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The soft budget constraint in China
ELSEVIER
Japan and the World Economy 8 (1996) 207 223
and the LD ECONOMY
The soft budget constraint in China Yingyi Q i a n a'*, G 6 r a r d R o l a n d b ~Department of Economics, Stanford University, Starz[brd, CA 94305, USA bECARE, CEME (UniversitO Libre de Bruxelles) and CEPR, Avenue F. Roosevelt 50, 1050 Bruxelles, Bel,qium Received 15 March 1994; accepted 15 December 1994
Abstract This paper identifies five factors affecting the degree of softness or hardness of budget constraints of enterprises in China. Budget constraints become harder: (1) under fiscal decentralization and competition between regions; (2) under more competitive labor and product markets reducing employment rents; (3) when there is a smaller number of enterprises within each jurisdiction. On the other hand, budget constraints become softer: (1) under monetary decentralization; (2) when enterprises have a larger size and social costs of layoffs are convex. We use these results to explain why township -village enterprises have harder budget constraints than state-owned enterprises.
Keywords: Soft budget constraints; Transition economies: Decentralization; Public enterprises; China JEL classification: E62; E63; H7; L30; P3
1. Introduction The soft budget constraint syndrome (Kornai, 1980, 1986) has been an important issue in China as well as in other transition economies. In Eastern Europe and the former Soviet Union, mass privatization is the method chosen to harden budget constraints. For obvious political and ideological reasons, such policy is not pursued in China. However, the experience of reform has *Corresponding author. Tel.: 415-723-3984; fax: 415-725-5702; e-mail: yqian(a leland, stanford.edu. 1234-5678,/96,/$15.00 Copyright ,(~") 1996 Elsevier Science B.V. All rights reserved SSD1 0 9 2 2 - 1 4 2 5 ( 9 6 ) 0 0 0 3 7 - 2
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shown that the degree of softness of budget constraints varies across public enterprises. For example, it has been observed that enterprises under the control of central or higher level governments tend to have softer budget constraints than enterprises controlled by lower level governments of townships and villages (Qian and Xu, 1993). In this paper, we study the soft budget constraint problem in China with the help of a macroeconomic model developed in Qian and Roland (1994), which is in turn based on Dewatripont and Maskin (1995). There are soft budget constraints in public enterprises because the government cannot credibly commit to terminate an enterprise activity due to the losses in private benefits for workers and managers if they lose their jobs. Knowing that they will be bailed out, the incentives of enterprises to observe financial discipline are weakened. Whether a soft or a hard budget constraint equilibrium prevails in the economy depends on the costs and benefits of bailing out inefficient projects by the government. We identify five factors that may affect government bailout decisions. First, we show that the budget constraint of enterprises can be hardened through fiscal decentralization and competition between regions. Even if regional governments share central government's valuation of private benefits for workers and managers, their opportunity cost of bailing out firms may differ. Fiscal decentralization gives local governments an incentive to enter into a fiscal competition (such as infrastructure investments to attract foreign capital) that raises the opportunity cost of bailing out loss-making enterprises. The distortionary effects of such excess investment may at the same time have the effect of hardening budget constraints. Second, we show that, due to the externalities associated with monetary circulation, monetary decentralization in general softens the budget constraints, as each region gets the full benefit of money creation while sharing its costs with other regions. Third, labor and product market conditions have important effects on the degree of softness of budget constraints. We show that a lower level of worker rents or quasi-rents inside public enterprises tends to harden the budget constraints of enterprises. Fourth, when there are externalities to layoffs which create convex social costs thus increasing returns to scale in refinancing, larger enterprises tend to have softer budget constraints. Finally, we show that the smaller the number of enterprises under one jurisdiction, the weaker the revenue-smoothing ability of the local government through cross subsidization, and consequently, the harder the budget constraint of enterprises. The paper is organized as follows. In Section 2, we provide the institutional background of the Chinese hierarchy and the sources of soft budget constraints for both public enterprises and governments in China. We present the
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basic macroeconomic model of the soft budget constraint in Section 3. In Section 4, we demonstrate the role of fiscal competition among local governments as a device to harden budget constraints of enterprises. In Section 5, we analyze how monetary decentralization softens budget constraints due to the externalities associated with monetary circulation. We study the effect of labor and product market conditions through the channel of employment rents in Section 6, analyze the effect of the size of enterprises under convex social cost functions with respect to layoffs in Section 7, and examine what effect the number of enterprises within each jurisdiction may have in Section 8. The conclusions are given in Section 9.
2. Background: Hierarchical jurisdictions of enterprises and sources of soft budget constraints China's governmental hierarchy has six layers: central, provincial, prefectural, county, township, and village (a municipality can be one of the levels of province, prefecture or county). From the perspective of control, there is a great variety of public enterprises in China, depending on the level of a controlling government body in the hierarchy (Table 1). Public enterprises generally fall into two legal categories: state-owned enterprises (SOEs) and collectives, most of the latter being township and village enterprises (TVEs). Each SOE subordinates to one of the first four levels of government: central, provincial, prefecture and county. Each TVE is controlled by a lower level of government at the township or village level. By the early 1990s, TVEs accounted for more than one third of the national industrial output while the share of SOEs controlled by the central government represented less than a quarter.
Table 1 China: Types of enterprise ownership Public State-owned enterprises (SOEs)
Private Non-state-ownedenterprises Collectives
Individual
Urban Urban Urban: Under control by central, District and neighborhood cooperatives individual provincial, prefecture,or enterprises county governments Rural: N/A
Township and Rural Rural village cooperatives individual enterprises (TVEsl
Others Private, Jointstock, Foreign, and Joint ventures
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It is useful, for analytical purposes, to distinguish between the budget constraint of an enterprise and the budget constraint of a government, although the two are closely related. Consider first the budget constraint of an enterprise. There exist two main sources for relaxing an enterprise's budget constraints (Fig. 1): the fiscal channel through soft taxation and soft subsidies from budgetary and/or extra-budgetary revenues, and the financial channel through soft credits such as bank loans, IOU's, and inter-enterprise credits. In China, soft taxation includes both the "adjustment tax" and the reduction of taxes through a practice known as "loan payments before taxes", which effectively makes all principal and interest tax deductible. 1 Subsidies to state-owned enterprises from fiscal revenues continue to be a fiscal burden. The annual fiscal subsidy to state-owned enterprises accounted for more than 1 5 0 of the budgetary revenue every year since 1986, and peaked at 20% in 1989 (Statistical Yearbook of China, 1994). However, there has been a general fiscal revenue decline during the reform period. Consolidated budgetary revenue fell from 35% of G D P in 1978 to about 16% of G D P in 1992 and from 44% to 33% if extra-budgetary revenue is included. Increasingly, the source of enterprise financing shifts to the financial system. This shift has paralelled the remarkable development of the Chinese financial system during the reform period. For
D
i
Local Gov(
Enterprises 4
Fig. 1. Sources of the soft budget constraint.
1According to a survey, about 50% of 203 large- and medium-sized state-owned enterprises which received assistance when facing financial difficulties between 1986 and 1988 had made loan repayment before taxes, see Qian (1994, Table 10).
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example, China's household bank deposits to GDP ratio increased from 6% in 1978 to about 50% in 1992, and the M2 to GDP ratio soared to about 100% in the early 1990s (Statistical Yearbook of China, 1994). The sources of a soft budget constraint of a local government are also twofold: either through soft fiscal transfers from higher level governments, or through access to credits. Due to the decline of fiscal revenue, and more importantly, to the introduction of the fiscal contracting system, fiscal transfers have been quite limited across all levels of government. It is observed that, at least on the fiscal side, regional governments at all levels in China do face hard budget constraints (e.g., Wong, 1991; Walder, 1994). This has pushed them to turn to the financial system, mainly the banking system, for additional funds. It is in this dimension that the capabilities of governments at different layers of hierarchy vary greatly. Governments at or above the county level, in particular at the central, provincial, and prefecture levels, have been quite successful in exerting enormous political influence on the lending decisions of bank branches and nonbank financial institutions in their regions. Hence, those local governments have had easy access to the financial system, which may take the form of indirect access through the enterprises under their control. Although fiscal transfers are limited, refinancing of local branches of financial institutions by the higher level branches is much easier, because, ultimately, refinancing comes from the central bank. As Table 2 shows, between 1985 and 1990, state banks in China received credits from the central bank which accounted for about 1/4 to 1/3 of their total liabilities.
