Competition, Policy Burdens, and State-Owned Enterprise Reform, by Lin, Justin Yifu; Cai, Fang and Li, Zhou, The American Economic Review 1998

Started in late 1978, reform of state-owned enterprises (SOE’s) is a long lasting cause in China. In the paper Competition,Policy Burdens, and State-Owned Enterprise Reform (AER P&P, 1998,681 citations), Lin, Cai and Li argue that the key for successful SOE reforms is to create enough a sufficient level of market competition and remove the policy burdens. In a less competitive world, the separation of ownership and controls makes managers’ incentives incompatible with those of the state. Various state-imposed policy burdens are often criticized to give a chance for soft-budget constraints.

In 1996, SOE’s employed 57.4 percent of urban workers and possessed 52.2 percent of total investment in industrial fixed assets. However, over 40 percent of SOE’s are losing money. By definition, SOE’s are owned by the state. However, the state needs to delegate their control rights to the enterprises’ managers. The separation of ownership and control is a common feature of any large modern corporation. Agency problems, such as the moral hazard, private information and managerial slacks will arise. To overcome the agency problems, at least in theory, the owners could monitor managers’ actions and base rewards on managerial efforts (Armen A. Alchian and Harrod Demsetz, 1972). In practice, complete monitoring is almost impossible and hardly incentive compatible. The cost could be prohibitively high. Free-rider problem in large corporations make no right incentives for any individual or a group of individuals (institutional investor) to monitor managers intensively.

The Soviet-type remedy for agency problems is to deprive managers of their autonomy. The state provided all inputs to SOE's for their production 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. Irrational it may appear, ambitions to mobilize a large sum of funds for heavy-industry projects in less-developed, capital-scarce economy are the endogenous root. Although it did succeed in building a few priority industries, the Soviet-type economy lacks of technical and allocation efficiency (Lin et al., 1996). Agency problems are not solved, but hidden away. Some problems, such as on-the-job consumption, looting, and other wrongdoings were not serious in SOEs because of the absence of managerial autonomy. Still, managers have no means to motivate the workers and no incentives to improve their operations.

There is another possibility to mitigate the agency problems: market competition. 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). The owners can design a managerial-compensation scheme that is either directly based on the rank of the firm’s performance in the industry (Holmstrom, 1982) or indirectly uses a firm’s past performance in a competitive market as signals about the managers’ talent and behavior (Eugene F. Fama, 1980).

Not studying the theory, but rather learning from reality, the Chinese government initiated a series of incremental, gradual reforms in 1979 that eventually resulted in a transition to a market economy. Initially, the Chinese government allowed the SOE’s to share part of the performance improvement by giving part (12 percent) of the increased profits or reduced losses to the enterprises. The SOE’s could use the retained income for paying bonuses to workers, supporting welfare programs, and investing in capacity expansions. Gradually, the SOE’s were asked to deliver predetermined amounts of revenue to the state and retained the residuals. Later, modern corporate system was introduced. The state was entitled to the dividend on its shares in the SOE assets. An unexpected effect of the above reforms was the entry and rapid growth of nonstate enterprises, especially the township and village enterprises (TVE’s) who benefited from release of previously strict limited access to key raw materials, equipment and markets and a new stream of surpluses generated by themselves in the reform for future investments. Nonstate enterprises faced hard budget constraints and they would not survive if their performance were poor. Sizable and health nonstate sector exerted a heavy pressure on the SOE’s and triggered the state’s policy of deepening the SOE managerial reforms.

However, competition itself is not sufficient for improving SOE’s efficiency. In fact, we observe that agency problems in SOE’s were worsened after the reforms. Another crucial condition for modern theory of firm (Fama 1980, Holmstrom 1982) to work is that firms face common uncertainties. However, this is not the case with SOE’s in China and other transitional economies. They bear a number of idiosyncratic policy burdens resulting from i) insufficient comparative advantages in capital-intensive industries, ii) retirement pensions, other social-welfare costs, and redundant workers and iii) suppression in prices of outputs that serves for “livelihood projects” such as energy and transportation. In theory, the state should be responsible only for the SOE losses due to policy burdens. However, because of the information-asymmetry problem, it is very hard for the state to distinguish between the policy-induced losses and SOE’s own operational losses. This gives rise to the so-called soft budget constraint problem. The state will account for losses due to managerial discretion as well as policy burdens. This in turn worsens the agency problems and invites more political interventions and policy burdens. As long as the policy burdens remain, the soft budget constraints will persist.

Whether state ownership or private ownership is more efficient cannot be determined a priori. More important is to have fair rules (competitive market) and a level play field (remove policy burdens) for enterprises. After all, as the paper concludes,

Fundamentally, for any large modern corporation, as pointed out by Fama (1980), there are no owners in any meaningful sense.

Referees

Alchian, Armen A. and Demsetz, Harold. "Production, Information Costs, and Economic Organization." American Economic Re view, December 1972, 62(5), pp. 777-95.

Fama, Eugene F. "Agency Problems and the Theory of the Firm." Journal of Political Economy, April 1980,88(2), pp. 288-307.

 Hart, Oliver D. "The Market Mechanism as an Incentive Scheme." Bell Journal of Economics, Autumn 1983, 14(2), pp. 366-82.

Holmstrom, Bengt. "Moral Hazard in Teams." Bell Journal of Economics, Autunm 1982, 13(2), pp. 324-40.

Lin, Justin Yifu; Cai, Fang and Li, Zhou. “Competition, Policy Burdens, and State-Owned Enterprise Reform.” The American Economic Review,Vol. 88, No. 2, Papers and Proceedings of the Hundred and Tenth Annual Meeting of the American Economic Association (May, 1998), pp. 422-427.

Lin, Justin Yifu; Cai, Fang and Li, Zhou. The China miracle: Development strategy and economic reform. Hong Kong: Chinese University Press, 1996.