Entrepreneurship in China 20070111

Determinants of Entrepreneurial Activities in China Jiangyong LU Department of Business Strategy and Policy, and Center for China in the World Economy, Tsinghua University, Beijing, 100084, China 86-10-62792726, lujy3@sem.tsinghua.edu.cn Zhigang TAO＊ Faculty of Business and Economics, The University of Hong Kong, Hong Kong, China 852-28578223, ztao@hku.hk January 2007 Abstract: The institutional environment – including protection of private properties and contract enforcement – has been rather unfavorable for the emergence and development of China’s private enterprises. This is in sharp contrast to the case of the developed economies where the institutional environment is conductive to the entrepreneurial activities and only the personal attributes of would-be entrepreneurs determine their entrepreneurship decision. We thus propose a theoretical framework for the entrepreneurship decision in China with a focus on the role of the institutional environment. Using a life-histories survey data of 2,854 respondents from twenty cities in China, we find strong support for the impacts of the institutional environment and its interactions with other determinants of entrepreneurship decision. Keywords: Protection of private properties; Contract enforcement; Institutional environment; Entrepreneurship ＊Financial support from Hong Kong Institute of Economics and Business Strategy (project no. AoE/H- 05/99) is greatly acknowledged. 1 Executive summary of “Determinants of Entrepreneurial Activities in China” This paper studies the determinants of entrepreneurial activities in China, which is one of the worlds’ four biggest emerging economies. Since 1978, China has undergone a gradual transition from a centrally planned economy dominated by public ownership to a market economy through selective privatization of state-owned enterprises (Cao, Qian, and Weingast, 1999; Bai, Li, Tao and Wang, 2000; Bai, Lu, and Tao, 2006a). With the dominant and yet inefficient state-owned enterprises, there have been ideological biases against private sector development throughout China’s economic reform. Indeed private enterprises were not even formally permitted to exist until 1988 – ten years after China initiated its economic reform. As a result, private enterprises have been subject to expropriation of their private properties and discrimination in business dealings including contract enforcement. The institutional environment, which includes property rights protection and contract enforcement (North, 1990), has been rather unfavorable for the emergence and development of China’s private enterprises. This is in sharp contrast to the case of the developed economies where the institutional environment is conductive to the entrepreneurial activities and only the personal attributes of would-be entrepreneurs determine their entrepreneurship decision. With the dominance of public ownership, both before and after the economic reform initiated in 1978, China’s would-be entrepreneurs generally have had working experience in enterprises of varying degrees of state ownership or public organizations or government agencies. The decision to become an entrepreneur often means quitting a position in an entity of public ownership and starting a private- ownership business with ambiguous legal status; hence in China entrepreneurship is often referred to as “jumping into the sea”. In particular, there are a set of personal attributes of would-be entrepreneurs (such as the political participation of would-be entrepreneurs as well as the public-ownership status of their current employers) that determine their payoffs from remaining in the public-ownership entities and therefore deter them from becoming entrepreneurs. We thus propose that the entrepreneurial decision in China is shaped by the institutional environment for private ownership on the one hand and by the personal 2 attributes of would-be entrepreneurs on the other hand. Using a life-histories survey data of 2,854 respondents from twenty cities in China, we find strong support for the role of institutional environment in the entrepreneurship decision, and for the importance of the personal attributes of would-be entrepreneurs such as the public- ownership status of their current employers and their status within those entities that determine their costs of entrepreneurship. In addition, we find evidence for the interactions between the institutional environment and these personal attributes, consistent with the theoretical argument that the legal environment for private enterprises affects the premium placed by would-be entrepreneurs on their payoffs from employment in public-ownership entities. Our results are also robust to the controls for general determinants of entrepreneurship that have been found to be important in the existing literature (such as gender, marital status, age, education, financial conditions, and altitude for taking business risks); and the impacts of some of these general determinants are also found to depend on the institutional environment for private sector development. Entrepreneurship has been recognized as one of the driving forces for market competitiveness and economic growth in the emerging economies. Our study on the determinants of entrepreneurial activities in China highlights the importance of the institutional environment for private sector development and has important implications for policy recommendations. 3 Determinants of Entrepreneurial Activities in China Abstract: The institutional environment – including protection of private properties and contract enforcement – has been rather unfavorable for the emergence and development of China’s private enterprises. This is in sharp contrast to the case of the developed economies where the institutional environment is conductive to the entrepreneurial activities and only the personal attributes of would-be entrepreneurs determine their entrepreneurship decision. We thus propose a theoretical framework for the entrepreneurship decision in China with a focus on the role of the institutional environment. Using a life-histories survey data of 2,854 respondents from twenty cities in China, we find strong support for the impacts of the institutional environment and its interactions with other determinants of entrepreneurship decision. 