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Essay Number 13
March 16, 1999  

Ambiguous Capital:

The Success of China's New Capitalists in the Township and Village Enterprises and Their Impact on the State Sector

thin rule
By Satya J. Gabriel

How has China's economy grown at such extraordinary rates in the 1980s and 1990s, with real GDP per capita quadrupling in two decades? We've seen some of the reasons in previous essays, including some of the ways economic reforms have worked to unleash the creativity and hard work of the Chinese citizenry.  Forget that China is still described (in polemical terms) as a communist country.  This rhetoric really doesn't mean much when it comes to the nuts and bolts of everyday economic life.  Or the perception that China's economy is severely lacking in flexibility and competition.  One of the hallmarks of the reforms has been the rapid growth of new economic institutions competing with the old and often stodgy state-owned capitalist enterprises.  Forget, too, that the Chinese financial markets have gone through a meltdown more severe than the one that hit Brazil after it devalued.  The valuation of Chinese publicly traded firms have discounted something close to Armageddon.  China's capitalist economy is far more vibrant than is understood by most on Wall Street or even in the financial district of Hong Kong.   The best way to see why China is a burgeoning capitalist economic power is to examine the nation's township-village (because they are owned by townships and villages) enterprises (TVEs).[1]  These former commune and brigade enterprises represent the vanguard in China's new capitalism.  The TVEs are hybrid institutions --- unusual alliances between TVE entrepreneurs and local  government officials (acting in the capacity of "owners" of TVE enterprises). 

Despite the mixture of private entrepreneurship with public ownership[2], the TVEs have achieved rates of success that would be welcomed in any capitalist economy.  The key seems to have been the ability of China's capitalist system to generate an adaptation to the standard relationship between managers and owners in capitalist enterprises.  This adaptation has taken the form of the creation of a local market for management control as a solution to the principal-agent problem, where the principal is, in this case, local government.[3]

In China, where the differential rights of managers and owners remains ambiguous, the TVE has provided an institution within which this ambiguity can become a source of competitive advantage.  Entrepreneurs/managers negotiate a contract with the relevant public officials that may contain both implicit and explicit conditions.  Managers can gain a great deal of flexibility in such contracts, while the relevant public officials secure for their local government (or for themselves) fixed claims to a portion of the enterprise cash flow and other agreed upon benefits in non cash form.  Managers may also obtain from public officials an agreement that such officials will provide special access to inputs (including new, upgraded machines and other forms of technology), public resources (including training for laborers), tax breaks, exemptions from legal restrictions (including restrictions designed to protect the rights, health, and safety of workers employed by the TVE)[4] , protection from rival state-owned enterprises and their supporters within the central government, or any number of other "incentives" that contribute to the competitiveness of the TVE.  This is not so unlike the various incentives provided by local governments in the USA and elsewhere in exchange for firm management agreeing to locate facilities in the local area or to not relocate existing facilities elsewhere or the sort of client-patron relationship created by corporate sponsorship of politicians (in the form of campaign contributions and related support, lobbying, and so on).  In the Chinese case this sort of arrangement becomes an important mechanism for institutionalizing the reform process.  It becomes in the interest of local officials to expand capitalism, since arrangements with TVEs become increasingly important to the local economy (and sometimes to meeting the personal needs, whether in cash or in kind, of the officials). 

In the TVE, public officials have a greater incentive to take seriously their role as a contracting agent (playing the role of owners) in negotiating conditions with the top level managers of TVEs, as well as in structuring rules and regulations to meet the cash flow needs of the TVEs, such as allowing more lay-offs (rationalization) of TVE workers.  The separation of ownership and management, in this context, creates an environment that fosters greater focus on generating cash flows than is the case in state owned enterprises (SOEs).  The managers have to satisfy residual claims on the firms' cash flow and are subject to much harder budget constraints than SOE managers.  Thus, unlike the conditions under which SOE managers operate, the managers of the TVEs have every incentive to cost minimize, including stricter oversight of the firm's existing assets, and to maximize the net present value of assets acquired during the management's tenure. [5] 

Managers, not surprisingly, have a keen interest in expanding their authority over these TVEs. Ambiguity in the ownership-management relation may generate some interesting and creative contractual solutions, but is not the "optimal" arrangement from the standpoint of managers. One can clearly observe a trend among the TVEs towards the "individualization of ownership," meaning that ownership shares are increasingly being distributed from the local governments to firm management, providing an additional incentive for firm managers to focus on creating share owner value. As one of my Nanjing University graduate students, Zhong Qizhi, describes it: "The town-village enterprises are still evolving. They are still mostly public enterprises, but a lot of local officials would be just as happy if they were private, as long as the taxes they get keep increasing." 

