Hayek, Local Information and the Decentralization of State-Owned Enterprises in China

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Hayek, Local Information and the Decentralization of State-Owned Enterprises in China1

Zhangkai Huang

Tsinghua University

Lixing Li

Peking University

Guangrong Ma

Renmin University of China

Lixin Colin Xu

World Bank

Abstract. Hayek (1945) argues that local knowledge is a key for understanding the efficiency of alternative economic systems and whether production should be organized in centralized or decentralized ways. In this paper we test Hayek’s central predictions by examining the causes of the government’s decision to decentralize state-owned enterprises (SOEs) under its oversight from 1998 to 2007 in China. We assume that the government that is located closer to an SOE has more information over that enterprise. Then when the distance between the oversight government and the enterprise is greater, an enterprise should be more likely to be decentralized (i.e., being delegated to a lower level of government). Moreover, where the oversight government’s uncertainty over an enterprise’s performance or communication costs is greater, the oversight government is more likely to decentralize enterprises so that lower oversight governments can better take advantage of local information. We find empirical support for these implications. The results suggest that Hayek’s insight on the importance of local information explains the governance of state-owned enterprises quite well.

Keywords: Local information; organizational structure; decentralization; distance.

JEL codes: D23, D83, L22, L23, P20, P31
“If we can agree that the economic problem of society is manly one of rapid adaptation to changes in the particular circumstances of time and space, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the sources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board, which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization.”

——— Hayek (1945)

  1. Introduction

One of the most important economic dramas in the last century was the emergence and then the decline of planned economy and state ownership. For more than half a century, it seems that socialism could be as productive, if not more, than capitalist economy. In the 1973 edition of the economics textbook (Samuelson 1973), for instance, Samuelson predicted that the Soviet Union’s income level would probably match that of the United States by 1990 and overtake it by 2010. The debate of the merits of market socialism in the first half of the last century thus involved top economists such as Oscar Lange, Abba Lerner, Ludwig von Mises, and Friedrich Hayek. The key arguments for why capitalism would be more efficient than socialism are perhaps two: the stronger individual incentives under the stronger protection of private property rights, and the efficiency of utilizing specific information dispersed among individuals and plants (Boettke, 2004). The second point is of course originated from Hayek (1945), one of the most influential papers of all time.2 The key importance of incentives, ownership and property rights for explaining performance in socialist and transitional economies is perhaps one of the most active areas for research in the past few decades (Shleifer and Vishny, 1994; Megginson and Netter 2001; Djankov and Murrell 2002; Knack and Keefer, 1995; Acemoglu, Johnson and Robinson 2001; Li and Xu 2004; Estrin et al., 2009). However, the importance of local information for efficiency in socialist or transitional economies or the state-owned sector, is rarely systematically empirically explored.

In this paper we examine the causes of decentralizing state-owned enterprises (SOEs) in China, focusing on the role of local information. The data we use is the Annual Survey of Industrial Firms (ASIF) 1998-2007, which covers non-state firms with sales exceeding 5 million yuan and all SOEs. Decentralization here is defined as the oversight government of an SOE shifting from a higher to a lower level of government—that is, from the central to provincial, or from provincial to municipality (alternatively called prefecture), or from municipality to county government.3 The availability of local information is captured by the distance between an SOE and its oversight government. A larger distance between the oversight government and the SOE implies that the oversight government can have less direct observations on firm performance, managerial competence, and firm competitiveness. Indeed, there is a large literature providing evidence that distance has huge consequences for firms. For instance, distance (in terms of trust level and physical distance) helps explain decentralization decision between multinational headquarters and oversea subsidiaries (Bloom, Sadun and Van Reenen, 2012); distance helps explain a headquarter’s investment allocation across plants in different locations (Giroud 2013); distance has been found to have profound implications for lending relationship between banks and firms (Peterson and Rajan 1994, 2002; Mian, 2006; Agarwal and Hauswalkd, 2010); and distance has been found to be a good proxy of information asymmetry in financial markets (Coval and Moskowitz 1999; Garmaise and Moskowitz, 2004; Grinblatt and Keloharju 2001; Hau, 2001).

