Capitalism with Chinese Characteristics: Entrepreneurship and the State

by Yasheng Huang

had always assumed, as do many other academics, that the Chinese reforms followed a gradualist trajectory – first beginning with modest, small steps and then accelerating the pace and the intensity of economic transformation over time. For many years, I held the view that the reforms in the 1990s were far more radical and far-reaching than the reforms in the 1980s.

A reader of this book would recognize that the thesis of this book is exactly the opposite. It shows that the true China miracle occurred in the 1980s and that it was a miracle created by the bottom-up entrepreneurship and considerable liberalization on many fronts. In the 1990s, there was in fact a substantial reversal of reforms.

The near-consensus view – or the view that has achieved the greatest traction – among economists is that China has grown by relying on unique, context-specific local institutional innovations, such as ownership by the local state of township and village enterprises (TVEs), decentralization, and selective financial controls. The conventional mechanisms of growth, such as private ownership, property rights security, financial liberalization and reforms of political institutions, are not central components of China's growth story.

Explicitly private entrepreneurship in the non-farm sectors developed vigorously and rapidly in rural China during the 1980s.

Financial reforms, again in the rural areas, were substantial in the 1980s, and the Chinese banking system channeled a surprisingly high level of credits to the private sector in the 1980s.

The Chinese definition of TVEs refers to their locations of establishments and registration (i.e., businesses located in the rural areas), not their ownership; Western researchers, on the other hand, have come to understand TVEs in terms of their ownership status.

Private TVEs were most vibrant in the poorest and the most agricultural provinces of China (and this feature of private TVEs also explains the understatement of their size in the conventional reporting as well as the connections between rural private entrepreneurship and poverty alleviation).

The key to our understanding of the China story is that China reversed many of its highly productive rural experiments and policies beginning in the early 1990s. In the 1990s, Chinese policy makers favored the cities in terms of investment and credit allocations and taxed the rural sector heavily in order to finance the state-led urban boom.

By the measure of private-sector fixed-asset investments, the most liberal policy epoch, by far, was in the 1980s; in the 1990s, the policy was reversed, and many of the productive rural financial experiments were discontinued. Rural administrative management was substantially centralized in the 1990s. Credit constraints on rural entrepreneurship, including private TVEs, rose substantially in the 1990s. Growth of rural household income in the 1990s was less than half of its growth in the 1980s, and the declining growth in the rural business income was especially pronounced. The size of government – measured in terms of headcounts of officials and the value of fixed assets it controls – expanded enormously in the 1990s. The directionally liberal political reforms of the 1980s were discontinued and reversed.

One is that Shanghai represents the classic urban-bias model – the city restricted the development of small-scale, entrepreneurial, and typically rural businesses while conferring tax benefits on foreign direct investment (FDI) and on businesses closely allied with the government.

Capitalism with Chinese characteristics is a function of a political balance between two Chinas – the entrepreneurial, market-driven rural China vis-à-vis the state-led urban China.

The father of Liu Chuanzhi, the main founder of Lenovo, ran China Patent Agent based in Hong Kong. China Patent Agent was a major shareholder of China Technology. Computer manufacturing is capital-intensive and requires substantial investments. It was the capital market in Hong Kong that met this high level of capital requirements of Lenovo. In 1993, Hong Kong Lenovo went public on the Hong Kong Stock Exchange. The initial public offering (IPO) raised US$12 million, which the firm plowed back into its investments in China. Lenovo is a success story of the market-based finance of Hong Kong, not of China's state-controlled financial system.

In the 1990s, China pursued a highly biased liberalization strategy that conferred substantial tax and policy incentives on FDI while restricting the growth potentials of the indigenous private sector.3 Until 2005, many of the high-tech and so-called strategic industries were declared off-limits to domestic private entry. Indigenous private entrepreneurs, many highly capable, could grow their businesses only via foreign registration. This is why Lenovo acquired a foreign legal status.

That corporate success in China requires a combination of Chinese management and foreign legal status is probably the cleanest illustration of the massive distortions in China's business environment – that this is a system that has imposed a straitjacket on the domestic private sector.

The story of Lenovo casts doubt on all these postulations. Yes, China lacks efficient legal and financial institutions, but it has access to them – in Hong Kong. Take the view that formal finance does not matter. The management of Lenovo certainly would not agree with this. The firm raised more than US$12 million from its Hong Kong IPO. Formal finance – and the institutions supplying it – is absolutely essential to the success of Lenovo. Informal finance might be sufficient to start small kiosk businesses or simple production, but it is not adequate for firms to acquire modern production facilities and to move up on the technological ladder.

The true contribution of China's open-door policy is not just about allowing foreign entry but also about allowing Chinese exit. It enabled some of China's own indigenous entrepreneurs to find an escape valve from a very bad system. To put it another way, China's success has less to do with creating efficient institutions and more to do with permitting access to efficient institutions outside of China.

