Competition, Policy Burdens, and State-Owned Enterprise Reform

Author(s): Justin Yifu Lin, Fang Cai and Zhou Li

Source: The American Economic Review , May, 1998, Vol. 88, No. 2, Papers and
Proceedings of the Hundred and Tenth Annual Meeting of the American Economic
Association (May, 1998), pp. 422-427
Published by: American Economic Association

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 CHINA'S ECONOMIC REFORMS: SOME UNFINISHED BUSINESSt
Competition, Policy Burdens,
and State-Owned Enterprise Reform
By JUSTIN YIFU LIN, FANG CAI, AND ZHOU Li *
One of the most important remaining issues
in China's transition to a market economy
is the reform of state-owned enterprises
(SOE's). When reforms started in late 1978,
SOE's dominated China's industrial sectors in
every aspect. After 18 years of gradual tran-
sition, the SOE share in China's total industrial
output has declined from 77.6 percent in 1978
to 28.8 percent in 1996. However, in 1996
SOE's still employed 57.4 percent of urban
workers and possessed 52.2 percent of total
investment in industrial fixed assets. Improv-
ing SOE performance is crucial for social
stability and sustained growth in China. How-
ever, over 40 percent of SOE's are losing
money. In this paper, we will argue that the
root of the SOE problem is the separation of
ownership and control and that the often-
criticized soft-budget constraints arise from
various state-imposed policy burdens, which
make the state accountable for the poor per-
fornance of SOE's. The key for a successful
SOE reform is to remove the policy burdens
and to create a level playing field so that mar-
ket competition can provide sufficient infor-
mation for the managerial performance of the
SOE's and make the managers' incentives
compatible with those of the state)'
t Discussants: Bary Naughton, University of California-
San Diego; Loren L. Brandt, Jr., University of Toronto.
* Lin: China Center for Economic Research, Peking
University, Beijing, 100871, China, and Department of
Economics, Hong Kong University of Science and Tech-
nology, Hong Kong; Fang Cai and Zhou Li: Chinese
Academy of Social Sciences, Beijing 100732. China.
' In this paper we limit our discussions to the reform
of large-scale SOE's, which consisted of 5.6 percent of
SOE's in terms of number of enterprises in 1996 but con-
tributed to 63.3 percent of the gross output value of SOE's
in the same year. For the medium- and small-scale SOE's,
lease, privatization, or bankruptcy are appropriate reform
programs.
422
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Io Competition and the Performance of Large
Corporation in a Market Economy
Although, by definition, the state owns the
SOE's, the state cannot operate them by itself
and needs to delegate their control to the en-
terprises' managers. The separation of own-
ership and control is a common feature of any
large modem corporation. Due to this separa-
tion, the issues of incentive incompatibility
and information asymmetry often arise be-
tween the managers and the owners. Agency
problems, such as the moral hazard and man-
agerial slacks and discretion, may surface. The
success of any large modem corporate insti-
tution depends on its ability to overcome these
problems. Intuitively, one possible way out for
the owners is to oversee the managers' actions
directly and to reward the managers according
to their managerial efforts (Armen A. Alchian
and Harrod Demsetz, 1972). In practice, total
observation of managerial actions in a large
modern corporation is either impossible or
prohibitively costly. Moreover, the owners of
a large modem corporation are numerous. Due
to the free-rider problem, any individual
owner of a firm will not have the incentive to
oversee the detailed activities of the firm. The
large modem corporation does not have own-
ers in the same sense as in the property-rights
literature.2
The prevalence of large modem corpora-
tions in the market economy indicates that
some institutional arrangements to mitigate the
agency problems must exist. The recent liter-
2 An institutional investor may own a large share of a
firm. However, the institutional investor is also an agent
who may not have the right incentives to monitor the man-
agers. The owners of the institution's funds may not have
incentives to monitor the institutional investor either.
