JournalofCorporateFinancexxx(2014)xxx–xxx
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JournalofCorporateFinance
journalhomepage:www.elsevier.com/locate/jcorpfin
InstitutionaldeterminantsofverticalintegrationinChina☆
JosephP.H.Fana,1,JunHuangb,⁎,RandallMorckc,2,BernardYeungd,3abcdCUHKBusinessSchoolandInstituteofEconomics&Finance,TheChineseUniversityof,,ChinaInstituteofAccountingandFinance,ShanghaiUniversityofFinanceandEconomics,Shanghai,ChinaUniversityofAlberta,NationalBureauofEconomicResearch,CanadaNationalUniversityofSingaporeBusinessSchool,Singapore
articleinfoabstract
Wherelegalsystemsandmarketforcesenforcecontractsinadequately,verticalintegrationcancircumventthesetransactiondifficulties.But,suchenvironmentsoftenalsofeaturehighlyinterventionistgovernment,andevencorruption.Verticalintegrationmightthenenhancereturnstopoliticalrent-seekingaimedatsecuringandextendingmarketpower.Chinaoffersasuitablebackgroundforempiricalexaminationoftheseissuesbecauseherlegalandmarketinstitutionsaregenerallyweak,butnonethelessexhibitsubstantialprovince-levelvariation.WereportthatChinesefirmsinthe2000'saremoreverticallyintegratedthantheU.S.firmsinthe1990s.Wefindthatverticalintegrationismorecommonwherelegalinstitutionsareweakerandwhereregionalgovernmentsareoflowerqualityormoreinterventionist.Further,firmsledbyinsiderswithpoliticalconnectionaremorelikelytobeverticallyintegrated.Finally,verticalintegrationamongpoliticallyunconnectedfirmsisassociatedwithelevatedpercapitaGDPlevelandgrowth,whileverticalintegrationamongpoliticallyconnectedfirmsisunrelatedtolocaleconomyperformance.
©2014ElsevierB.V.Allrightsreserved.
Articlehistory:
Received4December2013
Receivedinrevisedform23May2014Accepted25May2014AvailableonlinexxxxJELclassification:L22P14G38P16
Keywords:
VerticalintegrationRentseeking
InstitutionaldevelopmentGovernment
1.Introduction
Thispaperexplorestherelationshipofverticalintegrationtoinstitutionaldevelopmentanditsimpactoneconomyperformance.Wedefineverticalintegrationascommoncontroloveradjacentproductionstages.Inaneconomywithperfectmarkets–thatis,withnotransactioncosts–verticalintegrationisintrinsicallyinefficientbecauseitpreventsspecializationand
☆WearegratefulforhelpfulcommentsfromPedroDalBó,ZhiwuChen,KaiLi,HaroldMulherin,JoanneOxley,IvanPng,PabloSpiller,TracyWang,LarryWhiteandotherparticipantsinseminarsandconferencesattheAmericanFinanceAssociation,theChinaInternationalConferenceinFinance,HarvardBusinessSchool,theHassSchoolatUCBerkeley,theNationalBureauofEconomicResearch'sChinaWorkingGroupWorkshop,NewYorkUniversity,andtheUniversityofCopenhagen.JosephFangratefullyacknowledgesfinancialsupportfromtheInstituteofEconomics&FinanceofCUHK.JunHuangthankstheNationalNaturalScienceFoundationofChina(No.71102136,No.71272008andNo.71372038),theMOEProjectforKeyResearchInstitutesofHumanitiesandSocialScienceinUniversities(No.11JJD790008),theShanghaiPhilosophyandSocialScienceFoundation(2013BGL008),theInnovationProgramoftheShanghaiMunicipalEducationCommission(14ZS078),andtheProgramforInnovativeResearchTeamofShanghaiUniversityofFinanceandEconomics.RandallMorckthankstheSSHRCandtheBankofCanadaforpartialfunding.BernardYeungacknowledgespartialfundingfromtheLallySchoolofManagementandTechnologyatRensselaerUniversity,wherehewasavisitingscholarinJan2008.
⁎Correspondingauthorat:InstituteofAccountingandFinance,ShanghaiUniversityofFinanceandEconomics,No.777GuodingRoad,YangpuDistrict,Shanghai200433,China.Tel.:+862165904822.
E-mailaddresses:pjfan@cuhk.edu.hk(J.P.H.Fan),huangjun@mail.shufe.edu.cn(J.Huang),randall.morck@ualberta.ca(R.Morck),byeung@nus.edu.sg(B.Yeung).1Tel.:+85239437839.2Tel.:+17804925683.3Tel.:+6565163015.
http://dx.doi.org/10.1016/j.jcorpfin.2014.05.0130929-1199/©2014ElsevierB.V.Allrightsreserved.
