Decentralization, Strategic Policy Burdens and the SOE Reforms in China – Theory and Evidence

Abstract

This paper considers the non-monotonic effect of the partial privatization campaign on the capital allocation distortion of large SOEs in China by using the Chinese firm-level panel data. We construct a theoretical model to show that the rise in the degree of partial privatization has the non-monotonic effect of removing the capital allocation distortion problem which otherwise might prevent SOEs from improving their efficiency. In particular, at the beginning of partial privatization campaign, the rise in certain degree of privatization would remove some degrees of capital allocation distortion. However, when more private shares are transferred to SOE managers, further rise in degree of privatization of SOEs are found to even worsen capital allocation distortion. So there exists the U-shaped pattern between the capital allocation distortion and degree of partial privatization. There are two novel forces that are keys to our story. The first one is the large SOEs’ alignment with the optimal factor intensity of the economy- the so-called factor endowment convergence effect. The other is called the deviation effect of the SOEs’ factor endowment structure. We employ the Chinese manufacturing panel data from 1998 to 2007 to examine our theoretical predictions. We find that the empirical results presented at the end is broadly consistent with the theories proposed in the paper.