Driving Forces in China’s Corporate Governance Evolution: Process of Change - Corporate Governance and Business Ethics

While the most advanced economies – Western Europe, the United States, and Japan have converged in economies, business practices, and living standards over the last few decades, their corporate ownership and governance remained different, and different degrees of ownership concentration and labor influence have persisted. In identifying the rationale behind the different corporate ownership and governance patterns, Bebchuk and Roe developed in 1999 a theory of the path dependence of corporate structure. They argued that a country’s pattern of ownership structures at any point in time depends partly on the patterns it had earlier. Consequently, when countries had different ownership structures at earlier points in time because of their different circumstances at the time, or even because of historical accidents these differences might persist at later points in time ven if their economies have otherwise become quite similar. (Bebchuck and Roe 1999).

Although Bebchuck and Roe have the most developed countries in their sights, in our opinion, the consistency of the state’s dominance in Chinese SOEs’ ownership structure demonstrates a clear path-dependent process as well. That is, how the Chinese SOE's were owned at the starting point affected much the way they would be owned later. Every important change which happened in Chinese SOE's’ corporate governance was carried out on the basis of the existing ownership structure and did not mean to replace it with a different model, for example, a dispersed or a bank-based ownership.

It is worth noting that Bebchuck and Roe (1999) argued in their path-dependence theory that structure- and rule-driven path dependence exists. In this article, however, we mainly take the structure-driven path, i.e., how the governance structure of SOE's has evolved, into account, as official rules (laws, regulations) on SOE reforms have typically been brought into effect to support those structural changes. For example, the Company Law was enacted after the central government decided to transform traditional SOE's into modern enterprises. Therefore, the rule driven path dependence in SOE reforms is de facto in keeping with the structure driven one.

One may argue that the SOE ownership is self-evident, for the term of state ownership already literally describes the ownership structure. This view is correct as far as the owner or block holder of SOE's is concerned. However, the term of state ownership alone conceals any significant information on the structural changes in Chinese SOE's’ governance. Neither does it reflect what differences occurred in SOE's’ ownership structure and control along the reform path, as described in the section “Governance Practices in Chinese SOE's: Content of Change”, nor does it imply the driving forces behind such changes. In the following, we highlight several historical and environmental factors during China’s transition to a market economy, which have had significant impacts on the evolvement of the SOE reforms.

Two Radical Campaigns

Two radical campaigns that had hit China’s economy very hard took place in the first three decades of the People’s Republic of China. The first one happened shortly after China’s planned economy had been established by 1957. The initial planned system followed the former Soviet model that featured concentration of authority in the central government. Yet Mao Zedong was doubtful of the validity of the Soviet style (Qian 1999). Under his leadership, China began to restructure the Soviet planning model only one year after its establishment. In 1958, the Great Leap Forward (GLF), as the radical reform was called, was initiated to realize an accelerated and infeasible industrialization. However, the unrealistic economic expansion and continuously unfavorable weather conditions led to a disastrous famine, causing millions of deaths in rural areas during 1959–1961. At the same time, China’s light industry output and national income declined annually by 2% and 3.1%, respectively (Qian 1999) due to overemphasis of heavy industry, especially steel output (Luo 2004).

The second big-bang campaign began as Mao initiated the Cultural Revolution in 1966, aiming at “a further revolution under proletarian dictatorship”. Although the national economy still grew moderately during the 10 years (1966–1976) of this mass movement, the growth was slower than in the 14 years before and the six years after it (Chen 2008), implying that the radical movement suppressed the potential of China’s economy. Big problems during the Cultural Revolution included serious imbalance of the proportions among the sectors of the national economy and of the proportions between reserves and expenses, greatly lowered economic performance, and appearance of government deficit. Also the central government admitted later that the national economy suffered huge losses during these 10 years (CPC 1981).

