AN ANALYSIS OF CHINESE STATE-OWNED ENTITIES AND FINANCIAL MARKETS: MARKET VERSUS POLITICAL INCENTIVES LI, ZHAOHUA NATIONAL UNIVERSITY OF SINGAPORE 2007 AN ANALYSIS OF CHINESE STATE-OWNED ENTITIES AND FINANCIAL MARKETS: MARKET VERSUS POLITICAL INCENTIVES LI, ZHAOHUA （MBA）, MAASTRICHT SCHOOL OF MANAGEMENT A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY DEPARTMENT OF FINANCE AND ACCOUNTING NATIONAL UNIVERSITY OF SINGAPORE i ACKNOWLEDGEMENTS Working on this thesis has been an inspiring, sometimes exciting, often challenging, but always interesting experience that has been made possible by many people who have supported me. I am very grateful to my supervisor, Dr. Takeshi Yamada, who has guided me mentally and morally. I express my deepest gratitude for his invaluable guidance, supervision, encouragement, understanding, and continuous support during the course of this research. Also, I would like to extend my sincere thanks to Dr. Inmoo Lee, Dr. Hassan Navqi, Dr. Srinivasan Sankaraguruswamy, Dr. Anand Srinivasan, Dr. Nan Li, Dr. Michael Shih, and Dr. Jun Koo Kang for their helpful suggestions and comments. I thank my classmates and friends, including Ms. Yafeng Qin, Ms. Lei Luo, Ms. Xia Wu, Mr. Hao Jiang, Mr. Jianfeng Shen, Mr. Wen He, and Mr. Manoj Raj. Discussions with them gave me many inspirations. I thank two anonymous banks for providing me data. I also thank the bank officials for the helpful discussions we shared. Special thanks must be conveyed to Ms Waiying Lee. She is a friend when I am happy, a teacher when I am growing, a comforter when I am sorrowful, a savior when I am in trouble, and a searcher when I not know my heart. I give my thanks and praise to her. i Additional thanks go to my friends, including Ms. Jinye Zhao, Ms. Xi Zhang, Ms. Xiuxi Zhao, Ms. Sien Shen, Ms. Juan Wang, Ms. Hong Yu, Ms. Huiming Chen, Ms. Chen Li, Mr. Xiangqi Wang, Mr. Yue Xiong, Mr. Meng Dong, Mr. Yu Hong, and Mr. Yunpeng Tang. They brought me happiness beyond the research. I am also indebted to many church friends and to relatives in Singapore and China, including Ms. Junmei Wang, Ms. Wong Kah Wei, Ms. Yan Zhen, Ms. Poh Swee Lian, Ms. Luo Min, Ms. Phaik Sue, Ms. Yi Ruan, Mr. Xiping Zhang, Mr. Xiaohu Tong, Mr. Junfeng Song, Mr. Aaron Collver, Mr. and Mrs. Hooi Shing Chuan, Mr. and Mrs. Guang Cheng, Mr. and Mrs. Vincent Lau and many more . They helped me greatly when my family experienced an emergency and financial crisis. Without their help, I could not have finished this thesis on time. I would like to thank the faculty members and staff at the Department of Finance and Accounting, the Department of Economics, HSSM library, Central Library, and NUS Business School for their support academically and financially. Finally, I am grateful to my parents for their encouragement and love. Without them, this work would never have come into existence. Above all, I thank God for being with me in all situations. ii TABLE OF CONTENTS ACKNOWLEDGEMENTS I TABLE OF CONTENTS .III SUMMARY . VI LIST OF TABLES .VIII LIST OF FIGURES .VIII LIST OF SYMBOLS IX CHAPTER GENERAL INTRODUCTION 1.1 INTRODUCTION . 1.2 MOTIVATION AND OBJECTIVES OF THESIS . 1.3. POTENTIAL CONTRIBUTION OF THESIS . 1.4. ORGNIZATION OF THESIS CHAPTER HOW DOES THE CHINESE GOVERNMENT STRATEGICALLY MANAGE STATE OWNERSHIP? POLITICAL VS. ECONOMIC OBJECTIVES . 2.1 INTRODUCTION . 2. HYPOTHESES, MODEL SPECIFICATION, AND ESTIMATION . 12 2.2.1 MODEL SPECIFICATION AND ESTIMATION . 12 2.2.2 VARIABLE DESCRIPTIONS . 17 2.3 DATA AND DESCRIPTIVE STATISTICS . 23 2.3.1 IDENTIFICATION OF CENTRAL AND LOCAL SOES 24 2.3.2 DESCRIPTIVE STATISTICS . 26 iii 2.4 EMPIRICAL RESULTS 32 2.4.1 REDUCED FORM OF THE CHOICE MODEL . 32 2.4.2 DETERMINANTS OF FIRM VALUATION, PROFIT, AND LABOR INTENSITY 34 2.4.3 STRUCTURAL FORM OF THE CHOICE MODEL . 40 2.5 CONCLUSION . 44 CHAPTER 46 THE IMPACT OF THE COMMERCIAL BANK ACT ON THE 46 LENDING BEHAVIOR OF A STATE BANK 46 3.1 INTRODUCTION . 46 3.2 A SHORT HISTORICAL DESCRIPTION OF BANK REFORM IN CHINA 51 3.3 LITERATURE REVIEW 54 3.4 METHODOLOGY . 58 3.5 DATA . 60 3.5.1 VARIABLE DEFINITIONS . 62 3.5.2 SAMPLE DESCRIPTION 63 3.6 EMPIRICAL RESULTS 69 3.6.1 BANK LENDING RATES BEFORE AND AFTER 1995 . 69 3.6.2 SUBSAMPLE ANALYSIS OF CREDIT RATING . 75 3.6.3 NONPERFORMING LOAN PERFORMANCE AFTER THE COMMERCIAL BANK ACT . 82 3.7 ROBUSTNESS TESTING . 