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
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createsintra-organizationalcomplexityandpolitics(MilgromandRoberts,1988).Inaddition,integratingverticallyrelatedbusinessesunderthecommonownershipinducesorganizationalcosts,includingthehighercostsofmonitoringworkersandmeasuringperformanceinthemorecomplexorganizations(AlchianandDemsetz,1972;Klein,2014).However,avarietyofconvincingreasonscanexplainverticalintegrationinrealeconomies.
First,transactioncostsindealingsbetweensuppliersandcustomerscaninduceverticalintegration.Wellknowninformationasymmetriesandagencyproblemscaninduceanticipatableopportunisticbehavior,andsodistortinvestment.Iflegalinstitutionsandmarketforcesaretoodysfunctionaltoletfirmscontractaroundsuchtransactionsproblems,verticalintegrationisaplausiblesolution(KhannaandPalepu,1999;Kleinetal.,1978;Williamson,1975).
Second,weaklegalinstitutionsandmarketdisciplinaryforcescanreflectunderlyingpoliticaleconomyinfirmities–suchasexcessiveregulatoryburdens,politicalinterference,orcorruption–thatcanhindermarkettransactions.Verticalintegrationcanbearationalresponsetocircumventsuchbureaucraticimpedimentsandsecure,e.g.,reliablefactorsupplies(Stigler,1951).Butthisneednotendthestory,forsucheconomiesinducepoliticalrentseeking(Krueger,1974).Ifregulatoryburdens,politicalinterference,orevencorruptionbecomeimportantfactorsinday-to-daybusiness,firmsinvestresourcesininfluencingthemby“lawyeringup”,lobbying,orevenbribinginfluentialpublicofficials.Oncefirmsacquiretheabilitytoinfluencegovernmentofficials,lobbyingforregulatoryorotherbarrierstocompetitionisanaturaluseofsuchinfluence(Tullock,1965).Verticalintegrationreflectstheexpansionofarent-seeker'sboundaries.Inaddition,averticallyintegratedmonopolyisunambiguouslymoreprofitablethanasequenceofverticallyrelatedsingle-marketmonopolies(Spengler,1950).
Empiricalstudiesofverticalintegrationpredominantlyexamineagivenindustryinagivendevelopedeconomyforverticalintegrationasaresponsetoexpectedopportunisticbehavior(Chipty,2001;Fan,2000;Joskow,1987;Masten,1984;MonteverdeandTeece,1982;Mulherin,1986;Ohanian,1994;Teece,1976andothers).4Relativelyfewstudiestestforalinkbetweenverticalintegrationandinstitutionaldevelopmentorexaminetheimpactofverticalintegrationoneconomy-levelperformanceinthecontextofadevelopingeconomy.Yetthesearepreciselywherelegalsystemsandmarketforcesareknowntobeespeciallyproblematic(DeSoto,2000).Studiesofverticalintegrationinsucheconomies–wherecontractingsolutionsareunreliable,politicalrent-seekingisrife,andcorporategovernanceislargelyunsupervisedbyshareholders–shouldprovidethemostpowerfulevidenceofitseconomicfunctions.5AnotableexceptionisAcemogluetal.(2009),whousecross-countrydatatoshowthatverticalintegrationissignificantlygreaterincountrieswithhighercontractingcostsyetgreaterfinancialmarketdevelopment.Cross-countrystudies,thoughimmenselyvaluable,areunavoidablyvulnerabletoomittedvariableproblems,aswellasdatacomparabilityandmeasurementproblems.6Forexample,innumerablelatentfactorslinkedtoculture,history,politics,orevenlanguagecanaffecthumanbehaviorandhencetheorganizationoftheeconomyaswellasinstitutionaldevelopment.
Studyingprovince-leveldatafromChinamitigatesthesecriticisms,atleasttosomeextent;forthesefactorsarelargelycommonacrossprovinces.Duetovariationinproximitytotheoutsideworldandinpre-liberalizationconditions,differentprovincesstandatsubstantiallydifferentlevelsofinstitutionaldevelopment.ByWesternstandards,inthe1990sand2000'slegalsystemsinmanypartsofChinaseemsclerotic,politicalrent-seekinglooksrampant,andstatecontrolseemspervasive(Allenetal.,2005;CheandQian,1998;CullandXu,2005;Fanetal.,2007;Montinolaetal.,1995).Buttheseproblemsaremuchworseinsomeprovincesthaninothers(QianandWeingast,1996,1997).Againstacommonculturalbackground,thisvariationininstitutionaldevelopmentprovidesausefullaboratoryforexploringhowbusinessesorganizethemselvesinresponsetotheirinstitutionalenvironments.
