Corporate Governance and Performance
of State-Owned Enterprises in China
Hongman Gao
University of Mississippi
Abstract
In 2001, China joined the World Trade Organization (WTO). This event meant that Chinese State-Owned Enterprises (SOEs) would have to compete in the global economy and faced many challenges in competing with foreign companies. Because of these changes, the issue of corporate governance has become an important topic in the debate of how China’s businesses can become more competitive in the global economy. We propose a model, and collected the data, and tested to get the results of the performance of SOEs. Finally, we provide some suggestions about how to enforce the corporate governance of SOEs in China.
- Introduction
In 2001, China joined the World Trade Organization (WTO). This event meant that Chinese State-Owned Enterprises would have to compete in the global economy and faced many challenges in competing with foreign companies. Because of these changes, the issue of corporate governance has become an important topic in the debate of how China’s businesses can become more competitive in the global economy.
According to Brickley, Smith, and Zimmerman (2004)[1], corporate governance consists of internal control mechanisms (ownership structure, shareholder voting, board of directors, and management compensation), and external control mechanisms (market for corporate control - takeover, managerial labor market, and product market). (pp.503-507)
The purpose of the corporate governance mechanism is to solve the principal - agent problem. The owner of the enterprise is the principal and the manager of the enterprise is the agent. The owner hires a professional manager to deal with the on-going activities of the business when this activity is beyond the owner’s managerial abilities. The principal-agent problem arises because of costs associated with making a contract between the owner and the agent (Fama and Jenson, 1983).
From the time that Jensen and Mecking (1976) defined the concept of agency costs, there has been a lot of academic research in which Western scholars have applied the principal-agent theory to Western firms. There are much fewer examples of research dealing with this topic in China. One example is Zhang (1997)[2], he used the principal-agent model to explain why the Chinese central government has advocated the reform of State-Owned Enterprises in which the main idea of the reform is to shift the decision-making away from government officials and to the manager inside the firm. Zhang (2004-1) applied the principal-agent model to the Chinese public economy and concluded that privatization is the only way to solve the agent problem in State-Owned Enterprises.
During the ten years of the period known as the New Cultural Revolution, living standards of the Chinese people fell dramatically. Many Chinese people did not have the basic needs for living. Food shortages were a big problem during this time. As an example, my wife’s family sent her to live in a government boarding school just so that she could get enough food. The family was not able to get enough food for them and it affected the health of the family’s children.
The failures of the New Cultural Revolution made the Chinese government realize that the economy should be the number one priority of Communist Party. Their first step in reforming the economy was to divide the lands that were collectively farmed and give them to individuals. The second step was to shift the decision making process to insiders of the State-Owned Enterprises. Thus the government was no longer taking care of everything for the industries and protecting them from competition. Businesses had to learn to do business by themselves and then give a certain percentage of profit to the government.
The reform of State-Owned Enterprises was a difficult process. When facing competition for the first time, many firms made losses. One way that the government provided incentives for firms to make profits instead of losses is that the central government shifted the burden of losses from the central government to local government. Of course, the reform of State-Owned Enterprises has been very successful, and now the Chinese economy has transformed the planned economy into the market economy.
In China, the owner of SOEs is the whole Chinese people, which include the workers and the manager. The manager thus has a dual role in the principal-agent relationship. He is an agent for the owners and, at the same time, he is one of the owners. The manager of a SOE in China is not selected in a competitive labor market, instead he is appointed by government bureaucrats. The board of directors for Chinese SOEs consists of different people from government, banks, and insider workers, but none of them owns any shares of the SOEs, and they are just the nominal owners. As an example of how corporate governance works in China, Zhang (2004-2) has created a figure that shows the decision-making relationships for a business. This figure is reproduced in Figure 1.
Figure 1 Shanghai State Asset Management System
Source: World Bank (1997) and Zhang (2004-2)
- Literature Review
Following the reform of the State-Owned Enterprises in China, the Non-State-Owned Enterprises (NSOEs) have been developing significantly. NSOEs include Collectively-Owned Industries, Cooperative Enterprises, Joint Ownership Enterprises, and Private Enterprises. Thus an important topic has been comparing the performance of State-Owned Enterprises and Non-State-Owned Enterprises. This paper develops a model for comparing performance of these two types of enterprises in China and then empirically tests the model.
The basic reference for the model used in this paper is Boardman and Vining (1989). They developed a model to compare the performance of privately owned firms, state-owned firms, and firms that had a mix of private and state ownership. Their index of performance is profitability. Profit was measured in four different ways: return on equity, return on assets, return on sales, and net income. The results of running the model show that the mixed and State-Owned Enterprises’ performance is not as good as private enterprises.
Vining and Boardman (1992) investigated the ownership with competition, and used the same model to evaluate the efficiency in the different enterprises. The results of the estimation also show that the State-Owned Enterprises and Mixed Enterprises are not as efficient as private enterprises.