Table 2 China: Balance sheets of state specialized banks (share)
Assets Reserves Foreign assets Domestic claims Total assets Liabilities Domestic deposits Foreign liabilities Credit from central bank Capital account Others Total liabilities
1985
1988
1989
1990
1991
1992
1993
14.12 4.36 81.51 100.00
10.89 4.46 84.65 100.00
12.60 3.83 83.53 100.00
14,65 5.08 80,27 100,00
16.39 5.19 78.42 100.00
14.34 5.73 79.93 100.00
16.61 4.72 78.67 100.00
41.58 3.12 33.06
47.33 3.67 28.40
48.03 3.54 29.73
50.50 3.73 28.23
53.09 4.94 26.94
59.82 4.35 26.16
58.61 4.01 30.32
9.61 12.63 100.00
7.73 12.87 100.00
7.03 11.69 100.00
6.19 11.34 100.00
5.99 9.04 100.00
5.12 4.55 100.00
5.42 1.64 100.00
Source: International Financial Statistics Yearbook (1994, p. 281).
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Table 3 China: Balance sheets of Rural Credit Cooperatives (share)
1985 Assets Reserves at state bank Domestic claims
Total assets
50.09 49.91
1988 38.95 61.05
1989 37.54 62.46
1990
1991
35.41 64.59
33.62 66.38
1992 30.57 69.43
1993 30.44 69.56
100.00
100.00 100.00
100.00 100.00 I00.00 100.00
Liabilities Domestic deposits 90.45 Credit from state banks 4.11 Others 5.44 Total liabilities 100.00
94.05 95.23 2.42 2.15 3.53 2.62 100.00 100.00
98.08 99.44 98.39 95.07 1.92 1.86 1.71 1.33 - 0.00 - 1.30 0.00 3.60 100.00 100.00 100.00 100.00
Source: International Financial Statistics Yearbook (1994, p. 281).
In contrast, township and village governments' influence over financial institutions is very limited. Rural Credit Cooperatives are the only formal financial institutions in the rural area, and, as Table 3 shows, they have always been net lenders to the state bank - the Agricultural Bank of China. Total lending to the non-state sector, which includes township and village enterprises, has been less than 20% of total outstanding loans from the formal financial system (Qian, 1994, Table 11), despite the fact that the non-state sector accounts for about one half o f the national industrial output. This illustrates the fact that local governments at township and village levels have only limited access to credit.
3. The soft budget constraint in a macroeconomic model We present a stylized macroeconomic model of the Chinese economy to study the soft budget constraint problem in China. The model is drawn from Qian and Roland (1994) which in turn is a modified version of Dewatripont and Maskin (1995). Assume that the economy consists of N identical regions. Local social welfare is derived from three sources
Wi = x(Ki, Ii) + Yi + u(zi), where x ( K i, l i ) = f ( K i , I i ) - K i f K (Ki, Ii) denotes local rents from foreign investment (K i is foreign capital and I i is infrastructure investment in region i); yi denotes other private benefits (including private rents of workers and managers in the public sector); and z~ denotes local public goods consumption, li and z~ are assumed to be normal goods, and their levels do not decrease if government revenues increase. When taxes from public enterprises represent the sole source of government revenue, the government's budget constraint in region i during a given period
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can be represented by T i = G i + S i + I i -I- 21,
where T~ represents net tax revenue (total taxes minus transfers); G i denotes investment in new projects of public enterprises; S i is the level of subsidies for refinancing old projects; I~ is the level of infrastructure investment for attracting foreign capital; and z i stands for local public goods consumption. The activity of public enterprises is described by recurrent projects. At each time period, there is an inelastic supply of n new projects by public enterprises in each region. The starting cost of a project is equal to 1. The return on a project depends on the project type and on the effort by workers and managers. The return on a project of type i is defined by (R~,Bi) where R i is the taxable return and B i is a non-taxable, non-verifiable return accruing to workers and managers net of efforts. As is well known, workers and managers in public enterprises get various rents or quasi-rents in the workplace, mostly in the form of benefits in kind. Projects are of two types: a type 1 project, present in proportion ~, yields (Rq, Bq) after one period independently of worker and manager effort; and a type 2 project, present in proportion (l - ~), yields (Rq, Bq) after one period only if workers and managers choose a high effort level e h. However, if a low effort level e~ is chosen, then the project yields (0,0) after one period. In the latter case, we assume that the government and the enterprise can engage in ex post efficient renegotiation and bargaining. We assume that if arrangements can be made for injection of funds of 1 (strategy r in Fig. 2), a type 2 project will yield (R~, B~) one period later. For the sake of simplicity, we assume no discounting and R~ = 0. As far as managers' incentives are concerned, we assume that B s > 2Bq, which implies that if an enterprise draws a project of type 2, and if refinancing by the government is expected, a low effort is preferred. However, if there is a credible threat of termination of the project after period 1 (strategy t in Fig. 2), a high effort level is preferred, that is B~ > 0. 2 We will speak of soft budget constraints when the government chooses to refinance enterprises with type 2 projects and those projects, expecting this, choose e~; we refer to hard budget constraints when the government prefers to terminate non-performing enterprises with type 2 projects which choose e h. Soft budget constraints occur when the government's commitment to terminating a project is not credible, and conversely, hard budget constraints occur when the commitment is credible. 2We implicitly assume that it is impossibleto induce managers with type 2 projects to choose eh by positive financial incentives, so that the only effectiveinstrument used by the government is the threat of termination. One possible reason is the fact that all firms would have to be paid B~- 2Bq because of asymmetric information about types of the projects, and this might be more costly than the budgetary gain from commitment.
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=
~ (Rq, Bq)
~ ~
(Rq, Sq)
(o, o)
(Rs, Bs) Investment decision
Renegotlation/Bargaining: Reflnandng or terminating
Fig. 2. The mechanism of the soft budget constraint.
As the n new projects arriving each period are ex ante identical, the government can only decide whether to approve all of them or not. Assume that n is large and that ~(Rq - 1) - 2(1 - ~) > 0, which assures that total tax revenue is sufficient for financing all projects even if enterprises with type 2 projects choose e r Obviously, G i = 0 is not optimal and therefore G i = n. Government's choice variables are then ti, Si, I~ and z~. Because the structure of the problem is stationary, the solution of the problem will also be stationary and can be found by solving the one-shot maximization problem in any given period. In our model, the incentives for the government to bail out inefficient enterprises are endogenous, depending on the relative costs and benefits of doing so. Dewatripont and Maskin (1995) focus exclusively on how the benefits (returns to creditors) of refinancing are affected by the distribution of capital, assuming the cost of refinancing is fixed. In our paper, there is a scarcity of capital. In addition to benefits, we also study how the opportunity costs of refinancing vary in response to alternative institutional arrangements and economic conditions. The key observation is that these differences account for the value of alternative uses of the budget: the higher this value, the more costly it is to bail out inefficient enterprises ex post, and the more important it becomes to achieve ex ante commitment. 3 3Shleifer and Vishny (1994) also emphasize the costs to the politicians of bailing out inefficient firms.
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4. Fiscal decentralization and competition Fiscal decentralization may induce competition among jurisdictions if some factors are mobile. To make this clear, assume that there is a fixed amount of foreign capital K in China, but that it is perfectly mobile across regions. Thus, foreign capital flows into those regions with the highest returns. In China, this fiscal competition has taken the form of infrastructure investment to attract foreign capital; the so-called "development zone fever" is an example where most regions have been trying to set up their own development zone to host foreign enterprises and joint ventures. We show in this section that if local governments' infrastructure investment and foreign capital investment are complements, and if local governments' finance must come from their own budgets (which is true under the fiscal contracting system), fiscal competition for attracting foreign capital increases the marginal return to infrastructure expenditure of local governments, which may serve as a credible commitment to stopping bad projects. Foreign capital mobility implies that ~, K i = K,
f ;~(Ki, Ii) = p.