Hayek (1945) implies that it would be more efficient for the oversight government with a larger distance to the SOE to delegate (or decentralize) the control rights to a lower level of government, which in general has a shorter distance to the SOE. Moreover, when firms’ performance is harder to predict—and therefore local information figures more prominently—the same distance implies a stronger tendency to decentralize so as to better utilize local information. In addition, when communication costs are lower, the oversight government has less difficulty finding out what is going on in the SOE, and the same distance then implies a weaker tendency to decentralize. We should point out here that Hayek’s point does not imply that SOEs should always be decentralized so that the distance between the SOE and the oversight government should be minimal. Tilting the balance toward centralizing include other considerations, such as internalizing externality of the SOE, pursuing goals of upper levels of government, and making top-notch experts who can specialize in complex and difficult problems to be in charge of some sophisticated SOEs (Garicano 2000).

We find support for these conjectures implied by Hayek (1945). In particular, the larger the distance between the oversight government and the SOE, the more likely the oversight government is to decentralize the SOE. Moreover, the positive decentralization-distance link is stronger when firm performance exhibits more uncertainty, and when communication costs are higher (as proxied by lower density of road).

The relationship between decentralization and distance may be subject to other interpretations. To ensure that our interpretation is the right one, we conduct a number of checks. We mitigate omitted variable bias by including industry and year fixed effects, dummies indicating the same original oversight government, along with province-year-level macro controls (and in an alternative specification, fiscal conditions of the original oversight government and its lower level government). To guard against the possibility that the distance to the oversight governments may be simply a proxy for the distance to agglomeration centers, we construct a placebo distance to an alternative agglomeration city (at the same level as the oversight government), and this placebo distance measure is not significantly related to decentralization. Finally, we rely on exogenous source of variation of distance to identify its effect on decentralization. In particular, in the 1960s and 1970s, a large number of SOEs were relocated to inland provinces to confront the possibility of external wars with the Soviet Union and the U.S. As a result, their distance to their oversight governments was determined historically and likely had nothing to do with the decentralization decisions decades later. The instrumental variable results are qualitatively similar to our base specification.

To the best of our knowledge, this paper is the first paper that tests Hayek’s idea of the fundamental importance of local information for understanding the working of economic system, in particular, the centralization or decentralization of state-owned enterprises. We test rich implications of Hayek’s idea such as how decentralization depends on the distance to the oversight distance government, and how this link depends on firm heterogeneity and communication costs.

Our paper is most closely related to the empirical literature examining decentralization within firms. In particular, Aghion et al. (2007) provide evidence that the availability of public information to the headquarters reduces the need to delegate controls to the manager. Bloom et al. (2009) provide evidence that information technology and communication technology have different implications for within-firm decentralization, with the former facilitating, while the latter hindering, decentralization. Bloom, Sadun and Van Reenen (2010, 2012) find that competition and trust foster greater decentralization. Giroud (2013), perhaps the only paper that examines how the within-firm distance between headquarters and their plants affect plant performance, find that proximity of the headquarter to a plant significantly increases the plant’s investment and productivity. We differ from these papers in two ways. First, we focus on the role of distance between the oversight government and an SOE in the state sector for the decentralization decision of SOEs, and therefore directly addressing the original concern of Hayek in understanding the role of local information in determining efficiency of centralization versus decentralization. Second, the nature of our dataset allows us to explore changes in organizational structure, thus we study decentralization in a dynamic setting. Our findings thus are complementary to the literature on decentralization within an organization—here we view the whole state economy of China as a gigantic organization with the state as the ultimate owner—that emphasizes the role of information in determining the control rights structure. We offer empirical support for the insight of the critical importance of local information in shaping the organization structure in the largest “organization” (i.e., the state economy of China) in the largest country.

The paper is also related to a theoretical literature that sheds light on benefits of decentralization. Bolton and Dewatripont (1994) suggest that decentralization has the benefits of allowing the agent to specialize in some information processing and therefore reducing information acquisition costs, freeing the principal from information-processing time constraint. Aghion and Tirole (1997) suggest that when information advantage of agents is severe, and conflicts of interest is not large, it is efficient to formally delegate. Garicano (2000) suggests that in a hierarchy it makes sense to create a hierarchy of knowledge production, with bosses of higher layers of hierarchy focusing on more complex and difficult problems and employees of lower levels specializing in more basic and easier problems. Dessein (2002) suggests that when agents report information to their superiors strategically, it is often desirable for uninformed principal to delegate the formal authority to the agent. Alonso, Dessein and Matouschek (2008) suggest that when local information is important and division managers communicate strategically, a higher need for coordination improves horizontal communication but worsens vertical communication, and decentralization can dominate centralization even when coordination is extremely important relative to adaptation. These theoretical papers provide further insights about why sometimes it makes sense to decentralize. These papers greatly enrich the insights of Hayek (1945), highlighting factors that Hayek considered such as agent information advantage (Aghion and Tirole 1997), or not considered such as specialization in information acquisition (Bolton and Dewatripont 1994), hierarchy of knowledge production (Garicano 2000), and strategic reporting by agents (Dessein 2002; Alonso, Dessein and Matouschek 2008). Our evidence is consistent with some of the implications of these models, but our data do not allow us to test the more subtle implications of these new models. The key implications of Hayek (1945), however, are directly testable and receive a strong support.

