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A healthy hybrid: the technological dynamism of minority-state-owned firms in China

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Since the beginning of its economic reform in 1979 there has been a rapid growth in China's economy, but its dynamism has not been shared by the state-owned enterprises at its core. Although some progress has been made, a large proportion of SOEs remain inefficient and uncompetitive, and in general they have failed to exploit their advantages in scale, experience and resources. In contrast much attention has been paid first to the collective and township enterprises, and then to the private sector, now the largest and fastest growing of ownership types in the Chinese economy. However unlike some other developing countries (such as South Korea and Malaysia), ideology prevents the government from giving private businesses the level of assistance required to make of some of them the technological spearhead of development. It has however been prepared to give such support to firms with only a minority state shareholding and otherwise owned by private shareholders and employees. This paper compares them favourably with other ownership types and argues that in the Chinese setting the minority-state-owned hybrids can and should play a key role in future development.
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DISCUSSION PAPER SERIES






A healthy hybrid: the technological dynamism of
minority–state-owned firms in China


Jing Cai, University of Sheffield Management School
Andrew Tylecote*, University of Sheffield Management School

Discussion Paper No 2004.02
January 2004



*Address for correspondence:
Professor A B Tylecote
University of Sheffield Management School
9 Mappin Street
Sheffield, S1 4DT
Tel: + 44 (0) 114 222 3415
Fax: + 44 (0) 114 222 3348
A.Tylecote@Sheffield.ac.uk


Copies of discussion papers can be obtained by contacting the address below
Mandy Robertson
Sheffield University Management School
9 Mappin Street
Sheffield, S1 4DT
Tel: + 44 (0) 114 222 3380
Email: M.Robertson @sheffield.ac.uk




Abstract

Since the beginning of its economic reform in 1979 there has been a rapid growth in
China’s economy, but its dynamism has not been shared by the state-owned
enterprises at its core. Although some progress has been made, a large proportion of
SOEs remain inefficient and uncompetitive, and in general they have failed to exploit
their advantages in scale, experience and resources. In contrast much attention has
been paid first to the collective and township enterprises, and then to the private
sector, now the largest and fastest growing of ownership types in the Chinese
economy. However unlike some other developing countries (such as South Korea and
Malaysia), ideology prevents the government from giving private businesses the level
of assistance required to make of some of them the technological spearhead of
development. It has however been prepared to give such support to firms with only a
minority state shareholding and otherwise owned by private shareholders and
employees. This paper compares them favourably with other ownership types and
argues that in the Chinese setting the minority-state-owned hybrids can and should
play a key role in future development.


1. Introduction
From 1979 SOEs’ contribution to China’s economic growth has declined sharply. In
1980 slightly less than four-fifths of output was produced by SOEs with the rest
produced by collective enterprises. By 1999 the SOEs’ share dropped to 28% while
the collective share increased (to 28%) and the private sector came from nowhere to
44% (see table 1). However the SOEs continue to absorb nearly half of the fixed
capital investment.



Table 1: Comparison between state, collective and private sectors1
Collective, township and
Year State
sector
Private sector
village- sector
% of
% of gross % of fixed % of total % of loss
% of fixed % of gross % of fixed % of total
gross

industrial
capital
industrial
making
capital
industrial
capital
industrial
industrial
output
investment
employment
enterprises
investment
output
investment
employment
output
1980 76
82
-
-
23.5
5
0.5
13 -
1985 65
66
-
9.6
32
14
3
21
-
1990 55
66
-
27.6
35
12
10
22
-
1995 34
54
67
33.8
37
17
29
29
11
1996 36
53
66
33.6
32
15
32
32
12
1997 32
52
65
38.2
32
16
36
32
14
1998 28
54
57
-
32
15
40
31
26
1999 28
53
54
36
28
15
44
32
30
2000 -
50
51
-
-
-
-
35
35
2001 -
47
47
-
-
-
-
39
40


Sources
: China Statistical Yearbook 2002: tables 6-2,13-1,13-2; 2000: 408, 409; 1997:
412; 1993: 410; 1992: 404; 1991: 392. Lin & Zhu (2000).

