# Toward a theory of corporate governance in China's socialist market economy

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Corporate Governance in China: An Austrian Perspective

## Introduction

There is widespread interest in corporate governance both in the context of the economy of the People's Republic of China and in a global context. This interest is due to a convergence of historical factors. Within the PRC, the effort at restructuring the corporate and financial systems which occupied the Chinese economy during the 1990's, has removed the worst performing companies and produced state-owned enterprises which are mostly profitable (*** cite Goldman report ****). With this phase of economic reform complete, the focus has now turned to making Chinese corporations world class global corporations incorporating the most modern management techniques (*** need to go through State Council report and cite invivdual goals****).
This desire to improve efficency comes at a time in which corporate governance has received increase prominence globally. During the early 2000's, the United States underwent a series of scandals including those of Enron and Worldcomm (**** cite ****) which greatly increased interest in issues of corporate governance, particularly management accountability to shareholders and institutional efforts insuring corporate responsibility (**** cite *****). This has led to passage of laws such as Sarbanes-Oxley. (*** need to put Sarbanes in more context of corporate goverance ****)
This interest in corporate governance has created healthy debate and dialogue over the role of the corporation, the relationship between the state and the corporation, and what institutions and measures are needed to improve corporate governance. (*** The post-structuralist in me wants to deconstruct the idea of improving corporate governance. A meta-analysis of the role of the corporation would be useful here ****) In undertaking this discussion, it would be useful to think deeply about the concepts that we are using. For example what constitutes "good corporate governance" or "bad corporate governance"? What is the reason why corporate governance is "good" or "bad" or does this concept even make sense.
To focus this debate, it is useful to create normative models of corporate governance. These models should be consistent with our observed experience, yet provide guidelines for what policies to undertake. Difference between models can be discussed in order to further debate in which future public policy should be. In this paper we propose a model of corporate governance that is based on the concept within Austrian economics of the economic calculation problem. We argue that the notion of economic calculation gives rise to a normative model of corporate governance, and that this model produces results similar to that produced by traditional models in Western economies, but creates some unique outcomes when applied to the socialist market economy of the People's Republic of China.

