HOW DOES INSTITUTIONAL ENVIRONMENT AFFECT THE FORMATION OF FIRMS’ VARIOUS POLITICAL CONNECTIONS? YANG BENXIN A THESIS SUBMITTED FOR THE DEGREE OF MASTER OF SCIENCE IN BUSINESS DEPARTMENT OF BUSINESS POLICY NATIONAL UNIVERSITY OF SINGAPORE 2008 ACKNOWLEGEMENT This thesis would not be possible without the help and support from many of my tutors, friends, and colleagues. I greatly thank my supervisor, Associate Professor Ishtiaq Pasha Mahmood. Some of the ideas presented in this thesis are originated from my numerous discussions with him. He has the amazing ability to approach an interesting research question. His piercing insights, disciplined analysis, and passion inspire me to think critically and help me to improve the thesis in many aspects. I thank Miss Hong-jin Zhu and Dr Qiang Fu for the contributions that they have made to my research, as well as to the improvement of this thesis. I am grateful to senior students in NUS: Hong-jin Zhu, Zhong-hua Wu, Wei-wei Xu, Yi Yuan, Jian-feng Shen, and Wen He among many others. They are encouraging and considerate. I value the friendship that I have made with fellow students in NUS: Xue-juan Zhao, Zhi-ying Jiang, Qing-xia Kong, Xu-hui Jin, Navid Asgari, and Sairah Hussain among many others. They are the sparkles in my life. I thank them to be important sources of my encouragement. They have been my tutors at different points along the way. i Needless to say, I am solely responsible for any errors or imperfections that may remain in the thesis. Yang Benxin Dec, 19th, 2008 ii TABLE OF CONTENTS ACKNOWLEGEMENT........................................................................................ I TABLE OF CONTENTS.................................................................................... III SUMMARY ...........................................................................................................V LIST OF TABLES..............................................................................................VII INTRODUCTION..................................................................................................1 LITERATURE REVIEW AND THEORY ..........................................................5 1. PROPERTY RIGHTS INSTITUTIONS AND CONTRACTING INSTITUTIONS ..................................................................5 2. INSTITUTIONAL STATUS QUO AND CREDIBILITY ............................................................................................7 3. FORMAL POLITICAL CONNECTION AND INFORMAL POLITICAL CONNECTION.....................................................10 4. PROPERTY RIGHT INSTITUTIONS AND FORMAL POLITICAL CONNECTION ........................................................12 5. CONTRACTING INSTITUTIONS AND INFORMAL POLITICAL CONNECTION.....................................................13 6. MODERATION EFFECT OF POTENTIAL POLITICAL RECOURSES ON THE FORMATION OF POLITICAL CONNECTIONS ......................................14 EMPIRICAL SETTING......................................................................................17 1. INSTITUTIONAL ENVIRONMENT AND POLITICAL CONNECTIONS IN CHINA ......................................................17 2. ENDOGENOUS CONCERN OF POLITICAL CONNECTIONS ...............................20 DATA AND MEASURES ....................................................................................23 1. DATA SOURCE AND SAMPLE ............................................................................23 2. MEASURE........................................................................................................24 2.1 Dependent Variables .................................................................................24 2.2 Independent Variables...............................................................................25 2.3 Control Variables ......................................................................................26 EMPIRICAL ANALYSES...................................................................................29 1. SUMMARY STATISTICS ....................................................................................29 iii 2. ALTERNATIVE EXPLANATION.........................................................................35 3. REGRESSION RESULTS ....................................................................................36 DISCUSSION .......................................................................................................42 CONCLUSION ....................................................................................................45 BILIOGRAPHY:..................................................................................................47 iv SUMMARY While prior research has suggested that connections between business leaders and political actors are a primary determinant of firm strategy and performance, relatively little attention has been directed to how those political connections are determined by various institutional environments. Drawing on institutional theory and the perspective of social network, I argue that the weak institutional environment fosters the political connections. Specifically, as a complement to previous research that has clustered institutions, I unbundle institutions into property rights institutions and contracting institutions and specify how the status quo and the credibility of different institutions differentially affect the process of tie formation. Moreover, I investigate whether the effects of institutions may vary across different types of political connections. Lastly, I consider the moderation effect of entrepreneurs’ political capital on the relationship between institutional environment and tie formation. Based on a sample of 736 firm-year observations of Chinese private listed firms between 2002 and 2005, I found that: First, the better the status quo of institutional environment, the less likely the formation of political connections is. v Second, firms are likely to establish formal political connections when property rights institutions are not credible, whereas they tend to engage in cultivating informal political connections when contracting institutions are not credible. Third, entrepreneurs’ individual political capital negatively moderates the relationship between institutional environment and tie formation. vi LIST OF TABLES TABLE 1. SUMMARY STATISTICS ...........................................................................30 TABLE 2. CORRELATION MATRIX .........................................................................31 TABLE 3. DESCRIPTION OF THE SAMPLE OF POLITICAL CONNECTED FIRMS BY PROVINCE .....................................32 TABLE 4. DESCRIPTION OF THE SAMPLE OF POLITICAL CONNECTED FIRMS BY INDUSTRY......................................33 TABLE 5. DESCRIPTION OF THE SAMPLE OF POLITICAL CONNECTED FIRMS BY YEAR .............................................34 TABLE 6. DESCRIPTION OF THE SAMPLE OF POLITICAL CONNECTED FIRMS BY INSTITUTIONS................................34 TABLE 7. PROPERTY RIGHTS INSTITUTIONS AND POLITICAL CONNECTIONS .............................................................38 TABLE 8. CONTRACTING INSTITUTIONS AND POLITICAL CONNECTIONS .............................................................39 TABLE 9. FULL MODEL OF THE RELATIONSHIP BETWEEN INSTITUTIONS AND POLITICAL TIES .....................................44 vii Introduction Scholars have gradually recognized the importance of political connections between business people and political actors to firm performance in both developed economies and emerging economies (i.e. Fisman, 2001; Faccio, 2006). However, few papers studied the origination of political connections. Besides the micro determinants of political connections such as ownership types of firms (Xin and Pearce, 1996) and managers’ political capital based on family, hometown connections, alumni, and even colleagues (Peng and Luo, 2000; Li and Zhang, 2007), previous research suggested seemingly controversial findings of the effect of macro institutional environment on the emergence of political connections. Some studies suggest that political connections tend to proliferate in weak institutional environment because they serve as substitutes of the underdeveloped institutional support (i.e. Nee, 1992; Boisot and Child, 1996), while others imply that political connections, circumscribed by the strong institutional environment, are also very prevalent in developed economies due to the substantial resources and information they are able to leverage (Geletkanycz and Hambrick, 1997; Bertrand, et al., 2004). An interesting question for strategy research remains under-examined: How does institutional environment affect the formation of firms’ various political connections? In light of the institutional theory and social network perspective, I argue that how 1 institutional environment shapes firms’ political networking may be explained if the broad cluster of institutions is unbundled based on their distinct nature. Following Acemoglu and Johnson’s argument (2005), I view institutions as heterogeneous in the sense that two sets of institutions are pertinent to the survival and growth of firms: property rights institutions and contracting institutions (Williamson, 1975, 1985; De Long and Shleifer, 1993; Olson, 2000). The former institutions protect firms from expropriation by the government and the latter enable arm’s length transactions between firms (Acemoglu and Johnson, 2005). Moreover, I specify the status quo of institutional environment and the credibility of such environment. The status quo of institutional environment refers to whether the institutions are efficient to regulate property rights and the transaction between citizens (i.e. Brunetti and Weder, 1994; Borner, et al, 1994). And the credibility of institutions refers to whether institutional safeguards are provided to prevent arbitrary changes in institutions (Brunetti and Weder, 1994). Realizing that institutions are changing, I argue that firms may decide whether to cultivate political connections based on the status quo and the credibility of property rights institutions and contracting institutions. Specifically, I consider two types of political connections that are most prevalent and important among private firms and the state: formal political connections that arise when founders of private firms serve as members of the Congress or Parliament (Faccio, 2006) and informal political connections that are based on face-to-face interactions between corporate leaders and political actors (Chung, 2 Mahmood, and Mitchell, 2007). I argue that firms are likely to establish formal political connections when the status quo of property rights institutions is weak and the credibility of property rights institutions is low, whereas they tend to engage in cultivating informal political connections when the status quo of contracting institutions is weak and the credibility of contracting institutions is low. I further argue that these relations are negatively moderated by micro-level determinants, such as entrepreneurs’ political capital. I propose a contingency model to specify my argument of the emergence of political connections. I test this model in the setting of private listed firms in China from 2002 to 2005. The prevalence of political connections maintained by private listed firms as well as the diversity in institutional environment across 31 provinces makes Chinese private listed firms an attractive setting to examine the theoretical arguments. My empirical analysis is conducted using an extensive longitudinal dataset including 736 firm-year observations in total. The results are largely consistent with my hypotheses: The effects of the status quo and the credibility of institutions on the formation of political connections are contingent on the types of institutions as well as the types of political connections pursued. My study makes five key contributions to the literature. First, I contribute to network research by investigating the institutional origin of network ties between business arena and political arena, which has been under-studied in extant research. Second, by explicitly distinguishing two sets of institutions in which 3 firms are embedded in, I also enrich institutional theory by highlighting the heterogeneity of institutions in their nature and exhibiting their influence on organizational actions. Third, not only do I identify the effect of the status quo of institutions on firm’s behaviors, but my findings also first empirically support the importance of institutional credibility, an aspect of research on institutions that has received little notice in the literature. Fourthly, I conduct a cross-level analysis to indentify the moderation effect of micro-level determinants on institutional origin of network ties. Fifthly, my study also improves our understanding of the political strategy of Chinese private firms, which are a vital and fast growing component of China’s transition economy. 4 Literature Review and Theory 1. Property Rights Institutions and Contracting Institutions Acemoglu and Johnson (2005) summarized the growing consensus among economists and political scientists that “the broad outlines of North’s story are correct: the social, economic, legal, and political organization of a society, i.e., its ‘institutions,’ is a primary determinant of economic performance”. They view institutions heterogeneous in their nature and classified the cluster of institutions into two categories: On the one hand, following the contract theory literature, starting with Coase (1937, 1960) and Williamson (1975, 1985), Acemoglu and Johnson (2005) argued that the legal framework that enables contracts between organizations (i.e. contracting institutions) is provided by the state and associated institutions to facilitate economic transactions. On the other hand, Acemoglu and Johnson (2005) condensed the ideas from Jones (1981), De Long and Shleifer (1993), and Olson (2000), and argued that the state and associated institutions also enact laws and regulations to protect individuals and firms against expropriation by the