China's need for an efficient financial system is greater in the interior regions than it is in the coastal provinces precisely because the interior is so short of other conditions for growth.

Bad institutions are especially detrimental to rural entrepreneurship, the type of entrepreneurship that matters far more to the welfare of the vast majority of the Chinese, as compared with urban, high-tech entrepreneurship.

The open-door policies alone can do very little – and they did very little – to help these entrepreneurs in the interior regions.

China succeeded where and when bottom-up, private entrepreneurship flourished and it stagnated where and when entrepreneurship was suppressed.

One of the most important – if not the most important – hallmarks of a market economy is the role and magnitude of the private sector.

Using fixed-asset investment as a measure of policy, I show that the policy treatment of the indigenous private sector deteriorated substantially in the 1990s as compared with the 1980s.

When small-scale, market-oriented, broad-based, and politically independent rural entrepreneurship is accorded greater operating freedom and supported by policies, entrepreneurial capitalism thrives and produces many of its associated virtuous effects. When rural capitalism is restricted in favor of its urban counterpart, Chinese capitalism is less welfare-improving.

Private ownership, financial liberalization, property rights security, and even some degree of constraints on the political rulers are as essential to China's economic success as they are to economic successes elsewhere.

By most accounts, Huawei, with sales revenue of about US$5.7 billion and operating in more than 90 countries, is China's most successful private-sector firm. But our knowledge of its actual ownership structure is almost non-existent. Huawei is a microcosm of China's private sector – we know that it is there but we do not know its actual size and its boundaries.

For example, Huawei mandated that all of its employees purchase shares, which suggests that its employees own at least a portion of the firm. But the company has never issued any share certificates explicitly recognizing their ownership. The employees were required to sign share certificates upon purchasing the shares, but Huawei kept all the copies. Because there is no information about how many shares were issued, we do not know whether Huawei is an employee-owned company.

The firm was established in 1988 and, until very recently, the telecommunications sector was declared off-limits to private-sector firms in China. In addition, Chinese financial regulations have stringent restrictions about issuing shares to employees. It is all but certain that Huawei, by virtue of the fact that it is a private-sector firm, is in technical violation of many of these regulations. This hypothesis also dovetails with the widely held knowledge that Huawei has backing from the Chinese military.

The lawsuit also shows that a number of state-owned telecommunication firms in Shenzhen were granted shares by Huawei, although, again, there is no information about the amount of the shares. It is possible that Huawei has some state share capital on its balance sheet, but we can safely rule out the possibility that Huawei is a state-owned firm.

The longevity of the general manager is the most reliable way to distinguish a true private-sector firm from an SOE. The government frequently shuffles the management of SOEs and, therefore, SOE managers typically have very short tenures.

We distinguish between two types of measurements – output-based and input-based measures of the size of China's private sector. The output-based measure is often used by academics to gauge both the size of China's private sector and the evolving policy environment for the private sector. I show that this is the correct measure to assess the size of the private sector in China, but it is deeply problematic as a measure of the evolving policy environment. The basic problem is that this measure confounds the effects of two factors – the policy changes and the firm-level efficiency differentials between SOEs and private-sector firms.

The minuscule share of private plots in the Soviet Union suggests that a better measure of the changes in the policy environment should be based on an input allocated to private sector rather than its share of the output. The most appropriate input-based measure is the fixed-asset investment capital. Fixed-asset investments are equivalent to purchases of plants, property, and equipment in the Western accounting system. There are two reasons why this is a better measure of policy. One is that fixed-asset investments remain substantially controlled by the state; thus, changes in the patterns of fixed-asset investments are a more accurate reflection of the policy preferences of the Chinese state. The second reason is that in a poor country, capital is scarce relative to labor. So capital allocation is more indicative than labor allocations of the fundamental orientation of the economic system.

Equating the non-state sector with the private sector is problematic.8 Local governments control collective firms to varying degrees.9 The vast majority of the SOEs that have issued shares on China's stock exchanges are technically classified as non-state firms but they are still tightly controlled by the state.

Legal-person shareholding refers to cross-shareholding by firms. Probably because of the connotations of this term, the OECD economists might have assumed that legal-person shareholding implies that China has a keiretsu arrangement similar to that in Japan where firms own each others’ stocks. The difference with Japan, however, is that in China much of the legal-person share capital originates in the state sector, via SOEs establishing or holding significant equity stakes in other firms. These firms then become affiliates or subsidiaries of the SOEs. The subsidiaries of the SOEs, on account of their final ownership, are still SOEs.

