Innovation or Rent-Seeking: Institutional Environment and Entrepreneur Behavior in China's Transitional Period
Since its reform and opening up in the late 1970s, China's economy and social development have seen significant progress as well as many puzzles. On one hand, China's economy has been growing at an astonishing speed over the past two decades: during 1978-2004, China's real GDP realized an annual growth of 9.4%, with the real GDP per capita growing at an annual rate of 8.2%. The living standard of Chinese people enjoyed a tremendous improvement. On the other hand, however, many new problems have arisen during the process, and among them, widespread corruption and increasing gap between the rich and poor are the most prominent. The past two decades have seen increasing cases of bribery and embezzlement of government officials, leading to a large number of judicial charges every year. In the meantime, China's Gini coefficient jumped from 0.30 in 1982 to 0.45 in 2002. If China's high economic growth can be contributed to the entrepreneurs' innovation, while the corruption is closely related with their rent-seeking, then the question has to be raised: why did these entrepreneurs undertake many productive activities in favor of economic development, but simultaneously use their talents in non-productive fields? How can such a phenomenon be reasonably interpreted?
This paper attempts to shed some lights on these questions from a perspective of the allocation of entrepreneurial talents between innovation and rent-seeking, along the line of works by Schumpeter-Baumol-Murphy and others, who argue that entrepreneurial talents exist in all countries and that the allocation of these resources is determined by the institutional environment, i.e., the prevailing rules of game and the corresponding economic return structure. In other words, entrepreneurs would allocate their talents between productive and non-productive activities to maximize their benefits (including fortune, power and prestige). They are more likely to use their talents for non-productive activities like rent-seeking, when the government controls most of the resources, the property rights of wealth are ambiguously defined, or when the government officials have excessive power to collect rent arbitrarily. Oppositely, they are motivated to undertake productive activities, when there exists a large product market, the communications system for transactions, market entry, expansion, or financing through the capital market are easy for businesses, and property rights and patents are clearly protected, or when start-up enterprises are practically encouraged.
The Expediential Institutional Arrangements in Early Years of Reform and Their Double-sided Consequences
China's economy before the 1970s was, in Lenin's words, organized and run like a State Syndicate, where all economic resources were controlled by the government. In such an institutional environment, the only way for a person to bring his talents to a full play was to become a member in the bureaucratic system by joining the Communist Party. It was not until the end of the "Cultural Revolution" that Deng Xiaoping's reform and opening-up policy gained popularity in the Party. Instead of adopting the radical strategies like the "Big Bang", Deng implemented an "incremental reform". Through a number of expediential institutional arrangements, the central government attempted to introduce the market elements while maintaining a strong control over the economy. These arrangements include substituting the unitary system with the M-Form economic structure, delegating power and sharing profits with SOEs, and implementing a dual track system for distribution and pricing of capital goods. The "revenue-sharing system" introduced during the fiscal reform in the 1980s had changed the relations between the central and local governments, creating a multidivisional structure (M-Form) which is quite distinct from the unitary system. Under the new system, local governments were turned into independent economic bodies with strong incentives to promote local economy and to increase local revenues through developing local businesses. In the meantime, the reform of expanding enterprise autonomy starting from 1978 eventually evolved into the Enterprise Contracting System, which inspired the contractors to improve the performance of SOEs on one hand, and blurred the boundary of their property rights on the other hand. Private enterprises were allowed to develop under the precondition of not changing the dominant position of the public ownership. It was stated in the Constitutional Amendment in 1998 that the private sector should become "an important component of the socialist market economy", compared with its original role as "a supplement to the socialist public sector". To solve the problems of off-plan purchasing and marketing of the private sector, a dual-track system was introduced, which opened a second track for material distribution - a de facto market track - along with the state plan of material distribution. Gradually, the scope and trading volume on this market track expanded, allowing the private sector to survive and thrive by getting supplies and selling products through the market.