government and powerful elites (i.e. property right institutions). Highly supportive empirical result found by Acemoglu and Johnson (2005) confirms the distinction between contracting and property rights institutions: “They think of contracting institutions as mainly affecting the costs of enforcing 5 private contracts…Contracting institutions affect private transactions and create ex post transfers between parties… For example, when it is more difficult for lenders to collect their loans, interest rates increase, or banks that can monitor effectively will play a more important role, or reputation-based credit relationships will develop.” “On the other hand, property rights institutions determine the interaction between individuals and the government (and the political elites who control the government)…. Property rights institutions, which determine the degree to which the government, politicians, and elites are constrained in their relationships with the rest of the society…When property rights institutions do not constrain elites, these elites are more likely to violate the property rights of individual producers and expropriate their incomes or assets. When it comes to arrangements regulating property rights and the relationship between the state and individuals, i.e., property rights institutions, the option to engage in ex ante contracts to avoid ex post distortions is not available. Individuals cannot write contracts with the state to constrain future actions by the state and elites controlling the state…It is impossible to write credible contracts with the state to prevent future expropriation, since the state, with its monopoly of legitimate violence, is the ultimate arbiter of contracts (see Acemoglu 2003).” Acemoglu and Johnson (2005) also concluded that property rights institutions have a more important effect on economic outcomes than do contracting 6 institutions. Accordingly, property right institutions are fundamental to the survival and development of private firms. Without secure property rights, private firms are less likely to invest and grow. It is found that secure property rights are both necessary and sufficient to induce investment by entrepreneurs (i.e. Johnson, McMillan, and Woodruff, 2002). Thus, firms pursue long-lasting and reliable political protection of property right institutions. In contrast, contracting institutions regulate the transaction between private parties. They are concerned about issues such as resolving disputes and competing for resources. Quick response and problem-solving approaches are expected by the firms when they face troubles in contracting institutions. To get a fine-grained understanding about how firms are motivated to establish ties with local authorities in specific institutional environment, it is necessary to unbundle institutions based on their distinct nature and specify how firms mitigate specific institutional risk by taking advantage of political connections. Thus, in light of Acemoglu and Johnson’s argument (2005), I will investigate the distinct influences on organizations of property right institutions and contracting institutions in this paper. 2. Institutional Status quo and Credibility Prior studies have shown that strong institutional environments may promote the formation of political connections. It is found that political networks in developed 7 economies such as United States create conduits for timely market information, and abundant factor resources, which are likely to exert paramount influence on firm performance (Geletkanycz and Hambrick, 1997). However, weak institutional environments are more often seen as facilitating the proliferation of political connections (i.e. Nee, 1992; Boisot and Child, 1996). Due to the insufficient institutional support, such as reliable government and well-established legal system, firms cultivate political connections to manage uncertain environment and to satisfy their resource needs (Xin and Pearce, 1996). For example, Nee (1992) considered the close ties between private firms and local government in China, which are maintained by paying “management fee” for assistance in obtaining reliable access to factor resources and political protection. Two dimensions of the overall institutional goodness or perfectness are considered. Firstly, a number of prior studies have focused on how the status quo of the institutional environment may influence the emergence of political connections. Scholars examined how well the institutions are to regulate property rights and the transaction between citizens (i.e. Brunetti and Weder, 1994; Borner, et al, 1994), namely, are there enough institutions to regulate property rights and the transaction between citizens. For example, as Borner, Brunetti and Weder (1995) presented in their Nicaragua case: “Refining property rights in the narrow sense is merely a question of accounting: you must know how large a property is, who the owner is, and you must register this information…property-rights problems were more or less resolved in Nicaragua in 1993 (p50)”. Thereby, in this paper, I define 8 status quo of institutional environment as the amount of institutions which regulate the relationship between the state and the citizens, as well as the relationship among citizens in a region. Secondly, scholars also resorted to the credibility or reliability of institutions, which are characterized by “rules that are not enforced in an arbitrary fashion and a process of rule-making that is transparent and predictable” (Borner, et al, 1994 Brunetti, et al, 1998). For example, Borner, Brunetti and Weder (1995) presented: “Although, according to this narrow view, property-rights problems were more or less resolved in Nicaragua in 1993, the climate of constant threat to property has still had a devastating effect on the expectations of private investors. There is simply no confidence in the sanctity of private property and in the enforcement of property laws. We even argue that this uncertainty has spread to a general mistrust of the reliability of enforcement of all laws and regulation (p51)”. Furthermore, scholars provided detailed cases to support the importance of this institutional dimension in Thailand, Philippine and many other less developed countries (Brunetti and Weder, 1994; Borner, et al, 1994; Borner, et al, 1995). Compared with the situation with no institution, the context with a few institutions, where executives or the political elites still are endowed with large discretionary power, is better for entrepreneurs. Thus, to some extent, the status quo of institutions refers to the part of discretionary power that has been restrained. Better status quo of institutions associates with higher level of institutional 9 perfection. In contract, the credibility of institutions refers to the part of discretionary power that has not been restrained. For example, in Nicaragua case presented by Borner, et al, (1994), the institutional environment is not credible when entrepreneurs feel the property rights institutions are not reliable (i.e. a powerful politician could change laws at anytime. (p154)). For another example, in Indonesia case also presented by Borner, et al, (1994), the institutional environment is not credible when entrepreneurs feel the contracting institutions are not reliable (i.e. “the judge has enough discretionary power. The party who pays more will win the court case.”