Horizontal Variation in Local State Capitalism and Corporate Governance

Against this background, we argue that horizontal institutional variation concerns the character of local state–market relations; it probes the role of the local state in relation to the local market.

We directly borrow the frameworks developed by Zhang & Whitley (2013) and Zhang & Zhu (2017), where “local variety of state capitalism” within China is defined in terms of (1) the extent of state direction of the economy; and (2) the extent of business coordination of socioeconomic activities.

Following Zhang and Whitley (2013, p. 303), we define state direction of the economy as “the extent to which the state is directly and actively involved in the production and investment process”, and “organizes the economy through its efforts to promote or protect specific firms, sectors or industries”. If we define corporate governance as “the ways in which suppliers of

161 finance to corporations assure themselves of getting a return on their investment” (Shleifer &

Vishny, 1997, p. 737), then the return on investments for the local-SOEs in localities with strong state direction of the economy goes beyond pure economic benefit. Such returns also include implementation of industrial policy, social stability, and employment. Here, local-SOEs function less as market players and have a closer relationship with the local Party-state. SOEs embedded in such a local institutional environment have a relatively lower degree of marketization in their operations perusing a mix of political and economic objectives. From this, we expect consequences for the formal aspects of corporate governance structures of local-SOEs in terms of shareholding by MBMs as well as concentration of ownership.

Firstly, shareholding by MBMs is a good proxy for level of market orientation of an enterprise, and also can minimize agency risks and increase the firm’s financial value (J. He & Wang, 2009; Misangyi & Acharya, 2014; Shleifer & Vishny, 1997). In Chinese SOEs, the reward for good management performance has traditionally been political advancement in the Party-state hierarchy and not economic rewards (Brødsgaard, 2012). Only recently have market-based compensation schemes and management stockholding become a part of SOE reform programs (SASAC, 2018; State Council, 2016). Thus, we argue that higher state direction of the economy led to slower marketization reforms of local-SOEs as well as a preference for higher policy-orientation in SOE management structures, both of which could be reflected in lower shareholding by MBMs.

Secondly, a high concentration of ownership equals greater incentives and capacity to for the local state (the principal) to directly monitor and discipline the enterprise management (Aguilera et al., 2015, p. 487). Since the state is guided by political as well as economic objectives, its preferred corporate direction might be at odds with a corporate direction that would attract the interest of profit-oriented private investors (Jia et al., 2019, p. 229). In localities with high state direction of the economy, local-SOEs can function as important policy tools and constitute a supporting power base for local officials with political orientations towards economic interventionism. Thus, we would expect that high state direction of the economy leads to more extensive insider control in terms of higher concentration of ownership. This leads on to our first hypothesis, which focuses on variations in ownership concentration between the two left-hand quadrants of Table 1 below:

162 Hypothesis 1: Higher state direction of the economy results in local-SOEs with lower shareholding by MBMs, and a higher concentration of shares in the hands of local government institutions

The second dimension in defining horizontal institutional diversity is business coordination of socioeconomic activities, which (following X. Zhang and Zhu 2017, p. 8) we define as “the ability of business actors to organize themselves for collective action purposes.” Such an ability is embodied in “the degree of interfirm collaborations, the development of business associations and the density of interlinkages between firms and such third-party entities as financial and research institutions” (Ibid.). Extensive and long-term inter-firm linkages and networks can help firms build, integrate and reconfigure their internal and external competences (Zhang &

Whitley, 2013, pp. 304–305). By organizing economic activities in particular ways, they enable firms to respond to rapidly changing business environments and tackle market and technological challenges. Firms with well-developed relations with third-party entities and strong inter-firm networks will have stronger dynamic capabilities (Jiang et al., 2019). Business associations are particularly important: they contribute to economic governance and strengthen of the overall functioning of markets (S. Bell & Hindmore, 2009; Doner & Schneider, 2000). For example, business associations and guilds act as important inter-firm fora where collective interests are identified and begin to be pursued. They often constitute a key network governance arrangement that can link the state to the business sector (X. Zhang & Zhu, 2017, pp. 9–10). They can diffuse information, help restructure inefficient firms, set standards, upgrade technologies, and facilitating training and skill formation (X. Zhang & Whitley, 2013, p. 305).

We theorize that SOEs in localities with high business coordination of socioeconomic activities function more as ordinary market actors and have “outsider controlled” corporate governance setups. Dense inter-firm links create a business environment with well-defined legal setups and high levels of competition that fosters high levels of shareholding by MBMs. Firms that strengthen their networks would flourish in this type of environment: external board members and cross-ownership enhance an enterprise’s competitiveness.