Such expediential institutional arrangements provided necessary conditions for start-ups. Entrepreneurs began to invest their talents in productive innovations. The first was system innovation. Lacking a formal mechanism of property right protection and contract enforcement, Chinese entrepreneurs ingeniously created a series of alternative institutions to reduce the transaction costs in the early years of China's transformation. For example, some set up township-and-village enterprises (TVEs), affiliating their business with a unit of village or town or even with a public-owned enterprise (as so called, had "a red hat"); others leveraged the mechanism of bilateral and multi-lateral reputation to enforce the contracts; and still others financed through own capital, commercial credit, or some primal financial organizations. The second innovation was to optimize the resource allocation. After the establishment of the dual-track system, the price signal from the market track began to reflect the scarcity of resources. Naturally, private entrepreneurs turned to cheaper labors and focused their production on the scarce goods and services in the market. The statistics show that, from 1995 to 2002, private enterprises mainly grew in manufacturing, wholesale and retail, catering and construction industries, improving the overall industrial structure and the internal structure of each industry simultaneously. The private entrepreneurs in Zhejiang Province had in particular played a leading role in improving the resource allocation. The third involved technological introduction and innovation. The technological progress in Chinese enterprises was realized primarily through the technology transfer from the advanced countries in the form of "hard technology" ? purchase of set or key equipments. In the mid and late 1990s, the private sector became a major force in importing new technologies, along with its increasing share in the total fixed assets investment. Until today, independent technological innovation is still a weak area in most of the Chinese enterprises. The only exception is a few private enterprises that have successfully developed their core competence through technological innovations, such as Huawei in IT industry and Geely in auto industry.
To conclude, the expediential institutional arrangements unleashed the entrepreneurial talents hidden in Chinese people, and spurred the private start-up activities in an unprecedented manner. In 1998, the number and the gross output value of private enterprise reached, respectively, 1.2 million and RMB585.3 billion, which were13.2 times and 60.34 times as large as in 1989. In 2002, the two figures rose further to 2.44 million and RMB1533.8 billion. In the meantime, the share of the private sector in the total GDP went up steadily, moving from 33.8% in 1990 to 47.5% in 2001; and today, the share is believed to be over half of the total GDP. In Zhejiang Province, where the entrepreneurial activities are the most energetic, its GDP ranking among China's province level units had a leap from No. 24 in 1978 to No.4 in1998.
However, there exists the other side of the story. The expediential institutional arrangements were government-led in its nature, so the government still controlled the allocation of some key resources and the entry to some important markets. As a result, entrepreneurs had strong incentives to take non-productive activities in different ways. The first was rent-seeking under the dual-track system. Due to the great gap between the controlled price and the market price, anyone who could get the material with lower price would gain quick and huge profits no matter whether he sold it or used it for production. According to some economists, such rents accounted for about 20% of China's national income in1987, and in 1988 and 1992, the figures were about 40% and 32.3% respectively. Such a huge amount further motivated government officials to "design" and "create" the rent, which served to aggravate the corruption. Entering the 1990s, the cases of corruption in the land and capital allocation have kept emerging. The second involved the use of administrative power of local officials to enforce the contract. In order to ensure the contract enforcement in interregional transactions, entrepreneurs had to establish good rapports with the local officials of the regions where their trading partners were located, such that they could resort to the administrative power when necessary. Certainly, to receive such service from the officials, entrepreneurs must promise to share with them the profits from the transactions. Although the original intention of seeking the local officials' protection was to secure some kind of relief when the contract was infringed, the same administrative power was very likely to be abused to encroach upon the trading partner's benefits. The third was to seize state-owned assets, especially during the reform of delegating power and sharing profits. The management could easily expropriate the public property via various means, using the privilege they enjoyed. One common practice was to transfer the profits in the "public coffer" to their "private coffers". One case in point could be found in some state-owned security or future companies where "the profits were collected privately by the management while the losses were compensated publicly by the state". Another channel to misappropriate public property was done through subsidiaries. To make the profit transfer more convenient, a "multi-tier legal person system" with multi-level share-holding structure was formed in many SOEs, some of which even had as many as eight levels of holding relation.
Aggravated Corruptions and Income Inequalities
The negative impacts of expediential arrangements began to show in the mid and late 1980s. To deal with the problems, some economists called for a further reform and establishment of a real market economy based on the rule of law. However, due to the slow pace of the reform, the dual-track system prolonged and many economic and social problems arose. One prevailing view was that these problems were the result of the market economy, and that the "market defects" could only be remedied by strengthening the government's administrative intervention. As a result, the Chinese government has been reinforcing its administrative intervention in some aspects of the micro economy in the recent years. In the meantime, the government failed, due to the delay of the reform, to fulfill its market-friendly functions such as property rights protection, contract enforcement and market regulation based on the rule of law. This was further worsened by the retarded development of the financial market. Thus, the entrepreneurs' innovation was notably suppressed as the market expanded. It is fair to say that the slow advance of the reform strengthened entrepreneurs' incentives for rent-seeking activities in both absolute and relative terms.
