Reforming property rights in Chinese industry

/ ? 6- 2 S R]ES]EARC]H PAP]ER, S]EIK][]Es E S Y 19 9 Enterprise Behavior and Economic Reforms: A Comparative Study in Central and Eastern Europe and Industrial Reform and Productivity in Chinese Enterprises RESEARCH PROJECTS OF THE WORLD BANK CIINA SERIES May 1994 REFORMING PROPERTY RIGHTS IN CHINESE INDUSTRY by Gary H. Jefferson and John Zhiqiang Zhao Department of Economics Brandeis University Mai Lu Harvard Institute of International Development Cambridge, Massachusetts TRANSITIONECONOMICS DIVISION IJ1 K POLICY RESEARCH DEPARTMENT THE WORLD BANK  ACKNOWLEDGEMENT The research projects on "Enterprise Behavior and Economic Reforns: A Comparative Study in Central and Eastern Europe", and "Industrial Reforms and Productivity in Chinese Enterprises" are research initiatives of the Transition Economics Division (PRDTE) of the World Bank's Policy Research Department and managed by I.J. Singh, Lead Economist. These projects are being undertaken in collaboration with the following institutions: for the project in China, The Institute of Economics of the Chinese Academy of Social Sciences (IE of CASS), The Research Center for Rural Development of the State Council (RCRD), and The Economic Systems Reform Institute (ESRI), all in Beijing; and for the projects in Central and Eastern Europe The London Business School (LBS); Reforme et Ouvertures des Systemes Economiques (post) Socialistes (ROSES) at the University of Paris; Centro de Estudos Aplicados da Universidade Cat6lica Portuguesa (UCP) in Lisbon; The Czech Management Center (CMC) at Celakovice, Czech Republic; The Research Institute of Industrial Economics of the Janus Pannonius University, Pecs (RIIE) in Budapest, Hungary; and the Department of Economics at the University of Lodi, in Poland; and the National Center for Development Studies, Australian National University, Canberra, Australia. The research projects are supported with funds generously provided by: The World Bank Research Committee; The Japanese Grant Facility; The Portuguese Ministry of Industry and Energy; The Ministry of Research and Space; The Ministry of Industry and Foreign Trade, and General Office of Planning in France; and the United States Agency for International Development. The Research Paper Series disseminates preliminary findings of work in progress and promotes the exchange of ideas among researchers and others interested in the area. The papers contain the views, conclusions, and nterpretations of the author(s) and should not be attributed to the World Bank, its Board of Directors, its management or any of its member countries, or the sponsoring institutions or their affiliated agencies. Due to the informality of this series and to make the publication available with the least possible delay, the papers have not been fully edited, and the World Bank accepts no responsibility for errors. For additional copies, please send your written request to: Transition Economics Division The World Bank 1818 "H" Street, N.W. Room N 11-029x Washington, D.C. 20433 Attention: Mr. Christopher Rollison or FAX your request to (202) 522-1152 t~~~~~~~~~~~~~~~~~~~~~~~~~~~  ABSTRACT Within Chinese industry, the dichotomous distinction between "state-ownership" and "private-ownership" obscures important differences concerning the configuration of property rights as it affects incentives and performance. To investigate these differences between state and township-village enterprise, we appeal to a model of the finr as "a nexus of contracts" involving a central contracting agent endowed with certain management rights and assigned various risks and rewards. Using the contract as a unit of analysis, we analyze property rights reform not as a categorical choice, but rather as a continuum along which rights are allocated between state and enterprise and among agents within the enterprise. Finally, the paper investigates the impact of property rights reform on enterprise efficiency; the motive of government and enterprises for reform are also investigated. ii  CONTENTS Acknowledgement . .................................. i Abstract ............................ ......... ii 1. Introduction ....1..... ................... 2. Ownership Modes in Chinese Industry .............................1 3. The Firm as a Set of Rights and Contracts ..........2.............. 2 4. Property Rights in China's Pre-Reform Industry ......... ............. 3 5. Reform of the Legal and Regulatory Setting ......................... 4 A. Management Rights ...................................... 4 B. The Right of Residual Claimant .............................. 5 6. Management Rights Reform ..................................... 7 A. Rights of the Central Contracting Agent ...... 7 B. The Allocation of Intra-Firm Decision-Making Rights ..... 8 7. Redistributing Risk-Bearing .................. .... .... ...... 9 8. Cause and Effect of Property Rights Reform in China ...... ........... 11 9. Conclusions ......................................... 12 References . I ...... 21 LIST OF TABLES AND FIGuRE Table 1: Signatories of Contracts, 1991 .............................. 13 Table 2: The Allocation of Decision Rights, 1991 ...................... 14 Table 3: Distribution of Authority within Enterprises ....... ............. 15 Table 4: Summary of Allocation of Property Rights ........ ............. 16 Table 5: Specification of Risk-Bearing Rights .......... ............... 16 Table 6: The Efficiency Effect of Individual Decision-Making Rights .... .... 17 Table 7: Efficiency Effects of Property Rights Reform ................... 18 Table 8: Determinants of Property Rights Reform ...................... 18 Figure 1: Histogram of Decision-Making Authority in Chinese Enterprise .... 19 iii  1. INTRODUCTION The reform of property rights is a comerstone of the transition from a centrally planned economy to a market economy. There are two general approaches to property rights reform. One is privatization. a central feature of the transition scheme in Eastem Europe. The other approach is corporatization. In this paper, we define corporatization as a process involving three essential elements: (i) the establishment of a central contracting agent within the enterprise, (ii) the transfer to the agent of substantial risk and reward that is tied to enterprise performance, and (iii) the creation of a competitive market environment for the enterprise.' While, in China industry, a limited private sector has begun to emerge, it has largely emerged through the entry of small new start-ups rather than through the conversion of established state enterprises. Although the reform of China's state-owned and collective enterprises has principally relied on corporatization without privatization, we will demonstrate that, by the early 1990s, the process of industrial reform had fundamentally altered the allocation of property rights between state and enterprise and among parties within the enterprise. Within the analytical framework established in the paper, we document the shift in decision-making rights and the redistribution of risks to managers within the Chinese enterprise. We use this analytical framework to compare the nature of property nghts reform within the two largest ownership categories of Chinese industry: state industry and industry owned by the rural township-village sector. This paper is organized in the following way. Section 2 describes key distinctions between China's state-owned enterprises and township-village enterprises. Section 3 draws on the property rights literature to formulate a framework for analyzing property rights reform in Chinese industry. Section 4 analyzes the nature of property rights in prereform Chinese industry. Sections 5 and 6 analyze the enterprise reform program which emerged during the 1 980s, Section 5 examines the reform of management rights and Section 6 investigates changes in the distribution of risk-bearing. Finally, Section 7 tests the impact of property rights reform on the efficiency of China's industrial enterprises and examines the conditions which give impetus to property rights reform. 