Economic performance of state‐owned enterprises under the Chinese Communist Party's supervision: Some reflection on China's economic reform

• Author: Daniel C. Lee,Len‐Kuo Hu
• DOI: http://doi.org/10.1111/1468-0106.12298
• Date: 01 October 2020
• Published date: 01 October 2020

ORIGINAL MANUSCRIPT

Economic performance of state-owned enterprises

under the Chinese Communist Party’s supervision:

Some reflection on China’s economic reform

Len-Kuo Hu

1

| Daniel C. Lee

2

1

Department of International Business,

National Chengchi University, Taipei, ROC

2

Department of Finance, Law, and Real

Estate, CBE, California State University,

Los Angeles, California

Correspondence

Len-Kuo Hu, Department of International

Business, National Chengchi University,

Taipei, ROC.

Email: lkhu@nccu.edu.tw

Abstract

This study examines the economic behaviour of state-owned

enterprises in China with special emphasis on the role of the

state’s sole party as either an agent (management) or super-

visor in the enterprises. It is found that with the construction

of an incentive-compatible compensation design and the

Chinese Communist Party orchestrating an appropriate

objective guideline for its members to follow, state or social-

ist capitalism could still achieve efficient economic perfor-

mance. If party members did not behave prudently or

pursued their personal interests instead of the state’soverall

welfare, there could be grave consequences, including cor-

ruption, nepotism or even the breakdown of the system.

KEYWORDS

State-Owned-Enterprises (SOEs), principal-agent-supervisor model,

the economic role of party

1|INTRODUCTION

China was the largest and one of the most advanced economies in the world before the 18th century,

yet it declined precipitately thereafter. Despite generations of effort for national rejuvenation, China

did not reverse its fate until it introduced market-oriented reforms in 1979. Since then it has been the

most dynamic economy in the world and is likely to regain its position as the world’s largest econ-

omy before 2030. China has undergone a remarkable transformation over the past three decades. The

most remarkable part of this transformation, however, has been left largely untold: the central role of

the Chinese Communist Party.

The membership of the Chinese Communist Party surpasses 89 million. The party not only has a

grip on every aspect of government, from the largest, richest cities to the smallest far-flung villag es

Received: 8 August 2017 Revised: 14 October 2018 Accepted: 2 March 2019

DOI: 10.1111/1468-0106.12298

Pac Econ Rev. 2020;25:495–511. wileyonlinelibrary.com/journal/paer © 2019 John Wiley & Sons Australia, Ltd 495

in Tibet and Xinjiang, it also has a hold on all official religions, the media and the military. In partic-

ular, the party presides over large wealthy state-owned enterprises (SOE) and exercises control over

selection of senior executives of all government companies, many of which are in the top tier of the

Fortune 500 list.

China’s reform has produced tremendous achievements in the past 30 years but also some prob-

lems, most of them related to the gradual manner of reform and the confliction stemming from the

dual system of state (or party) planning and market mechanism. These problems can be conspicu-

ously reflected in the economic performance of the SOEs. Today there are some 4,000–5,000 large

SOEs. They face the same principal–agent problem as large enterprises anywhere. However, unlike

private or state enterprises in other countries, the party in China plays a pivotal role as both a princi-

pal and an agent of the SOEs. In his landmark 19th Communist Party Congress speech, Xi-Jinping

pledged a thought on socialism with Chinese characteristics for a new era which is then codified into

China’s Constitution. A key element of Xi’s thought is the rigid enforcement of one-party rule in

political and economic governance, with further blurring of the line between the party and the state.

Any large enterprise must engage in prudent management to protect the interests of its owners

(investors), thereby attracting more capital injection. In addition to tackling the problem of informa-

tion asymmetry and incentive incompatibility between owners and managers, the SOEs in China

have to clarify the ambiguous role of the party, which intertwines the interests of both the state and

the communist member itself. Another related issue is to what extent the SOEs should share the pol-

icy burden of the state. Justin Yifu Lin (2012) even argues that without spinning off the policy bur-

den inflicted on the SOEs, any privatization or liberalization program cannot properly resolve the

underperformance symptom of SOEs.

This study reexamines the economic behaviour of SOEs with a special emphasis on the role of

the party as either an agent (management) or a supervisor in the enterprises based on the optimal

supervisory mechanism design by Lin and Hu (2009). Instead of focusing on the cost incurred (exog-

enously or endogenously) in the collusion process (Tirole 1986, 1992, Laffont 2000, Laffont and

Tirole 1993, Faure-Grimaud, Laffont, and Martimore 2003), this study directly models a supervisory

information structure whose effectiveness depends on the supervisor’s effort level. As for the deter-

mination of the optimal supervisory effort, the principal must balance the increase in the supervisor

compensation (required to stimulate more supervisory effort), with the corresponding decreased com-

pensation to the agent until the resulting improvement in the information accuracy about the agent’s

service quality (and, thus, lessening the need of agent’s service effort) can fully offset the reduced

service quality owing to the reduced compensation to the agent.

Another critical issue is determining how to assure the loyalty of the party member toward the

state’s and party’s prime goal of safeguarding the public (principal) interest. Because any monetary

payout (compensation) to the party member who is a supervisor or an agent of SOEs would be the

outright cost to social welfare, we are facing the trade-off between the incentive enhancement

through an appropriate compensation scheme and the likely squandering of the government budget.

The present paper also endeavours to address the thorny problem of constructing a balanced party

objective guide for each party member to follow. If the party members pursue their personal interest

above the party’s or the state’s objectives, the problems of corruption or nepotism might be serious

enough to crack the system as a whole.

Recently, the four main Nordic countries (Sweden, Denmark, Norway and Finland) have

reinventing their model of capitalism. The Nordic countries are clustered at the top of league tables

of everything from economic competitiveness to social health to happiness. They have avoided both

southern Europe’s economic sclerosis and the United States' extreme income inequality. The reason

496 HU AND LEE