In China’s drive to catch up with the developed countries, the state has shown its will
to take the strategy of promoting the state-owned economy as its main vehicle. The
decision taken to reform its SOEs was not to privatise the large and medium SOEs,
but to transform them into ‘modern enterprise corporations’ in which the state retained
at least a majority shareholding. By the end of 2000, 70% of these SOEs had
completed this transformation, and some of them are listed on the stock exchanges.
This programme would continue to apply to the remaining SOEs (Xinhua News

1 Most figures in table 1 are calculated from China Statistical Yearbook (various years). The
2001 figure “ % of gross industrial output” of state sector and of the non-state sector couldn’t
be obtained, because the State Statistical Bureau changed the scope of variables by then. The
Private sector includes individual private enterprises, share-holding corporations and
enterprises funded by foreigners or by entrepreneurs from Hong Kong, Macao and Taiwan.
The ‘state’ and ‘collective’ sectors include the (relatively few) firms in which the
state/townships etc respectively hold minority shareholdings.



Agency, 13 September 2002). In November 2003 the decision, announced by Li
Rongrong, chairman of the cabinet’s state-owned assets and supervision and
administration commission (SASAC), was taken to proceed to an “‘acceleration and
intensification’ of the process of selling state enterprise assets to foreign and private
companies over the next two years” (Kynge, 2003, p.11). This would involve the
complete privatisation of a proportion of the medium SOEs, and the partial
privatisation of some of the largest:

At the moment, 196 of China’s largest and most strategic state companies are
managed by Sasac, but Mr Li indicated for the first time that even these companies
could be at least partly privatised, especially if they did not perform well over the
next two years. The state council (cabinet) has instructed Sasac to oversee the
emergence of 30 to 50 internationally competitive state enterprises, which would also
constitute the leaders in their industry sector, Mr Li said. Those companies that did
not meet this goal within two years would be restructured.….. Beijing remains
committed to retaining control of many state companies but is open to the idea of its
shareholding falling below 51%, Mr Li said. (Kynge, 2003, p.11).

In a recent article (Tylecote and Cai, 2004) we examined the technological
performance of Chinese SOEs. We used an analytical framework adapted from that
of Tylecote and Conesa (1999), which predicts the effects of forms of corporate
governance on a firm’s technological performance, contingent on the circumstances in
the sector; and we found that given the corporate governance structures and
relationships in which Chinese SOEs operated, their poor performance was entirely
predictable. (We also explained the specific patterns of distortion of their
technological activities.) We were, however, dealing only with enterprises majority-
owned, or wholly-owned, by the state (central, regional or local). In this paper we
report the findings of fieldwork conducted in spring 2003 to compare the managerial
character and technological and economic performance of different types of
ownership (majority state owned enterprise, collective enterprise, private enterprise
and ‘hybrid enterprise’ — minority state ownership combined with private ownership)
in terms of their economic performance and technological performance in the
electronic and telecommunications industries. A total of 18 interviews were conducted
between March and June 2003 with managers in 12 firms – seven SOEs, three
‘hybrids’, one collective, one foreign joint venture, and one private. Interviews were
also held, for background information, with senior managers in a management
consultancy and in the China Commercial Bank and China Development Banki, two
senior officials in the Ministry of Information Industries, and two senior academics.
Further information was obtained from secondary sources including company
websites. We focus here however on only four of those firms, one in each ownership
category, chosen to bring out the differences among them. Before doing so, however,
we review the relevant general literature. Thus in section 2 we show how the access to
scarce resources
– notably, but not only, finance and licenses – has been affected by
ownership type. In section 3 we show how the differing relationships to the state
(central, regional and local) have affected corporate governance and through that,
technological performance. In section 4 we come to our four firms, beginning with a
‘snapshot’ comparison of the four firms in terms of their current activities and
performance, followed by a brief history of each showing how its development was
affected by its ownership character – and showing indeed how that evolved. It is in
this section that we present the results of our fieldwork. Section 5 concludes.