(p5)). Therefore, lower level of credibility of institutions associates lower level of institutional perfection. Considering the fact that firms are likely to take actions, like cultivating political connections, based on their perceived institution (Duncan, 1972), I examine the effects of the status quo of institutions and the credibility of institutions on the likelihood of firms to form political connections. Specifically, I investigate the status quo of institutions and the credibility of two types of institutions that are crucial to the survival and development of firms: property right institutions and contracting institutions. 3. Formal Political Connection and Informal Political Connection I define political connections as individually-based linkages between business leaders and political actors such as party leaders, government officials, and elected 10 legislators (Taira and Wada, 1987; Zeitlin and Ratcliff, 1988). Specifically, I consider two approaches adopted by business leader to connect with the political arena (Chung, Mahmood, and Mitchell, 2007): Firms may get formally connected with politicians when their leaders occupy two distinct positions, one in business arena and the other in political arena. Firms may also establish informal political connections through face-to-face interactions between corporate leaders and political actors. The formal position interlocks provide firms with reliable conduits to pursue political protection because the corporate executive and the politician are the same person. Entrepreneur’s membership of the Congress or Parliament is one of the prevalent types of formal political connection (Faccio, 2006). However, the establishment of such political connections is time consuming with persistent investment of resources. Moreover, formal political connections usually face stringent public scrutiny from the media and other observers, thereby cannot facilitate firms unrestrictedly. In contrast, informal political connections are less reliable than formal ones in seeking long-lasting political protection because they highly depend on particular government officials. The change of regimes could quickly diminish the value of such political connections (Siegel, 2007). However, “grease money” and “protection money” always facilitate the quick constitution of informal political connections that are based on face-to-face interactions between corporate leaders 11 and political actors (Cai, Fang and Xu, 2007). Further, informal political connections are more inconspicuous than formal ones, and thus bear less opportunity costs resulting from the possible disclosure of malfeasance. Therefore, to maximize the benefit and minimize the cost of their political investments, firms could choose appropriate forms of political connections based on the specific institutional environment they face. 4. Property Right Institutions and Formal Political Connection As referred, property rights institutions are fundamental to the survival and development of private firms. Borner, et al. (1994) alleged that creditable property rights are “the most important precondition for development based on private-sector activity”. The secure property rights are both necessary and sufficient to induce investment by entrepreneurs (Johnson, McMillan, and Woodruff, 2002). Compared to formal political connections, though informal political connections are more flexible and efficient in problem solving and cost less, they cannot guarantee the long-lasting security of a firm because of the weak accountability of informal political connections (Chung, Mahmood, and Mitchell, 2007). Thereby, when property rights institutions are weak, especially when the credibility of property rights institutions is low, firms pursue long-lasting and reliable political protection, which does not change with the alteration of legislators and government officials. Entrepreneur’s formal political connections, 12 like the membership of the Congress or Parliament are very appropriate to provide firms with reliable conduits to impel the legislation, by which firms obtain the sustaining protection by a strong legal effectiveness of laws. In line with this argument, I propose the following hypotheses: Hypothesis 1a (Property rights institutions and formal political connections): The probability of a formal political connection decreases with the level of perfection of property rights institutions. Hypothesis 1b (Property rights institutions and formal political connections): The probability of a formal political connection decreases with the level of credibility of property rights institutions. 5. Contracting Institutions and Informal Political Connection Contracting institutions regulate transactions between private firms and other private parties. It concerns issues such as resolving disputes and competing for resources. Compared to informal political connections, formal political connections are more reliable and are able to provide sustaining protection, but they cost more and have response lag. When contracting institutions are weak, especially when the credibility of contracting institutions is low, firms prefer direct transactional facilitation approaches which can induce quick response and solve case-by-case problems in business transactions. A negotiation between 13 private firms and local authorities, facilitated by an informal political connection, appears to introduce flexibility into resolving problems with business transactions and to allow for the reconstitution of transactions to respond to new opportunities and changing circumstances. For example, Pye (1995) indicated that many business transactions in China are settled through negotiation between entrepreneurs and connected local government officials. Risks in transitions can be managed informally in the political networks on the basis of reciprocity rather than by reliance on formal laws of contract (Boisot and Child, 1996). Hence, I propose the following hypotheses: Hypothesis 2a (Contracting institutions and informal political connections): The probability of an informal political connection decreases with the level of perfection of contracting institutions. Hypothesis 2b (Contracting institutions and informal political connections): The probability of an informal political connection decreases with the level of credibility of contracting institutions. 