In the rest of the paper, Section 2 provides related institutional background and offers a simple conceptual framework to understand the causes of decentralizing SOEs in China. Section 3 provides empirical results on determinants of decentralization. Section 4 concludes.

  1. Conceptual Framework

The state sector of the Chinese economy operates like a huge corporation with multiple layers of hierarchy. At the top of the hierarchy are the giant central SOEs, controlled directly by the central government. Below lies a more decentralized local system with each province similar to the self-contained division of a large corporation, with independent accounting and independent performance measures and incentives. Within each province, provincial SOEs accounts for a large share. At the lower rungs of this complicated ladder are smaller SOEs controlled by municipal and county governments. The hierarchy of Chinese government consists of, from top to bottom of the ladder, the central, provincial, municipal, and county governments.

The enterprise reforms in the 1980s and 1990s in China aimed to decentralize the oversight of SOEs and to grant SOEs more autonomy in production, investment and financing (Xu 2000; Li, 1997). Some industries were decentralized earlier than others, such as machinery, which started decentralization as early as 1985. According to the Annual Survey of Industrial Firms (ASIF) data, on which we shall rely in this paper, the share of industrial output accounted for by county SOEs increased from 12.3% in 1985 to 25.8% in 1995.

A large wave of SOE restructuring began from 1997 (Xu, Zhu and Lin 2005). In 1998, the State Council decreed to decentralize all 94 central SOEs (and their subsidiaries) in the coal industry. As a result, 3.2 million workers and 1.3 million retirees were under the oversight of provincial governments (Nie and Jiang 2011). Similarly, the decentralization of provincial SOEs to municipality and county government SOEs was also widespread. Figure 1 shows the 1998 distribution of SOEs with oversight government at different levels, in terms of number of firms, employment, and output, respectively. Differing from earlier waves of decentralization, many SOEs, after being decentralized, were also privatized by lower governments. Indeed, many decrees of provincial governments mentioned that the purposes of decentralizing SOEs include facilitating firm restructuring, and even “first decentralize, then restructure ownership.”4

What determines which SOEs become decentralized? To understand this, consider a simplified economy with just two layers of government, upper and lower governments, under which an SOE can be governed. What benefits do the oversight rights entail for the oversight government? Even though all SOEs are state-owned, that is, belonging to the state, the actual control rights are in the hand of either the upper or the lower government. Consistent with the institutional features of China, the oversight government has private benefits of controls as follows. First, the oversight government can appoint key positions of the SOE under its oversight. These positions in general are paid well, and the control of these positions entails rents for the oversight government. Second, the oversight government has some rights over key strategic decisions of the SOE. For instance, the oversight government can prevent bankruptcy to maintain employment for the benefits of social stability (Demsetz and Lehn, 1985; Shleifer and Vishney 1994), a key criterion in evaluating local government officials. Third, and perhaps more importantly, the oversight government enjoys cash flow rights in the form of tax remittance and discretion over the SOE’s profit. After the 1994 fiscal reform, SOEs have to pay both local and national taxes, and the local government can retain some local tax revenues. In general, the oversight government obtains a significant share of various taxes that the SOE pays, such as value added tax and corporate income tax (Wong and Bird, 2008; World Bank and DRC, 2013).5 Finally, as direct owners of the SOE, the delegated local government also has more claims to the SOE’s asset returns.6 Oversight rights also entail costs. If the SOE loses money and needs much subsidy, the oversight government shoulders the burden.