An ironic consequence of transfering ownership to management might be a reduction in the willingness of TVE managers to take certain risks. When managers sign contracts granting them the right to receive and distribute the net cash flow, while ownership continues to be vested in the local government, then such managers may seek out opportunities that may have large payouts if successful, even if there is substantial risk that these payouts might not materialize. At the extreme, a failure to achieve desired results could lead to the failure of the managed firm. If managers are also the owners of the firm, the possibility of failure may represent a much more serious risk because the managers would suffer a significant reduction in their personal net worth. In addition, social prestige for managers has become increasingly linked to their ability to create and maintain positive cash flow and to avoid insolvency (as opposed to the political path to social prestige and material rewards of the old system). Managers might, under such conditions, seek to implement less risky business strategies that produce positive net cash flows but with a lower probability of extraordinary rates of cash flow growth (as has been common among TVEs). The result could be a sharp drop in the rate of growth generated within the TVE sector and therefore a slowdown in overall economic growth.

Another benefit of local government contracting TVEs to private management is that this arrangement offers significant strategic options to both parties. Depending upon the details and duration of the contract, local governments can retain the right to reacquire operational control of the firm and/or to dictate conditions for altering certain critical operational aspects, such as the level of employment or location of new facilities. To the extent this is the case, it limits the options for the private managers. On the other hand, it is also possible that the special relationship with local government will provide firm management with unique options for accessing favorable facilities, building sites, local area resources, skilled labor, and information (possessed by local authorities but not made public) which may be of strategic value. And it is also possible that local government authorities enter into the contract to create certain options that might not be politically feasible if they were to remain in direct control of the firm. For example, the contract may grant (explicitly or implicitly) the private managers the right to eliminate redundant workers or unprofitable facilities. Every contract involves the creation of a complex array of options, some of which represent trade-offs, but overall the benefits for both parties are likely to be significant and tangible.

Despite this very cozy working relationship between public authorities and firm management, one of the factors contributing to the success of the TVEs and providing encouragement to those supporting further privatization is that the TVEs have tended to engage in fairly aggressive self-policing of the sorts of corrupt business practices that have plagued most SOEs. This is in sharp contrast to privatization in Russia which resulted in an escalation in corrupt business practices and outright thuggery.[6]  While management inefficiency, misfeasance and malfesance continue to eat up substantial portions of the SOE surplus in China, the TVEs have achieved a level of efficiency that is more common to highly competitive capitalist firms in the so-called West. 

This should not, however, be taken to mean that the only or overriding objective of TVE managers is profit maximization. In many cases, TVE managers are more concerned about expanding market share. This in no way contradicts the capitalist nature of the TVE. They remain enterprises run by managers who appropriate surplus through voluntary contracts with wage laborers. To the extent enterprise managers focus on other criteria than profit maximization, they are acting in accordance with the long-term capitalist objective of maintaining the wage labor system and, no doubt, the short-term objective of satisfying their own self-interest. Indeed, it is not so uncommon for capitalist enterprises in the U.S.A. and other advanced capitalist nations to focus on such factors as expansion of market share, even at the expense of short-run profitability.  