 VOL 88 NO. 2 CHINA'S
ature suggests that market competition is such
an arrangement. Some summary indicators in
a competitive market, such as relative profits
of firms in the market, provide a sufficient-
statistic condition for evaluating managers'
performance (Bengt Holmstrom, 1982). With
the sufficient statistic, incentive compatibility
between the owners and the managers can be
achieved in two ways: directly, the owners can
design a managerial-compensation scheme
that is based on the comparison of the firm's
performance with the industrial average or on
the rank of the firm's performance in the in-
dustry (Holmstrom, 1982); indirectly, a firm's
performance in a competitive market provides
a signal to the managerial labor market about
the manager's talent and behavior, and the sig-
nal determines the manager's future wages
(Eugene F. Fama, 1980).3
II. Endogeneity of the SOE Management
Institution in a Soviet-Type Economy
A salient feature of traditional SOE's in the
Chinese economy and other Soviet-type econ-
omies was their lack of autonomy. The state
provided all inputs to SOE's for their produc-
tion according to central plans and covered all
their costs. In turn, the SOE's delivered to the
state all outputs and revenues. The state set the
wage rates of the SOE workers and managers.
All activities of the SOE's required the state's
approvals. Such a seemingly irrational ar-
rangement in effect was an endogenous re-
sponse to the agency problems in a traditional
Soviet-type economy.
The Soviet-type economy is known for its
maximal mobilization of resources for the es-
tablishment of capital-intensive heavy indus-
tries. These heavy-industry projects had three
characteristics: (i) they required a long ges-
tation; (ii) for a less-developed country, most
equipment for the projects needed to be im-
3 If only the firm's performance itself (but not the per-
formance of other firms in the market) is observable, com-
petition may also mitigate the agency problems by the
threat of liquidation (Klaus M. Schmidt, 1997) and re-
duction in the firm's profits which reduce the room for
managerial discretion (Oliver D. Hart, 1983), although
the optimal-contracting literature suggests that these ef-
fects are not very robust.
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ECONOMIC REFORMS 423
ported from developed countries; and (iii)
each project required a large lump-sum in-
vestment. However, the Soviet-type econo-
mies were built in low-income agrarian
countries which also had three characteristics:
(i) capital was scarce and the market-
determined interest was high; (ii) exportable
goods were limited, and the market-
determined price for foreign exchange was
expensive; and (iii) funds for large projects
were hard to mobilize because economic sur-
plus was small and scattered. For the purpose
of reducing the costs and mobilizing funds for
the heavy-industry projects, the Soviet-type
economy formed a distorted macroeconomic-
policy environment in which interest rates,
foreign-exchange rates, wage rates, and prices
for raw materials and other products were ar-
tificially suppressed (Lin et al., 1996).
The above macroeconomic-policy distor-
tions induced a total imbalance in the supply
and demand for credits, foreign exchanges,
raw materials, and other products. Because
nonpriority sectors were competing with pri-
ority sectors for the low-priced resources, the
state needed to have a plan that indicated pri-
orities for each project and then used admin-
istrative measures to allocate the resources
accordingly to guarantee that the scarce re-
sources would be allocated according to the
state's strategic goal. In that way, market com-
petition was suppressed.
Under such a macroeconomic-policy envi-
ronment and resource-allocation system,
agency problems would be a serious threat to
the state's goal of maximally mobilizing re-
sources for its priority projects. The replace-
ment of market competition by planned
allocation removed the possibility for the state
to rely on the observation of relative perform-
ances to evaluate the SOE managers. Further-
more, because of the distortions in the
macroeconomic-policy environment, the prof-
itability of an SOE was determined mostly by
its output and input prices. The influence of
managers' actions on the profitability of an
SOE was only secondary. Therefore, it was
also impossible for the state to discipline the
managers by simply observing the firm's profit
level alone. Moreover, an incentive contract
based on the comparison between current and
past performances would not solve the agency
424 AEA PAPERS AND
problems because of the ratchet effect (Martin
L. Weitzman, 1980) and also because the state
often failed to deliver materials on time or in
the quantity and quality required, so that man-
agers could blame the state for their failures.