2. Access to scarce resources

Scarce resources during the 1980s included bank loans, land procurements, various
licences (for example: equipment producers need production and sales licences for
their products; telecom carriers need the service licences to operate their networks)
and raw materials such as oil and coal etc. In the last decade, raw material could be
easily got from the free market but even now, different types of firms pay different
prices in obtaining them as well, and this is very much still the case for land. Bank
loans and licences were and continue to be considered as the bottleneck problems by
most firms.

In access to all of these scarce resources, SOEs have a striking advantage over other
types of ownership. According to Marx’s labour theory of value, the surplus value
produced by workers is exploited by capitalists who own the means of production.
Private economy in China’s early economic reform was defined as a supplement to
state economy: filling up the gap of employment, goods and services which have been
neglected by the state sector and stimulating the latter to greater efficiency through
competition (Tsang, 1994). Initially individual-owned businesses (getihu) were
allowed but with a maximum of 8 employees. In 1988 this limitation was removed
and private enterprise was defined as assets owned by individuals with more than 8
employees in pursuing profit-oriented business (siying qiye). Private businesses
remained restricted mainly to service and low-tech, labour intensive industries such as
retailing, catering, wholesaling, transportation, and construction (Liu, 2002 and Tsang
1994). In late 1997 the 15th Party Congress announced that the private economy is
also an important component of the socialist market economy and could take one of
the following forms: sole ownership, partnership or limited liability. Private business
is encouraged to take over small and medium-sized SOEs; to invest in infrastructure
field, to engage in import and export business and to get access to bank loans. But
ideology prevents the Chinese government from adopting an all-out effort to support
private business - so far it has merely reduced the restrictions on the private sector
(Liu, 2002).

One strategy used by private sector to circumvent regulation restriction was to register
as a “red hat enterprise” 2 -- a kind of “fake socialist economy” (Oi, 1995). By paying
a management fee to local government the red hat label could provide private firms
with economic benefit and avoid political campaigns. Some private enterprises
attached themselves to a state or collective enterprise which was called co-operation
(guahu). The guahu firm paid certain fee to public ownership in exchange the usage
of the public firm’s name, bank account and tax standard (Song, 1989). In the middle
1980s statistics showed that in Wenzhou city (a very famous private enterprise boom
city in Jiangsu province) 62% of the private firms were guahu firms (Parris, 1993).

Even guahu status was unlikely to do more than protect private firms from official
disapproval. Naturally state-owned firms can get licences from the state much more
easily, not simply because of their formal status, but above all because their managers
are, as more or less senior state employees, and Communist party members,
embedded in the necessary network of contacts – guanxi wang (Wank,1995,1996).

2 Red hat enterprises refer to collective, township, village or sometime even partnership
enterprises (in some regions) for they are regarded as the main part of socialist economy.


Collective, township or village-owned enterprises could get support from associated
local governments, but the guanxi wang that comes with us is inevitably on a limited
scale. The difficulty for private enterprises in getting licenses is frustratingly hard to
quantify. Quantification is easier for finance, to which we devote the rest of this
section.

Unequal access to finance
Excluded from the state allocation and blocked by ideological disfavour, private
sector finds it extremely difficult to raise funds. State-owned banks dominate the
Chinese financial system and hold more than 60% of the country’s banking assets
(Saussure, Frechette and Gryziak, 2001) – much more than that until recently. They
much prefer to lend to state-owned firms, and among the rest they show particular
aversion to private enterprise (Table 2). Even at the end of 2001, the private sector
received less than 1% of all loans granted by the state banking system (Tsai, 2002).

Table 2. Shares of loans granted to non-SOEs by state-owned banks (%)
Private enterprises and
Township or Village owned
Year Urban
collective-economy
individual
enterprises
1985 4.95
0.17
5.63
1988 5.58
0.17
7.59
1990 4.93
0.09
7.42
1992 4.76
0.012
7.48
1994 3.31
0.018
6.25
1998 -
0.03
2.51
Sources: Liu, 2002; Chinese Financial Yearbook, 1989-1999 editions

Private firms were obliged to find other sources of finance, and until recently that
meant tapping the informal financial system, which is called the curb market (Tsai,
2002; Song, 1989 and Liu, 2002). Table 3 shows the types of informal financial
methods (Tsai, 2002 and Langlois, 2001). Legal methods are those without the
involvement of the use of interest rates. Quasi-legal methods are those which are
tolerated by local authorities but may be illegal under the national regulations.

