Special Deals With Chinese Characteristics

Introduction

• China's economic growth is often attributed to the gradual improvement of formal economic institutions, such as:

  • Restoration of incentives to farmers.

  • Opening to foreign investment in the 1980s.

  • Centralization of the banking system in the mid-1990s.

  • Restructuring of state-owned firms and cleaning up bad debts in the late 1990s and early 2000s.

  • Accession to the WTO in 2001.

  • Gradual removal of internal migration barriers.

• However, this explanation is challenged by evidence of pro-market reforms being reversed.

• There's a lack of formal legal protection for private property and an independent judiciary.

• Formal rules and laws for private businesses are still complex.

• Many foreign companies face blocked access to the Chinese market for unclear reasons.

• The World Bank's Doing Business Indicators ranks China poorly in terms of ease of starting a business, similar to countries like Iraq and the Congo.

• The key to China's growth may lie in informal institutions that emerged in the early 1990s, characterized by the availability of "special deals" for private firms.

Special Deals

• Chinese private firms succeed by obtaining special deals from local political leaders, which allow them to:

  • Break formal rules.

  • Gain favorable access to resources.

• Special deals are common in countries with poor formal institutions.

• In China, the benefits of special deals may have exceeded the costs due to:

  • The enormous administrative capacity of local governments. *Helping hand to favored firms, including:

    • Exemptions to regulations.

    • Lobbying the central government.

    • Improving local infrastructure.

    • Providing land and credit at below-market prices.

    • Blocking the entry of competitors.

  • High-powered incentives for local political leaders to provide special deals:

    • Political benefits, such as recognition and promotion.

    • Monetary benefits, such as tuition payments or hidden equity stakes.

  • Competition among a large number of local governments.
    *Local governments compete to attract and support businesses.
    *This limits the predatory power of protected firms.
    *Firms have options when facing incompetent or predatory governments.

• China has "extractive economic institutions" where political elites extract rents.

  • Local political elites extract rents by enabling favored firms to generate more profits.

  • Local administrative apparatus is focused on supporting favored firms.

  • Thousands of local governments compete to attract and support firms.

Risks

• Special deals rely on the discretion of local officials and their incentives.

• The anti-corruption campaign since 2014 may dampen the incentive of local officials to provide special deals.

• This could result in lower growth.

• Tension between China and its trading partners arises because companies without access to special deals are disadvantaged.

• Foreign companies may have to make their own special deals and, face issues with intellectual property and contracts.

• It is a critical question of how the world trading system can accommodate countries based on rules as well as those based on access to special deals.

Relation to Previous Work

• Related to Huang (2008)’s account of "Capitalism with Chinese Characteristics."
  *Huang (2008) documents the emergence of special deals in China in the early 1990s and argues that such deals are harmful to economic growth.

• Related to Xu (2011)’s description of China as "Regionally Decentralized Authoritarianism."
  *Xu (2011) argues that powerful local governments are behind the growth of private firms, but is silent on the key fact that local support for private firms almost always takes the form of special deals.

• Suggests that it is the combination of special deals and powerful local governments that underpinned China’s economic success and created risks for the future.

Model of Special Deals

• The key idea is that a subset of firms benefit from special deals that other firms do not have access to.

• Preferences: U = (\int{0}^{1} Cz^{\frac{\sigma-1}{\sigma}} dz)^{\frac{\sigma}{\sigma-1}}

  • Where z \in [0, 1] indexes the product.

• Two technologies for each product:

  • (1-\delta)e^{A(1-z)} ("A" technology).

  • (1-\delta)e^{Bz} ("B" technology).

    • 0 < \delta < 1 represents the TFP loss from "bad" institutions.
      *Output is the product of the chosen technology and labor.

• Profit-maximizing price is the standard markup over marginal cost.

• Benchmark: Chosen technology is the product of 1 - \delta and max{e^{A(1-z)}, e^{Bz}}.

  • \tilde{z} is the cutoff where the A technology is chosen for z < \tilde{z} and B is chosen for z > \tilde{z}.

  • \tilde{z} = \frac{A}{A + B}

• Real wage: \omega = \frac{\sigma - 1}{\sigma} (1 - \delta) [\int{0}^{\tilde{z}} e^{A(1-z)(\sigma-1)}dz + \int{\tilde{z}}^{1} e^{Bz(\sigma-1)}dz]^{\frac{1}{\sigma-1}}

  • Where the cutoff product \tilde{z} is defined above.

Special Deal Regime

• Political leader provides two types of benefits to a subset of the A firms.

  • Increase in firm TFP from (1 - \delta)e^{A(1-z)} to (1 - \delta + \gamma)e^{A(1-z)} where 0 < \gamma < \delta.

    • \gamma captures the ability of the local government to alleviate the effect of poor overall institutions for specific firms.
      *Potential competitors of the favored firms are blocked from the market.

• All A firms z \in [0, z_c] are favored by the political leader
  *There are two effects of local competition:
  *Now have two cities supporting local firms instead of only one.
  *Local government can only protect their firms in their locality but has no power in the other locality.
  *A key difference is that the political boss in A can only block competitors in her jurisdiction, but has no power in B.

Growth with Chinese Characteristics

• Driven by the emergence of a special deal regime best characterized as a "high capacity and private benefits" regime.

• Four types of evidence:

  • Aggregate evidence of the growing importance of large firms and conglomerates.

  • Employment growth rates are higher in cities where returns to special deals are higher.

  • Direct evidence of political ties and preferences of successful firms.

  • Evidence that localities block better firms from selling into their markets.

Growth of Large Firms and Conglomerates

• Political leaders prefer to provide deals to larger firms.

• Large firms will gain relative to the other firms as a consequence of the availability of special deals.
  *Sales share of the top 1% firms in the employment size distribution Statistics:
  *Above-scale industrial firms increased from 25% to 33% between 1998 and 2007.
  *All industrial firms increased from 31% to 45% between 1995 and 2008.

• Largest firms in the Industrial Survey and Economic Census do not fully capture the extent to which large firms increasingly dominate the Chinese economy. *Examples:

  • East Hope Group.

  • Anbang Group.
    *Conglomerates have grown by creating joint ventures with other companies.

Heterogeneity Across Cities in Impact of Special Deals

*If high TFP firms benefit more from special deals, the effect of a city providing special deals on aggregate TFP in the city will be larger in cities where the right tail of the firm TFP distribution is thicker.
*Cities with more high TFP firms initially also grow faster over time.

Political Ties and Preferential Treatment

• Links of ties between political leaders and firms.
  *Firms owned by PC/PCC members have better access to bank loans.

Local Protection and Exports

• Special deals in China are provided by local governments.
  *Part of the deal is that competitors of the favored firms are blocked from the local market.
  *If Chery produces better cars it would out-compete Shanghai-GM in markets where Shanghai-GM is not protected.
  *Local protection breaks the relationship between productivity and local sales because some productive firms are blocked.

Risks of the Current System

*Creates powerful entrenched interests that make reforms very difficult.
*Once a special deal system is in place, local officials and large businesses benefit from the system, and their interests are threatened with any reform that reduces δ and the extent of the special deals.
*Companies based in other countries find themselves disadvantaged when they compete with Chinese companies with access to special deals that export into their market.
*Some of the characteristics that made the system work in the past, such as unfettered ability to make deals may no longer be there today.