86 3.7.1 POSSIBILITY OF CREDIT RATIONING 86 iv 3.7.2 CONTROLLING FOR MATURITY 86 3.7.3 CROSS-SECTIONAL RESULTS 87 3.7.4 REPRESENTATIVENESS OF THE BANK DATA 87 3.8 CONCLUSION . 88 CHAPTER 91 GENERAL CONCLUSIONS 91 4.1. SUMMARY 91 4.2. LIMITATIONS 91 4.3. IMPLICATIONS . 92 APPENDICES . 101 APPENDIX A. THE DATA COLLECTION ON REGIONAL INSTITUTIONAL FACTORS 101 APPENDIX B. THE ACT OF THE PEOPLE'S REPUBLIC OF CHINA ON COMMERCIAL BANKS (EXTRACT) . 102 APPENDIX C. THE EXCHANGE RATE OF THE RENMINBI AGAINST THE U.S. DOLLAR 105 v SUMMARY This thesis consists of two studies. The first study examines state-owned enterprises in China. Since 1978 the Chinese government has implemented many reforms of stated-owned enterprises (SOEs), including selling, merging, and closing SOEs. With these reforms, the central government has substantially reduced the number of its SOEs and retained control of only a small number of SOEs. In this study, we examine whether economic objectives or political objectives, principally on the employment level, have an effect on the decision of the central government to retain control of SOEs. Using Heckman’s two-stage estimation procedure and Lee’s (1978) method, we find that the central government controls SOEs the labor intensity of which is higher than that of local SOEs. We also find that the central government prefers to retain SOEs that are in the mining and information industries. Lastly, central government decision making varies strategically with the different degrees of development of the market and institutions in China’s provinces. In sum, the central government strategically manages state-owned enterprises. This finding suggests that in a partially privatized emerging market such as the market in China, government involvement in firm activities can affect the cross-sectional distribution of firm performance. The second study investigates state-owned banks in China. In 1995 the Chinese government enacted the Commercial Bank Act to enforce and regulate commercial banking activities. The government hoped that the Act, together with other bank reforms, would promote risk vi management among commercial banks, and hence the banks would stop policy lending to state-owned enterprises (SOEs). This study examines the lending behavior of a government-controlled commercial bank before and after the passage of the Act. Within a simultaneous framework in which the lending rate, maturity, and collateral status are written into the loan contract at the same time, we find that the bank tightened control of the credit risk of borrowers after the passage of the Act. We also find that SOEs are charged a rate of interest higher than that charged to private firms by basis points after controlling for other factors. vii LIST OF TABLES Table 1. Descriptive data 29 Table 2. Reduced form of the choice model . 33 Table 3. Determinants of firm performance and labor intensity . 38 Table 4. Structural form of the choice model . 41 Table 5. Descriptive data 65 Table 6. Individual loan terms and industry distribution across the two sample periods . 69 Table 7. Interest rate regressions . 71 Table 8. Analysis of credit rating and Altman’s Z score 78 Table 9. The impact of credit rating and Altman’s Z score on interest rates 81 Table 10. Nonperforming loan performance before and after the Act 83 Table 11. Recovery rate of NPLs 84 Table 12 NPLs of Commercial Banks as of end-March 2007 85 Table 13. Exchange rate of the renminbi against the U.S. dollar . 105 Table 14. Descriptive data for bank B 106 Table 15. Individual loan terms and industry distribution 107 Table 16. Interest rate regression for bank B 108 LIST OF FIGURES Figure 1. Probability of being a central SOE with respect to labor differentials 42 viii Bibliography Alchian, Armen A., and Harold Demsetz. 1973. The property right paradigm. Journal of Economic History 33(1): 16-27. Allen, Franklin, Jun Qian, and Meijun Qian. 2005. Law, finance, and economic growth in China. 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China’s state assets management system: How the state exercises its ownership. In Corporate governance and enterprise reform in China, 25-27. Washington, D.C.: World Bank and International Finance Corporation. 