Whether Chinese Business Groups Are Paragons of Parasites - Literature review Example

Introduction and background

When it comes to the economic growth of a country, every bit of contribution to productivity counts (Kang & Lee, 2008). In the past 3 decades, China has exhibited a phenomenal and outstanding economic progress, making the World Bank liken the individual provinces in the country to the twenty fastest growing countries in the world if each of them were an individual nation (Lee & Hahn, 2007). There are different schools of thought about the key contributing factors to the types of economic growth that China has been experiencing the past 3 decades. In one school of thought it is strongly held that the presence of small enterprises in the country acts as the foundation for growth for the country as a whole (Rafael, Lopez-de-Silanes & Shleifer, 1999). Proponents of this school of thought hold the argument that given the large population of China, giving room for individuals to start and nurture their own small scale enterprises serves to form a very large pool of productive contribution to the country’s economy (Guillen, 2000). There is another school of thought that attributes the success of economic growth in China to activities of large and medium enterprises (LMEs) (Sutherland & Guest, 2010). As these LMEs are suppliers to smaller enterprises, it has been held that their significantly increased share of industrial output is contributory to the overall productivity levels of the country.

The contributions made by smaller enterprises to the overall growth of China’s economy cannot be denied. However, Smyth (2000) posited that the large market capitalisation of LMEs, coupled with the extent of global competition they offer other international firms from different countries makes it appropriate to hold that these LMEs offer greater importance to China’s economic reformation. It is however interesting to note that when it comes to LMEs, there is an emerging theoretical trend which focuses on the analysis of enterprises by ownership rather than enterprise by scale (Claessens, Djankov & Lang, 2000). Closely related to theories about enterprise by ownership is the concept of business groups. Nolan (2002) has argued that business groups have sprung up in China in the last 3 decades and this can be attributed to a design of emergence rather than spontaneous emergence. A common evidence given to back the claim that business groups have emerged out of design is the formation of what has come to be known as ‘national team’ in China (Hoskisson et al., 2005). This is a group of 120 of the country’s largest LMEs with related policy trial, initiated directly by China’s highest decision making body which is China’s State Council (Morck, 2004). A large company and enterprise group strategy has been formed out of the national team, which has subsequently led to the formation of 100 LMEs, 20 of which are also members of the 120 enterprise groups (Heitor & Wolfenzon, 2006).

Emerging pyramidal groups as parasites

Almeida and Wolfenzon (2006) explain a pyramidal ownership as a form of control of firm through the use of chain of ownership relations. That is, families and other individuals use existing firms they control to set up new firms (Goto, 1982). Once this is done, the system deviates from the traditional practice of separating cash flow from the voting rights offered to the business owners (Almeida & Wolfenzon, 2006). Under the pyramid ownership, there are two major forms of control opportunities that owners, most of which are families possess. The first is that they gain access to all stock of retained earnings belonging to the original firms out of which they formed the new firm (Khanna & Yafeh, 2007). Secondly, they take part in the non-diverted payoff of the new firm with minority shareholders from the original firm (Haas School of Business & Stouraitis, 2004). To a very large extent therefore, it would be noted that the outcome of the pyramid ownership is mostly a win-win situation for the entrepreneurs who win in terms of both ownership and control. As seen in the introduction and background, there cannot be a stone left unturned when it comes to the contribution of private businesses to the growth of China’s economy. However, given the fact that 20 members of the 100 LMEs are also member of the 120 enterprise groups gives the indication of a possible emergence of pyramidal groups.