For any given (11 ..... IN), let the solution to the above system of equations be (K 1..... Ks). Then simple comparative statics will show that c~K~ ¢~I-~-> 0
for alli,
and
c~K~ < ~ 0
for alli:~j,
p r o v i d e d f K t ( K i , Ii) > 0, which we assume. Under fiscal decentralization, the local government of region i chooses S~, I i, and z~ so as to maximize W~ subject to its budget constraint and the factor mobility conditions, given the choice 1~ of any other region j (Wildasin, 1988). Given that all regions are identical, we will look at symmetric Nash equilibria. Let I~ be the optimal level of infrastructure investment for local government under a hard budget constraint equilibrium. It satisfies ~'~x(Ki, l~)
c3x(Ki, l ~ ) d K i +
-
¢~1i
-
- -
c~K
dl i
=
u'{z~),
iI)
where z~ = n(Rq - 1) - I~. Under fiscal centralization, the central government's objective is to maximize total social welfare, W-- E W~, subject to the aggregate budget constraint, by choosing t~, S~, I~, and z~. Because all regions are identical, at the optimum, K i = KIN. Let I~ be the socially optimal level of infrastructure investment under a soft budget constraint equilibrium. It is defined by ?~x(Ki, l~) ~I~
-
u'(z~),
t2)
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where : i = n [ o ~ ( R q - 1 ) - 2 ( 1 - ~ ) ] - I ~ . . We assume the above expression is greater than 1.4 The benefit of bailing out an inefficient project is Bs, while the opportunity cost of the bailing out would be (Ox(Ki, l~)/Oli)+ (t~x(Ki, I~)/OK) (dKi/dli) under fiscal decentralization and ( a x ( K i, I~)/~I~) under fiscal centralization. Comparing (1) and (2), one can see that if 63x(Ki, I~) c3x(Ki, I~) t~x(Ki, I~) d K i 6qIi < Bs < 63Ii qOK dI i ' then the budget constraint is soft under fiscal centralization and hard under fiscal decentralization, and there is an under-provision of local public goods in the latter case: z~d < Z~ (see Qian and Roland, 1994). The intuition behind the above argument is that fiscal competition under factor mobility increases the marginal local value of infrastructure investment above its marginal social value and therefore induces more infrastructure investment I~. For a given budgetary revenue available for I i and zi, an increased infrastructure investment diverts resources from local public goods consumption z i, thereby increasing its marginal utility, and thus increasing the opportunity cost of subsidizing bad projects of public enterprises. When this cost outweighs the benefits of subsidies B s, terminating bad projects becomes credible. Although hard budget constraints under decentralization yield more tax revenues, the cost of obtaining commitment is an under-provision of public goods. Despite the suboptimally high level of infrastructure investment and the suboptimally low level of public goods provision, decentralization allows the local governments to achieve commitment for hard budget constraints, which is an important policy goal under transition and may have first-order effects compared to the distortions created by decentralization. Wong (1991) argues that decentralization of fiscal authority in China has led to excessively tight regional fiscal budgets and some wasteful duplicated investment decisions. We argue precisely that tight regional budgets and excess infrastructure investment m a y have helped to harden budget constraints on public enterprises, as local authorities preferred to allocate budgetary resources to infrastructure investment rather than to bail out public enterprises:
4This implies that the opportunity cost of I yuan is more than 1yuan. This ensures that, at the optimum, the corner solution ti = 0 is obtained. 5We have assumed, for the sake of tractability, that all regions are identical. It is useful to note that additional distortions may appear under fiscal decentralization if there are significant regional differences. Richer regions will have more tax revenues to invest in infrastructure and to spend on local public goods. The resulting capital allocation and geographical provision of public goods may not equalize marginal rents from foreign capital and marginal utility of public goods across regions.
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5. Monetary decentralization We now extend the model slightly to integrate a monetary source of finance. Let us assume that R is the level of extra real resources available from inflationary taxation for additional government expenditures, and assume (a/2)R 2 to be the deadweight loss due to the distortionary costs of inflation. The total cost of inflationary finance is R + (a/2)R 2. In the case of fiscal and monetary centralization, which best describes classical socialist economies, the total social welfare function is given by W = N { x ( K i , li) + Yi + u(zi)} - R - (a/2)R z.
If each region is allocated R / N of the resources from inflationary revenue R, then the government's budget constraint in region i is represented by R / N + Ti =
G i q- S i -t- I i q- z i.
The first-order conditions give
&(g,, I~~) ~3li
= u'(z~~) = 1 + a R cc,
where the superscript cc stands for fiscal and monetary centralization. The case of fiscal and monetary decentralization in our model maintains all assumptions specified under fiscal decentralization, and in addition, we assume that each local government has de facto, if not de jure, authority over money supply. Decentralized monetary creation creates a negative externality as local governments get the full benefit of money creation but share the costs with the other regions, which leads to an extreme form of beggar-thy-neighbor policy, a "tragedy of the commons". We assume that when region i secures itself resources in amount R i from inflationary finance, it only bears costs of R J N . In other words, we assume that there is a probability 1/N that real resources are withdrawn from consumers in the same region. Moreover, the deadweight losses of inflation created in one region are shared equally by all regions. Under such circumstances, the local government in region i maximizes the local social welfare function Wi = x(Ki, Ii) + Yi + u(zi) - (R + (a/2)R2)/N
by taking other regions' decisions as given (including R j , j :/: i), subject to the budget constraint of the local government, R i + Ti =
G i -Jr-S i d- I i q- 7,i,
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where ZR~ = R. The first-order conditions for the corresponding Lagrangian are
c3x(K,, Ida) ~I i
+
c3x(Ki, Ida) d g i = u'(z~ ~) = (1 + aRdd)/N, c~K dI i
(4)
where the superscript dd stands for fiscal and monetary decentralization. Comparing (3) and (4), we can show (see Qian and Roland, 1994) that there is an excess monetary finance under fiscal and monetary decentralization not present under centralization (i.e., R dd > RCC). Fiscal and monetary decentralization may even transform hard budget equilibria under fiscal and monetary centralization into soft budget constraint equilibria. Therefore, if fiscal decentralization tends to harden budget constraints, monetary decentralization works in the opposite direction. If regions get automatic access to credit, which amounts de facto to enabling them to make independent decisions on monetary creation, thenoa generalized softening of budget constraints will occur together with a distortion in the composition of public expenditures. Budget constraints are soft under centralization if the marginal social cost of inflationary finance is smaller than the marginal benefit of bailing out enterprises. Under monetary decentralization, the cost to the region of printing money is even lower, which means that budget constraints can only be softened. On several occasions in the 1980s and 1990s, local governments in China at or above county levels have managed to secure easy credits from local branches of the central bank, which amounts de facto to a decentralization of money supply over which the central authority has lost control.
6. Labor and product market conditions In this section, we do some comparative statics allowing us to understand the harder budget constraints of TVEs. For simplicity, we omit infrastructure investment from the model of Section 3 and also abstract from monetary finance in Section 5. The local government's objective is to maximize the social welfare function I/Vi ~- Yi + U(Zi)
s.t.
T~ = Gi + Si + zi.
We now interpret the private benefit to employees of being bailed out, Bs, as the net difference between the employee benefits received from the enterprise and the outside option/reservation utility (i.e., rents or quasi-rents). This rent reduction in Bs may transform a soft budget equilibrium into a hard budget equilibrium. Suppose initially B ~ > u ' [ n ( ~ ( R q - 1 ) - - 2 ( 1 - - c 0 ) ]. Then a soft budget constraint equilibrium can be transformed into a hard budget constraint equilibrium if B~ falls below max[u'(n(Rq - 1)), 1, 2Bq].
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We may interpret this comparative statics result as a reduced form of the effect of labor and product market conditions on employee rents. Labor markets in China are segmented so that labor market conditions facing SOEs controlled by upper layer government differ significantly from those facing TVEs controlled by lower level governments. It is useful to discuss what elements in the labor market determine B~ and thus the relative benefits of bailing out enterprises. The first element is the extent of labor market competition. Almost all TVEs are operating on very competitive rural labor markets. They hire young employees who can be fired easily. This limits employmentrelated rents and quasi-rents. In contrast, SOEs hire employees in less competitive urban labor markets. Firing is much harder and many SOEs are old firms with many old employees and retirees. This tends to increase employment-related rents and quasi-rents. The second element is the state regulation of the enterprise provision of employees' welfare. The state requires SOEs to provide social welfare like health insurance, disability insurance, death benefits, and pensions according to national standards. But no such regulation exists for TVEs (Walder, 1994). The third element is due to the legacy of the planning system which assigned SOEs the responsibility of providing their employees with housing, meal service, day care, and medical clinics and hospital a practice known as "enterprise running social services". But newly established township and village enterprises provide few or none of these services. The final element concerns workers' options once unemployed. Workers being fired in the urban area not only lose all job-related benefits but also have a more difficult time finding a new job. In comparison, workers in rural areas always have the option of going back to work on the land, which is under family control since the introduction of the household responsibility system. The role of entry and competition in the product market has been emphasized by McMillan and Naughton (1992). Entry and competition tend to reduce Bs in the following way. First, entry of new firms provides opportunities for workers to be employed elsewhere, which increases their outside option and therefore reduces the net rents from current employment. Secondly, when there are monopolies in an industry or in a region, the entry of new firms controlled by governments of other regions or by lower level governments within the region provides second sourcing, mitigating the hold-up power of monopolies vis-fi-vis the government, and thereby also reducing the rents related to the refinancing of the monopoly.
