterprises had employee

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representatives on their boards of directors, and 69% had employee representatives on their boards of supervisors. In a similar survey conducted in 1,669 on enterprises in Hebei province, the ﬁgures were 92 and 98%, respectively (Tenev et al, 2002). The Company Law does not specify the proportion of shareholders’ representatives and employees’ representatives on supervisory committees. They require corporate charters properly stipulate the proportion. Theoretically, shareholders could specify a low proportion of employee representatives on the supervisory committee. However, because of the SOEs’ traditional business practices, shareholders appoint only about half of the supervisors. Leaders of party committees tend to assume the position of chair and vice chair in most listed companies. Unions are not represented on supervisory board to any signiﬁcant extent (ibid). Employees can also participate in corporate governance in their capacity as owners. Although the regulation by central government set up a limit of 2.5% on employee-held stocks in the stock-issuing, local regulation soon superseded this limit. In 1994, Shanghai allowed 10–30% of employee-held stocks. That same year the Shenzen Special Economic Zone allowed up to 30% of employee-held stocks. This proportion later rose to 50% and then exceeded this ﬁgure. Other provinces also followed suit (Tenev et al, 2002). 6.3 Among Employee-Owned Firms By 2000, most small and medium enterprises completed their transformation through ownership diversiﬁcation, which includes restructuring, merging, leasing, contracting, forming a joint-stock company, and ﬁling bankruptcy. For small and medium enterprises that have few opportunities of going public and are close-held, employees emerged the most important shareholders under the new ownership structure.7 Within the ﬁrm, there co-exist “three new committees” (i.e. the conference of shareholding employees, the board of directors, and the board of supervisors) and the “three old committees” (the workers’ congress, the party committee, and the trade unions).8 The existence of multiple representative bodies with overlapping functions has created conditions whereby employees perceive their shareholder rights merely as an additional instrument for furthering their narrow interests. Employees still 7 In Jin Hua, for example, most of the enterprises that changed their ownership emerged as 100% employee owned. The share of senior managers was relatively high, and on average amounted to 20 to 30% of all employee shares. The initial ownership structure was characterized by a signiﬁcant dispersion of ownership. The largest shareholders held between 3 and 25 times as many shares as the smallest shareholders and 2 to 10 times as many shares the average shareholder (Tenev et al, 2002). Unlike listed companies, state and legal person shares were in the minority in the transformed small and medium enterprises. 8 While many enterprises combined shareholders’ and workers’ congress meetings and had the same person serve as chair of the board of the directors and secretary of party committee, and even held joint meetings of various representative bodies, the conﬂicts between them were not avoidable that operational issues were decided at shareholders’ meetings using the one-share-one-vote method, and the issues concerned employee beneﬁts had to be decided at the workers’ congress using the rule of one person one vote method.

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see themselves as permanent workers, implicitly protected against layoffs, and shareholding often reinforces this perception. Such a conﬂict of interests hinders employees’ capacity to play a constructive role in corporate governance. Moreover, given the diffused ownership structure, employees were not motivated to spend the required time and effort to inform themselves about factors affecting enterprises performance and monitor management behaviors. The coexistence of old and new institutions has created conﬂicts between the functions of governing bodies and confusions by shareholders in their perception as owners and employees. The shareholders as owners tend to discourage workers from looking at contractual mechanisms to structure and protect their rights. As workers they tend to ask for compensation if ownership transformation would make them want to reduce their rights and thus make the transformation more costly. The current links between legal labor rights and ownership form create a bias in favor of the status quo.9 7 The Development of Private Enterprises While enhancing corporate governance of China’s SOEs has functioned as an alternative to direct privatization of many large Chinese enterprises, private enterprises have made a stride forward quantitatively and qualitatively since the beginning of reforms when 100% of China’s gross value of industrial output (GVIO) was produced by SOEs and COEs. Since the early 1980s, China’s private economy has grown at a rate 20% annually and has contributed to half of China’s economic growth. By the end of 2003, there were three million private ﬁrms with a registered capital of 334 billion yuan (or 40.4 billion dollars) (CCTV, 3/3/04), which represented a growth of 36.4% over the previous year’s 2.2 million private ﬁrms. This excludes proprietors of 23.77 million (People’s Daily, 11/22/03), employing nearly 30 million workers. In some locales, private businesses contribute more than 90% of local economy (CCTV 9, 9/14/03). In 2002, private businesses created 6.09 million new non-farm jobs, 72.5% of the total urban new jobs of 8.4 million (People’s Daily, 11/22/03). The share of GDP by the private sector had expanded from smaller than one quarter in 1998 to greater than one third in 2002. The deputy director of China’s State Statistical Bureau predicts the private sector to grow at an annual rate of 15–20% over the next ﬁve years (Financial and Economic Brieﬁng, CCTV, 3/3/03). Though the topic of corporate governance is less relevant at this stage than for large share companies (mostly SOEs), looking forward to an efﬁcient governance model for private businesses as they transform from small and family-run businesses into successful modern corporations remains important. In fact, whether private enterprises are able to recruit well-educated personnel with more advanced governing methods to carry out the transformation has become a key issue in the 9 Thus what is needed is a uniform approach to labor rights that treats all employees in a similar fashion irrespective of ownership. The legally embedded labor rights should be focused on the core traditional labor issues of compensation, working conditions, social beneﬁts, collective action, and so on, leaving rest to voluntary, legally enforceable arrangement (Tenev et al, 2002).

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development of Chinese private enterprises. We therefore share the following thoughts on the corporate governance of China’s private enterprises based on their current characteristics and development environment. First, China’s private businesses are on average smaller than 15 employees per ﬁrm (2.2 million ﬁrms employing nearly 30 million people in 2002, for example). As such, they are at a relative technical and scale disadvantage compared to the SOEs and other types of ﬁrms. Therefore, they are concentrated in small-scale manufacturing, retail and other service industries. Second, private enterprises must rely entirely on self-funding. As shown in Table 15.4, among all types of ﬁrms listed, private enterprises have the highest ratio, 94.66%, of the “fundraising and others” as the sources of investment. This occurs because in addition to being small and thus carrying higher risk, they have been discriminated against in the commercial credit market, have not been allowed to issue bonds before 2002, and have had trouble becoming publicly listed. Third, since Chinese banks are not to directly hold shares of companies, private enterprises can rely on banks as creditors at best. Moreover, seeing as bond ﬁnancing is a negligible source of ﬁnance for most large enterprises, it is less likely to help private ﬁrms in the near future, especially small ones. China’s private enterprises are consequently more likely to become close-held share companies if they become share companies at all. While they must continue to rely on internal sources for corporate ﬁnance, bank credit will become an important outside source of ﬁnance, especially as bank reform deepens and eliminates some discriminations against private enterprises. Fourth, the success of private enterprises at present has been mostly system driven. They have less severe problems than state enterprises face such as government interference, large number of retirees and other social responsibilities, soft-budget constraints, etc. But as other types of ﬁrms are gradually completing their systemic transformation and becoming more competitive, the systemic advantage of private enterprises may disappear and be outweighed by their disadvantages. A lack of scale and technology will be disadvantages if they do not start to develop. The development of private enterprises relies on how they maintain their systemic advantages and eliminate their disadvantages. One systemic advantage in their move toward building modern enterprises is that, unlike state enterprises where the government continues to be the principal, the principal-agent relationship in private enterprises will be between private entities. This will also simplify the relationship. They will continue to enjoy less government interference. Their systemic advantage also lies in their governance arrangements, which can be made with less inﬂuence of historical baggage SOEs must endure. In designing their governance structure, they must consider several factors. 1) They must take into consideration global competitiveness and global integration. 2) They must build their corporate governance model based on standardized criteria to ensure disclosure and transparency. 3) They must study and learn from lessons and experiences of existing models of corporate governance, especially those experienced by Chinese ﬁrms and other transition economies. 4) They must rapidly develop their scale economies, become technically more sophisticated, and employ improved management staff and personnel.

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8 Concluding Remarks Instead of rapidly privatizing its SOEs as suggested by the transition orthodox and experienced by eastern European economies, China takes a pragmatic approach allowing a gradual transition of ownership and corporate governance. The ownership and governance structures in China’s large SOEs have in turn become increasingly complex. China’s corporate governance structure is neither Japanese-German style, which banks have signiﬁcant control over corporations, nor Anglo-American style, which stock and managerial markets function to alleviate principal-agent problems in modern corporations. While Chinese banks remain the major ﬁnancier of investments in corporatized SOEs, they exert little supervision over corporations. Meanwhile, stock markets in China are still at infancy in terms of capitalization as percentages of total investment ﬁnanced and of GDP, of the limited number of ﬁrms publicly listed, and irregular operations of corporatized ﬁrms. There also lacks a managerial market. The government still has considerable control over who becomes managers and chairpersons of the boards. China’s enterprise reform, however, is striving to build a modern enterprise system resembling the Anglo-American mode of corporate governance. While the topic of corporate governance is now less relevant than for large share companies, mostly SOEs, recognizing the right direction for private businesses as they transform from small-scale into successful modern enterprises remains important. In fact, whether private enterprises are able to recruit well-educated personnel with more advanced governing methods to carry out the transformation is a key issue in the development of Chinese private enterprises. References Buck, T., I. Filatotchev, P. Nolan and M. Wright, “Different Paths to Economic Reform in Russia and China: Causes and Consequences,” Journal of World Business, 35, 4(2000): 379–400. Chen, A., “Chinese Industrial Structure in Transition: The Emergence of Stockoffering Firms,” Comparative Economic Studies, (1994), pp. 1–19. Chen, A., “Inertia in Reforming China’s State-owned Enterprises: The Case of Chongqing,” World Development, 26, 3 (March 1998): 479–95. Chen, J., “Ownership Structure as Corporate Governance Mechanism: Evidence from Chinese Listed Companies,” Economics of Planning, 34(2001): 53–72. Chen, A. and P. Li, “The Formation, Restructuring, and Performance of Chinese Enterprise Groups: the Case of Liaoning Province,” mimeo, Indiana State University. China Statistical Yearbook, various issues. Judge, Q., I. Naoumova and N. Koutzevol, “Corporate governance and ﬁrm performance in Russia,” Journal of World Business, (September 2003): 387–96. Lin, C., “Corporatisation and Corporate Governance in China’s Economic Transition”, Economics of Planning, 34(2001): 5–35.