6. Moderation Effect of Potential Political Recourses on the Formation of Political Connections Chinese entrepreneurs do not have influential political connections before they are involved in business arena. Nevertheless, the previous experiences of Chinese 14 entrepreneurs make their firms different in specifics of their potential political recourses. Consistent with previous studies, entrepreneurs may work in the government or join political party before they are involved in business arena (i.e. Faccio, 2006; Li, Meng and Zhang, 2006). For example, Mr. ZHOU Lian-Qi, the founder of Septwolves Group, which is a listed private firm in textile industry (Company ID is 002029 in my sample.) worked in a local branch of provincial ministry of finance 15 years before he started his business. Though these potential political recourses do not mean a direct linkage between business executives and political actors, they facilitate entrepreneurs’ understanding of the institutions and assist entrepreneurs to respond appropriately. For example, entrepreneurs worked in the government might experience an execution of public policies and have a chance to know the procedures of policy-making, and might have more information about the key persons in policy-making procedures (i.e. Faccio, 2006). Therefore, firms with potential political recourses are less likely to invest in political connections, ceteris paribus, in terms of their higher understanding of the institutions and their better responses, both of which are partial targets of firms to conduct political connections. Hence, I argue that the likelihood of the formation of political connections could be negatively moderated by this micro-level determinant, entrepreneurs’ potential political recourses. I propose the following hypothesis: 15 Hypothesis 3 (Both types of institutions and political connections): The relationship between the institutions and the political connections is negatively moderated by entrepreneurs’ political capital in that firm. 16 Empirical Setting 1. Institutional environment and political connections in China The diversity in institutional environments across 31 provinces as well as the prevalence of political connections maintained by private listed firms makes Chinese private listed firms an attractive setting to examine the theoretical propositions. The various institutional environments across different provinces result from not only the differences in economic development and indigenous social traditions that are deeply embedded and extremely persistent (Granovetter, 1985), but also from legal system characterized by multiple agencies regulating the economic life with laws, rules, and regulations. I note that the distribution of political power among agencies that constitute the institutions and the difference in effectiveness across laws, rules, and regulations may shed light on the institutions-political connection relationship in China’s transition economy. As indicated by Borner, Brunetti and Weder (1994; 1995), political discretionary power is institutionalized on two levels: First, the constitution allows some agencies to “enact institutions more or less without congressional approval”. Second, existing institutions “leave much room for interpretation and ad-hoc decisions, instead of providing clear and predictable interpretations”. Accordingly, laws are most credible. And credibility could not be established by rules or decrees because neither are they approved by 17 the congress nor are they decided transparently. They also nor leave much room for interpretation and ad-hoc decision (Brunetti and Weder, 1994). In China, both the provincial government and the provincial legislatures, including Provincial People’s Congress1 (PPC) and Chinese People’s Political Consultative Conference (CPPCC), have been empowered to constitute the provincial institutions by the National People’s Congress since 1979 (9th National People’s Congress, 1979; 15th National People’s Congress, 2000). The provincial government constitutes rules (decrees) as a quick response to the fast-changing demands and problems with the development of economy. PPC and CPPCC constitute laws to provide long-lasting institutions. Regulations, which balance the influence of government and the legislatures, are constituted by the provincial governments with the approval of PPC. The three forms of institutions have different legal effectiveness and credibility. The legal effectiveness is strongest for laws, followed by regulations, and then rules. The same hierarchy applies to the credibility of the three forms of institutions. Rules are most likely to be influenced by the changes in government officials and thus are least credible and stable, while laws are least affected by the “As stipulated by the Chinese constitution, People’s Congress is the highest organ of state power in China. Following the government hierarchies, there is People’s Congress at each administrative level, including the central, provincial and country levels.” (Li, Meng & Zhang 2006) “The Chinese People’s Political Consultative Conference (CPPCC) is an advisory body to the party/government in China, somewhat analogous to an advisory legislative upper house.” (Li, Meng & Zhang 2006) Before 1954, CPPCC is Chinese legislature, which constituted the first constitution of China. 1 18 alteration of legislators and bear sustaining effect. The more rules relative to laws are constituted, the less creditable the institutions are. Chinese entrepreneurs of private firms usually maintain extensive political connections through either formal position interlocks or informal relationships, or both (Li, Meng and Zhang 2006). Private firms lack the legitimacy and necessary political backing to enjoy reliable access to resources and thus are highly motivated to establish political connections. More than one third of Chinese private entrepreneurs are eager to obtain the membership of People’s Congress (central or local) and the membership of Chinese People’s Political Consultative Conference (central or local)” in 2006 (ACFIC 2006). However, it is not easy to establish formal political connections because the Chinese Communist party and the government control the election of members of PPC and CPPCC across different levels and entrepreneurs will not be able to obtain candidatures unless their firms meet certain criteria regarding size, profitability, tax contribution. Alternatively, Chinese entrepreneurs of private firms establish informal political connections by directly bribing the government officials or paying grey “grease money” with the guidance of “acquaintances”, such as classmates and homo-hometown townies. For example, Cai and his colleagues (2007) found that entertainment and travel cost (ETC) expenditures, which account for about 2.6% of the average Chinese manufacturing firm’s total sales2, are mainly composed of 2 Among all listed manufacturing firms in Korea, ETC expenditure is about 0.74 percent 19 “grease money” and “protection money” for government officials. ETC expenditures usually involve payment for eating, drinking, gifts, Karaoke, sports club membership, travel cost and so on (Cai, Fang and Xu 2007). To the extent that the ownership of property in China does not furnish unambiguous legal property rights and such rights still largely depend on the sanction of governments (Boisot and Child, 1996), private firms are eager to minimize the non-credibility of property rights institutions through the enactment of laws for long-lasting protection. Since PPC is the legislature and CPPCC serves as the advisory legislative upper house to PPC and government, joining PPC and CPPCC is the most direct and effective approach to manage uncertainty in property rights institutions. By sitting on the PPC and CPPCC, entrepreneurs can raise their concerns and put forward suggestions on how to protect their property rights. In summary, I have argued that the impact of the status quo and the credibility of institutions on the formation of political connections is contingent on types of institutions as well as the forms of political connections. 