Standard legal determination theory expects the ownership share of government institutions to decline as external investors feel better protected against expropriation by the firm’s controlling shareholders, and relatively strong intermediate institutions can provide such protections (Cai, 2009, p. 281; La Porta et al., 2000, pp. 14, 3). On the other hand, recent studies have shown that

163 localities with well-developed market institutions (where firms tend to receive more extensive assistance from business associations), protect their local-SOEs to a larger extent against ownership diversification and takeovers (Ye, 2017). Still other studies have found that during previous rounds of reform, richer and more marketized provinces tended to diversify the ownership of their SOEs to a lesser degree than their inland poorer counterparts (Bai et al., 2006; Cao et al., 1999, p. 116). Furthermore, higher competition and market deregulation coupled with a quest for fiscal revenue and the merit-based appraisal system’s focus on economic development, “compels local officials to act as the promoters and protectors of local businesses” (B. Wang, 2017, p. 11). Here, concentrated ownership might be a preferred structure since it can minimize agency risks and enhance firm performance – especially if well-functioning financial markets mitigate potentially adverse effects of ownership concentration (Jia et al., 2019; S. Ma & Naughton, 2010; Shleifer & Vishny, 1997; J. Wang et al., 2012).

While the literature is not clear on the institutional effects on ownership concentration, we will follow the standard legal determination theory. As such, theorizing in a way that highlights variations in ownership concentration and shareholding by MBMs between Table 1’s bottom two quadrants, we present:

Hypothesis 2: Higher business coordination of socioeconomic activities results in locally controlled SOEs with higher levels of shareholding by MBMs, and lower concentration of ownership.

Depending on the position on each of the two dimensions, four ideal types of local state capitalism can be identified, each with different consequences for corporate governance of locally controlled SOEs: interdependent, networked, classic and atomistic state capitalism (Table 1; see also X. Zhang & Zhu, 2017, p. 30).

Classic state capitalism describes localities with high levels of state direction of the economy and limited business coordination of socioeconomic activities. These localities typically have strong and close links with the central government, an economy dominated by large SOEs closely connected to a cohesive and resourceful local state apparatus. Accordingly, local-SOEs have a low degree of marketization in their operations and tend to have high concentration of ownership and low shareholding by MBMs.

164 Networked state capitalism describes localities with low levels of state direction of the economy and extensive business coordination of socioeconomic activities. These localities have a high level of marketization, strong international links, and a relatively liberal local government with loose and distant links to the central government. Accordingly, local-SOEs tend to have low concentration of ownership and high shareholding by MBMs.

Interdependent state capitalism describes localities with high levels of state direction of the economy combined with extensive business coordination of socioeconomic activities. In these localities, we find an economy with a mix of large SOEs and small private sector SMEs, strong international links, and mixed elements of interventionism and liberalism. In these localities, local-SOE corporate governance is in-between the extremes that we find in networked and classic state capitalism.

Finally, atomistic state capitalism describes localities with low levels of state direction of the economy and limited business coordination of socioeconomic activities. Relatively weak and distant central relations and an organizational fragmented local state apparatus characterize these localities. They have an economy with many SMEs, mixed with some to considerable state ownership. In these localities, local-SOE corporate governance is in-between the extremes that we find in networked and classic state capitalism.

This leads us to the third hypothesis derived from our theoretical framework, this time comparing the bottom-left quadrant with the top-right quadrant:

Hypothesis 3: The corporate governance structures of local-SOEs in “classic state capitalist” localities will have more insider-controlled corporate governance structures compared with local-SOEs in “networked state capitalist” localities.

165 Table 1: Predictive typology of varieties of state capitalism and local-SOE corporate

governance

State direction of the economy

Strong Weak

Business coordination of

socioeconomic activities

Strong

Interdependent state capitalism Local-SOE CG structure:

Medium/varied ownership concentration and shareholding by MBMs

Networked state capitalism Local-SOE corporate as typical outsider-controlled: Low

ownership concentration and high shareholding by MBMs



Weak

Classic state capitalism Local-SOE corporate as typical insider-controlled:

High ownership concentration, and low shareholding by MBMs

Atomistic state capitalism

 Local-SOE CG structure:

Medium/varied ownership concentration and shareholding by MBMs

Source: Authors’ adaption of framework first presented in Zhang and Zhu (2017), p. 11.