Lecture 08 Rural Industrialization and Privatization

8/6/2019 Lecture 08 Rural Industrialization and Privatization

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The Rise and Fall of Township and

Village Enterprises and their Private

Rebirth

Lecture 8


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Rise of Township and Village

Enterprises TVEs are industrial and

service enterprises owned(and sometimes, but not

always operated) by thelocal state

Came from nearlynothing in the late 1970sto nearly half theindustrial economy bymid-1990s

More than two-thirds ofexports

0

5

10

15

20

25

3035

40

45

1975 1985 1995

Percent of

industrialoutput


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The Fall of TVEs Even faster

What happened?

Where did they go?

0

5

10

15

20

25

30

35

40

45

1975 1985 1995 2003

Percent of

industrialoutput


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Chinas Privatization Movement and

the Rest of the World

Maybe 4 times more than the ROW combined

Almost unreported

Lots of misunderstandings:

Failure Corruption

Top down Policy driven

0

0.5

1

1.5

2

Milli

fFim

Chi ROW

?


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Understanding Privatization must first

understand Rise and Fall of TVEs

Not much new continuation of long string of

changes in Chinas rural firms

Driven by economic necessity decentralized policy played little role

Current privatization wave:

Example ofInnovative Institutional C ange

almost all insider privatization difficult problem to

solve

Determined by Economics


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Outline Rise of TVEs (Walder)

Evolution into contracting (Township

Enterprises)

Insider privatization


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The Rise of TVEs Local State Owned Firms

Millions of them

Engine of Chinas Economic Growth in the1980s


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Walder (1995): Most Concise /

Believable Explanation Combination of factors made TVEs the most optimal form of enterprise,

despite their shortcomings Sudden wealth from HRS + other reforms (demand by consumer)

Reform rural enterprises first (SOEs not allowed to deviate from plan)

High Profits

Fiscal Reform (can keep profits)

Lack of markets Inputs

Commodity Markets

Ideological baggage of Socialism

Formula for success: Build a factory; run it yourself (leaders had connections);

Build another; Hire a manager (profits are so high, do not need very goodincentives);

Etcetera (build a lot of factories; get rich; get promoted; protected by position)


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Puzzles and Misconceptions Lots of economists try to explain their success

Fuzzy Property Rights

Corrupted House of Cards

Communism Works

In fact, 10 years after their appearance, economists

were still trying to explain how firms could

function so well with poor incentives

What is problem with this work?


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Incentives were not so poor by late 1980s

0

1020

30

40

50

60

70

80

90

100

1985 1988 1991 1994

L d - un

-

x d-

Manager-run firm

after payment of

fixed fee, manager

keeps residual profits

Traditional,

Leader-run firm

incentive problems

Profit-sharing

leaders and

managers split

profits

Chen and Rozelle, JDE, 1999 based on

survey of 120 firms in ZJ/JS/JX/Hub


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Changing Environment

(Naughton, 1995)

Initially high profits

Entry of firms

FDI; new technologies

SOE manager reforms

High profits fall

Search for efficiency02

4

6

8

10

1214

16

18

20

1985

1988

1991

1995

Milli

ffim

;P

tP

fit

P fit

Fi m


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Explanation Why Shift / Who

Shifted First

Fixed Lease Firms:

Labor intensive Areas with good

markets

Busy leader (lots offirms)

Educated manager(educated leader ranfirm himself) 0

10

20

30

40

50

60

70

80

90

100

K-intense. L-intense. Poor mkts Good mkts

Fixed

Lease

Leader

Run


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Explanation: property rights were pretty good in

fixed lease firms, manager already had good:

income rights / good control rights

0

10

20

30

40

50

60

70

80

90

100

Leader rofit are Fixed ease

Hire/fire

Distribute rofits

Sell Assets

Types of Firms


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Village Enterprise Puzzle Chen and Rozelle,

JDE, 1999

Fixed Lease Firms: Labor intensive

Areas with good

markets

Busy leader (lots of

firms)

Educated manager

Mohapatra, Goodhue

and Rozelle, 2003

Fixed Lease Firms: Nothing is significant

Performance is not

enhanced by fixed

lease contract

Why?