7. The social cost of layoffs and the size of enterprises
It is often heard that an enterprise is "too big to fail". We relate this to the potential social cost of layoffs. This cost, which will ultimately be borne by the government, will have effects on the problem of soft budget constraints. To
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show this, we slightly change the model by assuming a variable size of enterprises measured by L, the number of employees. In the previous analysis, we had implicitly normalized L to 1. Let F(L) be the cumulative density function measuring the proportion of firms from size 0 to L, and C(L) be the cost borne by the government when an enterprise of size L is closed down. C(L) includes not only relocation and retraining costs but also costs of preventing social unrest. Although the first two components of the costs are likely to be proportional to L, the last component is likely to give rise to a convex cost of layoffs due to a layoff externality: the more people are being laid off, the higher the probability of social unrest. Then the net benefit for bailing out an enterprise with L employees is (B~ - 1)L - ( - C(L)) = (BsL + C(L)) - L, which is convex in L, and hence the net benefit per employee, Bs + C(L)/L - 1, increases in L. This provides a rationale for the "too big to fail" motive expressed in the following proposition. Indeed, define an enterprise size of L* defined by the following equality B~ + C(L*)/L* = u' [F(L*)nRq + (1 - F(L*))(~nRq - (1 - ~)n) - n].
(5)
The left-hand side represents the net benefit per employee of bailing out an enterprise whereas the right-hand side represents the per employee cost of bailout. Due to the convexity of C(L), for L > L*, the per employee benefit of bailout will be bigger than the cost, and vice versa for L < L*. The former will thus have soft budget constraints and the latter will have hard budget constraints. As SOEs are typically larger in size and TVEs are relatively small, the budget constraint of the former is likely to be softer. Further, due to high population density in the urban areas, mass layoffs there would be more likely to create social problems than in the rural areas for the same size of layoffs. This amounts to an upward shift of cost function C(L) for the urban areas as compared with the rural areas. Because the right-hand side of Eq. (5) decreases in L*, the critical value L* in the urban areas will be smaller than that in the rural areas. This explains one reason why SOEs located in big cities are more likely to have soft budget constraints than TVEs located in the rural areas.
8. The number of enterprises within a jurisdiction We have assumed so far that the number n of enterprises under one government jurisdiction is large enough so that the law of large numbers can be applied. This assumption is valid with higher layer governments that typically control many enterprises but is not very realistic for most township and village governments. With a smaller pool of projects in each period, liquidity imposes an additional limit on the government's ability to cross-subsidize and this
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tends to harden budget constraints. We will show this by putting forward two related arguments. First, one can show that as the number of projects in one jurisdiction n falls, a symmetric soft budget constraint equilibrium ceases to exist. Indeed, the probability of having at least one type 1 project out of n - 1 is 1 -(1 - ~ ) " - 1 . Hence, if all other enterprises with type 2 choose e~, then the expected private benefit for an enterprise with type 2 projects choosing e~ is at most ( 1 - ( 1 - ~ ) " - X ) B s . When n is sufficiently small, ( 1 - ( 1 - ~ & 1) B s < 2Bq. Therefore, even if the government wants to refinance when it has sufficient revenue, the enterprise with type 2 project has no incentives to choose el. 6 When n thus becomes small, if all type 2 enterprises choose e~, the probability that no type 1 projects are drawn in the next period becomes larger. In such a state, no tax revenue is generated and the projects have to be terminated. Secondly, one can show that p, the probability of an enterprise with a type 2 project choosing e h in a symmetric mixed strategy equilibrium, increases as n falls. To see this, assume Rq > 2n - 1 with n > 2. This condition implies that one type 1 project or one type 2 project with e~ will generate sufficient tax revenue to finance n new projects and refinance ( n - 1) old projects. Assume further that the government will refinance all projects as long as it has enough revenue. Consider the choice of e 1. Out of n - 1 projects, the probability of having at least one type 1 project or having at least one type 2 project with eh is 1 - ( 1 - 7 ) " - ~ ( 1 __p)n-2. In such events, refinancing will occur. If all n - 1 projects are of type 2 with e,, which happens with probability (1 - ~)"- 1(1 - p ) " - 2 , no refinancing will occur. In a mixed strategy equilibrium, the enterprise with a type 2 project must be indifferent between choosing e h and e I. Therefore we obtain (1 -
(1 - ~)"- 1(1 -- p ) " - 2 ) B s = 2Bq.
Differentiating both sides with respect to n yields d p / d n = (ln(1 - e) + ln(1 - p))(1 - p)/(n - 2),
which is negative. A fall in the number of enterprises in the jurisdiction thus hardens budget constraints. Note that these results depend only on the firms' incentives to provide high or low effort, regardless of government's incentives to refinance. Even if the government would be willing to refinance enterprises which have provided e,, the firms are still reluctant to choose e~ because of the greater difficulties of cross-subsidization when there are few firms in the jurisdiction.
6 F o r n = 1,
the enterprise with a type 2 project always chooses eh.
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9. Concluding remarks Table 4 summarizes the relevance of the above five factors for China. The first column shows the situation of SOEs under centralization before reforms. All factors identified in the model as softening budget constraints are present. The next column shows the situation under decentralization for SOEs. Fiscal competition tends to harden budget constraints, but easy access to credit eliminates the positive effects of fiscal competition. All other factors tend to soften budget constraints: large or medium employment rents or quasi-rents, the large size of enterprises, and the large numbers of enterprises under the control of one government. The last column describes the situation in TVEs. Fiscal competition is also present. For the rest, all other factors point toward hard budget constraints-access to credit is limited or difficult, employment rents or quasi-rents are small, the size of TVEs is not large, and the number of TVEs within each jurisdiction is not large either. Our theory is consistent with empirical evidence that has shown that TVEs have harder budget constraints than SOEs. For example, due to the government's austerity program, about three million township and village enterprises went bankrupt or were taken over by other enterprises in 1989 (People's Daily, 23 March 1990). The total employment in township and village enterprises fell from 48.9 million in 1988 to 47.2 million in 1989 and to 45.9 in 1990, reversing the trend of expansion of more than 10 years. In contrast, during the same period, employment in the state-sector increased (Chinese Statistics Yearbook, 1992). China benefitted greatly from regional decentralization in its first 15 years of reforms, and the Chinese experience shows that decentralization of fiscal authority has helped in advancing the reform. This is all the more important since large-scale privatization programs were excluded for ideological Table 4 The comparison chart
Centralization (SOEs)
Fiscal competion Access to credit Employment rents or quasi-rents Number of employees per enterprise Number of enterprises in control
Decentralization Higher layers (SOEs)
Lower layers (TVEs)
No Easy Large
Yes Easy/medium Large/medium
Yes Limited/difficult Small
Large/medium
Large/medium
Medium/small
Large
Large
Medium/smal
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reasons. In E a s t e r n E u r o p e a n d Russia, where such obstacles do n o t exist a n y m o r e , the d i c h o t o m y between p u b l i c a n d private enterprise has p u t too m u c h in the b a c k g r o u n d the d i m e n s i o n of fiscal federalism a n d the issue of efficient a l l o c a t i o n of a u t h o r i t y over v a r i o u s p u b l i c decisions. T h e r e are, of course, limits to the a d v a n t a g e s of d e c e n t r a l i z a t i o n . E x t r e m e d e c e n t r a l i z a t i o n a m o u n t s to s e p a r a t i s m which m a y have c a t a s t r o p h i c c o n s e q u e n c e s o n trade a n d welfare (Bolton a n d R o l a n d , 1993). T h e r e are also certain areas in which the costs of d e c e n t r a l i z a t i o n are likely to outweigh the benefits, even where d e c e n t r a l i z a t i o n is d e t r i m e n t a l to the progress of reforms. A m o n g the costs of d e c e n t r a l i z a t i o n we m e n t i o n e d the fiscal distortions. A n o t h e r cost is the increase in regional inequalities. Careful analysis of the u n d e r l y i n g m e c h a n i s m of d e c e n t r a l i z a t i o n is i m p o r t a n t , n o t j u s t for u n d e r s t a n d i n g what has happened in C h i n a , b u t also for the future direction of reforms in C h i n a a n d elsewhere.
Acknowledgements T h e a u t h o r s wish to t h a n k Erik Bergl6f, J i a h u a Che, M a t h i a s D e w a t ripont, R o n a l d M c K i n n o n , Barry N a u g h t o n , C h e n g g a n g Xu, a n d s e m i n a r p a r t i c i p a n t s in Brussels for helpful discussions.
References Bolton, P. and G. Roland, 1993, The break-up of nations: A political economy analysis, mimeo, ECARE. Dewatripont, M. and E. Maskin, 1995, Credit and efficiency in centralized and decentralized economies, Review of Economic Studies 62, 541-555. International Monetary Fund, International Financial Statistics Yearbook, 1994. Kornai, J., 1980, Economics of shortage (North-Holland, Amsterdam). Kornai, J., 1986, The soft budget constraint, KYKLOS 39(1), 3 30. McMillan, J. and B. Naughton, 1992, How to reform a planned economy: Lessons from China, Oxford Review of Economic Policy 8 (1), 130 143. Qian, Y., 1994, Financial system reform in China: Lessons from Japan's main bank system, in: M. Aoki and H. Patrick, eds., The Japanese main bank system: Its relevance for developing and transforming economies (Oxford University Press, Oxford). Qian, Y. and G. Roland, 1994, Regional decentralization and the soft budget constraint: The case of China, mimeo, Stanford University and Universite Libre de Bruxelles. Qian, Y. and C. Xu, 1993, Why China's economic reforms differ: The M-form hierarchy and entry/expansion of the non-state sector, The Economics of Transition 1(2), 135-170. Shleifer, A. and R. Vishny, 1994, Politicians and firms, Quarterly Journal of Economics CIX (4), 995-1025. Walder, A., 1994, The varieties of public enterprises in China: An institutional analysis, mimeo, Harvard University. Wildasin, D.E., 1988, Nash equilibria in models of fiscal competition, Journal of Public Economics 35, 229 240. Wong, C.P.W., 1991, Central-local relations in an era of fiscal decline: The paradox of fiscal decentralization in post-Mao China, The China Quarterly 128, 691 715.
