China's Evolving Managerial Labor Market TORIo Theodore Groves; Yongmiao Hong; John McMillan; Barry Naughton The Journal of political Economy, Vol. 103, No 4(Aug, 1995), 873-892 Stable url: http://links.jstor.org/sici?sici=0022-3808%28199508%29103%3a4%03c873%03acemlm%3e2.0.c0%03b2-h The Journal of political Economy is currently published by The University of Chicago Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.htmlJstOr'sTermsandConditionsofUseprovidesinpartthatunlessyou have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://wwwjstor.org/journals/ucpress.html Each copy of any part of a jSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission jStOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support@jstor. org http://www.jstor.org Fri may2123:08:432004
China,s Evolving Managerial Labor Market Theodore groves University of California, San Di Yongmiao Hong John Mcmillan and Barry Naughton University of California, San diego Recent reforms of Chinese state-owned enterprises strengthened a nascent managerial labor market by incorporating incentives sugges- tive of competitive Western labor markets. Poorly performing firms were more likely to have a new manager selected by auction be required to post a higher security deposit, and to be subject to more requent review of the manager's contract. Managers could be, and were, fired for poor performance. Managerial pay was linked to the firm's sales and profits, and reform strengthened the profit link and weakened the sales link. Thus the economic reforms helped develop an improved system of managerial resource allocation responsive market forces I. Introduction In this paper we give evidence that the reforms of the 1980s in Chi- nese state-owned enterprises significantly strengthened a nascent e thank the Ford Foundation for research support and Masahiko Aoki, Takeo Hoshi, John Litwack, Mark Machina, Yingyi Qian, Valerie Rar minar participants resere ford onmivesits we athe ackiversie ot Calitornv Slaa Diego, and an anonymous sity and the Economics Research Institute at the Chinese Academy of Social Sciences for their participation in the larger project, of which this paper is but a small part
JOURNAL OF POLITICAL ECONOMY managerial labor market. We suggest that one important result of the economic reforms was the development of an improved system of managerial resource allocation that is responsive to market forces The overall objective of the reforms was to move from a system under which enterprises obeyed detailed centralized commands to a decen- tralized system that rewarded enterprises for improved productivity As a part of this effort, the reforms transformed the role of manag ers, requiring them to sign contracts outlining their responsibilities nd rewards, and enacting new incentives and punishments. We dem onstrate below that this new system was working surprisingly well by he late 1980s: managerial efforts were being rewarded and manage- rial resources being assigned in accordance with criteria established by market forces This is perhaps a controversial thesis. The conventional view of China seems to be that managerial assignments in state-owned enter- prises are still governed by bureaucratic and political considerations and managers are subject to rigid supervision and control. It is, how ever, widely appreciated that the reforms of the 1980s were directed the efficiency of enterprises by replacing direct control at improvin ith managerial incentives. New incentive systems such from above w as the"profit responsibility system" were introduced that linked re- wards to managers to improvements in firm performance. However, hile necessary, it is not sufficient to provide incentives alone. Al- though some managers who were appointed prior to the reforms could be expected to welcome and respond to the new incentives others might be expected to have trouble adapting or, worse, be resis tant to change. a thoroughgoing reform must not just change the incentive environment but also must provide a mechanism for select- ing managers who will be responsive to the new opportunities. Ap- propriate supervision and replacement of managers may be as impor tant as the provision of incentives In this paper we first examine the process of managerial turnover. 'e show that managers changed jobs sufficiently frequently to sup- port a functioning managerial labor market. We further study those markets by analyzing two types of events. First, we analyze the circum- stances around the most recent change of managers and show that both the fate of the prev ous man and the conditions of the new manager's appointment can be partially explained by the firm's performance immediately before the change of managers. Second, we analyze the circumstances around the most recent managerial contract, which need not coincide with replace ment of the incumbent manager. Managerial contracts were the cen- tral innovation of the managerial reforms of the 1980s. Nearly all the managers in our sample had signed multiyear managerial contracts