Table 3: Types of informal financial methods used by private sector
Legal
Quasi-legal Illegal
(without interest involved)
-- Rural cooperative foundations
-- Interpersonal lending
-- Broker and money lenders
(Illegal since 1998)
-- Issuing notes and bonds to -- Financial centres/Capital
-- Private money houses
employees
mutual association
(underground banks)
-- Rotating credit associations
-- Pawn shops
-- Underground foreign
(in some areas)
(in some areas)
exchange houses
-- Pawn shops
-- Rotating credit associations

(in some areas)
(in some areas)


--Pyramidal investment schemes


Sources: Tsai, 2002 and Langlois, 2001

For most private firms the starting finance came from either personal saving or
interpersonal lending (friends or relatives) (see table 4). But data tabulated in table 4
may underestimate the power of those informal sources. A study conducted by Tsai
(2002) estimated that “informal finance has accounted for at least one quarter of all
financial transactions in China, and up to three-quarters of private finance”. Private
business was forced into irregular practice to raise funds.

Table 4: sources of capital used by private sector
Source
Mutual
Friend and
of capital
Enterprises Partners
Employee
Credit Fund/
Others
relatives
Year
Bank Loan
1987 37.5
-
20
1.9
40.6
-
1993 45.5
12.1
16.2
-
10.7
15.7
1997 69
24.9
- 1 -
5.1
Sources: Liu, 2002

Attitudes towards these informal financial systems vary from region to region.
Wenzhou is a classic example of a locality in which the local government “has
adopted an acquiescent attitude toward certain semi-legal or illegal economic
practices which derive from the existing state policy but are indispensable to the
smooth operation of the private economy” (Liu 1992: 297-8, quoted in Tsang,
1994:456). Hinterlands and western areas once dominated by heavy industries with a
higher proportion of SOEs have usually given no more than passive support to the
private sector. Coastal areas, including the south east, which once lagged behind, have
provided better institutional circumstances for the development of the non-state-
owned economy (Wong, 1991,1992). Apart from geographical factors, why in general
do local authorities have the motivation to skirt fiscal and budgetary regulation and
shelter illegal activities? Any explanation must be closely connected to the fiscal
reform by which central government gradually decentralized both its political and
economic power to local governments.

The fiscal reform started in 1980 with the objectives to release the central state’s
fiscal burden and to increase the incentive of local government in collecting tax. It
gives a clear definition of the localities’ share in terms of revenue and responsibility1.
In 1993 the central revenue dropped to 22% of total fiscal revenue compared with
38.4% in 1985. The new tax sharing system in 1994 increased the central share to
52.4% in 2002. However localities were burdened with various local responsibilities:

1 Revenue was divided into four parts: central fixed income, local fixed income, fixed rate
share income and adjustment income. The former two kinds of fixed incomes came from
associated types of ownership: a central enterprise remitted its profit to central fixed income
and a local enterprise remitted its profit to local fixed income. If a firm was under the multi
regulation, a fixed proportion of 80 to 20 would be submitted to central and local government.
The adjustment income mainly consisted of industrial-commercial tax (gongshang shui). It
was negotiable between centre and localities (Wong, 1992). In 1994 a tax sharing system was
introduced to reduce the negotiability and to increase transparency.


operating expenses, agriculture expenses, education and health, social welfare,
administration (Wong, 1991) (see table 5). Under fiscal pressure, local authorities
became more tolerant to those informal finances in order to expand the local
economy. Revenue retained by localities was mostly from extra-budget3. Before the
fiscal reform extra-budget was controlled within 5% of within-budget revenue. In
2000 the estimated total extra budget revenue took up 42.5 % of the within-budget
revenue (Oi, 1992 and China Statistical Yearbook 2002: table 8-13, 8-18).