Indeed, the aggressiveness of town-village enterprises has sent shock waves through the SOE sector. TVEs have not been afraid to engage in price cutting or to employ relatively sophisticated marketing of their products. They are not afraid to go head to head with much bigger SOEs. This is ultimately good for the SOEs, as well the TVEs. SOEs have been forced to concentrate more on upgrading their facilities, improving product quality, developing marketing plans, enhancing management skills and cutting prices. SOEs are more likely, in fact, than TVEs to devote a significant portion of their cash flow to research and development activities. And the SOEs have a good deal of slack that could be tightened to improve their overall performance: SOEs pay almost 10% more in wages than TVEs and SOE workers tend to have much lower productivity than the TVEs. Typically, the bigger and more powerful the SOE, the lower labor productivity. Any improvement in productivity or convergence of SOE and TVE pay scales would benefit the SOEs in this competitive battle. It is already the case that SOEs in more competitive markets have higher productivity and stronger cash flow than comparable SOEs in more protected market segments. And because i) the SOEs are generally located in urban areas, where the pool of talent available to fill managerial and direct producer slots is richer than for most rural TVEs and ii) there are greater opportunities for joint venture arrangements and other forms of cooperation with both foreign and domestic firms on technological innovation there is reason for optimism that the productivity gap might not only be closed but that it might eventually move in favor of the SOEs. All of these factors make it much more likely that some fraction of the SOEs will emerge as first-rate, competitive enterprises on the global economic stage. In any event, the end result --- better products, better services, lower prices --- is beneficial to Chinese society as a whole. 

As the TVE sector has become more corporatized, many of these enterprises have chosen a joint stock company designation within which shares are kept in the local community, in many cases owned primarily by employees (including management), with restrictions on the sale of such ownership shares. To keep shares in the family, so to speak, employees who seek to leave the firm may be required to sell to existing shareowners. Some of these joint stock companies have even required that new employees become shareowners, creating a corporate structures similar to that of the Mondragon corporate conglomerate in the Basque region of Spain (considered by some the largest "communal" corporation in the world). In this form of corporation, capital is substituted with a communal endowment of financial resources and skills, all owned and controlled by the workers themselves (including management). As in the case of the much larger Mondragon conglomerate, these firms have proven quite effective in generating surplus value (even if the form of this surplus value may be communal, rather than capitalist).

Throughout Chinese industry there is a rising culture of innovation and competition. You can see this first hand by visiting the TVEs or the more successful SOEs. For example, during my recent two year stay in China I had the opportunity to observe first-hand the effectiveness of corporate innovation within one of China's largest SOEs, Shanghai Petrochemicals. The firm's management is engaged in a wide-ranging strategy to upgrade technology and marketing. The company, which is publicly traded as ADRs on the NYSE, is also involved in several joint-ventures that will bring their managers into direct contact with some of the most sophisticated contemporary technology and management practices in the petrochemicals sector. The success of innovation within both the SOE and TVE sector is evident in China's export sector, which has remained healthy despite the Asian economic crisis and the wave of devaluations that put Chinese firms at a relative price disadvantage. 

The Chinese capitalist economy is in a relatively early stage of development. However, there are clear signs that managers in the TVEs and in the better of the SOEs are fast learners. Chinese firms are learning what it means to compete and to market. The advertising firm, Satchi and Satchi, is expanding in China in anticipation that it will be the world's largest source of advertising spending.  And quietly Chinese firms of all types are undergoing massive restructuring.  Mergers, acquisitions, plant closings, and rising unemployment in China are all signs of the commitment on the part of China's so-called communist leadership to advancing a Western-style capitalist economy. 

The current pessimism about China's prospects going forward are, no doubt, a product of the continuing lack of understanding of what is actually going on in China and continued confusion about what capitalism is really all about. [7] China is, after all, still called a "communist" country simply because the political system is ruled by a party that calls itself communist. The fact on the ground is, however, that China's industrial sector is not only capitalist but increasingly looks like capitalist sectors in the more advanced nations. Given this, the rather authoritarian nature of China's political system actually works to the advantage of Chinese capitalist firms.[8]

It reduces the possibility of disruption from organized labor or political risks, such as sudden devaluations. The costs of influencing governmental policy are probably not significantly greater than for many industries in the U.S.A. and other advanced capitalist nations. In addition, Chinese firms have the advantage of a large and rapidly growing domestic market coupled with a government that continues to fund large-scale infrastructural development (even as social service expenditures have been pared down due to SOE reorganization and, before that, the elimination of the communes).