In absolute term, the government's anti-market behavior was strengthened in two ways. First of all, the administrative power of resource allocation was reinforced. Since the turn of the century, China's economic development has entered the so-called "heavy industrialization" period under the leadership of local governments at all levels, with accelerated urbanization and drastic increase in the demand of land. Therefore, an unprecedented wave emerged, in which the farmers' land was acquired by local governments at low prices, and then leased to industrial and commercial enterprises or real estate developers. With the privilege of land leasing, local governments' intervention in micro economic activities reached the climax. Secondly, the government still controlled the market entry of the private enterprises by administrative licensing/approval system. In the late 1990s, with the acknowledgement of the legal status of the private sector and China's preparation for the WTO accession, the central government eventually allowed private enterprises to enter most of the industries and markets. However, government approval was still a prerequisite, which in fact decided the life and death of a private enterprise. In 2000, the Central Committee for Disciplinary Inspection of the Communist Party of China (CPC) proposed to "eliminate corruption from the root", calling for minimizing administrative licensing/approval, but met with great resistance. In 2003 when China's macro economy began to show symptoms of over-heating, the voice for the administrative control over investment rose again.
In relative term, a few factors had promoted rent-seeking activities. First, the mechanism of property rights protection and contract enforcement was not put in place. With the strengthening of impersonalisation of market transactions and the market competition evolving into innovation competition, enterprises need the government, as a fair third party, to provide legal relief in contract enforcement and intellectual property right (IPR) protection. However, in contrast with its rapid economic growth, China's legal construction was moving on slowly. Entrepreneurs had to resort to the government's administrative power when they were facing contract disputes and IPR infringement. In other words, entrepreneurs had to appeal to the local government officials for protection (including local judges) through illegal means like bribery. Such a mechanism to exploit the public power to provide relief has been fortified in recent years. Second, a highly efficient financial sector has not come into being in China. The banking system had numerous problems as the foundation of finance. In the big four (i.e. the four major state-owned commercial banks), the major problems included ill-defined property right relations, poor governance structure, owner's absence, and high ratio of non-performing loans that potentially leads to financial risks. With regard to the securities market, neither listing rules nor regulatory systems were properly formulated in China. Under such circumstances where a huge power of allocating financial resources fell into the government's hand and the financial market remained stagnant in its development, entrepreneurs with an urgent financing need had no other choice but to bribe government officials.
The increasing rent seeking activities in recent years have seriously affected China's economic and social developments. Lack of incentive for innovation in entrepreneurs weakens China's potential of sustainable economic development. According to the official statistics published in 2005, the proportion of China's service industry in GDP stood at 40.7%, which was not only lower than that of most developed countries, but also lower than that of India as a low-income country. Investment in R&D by Chinese industrial enterprises accounted for 0.56% of their sales revenue on average, indicating that most of Chinese industrial enterprises have barely engaged in any independent innovation activity at all. The fundamental truth behind these is that modern service industry and technological innovation both require a more sophisticated institutional environment, which is obviously absent in China. As a result, the transaction cost became so high that it eroded entrepreneurs' potential benefits and prevented them from putting their productive efforts into these two productive activities. In the meantime, corruption has been prevailing, ranging from collusion between officials and businessmen to trading of governmental posts. Over the years, the number of corruption-related cases has been increasing drastically, involving many senior government officials. In the financial sector, for example, the statistics show that, during 2001 and 2005, a total of 14 major corruption cases were exposed, involving more than 1 billion dollars. A good example of collusion between government officials and businessmen is that, in an investigation of corruption in 2005, 4,878 public servants and SOE managers admitted that they had shares in private coal mines, involving a total amount of RMB 737 million. In some parts of China, trading of government posts has been rampant since the mid 1990s. In a black name list publicized by the Central Committee for Disciplinary Inspection of the CPC, we could even find names of officials at provincial level. Along with these problems was the increasing income gap between different social strata. In China, much of the problem could be attributed to inequality of opportunity. Because of the expediential institutional arrangements, officials in control of resource allocation were more likely to gain huge wealth through rent-seeking. The statistics provided by the World Bank show that the Gini-coefficient of China as a whole went through a sharp rise from 0.30 in 1982 to 0.39 in 1988, and then to 0.45 in 2002. According to Chinese official statistics, the ratio of total consumption of the 20% richest households against that of the 20% poorest ones stood at 3.95:1, almost twice the figure in 1991.
The innovative activities of entrepreneurs have helped China maintain a high growth rate over the past two decades. Now the problem arises: can China sustain this rate of growth? Apparently, risks exist, at least from the perspective of the allocation of entrepreneurial talents. It can be argued that the healthy and sustainable development of China's economy in the future is determined by the effect of further reform in both economy and politics. The SOE and financial reforms must be pushed forward unremittingly while the fundamental systems required by modern market economy must be further improved so as to establish a real market economy in China that is based on the rule of law.
Wu Jinglian is Bao Steel Chair Professor of Economics at CEIBS, and Huang Shaoqing is Research Fellow of the Center of Chinese Private Enterprises at CEIBS.