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Lin, Y. and T. Zhu, “The Restructuring of Ownership and Governance in China: An Empirical Study of the Shareholding Reform,” Seoul Journal of Economics, 13, 3 (Fall 2000): 279–300. Marlin, C., and R. Xie, “The Development of Corporate Governance in China,” Journal of Contemporary China, 7, 17(March 1998): 33–42. Miller, R., “Corporate Governance and Management in China: Some Further Thoughts,” keynote speech at the Guangzhou (International) Conference on Financial and Enterprise Reforms, Guangzhou, China, July 13, (1996). Nakamura, M., “Mixed ownership of industrial ﬁrms in Japan: debt ﬁnancing, banks and vertical keiretsu groups,” Economic System, 26, 3(September 2002): 231– 47. OECD Organisation for Economic Co-operation and Development, China in the Global Economy China in the World Economy: The Domestic Policy Challenges – Synthesis Report, SourceOECD Emerging Economies, 7(2002): 1–75. Peng, Y., “Chinese Villages and Townships as Industrial Corporations: Ownership, Governance, and Market Discipline,” The American Journal of Sociology, (March 2001): 1338–70. Shi, S. and D. Weisert, “Corporate Governance with Chinese Characteristics”, The China Business Review, (Sept/Oct 2002): 40–44. Tam, O.K., The Development of Corporate Governance in China, (Edward Elgar Publishing Limited, 1999). Tam, O.K., “Ethical Issues in the Evolution of Corporate Governance in China,” Journal of Business Ethics, 37, 3(May 2002): 303–20. Tenev, S. and C. Zhang, Corporate Governance and Enterprise Reform in China: Building the Institutions of Modern Market, (World Bank and the International Finance Corporation, 2002). Tian, J. and C.M. Lau, “Board Composition, Leadership Structure and Performance in Chinese Shareholding Companies,” Asian Paciﬁc Journal of Management, 18, 2(June 2001): 245–69. Tong, D.D., The Heart of Economic Reform: China’s Banking Reform and State Enterprise Restructuring, (Ashgate Publishing Limited, 2002). Watanabe, M., “Holding Company Risk in China: A Final Step of State-owned Enterprise Reform and an Emerging Problem of Corporate Governance,” China Economic Review, 13 (2002): 373–81. Wei, Y., “An Overview of Corporate Governance in China,” Syracuse Journal of International Law and Commerce”, 30, 1(2003): 23–48.

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Chapter 16

The Productivity Efﬁciency of State-Owned Enterprises in China Chun-Chien Kuo1

1 Introduction China has many important challenges to face regarding inadequate ﬁscal resources, an insolvent banking sector, and an unusually small private sector. The tough choice is deciding which one to put the most emphasis on? Such a choice is inevitable due to ﬁnite capacity of the state. If SOE reform had been successful, development of the private sector need not be a top priority. If not, the promotion of the private sector is the ﬁrst priority task. The state-owned enterprises (SOEs) in China have always been criticized for inefﬁciency, corruption and threatened to be a serious halt on economic reform. Two major ﬂaws of China’s SOE system arise from the incentive structure for managers and soft budget. A manager’s future promotion is not dependent on his/her ability to maximize proﬁt. It is based on their capability to fulﬁll the workforce’s needs on compensation, housing, medical and education for the SOEs in China. The soft-budget phenomenon is also criticized as one of the major reason for SOEs’ revenue loss from imprudent investments. As China’s economic reform proceeds, SOEs still play an important role in China’ economy despite its gradually declining importance. Reform measures such as debt-equity swaps, state share-holding enterprises conversion, and privatization have been introduced to mitigate the heavy loading of inefﬁcient SOEs on the growing economy. The shareholding system is an essential form in modern enterprises. Since the poor management of China’s SOEs has been blamed as the main reason for the revenue losing, shareholding reform is considered as a remedy to bail out the continued losing SOEs. The shareholding mechanism, which separates ownership and management, is expected to improve the SOEs’ production efﬁciencies. The conversion of SOEs to state share-holding enterprises can increase the pressure for management improvement to avoid incentive ﬂaws. China began its experiment on the shareholding system without clear distinction between equity and debt since 1984. The early-stage reform attempt limits its experiment of shareholding system with a dominant state share in enterprises. The State holds a majority of the share of an enterprise. After many years of experimenting experiment, corportization had moved to the center of China’s enterprise reform. 1

Assistant Professor, Department of Economics, Shih-Hsin University in Taiwan.

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Since 1992, there was a strategic change of the nature of the state and enterprises in China’s reform since 1992. After the Fourteenth National Congress in 1992, China announced the key word guoying qiye, state-run enterprise, to be replaced by quoyou qiye, meaning state-owned but not necessarily state-run. In 1993, the Eighth National People’s Congress further legalized the change. Currently guoyou minying, state owned but privately or corporately run, has become the guideline for China’s economic reform. China plans to convert the majority of large and mediumsized state enterprises into shareholding corporations (zhuada) and to privitize most small ﬁrms (fangxiao). The party’s consensus at its Fifteenth National Congress in 1997 indicated a clear policy direction to transform the SOEs into corporations by enhancing pressure on managers to pursue maximized proﬁt. Since then, most SOEs have been converted into joint-stock companies with the state as a stockholder. The efﬁciency of the productivity of State-owned enterprise in China since economic reform from 1978 is under debate. How the productivity efﬁciencies of SOEs in different industries respond to the adopted reform measures is of particular interest. This chapter applies the stochastic frontier model to estimate the productivity efﬁciency change of China’s SOEs in 37 industry groups from 1994 to 2000. Industry-wide production efﬁciency changes and changes before and after the 1997 announcement of full-scale state share-holding enterprise reform regime are also of particular interest. A dummy variable is adopted to test the impact of conversion into stock shareholding on the SOEs since 1998. The primary ﬁnding is production efﬁciency of China’s SOEs did not improve since the convert to state share-holding type, and also imposes a negative impact on SOEs’ production efﬁciency. The other ﬁnding is the production efﬁciency of heavy-industry groups not as efﬁcient compared to other industry groups during 1994–2000. The remainder of the chapter is organized as follows. Section 2 provides literature review of the production efﬁciency of SOEs in China. The empirical model and variable description are shown in Section 3. Section 4 presents the empirical results. Conclusions will be drawn in Section 5. 2 Literature Review The efﬁciency of the productivity of state-owned enterprise in China since its economic reform from 1978 is under debate. Many researchers use total factor productivity to measure the productivity of China’s state-owned enterprises. The ﬁndings are inconsistent. Some studies identiﬁed the disappointed side on productivity performance (Woo 1994, 1997; Sachs 1997; Perkins 1999; Fan 1996). The continued proﬁt-losing state-owned enterprise has become a heavy burden of China’s economic growth. Others hold positive evaluation on the performance (Naughton 1992; Rawski 1994; Lin 1996; Jefferson 1992, 1994, 1996; Lo 1999). Studies also found an increased TFP with worsened ﬁnancial index for state-owned enterprise in China (World Bank 1995; Wada 1998; Li 1999; Liu 2001). Huang and Kalirajan (1998) measured the technical efﬁciency of China’s SOEs in 1992 by applying the stochastic varying coefﬁcient frontier approach to enterprises survey data from the costal cities. They concluded the new enterprise institutions, including the asset responsibility

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system, the contract system, the director responsibility system and the share-holding system are all insigniﬁcant on the production efﬁciency of China’s SOEs. After the green light of shareholding system endorsed by the Fifteenth National Congress in 1997, corporatization was moved to the center of China’s enterprise reform. This chapter estimates the stochastic frontier production functions of thirtyseven industry groups and the technical inefﬁciency of each industry group from 1994 to 2000. The impact of the 1997 share-holding institution enhancement on different SOEs in each industry group was also investigated. 3 Empirical Models and Variables This study focuses on the productivity performance of China’s state-owned enterprises in different industries from 1994 to 2000. The data covers thirty-seven industry groups, sourced from various years of the China Statistical Yearbook. Thus, the number of observations of each variable in this model is 259. Since the thirty-seven industry groups are invariant to time, they are included to estimate the stochastic frontier production function and the technical inefﬁciency in each group. The stochastic frontier production function to be estimated is: log(Y)i, t = αi + β1log(K)i, t – 1 + β2log(L)i, t – 1 + β3logT + Vi, t – Ui, t Where the technical inefﬁciency effects is deﬁned by: Ui, t = δ0 + δ1(KL)i, t – 1 + δ2(OLP)i, t – 1 + δ3(AL)i, t – 1 + δ4(CIR)i, t – 1 + δ5(KP)i, t – 1 + δ6SH + δ7HA + δ8Y98 + δ9T + Wi, t Y is the gross industrial output (in 100 million RMB) for the industry involved, K is the capital received by the state (in 100 million RMB), L is the number of Industrial workers and staffs, T is the time trend, KL is the capital to labor ratio, the ratio of total capital to the number of staff and workers in SOEs (%). OLP is the Overall labor productivity = (value added of Industry)/(average number of staff and workers) (%), AL is the assets-liability ratio = (total debts/ total assets)*100%. (%), CIR is the number of annual of turnover circulating funds (times/year). (%), KP is the ratio of realized proﬁt to total pre-tax proﬁt (%), SH is the state share-holding dummy: 1998–2000 = 1, 1994–1997 = 0. HA is the heavy industry dummy: heavy industry = 1, otherwise = 0. Y98 is the dummy variable for year 1998, 1998 = 1, otherwise = 0. The variable statistics are summarized in Table 16.1. The stochastic frontier production function can be viewed as a linerized version of the logarithm of the Cobb-Douglas production function. The capital-labor ratio, overall labor productivity, asset-liability ratio, the number of circulating fund turnover, the pre-tax realized proﬁt ratio, the state-shareholding dummy, the heavy-industry dummy, and the time trend variables are included in the estimation of the inefﬁcient model. The capital-labor ratio variable is adopted to illustrate the different industry structures among the 37 industry groups. However, its implication on production efﬁciency is uncertain. Higher overall labor efﬁciency for the state share-holding enterprise in an

260

Table 16.1

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Variable Statistics

Variable Mean Medium Standard error Minimum Maximum Y 426061.72 66525.08 1587586.43 3213.11 12057250.25 K 479244.79 106561.30 1515756.00 8712.68 13425464.37 L 1074.97 512.10 2708.72 83.25 22907.69 T 5.00 5.00 2.00 2.00 8.00 KL 401.18 198.71 1723.5 18.77 27671.25 KP 248.11 17.62 2468.95 -1020.31 29700.00 AL 10.42 0.93 23.65 0.01 79.69 CIR 12.89 1.18 187.33 0.54 3016.00 OLP 215.50 125.53 314.53 5.99 2200.56 SH 0.29 0.00 0.45 0.00 1.00 0.38 0.00 0.49 0.00 1.00 HA* Y98 0.14 0.00 0.35 0.00 1.00 Tt 4.00 4.00 2.00 1.00 7.00 * Heavy industry includes coal mining and dressing, petroleum and natural gas extraction, ferrous metals mining and dressing, nonferrous metals mining and dressing, nonmetal minerals mining and dressing, logging and transport of timber and bamboo, petroleum processing and coking, production and supply of electric power, steam and hot water, production and supply of gas, production and supply of tap water.

industry should increase the production efﬁciency. Thus, its coefﬁcient is expected to be negative in the estimation of the inefﬁcient model. A higher asset-liability ratio indicates a better ﬁnancial status of a SOE. It is reasonable to consider a healthy ﬁnancial SOE more efﬁcient in production. Therefore, the coefﬁcient of assetliability ratio variable is also expected to be negative. The number of annual circulating fund turnover (CIR) shows the relative capital mobility of a SOE. An efﬁcient enterprise is more likely to have a higher capital (fund) liquidity. The ratio of realized proﬁt to total pre-tax proﬁt (KP) indicates the actual proﬁt of a SOE before taxation. It is expected that an enterprise with a higher KP ratio will be more efﬁcient. Previous studies have identiﬁed a unique characteristic of China’s SOEs. The incentive clause of the manager of a SOE requires him/her to submit a proportion of proﬁt to the government. The proportion differs according to SOE performance. A more efﬁcient SOE hands in more proﬁt than the inefﬁcient. There is an incentive for the relative efﬁcient one to underreport its pre-tax proﬁt. With this respect, the coefﬁcient of KP ratio is positive. The state shareholding dummy variable (SH) tries to capture the change of production efﬁciency of a SOE before and after the state stock conversion change. The heavy industry dummy (HA) is adopted to identify the industry structure differences. 4 The Estimation Results The ﬁnal MLE estimates are listed in Table 16.2. The estimate for the variance parameter, γ, equals a small 0.92. It indicates the inefﬁciency effects are likely to be highly signiﬁcant in the analysis of the value of industrial output. The signs of the

