The Rise and Fall of Township and Village Enterprises and their Private Rebirth

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The Rise and Fall of Township and Village
Enterprises and their Private Rebirth

• Scott Rozelle
• Lecture 3, part 2

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Shenzhen 1980
Shenzhen 2002
Pix taken from the same spot
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Rise of Township and Village Enterprises

• TVEs are industrial and service enterprises owned
  (and sometimes, but not always operated) by the
  local state
• Came from nearly nothing in the late 1970s to
  nearly half the industrial economy by mid-1990s
• More than two-thirds of exports

Percent of industrial output
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The Fall of TVEs

• Even faster
• What happened?
• Where did they go?

Percent of industrial output
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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

?
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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 of Innovative Institutional Change
  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 the 1980s

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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 good incentives)
• 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/early
1990s
Traditional, Leader-run firm incentive problems
Manager-run firm after payment of fixed fee,
manager keeps residual profits
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 efficiency

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Explanation Why Shift / Who Shifted First
Leader Run

• Fixed Lease Firms
• Labor intensive
• Areas with good markets
• Busy leader (lots of firms)
• Educated manager (educated leader ran firm
  himself)

Fixed Lease
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Explanation property rights were pretty good
in fixed lease firms, manager already had good
income rights / good control rights
Types of Firms
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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 profit rates
  need for new investments in newer technologies

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Li and Rozelle (2004) paper we began our study
just as the privatization (gaizhi) movement was
starting

• What are the trends of the movement?
• How did they do it? The process
• What was the impact on performance?

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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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RecordRest of World

• No substantial improvement in performance in most
  privatization movements (Earle, 1998 Anderson et
  al. 1999)
• Privatized firms under-perform compared with
  other private firms (Frydman et al., 1999
  Barberis, Shleifer et al. 1996)
• Insider privatization least successful
• Two major reasons (Frydman and Rapaczynski, 1994
  Blanchard and Aghion, 1996 Barberis et al.,
  1996 Black et al., 2000)
• Lack of capital
• Lack of human capital

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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 million government-owned firms privatized
  spontaneously in the 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 shift of shares
• Controlling interest Share-shifting (CI-SS) gt 50
• Complete Privatization (CP) 100 private shares
• There were also fully private firms emerging
  during this time we will analyze these firms
  later

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Rates of Privatization of TE Firms, 1993 to 1999
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Differences among Townships on Rate of
Privatization, 1993-1999
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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) more
  complicated relationship

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The Case of Rural China

• 2 million government-owned firms privatized
  spontaneously in the 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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Inside Job
outsider

• Little choice of course, insider
• Almost 100 former managers
• On average, manager managed the firm 5 years and
  worked in the firm for 12 years

insider
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The Case of Rural China

• 2 million government-owned firms privatized
  spontaneously in the past decade
• Most firms are sold to insiders, especially
  former managers (Kung, 1999 Li and Rozelle,
  2003)
• Many potential reasons about why privatize
  (DETERMINANTS)
• 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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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 information
  asymmetries and get a good deal from
  privatization? And do they?
• Is there any contractual mechanism that
  facilitates insider privatization and helps
  increase the performance of privatized firms?
• Do privatized firms in rural China actually
  perform better after privatization (e.g., how do
  they do compared to private firms)? Is
  performance uniform across insider privatized
  firms?

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Big Problem Managers know firm prospects /
Leaders do not Asymmetric Information

• Each township owned 12 firms in 1994
• Each firm sold to 4 different destinations
• officials have other duties
• The manager managed the firm 5 years and worked
  in the firm for 12 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
  future profits
• Manager chooses one contract, pays V and becomes
  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 by
  manager earlier

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A Screening Theory (2)

• Good managers (or managers of high quality firms)
  choose high buyout price contract, while poor
  managers (or managers of low quality firms)
  choose low buyout price contract
• This occurs because
• Good managers know that they will earn profits in
  the future 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, face good
  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
By CPA Gaizhi committee
Premium
Discount
1
2
Buyout Price (2 examples)
Premium / discount established thru negotiations
leader manager
Book value Assets - Debt
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(Buyout Price to Base Value Ratio)
Base Value Book Value Assets minus Book Value
Debts
Pay a discount
Pay a premium
( BP) / (- BV)
Premium / Discount Level
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The Premium/Discount and the Tail
Percent
Poorer incentives on average, 40 go to township
govt
Good incentives ALL of profits to manager
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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 of
  information asymmetry (more the entrepreneur
  knows relative to govt, lower the buyout price)

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Measuring Performance

• 3 performance (effort) measures
• 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
  screening contract
• The buyout price decreases with the degree of
  information asymmetries

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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