The Great Leap Forward and the Cultural Revolution were accompanied by two waves of administrative decentralizations, which have taken great influences on China’s transition path. Both of the two decentralization waves took place under Mao’s leadership. For Mao, centralization would offer few incentives for people’s initiatives, and he preferred decentralization of government authority to local levels (Qian 1999). Mao’s preference was not purely personal, but backed by the communists’ long-time experience in time of war (CPC 1981). In those days, the revolutionary bases of the communists had been run in separate rural areas, and mobilization of local incentives for production in each base had been the main concerns of communists (ibid).

The first wave of decentralization occurred alongside the Great Leap Forward.

Two institutional changes were made with regard to restructuring the planning system. On the one hand, the central government deputed the control over most SOE's as well as the planning authority to local governments (Qian 1999).While there had been 9,300 SOE's subordinated to the central government in 1957, there were only 1,200 in 1958 (ibid). The local government gained the authority to make most decisions on regional fixed investments, material allocation, and expenditures. On the other hand, China established numerous People’s Communes, which served as local authorities and were responsible for agricultural production, commerce, bank affairs, education, and public health in the rural areas. Within a few months after the movement initiation, 99% of the peasants were organized in about 24,000 People’s Communes, with an average size of 5,000 households. With the communes established, a large number of so-called commune and brigade enterprises were founded to expand non-agricultural activities.

The disaster caused by the Great Leap Forward forced the central government to correct its 1958 policy. In the urban areas, recentralization of the planning system began. From 1961 on, all large and medium-sized industrial enterprises were again subordinated to the central government (ibid). Between 1959 and 1965, SOE's under the control of the central government increased from 2,400 to 10,533 In rural areas, the central government carried out a more liberal policy: communes were sustained, but became a less powerful institution; production teams consisting of 40–50 households became the basic production units; peasants were allowed to cultivate small private plots, run sideline productions, and open rural free markets.

During the Cultural Revolution, a second wave of administrative decentralization began in China due to a goal of high growth in the Fourth Five Year Plan (1971– 1975) and the preparation for war. From 1970 on, the economic planning was mainly conducted on regional levels. The 1970 wave of decentralization was similar to the 1958 one, but went much further. The control over most large SOE's as well as some planning authority in material allocation and fixed investment was again delegated to the local governments. After the decentralization, the central government supervised barely 142 SOE's, down from 10,533 in 1965. The types of material allocated through the central government were reduced from 579 in 1966 to 217 in 1971. The share of within-budget fixed investment by local governments rose from 14% administrative decentralization caused disarray and some recentralization measures were taken by the central government in 1973 under the name of consolidation ( Qian 1999). Yet in comparison with 1958, the extent of 1970 decentralization was greater, whereas the recentralization afterwards was much weaker (Qian 1999).

Incremental Reforms in the Non-State Sector

After the Cultural Revolution came to an end, the reformers, who could be divided into moderate and radical groups (Guo 2004), took control of the central government. Moderate and radical reformers all agreed on the necessity of economic reforms, but disagreed on the content, scope, and pace or extent of reforms. Moderate reformers insisted on maintaining basic socialist principles (such as planned economy, public ownership, and distribution according to labor). They were cautious and skeptical about dramatic departures from the planned economy and looked on the market as a supplementary mechanism for the allocation of resources and determination of prices to help establish a planned commodity economy they favored a slow, gradual, and experimental approach to reforms, through which imbalances generated by reforms could be repaired during readjustment periods.

In contrast, radical reformers favored a much less restrictive definition of socialist principles that should exclude the planned economy and remold the principle of public ownership more flexibly, so as to promote a diversified ownership structure while maintaining the dominant position of public ownership (Harding 1987). They wished to launch a market economy and avored a rapid and comprehensive structural reform to quickly remove the inefficiencies and rigidities of the traditional planned economy (Guo 2004).

After three decades of economic transition, most of those reform ideas from radical reformers have been realized in today’s China. Interestingly, the path of China’s transition has been one that was suggested by moderate reformers. In late 1970s, the central government under Deng Xiaoping at last chose to go down a gradual reform path and to change the national economy slowly in stages. Under the dual-track system, the market track facilitated several reforms in form of regional experimentations, including agricultural contracting, establishment of non-state enterprises, and special economic zones (SEZs). Without touching the existing ownership structure under tight governmental control, these reforms were incremental to the planning system.