## Corporate governance models

One major difficulty in discussing corporate governance is that there is disagreement as to what the goals of corporate governance are, and what the role of the corporation is in an economy. Corporate governance models can broadly be classified into two groups. (** harvard paper**) The agency model of corporate governance sees the corporation as consisting of managers who act as agents of the shareholders. This definition is associated largely with Anglo-American views of market economies in which there is an active control market for ownership and in which flexibility for corporate forms is encouraged. The stakeholder model of corporate governance, sees the corporation not merely as an agent for the shareholders to maximize profit, but also as an entity with responsibilities to other stakeholders, including the employees and society as a whole. This model of corporate governance is more associated with Germany and Japan, in which corporate forms are more strongly limited, and there is not an active model for control.
Within these two models, the focus of literature in corporate governance Ukraine has been focused on the interactions between several groups. Beale and Means focuses on the interaction between the owners of the corporation and the corporate managers, while La Porte focuses on the interaction between the dominant shareholders and the minority shareholders.
Papers discussing corporate governance must make assertions about the role of the corporation within a wider economy. However, in discussing different corporate models, one must not fall into the trap of automatically asserting these items.
In resolving these differences between different corporate governance models there are a number of alternatives.
The standard model of corporate governance in the West is basied on an "agency model" in which the goal of corporate governance is to have management act according to the will of the investors. (*** look at Roe's paper. This is overly simplified ***)
In 2000, Hansmann and Krankman argued for the "End of History in Corporate Law" and the premise that corporate law would converge on a Anglo-American model of shareholder value maximization. Where this to be the case, a standard definition of corporate governance used with Anglo-American corporations would be applicable. However Hansmann and Krankman's paper was written before the advent of the Enron and Worldcomm scandals which called into question the Anglo-American value of shareholder value maximization. (Suchan 2004)
The existence of multiple stable models of corporate behavior is significant because if there are two different models of corporate behavior in developed economies, the future evolution of the Chinese economy is no longer determined but could evolve in the direction of the Anglo-American model, the German model, or to something that does not resemble any current known corporate model. We believe that this is the case, and the path dependence of the future evolution of the Chinese economy is not predetermined opens the question of how one should evaluate the paths that China could take.
In particular, the agency model is problematic when extended to China's socialist market economy. The Berle and Means approach in which the definition of good corporate governance is to cause management to obey the will of the shareholders leads to incoherence if the dominant or only shareholder is the state. Taken to it's logically conclusion a Berle and Hall definition of corporate governance would imply that the solution to Chinese corporate governance is reimposition of central planning, a conclusion which most would find absurd.
An alternative definition of agency theory would include the interactions between dominant shareholders and minority shareholders, or would eschew agency theory altogether to create a sociological description of the corporation in terms of the interaction between various stakeholders (Aguliera). Although this approach is useful in undertaking comparative studies of corporate governance and for seeing how the corporation interactions with its surrounding environment, a sociological approach has the drawback that it is descriptive rather than normative. While these theories provide a view of how a corporation does work in a given social context, they provide little guidance in understanding how a corporation *should* work, and what changes in the sem ocial or legal environment are desirable.
(***fix****) One could attempt to resolve the question by using empirical data, however this approach has associated problems in that this empirical data makes implicit normative assumptions that can be challenged. For example, data that indicates that coorelates state ownership with shareholder value, often contains the implicit assumption that maximizing shareholder value is the goal of the corporation. Leaving aside the problem of data quality, this notion can be challenged on two grounds. First the notion that the goal of the corporation is to maximize shareholder value is itself a normative judgment which is not universially shared. Second, using internal metrics leads to self-inconsistency. If the markets and the corporate mechanisms are not mature and are unreliable, determining what should be done based on those metrics should also be unrealiable
(***fix****)
Another problem is choosing between the opposing differences in corporate governance. Although the economy of the PRC economy is often modeled as a transitional economy between central planning and market economics, the PRC economy is a hybrid in another sense in that the model for corporations also includes difference between German/Japanese corporate models and Anglo-American models for securities and banking. The PRC is based on a German civil law model and like the corporate law of Germany, the structure of the corporation is fixed by law. However like Anglo-American model, there is no centralized ownership by the banking system.
The hybrid nature of the PRC legal and economic system is the result of both historical and political factors. The historical factors involve the time at which China adopted a legal system and a corporate system. China adopted its legal infrastructure in the 1930's at a time in which the dominant models were Germany and Japan, which had adopted a German based legal system. The crucial decisions regarding corporate restructuring were done in the early 1990's when the United States had just succeeded in winning the Cold War and in which the Japanese model of corporate ownership had come under doubt due to the collapse of the real estate bubble.
In addition to these historical factors, there may be political factors at work in explain the choices made by the PRC government. A flexible corporate law, such as those found in the state of Delaware, requires a skilled and powerful judiciary in order to interpret that law in addition to a need for a substantial body of case law. The lack of pre-existing case law in addition to the lack of desire to create a powerful and independent judiciary capable of creating such a set of laws, may explain the attractiveness of the German model of corporate to the Communist Party of China in that detailed rigid legislation reduces the scope and power of the judiciary.
At the same time, the desire to prevent alternate centers of economic power leads to American models of securities and banking. The suspicion of concentrations of independent economic power which could potentially control or challenge the Party's rule, we argue coincidentally corresponds to American mistrust of concentrations of economic power and suspicion of economic elites controlling the government (Roe, 1994). We argue that this is why the Communist Party has chosen to adopt elements of American economic law such as the Glass-Stegall separation of commercial and securities as well as the prohibition of bank ownership of industry found in the Bank Holding Act of 1956. By adopting an economic model in which capital allocations decisions are made by Adam Smith's "invisible hand" rather than by a identifiable person, the Party removes the possibility of a group of people attempting to control or displace the Party through economic means.
We argue that the Western "agency concept" of corporate governance is a consequence of a broader definition of corporate governance, which is to set up the corporate institution so that it responds rationally to economic signals. We further argue that in the context of Western economies, our definition of corporate governance reduces to the agency concept of corporate governance, but it does not do so within the context of PRC listed corporations. Finally, we use our definition of corporate governance to suggest avenues for future development in PRC Corporate law.

## The economic calculation problem

We begin with the question of what were China's difficulties during the pre-reform period. Before 1978, the economy of the People's Republic of China was organized along a model of socialist central planning with the problems associated with these systems. The basic problem with central planning was first explain my Austrian economists such as Ludwig von Mises as the economic calculation problem.