100 APPENDICES APPENDIX A. THE DATA COLLECTION ON REGIONAL INSTITUTIONAL FACTORS I hand collected data from a series of books (Marketization Index for China’s Provinces) published by the National Economic Research Institute (NERI), China Reform Foundation. The data are from 1997 to 2001. The NERI uses the methodology of Economic Freedom of the World to rank Chinese provinces according to their level of market development. The Marketization Index provides valuable information on institutions and other variables of central importance to economic freedom but its primary purpose is to measure the development of competitive markets in China’s provinces. In other words, the index measures how far provinces have moved along the path to a market economy. The index has five areas: (i) government and market relationship index, (ii) private investment index, (iii) private employment index, (iv) local protectionism index, (v) credit market index, (vi) labor mobility index, and (vii) legal environment index. The NERI indices are widely used by economists and other social scientists who study institutions in China (see Fan et al. 2004 and Li et al. 2004). For more information on Economic Freedom of the World, please visit http://www.freetheworld.com/index.html. 101 APPENDIX B. THE ACT OF THE PEOPLE'S REPUBLIC OF CHINA ON COMMERCIAL BANKS (EXTRACT) Article Commercial banks should work under the principles of efficiency, safety, and fluidity with full autonomy and full responsibility for their own risks, profits and losses, and self-restraint. Commercial banks business in accordance with laws free from any interference by units and individuals. Article 34 A commercial bank should issue loans in accordance with the need of the national economy and social development and under the guidance of the State industrial policies. Article 36 A borrower should provide guarantees for commercial bank loans. A commercial bank should strictly check the repayment ability of the guarantors, the ownership and value of the mortgage and working assets, and the possibility of claims to them. A borrower which has been proved having sure creditability for repayment through checks and assessments by the commercial bank may not provide guarantees for the commercial bank. Article 38 A commercial bank should decide the interest rates of loans in accordance with the upper and lower limits of loan interest set by the People’s Bank of China. Article 39 A commercial bank should abide by the following stipulations of the ratio between assets and liabilities: (1) the capital sufficiency rate must not be less than 8%; 102 (2) the ratio between the balance of loans and the balance of deposits must not exceed 75%; (3) the ratio between the balance of current assets and the balance of current liabilities must not be lower than 25%; (4) the ratio between the balance of the loan of one borrower and the balance of the capital of the commercial bank must not exceed 10%; and (5) other stipulations of the People’s Bank of China governing such ratios. Article 40 Commercial banks are not allowed to issue credit loans to people who have connections with the bank and the conditions for issuing guaranteed loans to people who have connections with the bank must not be more favorable than those for such loans to other borrowers. The people who have connections with the bank as referred to in the preceding clause are: (1) the directors, supervisors, management personnel, and credit loan business dealers of the commercial bank and their close relatives; and (2) companies, enterprises, and other economic organizations which have the people mentioned in the preceding clause as investors or senior management personnel. Article 41 No unit or individual is allowed to force the commercial banks to issue loans or provide guarantees. In other words, commercial banks have the right to refuse any unit or body to force it to so. 103 The solely state-owned commercial banks should issue loans to special projects which have been approved by the State Council. The State Council will adopt corresponding measures to make up for the losses of the banks because of issuing the loans. What measures to adopt is up to the decision of the State Council. Article 47 Commercial banks must not raise or lower interest rates as against the stipulations or absorb deposits and issue loans through unjustified means. 104 APPENDIX C. THE EXCHANGE RATE OF THE RENMINBI AGAINST THE U.S. DOLLAR Table 13. Exchange rate of the renminbi against the U.S. dollar The exchange rates are reported by the Ministry of Commerce of the PRC. They are from 1990 to 2004. 