1. Introduction Entrepreneurship has been recognized as one of the driving forces for market competitiveness and economic growth. Business venturing introduces newer and better products and services, or offers existing products and services at lower costs, unleashing what Joseph Schumpeter called the forces of creative destruction (Schumpeter, 1976). To fend off potential competition from start-ups, large and established corporations have tried to nurture intra-firm entrepreneurial activities. Meanwhile, national and regional governments have raced to introduce policies that facilitate business venturing and encourage entrepreneurial spirits of their people.1 Behind firm strategies and government policies, there is a need for understanding the determinants of entrepreneurial activities. Existing studies have uncovered a set of 1 Some of the U.S. startups are set up by university researchers whose original research has been supported by government funding agencies. See for example Shane (2002), and Powers and McDougall (2005). In some of the East Asian countries, there are more explicit government policies promoting entrepreneurship (for example, the National Day celebration speech made by Singapore Prime Minister Lee Hsien Loong on August 2, 2005). 4 personal attributes of would-be entrepreneurs, such as gender, marriage status, age, education, financial conditions and altitude for taking business risks that may affect their entrepreneurial activities. Entrepreneurs are usually young, married males with reasonable levels of education, excellent personal financial conditions and preference for taking business risks (see, for example, Holtz-Eakin, Joulfaian, and Rosen, 1994; Blanchflower, and Oswald, 1998; Lévesque and Minniti, 2006). This paper studies the determinants of entrepreneurial activities in China. Before 1978, China was a centrally planned economy dominated by public ownership; and since then it has undergone a transition to a market economy through privatization of state- owned enterprises and establishment of private enterprises (McMillan and Woodruff, 2002). Unlike the formerly centrally planned economies in the Eastern Europe and the former Soviet Union where private ownership has arisen quickly through massive privatization of state-owned enterprises and mushrooming establishment of private enterprises, China has taken a gradual approach to privatizing its state-owned enterprises (Cao, Qian, and Weingast, 1999; Bai, Li, Tao and Wang, 2000; Bai, Lu, and Tao, 2006a). More importantly, with the dominant yet inefficient state-owned enterprises, there have been ideological biases against private sector development throughout China’s economic reform. Indeed private enterprises were not even formally permitted to exist until 1988 – ten years after China started its economic reform in 1978. As a result, private enterprises have been subject to expropriation of their private properties and discrimination in business dealings including contract enforcement. The institutional environment, which includes property rights protection and contract enforcement (North, 1990), has been rather unfavorable for the emergence and development of China’s private enterprises. This is in sharp contrast to 5 the case of the developed economies where the institutional environment is conductive to the entrepreneurial activities and only the personal attributes of would- be entrepreneurs determine their entrepreneurship decision. With the dominance of public ownership, both before and after the economic reform initiated in 1978, China’s would-be entrepreneurs generally have had working experience in enterprises of varying degrees of state ownership or public organizations or government agencies. The decision to become an entrepreneur often means quitting a position in an entity of public ownership and starting a private- ownership business with ambiguous legal status; hence in China entrepreneurship is often referred to as “jumping into the sea”. In particular, there are a set of personal attributes (such as the political participation of would-be entrepreneurs as well as the public-ownership status of their current employers) that determine their payoffs from remaining in the public-ownership entities and therefore deter them from becoming entrepreneurs. We thus propose that the entrepreneurial decision in China is shaped by the institutional environment for private ownership on the one hand and by the personal attributes of would-be entrepreneurs on the other hand. We further propose that the impacts of the personal attributes of would-be entrepreneurs, including both those found in the literature and those specifically relevant to China (political participation and public-ownership status of their employers) may change as China’s institutional environment for private ownership evolves. Using a life-histories survey data, this paper attempts to uncover the impacts of the institutional environment and the personal attributes of would-be entrepreneurs on their entrepreneurial decision. 6 The paper is organized as follows. In Section 2, we outline a theoretical framework about the determinants of entrepreneurial activities in the emerging economy of China, and develop testable hypotheses accordingly. In Section 3, the data set is described and key variables are constructed. The method of econometric analysis and the empirical results are presented in Section 4. The paper concludes with Section 5. 2. A Theoretical Framework and Hypotheses In his seminal work, North (1990) has established the importance of a country’s institutions in determining its economic performance. Institutions are the rules of games in a society or, more formally, are humanly devised constraints that shape human interactions. While institutions could be of many types, the one affecting firm operation and performance the most is the economic institutions. Douglas North has subsequently elaborated on the two basic elements in the economic institutions: protection of private property rights (vertical relation between the state and firms), and enforcement of contracts between economic agents (horizontal relation between firms). In most developed economies, there are both secure protection of private property rights and efficient contract enforcement. Thus the economic institutions are conductive to firm operation and performance including entrepreneurial activities. Under these circumstances, the decision of entrepreneurship is entirely determined by the personal attributes of would-be entrepreneurs such as gender, marriage status, age, education, financial conditions and altitude for taking business risks. 