2. OWNERSHIP MODES IN CH1NESE INDUSTRY One of the key features of China's enterprise reform during the 1980s was the emergence of a diversified industrial system in which state-owned enterprises (SOEs) represented a declining share of industrial production. Notwithstanding annual 8-10% real rates of growth in state industry, the robust performance of the non-state sector caused its share to rise from approximately 20% at the beginning of reform to more than half by the early 1990s. The most dynamic element of the non-state enterprises during the 1980s was China's rural township-village sector whose nearly one million enterprises combined in 1992 to produce one quarter of China's industrial output. These township-village enterprises (TVEs), which are publicly-owned rural collectives, expanded on the foundations established by the earlier efforts of local governments to promote rural industry (Perkins et al., 1977). Like their predecessors, township-village enterprises operate "under close supervision from the township or village industrial departments" which contribute start-up funds, appoint managers, and "are intimately involved in major strategic decisions" (Wong, 1993, Ch. 9; Ody, 1991, p. iv). I The more conunon definition of corporatization emphasizes the conversion of the traditional state enterprise with no independent legal status to a limited liability corporation, including a board of directors. As explained in Section 3, our definition places emphasis on the form of property rights reform and more on its substance. While a substantial number of industrial enterprises in China have been corporatized according to the conventional definition, this study focuses on property rights reform in the large majority of state enterprises which have not been converted to limited liability corporations. 1  2 Research Paper Series: China The success of China's TVEs has sparked interest in explaining their high rates of productivity growth, which persisted during the 1980s at two to three times the rate of SOEs. Recent studies direct attention to several features that distinguish TVEs from state enterprises: 1) information channels linking (government) principals with (managerial) agents tend to be shorter and simpler for non-state firms than for state-owned units (Groves et al. forthcoming); 2) local officials and non-state enterprise managers focus sharply on financial objectives (profit plus local tax revenues), while managers of state enterprises, burdened with responsibility for housing and other social services as well as industrial operations, face a more complex set of objectives (Byrd and Gelb, 1990); and 3) because localities lack the center's borrowing capacity, enterprises under local jurisdiction face harder budget constraints than state-owned enterprises and often fall into bankruptcy (Qian and Xu, 1992). Several researchers have also suggested that, despite the absence of well-specified property rights, the demographic stability of China's rural communities promotes the emergence of "invisible institutions" to provide a "moral framework for rights" or a "cooperative culture" that serves to reduce problems of shirking and monitoring found in most public enterprises (Byrd and Lin, 1990; Yusuf 1993a, 1993b; Weitzman and Xu, 1993). Others, see the dramatic productivity gains of TVEs during the 1980s as largely a matter of the rapid marketization of TVEs relative to SOEs (Zou and Wang, 1993) or as a refection of catchup to the more technologically sophisticated state enterprises (Jefferson, Rawski and Zheng, 1993). In this paper, we specifically examine and compare the extent of property rights reform within the state and TVE sectors. Our conclusion is that, as compared with the state sector, property rights reform in the TVEs are more developed along three dimensions. First, a larger bundle of rights has been transferred to firms in the TVE sector than to those in the state sector. Second, among directors, managers, party officials and workers within TVEs, these rights are more clearly designated to a single group (i.e., managers) than within SOEs. Finally, while a risk-reward structure involving bidding, bonding expenses and bonuses has emerged for managers within both ownership types, it is more evolved within TVEs than within state enterprises. In short, TVEs managers appear to enjoy the rights and incentives required to act as effective central contracting agents; by comparison, within SOEs property rights are neither as devolved to the enterprise nor within the enterprises as well-specified as in their TVE counterparts. We find that differences in property rights reform between the TVE and state sectors account for much of the difference in the performance of China's industrial enterprises. 3. THE FIRM AS A SET OF RIGHTS AND CoNTRAcrs In order to understand the evolution of property rights within China's industrial enterprises, we set forth a conceptual framework of the firm which draws on the notion of ownership as a "bundle of rights" and the firm as a "nexus of contracts" (Alchian and Demsetz, 1972). In this paper, we decompose the bundle of rights and examine the contract, both explicit and implicit, as the key instrument for specifying the distribution of these rights between govermnent and the enterprise and within the enterprise. Contracts are also the key instrument for determining the distribution of isk and rewards between the state and the central contracting agent within the enterprise. The virtue of this approach is that it allows us to decompose the fuzzy concepts of "state-ownership" and 'private-ownership" into discrete elements that bear on the actual rights and incentives of individual factors of production within the finm. Both Alchian and Demsetz (1972) and Jensen and Meckling (1976) argue that for purposes of understanding the firm's conduct and performance, the conventional notion of "ownership of the firm" is meaningless and misleading. Their central insight is that the firm is a set of contracts among factors of production. The design of a system of contracts that allocates rights and incentives among factors in the firm is critical to determining the conduct and net worth of the firm.  