Table 5: the share of fiscal income and expenditure between central and local
governments
Fiscal income
Fiscal expenditure
Year
% of central
% of local income
% of central
% of local
income to total
to total fiscal
expenditure to total
expenditure to total
fiscal income
income
fiscal expenditure
fiscal expenditure
1985
38.4
61.6 39.7 60.3
1990
33.8
66.2 32.6 67.4
1993 22
78
28.3
71.7
1994
55.7
44.3 30.3 69.7
1996
49.4
50.6 27.1 72.9
1999
51.1
48.9 31.5 68.5
2000
52.2
47.8 34.7 65.3
2001
52.4
47.6 30.5 69.5
Source: China Statistical Yearbook 2002: table 8-13 and 8-14

The fiscal reform also had its impact on the financial system. The central state was
unable or unwilling to support loss-making SOEs any more – or rather, to do so
directly. From 1979 the load of subsidies for SOEs was transferred to the banking
system. Instead of being based on the principles of commercial credit, a large
proportion of bank loans were lent to weak credit quality SOEs under government
policy (Wu, 2001). A report by Japan Rating and Investment Information Inc. (R&I)
found that the Non-Performing Loans (NPLs) of four state banks had risen to RMB
1.8 trillion at the end of 1998, equivalent to 28% of total lending, or 23% of GDP
(www.r-i.co.jp/eng/release/nr_asia/asia991020.pdf). Outside the state banking system
many shareholding commercial banks and city or regional private banks have recently
appeared in the financial system, many of them set up with financial and other support
from local and regional government. Even these, however, appear to discriminate
against the private sector: the new banks respond to guanxi wang like everybody else.
Perversely it may be economically rational to do so. Private firms are more likely to
be hit by bureaucratic actions or inactions beyond their control, and if they are
damaged by market misfortune or sheer mismanagement there will be no-one to help
them. They are thus worse risks. So most of the new banks prefer to lend money to

3 The revenue could also be grouped into within-budget revenue (yusuannei zijin) and extra-
budgetary revenue (yusuanwai zijin). Within-budget revenues are those taxes (income tax,
industrial commercial tax) on state and collective enterprises. Local income belongs to extra-
budgetary revenue which include: 1) local tax revenue such as slaughter tax, agriculture tax,
salt tax and tax on township village and private enterprises and 2) non-tax revenue including
management fee, surcharge for specific local projects and overseas donations etc. (Oi, 1992).


those large private firms with good credit or provide loan only against collateral (Liu,
2002 and Langlois 2001).

As another actor in the Chinese financial system, the Chinese stock market (mainland)
has developed very quickly since it was established in 1992. But it is hardly used by
the private sector as a channel to raise funds. The state decides the quotas of listing
and selects the one who may list on the stock market (Langlois 2001). If private
potential firm wants to be listed in the stock market one pragmatic way is to buy the
equities from the already listed enterprise, which incurs not only high cost but is also
subject to regulations (Bruton and Ahlstrom, 2003).

Venture capital financing on a limited scale has been taking place in China in recent
years. Statistics from the Ministry of Science and Technology indicate that by the end
of 1999, China had 92 venture capital companies with 7.2 billion yuan (US$870
million) of funds (People’s Daily February 20, 2002). 89% of the venture capital
companies chose to invest in high-tech projects (People’s Daily, August 1, 2000).
More than 80% of the venture capital funds in China were provided by the
government, with the remaining less than 20% from foreign and private investors (Lo,
2000). This has the effect of impeding venture capital financing. Inadequate
legislation coupled with the unreliable accounting system prevents venture funds
from flowing into start-up private firms. Instead firms seeking funds are required to
show at least three years of financial accounts. Apart from that, to evaluate the firm a
venture investor needs in particular to know the sort of guanxi which are possessed by
the firm and by its managers as individuals: as we have seen, these contacts constitute
valuable assets in Chinese business (Ahlstrom, Bruton and Liu, 2000 and Bruton and
Ahlstrom 2003).