Agricultural Household Contract Responsibility System

Before the dual-track system covered SOE's in 1984 (see the section “Dual-Track System” above), it had started in rural areas, with rapid and comprehensive liberalization of the agricultural sector. In 1978, as the rest of the Chinese rural areas were still operating under the collective farming system, several households in the Fengyang County of the Anhui Province began to contract with the local government for delivering a fixed quota of grain in exchange for farming on a household basis. This practice was soon imitated by other counties in the province and promoted by the provincial government. In 1980, the experimentation in Anhui was promoted by the central government through the official introduction of the Agricultural Household Contracting Responsible System (CPC 1980) to replace the commune-bridge system of collective farming.

Under the Agricultural Household Contracting Responsible System, individual peasant households were allowed to lease the former commune land by signing a contract. With the contract signed, the peasant households would take the full responsibility for the piece of land allocated for their use. Although these households remained obliged to fulfill the grain quota as set by the state, they obtained residual claims and control rights over the production on their land, say, cultivating more valuable crops and selling the surplus goods on the free market. By 1984, almost all peasant households across China had adopted the contracting method.

This contracting reform in the rural areas turned out to be a huge success. During the period of 1978–1994, growth in agriculture provided the major impetus to the Chinese economy (Sachs and Woo 1997). Shortly after the launch of the reform, the national grain production grew by 8.7% in 1982 and by 9.2% in 1983 (NBSC 1982, 1983). From 1978 to 1984, the per capita real income in the rural areas increased by more than 50% (Qian 1999). In the same period, the per capita consumption doubled in real terms (Sachs and Woo 1997).

However, this growth turned out to be rather temporary. From 1985 onward, the growth in the rural areas stagnated due to (1) farmers’ uncertainty about future land use rights, (2) state procurement prices not being raised in line with the increases in input prices, and (3) large reductions in state investment in agricultural infrastructure.

Rural Enterprises

Under the dual-track system in the 1980s, a few important relaxation policies in favor of free markets and the non-state sector were adopted. For example, all the previous black markets were now legal. Regulations on the registration and supervision of non-state enterprises were less strict than before. Private enterprises were allowed to employ more than eight people, which was illegal before 1984. The governments in rural areas encouraged collectives and peasants to invest in or to pool their funds to jointly set up various kinds of enterprises. Fiscal decentralization in this period, which primarily aimed at the state sector, also provided incentives for local governments to develop non-state enterprises, since the local governments did not have to share taxes generated through the non-state sector within the planning system (Qian 1999). These measures were greatly conductive to the emergence and growth of the rural enterprises. Between 1983 and 1988, total rural enterprise output increased by more than fivefold (Qian 1999).

In non-agricultural areas, most of the impetus has been coming from so-called township and village enterprises (TVEs). From 1983 to 1984, the former People’s Communes were changed into townships, and the erstwhile commune and brigade enterprises were renamed as TVEs. They were mostly owned directly by township and village governments and collectively by members of a village, and in some cases by private persons. Local governments enthusiastically supported TVEs, because (1) previous administrative restrictions against rural enterprise entry and expansion were removed from almost all industries due to liberalization policies on rural industrialization, and (2) they themselves relied heavily on the development of rural industry as the way to generate their revenue (Qian 1999). Since their emergence, TVEs have been expanding at a remarkable rate and dominating in the non-agricultural growth. Their share in total employment in China increased from 7% in 1978, to 11% in 1984, and further to 21% in 1995 (Sachs and Woo 1997). In 1987, TVEs were allowed to take part in foreign trade. Since then, TVE exports have experienced a dramatic growth, with a share of overall exports rising from 9.2% in 1986 to more than 40% in 1996.