7 The situation for the emerging economy of China is, however, quite different. From 1949 to 1978, the Chinese government followed the doctrine of the Socialist planned economy, eliminating virtually all the private enterprises in the economy and replacing them with state-owned enterprises. With material incentives completely suppressed under the planned economy, the Chinese economy came to a precarious state by mid 1970s, which led to the economic reform initiated in 1978. Unlike the formerly planned economies in the Eastern Europe and the former Soviet Union, however, China has taken a gradual approach in reforming its inefficient state-owned enterprises. One possible rationale for the gradual reform approach is that the Chinese government wants to maintain social stability during its reform process (Cao, Qian, and Weingast, 1999; Bai, Li, Tao and Wang, 2000; Bai, Lu and Tao, 2006a). In the first ten years of China’s economic reform from 1978 to 1988, the Chinese government started to open its economy to foreign trade and investment including entry of foreign invested firms; but there were still ideological biases against China’s indigenous private enterprises, the emergence and development of which was restricted to the rural areas (Qian, 2000). The legal status of private-ownership businesses was not granted until 1988, ten years after China started its economic reform. Article 11 of the 1988 amendment of the Constitution of the People’s Republic of China (approved by the First Plenary of the Seventh People’s Congress on April 12, 1988) reads: “The state permits the private sector of the economy to exist and develop within the limits prescribed by law. The private sector of the economy is a complement to the socialist public economy. The state protects the lawful rights and interests of the private sector of the economy, and exercises guidance, supervision and control over the private sector of the economy”. In the same year, three regulations 8 were issued by China’s State Council, which further specified rights and obligations of the private sector and provided executable protection for the private sector (Zhang and Ming, 2000).2 The role of private sector development was further elevated to being important to the Socialist market economy in the 1999 amendment of the Constitution (approved by the Second Plenary of the Ninth People’s Congress on March 15, 1999). Finally, in the 2004 amendment of the Constitution (approved by the Second Plenary of the Tenth People’s Congress on March 14, 2004), private sector development was called for, and formal protection of private property was offered. A survey of 3,073 private enterprises conducted in 2000 reveals that 39% of private entrepreneurs have paid informal levies for various government projects and 56% of them have called for anti-corruption policies, which reflecting poor protection of private properties (Bai, Lu and Tao, 2006b). The same survey also shows that, with the ambiguous legal status for private ownership, private enterprises have faced severe discrimination in all aspects of business operations. In particular, only 9.4% of the private entrepreneurs surveyed have resorted to the formal legal channels for dispute resolution. The unfavorable institutional environment (including property rights protection and contract enforcement) for entrepreneurship in China implies that, in contrast to the conventional theory of entrepreneurship for the developed economies, the legal status for private ownership should play an important role in the entrepreneurship decision for China’s would-be entrepreneurs.3 Specifically, during the sample period of our data set (1978-1994), Article 11 of the 1988 amendment of 2 These three regulations are: “The temporary regulation of private enterprises in China”, “The temporary regulation of company income taxes of private enterprises in China”, and “The temporary regulation of income taxes of individual investors in private enterprises in China”. 3 Aldrich and Fiol (1994) study some of the unique issues facing innovating entrepreneurs. In entering into new industries, there is a relative lack of legitimacy, as both entrepreneurs and crucial stakeholders may not fully understand the nature of the new ventures and their conformity to established institutional rules may still be in question. 9 the Constitution of the People’s Republic of China was a watershed as it formally permitted the existence of private enterprises in China. Thus, we have: Hypothesis 1: The granting of legal status for private enterprises in the 1988 amendment of the Constitution of the People’s Republic of China is expected to have a positive impact on the entrepreneurial activities in China. With the dominance of public ownership both before and after the economic reform initiated in 1978, China’s would-be entrepreneurs generally have to quit their positions in some public-ownership entities and then start their private ownership businesses. While the legal status for private ownership affects the would-be entrepreneurs’ benefit from starting private-ownership businesses, the cost of entrepreneurship is the payoffs the would-be entrepreneurs can have if they remain in the public-ownership entities. A would-be entrepreneur’s payoffs from remaining in public-ownership entities depend on the degree of public ownership of his current employer as well as his personal political participation. The entities of public ownership could be government agencies, public organizations, state-owned enterprises affiliated with the central government, state-owned enterprises affiliated with the local governments, collectively-owned enterprises, and others (including semi-private or even private enterprises), descending in the degree of public ownership. In any entity of public ownership, a person’s status is further enhanced and his control benefits are higher if he is a member of the Chinese Communist Party. This is because the Chinese Communist Party has control over the appointment of senior management of state-owned enterprises. In addition, membership of the 10 Chinese Communist Party is generally a precondition for senior positions in the government agencies or public