Boardman and Vining (1991) especially paid attention to the mixed enterprises, and found out why mixed enterprises are not very efficient, because of their particular behaviors, which is to achieve the sociopolitical objective.
Because of the ambiguous definition of ownership in State-Owned Enterprises, the absence of ownership representative has been a major problem in the process of the reform of State-Owned Enterprises in China. According to Kagawa (2004), there are two main advocates of solving the ownership problem. One is to sell the share of State-Owned Enterprises to employees or outside investors[3]. The other is to create a public share holding company to present the owner, and that will solve the problem of the ambiguous definition of ownership. Also Kagawa (2004) compared the two corporate governance models in U.S. and Japan. The major difference between the corporate governance in U.S. and Japan is the shareholder structure. In Japan, the shareholders are mainly big financial institutions or big companies, and in U.S., the shareholders are very dispersible and there is no big influence from the financial institutions.
- Model
Based on the work of Boardman and Vining (1989) and Vining and Boardman (1992), I have developed and tested a model to compare the performance of State-Owned and Non-State-Owned Enterprises in China. The basic model is presented below.
Model 1: %Profit = β0 + β1*Dummy + β2*%FixedAssets + β3*%Growth
In this model, % Profit is a measure of the rate of profit and is calculated as profits divided by sales. The variable Dummy is a dummy variable which is equal to 1 if the firms are State-Owned Enterprises and is equal to 0 if the firms are Non-State-Owned Enterprises. The variable %FixedAssets is total fixed assets divided by sales. The variable %Growth is a growth rate that is calculated as sales in year t minus sales in year t-1, divided by sales in year t-1.
%FixedAssets and %Growth are expected to be positively related to profits. Higher fixed assets and growth will cause higher profits. The key variable in the equation is the dummy variable. If State-Owned Enterprises have poorer performance than Non-State-Owned Enterprises this variable is expected to be negative and significant.
Model 1 can easily be used to develop regression equations specifically for the two types of firms analyzed in this paper. The two models below represent the performance models for State-Owned Enterprises and Non-State-Owned Enterprises.
Model 2 (State-Owned Enterprises):
%Profit = (β0 + β1) + β2*%FixedAssets + β3*%Growth
Model 3 (Non-State-Owned Enterprises):
%Profit = β0 + β2*%FixedAssets + β3*%Growth
- Data
To test the models in the previous section, I collected data from the National Bureau of Statistics of China ( I used 26 industries in my sample and collected data for State-Owned Enterprises and Non-State-Owned Enterprises for each industry. Therefore my sample size is 52. The industries used in this study are listed in Table 1.
Table 1 List of Industries
Coal Mining / Paper Products / Metal ProductsPetroleum/Gas Extr / Petroleum Process / Ordinary Machinary
Food Processing / Chemical Products / Special Equipment
Food Manufacture / Pharmaceutical / Transport Equipment
Beverage Manufact / Chemical Fiber / Electronic Equ.&Mach
Tobacco Processing / Plastic / Ele.&Telecomm. Equ
Textile Industry / Nonmetal Mineral / Instr.&Office Equi.
Garments / Ferrous Metals / Power&Water Supply
Leather / Nonferrous Metals
Source: China Statistical Year Book (2001, 2002)
To make the variables in my model I collected data by industry on the following: sales in 2001, sales in 2002, fixed assets in 2002, and profits in 2002. This data was used to construct the variables in the models (%Profit, %FixedAssets, and %Growth). The means of this data are presented in Table 2. it is interesting to note that in 2001, sales were divided roughly evenly between State-Owned businesses (1635 million Yuan) and Non-State-Owned businesses (1738 million Yuan).
Table 2 Variable Definitions and Mean Values (Million Chinese Yuan)
Definitions / State-Owned / Non-State-OwnedSales01 / Value of Sales in 2001 / 1635 / 1738
Sales02 / Value of Sales in 2002 / 1760 / 2183
Fixed02 / Fixed Assets in 2002 / 2316 / 1039
Profit02 / Value of Profit in 2002 / 99 / 111
%Profit / Profit 02 / Sales 02 / 0.0423 / 0.0691
Dummy / 1 or 0 / 1 / 0
%FixedAssets / Fixed 02 / Sales 02 / 1.166 / 0.589
%Growth / (Sales 02 - Sales 01)/Sales 01 / 0.029 / 0.261
Source: China Statistical Year Book (2001, 2002)
- Results
The regression results are presented in Table 3. We can estimate the following models according to the results.
