To understand the issues with privatization in China, it is worth noting that privatization is not simply the transfer of ownership from the state to individuals, but rather the very process by which the system of private property is introduced into a society.[1] Any state that undertakes a transition to a market-based economy must therefore answer fundamental questions about the ownership, valuation, and sale of state-owned assets.[2] With respect to ownership, the bundle of rights encompassed by state-owned asset (SOA) and state-owned entity (SOE) ownership requires definition, the assets subject to that definition must be identified and allocated, and those to whom the right will be allocated must also be identified. (Or even created, as in the case of legal entities.)[3] Valuations involve debates over pricing or auction methods, the formation of institutions capable of conducting such assessments, and the institution of measures designed to prevent corruption through practices like asset-stripping and kick-backs.[4] States must also provide the means to sell state-owned property and develop politically palatable criteria with which to identify and select potential buyers.[5] In other words, “privatization for transitional economies requires not only the restructuring of the economy but also the creation of private property and the institutions of a market economy, while ensuring a maximization of economic growth and a minimization of social, economic, and political disorder.”[6]
With respect to ownership, transition economies serve as an ideal environment in which to test the Coase theorem, which suggests that economic prosperity largely depends upon the definition and enforcement of property rights.[7]
The two essential elements of property rights are (1) the exclusive right of individuals to use their resources as they see fit as long as they do not violate someone else’s rights and (2) the ability of individuals to transfer or exchange those rights on a voluntary basis. The extent to which those elements are honored and enforced will determine how effectively prices in an economy will allocate goods and services.[8]Notably, of the nine institutional variables that explain over 80 percent of the international variation in per-capita gross national income, two are most significant: property rights and black market activity.[9]
This is not to discount the importance of transition mechanisms. Without an institutional framework in place to dispose of state-owned property with low transaction costs, the initial allocation of state-owned property and the fluidity of secondary markets can undermine the overall social welfare gains to be had from privatization.[10] Many Eastern European nations used a complicated voucher scheme in which private citizens and investment institutions could trade pseudo-stocks tied to the value of SOEs given legal personality by the state.[11] With one notable exception (that being Hungary), these transition mechanisms generally suffered from high transaction costs and other inefficiencies tied mostly to the sheer number of entities sold via the vouchers, the lack of efficient information, and the difficulties of organizing the system.[12] For this reason, many states rely upon auction mechanisms to both value and dispose of state-owned property[13]
Auctions determine the price of entities or assets based upon three primary variables: company performance and industry parameters, the auction process and its requirements, and the restructuring efforts required before an auction can proceed.[14] Company performance can include anything from pure financial metrics to the nature of contracts between the SOE and the state government, the level of privatization within a domestic economy, and the continued level of government control.[15] The process itself can influence values in the sense that the state can change prices by altering the process itself, packaging the SOEs in a particular way for sales, adjusting macroeconomic policies, protracting the auction process itself, allowing for competitive bidding, restricting foreign participation, imposing onerous bidding qualifications, or even simply by restricting auctions to buyers only willing to pay in cash.[16] Finally, pre-auction restructuring efforts likewise influence values because they often require management changes, layoffs, debt absorption, efficiency improvement programs, investment measures, or even reducing the amount of capital placed in the organization prior to a sale.[17] Notably, one of the key determinants in prices paid for state-owned property is the presence or absence of a labor union and the relationship between its employees and the management of the target.[18]
Perhaps this reflects the fact that any transition economy must balance between the social cost of transition and pure economic efficiencies.[19] If an SOE remains under government control, that control offsets the social costs otherwise incurred when a private holding company acquires the same asset.[20] Yet continued government control also allows the central authority to continue subsidizing underperforming businesses with the profits of more successful entities under the state umbrella, or to avoid liquidating businesses that would otherwise enter into bankruptcy, thereby delaying the adjustment process.[21] Government involvement is beneficial, however, in the event of unforeseen problems, but continued government involvement also undermines incentives to control costs.[22]
Indeed, aligning incentives is yet another core challenge in transition economies because managers of SOEs and the bureaucrats that regulate them face powerful conflicting considerations.[23] For SOEs and SOAs subject to divestment, agents in a position to monopolize insider information can trade upon that knowledge for their own benefit or that of their associates seeking to acquire state property.[24] For SOEs managed as a going concern, states hoping to modify agent behavior through stock options and bonuses must rely upon sub-standard accounting mechanisms to set values for their incentive compensation efforts or the fact that regulatory restrictions on a company’s stock may prevent them from being subject to option grants.[25] Government bureaucrats, however, represent the biggest challenge for states seeking to re-align incentives in that officials receive a fixed salary, do not face the threat of bankruptcy, and often use their offices as a platform for politically corrupt behavior, particularly when placed in a position of trust with respect to state-owned assets and compensated below rates available in the non-government sector. Indeed,
