The Political Economy of Chinese-Style Privatization: Motives and Constraints*

The Political Economy of Chinese-Style Privatization: Motives and Constraints

Guy S. Liu a, Pei Sun b,# , Wing Thye Woo c

a. Brunel Business School, Brunel University, the United Kingdom

b. The Business School, University of Nottingham, the United Kingdom

c. Department of Economics, University of California, Davis, the United States

Forthcoming in World Development, 2006

# Corresponding Author: Nottingham University Business School,

Jubilee Campus Wollaton Road

Nottingham NG8 1BB,

England, U.K.

Tel: +44 (0)115 84 66361

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Summary

The paper examines how the privatization of Chinese state-owned enterprises (SOEs) can be successfully triggered and completed. By identifying the motives of local government leaders and the constraints facing them during transition, we conclude that: first, whether local governments are motivated to privatize their SOEs depends on if the ownership transfer is expected to stimulate sufficiently high growth of local tax revenues without sacrificing bureaucrats private control benefits. Second, a specific privatization program can succeed only if it manages to satisfy the managerial cooperation constraint, the workers compensation constraint, and the bank debt-servicing constraint. The motives-cum-constraints political economy approach offers an important explanation for the pace and scope of ongoing Chinese-style privatization.

Keywords: Privatization, Enterprise Reform, Political Economy, Local Government, China

Acknowledgement

The authors greatly appreciate the access to the Year 2004 Enterprise Survey data permitted by the Institute of Enterprise Research, the Development Research Center of State Council, People’s Republic of China. We are also indebted to Stephen Green, Xiaoxuan Liu and Mike Wright for their valuable comments, and to the anonymous reviewers of World Development, whose constructive advice has helped to improve the quality of the paper significantly. The usual disclaimer applies.

1. INTRODUCTION

Unlike the big-bang mass privatization approach adopted by the Eastern European and Former Soviet Union (EEFSU) countries, the Chinese government until the mid 1990s was still trying to improve the SOE performance by establishing market-oriented incentives1 while maintaining its ownership and control over a great majority of industrial enterprises. Since then, China has entered a new phase of enterprise reform: the government has explicitly pursued a ‘2-R’ strategy – retain government control of large enterprises that operate in the strategic sectors and retreat from small and medium-sized enterprises that operate in highly competitive markets (e.g. Green and Liu, 2005).

With regard to the restructuring of large SOEs, corporatization and stock flotation are the key measures used to privatize a fraction of government cash flow rights, in return for funds to the extent that the government is still able to maintain ultimate corporate control (Liu and Sun, 2005b). Meanwhile, hundreds of thousands of small and medium SOEs at local level have been granted privatization permission during the last decade. Moreover, a large amount of evidence shows that the major players behind the rise of privatization are local governments, especially those at municipal and county levels (Tenev and Zhang, 2002; Garnaut, Song, Tenev and Yao 2005; OECD, 2005).2

Then natural questions arise on what motivates the government to relinquish its control of industrial firms, what constraints the smooth progress of privatizations, and what economic and socio-political factors affect the dynamics of government-initiated privatization programs. Unfortunately, in comparison with a vast amount of literature devoted to assessing the extent of success of privatization by examining the profitability and operational efficiency of privatized enterprises, in-depth analyses of the factors that initially trigger privatization and further constrain its progress are relatively inadequate both in general theoretical formulations and in empirical studies.

Amongst a limited number of existing works relevant to the research questions just posed, Yarrow (1999) makes a general conjecture that the worldwide spread of privatization during the 1980s and 1990s can largely be attributed to the escalating government expenditure relative to GDP growth, together with the increasing cost of government finance. So governments privatize SOEs in order to ease their fiscal pressures. This ‘fiscal pressure’ view seems to be a parsimonious answer, but it fails to capture the deep political economy nature of the privatization decision-making process. For instance, Biais and Perotti (2002) provide a model showing how privatization can be employed as a strategic policy by incumbent politicians to maximize their probability of winning the re-election.3 Although not directly applicable to the Chinese context, the ‘political-benefit’ view is illuminating in reminding us that political and institutional factors do have a direct bearing on government officials’ privatization decision.

