Does State Control Affect Managerial Incentives? Evidence from China's Publicly Listed Firms

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1. Introduction

In recent decades, worldwide privatization has drawn considerable research interest and generated a large number of theoretical and empirical studies concerning ownership, incentives and firm performance (1). Megginson and Netter (2001) and Djankov and Murrell (2002) provide comprehensive surveys of over 200 empirical studies on privatization in both developed and emerging market economies, most of which focus on the differential performance between state-owned enterprises (SOEs) and privately-owned firms. Overall, existing evidence supports the proposition that private ownership is associated with better firm performance than state ownership is (e.g., Boubakri and Cosset 1998; D'Souza and Megginson 1999; Sun and Tong 2003; Tvaronaviciene and Kalasinskaite 2005). A number of theories on privatization attribute the inefficiency of state ownership to weak incentives. For instance, Alchian (1965) and Shleifer (1998) argue that dispersed owners of state firms (the citizens) make it difficult to write complete contracts linking manager's incentives to the returns from their decisions. In their survey of corporate governance, Shleifer and Vishny (1997) argue that SOEs are actually controlled by bureaucrats who have extremely concentrated control rights but no significant cash flow rights, since the latter is widely dispersed amongst the country's taxpayers. Bureaucrats' main concern is to achieve their political objectives and economic benefits, which are often quite different from the objective of maximizing SOE profits (Shleifer and Vishny 1994; Boycko et al. 1996). Therefore, state owners are thought to be unwilling to adopt incentives that are tied to performance; thus, bureaucrats are free to use firms to address their own goals (Cragg and Dyck 2003). Even bureaucrats who have shareholders' interest at heart have very weak incentives to invest the time and effort required to design complete incentive contracts and monitor the performance of SOE managers, because the cost of doing so is much greater than the political/electoral payoff of modestly improving SOE performance (Megginson 2005). Furthermore, to safeguard economic rents, principals may use their power to protect SOEs from competition, bankruptcy and takeover through political mechanisms, such as soft budget constraints (Vickers and Yarrow 1991; Kornai 1998; Lin et al. 1998). As a result, the shield of state ownership weakens managerial incentives. Alas (2003) argues that countries with a socialist past have to deal with the satisfaction of needs at a lower level than traditional capitalist countries and this consequently influences managerial and workers' incentives. Tvaronaviciene (2004) provides a theoretical framework for formulating efficient state policy in incentive design for transition economies. However, Grossman and Hart (1986) and Cragg and Dyck (2003) argue that the exact form of ownership may not matter because managerial incentives within private enterprises can be imitated using appropriate contracts under state ownership. The tools that align incentives to performance are available to both private firms and SOEs. For instance, SOE Managers could be motivated to improve firm performance through incentive compensation based on achievement of certain targets, with poor-performing managers being punished through demotion or dismissals (Shirley and Xu 1998). In fact, Laffont and Tirole (1993) point out that theory alone is unlikely to be conclusive and econometric analyses are badly needed in this area.

Despite the importance of the issue, little is known about the relation between state control and managerial incentives due to limited information available on factors such as ownership structure, executive compensation and managerial turnover (2). Our study builds on and extends existing literature by providing a detailed examination of the relation between state control and managerial incentives using a large sample of partially privatized listed firms in China. …