The Productivity Efﬁciency of State-Owned Enterprises in China

Table 16.2

261

The MLE Estimation

coefﬁcient Stochastic Frontier Production Function: Constant 1.35 K 0.90 L 0.19 T -3.65 Inefﬁciency Model Constant -0.48 KL 4279.57 KP -27.29 AL -78.25 CIR -20.68 OLP -6139.80 HO 1.14 HA 2.06 Y98 -0.82 Tt -0.21 0.72 σ2s 0.92 γ Overall efﬁciency = 0.70 Log Likelihood function = -155.22 LR test of the one-sided error = 137.70

standard-error

t-ratio

0.30 5.55 7.56 2.07

4.57 16.26 2.52 -1.76

0.40 4281.98 174.60 64.18 11.63 4738.87 0.63 0.35 0.45 0.11 0.10 1.68

-1.21 1.00 -15.63 -1.22 -1.78 -0.13 1.82 5.87 -1.82 -1.94 7.20 55.01

coefﬁcients of the stochastic frontier are as expected. The capital and labor variables all have positive and signiﬁcant impact on the industrial output. The time trend variable has a negative effect on the industrial output. It implies the industrial output is declining for 1994 to 2000. The estimated coefﬁcients in the inefﬁcient model are of particular interest to this study. The variables with negative and signiﬁcant coefﬁcient are the realized proﬁt to pre-tax proﬁt (KP), number of annual of turnover circulating funds (CIR), year 1998 dummy and time trend variable. It implies the higher realized proﬁt of an industry and more frequent turnover of circulating fund is less inefﬁcient to the industrial output. They improve the production efﬁciency. On the other hand, variables with positive and signiﬁcant coefﬁcient are the state shareholding dummy and heavy industry dummy. It indicates the performance of the state shareholding enterprises is less efﬁcient than before the stock option transformation. But the interpretation of the above conclusion should be more cautious since the state-shareholding dummy could also capture other inﬂuences not included in the estimated variables. The estimated shows the overall production efﬁciency of state-shareholding enterprises has declined since 1997. The estimation result also indicates the SOE in the heavy industry groups are less efﬁcient than those in others. When looking at the estimated efﬁciency of these thirty-seven industry groups in the inefﬁciency model, before the conversion to state-shareholding enterprises in 1997 the top efﬁciency industries are tobacco processing, followed by food

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processing and petroleum processing and coking. The worse efﬁciency industries are production and supply of gas, followed by ferrous metals mining and production and supply of tap water. The average efﬁciency of the heavy industry group before 1997 is 0.38 compared to group average 0.75. The average efﬁciency of the heavy industry group after 1997 is 0.40 compared to group average 0.77. Industry-wise the instruments, meter, cultural and ofﬁce machinery industry, timber processing, bamboo, cane, palm ﬁber and straw products industry, and furniture manufacturing industry indicate the most improved production efﬁciency after 1997. The efﬁciency ﬁgures change from 0.56, 0.57, and 0.6 to 0.72, 0.72 and 0.72 respectively. On the other hand, the petroleum processing and coking industry, the cultural, educational and sports goods industry, and the logging and transport of timber and bamboo industry all experienced declined production efﬁciency after 1997. Production efﬁciency decreased from 0.89, 0.81, and 0.39 to 0.84, 0.77, and 0.36. 5 Concluding Remarks There are two main ﬁndings of the estimated results. First, the overall production efﬁciency of state-shareholding enterprises has declined since 1997. It indicates the performance of state shareholding enterprises is less efﬁcient than before the stock option transformation. One possible explanation of the result is the implicit transition and adjust costs involved in the early stage for the SOEs converted to state share-holding enterprises. The other possible ﬂaw is the data used here covers only 3 years after share-holding conversion. It could be too short to show the performance result after conversion. It is reasonable to observe the converted SOEs need to ﬁght against the various transition challenges in the short run to result in unsatisfactory performance. Once the conversion process becomes smooth and transparent, the production efﬁciency is expected to improve in the long run with the help of ﬁnancial market discipline. But the interpretation of the above should be cautious since the state-shareholding dummy could capture all the other inﬂuences not included in the estimated variables and how well the ﬁnancial market discipline will perform in China. Second, SOEs in the heavy industry groups are less efﬁcient than those in other industry groups. SOEs in different industries face different market competition. Heavy industry group is more likely to be a monopoly or have higher sunk cost. Less market competition or complete lack of could slow down its performance. These ﬁndings indicate an unsatisfactory improvement in the SOEs, so the promotion of the private sector is an important task that should be given ﬁrst priority for China’s economic development.

The Productivity Efﬁciency of State-Owned Enterprises in China

Appendix 1: The catalog of Industry in the Estimation # 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

Industry Coal Mining and Dressing Petroleum and Natural Gas Extraction Ferrous Metals Mining and Dressing Nonferrous Metals Mining and Dressing Nonmetal Minerals Mining and Dressing Logging and Transport of Timber and Bamboo Food Processing Food Manufacturing Beverage Manufacturing Tobacco Processing Textile Industry Garments and Other Fiber Products Leather, Furs, Down and Related Products Timber Processing, Bamboo, Cane, Palm Fiber and Straw Products Furniture Manufacturing Papermaking and Paper Products Printing And Record Medium Reproduction Cultural, Educational and Sports Goods Petroleum Processing and Coking Raw Chemical Materials and Chemical Products Medical and Pharmaceutical Products Chemical Fiber Rubber Products Plastic Product Nonmetal Mineral Products Smelting and Pressing of Ferrous Metals Smelting and Pressing of Nonferrous Metals Metal Products Ordinary Machinery Special Purpose Equipment Transport Equipment Electric Equipment and Machinery Electronic and Telecommunications Equipment Instruments, Meters, Cultural and Ofﬁce Machinery Production and Supply of Electric Power, Steam and Hot Water Production and Supply of Gas Production and Supply of Tap Water

263

The Revival of Private Enterprise in China

264

Appendix 2 Industry group-wise Technical efficiency estimates: (1) The production efﬁciency estimate from 1994 to 2000 Industry/time 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

1994 0.3284 0.4445 0.1969 0.5460 0.3906 0.3695 0.9140 0.8393 0.8177 0.9488 0.8526 0.7458 0.7583 0.5639 0.1942 0.7471 0.7032 0.7716 0.8771 0.7687 0.8733 0.6382 0.8093 0.6339 0.7005 0.7157 0.7743 0.7815 0.7600 0.6897 0.7696 0.8264 0.8355 0.5467 0.3235 0.1722 0.2029

1995 0.3365 0.4801 0.2400 0.5796 0.3772 0.3833 0.919 0.8157 0.8334 0.9516 0.8274 0.7013 0.6718 0.4883 0.6463 0.8103 0.5819 0.7909 0.9023 0.7901 0.8507 0.7624 0.8306 0.6793 0.6336 0.5445 0.7808 0.7291 0.7457 0.6636 0.7386 0.7969 0.8339 0.5521 0.3569 0.2102 0.2170

1996 0.3756 0.5116 0.2030 0.5573 0.3648 0.3989 0.9192 0.8560 0.8685 0.9516 0.8180 0.8293 0.7523 0.6119 0.8265 0.8056 0.6752 0.833 0.8733 0.8155 0.8738 0.6957 0.8813 0.8036 0.6309 0.5358 0.7104 0.7857 0.7205 0.6810 0.7422 0.8409 0.8762 0.5745 0.4153 0.1810 0.2262

1997 0.3079 0.4765 0.2246 0.5772 0.4033 0.4149 0.9108 0.8144 0.8621 0.9494 0.8043 0.8344 0.7805 0.6349 0.7213 0.7947 0.6761 0.8463 0.9319 0.7704 0.8512 0.6980 0.8704 0.7890 0.6025 0.5228 0.6670 0.7937 0.6822 0.6824 0.7244 0.8406 0.8903 0.5727 0.3558 0.1919 0.2315

1998 0.3195 0.4209 0.3332 0.6810 0.5935 0.3413 0.9140 0.7397 0.7276 0.9395 0.8006 0.8651 0.8954 0.8157 0.8391 0.7323 0.6739 0.8335 0.7438 0.7492 0.7822 0.6054 0.7888 0.7856 0.6171 0.5379 0.7030 0.841 0.7107 0.6881 0.6801 0.8328 0.8957 0.7657 0.3697 0.1483 0.1923

1999 0.3143 0.5878 0.2289 0.6069 0.4000 0.3958 0.9265 0.8349 0.8742 0.9497 0.8099 0.8133 0.7696 0.6695 0.6753 0.7522 0.7006 0.7413 0.8462 0.7532 0.8519 0.7015 0.8362 0.7554 0.6514 0.5740 0.7248 0.8088 0.7102 0.6931 0.7650 0.8306 0.9244 0.6763 0.4529 0.1805 0.2333

2000 0.3159 0.5757 0.2334 0.6063 0.3035 0.3551 0.9240 0.8668 0.8731 0.9536 0.8319 0.8144 0.8051 0.6741 0.6595 0.7366 0.6799 0.7324 0.9306 0.8127 0.8453 0.8073 0.8223 0.7546 0.6371 0.5570 0.6939 0.8110 0.7158 0.6777 0.7786 0.8177 0.9324 0.7175 0.4489 0.1970 0.2342

The Productivity Efﬁciency of State-Owned Enterprises in China

265

(2) The production efﬁciency estimate from 1994 to 2000 in heavy-industry group Industry

1994

1995

1996

1997

1998

1999

2000

1

0.3284

0.3365

0.3756

0.3079

0.3195

0.3143

0.3159

2

0.4445

0.4801

0.5116

0.4765

0.4209

0.5878

0.5757

3

0.1969

0.2400

0.2030

0.2246

0.3332

0.2289

0.2334

4

0.5460

0.5796

0.5573

0.5772

0.6810

0.6069

0.6063

5

0.3906

0.3772

0.3648

0.4033

0.5935

0.4000

0.3035

6

0.3695

0.3833

0.3989

0.4149

0.3413

0.3958

0.3551

19

0.8771

0.9023

0.8733

0.9319

0.7438

0.8462

0.9306

35

0.3235

0.3569

0.4153

0.3558

0.3697

0.4529

0.4489

36

0.1722

0.2102

0.1810

0.1919

0.1483

0.1805

0.1970

37

0.2029

0.2170

0.2262

0.2315

0.1923

0.2333

0.2342

Average

0.36487

0.38661

0.38808

0.3884

0.39512

0.40133

0.39664

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266

(3) The production efﬁciency estimate from 1994 to 2000 in non-heavy-industry group Industry