The governance features of TVEs are quite different from those of SOE's. For example, TVEs’ ownership and property rights are clearly defined as held by the local governments or individuals (Lin 2001). Another feature of TVEs is that they face hard budget constraints. In the late 1980s and early 1990s, the total size of the SOE industrial output was about twice that of TVEs, while loans to SOEs and TVE's accounted for about 86% and 8%, respectively (Qian 1999b). In case of a deficit, the local government cannot finance it without the approval of the central government. Since local governments are in deed involved in TVE's as owners, they logically have incentives to ensure TVE's’ efficiency and profitability by improving management (Lin 2001).

Opening-Up

The dual-track approach was also adopted to gradually open up China to the outside world and to attract foreign investment. In 1980, the central government chose four cities in the coastal areas in South China (Shenzhen, Zhuhai, Shantou, and Xiamen) to be the first four special economic zones (SEZ's). The SEZ's were export-oriented and had a special institutional environment. The local governments were granted the authority over their own economic development. They were allowed to approve foreign investment projects up to 30 million USD and to retain 70% of the increased foreign exchanges from exports. Foreign enterprises were subject to lower taxes than elsewhere in China. The SEZ's were also allowed to become market economies dominated by private ownership, while the rest of China was still under strict central planning and public ownership.

In 1984, the central government declared another fourteen coastal cities as “coastal open cities”, which began to enjoy authority similar to that of the first SEZ's. Each of these cities gained broader authorities in approving foreign investment projects and setting up development zones, where they could implement more liberal tax and foreign exchange policies for attracting foreign capital and technology. In 1988, Hainan became a separate province and was added as the largest SEZ. In 1992, five additional cities along the Yangtze River, thirteen border cities and towns, and eleven provincial capitals were granted special privileges as coastal cities.

As shown by statistical data (NBSC 1991, 1992, 1993), China’s extensive opening-up policies in early 1990s immediately boosted foreign investment and exports: Foreign direct investment (FDI) increased by 160% to 11.1 billion USD in 1992, and further by 130% to 25.8 billion USD in 1993. Registered enterprises with foreign investment expanded from 37 thousand in 1991 to 84 thousand in 1992, and further to 167.5 thousand in 1993. The value of exports in 1992 was 85.0 billion USD, up 18.2%, and that in 1993 was 91.8 billion USD, up 8%. In contrast, China’s exports in 1980, as the first SEZ's were established, merely reached 27.2 billion RMB (1 USD equalized 1.5 RMB in 1980 and 8.7 RMB in 1993). More notably, enterprises with foreign investment raised their share in exports from 16.8% in 1991 to 20.4% in 1992 and further to 27.5% in 1993.

Overall Performance of the Non-State Sector

Under the dual-track system, the total non-state sector, including household agriculture, rural industries, private enterprises, urban collective, and joint ventures, had been outperforming the state sector and changed the economy structure in China. Accordingly, the share of SOE production fell from 78% in 1978 to 69% in 1984, and further to 43% in 1993; while SOEs’ share in commerce was down from 55% in 1978 to 40% by 1993 (Sachs and Woo 1997; Qian and Wu 2000). As no SOE had been privatized by 1993, the changes of the relative weight of the state sector were solely caused by the rapid growth of the non-state sector.

Learning Process in SOE Reforms

Figure demonstrates the connections between the SOE reforms and the historical and environmental factors, i.e., the knowledge and experiences that the Chinese government gained before and during the transition has mainly backed its choice of the reform path for SOE's. The boxes marked with PRC (for the People’s Republic of China) over the time axis symbolize the path dependence of China’s SOE reforms at different stages since 1949 (see the section “Governance Practices in Chinese SOE's: Content of Change”). Being dominated by the state ownership, changes on this path are accompanied and affected by factors described in the sections “The Radical Campaigns” and “Incremental Reforms in the Non-State Sector” above, shown in the boxes under the time axis. In the following, we discuss how these factors affected the starting point of SOE's’ ownership structure and its later changes.