Apart from the trend described above which is used as a basis for arguing about the emergence of pyramidal groups, there are other business group related factors that suggest the emergence of pyramidal groups in China. One such factor is the fact that out of China’s top 50 groups, as many as 16 of them are considered to be pyramids (Masulis, Pham & Zein, 2011). Some of these include Sinopec, Sinochem Corporation, Bio Steel Group, Dongfeng Motor Corporation, China State Construction Engineering Corporation, China Minmetals, COSCO, and Haier, all of which are within the first 20 of the top 50. The evidence that there is the emergence of pyramidal business groups in China can therefore not be denied. In most modern literature, the attention of researchers has shifted from proving whether or not there is the emergence of pyramidal groups to identifying the impact of such groups. In this extent, there are two key lines of arguments, where one holds that pyramidal groups act as parasites (Fisman & Khanna, 2004). Those arguing pyramidal groups act as parasites have done so by focusing on the negative impacts of pyramidal business groups on the larger business community in China. In one such study, Lu and Yao (2006) kicked against the idea, claiming that it defeats the idea of even distribution of worth within the economy. Using Shanghai Electric Group as a case study, it would be noted that the company alone has operations in as many as 10 industries, amassing total assets of 95.7 billion RMB, and has since 2006 acquired seven subsidiaries (Sutherland et al., 2011).

Such instances where the distribution of wealth has been left with a few group of investors who form the pyramidal business groups is described as parasitic because it denies others the legitimate right of also getting a share of the national cake. Morck, Wolfenzon and Yeung (2005) complained that typical of parasites, they would always want to attach themselves to a host, where they deplete the host by either sucking its blood or causing some other forms of discomfort to it. Indeed using the case of Shanghai Electric Group, it would be said that those 10 industries the pyramidal groups of the business operate in have become hosts, where owners and shareholders of the company deplete their financial resources by offering unfair competition within these industries. What is more problematic with Shanghai Electric Group and other similar firms such as Sinopec is that the major business areas they operate within each industry each also consists of separate groups as has been depicted in figure 1 below.

Figure 1: Pyramidal formation within Shanghai Electric Group

Source: Sutherland et al. (2011)

With such a pyramidal formation as described in figure 1, it leads to a situation where there is a form of ownership structure in the groups, which leads to divergence between cash flow and control right in a classical business composition structure (Sutherland et al., 2011). Meanwhile, Yiu, Bruton and Lu (2005) kicked against such divergence between ownership structure and control, saying it kills the type of incentive and motivation, needed for tunnelling among large number of public investors who may be outside of China. To a large extent, the pyramidal business group that has emerged in China do not only act as a parasite against local businesses and smaller enterprises but also blocks opportunities with foreign direct investment (Ghemawat & Khanna, 1998). This is because such foreign public investors may harbour the fear that by investing in some of these companies, they may never full gain access to both ownership and control as this may be done by certain higher power local investors operating within different types of the pyramids. This negative effect is very expected as the apex listed firm in figure 1 is known not just to have ownership shares in three subsidiaries but that the subsidiaries (“Shanghai Mechanical & Electrical Industry Co., Ltd., 47%; Shanghai Power Transmission and Distribution Co., Lt., 84%; and Shanghai Diesel Engine Co., Ltd., 50%”) are all listed on the Shanghai Stock Exchange (Sutherland et al., 2011, p. 175, 6).

Emerging groups as paragons

In a contrary line of argument from the above, there are those who see the emergence of pyramidal groups as constituting paragons. That is, these emerging groups are classified as the outcome of strong business ingenuity and innovative ideology (White et al., 2008). For example, Xa, Yao and Xi (2006) posited that instead of focusing only on the possible negative effects of pyramidal business groups, it is also important to consider the impact that such businesses have on ownership diversification in China. This is because for a very long time, China has been known to be a highly communist country where the government hardly gave opportunity to the private sector to control the business client by establishing LMEs (Ma & Lu, 2005). With the reform which has led to the pyramidal business system, ownership diversification at the government level has led to opportunities to private entities, also controlling and owning businesses. The benefit that such ownership diversification comes with is that it helps in increasing the level of participation for the general public as shareholders and partakers of the national economy. Relating this to the thesis at the beginning of the paper, it would be noted that with the increased participation of the general public as shareholders contributes positively to the larger economic growth of China. This is said because with the general public partnering the government as business owners, it expands the scope of business and economic opportunities for the country.

