NBER Reporter: Fall 2001

Twelfth Annual East Asian Seminar on Economics: Privatization, Corporate Governance, and Transition Economies

The NBER's Twelfth Annual East Asian Seminar on Economics (EASE), sponsored jointly with Hong Kong University of Science and Technology (HKU), Korea Development Institute (KDI), Korea for International Economic Policy (KIEP), Tokyo Center for Economic Research (TCER), Chung-Hua Institution for Economic Research (CIER), and the Australian Productivity Commission, took place in Hong Kong on June28-30. The organizers were NBER Research Associates Takatoshi Ito, Hitotsubashi University, and Anne O. Kreuger, Stanford University. This year's theme was "Privatization, Corporate Governance, and Transition Economies." The following papers were discussed:

Chen Chien-Hsun and Shih Hui-Tzu, CIER, "Initial Public Offering and Corporate Governance in China's Transitional Economy"

Discussants: Deunden Nikomborirak, and Changqi Wu, HKU

David Li and Francis Lui, HKU, "Why do Governments Dump State Enterprises? Evidence from China"

Discussants: Deunden Nikomborirak, Thailand Development Research Institute, and Yun-Wing Sung, Chinese University of Hong Kong

Keijiro Otsuka, Foundation for Advanced Studies on International Development, and Tetsushi Sonobe, Tokyo Metropolitan University, "Productivity Effects of TVE Privatization: The Case Study of Garment and Metal Casing Enterprises in the Great Yangtze River Region"

Discussants: Yun-Wing Sung, and Yang Yao, Beijing University

Yang Yao, "Government Commitment and the Results of Privatization in China"

Discussants: Takashito Ito and David Li

Fumitoshi Mizutani, Kobe University, and Kiyoshi Nakamura, Waseda University, "The Japanese Experience with Railway Restructuring"

Discussants: Mario Lamberte, Philippine Institute for Development Studies, and Helen Owens, Australian Productivity Commission

Helen Owens, "Rail Reform: Privatize, Corporatize, Franchise, or Contracts - The Australian Experience"

Discussants: John McMillan, Stanford University, and Mari Pangestu, Centre for Strategic and International Studies

Tsuruhiko Nambu, Gakushuin University, "What Has Been Achieved in Japanese Telecommunications Industry since 1985?"

Discussants: Il Chong Nam, and Richard Snape, Australian Productivity Commission

Il Chong Nam, KDI, "Recent Developments in the Public Enterprises Sector in Korea"

Discussants: Cassey Lee Hong Kim, University of Malaya, and Aaron Tornell, NBER and University of California, Los Angeles

Sung Wook Joh, KDI, "Korean Corporate Governance and Firm Performance"

Discussants: Mario Lamberte, and Philip Williams, Melbourne Business School

Youngjae Lim, KDI, "Sources of Corporate Financing and Economic Crisis in Korea"

Discussants: Francis Lui and Chong-Hyun Nam

Philip Williams, and Graeme Woodbridge, Frontier Economics Australia, "Antitrust Merger Policy: Lessons from the Australian Experience"

Discussants: Charles Calomiris, NBER and Columbia University, and Chong-Hyun Nam

Simon Johnson, NBER and MIT, and Andrei Shleifer, NBER and Harvard University, "Privatization and Corporate Governance"

Discussants: Cassey Lee Hong Kim and Richard Snape

Charles Calomiris, and Joseph Mason, Drexel University, "How to Restructure Failed Banking Systems: Lessons from the U.S. in the 1930s and Japan in the 1990s"

Discussants: Simon Johnson and Mari Pangestu

Aaron Tornell, "Banks, Bailout Guarantees, and Risky Debt"

Discussants: Kyoji Fukao, Hitotsubashi University, and Sung Wook Joh

John McMillan, "Using Markets to Solve Public Problems"

Discussants: Kyoji Fukao and Tsuruhiko Nambu

Privatization, Corporate Governance, and Transition Economies

Chen and Shih investigate Chinese initial public offerings (IPOs) from mid-1995 to mid-1999 with a sample of 884 companies, 437 listed on the Shanghai Stock Market and 447 on the Shenzen Stock Market. The only industries in which listed Chinese companies display strong performance are public utilities, transportation, and finance, otherwise known as China's "sunrise" industries. The overall operational performance of other industries is unsatisfactory. Examining the financial indicators of the listed companies following the IPO, it appears that except for earnings-related indicators, there are no significant changes. What's more, the financial indicators tend to fall rapidly year after year. This means that the IPO is of little obvious help to the companies' operational performance, and actually may make things worse. This is in part because companies tend to submit inflated figures in the financial statements that they are required to provide in order to implement the IPO and secure stock market listing. Another possible explanation is the poor corporate governance characteristics of Chinese enterprises. One way to improve the quality of listed companies is to select only those which display strong performance, have strong development potential, and which occupy a leading or advantageous position within their industry. This would encourage hi-tech enterprises and companies in other emerging industries to make use of the capital markets.