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and the LD ECONOMY
The soft budget constraint in China Yingyi Q i a n a'*, G 6 r a r d R o l a n d b ~Department of Economics, Stanford University, Starz[brd, CA 94305, USA bECARE, CEME (UniversitO Libre de Bruxelles) and CEPR, Avenue F. Roosevelt 50, 1050 Bruxelles, Bel,qium Received 15 March 1994; accepted 15 December 1994
Abstract This paper identifies five factors affecting the degree of softness or hardness of budget constraints of enterprises in China. Budget constraints become harder: (1) under fiscal decentralization and competition between regions; (2) under more competitive labor and product markets reducing employment rents; (3) when there is a smaller number of enterprises within each jurisdiction. On the other hand, budget constraints become softer: (1) under monetary decentralization; (2) when enterprises have a larger size and social costs of layoffs are convex. We use these results to explain why township -village enterprises have harder budget constraints than state-owned enterprises.
Keywords: Soft budget constraints; Transition economies: Decentralization; Public enterprises; China JEL classification: E62; E63; H7; L30; P3
1. Introduction The soft budget constraint syndrome (Kornai, 1980, 1986) has been an important issue in China as well as in other transition economies. In Eastern Europe and the former Soviet Union, mass privatization is the method chosen to harden budget constraints. For obvious political and ideological reasons, such policy is not pursued in China. However, the experience of reform has *Corresponding author. Tel.: 415-723-3984; fax: 415-725-5702; e-mail: yqian(a leland, stanford.edu. 1234-5678,/96,/$15.00 Copyright ,(~") 1996 Elsevier Science B.V. All rights reserved SSD1 0 9 2 2 - 1 4 2 5 ( 9 6 ) 0 0 0 3 7 - 2
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shown that the degree of softness of budget constraints varies across public enterprises. For example, it has been observed that enterprises under the control of central or higher level governments tend to have softer budget constraints than enterprises controlled by lower level governments of townships and villages (Qian and Xu, 1993). In this paper, we study the soft budget constraint problem in China with the help of a macroeconomic model developed in Qian and Roland (1994), which is in turn based on Dewatripont and Maskin (1995). There are soft budget constraints in public enterprises because the government cannot credibly commit to terminate an enterprise activity due to the losses in private benefits for workers and managers if they lose their jobs. Knowing that they will be bailed out, the incentives of enterprises to observe financial discipline are weakened. Whether a soft or a hard budget constraint equilibrium prevails in the economy depends on the costs and benefits of bailing out inefficient projects by the government. We identify five factors that may affect government bailout decisions. First, we show that the budget constraint of enterprises can be hardened through fiscal decentralization and competition between regions. Even if regional governments share central government's valuation of private benefits for workers and managers, their opportunity cost of bailing out firms may differ. Fiscal decentralization gives local governments an incentive to enter into a fiscal competition (such as infrastructure investments to attract foreign capital) that raises the opportunity cost of bailing out loss-making enterprises. The distortionary effects of such excess investment may at the same time have the effect of hardening budget constraints. Second, we show that, due to the externalities associated with monetary circulation, monetary decentralization in general softens the budget constraints, as each region gets the full benefit of money creation while sharing its costs with other regions. Third, labor and product market conditions have important effects on the degree of softness of budget constraints. We show that a lower level of worker rents or quasi-rents inside public enterprises tends to harden the budget constraints of enterprises. Fourth, when there are externalities to layoffs which create convex social costs thus increasing returns to scale in refinancing, larger enterprises tend to have softer budget constraints. Finally, we show that the smaller the number of enterprises under one jurisdiction, the weaker the revenue-smoothing ability of the local government through cross subsidization, and consequently, the harder the budget constraint of enterprises. The paper is organized as follows. In Section 2, we provide the institutional background of the Chinese hierarchy and the sources of soft budget constraints for both public enterprises and governments in China. We present the
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basic macroeconomic model of the soft budget constraint in Section 3. In Section 4, we demonstrate the role of fiscal competition among local governments as a device to harden budget constraints of enterprises. In Section 5, we analyze how monetary decentralization softens budget constraints due to the externalities associated with monetary circulation. We study the effect of labor and product market conditions through the channel of employment rents in Section 6, analyze the effect of the size of enterprises under convex social cost functions with respect to layoffs in Section 7, and examine what effect the number of enterprises within each jurisdiction may have in Section 8. The conclusions are given in Section 9.
2. Background: Hierarchical jurisdictions of enterprises and sources of soft budget constraints China's governmental hierarchy has six layers: central, provincial, prefectural, county, township, and village (a municipality can be one of the levels of province, prefecture or county). From the perspective of control, there is a great variety of public enterprises in China, depending on the level of a controlling government body in the hierarchy (Table 1). Public enterprises generally fall into two legal categories: state-owned enterprises (SOEs) and collectives, most of the latter being township and village enterprises (TVEs). Each SOE subordinates to one of the first four levels of government: central, provincial, prefecture and county. Each TVE is controlled by a lower level of government at the township or village level. By the early 1990s, TVEs accounted for more than one third of the national industrial output while the share of SOEs controlled by the central government represented less than a quarter.
Table 1 China: Types of enterprise ownership Public State-owned enterprises (SOEs)
Private Non-state-ownedenterprises Collectives
Individual
Urban Urban Urban: Under control by central, District and neighborhood cooperatives individual provincial, prefecture,or enterprises county governments Rural: N/A
Township and Rural Rural village cooperatives individual enterprises (TVEsl
Others Private, Jointstock, Foreign, and Joint ventures
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It is useful, for analytical purposes, to distinguish between the budget constraint of an enterprise and the budget constraint of a government, although the two are closely related. Consider first the budget constraint of an enterprise. There exist two main sources for relaxing an enterprise's budget constraints (Fig. 1): the fiscal channel through soft taxation and soft subsidies from budgetary and/or extra-budgetary revenues, and the financial channel through soft credits such as bank loans, IOU's, and inter-enterprise credits. In China, soft taxation includes both the "adjustment tax" and the reduction of taxes through a practice known as "loan payments before taxes", which effectively makes all principal and interest tax deductible. 1 Subsidies to state-owned enterprises from fiscal revenues continue to be a fiscal burden. The annual fiscal subsidy to state-owned enterprises accounted for more than 1 5 0 of the budgetary revenue every year since 1986, and peaked at 20% in 1989 (Statistical Yearbook of China, 1994). However, there has been a general fiscal revenue decline during the reform period. Consolidated budgetary revenue fell from 35% of G D P in 1978 to about 16% of G D P in 1992 and from 44% to 33% if extra-budgetary revenue is included. Increasingly, the source of enterprise financing shifts to the financial system. This shift has paralelled the remarkable development of the Chinese financial system during the reform period. For
D
i
Local Gov(
Enterprises 4
Fig. 1. Sources of the soft budget constraint.
1According to a survey, about 50% of 203 large- and medium-sized state-owned enterprises which received assistance when facing financial difficulties between 1986 and 1988 had made loan repayment before taxes, see Qian (1994, Table 10).
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example, China's household bank deposits to GDP ratio increased from 6% in 1978 to about 50% in 1992, and the M2 to GDP ratio soared to about 100% in the early 1990s (Statistical Yearbook of China, 1994). The sources of a soft budget constraint of a local government are also twofold: either through soft fiscal transfers from higher level governments, or through access to credits. Due to the decline of fiscal revenue, and more importantly, to the introduction of the fiscal contracting system, fiscal transfers have been quite limited across all levels of government. It is observed that, at least on the fiscal side, regional governments at all levels in China do face hard budget constraints (e.g., Wong, 1991; Walder, 1994). This has pushed them to turn to the financial system, mainly the banking system, for additional funds. It is in this dimension that the capabilities of governments at different layers of hierarchy vary greatly. Governments at or above the county level, in particular at the central, provincial, and prefecture levels, have been quite successful in exerting enormous political influence on the lending decisions of bank branches and nonbank financial institutions in their regions. Hence, those local governments have had easy access to the financial system, which may take the form of indirect access through the enterprises under their control. Although fiscal transfers are limited, refinancing of local branches of financial institutions by the higher level branches is much easier, because, ultimately, refinancing comes from the central bank. As Table 2 shows, between 1985 and 1990, state banks in China received credits from the central bank which accounted for about 1/4 to 1/3 of their total liabilities.