2. Endogenous Concern of Political Connections The fact that Chinese entrepreneurs do not have influential political connections of their total sales in 2000-03 (Cai, Fang & Xu2007). 20 before they are involved in business arena eliminates the concern of endogeneity issue in our analysis. Unlike entrepreneurs in other Asian countries where social network ties mainly originate from entrepreneurs’ family members, friends, people from the same hometown, and even colleagues, Chinese entrepreneurs lack such political capital due to their specific development history in China. Before 1988, private firms were banned in China due to the legacy of the Soviet-style economic system3. As Chinese economy transformed from planned economy to market economy, private businesses revived in the form of the “individual economy” in 19784 (State Council, 1981; Young 1989). In 1988, “private business” gained its legitimacy (State Council, 19885) and proliferated fast in coastal provinces, such as Guangdong and Jiangsu (Young 1989, 1995). However, Chinese private businesses were still not fairly treated for ideological reasons (Young 1989, 1995). For instance, the actual tax burden for private firms was higher than that for the state-owned firms and collective firms. They were also discriminated by the banks even when they satisfy the criteria for loans. Along with the development of private business, the social status of Chinese entrepreneurs is rising. Before China’s reform starting from 1978, government When the Chinese Communist Party won the civil war and founded the People’s Republic of China in 1949, it began the socialist transformation of private businesses. Between 1952 and 1977, private businesses were completely banned in China (Li, Meng & Zhang 2006). 4 “Individual economy” is defined as an “individually or family-operated businesses where the owners relied on their own labor to make a living. See State Council, 1981. 5 The “private business” is defined as enterprises with privately-owned assets and employing over eight people. 3 21 officials and workers of state-owned enterprises were highly respected because they were eligible to enjoy the “fully expendable accommodation” which was extremely attractive in the planned economy. Workers in collective firms and autonomous rural organizations were ranked at the second place in social status. The remaining people were viewed as “pariah” or “dawdler” (Nee, 1992), and some capable ones succeeded in running private business and consequently became entrepreneurs. Due to their relatively low social status in the past, Chinese entrepreneurs had little chance to make friends with political actors and thus hardly maintain any political connections before the prosperity of their business. Hence, the empirical setting of Chinese private firms provides a good opportunity to investigate the impact of institutional environment on the emergence of political connections. 22 Data and Measures 1. Data source and sample I refer to multiple data sources to construct the database for the empirical analysis of this study. The data of formal political connections were collected from the yearbooks of People’s Congress, the yearbook of CPPCC and the official websites of these two institutions in each province. The data of informal political connections were manually coded from annual reports of listed firms in our sample. The information of institutions was collected from the Legislative Affairs Offices of the State Council and each province. I obtained the basic information about all private listed firms from the Sinofin database. As to the data of China’s macro economy, I referred to the annual People's Republic of China Yearbook from 2002 to 2005. I test the hypotheses with a sample of around 200 Chinese private listed companies from 2002 to 20056. Our sample is selected from more than 1500 Chinese listed firms in both Shenzhen and Shanghai Stock Exchanges. I dropped I start from 2002 because it is few private firms in Chinese Stock Market before 2002 due to the tight regulation of assessing to the stock market before 2002, when all candidate firms are compulsory to get recommendation from the government. But such recommendation is no longer a compulsory requirement after 2002. I stop at 2005 to keep the environment comparable in Chinese stock market, during which Chinese listed firms have two types of shares: (1) tradable shares, similar with the shares of listed firms in mature stock market, and (2) non-tradable shares, which are mostly controlled by majority shareholders, such as state-owed firms and the government. The latter type of share is usually over 50% of total share of listed firms. 6 23 cases of state-owned firms, collective firms, majority-state-owned firms, majority-collective firms and firms whose majority shareholders changed in the period from 2002 to 2005 as the alternation of majority shareholder may influence firms’ political strategy. In addition, observations of firms in finance industry were also dropped because they follow different accounting policy. My final sample consists of 736 firm-year observations, with 121 firms in 2002, 158 firms in 2003, 222 firms in 2004 and 235 firms in 2005. In my sample, firms achieve privatization through either initial public offering (IPO) or acquisition. All private majority shareholders control at least 40% of total shares of the listed firms. 2. Measure 2.1 Dependent Variables Formal Political Connection: I use the private firm’s founder’s membership of Provincial People’s Congress (PPC) and Provincial Chinese People’s Political Consultative Conference (PCPPCC) to measure the firm’s formal political connection. The value of this variable is 1 if the firm’s founder is a member of a PPC or PCPPCC, otherwise it is 0. Informal Political Connection: Following the study by Cai, et al. (2007), I proxy the informal political connections by a dummy variable indicating whether a firm’s subsidiaries operate in amusement and recreation services industry or 24 lodging industry. The value of this variable is 1 if a firm has a subsidiary in above industries, otherwise it is 07. It is a valid proxy because Chinese private firms establish subsidiaries in such industries may reduce its political investment because according to the tax policy in China, at most 2% of ETC expenditures are allowed to be deducted from the tax they need to pay. Entrepreneurs would prefer to establish subsidiaries in recreation industry or lodging industry if they invest a lot in informal political relations. It is because not only that subsidiaries establishment would reduce costs of ETC expenditures but also that the executives and the politicians feel safer to enjoy entertainment or bribery in a private place. A firm which invests more in informal relationship with politicians is more likely to establish a subsidiary in industries mentioned above. 