Model 1:
%Profit = β0 + β1*Dummy + β2*%FixedAsset + β3*%Growth =>
%Profit = 0.054 –0.0726*Dummy + 0.053*%FixedAsset –0.065*%Growth
t-Stat ( - 2.23 ) ( 2.70 ) (- 0.74 )
First, the R² is equal to 0.15. This means that 15 percent of the variation in profits is explained by the variables in the model. Fixed Assets and Growth are expected to be positively related to the profit rate. As expected, the Fixed Assets is positive and is statistically significant (because the t value is greater than 2). The growth variable has the wrong sign but is not statistically significant (because the absolute value of the t ratio is less than 2). The most important variable for this paper is the Dummy variable. It is negative and statistically significant (because the absolute value of the t-ratio is greater than 2). This is strong evidence that the performance of State-Owned Enterprises in China, as measured by a profit index, is not as good as performance of Non-State-Owned Enterprises.
We can use the other two models to get a point estimate of profits for the two types of firms analyzed in this paper. I have plugged in the mean values of %FixedAsset and %Growth into Models 2 and 3 and get the following:
Model 2 (State-Owned Enterprises):
%Profit = (β0 + β1) + β2*%FixedAssets + β3*%Growth =>
%Profit = (0.054 –0.0726) + 0.053*%FixedAssets –0.065*%Growth =>
%Profit = -0.0186 + 0.053*1.166 –0.065*0.029 = 0.041313
Model 3 (Non-State-Owned Enterprises):
%Profit = β0 + β2*%FixedAsset + β3*%Growth =>
%Profit = 0.054 + 0.053*%FixedAssets –0.065*%Growth
%Profit = 0.054 + 0.053*0.589 –0.065*0.261 = 0.068252
The point estimate of profits for State-Owned Enterprises is 0.041313. The point estimate of profits for Non-State-Owned Enterprises is 0.068252.
Table 3 The Regression Results
SUMMARY OUTPUTRegression Statistics
Multiple R / 0.39968716
R Square / 0.15974983
Adj. R Squ. / 0.10723419
Sta. Error / 0.07174683
Observ. / 52
ANOVA
df / SS / MS / F / Signif. F
Regression / 3 / 0.0469763 / 0.01566 / 3.041948 / 0.037747171
Residual / 48 / 0.2470852 / 0.00515
Total / 51 / 0.2940615
Coefficients / Sta. Error / t Stat / P-value / Lower 95% / Up. 95% / Low. 95% / Up. 95%
Intercept / 0.05486015 / 0.0268054 / 2.04661 / 0.046194 / 0.000964345 / 0.108756 / 0.000964 / 0.108756
X Variable 1 / -0.0726136 / 0.0325523 / -2.2307 / 0.030411 / -0.13806429 / -0.00716 / -0.138064 / -0.007163
X Variable 2 / 0.05311955 / 0.0196545 / 2.70267 / 0.009482 / 0.013601544 / 0.092638 / 0.013602 / 0.0926376
X Variable 3 / -0.0650564 / 0.0876755 / -0.742 / 0.461695 / -0.24133961 / 0.111227 / -0.24134 / 0.1112269
Table 4 The Results of t Stat and P-value
Coefficients / t Stat / P-valueINTERCEPT / 0.054860149 / 2.046609388 / 0.046193709
DUMMY / -0.072613605 / -2.230677406 / 0.030411161
%FixedAssets / 0.053119552 / 2.702665438 / 0.009482304
%Growth / -0.065056366 / -0.742013305 / 0.461694825
- Conclusionand Suggestions
The conclusion of this paper is that the performance of State-Owned Enterprises is worse than the Non-State-Owned Enterprises. This conclusion is consistent with the previous results of Boardman and Vining (1989) and Vining and Boardman (1992).
Since the State-Owned Enterprises’ performance is not good as the Non-State-Owned Enterprises, the Chinese government has been devoting the much efforts to reform SOEs. According to Brickley, Smith, and Zimmerman (2004)[4], corporate governance consists of internal control mechanisms (ownership structure, shareholder voting, board of directors, and management compensation), and external control mechanisms (market for corporate control - takeover, managerial labor market, and product market). Therefore, the goals of the policy should be to establish above internal & external control mechanisms. For example, the problem of absence of ownership representatives has still not been solved. Given the undeveloped stock market and the dominant indirect financing, the Japanese corporate governance model (financial institution holds the largest share in the Japanese companies) maybe more fit for China. Considering the huge amount of bad loans to SOEs, it is appropriate to convert them to stakes in SOEs. In fact, two years ago, several banks already established special assets management companies which become the big shareholders of a lot of SOEs. In addition, other internal mechanisms could include: appointing independent director and setting a competitive structure of managers' salaries. As for the external mechanisms, they could include: well-developed market of professional managers; the reliable independent auditors, sound legal systems.
- Future Work
The work in this paper is based on an initial small sample of 26 industries. Future work should be based on a larger sample. In addition the profit model in this paper could be evaluated with data from individual companies. Also, because the R² in my results was only 15 percent, future research should consider other variables in the regression equation.