Table 2 China: Balance sheets of state specialized banks (share)
Assets Reserves Foreign assets Domestic claims Total assets Liabilities Domestic deposits Foreign liabilities Credit from central bank Capital account Others Total liabilities
1985
1988
1989
1990
1991
1992
1993
14.12 4.36 81.51 100.00
10.89 4.46 84.65 100.00
12.60 3.83 83.53 100.00
14,65 5.08 80,27 100,00
16.39 5.19 78.42 100.00
14.34 5.73 79.93 100.00
16.61 4.72 78.67 100.00
41.58 3.12 33.06
47.33 3.67 28.40
48.03 3.54 29.73
50.50 3.73 28.23
53.09 4.94 26.94
59.82 4.35 26.16
58.61 4.01 30.32
9.61 12.63 100.00
7.73 12.87 100.00
7.03 11.69 100.00
6.19 11.34 100.00
5.99 9.04 100.00
5.12 4.55 100.00
5.42 1.64 100.00
Source: International Financial Statistics Yearbook (1994, p. 281).
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Table 3 China: Balance sheets of Rural Credit Cooperatives (share)
1985 Assets Reserves at state bank Domestic claims
Total assets
50.09 49.91
1988 38.95 61.05
1989 37.54 62.46
1990
1991
35.41 64.59
33.62 66.38
1992 30.57 69.43
1993 30.44 69.56
100.00
100.00 100.00
100.00 100.00 I00.00 100.00
Liabilities Domestic deposits 90.45 Credit from state banks 4.11 Others 5.44 Total liabilities 100.00
94.05 95.23 2.42 2.15 3.53 2.62 100.00 100.00
98.08 99.44 98.39 95.07 1.92 1.86 1.71 1.33 - 0.00 - 1.30 0.00 3.60 100.00 100.00 100.00 100.00
Source: International Financial Statistics Yearbook (1994, p. 281).
In contrast, township and village governments' influence over financial institutions is very limited. Rural Credit Cooperatives are the only formal financial institutions in the rural area, and, as Table 3 shows, they have always been net lenders to the state bank - the Agricultural Bank of China. Total lending to the non-state sector, which includes township and village enterprises, has been less than 20% of total outstanding loans from the formal financial system (Qian, 1994, Table 11), despite the fact that the non-state sector accounts for about one half o f the national industrial output. This illustrates the fact that local governments at township and village levels have only limited access to credit.
3. The soft budget constraint in a macroeconomic model We present a stylized macroeconomic model of the Chinese economy to study the soft budget constraint problem in China. The model is drawn from Qian and Roland (1994) which in turn is a modified version of Dewatripont and Maskin (1995). Assume that the economy consists of N identical regions. Local social welfare is derived from three sources
Wi = x(Ki, Ii) + Yi + u(zi), where x ( K i, l i ) = f ( K i , I i ) - K i f K (Ki, Ii) denotes local rents from foreign investment (K i is foreign capital and I i is infrastructure investment in region i); yi denotes other private benefits (including private rents of workers and managers in the public sector); and z~ denotes local public goods consumption, li and z~ are assumed to be normal goods, and their levels do not decrease if government revenues increase. When taxes from public enterprises represent the sole source of government revenue, the government's budget constraint in region i during a given period
Y. Qian, G. Roland / Japan and the World Economy 8 (1996) 207 223
213
can be represented by T i = G i + S i + I i -I- 21,
where T~ represents net tax revenue (total taxes minus transfers); G i denotes investment in new projects of public enterprises; S i is the level of subsidies for refinancing old projects; I~ is the level of infrastructure investment for attracting foreign capital; and z i stands for local public goods consumption. The activity of public enterprises is described by recurrent projects. At each time period, there is an inelastic supply of n new projects by public enterprises in each region. The starting cost of a project is equal to 1. The return on a project depends on the project type and on the effort by workers and managers. The return on a project of type i is defined by (R~,Bi) where R i is the taxable return and B i is a non-taxable, non-verifiable return accruing to workers and managers net of efforts. As is well known, workers and managers in public enterprises get various rents or quasi-rents in the workplace, mostly in the form of benefits in kind. Projects are of two types: a type 1 project, present in proportion ~, yields (Rq, Bq) after one period independently of worker and manager effort; and a type 2 project, present in proportion (l - ~), yields (Rq, Bq) after one period only if workers and managers choose a high effort level e h. However, if a low effort level e~ is chosen, then the project yields (0,0) after one period. In the latter case, we assume that the government and the enterprise can engage in ex post efficient renegotiation and bargaining. We assume that if arrangements can be made for injection of funds of 1 (strategy r in Fig. 2), a type 2 project will yield (R~, B~) one period later. For the sake of simplicity, we assume no discounting and R~ = 0. As far as managers' incentives are concerned, we assume that B s > 2Bq, which implies that if an enterprise draws a project of type 2, and if refinancing by the government is expected, a low effort is preferred. However, if there is a credible threat of termination of the project after period 1 (strategy t in Fig. 2), a high effort level is preferred, that is B~ > 0. 2 We will speak of soft budget constraints when the government chooses to refinance enterprises with type 2 projects and those projects, expecting this, choose e~; we refer to hard budget constraints when the government prefers to terminate non-performing enterprises with type 2 projects which choose e h. Soft budget constraints occur when the government's commitment to terminating a project is not credible, and conversely, hard budget constraints occur when the commitment is credible. 2We implicitly assume that it is impossibleto induce managers with type 2 projects to choose eh by positive financial incentives, so that the only effectiveinstrument used by the government is the threat of termination. One possible reason is the fact that all firms would have to be paid B~- 2Bq because of asymmetric information about types of the projects, and this might be more costly than the budgetary gain from commitment.
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=
~ (Rq, Bq)
~ ~
(Rq, Sq)
(o, o)
(Rs, Bs) Investment decision
Renegotlation/Bargaining: Reflnandng or terminating
Fig. 2. The mechanism of the soft budget constraint.
As the n new projects arriving each period are ex ante identical, the government can only decide whether to approve all of them or not. Assume that n is large and that ~(Rq - 1) - 2(1 - ~) > 0, which assures that total tax revenue is sufficient for financing all projects even if enterprises with type 2 projects choose e r Obviously, G i = 0 is not optimal and therefore G i = n. Government's choice variables are then ti, Si, I~ and z~. Because the structure of the problem is stationary, the solution of the problem will also be stationary and can be found by solving the one-shot maximization problem in any given period. In our model, the incentives for the government to bail out inefficient enterprises are endogenous, depending on the relative costs and benefits of doing so. Dewatripont and Maskin (1995) focus exclusively on how the benefits (returns to creditors) of refinancing are affected by the distribution of capital, assuming the cost of refinancing is fixed. In our paper, there is a scarcity of capital. In addition to benefits, we also study how the opportunity costs of refinancing vary in response to alternative institutional arrangements and economic conditions. The key observation is that these differences account for the value of alternative uses of the budget: the higher this value, the more costly it is to bail out inefficient enterprises ex post, and the more important it becomes to achieve ex ante commitment. 3 3Shleifer and Vishny (1994) also emphasize the costs to the politicians of bailing out inefficient firms.
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215
4. Fiscal decentralization and competition Fiscal decentralization may induce competition among jurisdictions if some factors are mobile. To make this clear, assume that there is a fixed amount of foreign capital K in China, but that it is perfectly mobile across regions. Thus, foreign capital flows into those regions with the highest returns. In China, this fiscal competition has taken the form of infrastructure investment to attract foreign capital; the so-called "development zone fever" is an example where most regions have been trying to set up their own development zone to host foreign enterprises and joint ventures. We show in this section that if local governments' infrastructure investment and foreign capital investment are complements, and if local governments' finance must come from their own budgets (which is true under the fiscal contracting system), fiscal competition for attracting foreign capital increases the marginal return to infrastructure expenditure of local governments, which may serve as a credible commitment to stopping bad projects. Foreign capital mobility implies that ~, K i = K,
f ;~(Ki, Ii) = p.