1994

1995

1996

1997

1998

1999

2000

7

0.9140

0.9190

0.9192

0.9108

0.9140

0.9265

0.9240

8

0.8393

0.8157

0.8560

0.8144

0.7397

0.8349

0.8668

9

0.8177

0.8334

0.8685

0.8621

0.7276

0.8742

0.8731

10

0.9488

0.9516

0.9516

0.9494

0.9395

0.9497

0.9536

11

0.8526

0.8274

0.8180

0.8043

0.8006

0.8099

0.8319

12

0.7458

0.7013

0.8293

0.8344

0.8651

0.8133

0.8144

13

0.7583

0.6718

0.7523

0.7805

0.8954

0.7696

0.8051

14

0.5639

0.4883

0.6119

0.6349

0.8157

0.6695

0.6741

15

0.1942

0.6463

0.8265

0.7213

0.8391

0.6753

0.6595

16

0.7471

0.8103

0.8056

0.7947

0.7323

0.7522

0.7366

17

0.7032

0.5819

0.6752

0.6761

0.6739

0.7006

0.6799

18

0.7716

0.7909

0.8330

0.8463

0.8335

0.7413

0.7324

20

0.7687

0.7901

0.8155

0.7704

0.7492

0.7532

0.8127

21

0.8733

0.8507

0.8738

0.8512

0.7822

0.8519

0.8453

22

0.6382

0.7624

0.6957

0.6980

0.6054

0.7015

0.8073

23

0.8093

0.8306

0.8813

0.8704

0.7888

0.8362

0.8223

24

0.6339

0.6793

0.8036

0.7890

0.7856

0.7554

0.7546

25

0.7005

0.6336

0.6309

0.6025

0.6171

0.6514

0.6371

26

0.7157

0.5445

0.5358

0.5228

0.5379

0.5740

0.5570

27

0.7743

0.7808

0.7104

0.6670

0.7030

0.7248

0.6939

28

0.7815

0.7291

0.7857

0.7937

0.8410

0.8088

0.8110

29

0.7600

0.7457

0.7205

0.6822

0.7107

0.7102

0.7158

30

0.6897

0.6636

0.6810

0.6824

0.6881

0.6931

0.6777

31

0.7696

0.7386

0.7422

0.7244

0.6801

0.7650

0.7786

32

0.8264

0.7969

0.8409

0.8406

0.8328

0.8306

0.8177

33

0.8355

0.8339

0.8762

0.8903

0.8957

0.9244

0.9324

34

0.5467

0.5521

0.5745

0.5727

0.7657

0.6763

0.7175

Average

0.7400

0.7396

0.7746

0.7625

0.7689

0.7694

0.7753

The Productivity Efﬁciency of State-Owned Enterprises in China

(4) The production efﬁciency of the heavy-industry group before and after 1997 Industry 1 2 3 4 5 6 19 35 36 37 Average

Before SSH 0.337100 0.478175 0.216125 0.565025 0.383975 0.391650 0.896150 0.362875 0.188825 0.219400 0.382000

After SSH 0.316567 0.528133 0.265167 0.631400 0.432333 0.364067 0.840200 0.423833 0.175267 0.219933 0.397700

267

268

The Revival of Private Enterprise in China

(5) The production efﬁciency of the non-heavy-industry group before and after 1997 Industry 7 8 9 10 11 12 13 14 15 16 17 18 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 Average

Before SSH 0.915750 0.831350 0.845425 0.950350 0.825575 0.777700 0.740725 0.574750 0.597075 0.789425 0.659100 0.810450 0.786175 0.862250 0.698575 0.847900 0.726450 0.641875 0.579700 0.733125 0.772500 0.727100 0.679175 0.743700 0.826200 0.858975 0.561500 0.75418056

After SSH 0.921500 0.813800 0.824967 0.947600 0.814133 0.830933 0.823367 0.719767 0.724633 0.740367 0.684800 0.769067 0.771700 0.826467 0.704733 0.815767 0.765200 0.635200 0.556300 0.707233 0.820267 0.712233 0.686300 0.741233 0.827033 0.917500 0.719833 0.771183

References Battese, G.E. and Coelli, T.J., “A Model for Technical Inefﬁciency Effect in A Stochastic Frontier Production Function for Panel Data”, Empirical Economics, 20(1995): 325–32. Chen, K., Wang, H., Zheng, Y., Jefferson, G. and Rawski, T., “Productivity Change in Chinese Industry: 1953–1985”, Journal of Comparative Economics (December) 12, 4(1988): 570–91. Coelli, T., “A Guide to FRONTIER Version 4.1: A Computer Program for Stochastic Frontier Production and Cost Function Estimation”, CEPA Working Paper 96/7 (University of New England, Armidale, NSW, Australia, 1996).

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Dollar, D., “Economic Reform and Allocative Efﬁciency in China’s State-owned Industry”, Economic Development and Cultural Change, 39, 1(October 1990): 89–105. Huang, Y. and Kalirajan, K.P., “Enterprises reform and technical efﬁciency of China’s state-owned enterprises”, Applied Economics, 30(1998): 585–92. Groves, T., Hong, Y., McMillan, J. and Naughton, B., “Productivity growth in Chinese state-run industry”, in F. Dong, C. Lon and B. Naughton, eds. Reform of China’s State-Owned Enterprises (London: Macmillan, 1995), 183–209. Jefferson, G., Rawski, T., and Zheng, Y., Growth, “Efﬁciency and Convergence in China’s State and Collective Industry”, Economic Development and Cultural Change, 40(1992): 239–66. Jefferson, G., Rawski, T., and Zheng, Y., “Productivity Change in Chinese Industry: A Comment”, China Economic Review, 5(1994): 235–41. Naughton, B., “What is Distinctive about China’s Economic Transition? State Enterprise Reform and Overall System Transformation”, Journal of Comparative Economics, 18, 3(June 1994): 470–90. Woo, W.T., “The Art of Reforming Centrally Planned Economies: Comparing China, Poland, and Russia”, Journal of Comparative Economics, 18, 3(June1994): 276– 308. Woo W.T., Wen, H., Jing, Y. and Fan, G. “How successful has Chinese enterprises reform been? Pitfalls in opposite biases and focus”, Journal of Comparative Economics, 18(1994): 410–37. Woo, W.T., Parker, S. and Sachs, J. eds, “Improving the Performance of Enterprises in Transition Economies”, in Economies in Transition: Asia and Europe (MIT Press, 1996), 8–11. You, Ji, Corporatisation and Privatisation in China’s Enterprise Reform changing state/society relations after Mao (Routledge Studies in China in Transition, 1998).

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Chapter 17

The Prospect of Private Economy in China Xiaowen Tian1

1 Introduction After the establishment of People’s Republic of China in 1949, the Communist Party launched one campaign after another to replace private ownership with public ownership. Private enterprises were by and large looked down at as an “ugly duckling” in the whole socialist planning period, particularly during the Cultural Revolution when any private businesses and economic activities were taken as “capitalist seedling” that had to be eradicated. Under the hostile policy, the private economy shrank dramatically, with the share of the private economy in the value of industrial output declining from 55.2% in 1952 to 0.2% in 1978. Along with marketoriented reforms after 1978, the private economy began to revive spontaneously, and the government relaxed its policy toward the private economy. China’s ofﬁcial attitude toward the private economy was, however, ambiguous, and was characterized by a “hate-and-love” mixture. Discriminations against the private economy prevailed in many areas, such as legislation, ﬁnance, taxation, business entry and market entry. This was understandable given that the thriving of the private economy was crucial to the efﬁcient operation of the economy on the one hand, and dangerous to a Communist regime committed to abolition of private property on the other. To overcome this dilemma, the Party advocated partial privatization, promoting the development of informal private sector, where private property rights existed within the framework, or under the disguise, of public ownership. Is partial privatization a solution or a transition? Will the private economy remain half-grown, or become a full-grown swan in China? In a sense, the answer to this question depends neither on the will of the Party nor on ideological considerations, but on the economic performance of the private economy in the transition to a market system. In a context of competitive markets, the private economy is doomed to outperform the public sector in terms of productivity gains. To maintain growth momentum, the Chinese government will have to adopt more radical reform measures to abolish discriminations against the private economy. It is, therefore, expected that the private economy will become a full-grown swan in China in the foreseeable future. 1

University of Nottingham, UK.

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The Revival of Private Enterprise in China

This chapter is organized as follows. The ﬁrst section discusses how the Chinese government has gradually changed its policy toward the private economy from 1978 onwards, and economic necessity for the change. The second section describes how the private economy arose in China after 1978, and the speciﬁc compositions of the private sector. The third section analyzes the limitations to the policy change, and the discriminations against the private economy. The fourth section shows the rise of an informal private sector under such policy constraints and discriminations. The ﬁfth section explains, from both theoretical and empirical perspectives, why the private economy will become a full-grown swan in the process of China’s transition to a market-based economic system. The ﬁnal section concludes. 2 The Pressure for Policy Change The Chinese government relaxed its policy toward the private economy not because the government liked it, but due to real economic pressure. After nearly 30 years of socialist development, China suddenly found itself still a less developed country in 1978, with per capita GDP much lower even than most of its Asian neighbors that adopted a capitalist system after independence. The fundamental cause for the economic underdevelopment was found in the public ownership that depressed incentives for hardworking and competition. State enterprises ran inefﬁciently, making an increasing amount of losses. The People’s Communes suffered from low productivity and could not even provide basic necessaries for their members. To demonstrate the superiority of the socialist system over its capitalist counterpart, the Chinese government had to reform the economic system to achieve rapid economic growth and decent living standards for its people. The reforms of the commune system were quite successful, but little progress was made in the reform of stateowned enterprises (SOEs). The numbers of loss-making state-owned enterprises were increasing, and the government had to spend an increasing amount of revenue to subsidize these loss-making SOEs. In the meantime, the private economy arose spontaneously, and played a key role in revitalizing the economy both in the countryside and in the cities. If the government would prohibite the development of the private economy, China could not achieve rapid economic growth and decent living standards. The real economic pressure pushed the Chinese government to move forward one step after another to change its policy toward the private economy. China divided what is considered as the private economy in the West into individual-owned enterprises (getihu) and private-owned enterprises (siyingqiye) according to the number of workers employed in the enterprises. Individual-owned enterprises have less than 8 employees, while private-owned enterprises have more than 8 employees. China started to encourage individual-owned enterprises immediately after the launch of economic reforms. According to the Chinese government, individual-owned enterprises were of private ownership in nature only in the sense that they have their own means of production. They were, however, based on self-employment, not exploitation. That is, the owners of individual-owned enterprises were the laborers at the same time. Although they were allowed to have 1–2 assistants and, if they had special skills, 3–5 apprentices, they were considered