Furthermore, it was impossible or prohibi-
tively costly for the state to oversee the
managers' actions directly. Under such a cir-
cumstance, if the state had granted business
autonomy to the managers, the managers of a
policy-determined profitable SOE could have
a lot of shirking and on-the-job consumption
because the state could observe neither their
wrongdoings directly nor the firm's ought-to-
be profits indirectly. For a policy-determined
loss-making SOE, similar agency problems
would arise because the state could observe
neither the managers' discretion nor the firm's
ought-to-be losses. One of the purposes of in-
stituting price distortions in the Soviet-type
economy was to maximally mobilize resources
for priority projects. To prevent the policy-
created economic surplus from being dis-
sipated by managerial discretion, it was
imperative for the state to deprive managers of
their autonomy and to make the SOE's like
puppets in the economic system. The fact that,
before the recent reforms, the state always had
to recentralize the management in order to
control walloping increases in wages after
each of the state's attempts to increase the au-
tonomy of SOE's in China and other Soviet-
type economies testifies to the above analysis.
III. The Effects of SOE Reform in China
The Soviet-type economy was very good at
mobilizing resources for building a few pri-
ority sectors. However, the economy was very
inefficient due to two reasons: (i) low alloca-
tive efficiency because of the deviation of the
industrial structure from the pattern dictated
by the comparative advantages of the econ-
omy; and (ii) low technical efficiency because
the managers had no means to motivate the
workers and no incentives to improve their op-
erations (Lin et al., 1996).
To improve economic efficiency, the Chi-
nese government initiated a series of in-
cremental, gradual reforms in 1979 that
eventually resulted in a transition to a market
economy. In the process, the reforms in the
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PROCEEDINGS MAY 1998
management systems led the reforms in the
resource-allocation systems, which in turn led
the reforms in the macroeconomic-policy en-
vironment. Specifically, the Chinese govern-
ment first allowed the SOE's to share part of
the performance improvement by a profit-
retention program, which initially gave 12 per-
cent of the increased profits or reduced losses
to the enterprises. The SOE's could use the
retained income for paying bonuses to work-
ers, supporting welfare programs, and invest-
ing in capacity expansions. The managerial
autonomy was gradually deepened through the
replacement of the profit-retention system by
a contract-responsibility system in which
the SOE's agreed to deliver predetermined
amounts of revenue to the state and retained
the residuals, and later the replacement of the
contract-responsibility system by the modem
corporate system in which the state was enti-
tled to the dividend on its shares in the SOE
assets. Parallel to the SOE managerial reform
was the decollectivization of agriculture,
which replaced the production-team system
with the household-responsibility system.
Meanwhile, a dual-track system was intro-
duced to reform the resource-allocation sys-
tem. After fulfilling the compulsory delivery
obligations, the SOE's were allowed to sell
their above-quota outputs to the markets at
market-determined prices. The enterprises
were also permitted to purchase inputs from
the markets to increase production or to ex-
pand production capacity.
An unexpected effect of the above reforms
was the entry and rapid growth of nonstate en-
terprises, especially the township and village
enterprises (TVE's). Rural industry already
existed before the reform as a result of the gov-
ernment's 1971 policy to develop rural pro-
cessing industries in order to finance the
agricultural mechanization program. How-
ever, being outside the state plans, the growth
of TVE's was severely constrained by their
lack of access to capital, raw materials, equip-
ment, and markets. The reforms created two
favorable conditions for the rapid expansion
of TVE's: (i) a new stream of surpluses
were brought about by the household-
responsibility-system reform and were re-
tained in rural areas, providing a resource base
for new investinent initiatives (Lin, 1992);
VOL. 88 NO. 2 CHINA'S
(ii) the dual-track system provided nonstate
enterprises with access to key raw materials,
equipment, and markets. In 1978, the output
of TVE's accounted for 7.2 percent of the total
value of industrial output in China. The output
share of TVE's increased to 31.1 percent in
1996.