Reforming Property Rights in Chinese lndustry 3 Alchian and Demsetz (1972) argue that what is unique about organization is the phenomenon of team production in which the marginal products of individual factors cannot be observed by market outcomes. In team production, the effort level of each factor affects the marginal products of other members of the team. The fact of team production, therefore, gives rise to opportunities for shirking and the need to monitor or "meter" effort levels of factors of production and the rewards they are paid. This is done through the designation of a central contracting party, an "owner-manager" or "entrepreneur," who is endowed with the requisite rights of a manager and the incentives of ownership. Unlike Alchian-Demsetz and Jensen-Meckling who view the entrepreneur as both manager and risk-bearer, Fama (1980) distinguishes between the functions of management and risk-bearing. We see this distinction as crucial, not only for understanding the principal-agent relationship within the modem corporation, involving outside owners and inside managers, but also for understanding the distribution of rights and incentives within publicly-owned enterprises, such as China's state enterprises and TVEs. The grant of managerial rights to the central contracting agent may consist of the right to be the central contracting agent (manager) within the firm with the associated rights to negotiate contracts, monitor and reward inputs, and alter the membership of the team. On the other hand, the transfer of ownership or risk-bearing to the agent includes the right to be a residual claimant and the right to sell or transfer management rights. It is this distinction between manager and risk-bearer that gives rise to the principal-agent problem and the issues addressed by Fama (1980), Jensen and Meckling (1976), Tirole (1990) and others concerning optimal contracting arrangements for motivating managers to monitor effectively and not indulge excessively in non-pecuniary consumption of the finn's resources. These issues of contract design add another layer of analytical possibilities that is relevant to both the corporatization of state enterprises and to various strategies for privatizing these enterprises. The fact that contracts have become the pervasive instrurnent of organization and reform for China's state-owned and township-village enterprises makes the contract approach to the firn particularly useful for analyzing institutional changes in China's industrial enterprises. For the empirical part of this paper, we use a sample of 950 state-enterprises and 300 TVEs that were surveyed in 1991. In that year, virtually all of the former and approximately 80% of the latter were operating under some form of management contract. 4. PROPERTY RIGHTS IN CHINA'S PRE-REFORM INDUSTRY It can be argued that, pnror to the reforms, the Chinese government's "ownership" of its enterprises was more meaningful than the term is in the industrial market economies. The state's ownership was far more complete than the ownership rights exercised by an entrepreneur over a firm in a market economy. Prior to reform, the state exercised extensive control over all factors of production within state industry. The rights exercised by the state included the following: specify the production plan of the enterprise, select suppliers and customers, install, alter and scrap fixed assets, allocate labor to the enterprise, fix levels of compensation, and redeploy or layoff labor. In all of these areas of authority, the bargaining rights of individual parties within the enterprise and those outside whose services or products were assigned to enterprises were severely limited. In the absence of product and factor markets, customers, suppliers, managers, technicians and production workers had no choice with respect to how to direct their resources. The absence of choice effectively precluded the right of factors of production to enter into voluntary contracts that specified their obligations and rewards. It is in this sense that the state's "ownership" of the "firm" was far more absolute than that available to principals operating in a market economy.  4 Research-Paper Series: China The key insight here is that the creation of markets (product markets, material markets, labor markets, and markets in managers, technologies, etc.) and the choices they give to their participants undermines opportunities for the use of coercion and the concentration of ownership. Markets disperse effective ownership and thereby make voluntary contracts clustered within the firm, not "ownership of the firm," the relevant unit of analysis for understanding the organization and behavior of the enterprise. The creation of competitive markets must be seen, therefore, not only for their traditional role in contributing to allocative efficiency, but also as an essential ingredient for the reform of property rights. 5. REFORM OF THE LEGAL AND REGULATORY SETTING Although incomplete and ambiguous, a legal, regulatory and policy structure has emerged since the early 1980s which has affected the pace and content of enterprise reform. Most important, this structure establishes a context in which various government agencies and the SOEs and TVEs they supervise negotiate contracts. It is our contention that this legal, regulatory and policy structure serves as a backdrop to the enterprise reform process. It establishes the broad parameters of enterprise reform, but it is relatively unimportant in determining the specific defacto rights of each enterprise. This observation is supported by Figure 1, which measures the distribution of enterprise rights within both state industiy and rural industry. If enterprise law and regulation were controlling, we would expect the distribution to be far more narrow that shown. In reviewing the evolution of official law, regulation and policy directed at enterprise reform, we distinguish between initiatives of the central government that bear on the transfer of management rights to the enterprise and those that involve the transfer of the risk-bearing function to the enterprise. A. Management Rights China's early enterprise reforms were based on the belief that the right of use can be separated from ownership. During the 1 980s, much of enterprise reform concerned the scope of use rights and the method by which they were transferred to enterprises. The process of the transfer of use rights can be divided into four periods: (i) Experiment (1978-1983): Experimentation with the transfer of use rights was begun in 1978 by the government of Sichuan province with six SOEs. The following year, the State Council formally sanctioned "organizing experiments of (the) management system."2 Thereafter, management reform spread rapidly to all levels of govermnent as various central agencies monitored and reported on "the expanding right of self-management."3 As expected, the early experiments in creating self-management rights were limited. Whatever authority was ceded to enterprise managers, it was still essential that "enterprises guarantee the fulfillment of all economic plans given by the state."' Still, the conception of unbundling the package of ownership rights and assigning some involving the use of the enterprise to managers was an important first step. 2 State Council Circular "The circular about reforming the management system in accord with the five documents of reform," July 1979. 3 State Council Circular, "A written instrument on the State Economic Commission's report about the situation of the expanding right of enterprise self-management and an opinion for the future," September 1980. 4 Ibid. State Council Circular.  