Determinants of the Re-partitioning of Property Rights between the Government and State Enterprises

Abstract

In moving toward a more market-oriented system, how did China's government and state enterprises partition control rights, incentives, and financial arrangements? In 1980, China's government owned and controlled its state enterprises, which were managed (inefficiently) by bureaucrats. During the 1980s, the government experimented with decentralizing state enterprises to boost productivity. By decade's end, China's state enterprises had become more market-oriented, and the structure of enterprise property rights had changed dramatically. One factor in the move toward a more market-oriented system was the use of performance contracts with incentive components to govern state enterprises. Xu examines how China's government and state enterprises partitioned property rights - how the government and enterprises decided about incentives, financial arrangements, and control rights. Xu assumes that the government is risk-neutral and the enterprise manager is risk-averse; that the government's goal is to increase revenue (or profitability), to retain maximum control of the firms, and to reduce the inequality of income across firms (by bailing out firms in financial trouble and collective heavier taxes on high-performing firms). The enterprise manager and employees, on the other hand, have an informational advantage over the government that allows them to earn a rent; that advantage leads to suboptimal efforts. Among Xu's findings: The government, in striving for equality, rewards inefficient firms while penalizing efficient ones (the so-called ratchet effect). Efficient firms are unwilling to reveal their true efficiency. They pretend to be inefficient by slacking, so they can get more transfers. There are inherent conflicts between two of the government's goals: Profitability and equality. And the government's desire to control state enterprises prevents many of them from becoming decentralized and improving their productivity. Capital-intensive firms depend more on bank loans and less on retained profits, probably reflecting both their greater need for capital and the banks' role in allocating investment funds. Larger firms rely more heavily on the government for investment, their managers have more autonomy, yet the firms are easier to control (it's easier to monitor 100 employees in one firm than to monitor one employee each in 100 firms). This paper - a product of the Finance and Private Sector Development Division, Policy Research Department - is part of a larger effort in the department to understand state-owned enterprise reforms and government behavior.