Being outsiders to the traditional system,
nonstate enterprises had to obtain credits and
inputs from competitive markets, and in turn,
their products were sold to markets. They
faced hard budget constraints, and they would
not survive if their performances were poor.
SOE's in China and other transitional econo-
The dynamism of nonstate enterprises exerted
a heavy pressure on the SOE's and triggered
the state's policy of deepening the SOE man-
agerial reforms. Firm-level studies show that
the increase in managerial autonomy and the
intensification of competition have signifi-
cantly improved the managerial incentives and
total factor productivity of SOE's (Wei Li,
1997).
When the reform started in 1979, most
SOE's were profitable. Taxes and revenues
from SOE's were the government's main
sources of fiscal income. However, in spite of
the significant increase in productivity, the
profitability of the SOE's has declined sub-
stantially since the reforms started. Currently,
evidence shows that more than 40 percent of
SOE's are operating at losses in spite of large
amounts of implicit subsidies from low-
interest loans and other policy protections. The
decline of the profitability of SOE's is partly
attributable to the dissipation of their monop-
oly rent. However, the walloping increases in
wages and other fringe benefits are other im-
portant reasons. The average annual growth
rate of the SOE wage fund in the state sector
was 16 percent during 1978-1996, while the
average annual growth rate of output in the
same period was 7.6 percent.
IV. Policy Burdens and Soft-Budget Constraints
Before the reforms, except for shirking,
agency problems such as on-the-job consump-
tion, looting, and other wrongdoings were not
serious in SOE's because of the absence of
managerial autonomy. The analysis in Section
II suggests that the increase of competition in
a market economy should have eliminated or
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ECONOMIC REFORMS 425
at least mitigated these agency problems.
However, agency problems in SOE's have
worsened after the reforms in spite of the in-
tensification of competition. What are the
reasons?
From the literature, we know that the ob-
servation of some summary indicators, such as
relative profits, will be a sufficient statistic of
managers' actions if firms face only common
uncertainties (i.e., do not have any idiosyn-
cratic shocks in input costs, output prices, or
production process) (Holmstrom, 1982).
However, this condition does not hold for the
mies. As legacies of prereform policies, the
SOE's encounter a number of idiosyncratic
burdens, including the following:
(i) The capital intensity of many large
SOE's is too high, judging from the
capital-scarcity nature of the Chinese
economy. They cannot survive if they
have to pay market-determined interest
rates and face market competition, es-
pecially competition from the capital-
abundant economies. Before the reforms,
both their investments and working cap-
ital came from interest-free fiscal appro-
priations. They were also shielded from
international competition. After the re-
form, the government replaced the fiscal
appropriations with interest-bearing
loans, and the protections were also grad-
ually eliminated. In a capital-scarce
economy, the capital-intensive enter-
prises industries are not competitive by
nature. However, the state views the
capital-intensive industries as strategi-
cally important and the SOE' s are
instructed to operate in those industries.
(ii) The SOE's bear a heavy burden from re-
tirement pensions, other social-welfare
costs, and redundant workers. Before
the reforms, the state adopted a low-
nominal-wage policy. The wage was
only enough to cover an employee' s cur-
rent consumption. The SOE's were re-
sponsible for their ernployees' retirement
pensions, housing, medical cares, and
other needs. Before the reform, this pol-
icy did not pose any extra burden on the
SOE's, because the state covered all the
426 AEA PAPERS AND
SOE expenditures by fiscal appropria-
tion. However, after the managerial
reform, the SOE's have had to be re-
sponsible for the wages and social
welfare of not only the incumbent em-
ployees, but also their retired workers.
The older an SOE is, the more retired
workers it has, and the heavier the bur-
den from retired workers' pensions and
social-welfare expenditures it carries. In
a similar vein, the heavy-industry-
oriented development strategy before the
reforms did not create enough job op-
portunities for urban residents. SOE's
were thus forced to employ many redun-
dant workers. In the interest of social sta-
bility, the SOE's are not allowed to lay
off the redundant workers.