Reforming Property Rights in Chinese Industry 5 (ii) Comprehensive implementation (1984-88): Encouraged by the success of its rural reforns, in 1984, the Chinese government launched a comprehensive set of urban reforms. Beginning in that year and continuing over the following four years, the government issued six documents expanding the use rights of SOEs.5 Under the enterprise responsibility system (discussed below), in principle enterprise managers were, in principle, granted wide autonomy in exchange for the guarantee of specified profit remittances. (iii) Stagnation (1989-91): During the austerity program designed to halt accelerating inflation, the government curtailed some enterprise's authority, particularly price setting and investmnent, which had been granted during prior years. Nonetheless, extensive local initiatives were taken in continuing the enterprise reform process, so that substantial use rights continued to be exercised by enterprise managers. (iv) Strengthening reforn (1992-present): Confronting rising losses in the state sector due to the toll of the austerity program and, more significantly, rapid entry from the non-state sector that has eroded state industries monopoly profits, govermments at all levels have sought to strengthen the use rights of state-owned enterprises.6 Under the State Council's 1992 Regulations, SOEs were given the right to: * refuse to fulfill state plans unless the plans originate with the appropriate agencies, include requisite inputs, and involves production for which there are contracted customers; * make autonomous decisions for investments for which funds and requisite inputs have been obtained by the enterprise; and l terminate labor contracts and layoff or fire workers according to the relevant laws and regulations and the rules of the enterprise. We see therefore, that by the early 1990s, a substantial body of law, regulation and policy had evolved emphasizing a substantial degree of autonomy for state enterprises. B. The Right of Residual Claimant In the absence of the right incentives, the grant of autonomy can be ineffectual or even counterproductive to achieving better enterprise performance. The key emphasis of incentive reform has been to tie rewards to enterprise profitability through bonuses, paid out of profits, and performance contracts. Central to the creation of profit-seeking incentives, the government has sanctioned a reweighing of the right of residual claim away from the state in favor of enterprises. We identify four periods in this reform: 5 These were: (i) "Temporary provisions concerning further expanding the authority of state enterprises" (State Council, Provisions 1984, May 1984); "The temporary provision about strengthening energy of large and medium-size state enterprises" (State Economic Commission and the State Economic System Reform Commission, Provisions 1985, September 1985); "The circular about issuing three regulations regarding state-owned industrial enterprises" (Central Party Committee and State Council, Circulars 1986, September 1986); "Regulation concerning deepening reform and strengthening the energy of enterprises" (State Council, Regulations 1986, December 1986); "Temporary provisions conceming the contract management responsibility system for state-owned enterprises" State Council, Provisions 1988, February, 1988); and "The law of the People's Republic of China conceming state-owned industrial enterprises" (passed by the National People's Congress in April 1988, Laws 1988). 6 Most notably the document "Regulations conceming the transformation of the management mechanism in state-owned enterprises" (State Council, Regulations 1992, July 1992).  6 Research Paper Series: China (i) Enterprise welfare fund and the share of profits (1978-80): In 1978, the state restored the labor incentive systems abandoned during the Cultural Revolution, including bonuses, piece rate work and the enterprise welfare fund.7 Rather than being attached to profits, however, bonuses were a fixed portion of the total wage and were tied to fulfillment of the state plan. Sichuan province was again the leader in enterprise reform. In October 1978, the provincial government inaugurated a series of experimental reforms going beyond these initial steps. Moreover, the State Council began its own experimentation with bonuses and various incentive compensation schemes in a number of large state-owned enterprises. (ii) Management responsibility system (1981-82): Inspired by the example of rural household responsibility contracts and anxious to stem the decline in revenues, local governments began to enter into responsibility contracts with enterprises. The best known of these is the 15-year contract negotiated between the State Council and the Beijing Capital Iron and Steel Company.8 Experimental enterprises were authorized to retain a portion of their profits after fulfilling the state plan. Under its "progressive profit responsibility system," Capital Iron and Steel was obligated to increase its profit remittance by a fixed annual rate of 7%, which in later years represented a real reduction in profit remittance as rates of inflation rose above the negotiated nomninal rate of increase.9 (iii) Turning profit submission to taxation (1983-86): In his Report on the Sixth Five-Year Plan, Premier Zhao Ziyang distinguished between reform measures for small-scale enterprises and large- and medium-size enterprises. The former were to adopt universally the responsibility system, and the latter were to supplement negotiated profit remittances with fixed rates of taxation. Beginning in April 1983, all profitable enterprises were to pay a 55% income tax. In addition, as the owner of these enterprises, the state was to share the remaining net profit. Furthermore, because some enterprises were deemed to make excessive profits due to special price and other advantages, they were subject to an ad hoc "adjustment tax." In 1983, to the satisfaction of the Finance Department, over 60% of the nearly ten percent increase in enterprise profits was captured by the state while enterprises retained under 40%. The result of expanding the state's profit share was a decline in the growth and then a fall of profits in state industry. Beginning with the last quarter of 1985, apparently due to the weak incentive effects of the new system, state industry profits fell continuously for 20 consecutive months. The government was forced to reconsider the allocation of profits between the state and its enterprises. (iv) Enterprise responsibility system (1987-present): During the mid 1980s, compared with the vast majority of SOEs which had converted to the taxation system, the twenty or so large and medium-size enterprises which had retained the responsibility system registered profit increases of more than 20% annually. Moreover in two provinces, Jilin and Guangdong, which converted back to the responsibility system earlier than other provinces, provincial and local government revenues grew. Following the emergence of declining revenues and growing deficits and the success of enterprises operating under the responsibility system, Zhao Ziyang personally advocated the restoration and universal implementation of the manager responsibility system. By the end of 1987, 80% of China's 12,000 large and middle-size enterprises had 7 Initially, the bonus and welfare fund had little to do with enterprise profits; rather, they were a fixed portion of the total wage and salary to be given if the enterprise fulfilled the state plan. 8 Koo( ) 9 The Departnent of Finance strongly opposed this innovation, but later, because of the conspicuous growth and diversification of Capital Iron and Steel, the experiment, notwithstanding the decline in real revenues, was considered to be a great success.  