What factors would prompt the incumbent oversight government to decentralize? Before we proceed, it is useful to realize that the decision rights were top-down, lying largely in the hands of the incumbent oversight government. In general, the incumbent oversight government wants to control important asset in order to maintain some control of the state over the economy. Indeed, around the beginning of our sample period, in the second half of the 1990s, the Chinese government launched a major privatization and decentralization campaign. The slogan for the reform included “grab the big and let go the small” (Xu, Zhu and Lin 2005). With limited attention span, information processing ability (Bolton and Dewatripont, 1994), and comparative advantage in handling complex tasks (Garicano 2000), it makes sense for the upper government to focus its attention to important SOEs.

A second motive for the incumbent oversight government to decentralize SOEs is likely to unload fiscal burdens. Over time, due to incentive problems, many SOEs had experienced declining profitability, which partially motivated the government to decentralize.. Since the cost of control is larger for ill-performing SOEs—with less rents to share and more subsidies to shoulder—we expect the incumbent oversight government to decentralize first ill-performing SOEs.

Prediction 1. The incumbent oversight government is more likely to decentralize less important and ill-performing SOEs.

A third likely motive for the government to decentralize is to revitalize SOEs to make them more efficient. Indeed, with many SOEs having difficulties in paying their employees and pension liabilities in the 1990s, some governments such as Shaanxi and Jiangxi provincial governments tried to provide sufficient incentives to local governments by sharing and shouldering some fiscal liabilities associated with SOE decentralization.7 It is thus not surprising that the oversight government would decentralize those SOEs who would gain the most in efficiency from decentralization.

Under what circumstances is an SOE more likely to increase its efficiency after decentralization? The literature, starting from Hayek (1945) and including Aghion and Tirole (1994), suggests that a key consideration for efficiency improvement by decentralization is to reduce information asymmetry. SOE managers have important information advantage about its production technology, profitable opportunities, cost conditions, and so on, that is, firm-specific information (Hayek, 1945). The oversight government could obtain some of the information from reporting of SOE managers, or via its own monitoring and observations of performance of similar firms. However, SOE managers and the oversight government have conflicts of interest. SOE managers, for instance, may be more interested in empire building, or a “quiet life” (Hicks, 1935). The reporting of SOE managers can thus be strategic, biased, and not to be relied upon ( Alonso et al. 2008).

The extent to which the oversight government can limit the information loss depends on its ability to directly acquire information and monitor the SOE. There are strong reasons that the ability to obtain direct information on the SOE depends on the distance between the oversight government and the SOE.8 The oversight government officials are subject to time constraints. When the distance is shorter, the official is more likely to travel to the site to observe first-hand how the SOE is performing and whether the SOE manager is doing a good job. Anticipating better information by the oversight government, the SOE manager is also more likely to report honestly. Indeed, Giround (2013) find that when the distance between headquarter and the subordinate plant is reduced exogenously (due to the introduction of a direct flight), the plant tends to obtain more investment and perform better. We thus predict that the larger the distance between the oversight government and the SOE, the more likely the oversight government is to decentralize the SOE in order to improve the performance of the SOE.

Prediction 2. The larger the distance between the oversight government and the SOE, the more likely the oversight government is to decentralize the SOE.

But distance is a rather crude measure of information asymmetry. For the same distance between the firm and the government, the amount of information asymmetry depends on how much information is publicly available for the oversight government (Aghion et al. 2007), and the magnitude of communication costs (Bloom et al. 2009). Indeed, centralized control rely more on the information of the principal, and a good indicator for the information of the principal is public available information about similar technologies (Acemoglu et al. 2007). When there is more uncertainty over firm performance by the principal, firm-specific local information is likely more important. In this case, oversight rights should be given to governments that are closer to firms (Hayek 1945). We thus conjecture that the positive relationship between decentralization and distance would be stronger for firms with higher performance uncertainty. This is similar to the prediction in Acemoglu et al. (2007) that decentralization is more likely for firms located in a more heterogeneous environment, in which case learning from the experiences of others is more difficult.

Similarly, whether or not to decentralize an organization should also depend on the cost of information acquisition (Bloom et al. 2012; Garicano and Rossi-Hansberg 2006; Giroud 2013). When communication costs between the SOE and its oversight government are lower, the principal faces less information asymmetry and can monitor more directly, and there may be less loss of information in the communication process between the principal and the agent. Thus, when communication costs are lower, the positive relationship between decentralization and distance should be smaller.

Prediction 3. The positive relationship between decentralization and distance would be stronger for firms with higher performance uncertainty, and for firms facing greater communication costs.

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