Path-dependence-in-China’s-SOE-reforms

Lessons from the Mistakes

As we have described, the central government firstly chose not to touch the existing planned system in urban districts at the beginning of the transition. This choice can be attributed to the central government’s concerns about the potential losses due to radical reforms. At that moment, it must have been be difficult for the central government to answer the question whether replacing the planned system and public ownership structure with a market economy and a diversified ownership structure, as radical reformers put it forward, would largely improve China’s economy. After all, there had been no experiences about how a market economy would function in China. Neither were there transition examples for China to learn from at that time.

Interestingly, if we look further back along the time axis in Figure, we will find another path dependence of ownership structure in China’s history since 1900. Before the foundation of the People’s Republic of China, private ownership of enterprises had existed in the Qing Dynasty and been protected by the Dynasty’s “Company Act” promulgated in 1903. The Republic of China, followed by the authorities in Taiwan, continued this path. In mainland China, however, this path was discontinued by the socialization process beginning in 1956. Such a break-off was not directly responsible for the later disasters during the Great Leap Forward and the Cultural Revolution, but it had excluded all existing private ownership and facilitated a total deviation from the former economy model to a state ownership model. The risks of such a total deviation were evidenced by the economy development during the Great Leap Forward and the Cultural Revolution, implying that the government should be cautious with radical economic reforms. Under concerns about failures and uncertainty of success, it was rational and low-risk for the central government to start with incremental reforms.

Our analysis echoes Bebchuck and Roe’s (1999) path dependence theory, in which the two authors define efficiency as one of the major reasons why prior ownership structures in an economy might affect subsequent structures. In a simplified sense, efficiency concerns the profits and costs of rebuilding the existing ownership structures or enacting a set of legal rules that support different ownership structures. Although a different type of ownership structure could appear more efficient from today’s perspective, a total reconstruction of the current system would be, in view of its potential profits, too costly to be realized. In their paper, Bebchuck and Roe give a numerical example of how companies will compare the potential profits and costs and decide not to restructure the existing ownership model into a different one. In contrast, at the beginning of China’s reform era, no such calculation was feasible. Thus, lessons learned in the previous radical campaigns might have helped the central government to make its choice of the reform path.

Pre-Reform Institutional Bases

In both of the two waves of decentralization and the recentralization measures afterwards, the changes mainly adjusted the relationship between the central and local governments and not the relationship between the state and SOE's. On the one hand, the de- and recentralizing policies dealt with the issue which governmental level should directly take the leadership in SOE operations. In other words, it was about how to allocate the SOE property rights within the administrative structure of the Chinese government. On the other hand, SOE's had not become autonomous economic entities, but remained subject to production instructions from either the central or the local governments. Consequently, the governmental control over SOE's was tight throughout the first three decades of the People’s Republic of China (Qian 1999).

Nonetheless, the two waves of decentralization had exerted a big influence on the structure of China’s planning system, making it not as centrally organized as in the Soviet model. Unlike the Soviet model, the Chinese planning system performed not through the central government granting power to subordinate local agencies to carry out its plans, but to a great extent directly on regional levels. Hence, a complete administrative centralization hardly ever existed in the Chinese planning system, except for the very beginning. Local governments and their agencies practically exerted much control, which made it easier to launch reforms on local bases, especially where the bureaucratic interests were weak.

In Bebchuck and Roe’s (1999) path dependence theory, another source of power for the persistence of old ownership are rent-seeking activities, practiced by the interest groups who have been enjoying the rents provided by their positions in the actual ownership structure. If a new ownership system pattern, however efficient it is supposed to be for a single firm or the whole economy, noticeably reduces their current rents, those interest groups would have incentives to impede the efforts to introduce such a pattern as well as the supporting legal rules for it.