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as laboring people, not exploiters. They were less incompatible with socialism than private-owned enterprises that were “exploitative” in nature according to orthodox Marxist literature. Therefore, China’s position to individual-owned enterprises was quite stable over the reform period. That is, China protected, encouraged, and helped individual-owned enterprises. This position was written down into the Constitution as early as in 1982. By contrast, the Chinese government was very cautious about private-owned enterprises, and relaxed its policy to it only in a gradual and reluctant way as the market-oriented reforms moved on. In a sense, the whole policy debate over the private economy in China focused upon the private-owned enterprises, rather than the individual-owned enterprises. At ﬁrst, China hesitated to recognize the privateowned enterprises that developed spontaneously in the early 1980s. There was, for instance a policy debate within the Party over the issue of the “fool melon seed”, a private enterprise in Anhui province that had developed into a large ﬁrm with more than 100 employees, and an asset of several million Yuan by the year of 1984. In response to conservative criticisms, Deng Xiaoping proposed that “we leave it alone for two years and then see what happens”.2 The wait-and-see policy to privateowned enterprises was written down in a number of ofﬁcial documents over that period, and was maintained until 1987. The driving force behind the policy change in 1987 had to be found, among others, in the advantage of private-owned enterprises over individual-owned enterprises. The small scale of individual-owned enterprises limited their capacity to compete in markets. To survive in competitive markets, individual-owned enterprises had to expand in terms of both capital and employment. From 1982 to 1988, according to ofﬁcial data, the average number of workers in an individual-owned enterprise increased from 1.22 to 1.59, and the average asset of an individual-owned enterprise increased from 273 Yuan to 2147 Yuan, respectively. In fact, individual-owned enterprises expanded far beyond what was shown by the ofﬁcial statistics, and many of them became de facto private-owned enterprises with a large number of employees and a large amount of assets. Without ofﬁcial endorsement and legal protection, however, these de facto private-owned enterprises existed under such titles as “specialized large production household” (zhuangyedahu), “large individual household” (getidahu), “employee enterprises” (gugongqiye), “new economic joint units” (xinjingjilianheti), or under the disguise of collective ownership (Zhang, 1999, p. 2). According to a survey conducted by the State Administration Bureau of Industry and Commerce in 1987, there were a total of 225 thousands of privateowned enterprises with a total of 3.6 million employees in China. That is, on average there were 14 employees in a private-owned enterprise. 51% of these privateowned enterprises were registered as individual-owned enterprise, 22% of them were registered as township and village enterprise (TVEs), and 27% of them were registered as cooperative enterprises (Zhang, 1999). It became increasingly clear that large-scaled private-owned enterprises could better ﬁt in with market competition. To deepen market reform, the government had to give up the wait-and-see policy. In preparation for a new round of economic 2

Selected Works of Deng Xiaoping, Volume III, People’s Press, Beijing 1994, p. 91.

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reform and opening-up featured by the “economic development strategy of coastal regions”, the Thirteenth Party Congress, held in 1987, announced that the Party would encourage the development of both individual-owned enterprises and privateowned enterprises. This position was later clearly expressed in Article 11 of the Amendment to the Constitution passed in 1988: The state allows the private economy to exist and develop within the limits set by the law and regulations. The private economy is a complement to socialist system of public ownership. The state protects the legal rights and interests of the private economy, and provides guidance, surveillance, and administration for it.3

Private-owned enterprises obtained, therefore, legitimacy in China a decade after the reforms started. In the same year, the State Council promulgated the Provisional Regulations on Private-Owned Enterprises of the Peoples’ Republic of China, which contained detailed regulations on private-owned enterprises in terms of business start-up, surveillance and administration, labor management and protection, taxation, and distribution of proﬁts, etc. Following the Tiananmen Square Incident in 1989, however, hostility against the private economy gained momentum. There appeared criticisms in leading Chinese newspapers that “the private economy was the social basis of capitalist liberalism”, that “the development of the private economy was equal to privatization”, and that “private entrepreneurs were the middle class who stirred up the disturbance” (Zhang, 1999, p. 42). Under increased pressure, top Party leaders tended to revise the policy to the private economy so as to “place restrictions to the negative impact of the private economy on socialist economy”.4 Hostility and discrimination against private enterprises were widely spread, and some private entrepreneurs were treated as the “targets of revolution” or even arrested on no legal ground. The conservative countercurrent gained in force until 1992 when Deng Xiaoping made his historical tour to southern China. In a series of talks during the tour, Deng Xiaoping called for restraining from the meaningless debate over socialism or capitalism, speeding up market-oriented reforms. He particularly mentioned the issue of “fool melon seed” to reconﬁrm the friendly policy toward private-owned enterprises. Since Deng’s southern tour, China’s market-oriented reforms were accelerated, and the policy toward the private economy became more and more friendly. The Fourteenth Party Congress, held immediately after Deng Xiaoping’s southern tour, asserted, for the ﬁrst time, that the goal of the economic system reforms is to establish a socialist market economic system, and that the state will create conditions for economies under various forms of ownership to compete in the market on equal footing, and treat all enterprises equally without discrimination. In 3 People’s Daily, 24 March 1988. Here the private economy referred to private-owned enterprises. 4 Jiang Zemin’s speech at the Fortieth Anniversary of the Establishment of The Chinese Communist Party. Sited from Zhang Houyi, “A New Force Suddenly Coming to the Fore: the Revival and Development of The private economy Since the Reform and Opening-Up,” in Zhang Houyi and Ming Lizhi (eds), A Report of the Development of Private Enterprises in China, Social Sciences Literature Press, Beijing, 1999, p. 39.

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1997, the Fifteenth Party Congress further raised the status of the private economy from a “complement to the socialist system of public ownership” to “an important component of the socialist market economy”. This new position was written into the Amendment to the Constitution that was passed in 1999.5 3 The Development of the Private Economy In accordance with changes in the government policy toward the private economy, the development of the private economy underwent three distinguishable stages. The ﬁrst stage covered the period of 1978–1988, and was characterized by the rise of individual-owned enterprises and the hidden development of privateowned enterprises. According to Chinese ofﬁcial classiﬁcation, individual-owned enterprises included only those in industry and commerce, not individual farming under the household contract responsibility system that was still formally under collective ownership. Individual-owned enterprises began to increase in the late 1970s, and grew rapidly in the 1980s. From 1981 to 1988, the number of individualowned enterprises increased by 9 times, the number of employees in individualowned enterprises increased by 10 times, the registered assets in individual-owned enterprises increased by 62 times. From 1983 to 1988, the value of retail sale of consumer goods of individual-owned enterprises increased by 5 times. In contrast, there were no ofﬁcial data of private-owned enterprises that were developing quietly and covertly. Private-owned enterprises were not formally registered until 1988. The second stage of the private economy development in China covered the period from 1989 to 1992. Following the Tiananmen Square Incident, the private economy experienced a crisis. Under the inﬂuence of conservative countercurrent, businessmen in both individual-owned and private-owned enterprises were fearful of political persecution and infringement of their property rights. The number of individual-owned enterprises dropped from 1453 in 1988 to 1247 in 1989, that is, a negative growth rate of 14.2. It was not until 1992 that the number of individualowned enterprises reached the pre-crisis level. The negative impact on privateowned enterprises was even greater. The registered private-owned enterprises numbered 90.5 thousands in 1989, only 40% of the number estimated by the State Administration Bureau of Industry and Commerce in 1987! This ﬁgure implied that most private-owned enterprises either quitted, or would rather exist in the form of individual-owned enterprises or under the guise of collective ownership. The third stage of the private economy development in China started after 1992 when Deng Xiaoping reconﬁrmed the friendly policy to the private economy in his tour to Southern China. This period was characterized by a boom of the private economy, particularly the private-owned enterprises. From 1993 to 1999, the number of privateowned enterprises increased by 6.2 times, the number of employees in private-owned enterprises increased by 5.4 times, the assets of private-owned enterprises increased by 15 times, the value of retail sale of consumer goods of private-owned enterprises increased by 22 times, and the output value of private-owned enterprises increased 5

People’s Daily, 17 March 1999.

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by 18.2 times. Individual-owned enterprises also grew, though at a slower rate. From 1993 to 1999, the number of individual-owned enterprises increased by 1.8 times, the number of workers in individual-owned enterprises increased by 2.1 times, and the assets of individual-owned enterprises increased by 4 times, the value of retail sale of consumer goods of individual-owned enterprises increased by 4.4 times, and the output value of individual-owned enterprises increased by 5.1 times. In the meantime, the average scale of private enterprises increased remarkably. From 1993 to 1999, the average amount of assets of private-owned enterprises increased from 280,000 yuan to 680,000 yuan, whereas the average amount of assets of individualowned enterprises increased from 4800 yuan to 10900 yuan. By 1999, private-owned enterprises had accounted for 74% of the total assets and 53% of the total industrial output, of the private economy in China. As far as the industrial distribution of the private economy is concerned, the majority of individual-owned enterprises (84%) concentrated in the tertiary industry while the rest were located in the primary industry (4%) and the secondary industry (12%). 64% of individual-owned enterprises were located in rural areas, and the rest were in towns and cities. This suggests that individual-owned enterprises were mainly engaged in services such as food, hotel, and transportation in rural China. By contrast, private-owned enterprises were mainly engaged not only in tertiary industry (53%) but also in secondary industry (45%), and the majority of them (63%) were located in towns and cities. As far as regional distribution of the private economy is concerned, 45% of individual-owned enterprises were in the Eastern region, 39% were in the Central region, and 17% were in the Western region. The concentration of the private economy in the Eastern region is even more outstanding for private-owned enterprises. 64% of private-owned enterprises were located in the Eastern region, 22% were in the Central region, and 13% were in the Western region. Unlike individual-owned enterprises, private-owned enterprises took various organizational forms. According to ofﬁcial classiﬁcation, private-owned enterprises were divided into three categories: sole proprietorship (duziqiye); ventures in partnership (hehuoqiye); and limited-liability company (youxianzerengongsi). The third category experienced the fastest growth in the 1990s. From 1989 to 1998, for instance, the growth rates of the number of the three categories of private-owned enterprises were 27.92%, 15.18%, and 76%, respectively. By 1999, 58% of privateowned enterprises were limited-liability companies, 33% were ventures exclusively with one’s own investment, and 9% were ventures in partnership. We should be aware that the development of the private economy was still very limited in China. By 1999, the private economy accounted for only about 10% of industrial output value, and 11.6% of employment.6 This was mainly due to policy constraints and discriminations.

6 Individual-owned enterprises accounted for 4.7% of industrial output value and 8.8% of employment, while private-owned enterprises accounted for 5.34% of industrial output value and 2.86% of employment. These ﬁgures are based on Yearbook of China’s Administration of Industrial and Commerce 2000.

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4 Policy Constraints and Discriminations Unlike in some of the Eastern European transition economies where Communist Parties have lost power, the policy change and the development of the private economy have been very limited in China where the Communist Party remains in power. Determined by communist ideology, China has never called for privatization, and has repeatedly claimed that public ownership should be dominant in the whole economy in the sense that “public assets dominate in the total assets in society; the state-owned sector controls the lifeblood of the national economy and plays a leading role in economic development”.7 In other words, it is no problem for the private economy to exist and develop as long as it does not achieve dominance in the total assets of the society, as long as it does not exercises control over the lifeblood of the national economy, and as long as it does not play a leading role in economic development. Beyond that limit, the government has to do something about it. That is to say, the Chinese government has actually adopted a policy of limited development of the private economy. In other words, the development of the private economy has to be limited in a way that it will not threaten the dominance of public ownership in the Chinese economy. This policy determines that there have been serious discriminations against the private economy in China. Legislation The ﬁrst, and the most signiﬁcant, discrimination stays at the legislative level. China’s Constitution stated clearly “socialist public property is sacred and inviolable. The State protects public property, and prohibits any organization or any individual to encroach upon or do damage to state and collective property with any means”.8 By contrast, the Constitution referred to the protection of private property with very general and weak wording. It stated “the state protects the legal rights of the citizen to legal income, savings, house, and other legal properties. The state protects the citizen’s rights to private property and inheritance according to legal regulations”.9 China has never declared that “private property is sacred and inviolable”, as it did for public property. It seems that China is unwilling to do so since it will fundamentally undermine the Communist principle of “abolition of private property”. The legal discrimination implies that the legal protection provided for the private economy is limited, leaving room for possible policy change at later stages. Finance and Taxation Owned and controlled by the government, large banks and ﬁnancial institutions in China maintained a lending policy in favor of public enterprises, particularly the

7 See Jiang Zemin’s speech at the 50th Anniversary of the Establishment of the People’s Republic of China, People’s Daily, 1 October 1999. 8 See the Amendment of the Constitution in 1993, People’s Daily, 30 March 1993, and the Amendment of the Constitution in 1999, People’s Daily, 17 March 1999. 9 See the Amendment of the Constitution in 1993, People’s Daily, 30 March 1993, and the Amendment of the Constitution in 1999, People’s Daily, 17 March 1999.