Why do governments choose to dump state enterprises by privatization or liquidation? Existing research on privatization has not paid much attention to this question. Li and Lui focus on two alternative theories of the issue. One theory explains that governments privatize or liquidate state enterprise in order to enhance efficiency. The other theory explains that increasing government revenue or ending subsidies to profit-losing state enterprises is the motivation. Based on a dataset from China, the authors reject the efficiency theory and support the revenue theory. In addition, they find that concerns about unemployment and losing the political benefit of control to the government are important obstacles to privatization or liquidation decisions. One simple implication of these findings is that it might make sense to propose second-best privatization or liquidation programs that take government objectives into account and are feasible with the government rather than first-best programs that will not be implemented.

Sonobe and Otsuka quantitatively assess the productivity of township and village enterprise (TVE) privatization. If recent privatization results in improvement of production efficiency, the question immediately arises as to why it did not take place earlier. Also, why did township- and village-run enterprises (TVREs) prosper in Jiangsu in the 1980s? These issues are critically important in understanding the growth performance of the Chinese economy in the 1990s and assessing its future growth potential for the early decades of the 21st century. As a first step toward a fuller understanding of the effects of TVE privatization on productivity, this paper looks at studies of the garment and metal casting enterprises in the Great Yangtze River Region extending from the suburbs of Shanghai to the western border of Anhui province.

Yao uses recent survey data to assess disparity in regional performance and then provides an explanation for it. He ascribes the disparity to the different degrees of local government commitment to privatization. For example, the survey that this study draws on finds that the amount of fees is equivalent to the amount of regular taxes among the surveyed firms. Privatization cannot exempt a firm from being subject to excessive charges. In other words, privatization does not mean the establishment of the rule of law. Yao presents a brief review of the Chinese government's policy toward privatization in the last 20 years, and then constructs a theoretical model to explain the relationship between privatization and government reform. The model treats government reform as a commitment device for the politician to commit himself to better state governance. To illustrate the theory, Yao then describes the government reform experience in Shunde, Guangdong province.

Mizutani and Nakamura summarize the privatization of the Japan National Railway (JNR), explaining the impetus for privatization, the steps by which it is being achieved, the restructuring options which were available at the time of privatization, and the general characteristics of this privatization. Then they describe how the management of the privatized JNR differs from that of the former JNR. While most privatization studies focus on regulatory changes, the authors want to concentrate here on managerial issues as well, such as corporate goals, relationships with interest groups, organizational structure, incentive systems, and task-improving activities. They describe the performance of the JNR companies since privatization, discussing not only overall performance but also rail fare, competition, and the operation of local rail service. Next, they consider several policy issues related to rail restructuring, using as a basis for discussion these topics: regional subdivision, vertical integration, and yardstick competition. Finally, with the situation of developing countries in mind, they outline important points related to rail privatization policy.

Railways in many countries have undergone significant changes in aspects of their organizational structure, ownership, and access arrangements during the 1990s. Widely differing approaches to rail reform are evident. These reforms have included structural separation (both vertical and horizontal), the introduction of commercial disciplines (corporatization and privatization), and arrangements for third-party access to track infrastructure. The wide range of reforms being implemented raises the question of whether one approach is superior to another. Owens argues that because rail networks differ in terms of their economic characteristics and the challenges they face, it is important that individual reform packages be tailored to each network. She draws on work undertaken by the Australian Productivity Commission in 1999.

Nambu analyzes the development of the Japanese telecommunications industry since 1985, when NTT (Nippon Telephone and Telegraph) public corporation (a natural monopoly) was privatized and competition was introduced into long distance (interprefecture) markets. At the outset of the analysis, he stresses the importance of changes in the mode of usage as well as in the technology, even though the time period is as short as 15 years.

Nam points out that Korea has made significant progress in privatizing the commercial businesses owned by the government. Korea's approach to commercial public enterprises and their privatization differs, in several respects, from that of the United Kingdom and New Zealand, or other European countries that are going through large-scale privatization. In network industries, privatization policies focused on partial sales of the shares owned by the government and did not pay much attention to industry structure, competition policies, and regulatory frameworks. The policy environment, by and large, was left intact as were the functions and organizations of the line ministries. Line ministries of commercial public enterprises in Korea have long been granted the authority to intervene in the relevant industries to promote a wide range of policy objectives. Separation among commercial operation of the public enterprises to be privatized, regulatory functions of the government, and the industrial policies of the government probably requires a fundamental change in the way the line ministries operate, and more generally in the way the government is organized. It appears that Korea was not ready to make such a change with regard to privatization. Another crucial factor that affected the privatization path of Korea was the absence of a properly functioning financial market and adequate corporate governance systems for large firms. Extensive reliance on the chaebol system and the accompanying heavy government intervention in the financial market during the past four decades deprived the financial sector of a fair chance of developing into a well-functioning market. The only governance systems that existed in Korea for large firms were essentially ownership and control by the government or control by chaebol families that crucially depended upon heavy government intervention in the financial market. Korea has yet to come up with a model of corporate governance for large commercial firms that can be relied upon by a majority of investors. For this to occur, the financial market must be made to work based upon sound profit incentives of banks and other financial companies and effective prudential supervision.