For the foreseeable future, it remains highly probable that Chinese firms, TVEs and SOEs, will continue the recent wave of corporate restructurings that are providing significant improvements in allocative efficiency. In addition, Chinese firms will continue to engage in innovation on a scale that far exceeds the norm in developing nations (no doubt with the support of the central government and its intelligence operatives). China's capitalist institutions are probably here to stay. It may not herald the "end of history," but it is clear that China's leadership has concluded that the most pragmatic solution to the problem of Chinese economic development and political stability is to allow the capitalist sector to prosper and grow. 

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[1] Township and village enterprises comprise about 60% of enterprises not classified as state-owned (meaning central or provincial government owned). There are approximately 500,000 such non-state-owned enterprises recognized for tax collecting purposes in China. TVEs are increasingly important sources of income and employment (generating almost a third of Chinese gross domestic product and employing approximately 131 million workers). TVEs are particularly important in the production of clothing (sweatshop manufacturing), including contract manufacturing of clothing for export. Given the importance of generating hard currency reserves via exports, one should also note that the TVEs are responsible for more than a third of export earnings. Thus, TVE sales play a critical role in the "Four Modernizations" (which must be financed with such hard currency earnings).

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[2] Most town-village enterprises are owned, in whole or in part, by local governments. A significant portion of the sector represents what's left of industrial enterprises started during the commune era.  The output generated within these enterprises was depressed by the late 1950s famine, which was partly the result of the chaotic conditions created by the Great Leap Forward. The pro-ancient (promoting self-employment in agriculture and handicrafts) reforms adopted in the late 1970s generated a sharp rise in rural incomes. This sharp rise in rural incomes created a market for the output of rural industrial enterprises. These rural industrial enterprises within the communes were organized along feudal lines (as discussed in earlier essays) and would later morph into state capitalist firms. Thus, the first stage of the rapid economic growth was generated within the ancient (self-employment) sector of the Chinese economy, not the capitalist sector, but then had knock-on effects in the nascent state-capitalist TVEs. It is ironic that the early growth in self-employment would have been so critical to TVE growth because the TVEs now represent a significant threat to the survival of ancient farmers and artisans, as TVEs expand and encroach upon markets that had been captured or created by self-employed farmers and artisans and the government takes a more pro-capitalist stance, promoting the growth in surplus labor (by making millions of workers in state-owned enterprises redundant).

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[3] This local market for management control, created by the commoditization of management, can be differentiated from the typical market for corporate control in which ownership is both commodified and traded in highly liquid markets. In the latter case, it is the struggle over control of ownership, by vying for controlling percentages of equity shares, that determines control over management. These struggles are shaped by the specific nature of liquid financial markets within which ownership shares are traded and the political processes governing both the transfer of ownership control and the specific rights of owners to replace management. The local market for management control, created in the town-village case, is epitomized both by a high degree of illiquidity and the fact that ownership is not for sale. The private transactions that determine management contracts leaves a great deal of latitude in the hands of the owners, in this case local governments, about whether, when, and under what conditions to alter management. Ownership itself remains uncontested.

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[4] The role of public authorities as owners of enterprises dependent upon distributed shares of surplus value and as the protectors of citizens' rights to health and safety are in basic conflict in the Chinese system. This is epitomized by the failure of public authorities to carry out the latter function, opting instead to take actions in support of higher rates of exploitation in the township-village enterprises by the contracted management. Studies of the TVEs have shown that cost minimization in the context of supportive public policies has resulted in longer work days, poor safety conditions, and physical and emotional abuse of workers in those enterprises. TVEs account for more work-related deaths than the SOEs, despite the fact that SOEs employ far more workers. TVE managers have been found to violate rules on overtime, often forcing workers to perform unpaid labor. Both TVEs, private firms, and foreign firms have been found to engage in beatings and other forms of abuse of workers. See for example Xiaojun Xu's 1995 paper "You Xianqin Lingli dao Gongye Guanxi --- Xianzhen Qiye Laodong Guanxi de Zhuangkuang yu Tedian (From the Neighbor Next Door to Industrial Relations --- the Conditions and Characteristics of Labor Relations in Township and Village Enterprises), in Chang and Zhao (eds.), Laodong Guanxi, Laodongzhe, Laoquan --- Dangdai Zhongguo de Laodong Wenti (Labor Relations, Laborers, and Labor Rights --- the Labor Conditions in Contemporary China), published in Beijing by Zhongguo Laodong Chubanshe (China Labor Press). Thanks to Natalya Marusich and Zhong Qizhi.