Moving to the developing country context, Bienen and Waterbury (1989) not only mention the significance of fiscal austerity and international donor duress in triggering privatization, but argue that ‘to assess the constraints on and possibilities for privatization, one must have a clear picture of … the gains and losses that will be sustained by the constituent elements of dominant political coalitions’ (p.618). ‘… even in nonelectoral systems, leaders must find enough support or create new bases of support to sustain privatization policies’ (p.629). Such insights are echoed and further elaborated by the World Bank (1995) in a chapter entitled ‘The Politics of SOE Reform’. On the basis of a comprehensive study of the reform experience in the developing world up to the early 1990s, the policy research report generalizes some essential conditions of a successful privatization program, notably the political desirability from the leaders’ viewpoint and the political feasibility ensured by government leaders in withstanding opposition from potential losers.

This paper closely follows the ‘political-benefit’ view suggested by the aforementioned literature in general; and the discussion of motives and constraints involved in China’s privatization in the last decade serves to update and enrich our understanding of the critical issues concerning political desirability and feasibility in particular. In fact, the World Bank (1995) did touch upon the case of transition China when discussing the two conditions. But obviously its assessment was grounded on the extremely limited, if any, formal private ownership presence in the Chinese industrial sector in the late 1980s and early 1990s. The transformation of the industrial landscape since the mid 1990s, however, prompts us to rethink how the incentive structure within the authoritarian regime and the change of wider institutional environments can interact to significantly alter the desirability and feasibility of privatization in transition China.4

In the paper we aim to answer the ‘why-privatize’ question by identifying the unique institutional settings that have shaped the incentive structure of the privatization-friendly Chinese local government leaders. Based on an analytical framework that integrates the extant China-based studies, we maintain that local government leaders will be keen to privatize their SOEs only if they can assure themselves of both higher growth of fiscal revenues and the retention of their private benefits from the privatized firms.

Moreover, the willingness of government officials to privatize SOEs alone does not necessarily translate into the success of privatization programs in practice. Rather, they are subject to a series of entangled economic and socio-political constraints that are always of country-specific nature, since privatization itself means a complete reshuffling of the extant interest structure concerning not only governments, but also managers, workers, and creditors. In the paper we highlight some essential constraints imposed by the key stakeholders in privatization, namely the managerial cooperation constraint, the workers compensation constraint, and the bank debt-servicing constraints. In particular, for a detailed privatization plan to proceed smoothly, government leaders must be able to enlist the cooperation of the SOE managers, compensate the workers to an extent they deem sufficient, and guarantee the payment of existing bank loans after the restructuring.

The rest of the paper is organized as follows: section two provides an aggregate picture of the latest ownership structure in the Chinese industrial sector. Section three is devoted to an in-depth analysis of the evolution of institutional environments during the 1990s China, which shapes the incentive structure of local leaders in making their privatization decision. Based on the recently introduced integrative framework, section four illustrates the conditions that need to be satisfied to make local leaders committed to privatization. Section five moves on to identify the key constraints that need to be overcome if the desire for ownership transfer is to be turned into reality. The sixth section presents further statistical evidence in support of the motives and constraints propositions. Section seven concludes.

2. THE OWNERSHIP TRANSFORMATION OF THE CHINESE INDUSTRIAL SECTOR: LATEST DEVELOPMENTS

More than twenty-five years of economic reform has completely transformed China’s industrial landscape to the extent that, at the beginning of the century, according to the official statistics shown in Table 1, the private sector already accounted for more than 40% of national industrial output and employment, in comparison with the SOE sector that now only accounts for less than one quarter in the two aggregate indicators. This is in stark contrast to the composition in 1980, when the state, collective and private sectors respectively contributed 76%, 23.5% and 0.5% of the national industrial output.

