Principal Agent Theory and Private Property Rights in China's Economic Reform

Beginning of article

China's economic reforms over the past 30 years have been very successful. Gross domestic product has been growing at roughly ten per cent per year. The centrally planned economy has been transformed into a market economy. Although government intervention is still widespread, some industries in China are part of the most intensive competition in the world.

The miracle of China's success, in contrast with the relatively mediocre performance in Eastern Europe, has attracted scholarly attention. In the past, scholars observed forms rather than the essence. For example, in China the reforms were gradual rather than "big-bang"; agricultural reform preceded industrial reform, etc. Later, scholars investigated the institutional arrangements and proposed theories to explain China's success. For instance, the "local state corporatism" thesis, (1) "local governments as industrial firms" thesis, (2) "state entrepreneurialism" thesis where local governments constituted and coordinated the corporations, (3) "federalism" thesis, (4) "semi-federalist government" thesis (5) or "federalism, Chinese style" thesis, (6) "privatisation from below" thesis (7) or "privatisation and Chinese style" thesis (8) or "insider privatisation" thesis. (9)

Some scholars focussed on the reform of the state-owned enterprises (SOEs). They measured the changes in the performance of the SOEs after different reform measures such as the increase in managerial autonomy, (10) performance contracts, (11) modern enterprise system, (12) privatisation, etc. (13) The results were mixed. (14) Many theories or models were used to explain this. Examples were the multi-task theory, (15) competition, (16) policy burden (17) and soft budget constraint. (18) However, the most popular approach was the principal agent (PA) theory. This article demonstrates that the PA theory is not suitable for analysing China's public enterprises due to the enigmatic identity of the principals and the inability of deducing refutable hypotheses.

A noticeable difference between China and other transition economies was the growth of the non-state sector, notably the township and village enterprises (TVEs) in the 1980s. It is generally agreed that the growth of TVEs not only increased the size of the economy but also increased competition which substantiated and induced further reforms. Scholars diverge on the nature of TVEs. Numerous theories or models were adopted or proposed to explain the success and governance of TVEs. Examples included the "hybrid form" thesis, i.e., a form that falls between market and hierarchy, (19) the "vaguely defined cooperatives" thesis, (20) the "ambiguous property right" thesis, (21) the "insecure property right" thesis, (22) as well as the "double-sided moral hazard" model. (23) One primary reason for the divergent views on the identity of principals of the public economy and the nature of TVEs was the widespread misconceptions about the private property rights. This article reveals that the nature of TVEs is perfectly understandable if one has a correct concept of private property rights.

The main purpose here is to demonstrate that misconceptions in private property rights could lead to misleading views about enterprise reform in China. Given that China's transition experience is arguably the most important one in human history, a correct understanding of China's enterprise reform is vital to the understanding and development of institutional economics. The focus here is identification of the mistakes which could possibly bewilder future readers. Three interrelated areas are examined in detail: the merits of principal agent theory in explaining China's enterprise reform, the concept of private property rights and the nature of TVEs.

Applicability of PA Theory in China's Enterprise Reform

It has been popular to approach the issues of corporate governance in China's SOEs and TVEs with PA theory. PA theory has been widely used to analyse corporate governance in advanced capitalist economies. A PA relationship happens when a principal entrusts an agent to perform a certain task. There must be a subject, the principal, who shall be able to make decisions. Whether a state or a department could be the principal is doubtful, as both are merely concepts instead of decision-making persons. In addition, where the principal can entrust something to the agent, by definition, the principal to some extent has property rights. However, it is well-known that property rights were poorly defined at least in the early transition period of China's reform. Hence, there are a priori reasons to believe that PA theory is not suitable for analysing China's enterprise reform. One problem is the enigmatic identity of the principals. The other lies in the merit of the theory in deriving refutable hypotheses.

Who are the Principals?

In studies of corporate governance in China's public enterprises, researchers differed in identifying the principals and agents. Table 1 lists the PA relationships described by 17 articles on Chinese enterprises' corporate governance. Generally, researchers believed that the government or the state was the principal. (24) Indeed, Li and Wu made the generalised remark that "government agencies are principals". (25) This apparent contradiction is surprising, but it somehow reveals the difficulties in identifying the principals in the SOEs.

Some researchers distinguished government from government officials. Perhaps they were aware of the fact that principals should be able to make decisions. For instance, Chen and Rozelle (26) and Shirley and Xu (27) thought that "government officials", instead of "government" itself, were the principals. Lin and Zhu (28) did not distinguish "government" from "the people", claiming that "government (or the people)" was the first-tier principal, while "government bureaucrats" lied in the middle-tier who were both the agent to the first-tier principal and principal to the lower-tier agents. Likewise, Tylecote and Cai (29) and Zhou and Wang (30) thought that the "state" or "people" was the first-tier principal, but they distinguished the "state" from the "government", arguing that the "government" was the first order agent who in turn was the principal to lower order agents. Hence, two-tiered or multi-tiered PA relationships were introduced.

Even more complicated PA relationships have been discussed as well. For instance, Zhang presented a "dual hierarchical PA chain" consisting of an upward PA relationship and a downward PA relationship. (31) The former consisted of "residual claimants (co-owners) of the public economy" as principals and "central committee representing the whole community" as the agent, while the latter consisted of the central committee as the principal and "insider members of the firm" as the agent. Hence, the PA relationship of the public economy was "typically characterised by two 'macro' hierarchies".

The first hierarchy was formed via a delegation chain of power from the principals to the central committee. The second was formed via a delegation chain from the central committee to the insider members of the firms. Each player played two roles: he was the agent of the principal and the principal of the agent. The same author in one of his later papers introduced two other systems of PA relationship. (32) Zhang claimed that before the reform, there were two principals, namely, "ordinary citizens" as the "original principal", and the "central planners" as the "acting principals"; while "industrial bureau" served as both the agent to the acting principals and the principal to the lower tier agent which was the insider member of the firm. The author further described the situation after reform as one where there were two "legitimised principals", namely, the government and the insider members of the firm, and one "double-faced agent", namely, the industrial bureau. Unfortunately the introduction of such sophisticated systems of PA relationships did not help explain economic matters, as no refutable hypotheses could be deduced from these systems.

Instead of referring to either the government or the people, Cauley and Sandler argued that although "an SOE represents a multilevel organisation, for which principal agent interactions exist between each pair of hierarchical levels", the focal PA relationship should be between the manager as the principal and the workers as the agents. (33)

Researchers sometimes changed their minds. Examples were Zhang, (34) mentioned above and Shirley and Xu. (35) Shirley and Xu thought that "SOEs have no clear residual claimant" and "they are subject to many principals". (36) However, in their later work, they took "government officials" as the principal. (37)

The wide divergence in identifying who are the principals in the corporate governance of China's enterprises raises the question of whether the principals exist at all. …