CHINA S MANAGERIAL LABOR MARKET hat committed them to meet specified performance indicators, in- cluding profitability. We find that firm performance is again related to managerial incumbency and replacement in predictable ways Of the results of au an experimental reform that was carried out in about 14 percent of es. We also examine the relatio rial compensation and enterprise profits and sales. We show that Chi nese managers'total compensation is positively related to both firm profits and sales and that, after a reform contract, the correlation etween total compensation and profits increased, whereas that be- tween total compensation and sales decreased. Finally, we examine the relationship between the new financial incentives given managers and the productivity of firms. We find that the direct monetary incen tives given managers improved firm productivity and that this im- provement was strengthened by the reforms. In short, we argue that managers were hired, fired, and paid increasingly over the decade of the 1980s in accordance with market-dominated criteria In assessing the managerial reforms, we are examining conse- quences of decisions made by two different sets of agents. One set of decisions is those made by bureaucratic superiors of the firm: (i)deci sions to promote, demote, or transfer a current manager;() the choice of selection method when a new manager is appointed; and (iii)the form of contract to offer the firm that governs the remunera- tion of managers. The other set of decisions is those made by manag ers in response to the incentives provided by the decision rules of eriors The decade of the 1980s in China was a period of remarkable innovation and experimentation in alternative methods of economic reform(see Naughton 1995). Thus our evidence is not that the whole state-owned sector was converted at once or even over the decade from bureaucratic to market-driven managerial appointment meth ods. But by the latter part of the decade, reforms emphasizing market solutions were quite widespread Managerial contracts and auctioning of firms were both broadly implemented for the first time during the latter part of the 1980s. The nature of our evidence does not permit direct comparison between the situation in the late 1980s and the prereform"period before such institutions existed. But we can say that the real allocation of managerial resources displays patterns that we would expect if the reforms were successful. It is reasonable to attribute those patterns to the reform innovations that were intended to produce such an outcome. Overall, the gains from the partial reform of China's state firms are demonstrable. Output per worker rose 67 percent (in constant prices) between 1980 and 1989 for the enterprises in our sample, and
876 JOURNAL OF POLITICAL ECONOMY total factor productivity rose 36 percent(Groves et al. 1994). Not all of this improvement in productivity is attributable to the particular reforms that we investigate here. Firms also faced increased product market discipline because of greater competition from other state firms and from new, nonstate firms, and this was an important source of productivity gains(McMillan and Naughton 1992). Gains also came from granting firms autonomy in their output decisions and increas- ing the share of profits firms were allowed to retain(Groves et al 1994). Managerial reforms would probably not have been effective had they not been made in conjunction with increased autonomy and increased product market competition Section II describes the selection of managers and the changes the overall environment within which Chinese managers operate since the reforms of the 1980s. Section Ill presents and interprets the main empirical results Section IV summarizes the findings and presents further speculations on the process of change in China. The Appendix provides details of our data set and the basic model speci- II. Selection of Managers and reforms of the 1980s In the prereform Chinese command economy, enterprises are best thought of as branch plants of a single giant firm. Enterprise manag ers were hired and fired by officials in the industrial bureaus, which vere in turn organized into sectoral and geographical divisions. The entire industrial system was accountable to a national or regional planning commission, which steered the entire system through a com- plex system of highly specific commands that extended all the way down the hierarchy to managers at the plant level. Authority relations were complicated by the intrusive role of the Communist Party, which functioned more or less as the personnel department of this enor mous corporation, maintaining dossiers and tracking managerial ca- reers. Managers were rewarded for following orders and for subservi- ence to political dogma. The inefficiency of which this system wa able is well know During the 1980s, China sought to improve industrial efficiency I Production function estimates from several other data sets also show increases in state firms' productivity. Gordon and Li(1989), using a sample of 400 state er by 4.6 percent Dollar(1990), using a sample of 20 state ent data, estimated that productivity rose between 1. 9 over the period 1978-88. See also Perkins(1988), Hay and Liu(1991), and jeffers Rawski, and Zheng (1992)
CHINA S MANAGERIAL LABOR MARKET through a multistranded program of experimental reforms. First, reformers sought to enhance the authority of enterprise managers This involved reducing the power of Communist Party officials to intervene in enterprise decision making and giving managers legal responsibility for enterprise decisions. Factory manager responsibil- ity systems"were implemented in the majority of enterprises in our sample- by the mid-1980s and were predominant by 1988. Enhanced cifc aerial authority also implied a reduction in the number of spe- cific instructions given to managers by bureaucratic superiors. Sec ond, enterprises were provided with significant incentive funds. Profit retention schemes allowed enterprises to draw funds for worker bo- nuses,worker welfare facilities, and enterprise investment in accor- dance with improvements in profitability. These schemes clearly gave the enterprise as a whole an interest in increasing productivity. They also implied a substantial increase in the economic resources over which managers had direct control. Thus the authority and control of resources by factory managers increased substantia a third strand of reform-the primary focus of the present pa per-was to develop new mechanisms to reward managers and link managerial careers more effectively to firm performance. The most common means for doing this was long-term managerial contracts which were in force in 92 percent of the state-owned enterprises our sample. Contracts generally had 3-or 4-year terms, and they were signed by the enterprise manager as an individual (70 percent of firms)or by a managerial group(26 percent of firms). The contracts committed the manager to meeting certain performance indicators and established a structure of rewards and penalties. Profitability was always one of the performance indicators and was listed as the most nportant indicator by 72 percent of managers; 28 percent listed important. In many cases, long-term contracts also committed malle output targets, cost reduction, or other specific indicators as m ers to certain minimum levels of reinvestment in the enterprise. 