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[5] These contracts represent a more efficient solution to the problem of agency costs than the bureaucratic solution attempted in the larger state-owned enterprises (soes): in the soes the owner-agent, the central or provincial government, attempts to control the behavior of management by appointing a majority of the policy-making board members (previously the bureaucracy directly appointed the top-level management) who, in turn, appoint and monitor management. As has been pointed out by others, the political objectives of government bureaucrats may generate suboptimal management strategies in firms where these bureaucrats weild power directly: government bureaucrats appointed to boards of directors are likely to place political objectives above maximizing the net present value of corporate assets. This problem is solved within the TVEs where private parties, who are more likely to be focused on maximizing the net present value of corporate assets, set and implement corporate strategy.

It is worth noting that the problem of agency costs is not unique to Chinese capitalist firms, whether publicly or privately owned.  

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[6] Jeffrey Sachs, the former advisor to the Russian state, described the privatization process as "corrupt asset grabs, managerial plunder of enterprises and paralysis of firms." The Russian version of capitalism had a lot in common with the late 19th century USA era of robber barons and organized crime, giving renewed emphasis to Marx's writings on primitive accumulation.

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[7] Government has always played an active role in shaping market exchange processes, especially under capitalism and slavery (the two most market dependent economic systems): at the most basic level, complex exchange relationships presume the existence of contracts and contracts presume the existence of government. Perhaps more to the point, under capitalism, as Armen Alchian and Harold Demsetz have pointed out, an organization (in capitalism the wage labor dependent firm) is understood as a nexus of contracts and agreements --- by nature dependent upon political and cultural processes. Although the Alchian-Demsetz approach to institutional analysis assumes voluntary agreements (and the wage labor contract under capitalism is certainly more voluntary than the conditions of labor of slaves or feudal serfs), in reality most agreements are the product of a combination of coercion, concord, and conflict. In particular, the wage labor market exists because of historical processes within which income inequality and the creation of severe limitations of access to land, other natural resources, and technologies forced large numbers of individuals into labor markets. Thus, the wage labor contract is voluntary only in a relative sense. Nevertheless, governments have played important roles in creating and reproducing these voluntary wage labor markets: the most fundamental contractual relationship in capitalism is that between wage laborer and capitalist firm. The misspecification of the role of government in the behavior of individual capitalist firms comes, in part, from the notion of "market externalities" which takes factors, such as political rule-making and rule enforcement and cultural processes by which economic agents come to particular understandings of economic relationships, as separable from and outside of market exchange relationships. This is an ontological problem in neoclassical economic theory. In reality, the government is either a visible or invisible partner in every market transaction, every contract that is agreed to, and every aspect of the social relationships that result in the creation of new value in the firm and the greater society.

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[8] A number of social scientists have noted the important role of the Chinese government in the economic growth of the reform era. C. Bramall, In Praise of Maoist Economic Planning, 1993; and G. White, The Chinese State in the Era of Economic Reform, 1993 are two excellent examples of the developmental state approach as applied to China. Developmental states, whether in Japan, South Korea, or even the 19th century United States of America, have played important roles in advancing capitalist relationships. It is unlikely, perhaps impossible, that China could have generated the dramatic growth of the past two-plus decades without the hyper-active role of the Chinese state. It is likely that the Chinese state will continue to play an important part in the growth of Chinese capitalism, albeit a very different one from the past. This is the challenge of China's pragmatic modernists, to remain flexible enough to adjust the role of the state to fit the needs of not only China's changing economy but a changing global economic environment, as well.

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 Copyright © 1999 Satya J. Gabriel, Mount Holyoke College.   All Rights Reserved. 

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