Political Constraints, Organizational Forms, and Privatization Performance: Evidence from China

Abstract

This paper explains why China’s share issue privatization (SIP), by far the largest one in history, failed to improve operating performance. Due to political constraints, approximately three quarters of the SIP firms went through an “incomplete restructuring” process, creating a parent-subsidiary structure in which the subsidiary was listed and the parent company kept the redundant workers and debt burdens. In a country with weak property rights protection, the parent company had both the incentive and the ability to expropriate resources from the listed company, resulting in weak performance. We present three sets of results. First, we show that when political opposition to layoffs is greater and when the government has less fiscal capacity, the firms are more likely to be incompletely restructured. Second, incompletely restructured firms have significantly lower operating performance. This result is robust to IV estimation using government incentives as instruments. Third, we present evidence of the root cause of weak performance, i.e., expropriation by large shareholders. Based on hand-collected data on 2616 related-party transactions, we document that incompletely restructured firms are more likely to engage in related-party transactions with their largest shareholders, including transfer pricing of goods and services, assets sales, and extracting trade credit. Further, these transactions are associated with inferior firm performance, confirming that they are expropriative in nature. Incompletely restructured firms also pay less dividends so that corporate resources are kept in the firm and under their control. Finally, expropriation does not seem to be fully discounted in prices ex ante and minority shareholders realize lower stock returns ex post.