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SOEs. To private enterprises, they in principle do not give loans for investment in ﬁxed assets, and only give limited loans for short-term working capital under strict conditions. Private enterprises can get little loans from formal state-owned ﬁnancial institutions. It was estimated that private enterprises accounted for only 2.3% of the total loans from state banks in China in 1994. In Shanghai, of the total loans of 377.7 billions in 1997, 53.33% went to SOEs, 22.36% went to collective enterprises, 6.75% went to foreign funded enterprises, and only 0.15% went to private enterprises (Zhu, Yao, Zou and Hu, 1998, p. 454). In addition, private enterprises are denied the access to the two stock markets in Shenzhen and Shanghai. As a result, businessmen under private ownership had to turn to so-called “non-governmental ﬁnancing” at an interest rate much higher than the ofﬁcial rate. It was estimated that in the 1990s, the interest rate for non-governmental lending was two or three times as high as the ofﬁcial interest rate (Qi, 1998, p. 69). In the meantime, as compared with state-owned enterprises that enjoyed ﬁnancial subsidies from the government and foreign-funded enterprises that enjoyed taxation deduction and exemption, private enterprises do not enjoy any preferential policy treatments in this regard. On the contrary, they suffered from so-called “arbitrary ﬁnes, arbitrary charges, and arbitrary ﬁnancial levies” set by government departments at various levels. It was estimated that they were normally under the administration of more than 20 government departments, to which they had to deliver about 50–80 types of taxes and fees. 50% of the taxes and fees were arbitrarily collected by the government departments themselves. The arbitrary taxes and fees were 2–3 times higher than the ofﬁcial tax rate (Zhang, Xie and Li, 1994, pp. 71–104). Business Entry and Market Access Private enterprises were denied entry to key industry sectors that are under the state monopoly, such as banking, telecommunication and post, railway, airline, electricity, ammunition. The policy is understandable provided that some of these key industry sectors are in the state hand even in market economies. Private enterprises are, however, denied entry to certain industry sectors that are not normally under state monopoly in market economies. They are, for instance, not allowed to engage in production of a wide range of goods, such as tobacco products, steel products, petrol products, gold and silver products, cofﬁns and related products, army uniform and police uniform, printed trade marks, ﬁlm-recording and picture-recording products, tea product of minorities, emulation toy guns, dangerous chemicals, hunting riﬂes, medicine under special regulations, explosive goods for civil use, round spring scales, etc. In the meantime, private business and enterprise are banned from the whole sale of certain kinds of goods, such as goods under state monopoly, goods under state planning, necessaries closely related to people’s living, books and periodicals, western medicine, goods for labor protection, etc. In the meantime, they are denied the retail sale of a wide range of goods, such as imported books and periodicals, cotton, nonferrous metal including discarded non-ferrous metal, discarded productive metal, color TVs including discarded color TVs, silks, fertilizers, farm chemicals, cultural relics, pearls, crystals, etc. (Wei, 1999, pp. 411–13). In addition, private enterprises

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also suffer from restrictions to entry to international markets, and only very few large private enterprises are qualiﬁed for the rights of direct imports and exports.10 Besides the above major areas, private enterprises are also discriminated against in other areas. Private enterprises are virtually not allowed to make a requisition of land. They have to pay a much higher fee for certain public goods and services than state-owned enterprises. It was estimated that in 1997, the fee for electricity was twice or three times higher for private enterprises than for state-owned enterprises. The use of railway carriages was under state planning, private enterprises had to pay a much higher fee for renting the carriage than state enterprises (Qi, 1998, p.69). There were a lot of restrictions to business start-up for private enterprises, and the approval procedure took a very long period of time. In addition, businessmen in private enterprises were discriminated against in joining the Party and working in the government.11 5 The Prevalence of Partial Privatization Owing to the policy constraints and discriminations, partial privatization became popular in China. By partial privatization, it is meant that there arose an informal private sector along with the formal private sector described above. Expressed in various terms such as “partial private”, “mixed forms of ownership”, “intermediate forms of ownership”, “hybrid property forms”, the informal private sector referred to economic units in which private property rights developed within a formal framework of, or in association with, or under the guise of, public ownership. The most important case was the rights to land in agriculture. Along with the adoption of the “household contract responsibility system” in the late 1970s and early 1980s, farmers obtained the rights to use a piece of land for a period of time. From the mid1980s onwards, the length of the land contracts were extended, ﬁrst to a minimum duration of 15 years, and then to a minimum duration of 30 years. In the meantime, the land could be subcontracted, and the rights to use land could be traded. As a result, a second market for the rights to use land emerged. Although collective ownership to the land was formally maintained, “the land was reprivatized de facto” under the household contract responsibility system (Kornai, 1990, p. 451), since “such a long duration brought lease contracts close to full ownership” (Krug, 1997, p. 279). Another example of informal privatization could be found in public enterprises that were transformed into share-holding companies or joint ventures. Some state-owned enterprises turned into share-holding companies with property rights reassigned to individual shareholders to varying degrees. It was estimated that by 1997, 9200 stateowned enterprises had been transformed into share-holding companies, accounting for one fourth of the total share-holding companies. Although they were ofﬁcially 10 According to recent regulations, for instance, only private enterprises with assets more than 8.5 million yuan, business income more than 50 million yuan, and export goods more than 1 million US dollars can apply for the rights to imports and exports. 11 The Chinese government has recently taken reform measures to remove these restrictions and simplify the procedures. The Party has also recently announced that private entrepreneurs can join the Party.

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called “mixed ownership” by the Chinese authorities, they acted in very much the same way as private share-holding companies. Furthermore, some public enterprises were combined with, or even de facto merged by, private enterprises in the form of joint ownership or joint operation. Some of them were “effectively controlled if not formally owned by an individual” and, therefore, “much closer to private enterprises” (World Bank, 1996, p. 51). A third example of informal privatization could be found in so-called “fake collectives”, i.e. enterprises that were private in nature, but the used collective labels for political protection and economic beneﬁts. A large number of TVEs were, for instance, found to be “fake collectives”. Many case studies suggested that the kind of TVEs that served as a form of “disguising of private enterprises” were commonly observed in coastal regions, but were rare in interior region in the 1980s. Into the 1990s, however, the interior began to “feel this trend” (Oi and Walder, 1999, p. 15). Ofﬁcial estimates of “fake collectives” varied from one survey to another, but the nationwide survey, conducted by the State Administration of Industry and Commerce in 1995, suggested that 20.8% of collectives were in fact fake collectives in the sense that private-owned assets accounted for more than 51% of the total assets (Zhang, 1999, p. 51). Including collectives that, despite having less than 51% of private-owned assets, were de facto under private control, the share of fake collectives would be even larger. According to an ofﬁcial survey, about 83% of township and village enterprises were fake collectives to varying degrees (Zhang, Xie and Li, 1994, p. 71). As a result, many found that “the labels ‘collective’ and ‘private’ would tell us little about the actual property rights relationships” (Oi and Walder, 1999, p. 12). Other examples of informal privatization were found in share-holding cooperatives, leased public enterprises, and public enterprises with foreign direct investment in the form of equity joint ventures and cooperative joint ventures, etc.12 The informal private economy played an extremely important role in China’s economic reform and development, and was described by many China observers in terms such as “partial privatization”, “hidden privatization”, and “covert privatization” (Krug, 1997; Francis, 1999). Therefore, despite the fact that Chinese leaders have resisted calling for “widespread formal privatization of majority stakes in the larger state ﬁrms”, large-scale informal private economy has been growing in China quietly, and “much of the Chinese economy has moved away from state ownership, some into private hands but most into intermediate forms of ownership” (World Bank, 1996, p. 49). As a result, the Chinese economy has now been much more diversiﬁed in terms of ownership structure than ever before. Owing to the nature of the informal private sector, it is very difﬁcult, if not impossible, to estimate exactly to what extent the Chinese economy has been partially privatized according to ofﬁcial statistics. The Party appeared to be more comfortable with the informal private sector than with the formal private sector, since it could easily arrange various forms of mixed ownership in a way that public ownership looked still dominating the whole economy, and yet made use of private property rights that were developing in the 12 Up to 1997, there were 4 million of share-holding cooperatives, and about one third were located in rural China.

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framework of public ownership to improve economic efﬁciency. In 1984 the Party pronounced clearly that it would “develop a wide range of ﬂexible and diversiﬁed forms of cooperations and economic combinations between state, collective, and individual economies on the basis of voluntariness and mutual beneﬁt” (Qi, 1998, p. 12). In 1987, the Party ofﬁcially endorsed the share-holding system, and encouraged “enterprises to combine, merge, or organize themselves into conglomerations” (Qi, 1998, p. 13). In 1992, the Party acknowledged “along with the ﬂow and rearrangement of property rights, economic units under mixed ownership of property would increase, and form a new ownership structure of properties” (Qi, 1998, p. 15). In 1997, the Party clearly stated that “public economy includes not only state economy and collective economy, but also the state components and collective components in economic units under mixed ownership”, and promised to encourage the development of share-holding cooperatives (Qi, 1998, p. 17). On the one hand, private businessmen also felt politically safe and economically beneﬁcial under the umbrella of public ownership, as it could enable them to get rid of various forms of discriminations against the private economy. There were lots of cases that private enterprises were willingly merged with state or collective enterprises, or reorganized in the form of share-holding cooperatives.13 It seems that the Party has found in partial privatization a solution to the dilemma in its policy toward the private economy. 6 Toward a Full-Grown Swan After two decades of economic reform, as shown above, the private economy is no longer an ugly duckling in China, but it has not yet become a full-grown swan either. It is a half-grown swan in the sense that the formal private sector, particularly the private-owned enterprise, is still very small and weak, and is still seriously discriminated against. It is a half-grown swan also in the sense that private property rights have to develop within the framework of, or under the disguise of, public ownership in the informal private sector. Will the private economy become a fullgrown swan? In other words, is the day to come when the private economy is not discriminated against, and when it does not have to mix up with public ownership, as has been in market economies? Recent developments in China all point to a positive answer to this question. First, the Party has shown its commitment to moving toward a market-based economic system. According to property rights theory, well-deﬁned private property rights are the bases for the proper functioning of markets and for economic gains in productivity and efﬁciency. The more clearly the private property rights are deﬁned, the greater are the efﬁciency gains, and the better is the economic performance. Based on this theory, if China is to establish a properly functioning market system and achieve efﬁciency gains, it has to move toward more and more clearly deﬁned private property rights. Therefore, the formal private sector has to be developed, and the mixed ownership is only a transition toward full private ownership.