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Data source: Ministry of Commerce website USD to RMB 4.7838 5.3227 5.5149 5.7619 8.6187 8.3507 8.3142 8.2898 8.2791 8.2796 8.2784 8.2770 8.2770 8.2770 8.2765 105 Appendix D. The Data Analysis for Bank B Table 14. Descriptive data for bank B This data set comprises 652 bank loans from 1999 to 2004 from bank B. Panel A presents the basic data on lending terms for the whole sample. Panel B presents the subsample data classified according to ownership. Panel C presents the subsample data classified according to collateral status. Panel D presents the subsample data classified according to firm size. Panel A Whole Sample Variables N Mean Std. Dev. Min Max Amount of loan 652 37,500,000 46,200,000 39,000 500,000,000 Loan size 652 16.659 1.557 10.571 20.030 R_diff(%) 652 -0.192 0.348 -1.071 2.520 Maturity 652 0.786 0.971 0.008 15.011 Firm_grading 652 4.580 2.520 1.000 8.000 652 0.533 0.529 0.000 2.040 Relation_length Panel B Variables Amount of loan Loan size R_diff Maturity Firm_grading Relation_length N 216 216 216 216 216 216 SOEs Mean 43,500,000 16.961 -0.204 1.069 4.116 0.579 Private firms N Mean 436 34,500,000 436 16.509 436 -0.186 436 0.645 436 4.810 436 0.511 Difference 9,058,192* 0.452** -0.0182 0.424** -0.694** 0.067 Panel C Variables Amount of loan Loan size R_diff Maturity Firm_grading Relation_length Collateral_loan N Mean 578 37,400,000 578 16.605 578 -0.187 578 0.699 578 4.740 578 0.518 Noncollateral_loan N Mean 74 38,200,000 74 17.083 74 -0.226 74 1.462 74 3.324 74 0.655 Difference -800,000 -0.478** 0.039 -0.763** 1.416** -0.136* Panel D Small firm Medium firm Variables N Mean N Mean Amount of loan 225 27,500,000 259 33,300,000 Loan size 225 16.105 259 16.636 R_diff 225 -0.238 259 -0.141 Maturity 225 0.639 259 0.823 Firm_grading 225 6.178 259 4.363 Relation_length 225 0.334 259 0.529 * Significant at the 5% level; ** significant at the 1% level. Large firm N Mean 168 57,300,000 168 17.435 168 -0.208 168 0.924 168 2.774 168 0.806 106 Table 15. Individual loan terms and industry distribution across the two sample periods for bank B This table describes the borrowing terms, borrower characteristics, and the bank’s industry portfolio for SOEs and private firms across the two sample periods using data from bank B. 1999-2004 Variables SOEs Private firms Panel A N Percentage N Percentage Collateral_loan 216 0.713 436 0.972 Small firm 216 0.148 436 0.443 Medium firm 216 0.435 436 0.378 Large firm 216 0.417 436 0.179 Panel B Commerce Construction Public Utilities Manufacturing Nonclassifiable Establishment Real Estate Conglomerate N 216 216 216 216 Percentage 0.171 0.060 0.236 0.259 216 0.065 216 216 0.065 0.144 N 436 436 436 436 436 Percentage 0.188 0.018 0.073 0.323 436 436 0.078 0.294 0.025 107 Table 16. Interest rate regression for bank B This table estimates the factors that affect the maturity, collateral status, and interest rate simultaneously. Relation_length, Maturity_year, and Firm_grading are centered by subtraction from the mean to avoid the multicollinearity problem. This rescaling has no effect on the correlation properties of the rescaled variable. Panel A 1999-2004 Maturity (1) Fitted maturity Fitted collateral State Medium firm Large firm Collateral Loan (2) -1.041 (-0.06) -1.136** (-8.25) -0.106 (-1.17) 0.077 (0.81) 0.194 (1.65) Relation_length Firm_grading Firm_grading2 -0.576 (-0.01) -0.396 (-0.03) -0.272 (-0.01) -0.007 (-0.00) 0.004 (0.24) 0.012 (0.88) Past_loan_status 0.083 (1.63) Conglomerate Public Utilities Construction Commerce Nonclassifiable Real Estate Constant 0.879** (4.86) Year Dummies Observations AIC Log likelihood Schwarz Criterion * Significant at the 5% level; ** significant at the 1% level. 1.199 (0.02) R_diff (3) 0.018 (1.33) 0.042 (0.94) -0.018 (-0.58) 0.142** (4.36)) 0.100** (2.39) -0.083** (2.73) -0.002 (-0.35) 0.328** (3.31) 0.065 (1.86) 0.006 (0.13) 0.016 (0.21) 0.068 (1.74) -0.04 (-0.58) -0.005 (-0.09) -0.382** (-6.22) Yes 652 2239 -1080 2413 108 [...]