## The role of the corporation in market economies

Although Austrian economics has a well developed theory explaining the failure of socialist central planning, a theory of the firm is less established. (Klein) Building on recent work which explains the existence of Korean congolmerates, we propose a theory of the firm based on information principles. With small groups of individuals, the amount of information uncertainty is minimized, and planning is possible. At the level of a national economy, the amount of information processing needed to undertake planning makes it impossible. Therefore at some size between that of the individual and a national economy, there is a transition between planning and the market. This makes it possible to speak of the market consistent of "planning units" of different sizes, and we propose that these planning units correspond to corporations in a market economy.
This theory of the firm is similar to that of Coase (1937) which views the firm as transition between management costs and the transaction costs associated with a market. However, unlike Coase, we view the transition as necessary not because of transaction costs, but because of the necessity of economic planning at small scales, and the impossibility of economic planning at large scales.
Between the planned firm and the unplanned market there is an interface at which pricing signals from the decentralized market are transmitted to the centralized firm. We argue that whether this transmission of signals works correctly is dependent on the institutional characteristics of the corporation. The fact that transmission of market signals depends on the institutional characteristics forms the basis for our definition of corporate governance.

## Corporate goverance defined

We define corporate governance as establishing mechanisms by which the units of planning with in a market economy response in a economically rational manner to market signals. (Bergof 1995) This definition contrasts with the definitions of corporate governance which define corporate governance as structuring a corporation such that management carries out the will of the shareholders or those that view governance as actors within an institutional framework (Aguilera)

### Rationality defined

We define the term rationality as stating that given a set of corporate goals, the corporation will implement policies that will maximize profit within those set of goals, and that the corporation will also act in a manner that does not threaten its long term viability. By choosing this definition of rationality, we are deliberately avoiding the question of what goals the corporation should seek, and therefore avoiding the debates on the corporate social responsibility.
Although these two definitions are different, we argue that in an established market economy such as those in the United States or Britain that these two definitions are consistent with each other. In these economies, large corporations have already institutionally set up such that having management interact with the shareholders in a proper way will cause the firm to act in an economically rational manner.

### Compared with agency definition

The advantage of the market signal definition of corporate governance over the agency definition is that it expands corporate governance to include the identities of the shareholders as well as includes the supporting market institutions within the definition of corproate governance. It also expands the remedies involved improving corporate governance to include not only legal remedies, but also those that involve interactions between the shareholders. The problem of overdilution of share power can be solved by combining shareholders into institutional investors, whereas the problem of overconcentration of share power can solved by splitting up the shareholders.

## Why corporations exist

The corporation serves as a unit of planning within the context of a market economy. Profits and losses from the corporation can be measured and the net contribution or drain that the corporation has on the economy can be measured. Without additions capital inputs, a corporation which is unprofitable will eventually run out of cash and cease operations. If it is considered socially desirable for the corporation to continue to exist, the amount of social resourced need for the corporation to continue can be measured and decisions can be made accordingly.
With this framework, we see why converting state-owned-enterprises into corporations is useful even in the absence of changes in management. A badly managed corporatized SOE will drain cash and require infusions of cash for it to continue economic activities, and those cash infusions can be measured and rationed. By contrast in a classical centrally planned economy, economic activities which destroy value can be maintained indefinitely. The corporation creates effectively a firewall to insure that economically destructive activities will destroy the corporation before it destroys the entire economy.

## The problem of the dominant shareholder =

Dominant shareholders can leverage corporate control to undermine market mechanisms.
It is important to note that the objections to dominant shareholders exist regardless of the identity of shareholder is the state actor or is a private actor.
They do not may not exist when the dominant shareholder is merely a shell for diversified owners.

## State actors and dominant shareholders

The objections to dominant shareholders for large industrial companies may seem to preclude any form of state ownership. However, this assumes that the state is a unified, monolithic body. While this assumption make hold in some cases such as the Soviet Union or pre-reform China, the view of the state as a unified, monolithic body is questionable within current institutions of the People's Republic of China.
Chinese economic reform has been characterized by decentralization of economic power from the center to the provinces and to localities. This decentralization has led some to characterise the Chinese system as de-facto federalism (cite Qian). Disputes between center and local officials and between provinces are very common (citation). Although the Communist Party maintains a coordinating role, and the center maintains a tight control over the military which is the ultimate guarantor of national unity, these two controls do not create a single unified actor.
This creates the potential for a model of diversified state ownership.