WeuseChina'sinput–output(IO)tabletomeasuretheprevalenceofverticalintegrationamongpubliclylistedfirms(excludingfinancialfirms)ineachofChina'svariousprovinces,specialadministrativeregions,andautonomousregions—whichwecollectivelycall“provinces”forbrevity.7Controllingforpotentialassetspecificity(Kleinetal.,1978;Williamson,1979)andotherplausiblefactors,wefindverticalintegrationmorecommoninregionswithweakerlegalsystems,worselocalgovernment,andlessdevelopedmarketeconomies.Weinterpretthisasconsistentwithverticalintegrationasacorrectivemeasuretocircumventinstitutionallacunaandamanifestationofpoliticalrentseeking.
Frombiographicalinformation,wedefineeachfirm'stopexecutives,whomwecallCEOsregardlessoftheirChinesetitles,asapparatchiksiftheyarenoworhaveeverbeenCommunistPartyorstateofficials.Wefindapparatchik-runfirmstobeunusuallypronetoverticalintegration.Alternatively,wemeasurepoliticalconnectionsasaccesstotheprivilegeofindustryentryandtobankloans,bothofwhicharedefactorationed.Thesefurtheranalysesagainshowthatmorepoliticallyconnectedfirmsaremoreverticallyintegrated.Theseresultsareconsistentwithatleastsomeverticalintegrationarisingtoexpandreturnstopoliticalrent-seeking.
SeeLafontaineandSlade(2007)forasurveyoftheliterature.
Parallelconceptsareinvestigatedintheforeigndirectinvestmentliterature,whichfindsthatmultinationalfirmspreferfullownership(i.e.,integration)oftheirforeignsubsidiarieswheretransactiondifficultiesintrinsictothenatureofthebusinessarehigh(e.g.,Henisz,2000).Unfortunately,suchstudiesshedscantlightonintegrationasaresponsetoweaklegalormarketinstitutionsbecauseconfoundinginterpretationsarise.Forexample,foreignanddomesticfirmshavedifferentcapabilitiesfordealingwithawiderangeofinstitutionalinfirmitiesbeyondweaklegalandmarketinstitutions.Thesedifferencesconstraintheirrolesasacquirersandacquired(seee.g.FeenstraandHanson,2005).6Forexample,industriesthatareverticallyrelatedintheUnitedStatesmightnotbeelsewhere,wheredifferenttechnologiesrequiredifferentinputs.Also,contractingcostmeasure,tobecomparable,mustbesimple—forexample“thenumberofstepsrequiredincollectingadebt.”Yet,asimilarstepmightbemoreonerousinonelegalsystemthananother.Acemogluetal.(2009)findmeaningfulresultsdespitesuchchallenges.7ThismethodologywasdevelopedbyFanandLang(2000),andusedbyShahrur(2005),FanandGoyal(2006),Acemogluetal.(2009),andAcemogluetal.(2010).
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
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Finally,weareinterestedintherelationshipbetweenverticalintegrationandregionaleconomydevelopment.Ifverticalintegrationisasecondbestsolutiontotransactiondifficultiesunderweakinstitutions,itwouldcorrelatewithimprovedeconomyperformance.Onthecontrary,ifverticalintegrationisforrentseeking,itsimpactoneconomicperformanceislesscertain.Weexaminethisbyaveragingtheextentofverticalintegrationacrossconnectedandunconnectedfirmsbasedinagivenprovincetoconstructprovince-levelmeasuresoftheprevalenceofverticalintegration.TheresultsshowthatmoreprevalentverticalintegrationaccompanieshigherprovincialpercapitaGDPlevelsandgrowthratesinprovinceswhoseverticallyintegratedfirmsarepredominantlyrunbynon-apparatchiks.Incontrast,widespreadverticalintegrationisnotsignificantlyrelatedtopercapitaGDPlevelsorgrowthratesinprovinceswhoseverticallyintegratedfirmsarepredominantlyapparatchik-run.Totheextentthatouranalysisissubjecttocaveatslikeomittedvariablesandalternativeinterpretations,thefindingsherearetentative.