Also related to the issue of expanded business opportunities, Yeung (2002) indicated that the formation of pyramidal businesses is associated with constituting de facto privatization given to insiders of the parent companies. In the case of China, most of the parent companies are state owned as in the case of China State Construction Engineering Corporation, whereas the insiders are private investors. With time, the de facto privatization given to the insiders often extend into becoming de jure privatization when there is management buy outs among the insiders (Kang & Lee, 2008). As this happens, these private insiders become economically empowered to create more avenues for further business expansion and growth as they also establish companies, which become subsidiaries of the parent companies. To a large extent, it would be claimed that pyramidal business groups makes room for privatization within the Chinese economy, which for long, and before the economic reform in the country had been absent (Lensink, Huanjun & Ees, 2009). Meanwhile, the benefits of privatization to the economic growth of countries are well documented in literature. For example, Khanna and Yafeh (2007) indicated that privatization is an important variable for the promotion of healthy competition within the business environment. Today, as part of the pyramidal business group system, there are more than 1000 private business groups currently operating in China. Today, there are private firms whose market capital and total assets run parallel with the GDP of China, given the opportunities given to them through pyramidal business groups to grow.

Also supporting the position that the pyramid business groups constitute paragons rather than parasites, Yiu, Bruton and Lu (2005) stressed that it is important not to focus only on the personal gains that private investors make from their participation in minority shareholding in pyramidal business groups. This is because it cannot be expected that the gains that these private individuals make only go to promote their personal benefit. Rather, as more minority shareholders are created at the lower tiers of the pyramid, Kang and Lee (2008) posits that they go a long way to serve the same purposes that the group corporations at the top of hierarchies stand for. By this, reference is made to the fact that there is an expropriation of minority shareholders, whose business activities ensure there is maintenance of employment, provision of social services, conduct of social responsibilities, and often course sufficient circulation of money in the financial system (Almeida, Park & Subrahmanyam, 2011). With this in mind, it would be deduced that the use of pyramidal business groups is an innovative means by which China as a country shifting from exclusive communist to capitalism, creates room for reducing unemployment, providing career opportunities, and improving social welfare for its citizens.

Addressing concerns that pyramidal business groups only provide business opportunities for minority of citizens who are in the elite status, Yeung (2002) emphasised that participation in any part of the pyramid is always open to public participation and that as long as a private investor is ready to be part of it, there are no hindrance to it. This is particularly so as most industries in which these pyramid businesses operate function in a perfect market structure. With such a perfect market structure, new entrants are encouraged with little or no opposition to entry (Lensink, Huanjun & Ees, 2009). This really creates room for making use of empty spaces within the business environment that are yet to be taken advantage of. In direct relation to this, Masulis, Pham and Zein (2011) was also positive about the fact that pyramids actually allow for easy expansion among investors and entrepreneurs who on their own would not have been able to raise capital for start-up businesses. This is because becoming a shareholder or creating new business out of an existing one often requires limited capital (Keister, 2001). This situation of needing limited capital is created largely because the pyramid groups “draw from public investors to socialise the risk of business group expansion” (Sutherland, et al., 2011, p. 177).

Conclusion

The fact that there is an emergence of pyramid business groups in China is a situation that cannot be denied. This is because of the strong evidence provided in this paper with specific companies. It would also be acknowledged that there are some negative effects that comes with the presence of pyramid business groups. However, to reiterate the thesis statement, it would be said that when it comes to economic development of a country, every contribution to productivity counts. Consequently, describing the emergence of pyramidal business groups in China as parasitic will be an unfair position. This is because the general notion behind the description of pyramids as parasites is that they are in place to suck up the interest of other business entities for their selfish good, while leaving out the benefits that will come to the other entities.

Since the pyramidal groups were formed out of designed strategy at the national level, it cannot be thought of that they were formed with the primary motive of displacing other entities, especially smaller enterprises in terms of business opportunities. Rather, the pyramids were formed as an act of innovation and ingenuity, aimed at providing alternative growth opportunities for all businesses and investors. Indeed, the global business environment is highly competitive today and China cannot take chances of its impressive economic growth rate. To consolidate its current global economic position and also seek sustainable growth opportunities, it is only a step in the right direction that such business growth opportunities that emerge from pyramidal business groups be taken. With basis in this, it will be concluded that even though there is evidence to the emergence of pyramidal business groups in China, these groups can only be said to be paragons and not parasites.