Political Constraints, Organizational Forms, and Privatization Performance: Evidence from China Jianping Deng, Jie Gan*, and Jia He1, 2 1 Deng: University of Electronic Science and Technology of China; Gan: Cheung Kong Graduate School of Business, Beijing, China; He: Chinese University of Hong Kong. 2 We benefit from discussions with Efraim Benmelech, Kalok Chan, Francesca Cornelli, Sudipto Dasgupta, Roger Gordon, Mike Lemmon, Peter Mackay, Paul Malatesta, Roni Michaely, Randy Morck, David Robinson, Antoinette Schoar, Jeremy Stein, Mike Weisbach, Chenggang Xu, and comments from seminar and conference participants at Hong Kong University of Science and Technology, Qinghua University in China, and City University of Hong Kong, American Finance Association Conference, Queens University Conference on International Finance, ISB Finance Research Camp, and Emerging Market Corporate Finance in Turkey. Deng and Gan acknowledge, respectively, the financial support from the National Natural Science Foundation of China (Project # 70802011) and Hong Kong Research Grants Council (Project # HKUST6490/06H). * Corresponding author: Cheung Kong Graduate School of Business, Oriental Plaza E2-2005, 1 East Chang An Ave, Beijing 100738, China. Email: [email protected]; Tel: 86 10 85188858; Fax: 86 10 85186917. Political Constraints, Organizational Forms, and Privatization Performance: Evidence from China Abstract This paper explains why China’s share issue privatization (SIP), by far the largest one in history, failed to improve operating performance. As a result of political compromises and fiscal constraints, approximately three quarters of the SIP firms went through an “incomplete restructuring” process, creating a parent-subsidiary structure in which the subsidiary was listed and the parent company kept the redundant workers and debt burdens. In a country with weak property rights protection, the parent company had both the incentive and the ability to expropriate resources from the listed company, resulting in weak performance. We present three sets of results. First, we show that when political opposition to layoffs is greater and when the government has less fiscal capacity, the firms are more likely to be incompletely restructured. Second, incompletely restructured firms have significantly lower operating performance. This result is robust to IV estimation using government incentives as instruments. Third, we present evidence of the root cause of weak performance, i.e., expropriation by large shareholders. Based on hand-collected data on 2616 related-party transactions, we document that incompletely restructured firms are more likely to engage in related-party transactions with their largest shareholders, including transfer pricing of goods and services, assets sales, and extracting trade credit. Further, these transactions are associated with inferior firm performance, confirming that they are expropriative in nature. Incompletely restructured firms also pay less dividends so that corporate resources are kept in the firm and under their control. Finally, expropriation does not seem to be fully discounted in prices ex ante and minority shareholders realize lower stock returns ex post. JEL Classification: P16, L33, G34 Key Words: Chinese Economy, Political Economy, Privatization, Organizational Forms, Large Shareholders, Expropriation 1 Introduction Privatization of state-owned firms has become a popular practice around the world as governments increasingly use market mechanism to allocate economic resources. Empirical studies of these privatization reforms suggest that privatization does work in the sense that privatized firms generally exhibit improved operating efficiency (Megginson et al, 2001). One outstanding exception to these successful stories, however, is the case of China. Despite its extraordinary economic achievements in the past two decades, China’s share issue privatization (SIP), by far the largest privatization in human history, has turned out to be a failure. Operating efficiency of Chinese SIP firms dropped significantly during the three years after privatization (Sun and Tong, 1999). Why has China’s efforts to privatize its state-owned enterprises (SOEs) through SIP produced a result so different from that in most other countries? Relying on a unique set of database which consists of hand-collected detailed information about 295 share issue privatizations in China, this paper aims to answer these important questions with an attempt to draw implications for the design of economic institutions in general. Specifically, we show how political constraints faced by the government in the process of privatization may shape the organizational forms of the privatized firms in ways that often result in mis-aligned economic incentives and therefore inferior performance. China took a gradualist approach to its economic reform. Privatization, commonly perceived to be the biggest threat to its ideology, was initiated only after several earlier attempts at enterprise reform had failed.3 At that point, most of the state-owned enterprises (SOEs) were unprofitable and had zero or negative equity. The government thus adopted a strategy so-called “retaining the larger 3 In the initial stages of state-owned enterprises (SOE) reforms, the emphasis was placed on more autonomy and better incentives and later on long-term contracts, specifying profits, taxes, and other financial targets, between enterprises and their bureaucratic superiors. While the reform brought about improvements in productivity and innovation, without ownership reform, SOEs continue to bear many social responsibilities — such as social security, housing, and education – that make it harder for the government to establish a system of uniform market-determined prices or to impose hard budget constraints. In the end, the state acts as the residual claimant absorbing the losses. This imposes a severe stain on the country’s banking system: with SOEs taking in 70% to 80% of all bank credit, banks are saddled with as much as $200 billion in uncollectible debt which accounts for, by conservative estimates, a quarter of all outstanding bank loans. 2 ones and letting go of the smaller ones (zhua da fang xiao).” The large SOEs over which the government intended to retain control were privatized through SIP in which the government retained at least 50% ownership and thus dominant control. These large SOEs typically serve the national markets and are therefore considered important. In preparing these SOEs for public listing, the biggest challenge the government faced was how to restructure money-losing SOEs. Restructuring requires layoffs of excess workers, who are a main source of inefficiency under state control, and injection of capital, to pay off bank debt accumulated from years of negative earnings. Both are politically painful and financially costly — thus only a quarter of the companies went through the necessary restructuring and became independent entities before public listing. For the remaining firms, as a political compromise, the government introduced so called “incomplete restructuring” that was less painful and costly: the firms were organized into a parent/subsidiary structure, in which the most profitable assets were carved out for public listing while the parent companies became the largest shareholders and kept the excess workers, obsolete plants, and debt burdens. Thus, instead of solving the problems under state control, an incomplete restructuring kept and hid these problems in the parent companies. The parent companies, as the largest shareholders with close business relationships with the listed companies, had strong incentive and ability to expropriate corporate resources at the expense of outside minority shareholders. Moreover, for ideological reasons the government retained controlling shares and made all government shares non-tradable so that control would not be transferred to the private sector through future trading. Non-tradability of government-owned shares further intensified the large shareholders’ incentive to expropriate because they could not benefit directly from high share prices. 3 Given that incompletely restructured firms account for three-quarters of all SIP firms and that SIP firms represent more than 80% of market capitalization of the Chinese stock market4, the expropriation problem inherent in the listed firms is wide spread. This has discouraged the development of well-functioning capital markets (La Porta et al., 1997) and poses a big challenge to the country’s overall economic prospects. To systematically document and quantify the role of political incentives in the privatization process and the impact of such process on incentives and performance, we perform three sets of analyses. First, we examine how political incentives shape the choice of restructuring methods and the organization forms of the SIP firms. We find that, consistent with the stated goal of social and political stability, the government is more likely to incompletely restructure the SOEs when it does not have sufficient fiscal resources and when redeployment of laid-off workers is likely to be difficult because of the under-development of the private sector in the region. These results highlight that the design of economic institutions is critically shaped by political factors. They also provide guidance in interpreting our later results on privatization performance. Second, we demonstrate that incomplete restructuring is associated with significant efficiency