Among the fruits of office is the ability. . .to siphon off a certain portion and secrete ill-gotten gains abroad. Another is the ability to negotiate the entry of multi-national corporations whose voracious appetite for new business enables public officials to demand and receive personal favours [sic] in the form of monopoly dealerships, kickbacks and influence-peddling. Even prolonged peace may induce corruption by lulling people into egotistical pursuits which loosen social bonds.[26]Overall, then, it is almost impossible to align perfectly the incentives of managers and bureaucrats with the goal of social welfare maximization.[27]
The Chinese government largely side-stepped many of the issues with privatization by focusing on the creation of a vibrant non-public sector.[28] Rather than going through the same steps as its Eastern European cousins, China avoided the issues of ownership and valuation, instead using dispositions in order to create a non-government sector and forestall the social cost of transition.[29] Even so, SOEs are the Achilles heel of China’s economy, in that even some of the largest central-level SOEs continue to incur losses.[30]
The reason is that the manager knows that his firm is less likely to go bankrupt under government control. If his firm fails, the government will try to rescue the firm in order to avoid the social costs of liquidation. Thus the manager faces a soft budget constraint, and he will not carry through a painful restructuring of his firm or spend enough effort to modernize the production process because he rationally anticipates that the government will bail him out in case he fails.[31]Today, China’s private sector cross-subsidizes SOEs when private citizens deposit their savings into the big four state-run banks and those state banks use that savings to re-finance loss-leading SOEs, or when private citizens use their savings to purchase shares of SOEs in initial public offerings.[32] The SOEs, for their part, have resisted attempts by the State Asset Supervision and Administration Commission (SASAC) to force them into declaring dividends to the central government, despite five years of unprecedented profitability. China has therefore rightly attempted to revitalize and restructure its non-financial state-owned businesses in order to eliminate the incentive and performance problems of its SOEs and the political appointees who manage them.[33]
In doing so, however, China has put off required institutional reforms both within the SOEs themselves and the government organs responsible for SOE oversight. Within the SOEs, China has struggled to align management incentives with those of the State, in part because of inefficient accounting mechanisms, the inability to use stock options as an incentive mechanism in a declining market, the continuing use of price controls, and the fact that China does not fully extend its bankruptcy laws to SOEs. Agency problems existing both within and without the SOEs in that companies remain subject to de facto by the state in the form of overly decentralized approvals, “supervision,” and vertical and horizontal lines of authority.[34] These problems are better explained, however, with reference to the SOE regulatory environment, which I will explain in part 3.
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[1]. See Roman Frydman & Andrzej Rapaczynski, Privatization in Eastern Europe 10 (1994).
[2]. See E.S. Savas, Privatization in Post-Socialist Countries, 52 Pub. Admin. Rev. 573, 576 (1992).
[3]. Savas, at 577. Notably, while some States must consider questions of whether to pay restitution towards prior owners of nationalized property, the stratification of Chinese society in the Imperial period and the subsequent upheaval of the Cultural Revolution largely obviated this concern.
[4]. Savas, at 578. The term “asset stripping” refers to the practice in which government officials charged with the privatization of state-owned entities and assets seek lower compensation in sales for those assets in return for bribes and other compensation.
[5]. Savas, at 578.
[6]. Lan Cao, Chinese Privatization: Between Plan and Market, 63 L. & Contemporary. Problems 13, 18 (2000).
[7]. See Gerald P. O’Driscoll Jr. & Lee Hoskins, Property Rights The Key to Economic Development 1 (Cato Inst. Pol’y Anal. No. 482), http://www.cato.org/pubs/pas/pa482.pdf.
[8]. Id. at 8.
[9]. Id. at 3 (The other variables are regulation, inflation, civil liberties, political rights, press freedom, government expenditures, and trade barriers).
[10]. Cao, at 22.
[11]. Klaus M. Schmidt & Monika Schnitzer, Privatization and Management Incentives in the Transition Period in Eastern Europe, 17 J. Comp. Econ. 264, 269 (1993).
[12]. Id.
[13]. Florencio López-de-Silanes, Determinants of Privatization Prices, 62 Quarterly J. Econ. 965 (1997).
[14]. Id.
[15]. See id. at 969.
[16]. See id. at 970 tbl. 1.
[17]. See id.
[18]. See id.
[19]. Schmidt & Schnitzer, at 267-68.
[20]. Id. at 266.
[21]. Id.
[22]. Id.
[23]. Zsuzsanna Fluck, et al., Privatization as an Agency Problem: Auctions Versus Private Negotiations, 31 J. Banking & Fin. 2730, 2732 (2007).
[24]. Id.
[25]. Schmidt & Schnitzer, at 272-73.
[26]. Gerald E. Caiden, Toward a General Theory of Official Corruption, 10 Asian J. of Pub. Admin. 3, 11 (1988).
[27]. Schmidt & Schnitzer, at 282.
[28]. Cao at 23.
[29]. Id. at 26.
[30]. Harry G. Broadman, The Business(es) of the Chinese State, World Econ. (2001), at 1; Jing Ulrich, Dividends from China’s State-owned Enterprises, Fin. Times, Jan. 21, 2008.
[31]. Schmidt & Schnitzer, supra note 18, at 266.
[32]. Cao at 16.
[33]. Geoff Dyer & Richard McGregor, China’s champions: Why state ownership is no longer proving a dead hand, Fin. Times, Mar. 16, 2008.
[34]. Cao at 37.
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