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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? [1] 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 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 so-called town-village enterprises (TVEs).  These TVEs 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, 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. 

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, public resources, tax breaks, 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.  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 these arrangements with TVEs become increasingly important to the local economy (and sometimes to meeting the personal needs 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.  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 firm assets. 

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." 

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. While agency costs continue to eat up substantial portions of the SOE surplus, 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. 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. 

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. 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. 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. 

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] See China Statistics Yearbooks for a regular accounting of this rapid economic growth. According to the Yearbooks, the Gross Domestic Product (GDP) per capita for China was only 695 yuan in 1978, the date that is typically given for the start of the economic reforms, grew to 1464 yuan (more than doubling!) in only ten years (by 1988) and had nearly doubled by 1996 when per capita GDP was calculated to be 2786 yuan. Post-essay update: According to the latest Statistical Yearbook, GDP per capita had more than doubled again from 1988 to 1998, from the aforementioned 1464 yuan to 3202 yuan. This long a period of rapid economic expansion, covering such a large population and geographic area, is unprecedented.

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

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