## Diversifying ownership in SOE's

The varied number of state actors in the China's socialist market economy allows for a novel way to resolve the problem of the dominant shareholder, by dividing state owned shares among different state actors, and by combining those actors with private actors to insure a diverse set of interests in the corporate governing boards. While these actors may have very different and contradictory interests, they are joined by the desire to see the corporation act in an economically rational manner.

## The role of the state

Within our framework, we see that the state can serve three different and conflicting roles:
* the state as shareholder - in which it transmits market signals to the firm
* the state as referee - in which it maintains the institutions of the market and adjudicates disputes
* the state as corrector - in which the state intervenes in the market to correct some failure such as mispricing of externalities or to provide public goods.
In most western economies the state has served the latter two roles as referee and as corrector. However, the idea of the state as a shareholder which is one of many actors transmits market signals has largely not been explored in Western economies, and we argue that this is due to the path dependence of economic development. In the West, large corporations began as private enterprises, and the theoretical justifications for nationalization and state ownership were based on the premise that markets were unable to allocate goods in a socially equitable manner. Hence the idea of state ownership in Western economies has been to view state-owners as anti-thetetical to the market rather than consistent with it.
By contrast the historically development of China has been different. At the start of the reform period, the entire Chinese industrial infrastructure was state-owned, with non-state actors only appearing later. The Chinese state has in addition taken an active role in forming and providing capital to Chinese industry since the Song Dynasty (cite Hills Knownton). As such, arguments that the state should continue to play a role in managing state owned enterprises need not be premised on the idea that the market is inherently bad or that in in an idealized economy, that the state ownership is inherently better than non-state ownership, or even that state actors are better being shareholders than non-state actors. All that is necessary is to point out that China has started out with an environment in which large sectors of the economy are state-owned and that having an efficient environment is not incompatible with the state continuing to act as a shareholder.
In debating this issue, one can see the literature that argues that state owned enterprises are less performant than non-state enterprises. However, this literature is deficient in a number of ways. The first is that is that comparisions between the state sector and non-state sector do not correct for differences in the type of industry, the location of the firm, and the fact that state-owned enterprises were responsible for health and welfare benefits that were not available to non-state. In addition, aggregate comparisons do not distinguish between different types of SOE's, putting small SOE's and large SOE's in the same category despite their different characteristics (see Guo). Finally is that a comparison that shows that state-owned enterprises are not as performant as non-state owned enterprises does not illustrate that non-state owned enterprises are *inherently* incapable of being run as well as private industry.
However, despite the fact that Western economies do not formally view the state as shareholder, there are Western institutions in which states do act as shareholders to maximize profits. Examples of these are the state pension funds of California and Michigan or the large endowment funds of public universities (UT Austin). In some cases, these state entities acting

## Paradoxes

Our model resolves certain paradoxical elements of Chinese economic reform. The first is involves reconciling the desire to separate ownership from management with the opposition to management buy outs. The separation of ownership from management is intended to prevent non-market signals from interfering with the management of corporation, while a management buyout completely removes market discipline from the operation of the corporation.
Our model also provides a guide that explains why a middle way between the dominant shareholder and the non-dispersed share holder model may be desirable in the Chinese market, but unnecessary in the American market. The goal of corporate governance is to allow for market signals to control the behavior of management. This is not done when there is either one signal shareholder that, short of bankruptcy, can avoid market discipline, nor is this the case when ownership is too widely dispersed unless countervailing mechanisms can be put into practice.
Finally our model may explain the paradox explored by Allen and Jian of how China has such extraordinary growth in the absence of traditional measures of corporate governance. One should note that in the areas of the Chinese economy with especially large economic growth are areas in which the planning constraint is not very highly developed and in which market signals can be translated very quickly into implementation.