Reforming Property Rights in Chinese Industry 7 adopted the responsibility system, and the responsibility contract had become the principal vehicle for implementing enterprise reform. Most of China's publicly-owned industrial enterprises are now operating under the second or third generation of these three to five-year contracts. Individually negotiated between enterprises and their supervisory bodies, the emphasis of these responsibility contracts was on "a fixed rate for the state,.. .the larger the profit, the larger the share for the enterprise, enterprises be responsible for their own losses." In conclusion, we find that during the latter half of the 1980s and continuing with brief interruption during late 1989-90, China's central government established the broad outlines for corporatizing the state enterprise system. Supervisory agencies were mandated to transfer substantial authority, risk and rewards to enterprises and their managers. We see below, however, that the actual reallocation of authority, risk and rewards varied widely across enterprises, both within state industry and as between state enterprises and TVEs. 6. MANAGEMENT RIGHTS REFORM For the purpose of evaluating the extent to which China's enterprise reforms have involved the transfer of specific property rights from the state to a "central contracting agent" within SOEs and TVEs, we use as our empirical base a World Bank enterprise survey (1991), covering both state-owned enterprises and township-village enterprises. In this section, we examine the degree to which decision-making rights have been transferred to the enterprise and concentrated in the hands of a central contracting agent. In the following section, we examine the extent to which designated central contractors are also risk bearers. We first identify the signatory within the enterprise who contracts with the supervisory body to perform as the manager or central contracting agent within the enterprise. Table 1 shows three categories of signatories: a single director, a group of directors, and all employees. Among the SOE and TVE respondents in our sample, the data show that within state enterprises the designated contractor is most often a single director; in TVEs, by comparison, groups tend to accept the delegation of rights and responsibilities under the contract system. A. Rights of the Central Contracting Agent Using enterprise data, we evaluate the extent to which specific rights have been allocated by supervisory agencies of the state to the central party within the enterprise. As explained in Section 3 above, these consist of the rights to be the central party common to contract with all factors of production, including the setting of rewards and performance standards, to monitor input behavior, to enforce and alter contracts, and to change the membership of the team. Specifically, in the Chinese case, the central contractor may potentially acquire the rights to specify product mix, determine the destination of sales and source of supplies, negotiate prices with customers and suppliers, recruit and dismiss workers, and establish the terms of employment, including compensation. To examine the extent to which rights have been reallocated from the state to the enterprise, the World Bank survey asked managers to identify the locus of decision-making authority along eleven dimensions of management. The three possible choices consisted of: (i) the enterprise has the decision right (or no limit on the authority of the enterprise), (ii) the decision is made jointly (or some limitation), and (iii) the supervisory body has the decision right (or enterprise authority is completely limited). The data shown in Table 2 show the proportion of firms indicating each of the three possibilities. These results show that township-village enterprises enjoy considerably more autonomy in setting production plans; only 29% of the state enterprises report having this unfettered right, whereas twice the proportion of TVEs  8 Research Paper Series: China enjoy the right to set production plans. With respect to the choice of customer and the specification of prices, arguably the most important part of the sales contract, TVEs again enjoy more autonomy than their SOE counterparts. For both groups of enterprises, the right to set prices was more circumscribed than the right to choose customers, particularly for the sample of SOEs in which only one-fifth reported no limnits on their ability to set prices. With respect to autonomy in selecting suppliers, both SOE and TVE managers enjoy rights that appear similar to their rights to chose customers. A second major area of operating authority is in negotiating contracts with employees working within the firm. In the area of compensating workers, SOEs enjoy less autonomy in setting wage differentials than TVEs, but their authority to set the overall level of bonuses and bonus differentials is both high and greater than that of TVEs. While SOEs enjoy a relatively high degree of autonomy in fixing employees' compensation, their authority to change the membership of the tearn is more limited. SOEs enjoy a surprising degree of authority to dismiss employees, as do TVEs, but unlike TVEs, the authority of SOEs to recruit workers independently is limited. Both SOEs and TVEs are severely limited in their authority to appoint upper-level managers. Finally, we examine the right of the enterprise to alter the finn's capital stock through the investment process. Table 2 shows that for both SOEs and TVEs, this authority is limited. No more than a quarter of TVEs and less than one-sixth of SOEs report having this unfettered right. In the majority of cases, for both SOEs and TVEs, this decision is made jointly between the state and the enterprise. In order to examine the extent to which enterprises have accumulated any or all of the eleven decision-making -rights identified in Table 2, we constructed a histogram showing the distribution of accumulated rights for both the SOE and TVE samples. Figure IA shows that the distribution of rights for TVEs is skewed to the right of the distribution of SOE decision rights. For the SOEs, the plurality of enterprises had acquired five kinds of decision- making rights, whereas for the TVEs, a plurality enjoyed eight of the ten rights. Virtually none of the SOEs or TVEs exercised all eleven rights. Since the. survey was conducted in 1991, reforms have continued to be implemented. Under the State Council's 1992 Regulations, described in an earlier section, SOEs were authorized to receive expanded rights. The regulations appear to strengthen the authority of state enterprises in production planning and investment, two of the six areas in which a majority of state enterprises reported that they do not have full authority. While a majority of enterprises did report having the authority to dismiss workers, the third provision appears to further expand the rights of enterprises to terminate labor contracts and dismiss workers. B. The Allocation of Intra-Firm Decision-Making Rights The establishment of an effective central contracting agent, or monitor, within the enterprise not only requires that the firn be the locus of decision-making, but it also requires that within the firn, rights are exercised by a clearly-defined and limited group. Table 3 demonstrates that the locus of decision-making within both SOEs and TVEs is the management group. In TVEs, in all nine areas, management dominates. This is not the case for SOEs, in which in managers exercise the dominant authority in just five of the nine areas. In no area does the director exert exclusive authority. The state enterprise party committee plays a key role in the appointrnent of upper-level personnel, particularly in the appointment of assistant directors and middle-level cadres. Otherwise, the role of the party appears to be marginal. SOE employees, or employees' congresses, play a dominant role in one area of management: decisions to dismiss  Reforming Property Rights in Chinese Industry 9 employees. Employees also exercise formal influence over decisions regarding compensation, particularly in the setting of wage and bonus differentials among workers, but their authority is secondary to that of management. Using the summary of the reform of decision rights shown in Table 4, we can evaluate the reallocation of rights along two dimensions. The first, is the degree to which rights have been reallocated to a central contracting agent within the enterprise. The data, summarized in Table 4, show that for a majority of the TVEs, all but two of the eleven areas of decision rights have been transferred to the enterprise. For the sample of SOEs, authority has been effectively transferred to the enterprise along only five of the eleven dimensions