2.2 Independent Variables To differentiate property rights institutions from contracting institutions, I selected 36 out of 66 categories of institutions, such as the institutions for “opening-up policy” and special economic zones, which regulate the relationships between the government and private parties and then I developed the measures of the status quo and the credibility of property rights institutions based on that 36 categories of institutions., Similarly, I selected 12 out of 66 categories of institutions, such as For example, SHANG HAI NINE DRAGON CO., LTD. (600555.Shenzhen), an apparel manufacturing firm operates a golf course. GUANGMING GROUP FURNITURE CO., LTD (000587.Shanghai), furniture and fixtures manufacturing firm, SICHUAN NEW HOPE AGRIBUSINESS CO., LTD (000876.Shanghai), a food manufacturing firm, and CHONGQING HUAPONT PHARM. CO., LTD (002004.Shanghai), a pharmaceutical firm operate hotels. 7 25 contract law and the institutions for consumer right protection, which regulate the relationship between private parties and developed the measure of unpredictability of contracting institutions based on them. The Status quo of Institutions: With a stating point with nearly no institution in 1978, the context with more institutions, which suggests that executives or the political elites are endowed with smaller discretionary power, the better the institutional environment is. And till late 1990s, institutions, including laws, regulations and laws are quite few in China. The institutions launched before 2000 account for 20% of the total institutions in 2007 at the very best. I use the sum of the number of laws, regulations and rules to measure the status quo of institutions. The higher the number, the better the institutions are. I created two measures of the status quo of institutions, one for property rights institutions and the other for contracting institutions. Credibility of the Institutions: I use the ratio of rules to laws in a specific province to measure the credibility of institutions of various provinces. The higher this ratio, the more non-credible institutions are. When it equals to 0, it means that the institutions are absolutely creditable because they are fully composed of laws. I created two measures of the credibility of institutions, one for property rights institutions and the other for contracting institutions. 2.3 Control Variables 26 2.3.1 Institutional factors and macro-economic factors I control for the initial total institutional environment using the number of laws, and the percentage of laws in laws, regulations, and rules of specific types of institutions in the period of t-1. In addition, I control the provincial GDP growth, provincial imports and exports per capital. 2.3.2 Firm Specific Factors First, I control for the political capital of a firm in other forms, including entrepreneurs’ membership of Chinese Communist Party, entrepreneurs’ working experience in governments and entrepreneurs’ membership of semi-official professional associations. They are measured by dummy variables called Membership of Communist Party, Government working experience and Membership of professional associations, respectively. Second, I control the reputation of private firms, by developing an ordinal variable to capture whether the number of a firm’s awards (including local and provincial awards) is more than the average number of awards won by all firms in the same province in a specific year. It is coded as 1 if the number of a firm’s awards is greater than the average number. It is coded as 0.5 if the number of a firm’s awards is equal to the average number. Otherwise it is 0. Similarly, I control the 27 long-term loans of private firms, by creating an ordinal variable to capture whether the scale of the firm’s long-term loan is more than the average of all firms in the same province in a specific year. It is coded as 1 if the amount of the firm’s long-term loan is greater than the average. It is coded as 0.5 if the amount of the firm’s long-term loan is equal to the average. Otherwise it is 0. In addition, I control firm size by the log of sales, abundance of cash by current ratio, firm age, and firm’s innovation capability by the number of patents. Industry dummies and year dummies are included as well. 28 Empirical Analyses 1. Summary statistics Table 1 and Table 2 report summary statistics and the correlations between variables. It is shown in Table 1 that there is significant heterogeneity in the status quo and the credibility of institutions, with the status quo property rights institutions and contracting institutions respectively having standard deviation at 1357.09 and 127.04, and with the credibility of these two types of institutions respectively having standard deviation at 15.49 and 19.14. This characteristic fits the prerequisite for the status quo and the credibility of institutions to serve as origins of political connections, which is to be heterogeneous in their distribution. Table 3 reports the description of the sample of political connected firms by province. Consistent with our investigation that the Chinese private firms are more flourishing in the coastal region, the table shows that my sample is dominated by the firms in Zhejiang, Guangdong and Jiangsu province. In Table 4, I show that my sample is dominated by manufacturing firms due to the natural properties of Chinese stock market. Moreover, I also summarize the sample of political connected firms by year in Table 5. It is obvious that the number of Chinese private firms stably increases from 2002 to 2005. In these 3 tables, politically connected firms and non-politically connected firms are all differentiated by the types of political connections. There are significant variations in the distribution 29 of firms’ political connections, which makes my sample very appropriate to examine the hypotheses. Table 1. Summary Statistics Variable Mean Std. Dev Min Max 1. Formal Political Connection 0.2567 0.4371 0 1 2. Informal Political Connection 0.0964 0.2954 0 1 3. The Status quo of Property Right Institution 2659.45 1357.09 267 10963 4. The Status quo of Contracting Institution 242.72 127.04 25 978 5. Credibility of the Whole Institutions 15.04 9.11 2.92 68.89 6. Credibility of Property Right Institution 22.29 15.49 4.62 119.18 7. Credibility of Contracting Institution 8. Initial Law Institution 24.06 19.14 3.61 101.12 112.28 34.70 42 171 0.0326 .0115 .1884 (Including Property Right and Contracting Institution) 9. Initial Percentage of Law in Total Institutions 0.0594 10. GDP Growth 15.05 4.81 3.61 26.11 11. Imports and Exports per Capital 0.7373 0.7956 .0425 3.88 12. Communist Party Membership 0.4932 0.5002 0 1 13. Government Working Experience 0.1562 0.3633 0 1 14. Professional Associations Membership 0.4089 0.4919 0 1 15. Reputation Dummy 0.5550 0.3955 0 1 16, Long-term Loan Dummy 0.5013 0.4780 0 17. LnSales 19.97 1.26 12.55 23.78 18. Current Ratio 1.66 1.22 .0293 10.07 19. Firm Age 9.96 4.07 3 26 20. Patent 4.46 12.83 0 142 1 30 Table 2. Correlation Matrix Variable 1. Formal Polit. Conn. 2. Informal Polit. Conn. 3. The Status quo of PRP 4. The Status quo of Contr. Institu. 