Skip to main content

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.


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.


Popular posts from this blog

Shadow Banking in China (Chen, Ren and Zha 2018 AER)

Shadow Banking in China receives rising attention from both the press and the academia. In  The Nexus of Monetary Policy and Shadow Banking in China  (2018 AERNBER WP23377NBER WP21890), Chen, Ren and Zha discuss the interplay between China's quantity-based monetary policy and commercial banks' reaction in terms of shadow banking activity. In this blog, I highlight their theory and  findings on shadow banking in China.

One feature in China's banking system is an institutional division of state and nonstate commercial banks. State banks are state owned and the remaining commercial banks, as a whole represent almost half the size of the entire banking system, are nonstate banks. State banks adhere to the government's own policy against actively bringing shadow banking products into their balance sheet. This is not true of nonstate banks, however. As found in the paper, nonstate banks take advantage of regulatory arbitrage by bringing shadow banking products into a sp…

Dividends and expropriation, Faccio, Lang, and Young (2001 AER)

The failures in East Asian corporate governance are blamed for the East Asian financial crisis.  In East Asia, the predominant form of ownership is control by a family, termed as "crony capitalism", and the top managers are often from the family. In Faccio, Lang, and Young (2001 AER, citation 1861), they document ownership and control structures among East Asian corporations and analyze the salient agency problem, namely the expropriation of outside shareholders by controlling shareholders, by looking at dividend behavior.

To start with, they show an extraordinary concentration of control in East Asia, whereby 6 groups control more than 20% of the corporations in the 9 most advanced East Asian economies. This control is obscured behind layers of corporations, hence insulated against the forces of competition on less-then-transparent capital markets. However, family control is also predominant in West Europe, though the group sizes are smaller, with 5 groups control about 10%…

China’s Gradualistic Economic Approach and Financial Markets (Brunnermeier, Sockin, Xiong, AER P&P, 2017)

"A key approach successfully employed by China to reform its economy in the past 30 years is the so-called "crossing the river by touching the stones" approach, a gradualistic method that optimizes policy through experimentation. The government will start with an initial (usually small) policy change, and gradually modify the policy based on the reaction from the economy to this change." BUT, "Can China continue to use its gradualistic approach in the presence of active financial markets?"

In Brunnermeier, Sockin, Xiong, (AER P&P, 2017), they provide the theoretical rationale for potential ineffectiveness of gradualistic policy approach with the existence of an active financial market. In align with the well-known time-inconsistency problem (Kydland and Prescott (1977) and Barro and Gordon (1983) ), incentives of front-run by private agents in expectation of ex post non commitment of the policymaker renders the gradualistic approach ineffective. 

The po…