For any given (11 ..... IN), let the solution to the above system of equations be (K 1..... Ks). Then simple comparative statics will show that c~K~ ¢~I-~-> 0
for alli,
and
c~K~ < ~ 0
for alli:~j,
p r o v i d e d f K t ( K i , Ii) > 0, which we assume. Under fiscal decentralization, the local government of region i chooses S~, I i, and z~ so as to maximize W~ subject to its budget constraint and the factor mobility conditions, given the choice 1~ of any other region j (Wildasin, 1988). Given that all regions are identical, we will look at symmetric Nash equilibria. Let I~ be the optimal level of infrastructure investment for local government under a hard budget constraint equilibrium. It satisfies ~'~x(Ki, l~)
c3x(Ki, l ~ ) d K i +
-
¢~1i
-
- -
c~K
dl i
=
u'{z~),
iI)
where z~ = n(Rq - 1) - I~. Under fiscal centralization, the central government's objective is to maximize total social welfare, W-- E W~, subject to the aggregate budget constraint, by choosing t~, S~, I~, and z~. Because all regions are identical, at the optimum, K i = KIN. Let I~ be the socially optimal level of infrastructure investment under a soft budget constraint equilibrium. It is defined by ?~x(Ki, l~) ~I~
-
u'(z~),
t2)
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where : i = n [ o ~ ( R q - 1 ) - 2 ( 1 - ~ ) ] - I ~ . . We assume the above expression is greater than 1.4 The benefit of bailing out an inefficient project is Bs, while the opportunity cost of the bailing out would be (Ox(Ki, l~)/Oli)+ (t~x(Ki, I~)/OK) (dKi/dli) under fiscal decentralization and ( a x ( K i, I~)/~I~) under fiscal centralization. Comparing (1) and (2), one can see that if 63x(Ki, I~) c3x(Ki, I~) t~x(Ki, I~) d K i 6qIi < Bs < 63Ii qOK dI i ' then the budget constraint is soft under fiscal centralization and hard under fiscal decentralization, and there is an under-provision of local public goods in the latter case: z~d < Z~ (see Qian and Roland, 1994). The intuition behind the above argument is that fiscal competition under factor mobility increases the marginal local value of infrastructure investment above its marginal social value and therefore induces more infrastructure investment I~. For a given budgetary revenue available for I i and zi, an increased infrastructure investment diverts resources from local public goods consumption z i, thereby increasing its marginal utility, and thus increasing the opportunity cost of subsidizing bad projects of public enterprises. When this cost outweighs the benefits of subsidies B s, terminating bad projects becomes credible. Although hard budget constraints under decentralization yield more tax revenues, the cost of obtaining commitment is an under-provision of public goods. Despite the suboptimally high level of infrastructure investment and the suboptimally low level of public goods provision, decentralization allows the local governments to achieve commitment for hard budget constraints, which is an important policy goal under transition and may have first-order effects compared to the distortions created by decentralization. Wong (1991) argues that decentralization of fiscal authority in China has led to excessively tight regional fiscal budgets and some wasteful duplicated investment decisions. We argue precisely that tight regional budgets and excess infrastructure investment m a y have helped to harden budget constraints on public enterprises, as local authorities preferred to allocate budgetary resources to infrastructure investment rather than to bail out public enterprises:
4This implies that the opportunity cost of I yuan is more than 1yuan. This ensures that, at the optimum, the corner solution ti = 0 is obtained. 5We have assumed, for the sake of tractability, that all regions are identical. It is useful to note that additional distortions may appear under fiscal decentralization if there are significant regional differences. Richer regions will have more tax revenues to invest in infrastructure and to spend on local public goods. The resulting capital allocation and geographical provision of public goods may not equalize marginal rents from foreign capital and marginal utility of public goods across regions.
Y. Qian, G. Roland / Japan and the World Economy 8 ¢1996) 2 0 7 - 2 2 3
217
5. Monetary decentralization We now extend the model slightly to integrate a monetary source of finance. Let us assume that R is the level of extra real resources available from inflationary taxation for additional government expenditures, and assume (a/2)R 2 to be the deadweight loss due to the distortionary costs of inflation. The total cost of inflationary finance is R + (a/2)R 2. In the case of fiscal and monetary centralization, which best describes classical socialist economies, the total social welfare function is given by W = N { x ( K i , li) + Yi + u(zi)} - R - (a/2)R z.
If each region is allocated R / N of the resources from inflationary revenue R, then the government's budget constraint in region i is represented by R / N + Ti =
G i q- S i -t- I i q- z i.
The first-order conditions give
&(g,, I~~) ~3li
= u'(z~~) = 1 + a R cc,
where the superscript cc stands for fiscal and monetary centralization. The case of fiscal and monetary decentralization in our model maintains all assumptions specified under fiscal decentralization, and in addition, we assume that each local government has de facto, if not de jure, authority over money supply. Decentralized monetary creation creates a negative externality as local governments get the full benefit of money creation but share the costs with the other regions, which leads to an extreme form of beggar-thy-neighbor policy, a "tragedy of the commons". We assume that when region i secures itself resources in amount R i from inflationary finance, it only bears costs of R J N . In other words, we assume that there is a probability 1/N that real resources are withdrawn from consumers in the same region. Moreover, the deadweight losses of inflation created in one region are shared equally by all regions. Under such circumstances, the local government in region i maximizes the local social welfare function Wi = x(Ki, Ii) + Yi + u(zi) - (R + (a/2)R2)/N
by taking other regions' decisions as given (including R j , j :/: i), subject to the budget constraint of the local government, R i + Ti =
G i -Jr-S i d- I i q- 7,i,
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where ZR~ = R. The first-order conditions for the corresponding Lagrangian are
c3x(K,, Ida) ~I i
+
c3x(Ki, Ida) d g i = u'(z~ ~) = (1 + aRdd)/N, c~K dI i
(4)
where the superscript dd stands for fiscal and monetary decentralization. Comparing (3) and (4), we can show (see Qian and Roland, 1994) that there is an excess monetary finance under fiscal and monetary decentralization not present under centralization (i.e., R dd > RCC). Fiscal and monetary decentralization may even transform hard budget equilibria under fiscal and monetary centralization into soft budget constraint equilibria. Therefore, if fiscal decentralization tends to harden budget constraints, monetary decentralization works in the opposite direction. If regions get automatic access to credit, which amounts de facto to enabling them to make independent decisions on monetary creation, thenoa generalized softening of budget constraints will occur together with a distortion in the composition of public expenditures. Budget constraints are soft under centralization if the marginal social cost of inflationary finance is smaller than the marginal benefit of bailing out enterprises. Under monetary decentralization, the cost to the region of printing money is even lower, which means that budget constraints can only be softened. On several occasions in the 1980s and 1990s, local governments in China at or above county levels have managed to secure easy credits from local branches of the central bank, which amounts de facto to a decentralization of money supply over which the central authority has lost control.
6. Labor and product market conditions In this section, we do some comparative statics allowing us to understand the harder budget constraints of TVEs. For simplicity, we omit infrastructure investment from the model of Section 3 and also abstract from monetary finance in Section 5. The local government's objective is to maximize the social welfare function I/Vi ~- Yi + U(Zi)
s.t.
T~ = Gi + Si + zi.
We now interpret the private benefit to employees of being bailed out, Bs, as the net difference between the employee benefits received from the enterprise and the outside option/reservation utility (i.e., rents or quasi-rents). This rent reduction in Bs may transform a soft budget equilibrium into a hard budget equilibrium. Suppose initially B ~ > u ' [ n ( ~ ( R q - 1 ) - - 2 ( 1 - - c 0 ) ]. Then a soft budget constraint equilibrium can be transformed into a hard budget constraint equilibrium if B~ falls below max[u'(n(Rq - 1)), 1, 2Bq].
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We may interpret this comparative statics result as a reduced form of the effect of labor and product market conditions on employee rents. Labor markets in China are segmented so that labor market conditions facing SOEs controlled by upper layer government differ significantly from those facing TVEs controlled by lower level governments. It is useful to discuss what elements in the labor market determine B~ and thus the relative benefits of bailing out enterprises. The first element is the extent of labor market competition. Almost all TVEs are operating on very competitive rural labor markets. They hire young employees who can be fired easily. This limits employmentrelated rents and quasi-rents. In contrast, SOEs hire employees in less competitive urban labor markets. Firing is much harder and many SOEs are old firms with many old employees and retirees. This tends to increase employment-related rents and quasi-rents. The second element is the state regulation of the enterprise provision of employees' welfare. The state requires SOEs to provide social welfare like health insurance, disability insurance, death benefits, and pensions according to national standards. But no such regulation exists for TVEs (Walder, 1994). The third element is due to the legacy of the planning system which assigned SOEs the responsibility of providing their employees with housing, meal service, day care, and medical clinics and hospital a practice known as "enterprise running social services". But newly established township and village enterprises provide few or none of these services. The final element concerns workers' options once unemployed. Workers being fired in the urban area not only lose all job-related benefits but also have a more difficult time finding a new job. In comparison, workers in rural areas always have the option of going back to work on the land, which is under family control since the introduction of the household responsibility system. The role of entry and competition in the product market has been emphasized by McMillan and Naughton (1992). Entry and competition tend to reduce Bs in the following way. First, entry of new firms provides opportunities for workers to be employed elsewhere, which increases their outside option and therefore reduces the net rents from current employment. Secondly, when there are monopolies in an industry or in a region, the entry of new firms controlled by governments of other regions or by lower level governments within the region provides second sourcing, mitigating the hold-up power of monopolies vis-fi-vis the government, and thereby also reducing the rents related to the refinancing of the monopoly.