3 In most cases, the hierarchical structure of authority was main- tained intact. Over 80 percent of the managers in our sample were appointed by industrial bureaus in the traditional way. For most man- agers,careers continued to be determined by the evaluations of bu- reaucratic superiors and it is therefore rocess by which the bureaus select and supervise managers. We ar gue below that there were significant changes both in the incentive ppendix, sec. A, for a description of the sample of 769 state-owned Chine ed our data set nal descriptions of long-term managerial contracts, see China Enterprise Research Group(1988)and Naughton(1995)
8 JOURNAL OF POLITICAL ECONOMY environment facing the industrial bureaus and in the procedures they sed to select managers. In some cases, reforms broke out of the traditional mold of appointment by bureaucratic superiors. The most significant was the system of selection by competitive auctions. About 14 percent of the managers in our sample were selected by competi- tive auctions. These reforms were experimental and gained momen- tum in the late 1980s. Two years alone, 1987 and 1988, accounted for over half (57. 4 percent) of the competitive auctions in the decade, although for only 23 percent of all managerial changes The use of competitive auctions for selecting managers is quite revealing of the extent to which market ideas have penetrated the Chinese state-owned enterprise system. After all, an auction is an extreme market method for allocating resources. Auctions funda mentally are devices for revealing information; an auction is used when there is much uncertainty about the value of the item being exchange il tract, or a shipment of eggplant (McAfee and McMillan 1987). China's managerial auctions serve to reveal information about both the potential managers' capabilities and the firms'inherent productivity, especially in the case in which the incumbent manager is bidding In a fully functioning managerial labor market, information about potential managers comes from long-term observation of their performance in lower management jobs. In the transition economy, starting with the leftovers of the planned economy, information on past performance is unreliable or nonexistent Auctions are an alternative source of information Auction procedures varied among regions in China, but certain common procedures can be described(Naughton 1995). Enterprises were generally put up for auction by municipal governments(which control most enterprises in China). In some cases, the industrial bu- reau acted jointly with the municipal budgetary authorities to carry out the auction In other cases, an"evaluation commission"was estab- lished with outside experts participating as well. Before the auction the firm's accounts were made available for inspection by any poter tial bidder. The most important component of the bid was a promise to turn over a specified amount of enterprise profit to municipa authorities over the following 3-5 years. Thus the auction proces esembled a competitive leasing procedure. Minimum bids were often stablished by auction commissions. However, firms were not simply auctioned to the highest bidder. Bidders submitted management 4 An alternative experimental reform involved the se by workers' ongresses in the enterprise, hanner somewhat like the yug em of worker nanagement. About 4 percent of the managers in our ed by workers ongresses. The sample is too small for statistical analysis, ar this subgroup further
CHINA S MANAGERIAL LABOR MARKET plans describing investment and product development. In most cases, bidders made commitments to invest a certain minimum of enterprise retained profits in output expansion, and sometimes made commit ments to reach a specified output level as well. Bidders were assessed for reliability and professional skill, sometimes through an explicit point system. The auctioneers then chose the winning bidder on the basis of promised profit delivery, the soundness of the management plan, and the characteristics of the individual bidder Regardless of whether firms were subjected to competitive auction r not, the top manager was generally required to sign a management contract. In many cases, the manager was required to put up a secu- rity deposit, which could be forfeited if the firm failed to perform as omised. This security deposit was substantial: the mean level in our sample was 8, 500 yuan, compared to an annual average wage of 2, 177 that some managers did indeed lose some or all of their security deposit following poor firm per genuinely at risk Like the auctions themselves, the security deposits can be interpreted as substituting for other managerial incentives found in established managerial labor markets. In the West, managers often have a stake in the firm in the form of stockholdings or stock options: security deposits similarly serve to give the manager a stake in the firms per- formance III. Empirical Evidence of the Market Hypothesis A. Manager and Worker Turnover In a well-functioning market, one expects to see a relatively large number of transactions. Thus a first question to ask about the Chinese managerial labor market is whether there is evidence of much turn over. The answer is yes. Only 1l percent of managers serving at the end of the period had been appointed before 1980, and 44 percent had been appointed since 1985. Since less than a quarter(23 percent) of the current managers replaced retiring managers, turnover is oc- urring for other reasons. a clue can be gleaned from the observation that of the remaining group, 38 percent replaced managers who were promoted, 46 percent replaced ones who were moved laterally, and 16 percent replaced ones who were demoted We can compare this turnover in a rough way with average tenure lengths for American and Japanese chief executives. Kato and Rockel (1992, p. 34)report that incumbent chief executives have held their positions in the United States and Japan for an average of 7. I and 7.7