of decision-making. For both SOEs and TVEs, the two common areas of decision-making rights that have not been transferred-appointment of upper management and investment decisions-are those which are typically retained by boards of directors of capitalist enterprises. We also evaluate the extent to which decision-making rights have been designated to a single party within the enterprise Within our sample of TVEs, we find that, in a majority of cases, a single director or group of managers exercise all nine areas of decision rights. For the SOEs, only six of the nine areas are concentrated in the director and a management group; in three areas, rights are allocated either to a party committee or to an employees' council. Figure lB portrays this distribution of decision rights within the enterprise. We can see from this figure that, at the time of the survey, approximately 40% of TVEs, all nine decision rights were vested in management (including a single director). In the case of SOEs, however, for the plurality of enterprises, only six of the nine decision rights were vested in management. For a substantial share of enterprises, half or fewer of the decision rights were vested in management. The second dimension of property rights analysis concems the extent to which the bundle of rights clearly reside with a specific party, irrespective of whether it is the state or the enterprise, or if they are diffused over more than one party. In this sense, TVEs have achieved a relatively high degree of clarity in their specification of property rights. In only one case (investment decisions) is authority generally shared between the state and the enterprise. For SOEs, in four areas of decision-making, a plurality of enterprises indicated that decisions are shared. This fact, in combination with the finding that, within TVEs, the director and/or a group of managers typically share power, whereas in SOEs internal authority is more diffuse, leads us to the conclusion that not only do SOEs enjoy fewer decision rights than TVEs, but the allocation of authority between the state and SOEs and within SOEs is not so clearly concentrated as it is for TVEs. While this is not a problem for the appointment of upper-level managers where the state exercises dominant authority, it is a problem for sales, for which enterprises can choose customdrs but not set prices. The diffusion of authority is also a problem for managing the work force, since enterprises can dismiss, but not recruit, workers; moreover, within the enterprise the authority for dismissal is vested in the employees and the authority to recruit is vested in management. There remains the important issue of the incentive structure of managers. This is critical, because weak incentives on the part of the central contracting party to economize on input costs and to limit the consumption of non- pecuniary benefits for the manager's own consumption will create inefficiencies and erode the firm's net worth. For this reason, it is important to examine the role of the central contracting party as risk-bearer. 7. REDISTRIBUTING RISK-BEARING If the incentives of Chinese managers have been strengthened, we would expect that they would have a financial stake in the performance of the enterprise. In order to give greater weight to profit-seeking behavior within the finn, the government has expanded the right of the firm as residual claimant From virtually zero before the reforms, the average profit retention rate of both state enterprises and township-village enterprises within our samples hovered at about 35% during 1989-90. In principle, a 55% corporate income tax is levied on SOEs and a variety of taxes are levied on  10 Research Paper Series: China TVEs, but negotiated profit remittances often substitute for these tax obligations." 'The 35% retention rate disguises large differences which varied duringthe period 1986-90 from zero in both samples to 100% for the SOEs and to 88% to 98% for various years for the TVEs. In the contracts negotiated during 1990-91, a variety of risk-bearing schemes were continued from the initial contract phase (approx. 1987-90). The distribution of profit allocation types shown in Table 5 indicates that there is no single dominant contract form. About one-sixth of both SOE and TVE managers within the sample operate under a system in which they pay a kind of lump-sum tax and retained all of the above-quota residual. A substantial share of contracts, larger for TVEs (36%) than for SOEs (28%), gives the enterprise the right to capture an increasingly large profit share as profits rise. Among the clearly identifiable schemes (omitting "other" and contracts for loss- reduction), the dictum "the larger the profit, the larger the share" does seem to hold for a majority of contracting arrangements. To what extent are managers and workers able to capture direct rewards from enterprise profitability? First, using the same World Bank data set, Jefferson and Rawski (1994) show that for SOEs a one percent increase in gross profit translates into a virala one percent increase in bonuses. The importance of bonuses in employee compensation is demonstrated by the fact that among SOEs, bonuses represent 55% of total cash compensation; for our sample of TVEs, the figure is 80%. Our data do not distinguish between the rewards to workers and the rewards to managers of increased profitability, but if bonuses are paid in proportion to wages, the incentive to managers is substantial, particularly for TVE managers for whom total compensation depends largely on bonus income. In addition to the link between bonuses and enterprise perfornance, managers are often required to commit their own collateral as a form of performance guarantee. Jensen and Meckling (1976) call these "bonding expenses" used to guarantee that agents do not engage in certain actions that would harm the interests of the principal. Enterprise losses, for example, can be partially financed from these bonds or collateral. Our data, reported in Table 5, show that :20% of the signatories in state-owned enterprises reported having committed some amount of collateral as compared with 30% of their TVE counterparts. For SOE managers, the average payment was 13,200 Rmb; for TVE managers, the average was 38,800. 1 Finally, various analysts of the principal-agent problem emphasize the importance of a market in managers. With such a market, managers who perform poorly or who overcharge for their services can be challenged by other managers or- replaced by more cost-effective performers. Our survey data indicate that a market for managers is beginning to emerge in China's urban centers. We do not know how competitive the selection process is, but we do know that during the contracting for 1990-91, a fraction of managers were chosen through bidding processes. For SOEs, the proportion was 3.4%, while for TVEs the share was 4.3%. Among the TVEs, 10% were elected from within the enterprise, while within state industry those internally elected represented 3.4% of the total. In conclusion, we do find that an incentive structure is emerging in the state and TVE sectors in which managers are becomning substantial risk-bearers. A comparison of the two systems indicates that the basic structure of the two systems is simnilar: managers are appointed by supervisory bodies, collateral is common but not a general requirement, profit retention rates are similar and bonuses, indicative of enterprise performance, are used extensively. There are, however, differences in the parameters of the two similar systems: bonuses, the variable component of compensation, 10 In early 1994, a uniform 33% corporate income tax was implemented for all enterprises. 