7. The social cost of layoffs and the size of enterprises
It is often heard that an enterprise is "too big to fail". We relate this to the potential social cost of layoffs. This cost, which will ultimately be borne by the government, will have effects on the problem of soft budget constraints. To
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show this, we slightly change the model by assuming a variable size of enterprises measured by L, the number of employees. In the previous analysis, we had implicitly normalized L to 1. Let F(L) be the cumulative density function measuring the proportion of firms from size 0 to L, and C(L) be the cost borne by the government when an enterprise of size L is closed down. C(L) includes not only relocation and retraining costs but also costs of preventing social unrest. Although the first two components of the costs are likely to be proportional to L, the last component is likely to give rise to a convex cost of layoffs due to a layoff externality: the more people are being laid off, the higher the probability of social unrest. Then the net benefit for bailing out an enterprise with L employees is (B~ - 1)L - ( - C(L)) = (BsL + C(L)) - L, which is convex in L, and hence the net benefit per employee, Bs + C(L)/L - 1, increases in L. This provides a rationale for the "too big to fail" motive expressed in the following proposition. Indeed, define an enterprise size of L* defined by the following equality B~ + C(L*)/L* = u' [F(L*)nRq + (1 - F(L*))(~nRq - (1 - ~)n) - n].
(5)
The left-hand side represents the net benefit per employee of bailing out an enterprise whereas the right-hand side represents the per employee cost of bailout. Due to the convexity of C(L), for L > L*, the per employee benefit of bailout will be bigger than the cost, and vice versa for L < L*. The former will thus have soft budget constraints and the latter will have hard budget constraints. As SOEs are typically larger in size and TVEs are relatively small, the budget constraint of the former is likely to be softer. Further, due to high population density in the urban areas, mass layoffs there would be more likely to create social problems than in the rural areas for the same size of layoffs. This amounts to an upward shift of cost function C(L) for the urban areas as compared with the rural areas. Because the right-hand side of Eq. (5) decreases in L*, the critical value L* in the urban areas will be smaller than that in the rural areas. This explains one reason why SOEs located in big cities are more likely to have soft budget constraints than TVEs located in the rural areas.
8. The number of enterprises within a jurisdiction We have assumed so far that the number n of enterprises under one government jurisdiction is large enough so that the law of large numbers can be applied. This assumption is valid with higher layer governments that typically control many enterprises but is not very realistic for most township and village governments. With a smaller pool of projects in each period, liquidity imposes an additional limit on the government's ability to cross-subsidize and this
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tends to harden budget constraints. We will show this by putting forward two related arguments. First, one can show that as the number of projects in one jurisdiction n falls, a symmetric soft budget constraint equilibrium ceases to exist. Indeed, the probability of having at least one type 1 project out of n - 1 is 1 -(1 - ~ ) " - 1 . Hence, if all other enterprises with type 2 choose e~, then the expected private benefit for an enterprise with type 2 projects choosing e~ is at most ( 1 - ( 1 - ~ ) " - X ) B s . When n is sufficiently small, ( 1 - ( 1 - ~ & 1) B s < 2Bq. Therefore, even if the government wants to refinance when it has sufficient revenue, the enterprise with type 2 project has no incentives to choose el. 6 When n thus becomes small, if all type 2 enterprises choose e~, the probability that no type 1 projects are drawn in the next period becomes larger. In such a state, no tax revenue is generated and the projects have to be terminated. Secondly, one can show that p, the probability of an enterprise with a type 2 project choosing e h in a symmetric mixed strategy equilibrium, increases as n falls. To see this, assume Rq > 2n - 1 with n > 2. This condition implies that one type 1 project or one type 2 project with e~ will generate sufficient tax revenue to finance n new projects and refinance ( n - 1) old projects. Assume further that the government will refinance all projects as long as it has enough revenue. Consider the choice of e 1. Out of n - 1 projects, the probability of having at least one type 1 project or having at least one type 2 project with eh is 1 - ( 1 - 7 ) " - ~ ( 1 __p)n-2. In such events, refinancing will occur. If all n - 1 projects are of type 2 with e,, which happens with probability (1 - ~)"- 1(1 - p ) " - 2 , no refinancing will occur. In a mixed strategy equilibrium, the enterprise with a type 2 project must be indifferent between choosing e h and e I. Therefore we obtain (1 -
(1 - ~)"- 1(1 -- p ) " - 2 ) B s = 2Bq.
Differentiating both sides with respect to n yields d p / d n = (ln(1 - e) + ln(1 - p))(1 - p)/(n - 2),
which is negative. A fall in the number of enterprises in the jurisdiction thus hardens budget constraints. Note that these results depend only on the firms' incentives to provide high or low effort, regardless of government's incentives to refinance. Even if the government would be willing to refinance enterprises which have provided e,, the firms are still reluctant to choose e~ because of the greater difficulties of cross-subsidization when there are few firms in the jurisdiction.
6 F o r n = 1,
the enterprise with a type 2 project always chooses eh.
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9. Concluding remarks Table 4 summarizes the relevance of the above five factors for China. The first column shows the situation of SOEs under centralization before reforms. All factors identified in the model as softening budget constraints are present. The next column shows the situation under decentralization for SOEs. Fiscal competition tends to harden budget constraints, but easy access to credit eliminates the positive effects of fiscal competition. All other factors tend to soften budget constraints: large or medium employment rents or quasi-rents, the large size of enterprises, and the large numbers of enterprises under the control of one government. The last column describes the situation in TVEs. Fiscal competition is also present. For the rest, all other factors point toward hard budget constraints-access to credit is limited or difficult, employment rents or quasi-rents are small, the size of TVEs is not large, and the number of TVEs within each jurisdiction is not large either. Our theory is consistent with empirical evidence that has shown that TVEs have harder budget constraints than SOEs. For example, due to the government's austerity program, about three million township and village enterprises went bankrupt or were taken over by other enterprises in 1989 (People's Daily, 23 March 1990). The total employment in township and village enterprises fell from 48.9 million in 1988 to 47.2 million in 1989 and to 45.9 in 1990, reversing the trend of expansion of more than 10 years. In contrast, during the same period, employment in the state-sector increased (Chinese Statistics Yearbook, 1992). China benefitted greatly from regional decentralization in its first 15 years of reforms, and the Chinese experience shows that decentralization of fiscal authority has helped in advancing the reform. This is all the more important since large-scale privatization programs were excluded for ideological Table 4 The comparison chart
Centralization (SOEs)
Fiscal competion Access to credit Employment rents or quasi-rents Number of employees per enterprise Number of enterprises in control
Decentralization Higher layers (SOEs)
Lower layers (TVEs)
No Easy Large
Yes Easy/medium Large/medium
Yes Limited/difficult Small
Large/medium
Large/medium
Medium/small
Large
Large
Medium/smal
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reasons. In E a s t e r n E u r o p e a n d Russia, where such obstacles do n o t exist a n y m o r e , the d i c h o t o m y between p u b l i c a n d private enterprise has p u t too m u c h in the b a c k g r o u n d the d i m e n s i o n of fiscal federalism a n d the issue of efficient a l l o c a t i o n of a u t h o r i t y over v a r i o u s p u b l i c decisions. T h e r e are, of course, limits to the a d v a n t a g e s of d e c e n t r a l i z a t i o n . E x t r e m e d e c e n t r a l i z a t i o n a m o u n t s to s e p a r a t i s m which m a y have c a t a s t r o p h i c c o n s e q u e n c e s o n trade a n d welfare (Bolton a n d R o l a n d , 1993). T h e r e are also certain areas in which the costs of d e c e n t r a l i z a t i o n are likely to outweigh the benefits, even where d e c e n t r a l i z a t i o n is d e t r i m e n t a l to the progress of reforms. A m o n g the costs of d e c e n t r a l i z a t i o n we m e n t i o n e d the fiscal distortions. A n o t h e r cost is the increase in regional inequalities. Careful analysis of the u n d e r l y i n g m e c h a n i s m of d e c e n t r a l i z a t i o n is i m p o r t a n t , n o t j u s t for u n d e r s t a n d i n g what has happened in C h i n a , b u t also for the future direction of reforms in C h i n a a n d elsewhere.
Acknowledgements T h e a u t h o r s wish to t h a n k Erik Bergl6f, J i a h u a Che, M a t h i a s D e w a t ripont, R o n a l d M c K i n n o n , Barry N a u g h t o n , C h e n g g a n g Xu, a n d s e m i n a r p a r t i c i p a n t s in Brussels for helpful discussions.
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