3. How the relationship with the state affects corporate governance and thus
technological performance


The structures of ownership directly affect both the commercial and technological
performance of firms, for they create different disciplinary and incentive mechanisms.
Tylecote and Cai (2004) argue that Chinese state-owned enterprises have a corporate
governance system which is in one respect similar to the typical large listed firm in
the UK or USA: that is, the dominant shareholder(s) is/are disengaged from
management, causing it/them to have a lack of firm-specific understanding of
technological change. This (in either case) must lead management to avoid investment
with low visibility. In the Chinese SOE case this generally leads them to look to
external, often foreign sources for discrete packages of technology – which leaves
them still dependent on external sources for the next ‘upgrading’, since they do not
really acquire technological competence. It is also an expensive option; but for them
bank loans are or used to be very cheap – typically 1% interest from a state-owned
bank (Parris, 1993). Another pressure on the managers of SOEs, as Tylecote and Cai
point out, is the need to maintain employment, particularly in the depressed areas in
the North East and the inland provinces where there are few if any alternative job
prospects. The manager may simply use his guanxi with local branches of state-
owned banks to cover operating losses out of new loans; alternatively the money may
be used for real investment capital, but with a view to diversification into
technologically undemanding areas in which by selling at a loss (if necessary) the


firm will get a toehold in the market and thus keep some workers employed.

At the other end of the technological scale are SOEs which have been created from
research institutes and similar organisations. These cannot be described as lacking in
technological competence – far from it (see the Datang case, below). But what they
have in common with the loss-making low-technology SOE is a soft budget
constraint: they get finance and land (and maybe other resources) at below market
rates and even then they are not under heavy pressure to make profit (they are likely
to have excellent guanxi). What they typically fail to do, in consequence, is not to
develop technological competence, but to commercialise it. Private firms on the other
hand have the motivation to keep pace with technological changes, and commercialise
them – if they can find the funds to do so - since the more they invest in new products
the more profit they will get. The collective and township or village firms lie in
between SOEs and private firms: on the one hand they cannot enjoy soft budget
constraints like (majority-) SOEs; on the other hand they may still to some extent be
shielded by local authorities from market discipline (Goldstein, 1995).

Bureaucratic intervention is regarded as one of the major barriers which hamper
firms’ commercial development. In principle the higher the degree of political
intervention the worse the firms’ economic performance will be. But in exchange for
the bureaucratic intervention firm could also enjoy political and economic benefits.
Bureaucratic intervention into SOEs is broadly in two areas, manager selection and
operational decisions. In Tam’s (1999) research into listed SOEs, 74% of the board
chairmen, 80% of the directors and 90% of the supervisors claimed that they were
elected to their appointments. However, the percentage of election should be
interpreted critically and cautiously. In fact, in SOEs and state controlled companies,
the shareholders ‘electing’ directors and supervisors were in effect in the government
ministries. The state could also influence some operational decisions in order to
maximize employment.

A common characteristic of both SOEs and collective (or township and village)
enterprise is that they are managed by different levels of government organisations.
Localities keep control over local firms since they could use their power to extract
profits directly from them and redistribute revenue among them. For example they
may take profit from one enterprise and use it to support another (Oi, 1995). Various
surcharges have become major resources for local expenditure. In exchange local
authorities use their extensive connections to help local firms to deal with higher
levels of government, to facilitate business transactions and to grant tax exemptions,
since local budget and local cadres’ economic benefit (personal income) are highly
dependent on the financial health of the local economy (Goldstein 1995). Although a
sound private economy is crucially important to local fiscal revenue, localities would
rather contract or lease collective enterprises to individuals than privatize them. In the
turbulent political environment, maintaining a good relationship with local authorities
is essential to the success of private business. It could provide not only more
opportunities to get raw material but also the political harbour to shield some illegal
activities such as tax evasion. Lots of money had to be spent on taking people to
dinner and giving gifts to build and maintain these relationships (Tsang 1994).
Sometimes a private firm offers shares in it to local cadres. Just as one private owner
said “the business in the beginning is hard. Once you get access to those contacts the
business will become smooth” (Song, 1989).


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A healthy hybrid: the technological dynamism of minority-state-owned firms in China

 

 

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