Towns Villages


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Resultsdescriptive evidence (tables)

Table 1. Profit sharing contracts

All Regions

Contract type 1988 1995

Fixed wage 26 16

Share 24 25

Fixed rent 50 59

Puzzle: Why did

village enterprises

behave so differently?

-- no change in

contract

-- no systematic

determinants of firm

types


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Resultsdescriptive evidence(contd)

Table 2. Investment Bonding contracts

All

firms

Fixed

rent

firms

Non-fixed

rent firms

% of firms with Investmentbonding 35 74 26

Investment amounts-all sources

(as a percentage of total investment)

Managers 24 35.30 8.66

Village funds 26 20.12 34.75

Bank loans 22 14.81 31.07

Individual loans 12 11.01 13.73

Firms own funds 12 13.10 10.90

Village lenders 4 5.59 0.81


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Performance of Village-run Firms,

1988 to 1995 No impact of

fixed leasing

(unlike TEs) Performance of

all firms the same

Except when

managers havecurrent incentives+ long runincentives

0

1

2

3

4

5

6

7

Percentperyear

gr

Profits

Leader-run Fixed Lease Bonded Lease +

Bonding


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Summary Rural Industry on the

Eve of the Privatization Wave Most firms leased to their managers

Income rights

Most of control rights

Increasing use of investment bonding

Make manager invest in part of firm

Mid-1990s: very competitive; low profitrates; need for new investments in newertechnologies


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Background of our Study International privatization movement:

US / Western Europe / Australia and New Zealand

But especially: Central and Eastern Europe / CIS

The experiences colored our view of things

provided a series of maintained hypotheses

some of which were hard to un-maintain


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Insider Privatization

Insider Privatization: the sale of a government-

owned firm from the government official

(seller) to its manager or employees (buyer)

Practice very common in: Russia (Boycko, Shleifer, and Vishny, 1995; Blanchard

and Aghion, 1996; Carlin and Aghion, 1996; Earle and

Estrin, 1996)

CEECs (Carlin and Aghion, 1996; Frydman et al.,

1999)

Asian countries: Mongolia (Anderson et al., 1999)


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One of biggest constraints to insider

privatization: Valuation

Asymmetric information between official (seller)

and manager (buyer) (Frydman and Rapaczynski,

1994; Putterman, 1997)

Managers possess insider knowledge and have

incentives to understate the value of the firm

There are no good CPAs that can provide

objective valuations The officials problem: has to accept low price or

not to privatize at all


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Data Primary data collection: focused on TEs Stratified random sampling by income

59 townships in two provinces: Jiangsu and Zhejiang

Township level survey

Township Census: all TEs existed in 1994 (670 firms)

Township government official survey

Firm-level survey (3 firms per township, 168 firms in total,

94-97) reinterviewed in 1999/2000

Include 33 private firms

Manager interview on privatization, governance, finance Firm accounting information: cash flow and balance

Bank Survey: bank behavior and balance sheet data


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The Case of Rural China

2 illion govern ent owned fir s privatized

spontaneously in t e past decade

Most firms are sold to insiders, especially former

managers (Kung, 1999; Li and Rozelle, 2003) Many potential reasons about why privatize

Information is also asymmetric: valuation problem

(Putterman, 1997; Kung, 1999; Lin and Kung

2000)

Not all privatized firms have succeeded

Lack of capital and human capital cannot explain all


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Privatization Trends Not all the same way three types of

privatization

Share-shifting (SS) any s ift of s ares

Controlling interest Share-shifting (CI-SS) > %

Complete Privatization (CP) % private s ares

There were also fully private firms emergingduring this time we will analyze these firmslater


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Rates of Privatization of TE Firms,

1993 to 1999

0

20

40

60

80

100

SS I-SS Full

TE

Priv tized


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Differences among Townships on

Rate of Privatization, 1993-1999

0

5

10

15

20

25

30

Percent

fFirmsPriv

tized

0-20 21-40 41-60 61-80 81-100


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Privatization, 2004 Accelerated over mid- to late 1990s!