Appendix - Data Set (Million Chinese Yuan)
Sales-02 / Sales-02-S / Sales-02-N / Sales-01 / Sales-01-S / Sales-01-N / Profit-02 / Profit-02-S / Profit-02-N / Fixed-02 / Fixed-02-S / Fixed-02-NCoal Min / 1960 / 1628 / 332 / 1503 / 1271 / 232 / 84 / 58 / 26 / 3752 / 3547 / 205
Petr./Gas / 2640 / 2511 / 129 / 2658 / 2537 / 121 / 912 / 854 / 58 / 6353 / 6263 / 90
Food Proc. / 4515 / 1056 / 3459 / 3823 / 1120 / 2703 / 115 / 8 / 107 / 1798 / 710 / 1088
Food Man. / 1827 / 425 / 1402 / 1519 / 400 / 1119 / 82 / 19 / 63 / 1139 / 368 / 771
Beverage / 1872 / 832 / 1040 / 1727 / 831 / 896 / 120 / 66 / 54 / 1630 / 806 / 824
Tobacco / 1994 / 1968 / 26 / 1756 / 1736 / 20 / 212 / 211 / 1 / 1022 / 1004 / 18
Textile / 6038 / 1344 / 4694 / 5209 / 1409 / 3800 / 184 / 11 / 173 / 3878 / 1379 / 2499
Garments / 2725 / 122 / 2603 / 2415 / 141 / 2274 / 111 / 1 / 110 / 860 / 76 / 784
Leather / 1677 / 41 / 1636 / 1427 / 70 / 1357 / 57 / -2 / 59 / 448 / 39 / 409
Paper Pro. / 1968 / 462 / 1506 / 1685 / 427 / 1258 / 98 / 19 / 79 / 1754 / 682 / 1072
Petr. Proc. / 4893 / 4289 / 604 / 4629 / 4195 / 434 / 50 / 31 / 19 / 3712 / 3414 / 298
Chemical / 6974 / 3062 / 3912 / 6033 / 2907 / 3126 / 279 / 43 / 236 / 6518 / 4696 / 1822
Pharmace. / 2274 / 1015 / 1259 / 1924 / 922 / 1002 / 201 / 79 / 122 / 1428 / 736 / 692
Chem. Fib / 1086 / 396 / 690 / 957 / 414 / 543 / 29 / 7 / 22 / 1207 / 709 / 498
Plastic / 2371 / 223 / 2148 / 2040 / 248 / 1792 / 112 / 9 / 103 / 1383 / 255 / 1128
Nonmetal / 4226 / 1019 / 3207 / 3671 / 991 / 2680 / 154 / 7 / 147 / 4300 / 1770 / 2530
Ferrous / 6471 / 4356 / 2115 / 5600 / 4122 / 1478 / 294 / 211 / 83 / 7192 / 6379 / 813
Nonferrous / 2547 / 1187 / 1360 / 2260 / 1139 / 1121 / 81 / 38 / 43 / 2120 / 1562 / 558
Metal Pro. / 3083 / 301 / 2782 / 2635 / 312 / 2323 / 123 / 4 / 119 / 1408 / 286 / 1122
Ordinary M. / 3992 / 1458 / 2534 / 3222 / 1206 / 2016 / 191 / 37 / 154 / 2471 / 1348 / 1123
Special E. / 2630 / 948 / 1682 / 2158 / 819 / 1339 / 124 / 7 / 117 / 1574 / 945 / 629
Transport / 8030 / 5225 / 2805 / 6220 / 4206 / 2014 / 490 / 321 / 169 / 4221 / 3208 / 1013
Ele. Equ. / 5749 / 903 / 4846 / 5099 / 904 / 4195 / 285 / 15 / 270 / 2431 / 730 / 1701
Ele.&T. E. / 10957 / 2756 / 8201 / 8899 / 2915 / 5984 / 468 / 111 / 357 / 3611 / 1300 / 2311
Ins.&O Eq. / 1089 / 198 / 891 / 933 / 189 / 744 / 52 / 3 / 49 / 473 / 213 / 260
Power&W. / 8958 / 8041 / 917 / 7712 / 7094 / 618 / 576 / 426 / 150 / 20570 / 17805 / 2765
Source: China Statistical Year Book (2001, 2002)
References
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1
Special thanks goes to Dr. William F. Shughart II (Professor of Economics Department, University of Mississippi) for his instruction of this research.
[1]. In this textbook, it only points out the governance mechanisms in publicly traded firms.
[2] .Dr. Zhang is an advocate of privatization of State-Owned Enterprises.
[3] Actually, it is a kind of privatization.
[4]. In this textbook, it only points out the governance mechanisms in publicly traded firms.