It is worth noting, however, that the official data acts, at best, as a crude estimate, since the mixed ownership structure has become commonplace in corporate China, and is present in virtually all enterprises however they are classified in Table 1. In particular, the collective sector shown in Table 1 is a highly ambiguous ownership category, as a large number of listed and limited liability companies, or even the collective firms, are ultimately controlled by either government units or the private ones (e.g. Liu & Sun, 2005a, b). An early attempt to remedy the problem was undertaken by us through the use of the China Statistical Bureau 2001 national survey data. By combining the survey data and the official statistics, we find that, in terms of ultimate ownership, the state, the collective, and the private in 2001 respectively accounted for 31%, 12% and 36% of China’s industrial output.5

Subsequent estimation efforts in this respect, despite some arbitrary assumptions that have to be made, have managed to illustrate a clear trend of ownership evolution from the late 1990s to the early 2000s (Garnaut et al, 2005; OECD, 2005). For example, Table 2 suggests a gradual but steady rise of the private sector during 1998-2003: by the end of 2003, domestic private firms had gained an equal weight to that of the state-controlled ones in their contribution to China’s GDP. If we focus on the industrial/non-farm business sector, Table 3 reports more rapid growth of the private sector and decline of state ownership during the same period, with the collective segment nearly halving.

It goes without saying that the change of ownership structure at the macro level is accompanied by significant divestment and transformation of the SOEs across industries and regions.6 While a complete record of SOE ownership restructuring is not available in China, the latest national-scale survey7 reveals both the pace and the main forces driving the restructuring, details of which are shown in Table 4. It can readily be seen from the Table that the pace of ownership restructuring was gradual but gained momentum at the start of the century. Notwithstanding the potential over-sampling of non-restructured SOEs in our survey,8 more than 42% of firms have been fully or partially privatized during the whole period under investigation.9 And within the restructured firms, more than three quarters undertook the transformation during 2001-2003. Regarding the choice of full versus partial privatization, unfortunately only 997 firms reported the information. It is found that only 31.4% of the firms have undergone a full privatization so far, which suggests that a limited amount of control transfer has taken place.

Moreover, a breakdown of the sample SOEs based on central and local government affiliation indicates that it is local governments that have been keen to promote the ownership restructuring programs over the past few years. While less than one quarter of the centrally controlled SOEs in our sample experienced ownership restructuring, more than one half of their local counterparts were already privatized by the mid 2004. The difference in the choice of full versus partial privatization is also significant in the sub-sample just mentioned: nearly 40% of the restructured local SOEs can be classified as full privatization, in contrast to 10% in the transformed central SOEs.

Overall, the preceding data presentation implies two stylized facts on the pace and scope of China’s ownership restructuring over the last decade. First, the progress of the transformation is gradual but steady, with a mixture of full and partial privatization arrangements. Second, SOEs controlled by local governments take the lead in the transition process both in terms of scale measured by the percentage of firms having been restructured, and of depth indicated by the proportion of firms that have undergone full privatization.

3. CHANGING INCENTIVE STRUCTURE OF LOCAL GOVERNMENT LEADERS: AN INSTITUTIONAL ENVIRONMENT PERSPECTIVE

Given the latest developments of the ongoing privatization in China, in the section we examine the multifaceted institutional forces responsible for the emergence of the pro-privatization attitude on the part of local government leaders. While several pieces of work have already touched upon the causes of privatization in China, they either omit some of the key institutional factors driving privatization (Qian & Roland, 1998; Cao, Qian, & Weingast, 1999; Li, Li, & Zhang, 2000), or amount to little more than a collection of loosely knitted hypotheses (Garnault et al, 2005; Guo & Yao, 2005).

Specifically, Qian & Roland (1998), Cao et al (1999), and Li et al (2000) address the question by means of the following reasoning: first, the fiscal and monetary recentralization in the 1990s contributed to the significant hardening of budget constraints on local governments, which means that they now have to assume the primary responsibility for local economies, in correspondence with their control of independent revenue sources granted by the 1980s decentralization. Second, the intensification of cross-regional competition in product markets is the driving force behind local governments privatizing their enterprises to supply more incentives to managers and to improve the enterprises’ competitiveness, which in turn increase their fiscal revenue. These arguments do touch upon the fundamental contributing forces that trigger the Chinese-style privatization, but as will be shown below, the combination of fiscal reform and intensified market competition itself is still not adequate to nurture the appropriate conducive institutional environment for privatization. More crucially, none of them explicitly analyze the cadre management system during the reform era and the private benefits the local bureaucrats can capture from the state and privatized firms, which can play a critical part in their decision-making.