Lots (most?) townships have privatized 100%

SOE privatization is only thing of interest now(TVEs are all done!)

Local state still involved in many firms (formal /informal explicit / implicit) morecomplicated relationship


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2 million government-owned firms privatizedspontaneously in the past decade

Most fir s are sold to insiders, especiallyfor er anagers (Kung, ; i and Rozelle,

2003)

Many potential reasons about why privatize

Information is also asymmetric: valuation problem(Putterman, 1997; Kung, 1999; Lin and Kung

2000)




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Inside Job Little choice: of course,

insider

Almost 100% formermanagers

On average, manager

managed the firm 5 years

and worked in the firm for

2 years

Even if not insider there

was close connection

Ca re

PartyMember

l ier /

F rmal

P siti

Frie /

Relativef Lea er

Other


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2 million government-owned firms privatizedspontaneously in the past decade

Most firms are sold to insiders, especially formermanagers (Kung, 1999; Li and Rozelle, 2003)

Many potential reasons a out w y privatize(DETERMINANTS)

Information is also asymmetric: valuation problem(Putterman, 1997; Kung, 1999; Lin and Kung

2000)




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Hypothesis 1: Policy Privatization is purely policy driven

Policy measures

County policy indicator (1 if there is a county

level privatization policy)

Policy intensity: the deadline (number of

months) to privatize all firms

If privatization is purely policy driven, then

other variables should have no effect


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Hypothesis 3: Competition Privatization is more likely when the market

becomes competitive Ownership structures of TVEs is a result of

Governments monopolistic power (Chang and Wang,1994)

Government regulations in market transactions (Li,

1996)

When the monopolistic power is gone and thereare fewer regulations, government ownershipbecomes less preferable due to its large agencycost (this means local leaders just dont care asmuch about profits for their firms / are too busy tocare)

Measure of market competitiveness: an barriers-to-entry index developed by Yang (1998)


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Hypothesis 4: Hardening Budget Privatization is more likely when the government faces a

hard budget constraint from the bank TVE expansion in the 1980s and early 1990s was

accompanied by credit expansion in rural China Soft credits came from ABC and RCCs, which were guaranteed by

township governments

Local governments got further financing even if projects wereunsuccessful from the beginning (Oi, 1999)

Bank reform in 1994 hardened the budget and led toprivatization Lending authorities were centralized to upper-level banks (Park

and Shen, 2003)

Township officials do not have advantage in getting loans They care more about firm profitability

Measurement of budget hardness: an indicator 1 if officials cannot persuade banks to give extensions of overdue

loans to TEs before liquidating them


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Other Determinants Firm quality

Profitability

Exporting firms

Size

Smaller firms are more likely to be privatized


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Summary of Hypotheses

Privatization is policy driven

Privatization is an institutional evolution;and is more likely when

Managers have comparative advantage

Budgets are hard

Markets are more competitive

Firms are smaller [profitability? could go either way ]


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FindingsDeterminants Analysis Privatization is more likely when the managers are more

educated or older

Privatization is more likely in more competitive industries

(controlling firm size)

Privatization is more likely when governments face hardbudget constraint

Pressure from upper-level governments cannot explain

privatization of the sample Smaller firms are more likely to be privatized

[profitability? Some studies more profitable, more likelyto privatize / others privatize the losers]


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Endogeneity: Budget Hardness

The hardness of the budget could be endogenous Reverse causality: governments may privatize to harden

the budget

Omitted variable bias: both privatization and hardbudget may be determined by other unobservedtownship characteristics

Two methods to deal with endogeneity IV method (the hardness of budget in neighboring

townships and county indicators as IVs) Excluding firms privatized in 1994

Results are similar to previous findings


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Conclusions Privatization is prevalent in rural China

regardless of the definition

Privatization

Not central policy directed or outright

corruption

A response to changing environments

The rise of TVEs was a response to the imperfect

conditions of the market and state

The privatization of TVEs is a response to the

improving conditions / competitive pressures


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Summary Massive privatization

Sell to insiders

Mainly spontaneous

NOW question for China:

How privatize?