13 Economic Daily, 7 June 1998; also see Whiting (1999) and Vermeer (1999).

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Secondly, the Chinese government has shown its determination to respect facts rather than doctrines. The Party has repeatedly stated that practice is the sole criterion against which truth is tested, and that everything has to be judged by whether it promotes the development of productive force. Evidence is increasing that private enterprises indeed performed better than both partially privatized sector and the public sector in productivity gains, that the more property rights moved into private hands the better was economic performance, and that partial privatization of SOEs through share-holding did not reached the desired effect (see Garnaut and Song, 2004). To achieve efﬁciency and maintain growth momentum, the Party has to, though against its orthodox doctrine, move further to develop the private economy in China. We therefore expect that China will take radical reform measures to abolish all kinds of discriminations against the private economy in the coming years. On January 4 2000, Zeng Peiyan, the Chairman of the State Commission for Development and Reforms, announced that China would “eliminate all restrictive and discriminatory regulations that are not friendly toward private investment and private economic development in taxes, land use, business start-up, and import and export”.14 China’s entry to WTO will further push China in this direction, as domestic private enterprises will ask for treatments equal to those for foreign investors. The reform process is painful and lengthy as it touches the cornerstone of the orthodox communist doctrine, but it is inevitable in the transition to a market-based economic system. References Francis, C.B., “Bargained Property Rights: The Case of China’s High-Technology Sector” in Oi, J.C., Walder, A.G. eds. Property Rights and Economic Reform in China (Stanford: Stanford University Press, 1999), 227–39. Furubotn, E.G. and S. Pejovich, “Property Rights and Economic Theory: A Survey of Recent Literature”, Journal of Economic Literature, 10(1972): 1137–45. Garnaut, R. and Song, L.G. (eds), China’s Third Economic Transformation (London: Routledge, 2004). Kornai, J., “The Afﬁnity between Ownership Forms and Coordination Mechanisms: The Common Experience of Reform in Socialist Countries”, Journal of Economic Perspectives, 4(1990): 451–566. Krug, B., “Privatization in China; Something to Learn From?” in Giersch, H. ed. Privatization at the End of the Century (Berlin: Springer, 1997), 227–47. Qi, G., 20 Years of Ownership Reform in China (Zhongguo Suoyouzhi Gaige 20 Nian) (Zhengzhou: Zhongzhou Guji Pess, 1998). Oi, J.C., Walder, A.G., Property Rights and Economic Reform in China (Stanford: Stanford University Press, 1999). Vermeer, E.B., “Shareholding Cooperatives: A Property Rights Analysis” in Oi, J.C., Walder, A.G., eds, Property Rights and Economic Reform in China (Stanford: Stanford University Press, 1999), 123–44.

14 People’s Daily, 4 January 1999.

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Wei Guanglang, ed., China Policy: 1998.1–1999.1 (Zhongguo Zhengce) (Beijing: China Legislation Press, 1999). Whiting, S.H., “The Regional Evolution of Ownership Forms: Shareholding Cooperatives and Rural Industry in Shanghai and Wenzhou’ in Oi, J.C., Walder, A.G., eds. Property Rights and Economic Reform in China (Stanford: Stanford University Press, 1999), 217–20. World Bank, World Development Report (New York: Oxford University Press, 1996). Zhang Houyi, “A New Force Suddenly Coming to the Fore: The Revival and Development of the Private Economy Since the Reform and Opening-Up” (Youyizhi Yijun Zai Tuqi: Gaigekaifang Yilai Siyingjingji De Zaisheng Yu Fazhang), in Zhang Houyi and Ming Lizhi (eds), A Report of the Development of Private Enterprises in China (Zhongguo Siyingqiyie Fazhan Baogao), Social Sciences Literature Press (Beijing: Shehui Kexue Wenxian Chubanshe, 1999), 36–51. Zhang Xuwu, Xie Minggan and Li Ding, eds, Yearbook of the Private Economy in China: 1978–1993 (Zhongguo Siyingjingji Nianjian) (Hong Kong: Hong Kong Economic Herald Press, 1994). Zhu Fangming, Yao Shurong, Zou Yi and Hu Shifa, The Private Economy in China: Reality, Puzzle and Trend of the Change of the Private Economy (Siyingjingji Zai Zhongguo: Siyingjingji Shanbian De Xianshi, Kunhuo Yu Qushi), China City Press (Beijing: Zhongguo Chengshi Chubanshe, 1998).

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Index

Agricultural Bank of China (ABC) 72, 127, 240 Agricultural Development Bank of China (ADBC) 128 n5, 240 agriculture sector 5, 11, 34, 55–6, 60, 61–2, 70, 84, 91, 93–5, 97–8, 103, 169, 170, 173, 279 and China’s membership of WTO 176, 177, 178, 179 Alekperov, Vagit 186 190 Allende, Salvador 94–5 Alvarado, Juan Velasco 94 Anglo-American model of corporate governance, see under corporate governance Anhui 20, 37, 159, 273 Argentina 94–5 asset management companies 127, 242, 244 Australia 94, 238 Bank of China (BOC) 127, 138, 240, 242 banks and banking sector 101, 155, 156, 161, 163, 239, 240, 242, 243, 254 and collectives 72–3, 278 and ﬁnancial reform 93, 127–9, 135–6, 137, 172–3, 180–81, 240–43, 253 and non-performing loans (NPLs) 2, 5, 127–40 and non-state-owned enterprises (non SOEs) 36, 130, 133–7, 172–3, 180–81 and private-owned enterprises 72–3, 75, 107, 172–3, 180–81, 253, 277–8 and state-owned enterprises (SOEs) 5, 36, 127–40, 181, 240–42, 254, 278 see also state owned commercial banks Beijing 20, 37, 153, 158, 194, 224 Belgium 143 biomedicine industry 153, 154, 155 Bogdanov, Vladimir 186, 190 Bolsheviks (Russia) 90, 96–7, 99, 185 Brazil 177, 178

Canada 94, 143, 230, 238 catering industry 174, 175 Central Europe 180, 201 Changchun 159 chemicals industry 179 Chengdu 158 Chernomyrdin, Viktor 187, 189, 191, 197 Chile 94–5 China Construction Bank (CCB) 127, 138, 240, 242 Chinese People’s Political Consultative Conference 56 n6 Chongqing 20, 81, 159 Chow Eng-lai 94 collectively-owned enterprises (COEs) 34, 35, 37, 39, 40, 54, 60, 62, 79 n48, 243, 244, 273, 275, 280–81 and employment 2 legal rights of 69–77, 81–2, 85–6 and taxes 70–73 see also under industrial output collectives, see collectively-owned enterprises (COEs) commerce sector 34, 70 Communist Party of China (CPC) 56 n6, 62 n9, 65, 99 n13, 237, 271, 277, 279 see also CPC National Congress, government (central) construction industry 23, 25, 28, 34 consumer goods industries 153, 155 consumer industries 91 corporate governance 7, 91 Anglo-American model of 7, 238–9, 254 insider-control model 239, 247 Japanese-German model of 7, 238–9, 254 and private enterprises 237–8, 252–4 and state-owned enterprise reform 6, 199–204, 205, 212, 216, 237–8, 245–50, 252–4 CPC National Congress 65, 237, 258, 259, 274, 275

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Cuba 94 Cultural Revolution 94, 103, 271 Dalian 159 Dongguan 111 Eastern Europe 35, 53, 79 n48, 91, 92, 93, 180, 201, 239, 254, 277 Echeverris, Luis 95 economic growth 2 and central government 58–9, 64, 66 and collectives 69–70, 73, 77–86 and foreign trade 38–48, 80, 84, 169 and government spending 33, 38–48 and human capital 38–48, 80, 84 and illiteracy 38–48, 80, 84 and investment 3–4 and local governments 54, 57–9, 66 and population 38–48, 80, 84 and private sector 4, 33–48, 69–70, 73, 77–86, 169, 252 and property rights 69–70, 73, 77–86, 169 and resource allocation 3–4, 33–48 and state-owned enterprises (SOEs) 19–30, 33–48 economic reform 89–103 see also under government Economic and Technological Development Zones 36 electronics industry 154, 155, 179 employment, see labor Export and Import Bank of China 128 n5, 240 ﬁnancial sector 2, 93, 102, 177 see also banks, venture capital ﬁscal policy, see under government foreign capital, see foreign investment Foreign Direct Investment (FDI) 56, 77 n47, 92, 94 n7, 101–2, 280 foreign exchange 100–101, 102 foreign investment 54, 56, 92, 94 n7, 101–2, 153, 165, 224, 227, 237–8, 241, 243, 243, 280, 282 see also Foreign Direct Investment, foreign-owned enterprises, Sinoforeign joint-ventures, venture capital foreign-owned enterprises 1, 35, 54, 99, 173–6, 204, 214, 224, 227, 244, 278 see also Sino-foreign joint-ventures

foreign trade 94–5, 176–81, 279 exports 38–48, 100–101, 176–81 impact of WTO accession on 176–81 imports 6, 38–48, 101, 176–81 France 100, 143 Fujian 19, 20, 37, 158 Fujian Industrial Bank 240 Gansu 20, 37, 159 Germany 143, 238, 241 see also Japanese–German model of corporate governance Gorbachev, Mikhail 190 government, central budgets 62–3 expenditure 38–48 Ministry of Finance 127, 159, 161 Ministry of Health 224 Ministry of Science and Technology 158–9, 161 policies, regulations and intervention 11 and business entry 8, 271, 278–9 and economic reform 55–7, 62–4, 65, 90–95, 99–103, 170, 171, 180–81, 209–10, 258 and ﬁnancial reforms 5, 8 ﬁscal 55–9, 62–4, 66, 143–5, 148, 152–7, 161–6, 271, 277 foreign 94–5 and foreign trade 100–101, 170, 180–81 and legislation 8, 69–77, 81–2, 85–6, 271, 277–8 and local governments 57–9, 61, 62–4, 66 and market access 8, 271, 278–9 and medical sector 223–5, 230–32 and private property rights 4, 53–67, 69–77, 81–2, 85–6, 247, 271, 277 and private sector 7–8, 36, 53–67, 69–77, 81–2, 85–6, 180–81, 195, 271–5, 277–9, 281–2 and privatization 5, 6, 69–77, 81–2, 85–6, 187–9, 192–8, 209–10, 231–2, 244, 245–50, 258, 271, 277, 279–81 and resource allocation 36 and taxation 8, 58, 61, 62–4, 70–73, 75, 271, 277–8

Index and venture capital 143–5, 148, 152–7, 161–6 see also Communist Party of China (CPC), CPC National Congress, State Council government, local budgets 62–3 expenditure 38–48 policies, regulations and intervention and economic reform 57, 62–4, 209–10 ﬁscal 57–9, 62–4, 66, 107, 152–3, 156–7 and private property rights 4, 53–67, 75 and private sector 4, 36, 53–67, 75, 107–8 and resource allocation 36 and taxation 58, 61, 62–4, 107 and venture capital 152–3, 156–7, 161 Great Britain 100, 143, 230, 238 Great Leap Forward 94 Gross Domestic Product (GDP) 42–3, 46–7, 80, 163, 272 provincial 19–30, 20, 37, 39, 54 and resource allocation 3–4, 33–48 Russia’s 185, 187, 191, 195 compared with China’s 4, 89, 101 and stock markets 7 see also economic growth Guangdong 19, 20, 37, 159 Guangdong Development Bank 240 Guangxi 20, 37, 158 Guangzhou 111, 158 Guizhou 19, 20, 37, 158 Haerbin 159 Hainan 20, 37, 158, 242 n2 Hebei 20, 37, 158, 251 Heilongjiang 10, 20, 37, 159 Henan 20, 37, 158, 250 hi-tech industry 5, 144–5, 153–60, 161–6, 179 Hong Kong 35 n4, 80, 101, 131 n10, 173–6, 179, 243, 243, 245 hospitals for-proﬁt versus not-for-proﬁt 6, 223–32 private versus state 6, 223–32 household responsibility system 1, 60, 70, 275, 279