Joh explains that high debt/equity ratios and low firm profitability under a weak corporate governance system helped cause Korea's 1997 economic crisis. High debt stemmed from government incentives for large firms, firms' exaggeration of their sizes, and bank lending to poorly performing firms. Low profitability was caused partially by unprofitable investment in affiliated firms. High disparity between control and ownership correlated with low profitability. These results suggest that controlling shareholders divert firm resources for private benefits. Moreover, Korea's weak governance system allowed such low firm profitability to persist for nearly ten years before the crisis. This system includes no credible exit threat, inadequate financial information, little financial institution monitoring, few minority shareholder rights, and negligent boards of directors. Analysis of daily stock market prices suggests the effects of recent corporate governance reform. First, investors believe that chaebols behave more independently. Second, they believe controlling shareholders' private benefits are smaller now, but are still high.

Lim documents that Korean financial institutions have undergone substantial changes in their customer (borrowing firm) base, in particular, after the economic crisis began in 1997. After the crisis, the largest firms left financial institutions and switched to the capital market or to the stock market for their corporate financing. As a consequence, financial institutions increasingly are forced to select their loan customers from the pool of small- and medium-sized firms. This change in the loan customer base of financial institutions (banks), which they expect to continue at an accelerated pace in the future, has an important implication for the future of the banking industry in Korea. Selecting high quality loan customers from the pool of small- and medium-sized firms requires that financial institutions have the capacity for credit evaluation. Unfortunately, many financial institutions did not develop this capacity for credit evaluation before the outbreak of the economic crisis. In the past, financial institutions had access to the pool of large loan customers with implicit loan guarantees by the government, and hence, incentives for good credit evaluation were virtually removed from financial institutions. But recently, with financial institutions still not equipped with credit evaluation capacity, their loan customer base began to shrink at a rapid pace. This is the current dilemma for financial institutions in Korea. Trying to restore their loan customer base without developing the capacity of credit evaluation will result in much riskier assets, which implies an increased possibility of failure of financial institutions in Korea. On the other hand, accepting the shrinking loan customer base will lead to overcapacity of the industry as a whole, and thus, the number of viable financial institutions will be much smaller in the future.

According to Williams and Woodbridge, study of the operation of Australia's merger policy over the last 27 years can yield lessons for countries that are contemplating the introduction of their own antitrust policy. Merger policy should provide that any possible increase in monopoly power be weighed against any increases in efficiency. Williams and Woodbridge argue that the process by which this is achieved should be undertaken with speed and secrecy so as not to deter efficiency-enhancing mergers. The twin requirements of speed and secrecy, in turn, will present problems in achieving fair process and the creation of precedent.

According to Johnson and Shleifer, effective privatization requires enforceable investor protection. There is no evidence that strong investor protection emerges spontaneously from private contracts or political institutions. Attempts to"opt in" by listing privatized firms in high investor protection countries have only limited value. One way to protect investors is by instituting strong domestic regulation for privatized companies, mutual funds and financial intermediaries. For countries with relatively weak legal systems, Poland offers a good model.

Calomiris and Mason explore the motives for government assistance to weak banks, which include the legitimate goal of mitigating credit crunches and politically motivated assistance to powerful banks and their clients. The authors contrast the relatively successful experience of Reconstruction Finance Corporation assistance to U.S. banks during the Depression with Japanese government assistance to banks in the late 1990s. They argue that there are ways to construct policies that maximize the potential benefits of government assistance by ensuring selectivity in providing assistance and by constraining bank abuse of government funds. Desirable rules include common stock issuing matching requirements for dividends, and the reform of prudential regulation to incorporate market discipline into prudential capital regulation.

McMillan reviews four public-sector uses of markets: for spectrum allocation, electricity supply, pollution control, and fishery management. Governments can successfully use markets for allocation. But the market must be well-designed, and it cannot supersede the government's regulatory function.

These papers will be published by the University of Chicago Press in an NBER Conference Volume. Many of them are also available at Books in Progress on the NBER's website.

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