Did they succeed?When insider privatization in

other countries failed


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Research Questions

How can local officials overcome informationasymmetries and get a good deal from privatization?And do they?

Is there any contractual mechanism that facilitatesinsider privatization and helps increase theperformance of privatized firms?

Do privatized firms in rural China actually performbetter after privatization (e.g., how do they docompared to private firms)? Is performanceuniform across insider privatized firms?


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Big Problem: Managers know firm

prospects / Leaders do not[Asymmetric Information]

Each township owned 12 fir s in 1994

Each firm sold to different destinations

officials have otherduties

The manager managed the firm5

years andworked in the firm for12 years

Question: how can (insider) privatization move forward?


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The Screening Theory (1)

Follow Laffont and Tirole (1986) Official offers a menu of contracts

Low buyout price, government shares future profits(leaving a tail with the government)

High buyout price, government does not share futureprofits

Manager chooses one contract, pays V andbecomes the new owner

Manager put effort e to manage the firm Profit is realized and divided between the two

parties according to the contract chosen bymanager earlier

A S i Th (2)


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A Screening Theory (2)

Good managers (or managers of high quality firms)

choose high buyout price contract, while poormanagers (or managers of low quality firms) choose

low buyout price contract

This occurs because

Good managers know that they will earn profits in thefuture and will choose the contract that let them keep

most or all future profits -- hence they are willing to

pay for this

Poor managers, on the other hand, do not expect to

make large future profits, and so choose the contract in

which they do not have to make a large up front buyout

price


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A Screening Theory (3)

Consequences The size of the buyout price will be positively

related to the share of future profits kept by the

manger

Managers that pay low buyout prices, only

receive part of future profits, and will under-

perform

Managers that pay high buyout prices, facegood incentives, and will perform well in the

future


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Privatization Process

Evaluation and the buyout price

base value = assets - debts

buyout price = base value + premium (discount) The normalized buyout price

Premium (discount) = buyout price book value of equity

Premium (discount) rate = premium/assets

The tail Postprivatization sharing rule

Screening contract indicator


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Example of Establishing Buyout

Price / Premium or Discount

-20

0

20

40

60

80

100

ssets e t B k V l.

By CPA + Gaizhi committee

Book value = Assets - Debt

Premium

Discount

Premium / discount

established thru negotiations:

leader & manager

Buy ut Price (2 ex ples)

1 2


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(Buyout Price to Base Value Ratio)

0

0

20

2

Nu

ber

fs

plefir

s

0-20 2 - 0 -7 76- 00 > 00 NEGATIVE

Premium / Discount Level

Pay a discount Pay a premium

Base Value = Book Value Assetsminus Book Value Debts

(+ BP) /

(- BV)


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The Premium/Discount and the Tail

0

1020

30

40

50

60

7080

90

100

Firmsin

ich

n er

P id

Premium

With utT il WithT il

Percent

Good incentives: ALL of

profits to manager

Poorer incentives: on

average, 40% go to

township govt


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Hypotheses

H1: the tail (share of govt) is negatively

correlated with the buyout price

H2: the postprivatization performance of a firm

increases with the buyout price

H3: the postprivatization performance of a firm

decreases with the tail (the profit share of the

government)

H4: the buyout price decreases with the degree ofinformation asymmetry (more the entrepreneur

knows relative to govt, lower the buyout price)


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Measuring Performance

3 perfor ance (effort) easures

Managers work time: number of hours per

week Accounts receivable management

=1-accounts receivable/asset value

Value added per worker (in log)


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Summary of Empirical Findings

Results support all four hypotheses

The tail is negatively correlated with the buyout price

Performance increases with the buyout price

Both OLS and fixed-effect estimations

Performance and the tail

Performance decreases with the size of the tail

Performance is lower when governments use the screeningcontract

The buyout price decreases with the degree of informationasymmetries


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Conclusions Insider privatization prevalent in rural China

Privatization

Not central policy directed

A response to changing environments

Institutional flexibility allows officials and managers to

solve a difficult economic problem, and have successful

insider privatization

Chinas rural industry

Performance will improve over time

Private firms will be important

Lecture 08 Rural Industrialization and Privatization

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