JOURNAL OF POLITICAL ECO years, respectively. This compares to the average tenure of currently serving Chinese managers in our sample of 5.5 years. Thus Chinese managerial turnover in the 1980s appears to be slightly more fre. quent than that of managers in the United States and Japan. Since one of the key features of an active, mature market is a high number of transactions, this evidence on turnover of managers is supportive of the idea that there is developing in China a labor market for mana genial resources Active managerial turnover contrasts sharply with limited turnover of production workers in China. Most ordinary workers enjoy lifetime employment and almost never change jobs. For example, in our sam le,in 1984, only 3.7 percent of the workers quit, were fired, or were transferred(1.3 percent retired); in 1989, only 2.8 percent quit, were fired, or were transferred (1.3 percent retired). (An average tenure or managers of 5.5 years corresponds roughly to an 18 percent arly turnover. )It is worth stressing, then, that while ordinary Chi nese workers rarely change jobs, Chinese managers in the 1980s fre- quently did. This activity contrasts sharply with the conventional view of a relatively rigid management structure B. Manager Selection and Contract Terms Both before and after the reforms, the managers of Chinese state- owned firms were selected by the industrial bureau charged with regulating the firm. There is a classic princip al-agent relationsh between the industrial bureau and the manager. The agent-the pro- spective or current manager--has some relevant information that ot known by the principal-the industrial bureau. This information may concern the manager's own abilities or the firm's potential pro- ductivity. Either kind of information can generate adverse selection In addition, the manager may take actions that affect the firms pro- ductivity and cannot be directly observed by the industrial bureau moral hazard is present. The bureau cannot know whether poor per formance by the firm is attributable to(a) inherently low productivity firm,(b)managerial incompetence, (c) managerial decisions that pursue goals other than productivity, or(d)bad luck The selection of a new manager provides an opportunity to observe the principal's actions designed to motivate the agent. For example, the treatment of the former manager should be related to firm per Thus a model of the firm similar to that of Laffont and Tirole(1986)applies here xpected to be at least as ill informed as the industrial bureau, with one exception, namely, the benefit of hindsight: a firm's ex post perfor
CHINAS MANAGERIAL LABOR MARKET formance, with managers of poorly performing firms being demoted more frequently than other managers. Moreover, we would expect both the method of selecting a new manager and the terms of the new managerial contract to be related to the principal's evaluation of he existing situation in the enterprise. We examine two main meth ods for selecting a new manager-appointment by superior and com- petitive auctions-and attempt to explain the choice of appointment method made by the industrial bureaus. Since the choice between these two methods is made by the industrial bureau, the basic princi- pal-agent relation is unchanged by the choice of managerial selection and should be seen as a choice made by the principal (the industrial bureau)in order to elicit the desired behavior from a class of potential Auctions, as noted above, serve to reveal information. Imagine that the industrial bureau, seeing that a firm is performing poorly, does not know whether the poor performance is due to bad management or to features of the firm beyond the manager's control. Then it might decide to use an auction, for the bidding process will reveal the identities of alternative potential managers, and the bids will re- veal their various estimates of the firms potential. Thus we might expect that the industrial bureau will tend to opt for auctions for firms that are performing poorly and appointment for firms that are In addition, the structure of the new type of contracts offered managers under the reforms might be expected to refect the perfor mance of the firm. Poorly performing firms might be put on a horter leash"by the industrial bureaus. In particular, larger security deposits might be required of new managers taking over such firms and shorter contract terms offered. Security deposits generate incen- tives for the manager, and they are needed more in poorly per for orming firms. A shorter contract term for poorly performing firms so serves both principal(bureau) and agent (new manager).It heightens the scrutiny of the manager and enables the bureau to dump poorly performing managers after a shorter time. but a shorter contract also reduces the risk for a new manager by not lock- ing him for a longer time into a firm that was performing poorly ecause of firm-specific reasons 1. Test of Relation of Performance to Contract Terms and Manager Selection To test whether or not Chinese bureaucrats in charge of selecting firm managers were influenced by the performance of the firms un der their managers, we estimated the relationship between various