... performance However, government can behave like a helping hand when there are market failures, which often justify government intervention in the marketplace and corporations Empirical studies yield mixed results on government ownership and firm performance Kole and Mulherin (1997) find that the performance of American government -owned companies is not significantly different from the performance of private... effectively transferred the property rights of most state- owned enterprises to local governments In addition, since 1994, managers of SOEs have been granted a growing degree of autonomy from the government They enjoy the right to set product prices, to hire and fire workers, to make investments, and so on 7 performance of SOEs with that of private enterprises and find that state ownership is not better than private... Dewenter and Malatesta (2001) show that government -owned firms are significantly less profitable than are private firms The controversy on government ownership and firm performance is also found in studies that are conducted using Chinese data Many of these empirical findings are related to the 6 Chinese SOE reform.1 Groves et al (1994) offer evidence that the productivity of Chinese stated -owned firms... incorporate the incentive of managers into their analysis and study how decentralized incentives can positively affect firm performance However, Sun and Tong (2003) find that state ownership has a negative impact on firm performance after share issue privatization Similarly, Wei et al (2005) find that state shares are significantly negatively related to Tobin’s Q, and that significant convex relations exist... because a government usually has two kinds of incentives and they are not always desirable The first is the incentive from the market In a good market economy, the price of a product clears the demand and supply from consumers and producers and the property rights are secured by law To develop such a market, a government needs to design a set of institutions to get the market to work After that, economic... policy makers and investors to evaluate the performance of government banks over the past 14 years It shows the change in government bank-lending strategies and the positive effects that the enactment of the Act have had on Chinese commercial banks 1.4 ORGNIZATION OF THESIS The remainder of this study is organized as follows Chapter 2 is an independent essay that examines the central government incentives. .. the world has significant and long-term consequences for economic and financial development High government ownership of banks in 1970 was associated with slower subsequent financial development and lower growth of per capital income and productivity One need not look only at banks; government ownership of enterprises is also common and influential around the world Usually the government is the largest... Governments use various means, such as regulations and taxes, to engage in economic development activities One clear manifestation of government participation in the economy is government ownership of economic entities La Porta et al (2002) find that the pervasive government ownership of banks (in 1995, 42% of equity of the 10 largest banks was state owned) around the world has significant and long-term consequences... forcing the price of sugar in the country to stay at a level twice as high as the international level (World Bank, 1995) This kind of example can be found in almost any country, and similar stories can be told about government -owned banks Credit Lyonnais in France lost US$30 billion when it attempted to become a largest bank in Europe to rival Deutsche Bank and the major American investment banks This ambition... convex relations exist between Tobin’s Q and state shares The difference in the findings can be attributed to the perspective that the authors take In the studies of Groves et al (1994) and Li (1997), the researchers examine whether the output of SOEs increases over time They compare the performance of SOEs before and after reforms In the studies of Sun and Tong (2003) and Wei et al (2005), the researchers . 2007 i AN ANALYSIS OF CHINESE STATE-OWNED ENTITIES AND FINANCIAL MARKETS: MARKET VERSUS POLITICAL INCENTIVES LI, ZHAOHUA （ MBA ） , MAASTRICHT SCHOOL OF MANAGEMENT . AN ANALYSIS OF CHINESE STATE-OWNED ENTITIES AND FINANCIAL MARKETS: MARKET VERSUS POLITICAL INCENTIVES LI, ZHAOHUA NATIONAL UNIVERSITY OF SINGAPORE. sincere thanks to Dr. Inmoo Lee, Dr. Hassan Navqi, Dr. Srinivasan Sankaraguruswamy, Dr. Anand Srinivasan, Dr. Nan Li, Dr. Michael Shih, and Dr. Jun Koo Kang for their helpful suggestions and comments.