5. Credi. of the Whole Institutions 6. Credi. of Property Right Institu. 7. Credi. of Contr. Institution 8. Initial Law Institution 9. Initial Per.of Law in Tot. Institu. 10. GDP Growth 11. Imports & Exports per Capital 12. Communist Party Membership 13. Govern. Working Experience 14. Profess. Assoc. Membership 15. Reputation Dummy 16, Long-term Loan Dummy 17. LnSales 18. Current Ratio 19. Firm Age 20. Patent 1 1 -0.04 -0.08* -0.08* -0.05 -0.04 -0.04 -0.05 0.01 0.06^ -0.06^ 0.14** -0.00 0.14** 0.01 -0.01 0.05 -0.03 -0.07* 0.00 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1 -0.05 -0.05^ 0.00 0.00 -0.05 -0.07* 0.00 -0.06^ -0.08* -0.08* 0.04 -0.01 -0.08* 0.04 0.06^ -0.07* 0.09** -0.09* 1 0.95** 0.78** 0.77** 0.51** 0.11** -0.56** 0.28** 0.10** -0.02 0.03 0.03 0.00 -0.00 0.12** 0.16** -0.00 -0.00 1 0.76** 0.75** 0.59** 0.10** -0.56** 0.20** 0.01 -0.06^ 0.02 0.01 0.00 -0.00 0.09** 0.14** 0.00 -0.04 1 0.99** 0.71** -0.28** -0.59** 0.00 -0.07* -0.01 0.02 0.00 0.00 0.00 0.02 0.22** -0.07* -0.07* 1 0.71** -0.26** -0.54** -0.03 -0.05 -0.03 0.03 0.00 0.00 0.00 0.01 0.22** -0.08* -0.07* 1 -0.18** -0.35** -0.08* -0.07* 0.00 0.03 -0.00 -0.01 -0.00 0.07* 0.16** -0.15** -0.07* 1 0.25** -0.02 0.59** -0.11** 0.01 -0.00 -0.02 -0.00 0.07* 0.01 0.02 0.08* 1 0.00 0.09* -0.12** -0.01 -0.07* -0.04 -0.00 -0.07* -0.13** -0.08* 0.04 1 -0.08* 0.05 -0.03 0.07^ -0.03 -0.00 0.16** -0.08* 0.00 0.09* 1 -0.04 0.03 0.05 -0.03 -0.00 0.09** 0.06^ -0.06^ 0.09** 1 0.09** 0.05** 0.10** 0.09** 0.15** -0.04 -0.09** 0.06^ 1 -0.06^ -0.02 -0.04 -0.08* 0.00 0.08* -0.04 1 0.08* 0.03 0.18** 0.09** -0.18** 0.11** 1 -0.03 0.13** 0.10** -0.09** 0.11** 1 0.10** -0.15** 0.05 0.05 1 -0.10** -0.06^ 0.18** 1 -0.28** 0.00 1 -0.12** 1 Note: ^: p[...]... suggestions on how to protect their property rights In summary, I have argued that the impact of the status quo and the credibility of institutions on the formation of political connections is contingent on types of institutions as well as the forms of political connections 2 Endogenous Concern of Political Connections The fact that Chinese entrepreneurs do not have influential political connections of their... sources to construct the database for the empirical analysis of this study The data of formal political connections were collected from the yearbooks of People’s Congress, the yearbook of CPPCC and the official websites of these two institutions in each province The data of informal political connections were manually coded from annual reports of listed firms in our sample The information of institutions... decreases with the level of credibility of contracting institutions 6 Moderation Effect of Potential Political Recourses on the Formation of Political Connections Chinese entrepreneurs do not have influential political connections before they are involved in business arena Nevertheless, the previous experiences of Chinese 14 entrepreneurs make their firms different in specifics of their potential political. .. potential political recourses I propose the following hypothesis: 15 Hypothesis 3 (Both types of institutions and political connections) : The relationship between the institutions and the political connections is negatively moderated by entrepreneurs’ political capital in that firm 16 Empirical Setting 1 Institutional environment and political connections in China The diversity in institutional environments... examine the theoretical arguments My empirical analysis is conducted using an extensive longitudinal dataset including 736 firm-year observations in total The results are largely consistent with my hypotheses: The effects of the status quo and the credibility of institutions on the formation of political connections are contingent on the types of institutions as well as the types of political connections. .. propose the following hypotheses: Hypothesis 1a (Property rights institutions and formal political connections) : The probability of a formal political connection decreases with the level of perfection of property rights institutions Hypothesis 1b (Property rights institutions and formal political connections) : The probability of a formal political connection decreases with the level of credibility of property... Faccio, 2006) Therefore, firms with potential political recourses are less likely to invest in political connections, ceteris paribus, in terms of their higher understanding of the institutions and their better responses, both of which are partial targets of firms to conduct political connections Hence, I argue that the likelihood of the formation of political connections could be negatively moderated... cultivating political connections, based on their perceived institution (Duncan, 1972), I examine the effects of the status quo of institutions and the credibility of institutions on the likelihood of firms to form political connections Specifically, I investigate the status quo of institutions and the credibility of two types of institutions that are crucial to the survival and development of firms: property... formal laws of contract (Boisot and Child, 1996) Hence, I propose the following hypotheses: Hypothesis 2a (Contracting institutions and informal political connections) : The probability of an informal political connection decreases with the level of perfection of contracting institutions Hypothesis 2b (Contracting institutions and informal political connections) : The probability of an informal political. .. entrepreneurs Due to their relatively low social status in the past, Chinese entrepreneurs had little chance to make friends with political actors and thus hardly maintain any political connections before the prosperity of their business Hence, the empirical setting of Chinese private firms provides a good opportunity to investigate the impact of institutional environment on the emergence of political connections ... under-examined: How does institutional environment affect the formation of firms’ various political connections? In light of the institutional theory and social network perspective, I argue that how institutional. .. hypotheses: The effects of the status quo and the credibility of institutions on the formation of political connections are contingent on the types of institutions as well as the types of political. .. Table shows the results regarding how the institutional status quo and the credibility of property rights institutions affect the formation of two forms of political connections Model is the baseline