The high concentration of the ownership structure of the legal-person shareholding firms is another sign that these firms are not private at all. In the NBS dataset, SAIC Motor has the most dispersed shareholding structure among the legal-person shareholding firms because 30 percent of its shares are held by individual shareholders. (This is because the firm is listed.) In contrast, of 16,871 legal-person shareholding firms in the NBS dataset for 1998, 75 percent have zero individual share capital. The average individual share capital is only 3.7 percent. This is entirely expected given the heavily accounting nature of the SOE reforms. As evidence, 7,612 of these so-called legal-person shareholding firms are actually factories – they are simply production subsidiaries of other SOEs. This explains the extraordinary concentration of ownership and control of these firms.

At the end of the twentieth century, the size of the indigenous private sector in China was minuscule. By 2005, however, the indigenous private sector did become sizable (at 22 percent of the industrial value-added). The flourishing of the indigenous private-sector firms is a very recent development.

This definition is too narrow because under Chinese law, any firm with 25 percent of foreign share capital is classified as an FIE and an FIE is subject to the regulatory regime of the foreign sector.

In fact, the data on aggregate size obscure the extent to which indigenous private-sector firms are undersized. This is because there are far more indigenous private-sector firms than there are FIEs. Let me illustrate this point using the OECD definition. The 5.9 percent share of indigenous private-sector firms in 1998 was spread among 19,322 firms, whereas the 11.7 percent share of FIEs was produced by 15,934 FIEs. The aggregate size of the indigenous private-sector firms is less than half the size of the foreign private-sector firms, and their individual sizes are even smaller. Even the latest data for 2005 show a larger foreign sector – at 28.8 percent – than the indigenous private sector at 22 percent.

To the extent that the Chinese economy is capitalistic, it is based on foreign capital, not on indigenous private capital. This is prima facie evidence of the severity of the policy biases in China.

The private firms are more efficient than the SOEs and, therefore, even given a very narrow business space, they can out-compete the SOEs. This suggests, at least theoretically, that the ratio of the private to the state sector can rise without any improvement in the policy environment for private-sector firms and with rising inefficiencies of SOEs.

The fact that the private sector was still able to grow in an enormously difficult environment after the Tiananmen crackdown is a tribute to the agility and acumen of Chinese entrepreneurs, not to the wisdom of the policy of the Chinese government.

The input we focus on is capital allocated for fixed-asset investments (FAIs). There are several advantages to using fixed-asset investment data as a measure of China's evolving policy environment.

Contrary to the view that the state was divesting from the SOEs in the 1990s, the investment growth rate of the state sector in the 1990s and 2000s accelerated over the growth rate in the 1980s.

The argument is that China had rapid GDP growth during both the 1980s and the 1990s but the welfare implications for the Chinese people during these two periods have been very different. During the entrepreneurial decade of the 1980s, fast GDP growth was accompanied by equally fast household income growth. During the state-led 1990s, fast GDP growth diverged from household income growth. In particular, rural income – the best measure of the welfare of the majority of the Chinese population – sharply declined in terms of its growth rates compared with the 1980s.

This book is concerned with three economic institutions and their effects in China – the organization of firms (e.g., TVEs), the orientation of providers of finance, and property rights security.

The Chinese define TVEs as a geographic phenomenon – that TVEs are businesses located in rural areas. The Western academic literature has an ownership understanding of TVEs – that TVEs are owned by townships and villages. How substantial is this gap in these two understandings of TVEs? Data from the Ministry of Agriculture show that as early as 1985, out of 12 million businesses classified as TVEs, more than 10 million were purely private. If we get the facts right, TVEs, as it turns out, are a huge private-sector success story.

legal institutions on economic growth as well as

The essence of the argument I put forward in these chapters is that rural China matters for the country not just economically but also institutionally. The economic importance of rural China derives from the fact that China – even today – is deeply rural. The institutional importance of rural China is that rural China was always more predisposed toward capitalism and entrepreneurship.22

One of the deepest puzzles in the history of Chinese economic reforms is why the supply response of rural entrepreneurship was so massive in the early 1980s. The economic policy change is believed to be “modest,” for one thing. For the other, millions of rural entrepreneurs took upon themselves considerable risks. They put up a significant amount of capital,

Institutional convergence with democracy, clean government, and quality governance may now be necessary to move the Chinese economy to the next stage because both the private-asset stakes and the value of political predation have increased substantially.

most substantial reversal occurred in the area of rural finance. Private-sector access to capital to engage in nonfarm activities became very difficult in the 1990s. The embryonic rural financial liberalization – decentralization of management of local savings and loans organizations and a permissive stance toward private entry into the financial services sector – was completely stopped. Rural political and fiscal management was centralized. In more recent years, lease holdings of land have become increasingly insecure as local officials have grabbed land on a massive scale. Directional liberalism turned into directional illiberalism. Not a single new political reform initiative was proposed in the 1990s and many of the political reform initiatives of the 1980s were discontinued (Pei 2006, p. 11).