## China is not a transitional economy

Based on our theoretical framework we argue that China should not be seen as an economy transitioning between socialist and capitalist forms of economy (cite Huang), nor do agree those that would argue that China is in a "trapped transition" (cite Pei). Those views of the Chinese economy assume that that there is a natural progression between a Russian style centrally planned economy and Anglo-American economy to which all economies should naturally converge.
We dispute this picture on two points. First we argue that the People's Republic China has already made the crucial transition between a system in which resources were administratively allocated and one in which resources are allocated by a pricing system. Although there remain some commodities whose price is fixed by the state (namely energy products) most prices are fixed by the market, and this has been the case since the end of the dual pricing system in 1993. As Mainland China has a functional pricing system, we argue that the basic infrastructure needed to solve the economic calculation problem now exists.
Given that the People's Republic of China is a socialist market economy, the question is how do firms behave within this environment. In contrast to those that speak of the "End of the History of Corporate Law" and believe that the world will covergence to an permissive system of corporate law similar to that of Delaware, the fact that corporations have so many different variations across the world, and the fact that the reasons for those variations have to do with accidents of history, lead us to doubt that the economic structure of the Mainland Chinese economy will naturally converge to the Delaware model or any other model.
Comment: Agree that China is not a transition economy. However, it is also incorrect to describe it as a market economy . Major companies remain under the control of government, as do key inputs (energy, resources, capital), which fundamentally distorts pricing. Key long term strategic decisions are out of the hands of the companies which can therefore only effectively control short-term pricing (though collusion is common, again weaking the competitive market assumption). Strategic decisions reflect the compromise solutions of the ruling party, as expressed through items such as industrial policies. Market transactions are more akin to corner vegetable markets than true market-based supply/demand equations, while major decisions reflect government policy objectives. The best label remains "socialist market economy" - China has no other expressed or implicit goal.

## Corporate law with Chinese characteristics

Based on the above discussion, we make the following recommendations for the development of law within the People's Republic of China.

### Unify corporate law

Clarke argues for a division of law between non-state and state enterprises so that state enterprises. (*** check to see if Clarke actually argues this ***)
We argue that any effort to create a division of law is outweighed by its disadvantages. First by having different corporate laws implies a difference between *state-owned* firms and *non-state owned* firms. This division is undesirable because both state-owned firms and non-state owned firms exist in a single economy with a single market mechanism responsible for the performance of both state-owned and non-state owned firms. Having a legal distinction between the firms makes it easier for the state to impose regulations that benefit either state firms or non-state firms, and this means that the question of economic efficiency would be resolved by political means rather than through the market.
We believe that having a unified corporate law would allow for increased diversity of ownership which would allow each company to have a combination of state and non-state actors acting as owners.
Finally we note the difference between the role of corporations in the English common law and the German civil law tradition from which Chinese corporate law is described. In the common law tradition, the corporate firm is regarded as a natural person whose will comes from the combination of wills from the principles founding the corporation. By contrast the German conception of the corporations is much less flexible and allows creation of corporation only within certain corporate forms. (*** cite ***)

### Encourage diversity of ownership

Early Chinese reform was characterized by a "dual track" system (should be able to cite Stiglitz) which divided the economy into a market driven economy and a centrally planned one. By dividing the Chinese economy into these two forms, this dual system allowed the market economy to grow without creating any losers and political opposition in the centrally planned economy.
At this point except for a few commodities, resources are allocated according to the market rather than according to state plan. With the unification of the economy in market forms, we argue that it is now necessary to have standardized corporate forms to allow unification and diversification of ownership. In contrast to Clarke, we do not believe it to be desirable to maintain a split between state-owned and privately-owned corporation, but rather we believe that it is desirable to have a unified corporate law that does not distinguish between state forms and non-state forms.

### Diversify state holdings

In contrast to approaches which attempt to solve the problem of the dominant shareholder by legal efforts that protect the minority shareholders, we believe that a better approach would be to diversify state holdings by stock swaps so that there are several unconnected state actors amoung the owners of a corporation. In combination with institutional investors among the non-state shareholders, these formulation should provide effective oversight to insure that market signals are transmitted to the management without distributing share ownership among too many actors.
(Compare and contrast with TSP model of Sujian Guo)

### Incentive state shareholders to seek profit
## Conclusions

We have proposed a definition of corporate governance which is consistent with the agency definition of corporate goverance in Western economies, but which is expandable to include the special case of the socialist market economy of the People's Republic of China.
In addition this definition leads to some areas of further research. What is the optimum structure of shareholding which will lead to the best transmission of market signals.