(iii) Some SOE output prices are still dis-
torted. Before the reforms, the prices of
energy, raw materials, and other products
or services, which were considered as in-
puts to the heavy-industry projects, were
artificially suppressed. After 18 years of
reform, most prices have been liberal-
ized. However, the prices of energy,
transportation, and a few other pro-
ducts are still kept below the market-
equilibrium level. These prices often
cannot cover production costs.
The above policy-determined burdens put
the SOE's in a disadvantaged position in. com-
peting with nonstate enterprises. Because each
SOE was established at a different time, has
somewhat different technology and capital in-
tensity, and has a different number of retired
as well as redundant workers, the impact of
the above policy burdens on the competitive-
ness of SOE's is idiosyncratic. Therefore,
competition among the SOE's or between the
SOE's and nonstate enterprises cannot serve
as a device to extract information optimally.
Under this circumstance, the expansion of the
managerial autonomy of SOE's will worsen
the agency problems.
In theory, the state should be responsible
only for the SOE losses that arise from the
policy burdens. However, because of the
information-asymmetry problem, it is very hard
for the state to distinguish between the policy- tracts between the state and SOE's are not enforceable and
induced losses and the own operational losses
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PROCEEDINGS MAY 1998
of SOE's. The managers of SOE's will ascribe
all their losses to the state's policies, no matter
whether the losses are due to the policy burdens
or due to their own managerial discretion. Con-
sequently, in most cases, the state in practice
has to be responsible for all the SOE losses. As
such, the budget constraints of SOE's become
soft. The soft budget constraints in turn worsen
the moral hazard, managerial slacks, on-the-job
consumption, and other agency problems. To
constrain the agency problems, the state will
have to intervene directly into the operations of
SOE's. Then there will arise a vicious cycle of
policy burdens, subsidies, agency problems,
and political interventions in the SOE manage-
ment systeM .4
V. Fair Competition and SOE Reform
The failures of 18 years of managerial re-
forms to harden the budget constraints of
SOE's and to improve their performance have
made privatization an attractive alternative to
some economists. However, as long as the pol-
icy burdens remain, even if the SOE's are pri-
vatized, the state cannot excuse itself from the
policy-induced losses, and the soft budget con-
straints will persist. The evidence after the pri-
vatization in Eastern Europe and the former
Soviet Union supports the above statement
(World Bank, 1996 p. 45). Therefore, for the
SOE reform to be effective, it is necessary to
remove the policy burdens of SOE's and to
provide them with a level playing field first.
Some Pareto-improvement measures can be
introduced to deal with each of the above pol-
icy burdens (Lin et al., 1998). Without policy
burdens, the state is no longer accountable for
failures of SOE's and can thus impose hard
budget constraints on them. Without the state's
subsidies, the SOE managers in turn can resist
unnecessary political interventions in their
4 The agency literature suggests that, without compe-
tition, it is still possible to design a second-best incentive
contract to minimize the principal's problem. However,
the literature assumes that the shocks, no matter common
or idiosyncratic, are exogenous and that the contract is
enforceable. In the case of policy burdens, the state has to
be accountable for the burdens. As such, incentive con-
will not mitigate the principal's problem.
VOL 88 NO. 2 CHINA'S
operations. Certainly, a level playing field
does not guarantee that SOE performances
will necessary be good. If an SOE fails to per-
form well, other enterprises, including those
privately owned, will have incentives to take
over, replace its managers, improve the effi-
ciency, and make profits from the takeover be-
cause, without policy burdens, an SOE should
be able to make a normal profit with a normal
management. However, whether privatization
is a necessary condition for improving the ef-
ficiency of the SOE's cannot be determined a
priori. Fundamentally, for any large modern
corporation, as pointed out by Fama (1980),
there are no owners in any meaningful sense.
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