In a rent-seeking context, the structural character of China’s planning system could explain why real reforms did not initially take place in SOE's in urban areas, but in rural areas. Provided that the central government had been thinking about a radical SOE reform (for example, a diversification of the ownership) in the 1970s, there could have been much resistance against it from those agencies and persons who had been controlling SOE's for a long time, because their control would be reduced, and the profits of the reform were not certain. Compared to that in urban areas, governmental control in the rural areas was, on the one hand, less tight after the first wave of decentralization. On the other hand, bureaucratic interests in the agricultural sector were weak, and the vested interests of local officials at the commune and the brigade levels were not well organized (Qian 1999).Wan Li, the former party secretary in the Anhui province, who led the first rural eform in the late 1970s, once confirmed the situation:

Why did reform make its first breakthrough in the rural area? This is by no means an accident and has historical reasons. This is because peasants suffered the most under the old rigid system and thus had the strongest desire for reform. At the same time, rural areas were the weak sector in the old system, and became the breakthrough point of reform. (ibid)

Learning from the Non-State Sector

As we have discussed in the sections “Lessons from the Mistakes” and “Pre-Reform Institutional Bases” above, pre-reform mistakes and existing institutions bases can explain why China’s reforms started in areas outside of the planning system. After China’s transition began, experimentation with relaxation over the non-state sector has been providing abundant and exemplary experiences with other forms of ownership and governance structure for SOE's to learn from. Such a method has been useful for China’s transition, because, as argued by Qian (1999), reform was a highly uncertain event and the government’s knowledge about it had been very limited. Considering the high uncertainty, experimentation is a way to minimize costs through structured learning.

Experiences gained with those incremental reforms in the non-state sector have practically backed the SOE reforms. Seeing the impressive agricultural growth in the early 1980s, decision-makers in the central government firstly borrowed the idea of contracting from the agricultural reform to launch a similar system for the state sector. However, the contracting approach did not function well for the state sector, suggesting that the government should not only provide incentives, but also reform the entire state sector.

The rise of the non-state enterprises had helped to establish and to strengthen market forces in China. In the early 1990s, the planned track was largely phased out, and prices were mostly determined by the market rather than the state. SOE's were facing direct competition in a number of industries. This environmental change facilitated not only the launch of a market economy in China, but the corporatization and the restructuring of the state sector as well. On the one hand, it was more efficient for the state to draw back from where SOE's had been uncompetitive and to focus on a few industries where the state has been enjoying a monopoly status. On the other hand, rent-seeking activities by interest groups became much less in those uncompetitive SOE's. As a result, reforms were much easier due to less resistance. More importantly, the experiences gained in the non-agricultural sector outside of the state-sector could further be utilized by SOE's in their reforms. Among the no state enterprises, especially the huge success of TVE's impressed the leadership in Beijing. Deng Xiaoping said on 12 June 1987.

In the rural reform our greatest success and it is one we had by no means anticipated has been the emergence of a large number of enterprises run by villages and townships. Their annual output value has been increasing by more than 20 percent a year for the last several years. This increase in TVE's, particularly industrial enterprises, has provided jobs for 50 percent of the surplus labor in the countryside. Instead of flocking into the cities, the peasants have been building villages and townships of a new type. Our success in rural reform increased our confidence, and, applying the experience we had gained in the countryside, we began a reform of the entire economic structure, focused on the cities. (Deng Xiaoping 1987/1994).

Deng Xiaoping’s statements showed that the central government had been thinking about transplanting the experiences in the non-state sector to SOE's. In fact, the SOE reforms at the corporatization stage since 1993 have absorbed a few important elements of TVE’s governance. Both ownership/property rights and hard budget constraints have been taken in by the SOE corporatization policies to enhance SOE's’ efficiency.

With respect to China’s opening-up practices, we believe that they have not only exceedingly contributed to the growth of FDI and exports, but also to the changes of SOE governance. For one thing, the boost of foreign enterprises and joint ventures are themselves vivid examples of how modern enterprises look and how to manage them efficiently. For another, China’s increasing exchanges with developed countries have helped the Chinese to master know-how in management as well as modern firm theories. Slogans like “separation of enterprises from the government” and “scientific management” demonstrated that the SOE corporatization process has been learning from the opened environment.


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