287

Hubei 20, 37, 111, 158 Hunan 20, 37, 159 IDG 157 income inequality 2, 12–18, 38 India 177, 178 individual-owned enterprises 7, 35, 54, 56, 62, 64, 272–6 see also under industrial output Indonesia 177, 244, 245, 250 Industrial and Commercial Bank of China (ICBC) 127, 240, 242 industrial output 38, 45, 54, 172–4 and collectively-owned enterprises (COEs) 1, 10, 11, 36 n7, 54, 74, 172, 172–4, 252 and individual-owned enterprises 36 n7, 54, 276 and non-state-owned enterprises (nonSOEs) 35–6 and private enterprises 1, 10, 11, 33–4, 54, 60, 74, 77, 172, 172–4, 271, 275–6 and state-owned enterprises (SOEs) 1, 10, 11, 17, 22–4, 25, 28, 33–4, 35–6, 36 n7, 54, 74, 171–2, 172–4, 252, 259–61 in Wenzhou 54, 60 industrial sector 11, 23, 25, 28, 30, 34, 70, 91, 93, 99, 102, 170, 177, 179 inﬂation 102 information technology sector 153, 155 infrastructure industries 153, 155, 243 Inner Mongolia 20, 37, 158 Innovation Fund for Small Technologybased Firms (IFSTF) 148, 154, 155–6, 156, 158–9, 161–2 International Monetary Fund (IMF) 91 investment 2, 3–4, 7, 91, 241–5, 241–3, 246, 254 sector 23, 25, 28 see also foreign investment, stock markets, venture capital Israel 143 Japan 94, 95, 98–9, 143, 177–8, 177, 238–9, 241, 245 see also Japanese-German model of corporate governance

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The Revival of Private Enterprise in China

Japanese-German model of corporate governance, see under corporate governance Jiangsu 19, 20, 37, 37, 158 Jiangxi 20, 37, 158 Jilin/Jiling 20, 37, 158 joint-stock cooperatives (JSCs) 64–5, 244, 258 joint ventures 1, 12, 35, 170, 243, 244, 280 Khodorkovsky, Mikhail 186, 191, 192, 194 Korea 245, 250 labor and employment 91, 93–4, 95, 98, 177, 177, 192 and education 13–18 and private sector 2, 3, 11–18, 174, 175–6, 250–52, 276 and public sector 2, 3, 11–18, 20–30, 250, 259, 261 rural 2, 12, 55, 60, 93, 98, 170–71 unemployment 2, 55, 91, 202, 212 urban 2, 12, 55, 252 and wage differentials 12–18 see also under state-owned enterprises Latin America 94–5 Liaoning 11–12, 20, 37, 158 Lin Biao 94 Macao 35 n4, 80, 173–6, 243 manufacturing sector 5, 169, 173, 176, 195, 253, 276 medicine and medical-care services 7, 155 see also hospitals Mexico 94–5, 244, 245 migration 22, 30, 99, 171 Mongolia 204, 214 Nanjing 158 National Development Bank 128 n5, 240 National People’s Congress, see CPC National Congress Nationalist government 99 Neimonggu, see Inner Mongolia Netherlands 143 New and High-Tech Industrial Development Zones 36 Ningbo 158 Ningxia 20, 37

non-performing loans (NPLs) 2, 5, 127–40, 241 non-state-owned enterprises (non-SOEs) 11–18, 36, 107, 170, 244 and economic growth 33–48 and labor 11–18 and wage differentials 12–18 see also under industrial output Ohio state government and private enterprise community development function 112–17 management function 117–23 service function 108–12 Peiyan, Zeng 282 People’s Bank of China (PBOC) 128, 131, 138, 240 People’s Congresses 56 n6 Peru 94 Pinochet, Augusto 95 Poland 195–6 Potanin, Vladimir 186, 190–91 private-owned enterprises (POEs) 7, 10, 11, 56, 62, 107, 170–76, 243, 243, 244, 252–4, 272–6, 281–2 and legal rights 69–77, 81–2, 85–6, 277–9 and taxes 70–73, 75, 277–8 and venture capital 162 see also non-state-owned enterprises (non-SOEs), privatization, stateowned enterprise: reform of, and under banks, corporate governance, government, industrial output private property ownership and rights 4, 6, 53– 67, 91, 247, 271, 277, 279, 280–82 and China’s membership of WTO 169–70, 176–81 and economic growth 69–70, 73, 77–86 and productivity 69–70, 73, 77–86, 271 see also under government (central and local) private sector, see non-state-owned enterprises (non-SOEs), privateowned enterprises (POEs), and under government (central and local) privatization 2, 5, 6, 36, 56, 69–70, 73, 77, 79 n48, 107, 170, 171, 185–98,

Index 231–2, 252–4, 271, 277, 279–81, 282 see also under Russia, state-owned enterprises production 20–30 productivity agricultural 95 and collectives 69–70, 73, 77–86 and private sector 4, 69–70, 73, 77–86, 282 and state-owned enterprises (SOEs) 7, 23, 25, 200, 201, 208, 257–68, 282 public expenditure, see under government public sector, see state owned enterprises (SOE) Putin, Vladimir 189, 192 Qingdao 159 Qinghai 20, 37, 37, 40, 81, 84, 159 Quizhou 40 real estate industry 194 resources, allocation of 3, 11–18, 33–48, 91, 223 retail sector 5, 23, 25, 28, 169, 174, 175, 253 Rhongji, Zhu 102 rural sector 1, 59–60, 61–2, 70, 93, 169, 170–71, 276 labor and employment, see labor Russia compared with China 4–5, 6, 89–103, 192–8 economic reform in 89–103 privatization in 6, 185–6, 187–92, 239 Russian Communist Party 185, 188 service sector 5, 169, 174, 176, 177, 253, 276 Shaanxi 20, 37 Shandong 20, 37, 158 Shanghai 19, 20, 37, 40, 153, 158, 278 Shanghai Pudong Development Bank 240 Shanghai Stock Exchange 237, 248, 251, 278 Shanxi 20, 37, 159 Shengyang 158 Shenzhen 153 Shenzhen Development Bank 240 Shenzhen Stock Exchange 237, 251, 278 Sichuan 20, 37, 37, 81, 158 Singapore 177, 178, 245 Sino-foreign joint-ventures 54, 56

289

Socialist Revolutionary Party (Russia) 97 South Korea 95, 100, 177–8, 177, 224 Soviet Union 6, 35, 89 n2, 91, 92, 94, 95, 185, 187, 190, 191 republics of former 91, 95 Special Economic Zones (SEZs) 36, 92, 251 Stalin, Joseph 35 State Asset Management Commission (SAMC) 247 state asset management companies, see asset management companies State Bureau of General Taxation 64 State Commission for Development and Reforms 282 State Council 61, 62 n9, 71 n5, 74–5, 155, 165, 200 n5, 274 State Economic and Trade Commission (ETC) 209 state owned commercial banks (SOCBs) 127–9, 137–8 and private sector 2, 181 state owned enterprises (SOEs) 11–18, 62, 100–101, 169, 170, 171, 173, 180 corporatization of 199–201, 203, 237–8, 257 and economic growth 3–4, 19–30, 33–48 government ﬁnancial support of 127–9, 132–8, 278 and investment 3–4, 240–45 and labor 2, 3, 11–18, 20–30, 61, 128, 246, 250 and local government 54, 245 and non-performing loans 5, 127–9, 241 ownership and ownership reform of 6, 100, 199–219, 237–8, 245–50, 252–4 and private sector 61 privatization of 77, 199–201, 203, 237–8, 245–50, 252–4, 257, 279–81, 282 and production 20–30 and productivity 7, 23, 25, 200, 201, 208, 257–68, 282 reform of 55, 77, 92, 128, 129, 136, 137, 199–219, 250, 272 and agency costs 199–203, 210–16 and autonomy 201–3, 205, 209, 210–18, 246–7, 250 and corporate governance 199–204, 205, 212, 216, 237–8, 245–50, 252–4

290

The Revival of Private Enterprise in China

and labor deployment 200–201, 202–3, 209, 212–14, 216 and performance 199–204, 205–19 and political costs 199–204, 212–14 and productivity 200, 201, 208, 257–68 and venture capital 162 and wage differentials 12–18 see also under industrial output State System Reform Committee (SRC) 209 stock markets 7, 92, 129–30, 131 n10, 237, 242, 243–5, 245, 251, 254, 278 Sung Dynasty 97–8 Taiwan 35 n4, 59, 80, 95, 100, 101, 173–6, 243, 245 tariffs 36, 176, 179 tax 2, 8, 23, 33, 36, 70–73, 75, 97–8, 278 collection of 58, 62–4 value-added (VAT) 64 see also under government (central and local) telecommunications industry 153 textile and apparels industry 60, 178–9 Thailand 244, 245 Tiananmen Square incident 8, 75, 89 n2, 92, 274, 275 Tianjin/Tianjing 20, 37, 159 Tibet 20, 37, 48, 81, 84 township and village enterprises (TVEs) 1, 57–8, 62, 63, 70, 72, 169, 170, 273, 280 transportation sector 34, 153, 155, 243 Ukraine 95 unemployment, see under labor United Kingdom (UK), see Great Britain United States of America (USA) 94–5, 99, 101, 172, 177–8, 177, 238, 239, 241, 245 central government 5 China’s relations with 94

local government 5 medical-care services in 7, 224–5, 227–32 and private enterprises 107–8 trade with China 178, 179 and venture capital 5, 143–52, 160–61, 162, 164, 165 see also Ohio state government urban sector labor and employment, see labor USSR, see Soviet Union venture capital 143–66 foreign 153, 165 and hi-tech industry 5, 144–5, 153–60, 161–6 private 5, 143–4, 145, 165–6 public 5, 143–8, 163–6 public-private partnerships 148, 157–63, 165–6 see also under United State of America Videla, Jorge Rafael 95 Vyakerev (Vyakhirev), Rem 186, 189–90 Wenzhou 4, 53–67 wholesale sector 174, 175 World Bank 91 World Trade Organization (WTO) 2, 3, 5–6, 8, 66, 102, 169–81, 224, 282 Wuhan 158 Xiamen 158, 224 Xiaoping, Deng 1, 8, 65, 75, 82, 86, 92, 102, 273, 274, 275 Xinjiang 20, 37, 37, 159 Yeltsin, Boris 95, 100, 185, 197 Yunnan 20, 37, 158 Zedong, Mao 84, 94 Zemin, Jiang 65, 102, 274 n4, 277 n7 Zhejiang 19, 20, 20, 37, 37, 40, 158 Zhu Rongji 102, 128–9

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