11 In 1991 when the survey was implemented, the exchange rate was approximately Rrnb5.7:$1.  Reforming Property Rights in Chinese Industry 11 is larger in TVEs, collateral is required more frequently, and the size of these performance guarantees is larger in TVEs. Finally, more managers are selected through bidding or election processes within TVEs than SOEs. 8. CAUSE AND EFFECT OF PROPERTY RIGHTS REFORM IN CHINA If property rights reform has succeeded in altering the conduct of China's state enterprises, we should observe that those enterprises in which rights have been most extensively reallocated to the enterprise are also the most efficient."2 To test this hypothesis, we embed an index of property rights reform into an efficiency equation, InA = InA0 + axlnQ + PR,, where Q represents enterprise scale, measured in terms of gross output, and PR, is an index which measures the extent to which each decision right is held by the enterprise (I=state, 2=joint, 3=enterprise). We embed the efficiency equation into a three-input Cobb-Douglas production function (KLM, including energy) and convert the equation into intensive form. We estimate the equation for each of the eleven decision rights. Table 7 ranks the impact of each of these individual rights on total factor productivity. According to Table 7, for the SOE sample, five of the eleven rights demonstrate a positive and statistically significant impact on efficiency, five demonstrate no impact and one demonstrates a negative impact. For the TVEs, three have a positive impact, seven show no imnpact and one demonstrates a negative impact.13 It is particularly curious that rights to set prices and select customers and suppliers should demonstrate a negative or neutral impact on efficiency. One plausible explanation of this seemingly neutral or perverse association is that, as compared with firms operating with controlled prices, firms that operate outside the plan in both product sales and input procurement may face input prices that are high in relation to product prices. The fact that price setting -and sales and procurement autonomy are strongly positively associated with net output efficiency (omitting material inputs) lends support to this conjecture. In order to examine the efficiency effect of a bundle of decision rights consisting of those shown to affect efficiency individually, we construct an index of property rights. This index, constructed 'for each enterprise, is a simple sum of the assignment given to each of the five measures of managerial authority shown to have a positive and significant effect on state enterprise efficiency. The efficiency effect of the reformed bundle of decision rights is tested by using the same functional form as that used for testing the efficiency effects of individual rights. The results, shown in Table 7, demonstrate that the transfer of one or any combination of the five decision rights has a significant effect on state enterprise efficiency. While not as statistically significant in their effect, the same bundle of decision rights with TVEs also has a significant efficiency effect. Can we explain the conditions that account for differences in the degree of property rights reform across enterprises? Jefferson and Rawski (1994) develop an account of China's industrial reform process in which they contend that a substantial part of the reform occurs through an endogenous reform process. By their account, reform leads to competition, competition, in turn, erodes monopoly rents that had been concentrated in the industrial sector, declining profitability leads to slower revenue growth, and fiscal pressures motivate governments to confer greater property rights reform on enterprises. The result is an endogenous, circular process of reform in which reform begets more reform. 12 Lee (1991) finds that the introduction of the contract responsibility into a sample of state-owned iron and steel enterprises had a modest effect in elevating levels of productivity. 13 Measurement error associated with categorical measures of the allocation of rights (i.e., 1,2,3) may cause a downward bias in estimates and a tendency to reject the hypothesis of statistical significance.  12 Research Paper Series: China Confronting cyclical losses in the state sector due to the austerity program of 1988-91 and a secular decline in profitability resulting from the rapid entry of non-state enterprises that has eroded the monopoly profits of state industry, governments at all levels have sought to strengthen the grant of autonomy to state-owned enterprises while also making them more accountable for the financial status of the enterprise.n4 To test this hypothesis of endogenous property rights reform, Jefferson and Rawski investigate the impact of the degree of enterprise competition profitability on the degree of property nrghts reform. Our results, shown in Table 8, support the endogenous reform hypothesis for the state sector. That is, the greater the competition"5 and the lower the profit ratio, the more extensive the grant of decision-making rights. This process of circular reform is not so evident in our sample of TVEs. Together, the results shown in Table 7 and 8 imply a kind of "virtuous circle" of property rights reform in China's state industry. 9. CONCLUSIONS This paper employs the theory of the firm as a "nexus of contracts" to evaluate and compare the degree of property rights reform in China's publicly-owned industrial enterprises. We find that property rights have been substantially reallocated to state enterprises and TVEs, although the transfer has been less complete for the former than for the latter. Also, the distribution of decision-making rights within state enterprises is more diffuse than for TVEs as they tend to be shared by a group of managers, the party secretary and employees. In addition to finding that a central contracting agent has begun to emerge within SOEs and TVEs with managerial authority, we find that these managers are also becoming residual claimants. Retained earnings and substantial bonuses, as well as collateral, and evidence of an emerging competitive selection process are causing managers to incur the risks and rewards associated with enterprise performance. As anticipated, property rights reform is significantly affecting the performance of enterprises. The more complete implementation of property rights reform in TVEs appears to account, in some part, for higher rates of growth of productivity observed in the TVE sector. Generally, property rights reform is analyzed without questioning the motive of agents responsible for devolving authority to enterprises. We find that in state industry competition and financial pressures give rise to property rights reform. The conditions are likely to motivate enterprises to lobby harder for autonomy and to also make governments that are fiscally stressed more likely to devolve authority and responsibility to enterpn'ses, i.e., "send enterprises to market." This circular reform process is not as pronounced for TVEs. Notwithstanding this movement toward reform, this study also demonstrates the shortcomings of the existing state of property rights. Particularly in state industry, management rights remain only partially reallocated to enterprises. In TVEs, where a majority of enterprises report having secured control over key decisions, a substantial minority of enterprises still report that they do not have that authority. Moreover, in state industry, the distribution of authority among various parties is not concentrated in a single individual or group; directors, managers, party secretaries and workers share authority. 