From the editor: Starting with this issue, The Chinese edition of Knowledge @ Wharton will begin publishing summaries of China‘s most recent research papers on economics and business management. The goal is to introduce global readers to research findings of Chinese scholars and promote international academic exchange.


As China transitions from a planned economy to a market economy, the lack of a normal channel of financing for private enterprises is closely watched. Many scholars have done studies examining the pros and cons of how business owners seek access to capital.


Zhang Jun, an economics professor at Fudan University, has been studying China‘s business reform and economic transition since 1994. Dozens of his papers on related topics have appeared in prominent domestic and foreign journals. In his most recent research paper, titled, “Financial Discrimination, Corruption, and the Rise of China’s private enterprises,’ he says that China’s private entrepreneurs rely on befriending what he described as “government entrepreneurs’ to finance their businesses. While such a relationship implies corruption as government officials use their political powers for personal gains, it provides the lowest-cost financing for private business owners because China lacks a normal business funding channel. Businesses often rely on relationships with politicians, a situation they refer to as their “second-best financing option.’


Zhang broadly defines what he means by “government entrepreneurs’ in his paper. They include not only government officials, but also individuals, such as bank loan officers, who have a say in how state assets are allocated during China‘s economic transition. Using the political connections they have, those in the government help finance private businesses in exchange for ownership stakes in the businesses and other rewards. This type of financing often leads to dilution of ownership stakes and “tunneling behaviors,’ such as insider trading and illicit transfer of company assets. At its worst, such financing can cripple a company’s operations and may even bankrupt a business.


Resorting to the law as a way to control corruption won’t eradicate this form of financing, a natural byproduct of an economy that still subjects its private business owners to “financial discrimination,’ Zhang says in his paper, adding that developing a formal system of, and regulating, private financing will be the only solution.


Government Entrepreneur-Enabled Financing


To support his argument, Zhang has built a two-stage financing model involving the participation of three parties: the government, government entrepreneurs and private businesses. Using rigorous mathematical models, he reaches some new conclusions based on the assumption that private enterprises face “financial discrimination’ amidst China’s economic transition, in part because they can’t get the funding that they need. He also assumes that private business owners can’t make full use of their talents because of the ownership dilution.


As China transitions from a planned economy to a market economy, private entrepreneurs, who don’t have normal access to capital rely on their ties with those in the government to obtain financing to expand their businesses. They have to reward those “government entrepreneurs,’ and that includes at times giving up a part of their ownership stake. That reward leads to “second-best investment value’ as it reduces the total investment value that private businesses would have been able to reach in a healthy market economy.


Zhang points out another problem as well. “Government entrepreneurs’ who are compensated, become company shareholders and get involved in management take away the opportunity for private entrepreneurs to use their talents to the fullest. The more funding and help private business owners receive from those in the government, the bigger a controlling stake of the company they will have to give up. 


Zhang also finds an interesting phenomenon in his statistics. China‘s “government entrepreneurs’ like to start their own private businesses, while private entrepreneurs vie for a position in the government to become “government entrepreneurs’ themselves. Based on Hart’s Incomplete Contract Theory, Zhang uses economic theory to describe why such a phenomenon exists. Against the backdrop of financial discrimination facing private business owners, the best business development model can be achieved when private entrepreneurs have a position in the government so they can have access to capital and also business control. Zhang provides two case studies that have been widely discussed in China to prove his point.


Case Study One: Sun Dawu‘s Idealism


Sun Dawu, chief executive of Hebei Dawu Farming and Stock Breeding Group in China‘s Hebei province, despised currying favors from local government leaders or bribing local bank loan officers to get financing for his business. Barring help from “government entrepreneurs,’ he had to resort to a form of financing that cost his business more: He turned to nearby villagers for help and set up individual loan contracts. Even with that, he wasn’t able to stay clear of misfortune. As a county people’s congress representative, he was a “government entrepreneur.’ That allowed him to tap funding from local residents with implicit consent from local governments. As soon as he was no longer in that position, he was immediately arrested for “illegally taking savings from the public.’


The studies of companies under the framework of New Classical Economics assume that businesses don’t have any problem getting access to capital, Zhang said in his paper. Businesses operating under such a framework are considered “new-classical enterprises,’ and their owners, in the case of Sun Dawu, a “neo classical entrepreneur,’ Zhang says. “I would rather shell out more money than engage in bribery; I will bargain righteously instead of seeking unfair advantage,’ Sun Dawu was known as saying. Unfortunately, such an ideal market place won’t exist in China until the country establishes a healthy private financing system, Zhang says.

Sun Dawu could have significantly lowered his cost of borrowing if he had obtained a lump-sum loan from a bank instead of wasting his time looking for villagers and signing multiple individual loan contracts, each in small amounts. His moral high ground resulted eventually in his own arrest. The cost to his own business was inestimable. Against the background of financial discrimination facing private businesses, the involvement of government entrepreneurs in private business financing may be a necessary evil, Professor Zhang concludes.


Zhang also points out Sun Dawu‘s former position as county people’s congress representative and how that role gave him implicit government permission to raise funds through villagers’ personal savings. As soon as he was no longer in that position, his financing measure was immediately labeled illegal. That led to Zhang’s third conclusion: It’s advantageous to the growth of a company if its private owner also holds a government post during the current economic transition.


Case Two: Negative Impact of “Government Entrepreneurs’


If the example of Sun Dawu illustrates why private business owners obtain financing through the help of those in the government, the other case study about Hongzhi Keji reveals its problems. 


Hongzhi is a private technology company based in China‘s Fujian province. Original company shareholders, such as Wang Dong, who were eager to raise funds to list company shares on the stock market, invited several key provincial government officials, including Li Shaolin, to join the company board. Unfortunately, Li was not interested in the growth of the company. He and other officials used “tunneling behaviors’ — such as share transfer, dilution and insider trading — to increase their stakes in the company. With the majority stake, they froze the stake of original shareholders and arbitrarily impeached high-level management. These series of behaviors crippled the company’s operation and led to huge business losses.


Zhang applied outside research on “tunneling’ theory to the Chinese economic context. Lacking the existence of a healthy market system, developing countries rely many times on non-market forces for asset allocation. That often leads to corruption and government officials using their political powers for personal gains, resulting in increased occurrences of “tunneling.’


Zhang reached his second conclusion from Hongzhi’s case. Government entrepreneurs who become company shareholders will minimize the application of private entrepreneurial talent. Wang Dong and his partners didn’t have as many motivations to grow the company after they were forced to give up for free a percentage of their ownership stake and other rewards to Li Shaolin and the other officials. Meanwhile, Li and others exercised their shareholder powers at will and impeached top company management for no reason. That also led to the reduction of the full use of entrepreneurial talent.


Hongzhi’s case also proved Zhang’s point that the more financing private business owners gets from government entrepreneurs, the more control of the businesses they have to give up. Hongzhi’s ownership stake was split three ways among original shareholders, such as government officials like Li Shaolin, and tradable stock shareholders, each of whom held 31.18%, 32.46%, and 36.36% separately. Li Shaolin and other officials had an even higher stake of the company than did original owners like Wang Dong.


These points, according to Zhang, are warning signals for China‘s current financing system. If the financing structure isn’t revamped, legal control of corruption will achieve little to solving the problem. Only through regulating and developing a complete system of private financing will business owners have normal access to capital.