14 Most notably the document "Regulations concerning the transformation of the management mechanism in state-owned enterprises" (State Council, Regulations 1992, July 1992). 15 Managers are asked to assess the degree of competition faced by their enterprises.  Reforming Propertvl Rights in Chinese Industry 13 The data used in this study are based on self-reported assessments of the locus of rights as between the state and the enterprise and within the enterprise. As such, they reflect a mix of experience concerning the terms of various implicit and explicit contracts and the degree of enforcement of these contracts. Ideally, we could distinguish between the negotiated terms of transfer of authority, established by bilateral contract, and the enforcement of these terms. which depends on the legal, regulatory and cultural context of contracting. In this regard, the mechanisms of contract enforcement, both formal and informal, are critical to understand. This is an area that requires further investigation. Table 1 Signatories to Contracts, 1991 (percent) SOE TVE director 66 24 group 17 65 al/ employees 16 8 other 1 3 observations 866 231 Source: World Bank Enterprise Survey .  14 Research Paper Series: China Table 2 The Allocation of Decision Rights, 1991* (% of total respondents) SOE TVE set production plan enterprise 28.8 57.7 consultation 43.6 20.4 supervisory agency 27.6 21.8 authority to set prices no limit 19.6 66.6 somewhat limited 54.1 23.3 completely limited 26.3 10.1 authority to choose customers no limit 75.1 90.2 somewhat limited 19.8 4.9 completely limited 5.0 4.9 authority to choose suppliers no limit 71.3 90.2 somewhat limited 24.6 6.3 completely limited 4.2 3.5 set bonus level enterprise 62.8 54.4 consultation 18.2 27.0 supervisory agency 18.9 18.6 set wage differentials enterprise 43.6 79.2 consultation 19.8 11.7 supervisory agency 43.6 9.2 set bonus differentials enterprise 93.3 86.9 consultation 4.4 8.2 supervisory agency 2.3 5.0 appoint leaders enterprise 1.1 15.8 consultation 17,9 24.2 supervisory agency 80.9 60.0 recruit employees enterprise 22.6 66.7 consultation 50.0 29.8 supervisory agency 27.4 3.5 dismiss employees enterprise 62.8 72.2 consultation 26.4 23.6 supervisory agency 10.8 4.2 investment decisions enterprise 14.4 24.5 consultation 57.1 59.6 supervisory agency 28.6 16.0 no. of observations 915-930 282-285 The three numbers represent the following: The first number is the percentage of respondents indicating that the enterprise decided by itself, and the third number is the percentage indicating that the supervisory bureau decides. The second number is the difference between the first and second numbers. The balance (100% - the sum of one and three) represents the proportion of firms reporting that the enterprise and supervisor jointly decide.  Reforming Property Rights in Chinese Industry 15 Table 3 Distribution of Authority within Enterprises (percent) SOE TVE fix production plan director 4.3 19.4 management 76.3 72.7 party committee 8.8 6.8 employees group 10.6 1.1 set bonus level director 4.0 20.4 management 62.1 63.6 party committee 9.3 12.0 employees group 24.6 4.0 set bonus differentials director 3.2 19.6 management 60.1 68.9 party committee 10.1 7.5 employees group 26.7 3.9 set wage differentials director 1.8 19.9 management 48.4 68.1 party committee 16.2 7.6 employees group 33.6 4.4 allocate retained profits director 5.5 19.6 management 65.8 60.7 party committee 14.6 18.2 employees group 14.1 1.4 appoint assistant directors director 3.4 19.7 management 9.7 32.0 party committee 85.0 47.2 employees group 1.9 1.1 appoint middle level cadres director 3.1 31.2 management 23.5 52.8 party committee 72.8 13.5 employees group 0.7 2.5 recruit new employees director 5.2 28.2 management 73.1 59.3 party committee 13.8 9.6 employees group 7.9 2.9 dismiss employees director 1.7 22.0 management 31.3 50.2 party committee 14.6 13.4 employees group 52.4 14.4 no. of observations 784-939 269-280  16 Research Paper Series: China Table 4 Summary of Allocation of Property Rights SOEs TVEs Distribution of specific rights: to the enterprise 5/11 .9/11 enterprise and state jointly exercised 4/11 1/11 Internal allocation of rights: director/manager 6/9 9/9 Table 5 Specification of Risk-Bearing Rights (percent) SOE TVE A. form of profit: allocation fixed quota retain 100% extra 15 78 contract basic quota retain progressive share of extra 28 36 contract basic quota share extra 29 9 contract/reward for reducing losses 9 17 other 30* 18 observations 876 160 B. retained earnings: (share of gross profit; average 1989-90) 35 35 C. bonus: share of gross profit share of retained earnings share of total wage and bonus 55 80 D. bonding expenses: required: yes 20 30 no 80 70 amount: 13,200Rmb 38,800Rmb observations 826 231 'these consist of "two guarantees and one link' (19%) and "second stage tax for profits' (1 1 %). Source: World Bank Enterprise Survey  Reforming Property Rights in Chinese Industry 17 Table 6 The Efficiency Effect of Individual Decision-Making Rights SOEs TVEs positive: set production plan set production plan appoint factory leader set bonus levels recruit new employees invest and expand invest and expand set bonus levels* neutral: dismiss employees appoint factory leaders differentiate wages recruit new employees differentiate bonuses dismiss employees select customers differentiate wages select suppliers differentiate bonuses set prices select customers negative: set prices select suppliers Note: All 'positive' and "negative" estimates are statistically significant at the 2.5% one-tail significance level, unless designated with a (*) in which case the significance level is 10%.  18 Research Paper Series: China Table 7* Efficiency Effects of Property Rights Reform (dependent variable = Q/L) SOE TVE constant -1.586 -1.753 (6.827) (5.000) k-/ ratio 0.479 0.366 (9.580) (7.432) mn-I ratio 0.391 0.232 (7.602) (2.956) scale 0.260 0.352 (11.962) (10.104) PRI( ) 0.057 0.043 (4.446) ( 1.899) No. 501 181 R 20.539 0.605 the output (scale), capital, labor, materials, and profit data are all 1990 data. The data for property rights and competition were collected in 1991/2. Table 8 Determinants of Property Rights Reform Idependent variable = PRI(5)] SOE TVE constant 10.628 10.638 (32.145) (21.509) competition 0.259 -0.546 (2.323) (1.903) log (profit) -0.125 -0.062 (2.161) (0.524) heavy-industry -0.347 -0.055 dummy (1.971) (0.148) No. 487 145 R2 0,031 0.027 t  FIGURE 1. Histogram of Decision-Making Authority in Chinese Enterprise A. Distribution of Authority Between the Enterprise and the State 25T 20 1 2 3 4 5 6 7 8 9 10 11 Total Areas of Decisijon-Making Authority |* Total number of decision-making rights which have been transfered to the enterprise (not retained by the state or made jointly by the state and the enterprise). B. Distribution of Authority within the Enterprise 40 E2 5 0 1 2 3 4 2 6 7 8 9 Total Areas of Decision-Making Authority *Total number of decision-making rights which have beex taserieyted dietor the etherpriseco and top ratretary of thoritrmWirhin themploerp gri 20 1 2 3 4 5 6 7 8 9 Total Areas of Decision-Making Authority *Total number of decision-making rights which are exercised by the director or the director and top manager (not by the party secretary within the firm or an employees' group).  I I  Reforming Property Rights in Chinese industry 21 REFERENCES Alchian, Annen and Demsetz, Harold (1972) "Production, Information Costs, and Economic Organization," The American Economic Review, 62: pp. 777-795. Boycko, Maxim, Andrei Shleifer, and Robert W. Vishny, "Privatizing Russia," prepared for the Brookings Panel on Economic Activity, September 9-10, 1993. Byrd, William A. and Alan Gelb, "Why Industrialize? 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