Thepaperproceedsasfollows.Section2developsourhypotheses.Section3describesthesample,discussesempiricalmeasures,andprovidesdescriptivestatistics.OurmainresultsarereportedinSection3.4.3.Section4concludes.2.Theeconomicsofverticalintegration
Byverticalintegration,wemeantheintegrationofactivitiesbelongingtodistinctlyidentifiableseparatebutverticallyrelatedindustries.Toillustrate,considerWeiqiaoGroup,thelargesttextilecompanyinChinainthe2000s.Thegroup'sprimarybusinessisproducingtextiles.Butitalsogrowsitsowncotton,makesthecottonintoyarn,weavesandfabricatestheyarnintotextiles,imprintsthetextileswithcolorsbeforesellingthemtocustomers,andoperatesitsownelectricityplanttopoweritsotheroperations.WeiqiaoexemplifiesadegreeofverticalintegrationcommonplaceinChina,butrareindevelopedmarketeconomies.Whatarelikelyexplanationsandeconomicimplications?2.1.Transactioncostsandverticalintegration
Markettransactionsbetweenseparatelyrunverticallyrelatedfirmscanbecostly.Coase(1937)positsthattransactionsoccurwithinafirm(verticalintegration)ifthecostofarm'slengthtransactionsbetweenspecializedfirmsexceedsthatofcoordinatingmultipleactivitieswithinonefirm.Coase'sinsightbegataninfluentialliteratureonthecostsoftransactionsbetweenverticallyrelatedbusinesses(e.g.,Kleinetal.,1978;Lucas,1978;andWilliamson,1973,1975).
Kleinetal.(1978)andWilliamson(1979)pointoutthatanticipatedopportunisticbehaviorstemmingfromassetspecificity,lowtransactionfrequency,anduncertaintyassociatedwiththetransactionsinquestionleadstoinefficiency.Considertwoindependentunitsengaginginupstreamanddownstreamproduction,eachmakingaspecializedinvestmentinperiodonetoprepareforproductioninperiodtwo.Onceaninvestmentismade,theresultingassetcannotbeusedforanotherpurposewithoutasubstantiallossinitsvalue.Thiscostofadaptingtheassettootheruses,calledassetspecificity,caninducetheothertransactingpartiestoextractrentsexpost(Kleinetal.,1978).InthecontextofChina,forexample,onemanifestationofsuchbehaviorisonlowsupplyofqualitythatmakesithardtosafeguardexposttroublestoverticallyrelatedfirms.Thissortofopportunisticbehaviorispossiblebecauseofinformationasymmetryaroundthetransaction—eitheragenuinelyexogenousunanticipatedchangeoracalculatedrent-extraction.Thisforeseeablepossibilityinducestime-inconsistentbehaviorthatreducestheexpectedreturntospecializedinvestment,andthereforecurtailsit,resultinginadeadweightlosstotheeconomy.Anothersourceofinefficiencyarisesbecausethevalueofoneverticallyrelatedbusinessdependsontheother—onitseffortlevelandflexibilityaswellasitswillingnesstoshareinformationandtocoordinateemploymentandinvestmentstrategies.
Iftheseinefficienciesarelarge,integratingtheverticallyrelatedfirmsintoasinglecompanymaybelesscostlythanmarkettransactionsbetweenseparatefirms(Coase,1937).Sincethecostsofarm'slengthtransactionsareduetoweaklegalsystemsrenderingcontractsunenforceable,andpropertyrightsthereforeunprotected,reorganizingthebusinessesunderacommonowneralleviatestheseproblems(Alchian,1965).
Assetspecificity,wherebyassetsinplacecannotbereassignedtootheruses,anduncertaintyaboutthevalueofcontractsarefundamentaldeterminantsoftransactioncosts.Assetspecificityoftendependsonaccesstoalternativesuppliersandcustomers.Forexample,afactorybuiltinacitywithinadequateroadandraillinkstoothercitiescanbeatthemercyoflocalsuppliersandcustomerswhodemandchangesinthetermsofcontracts.Butafactoryinacitywithefficienttransportationlinkstoothercitiescandobusinesswithmoredistantsuppliersorcustomersiflocalonesbecometooirksome.Ofcourse,iflocalcustomersandsupplierscanbetrustedtoperformastheyhaveagreed,efficienttransportationlinksarelesscritical(see,e.g.,Joskow,1987).
Thus,ourstartingpointisthatafirmislikelytobemoreverticallyintegrated,ceterisparibus,ifitstransactionsaresubjecttohighperformanceuncertaintyanditislocatedinaregionwithpoortransportationinfrastructure.2.2.Institutionaldeterminantsofverticalintegration
Whileintegrationintoasinglefirmcouldbeasolutiontothesetransactiondifficulties,itsdrawbackisthatextensiveverticalintegrationrenouncesthebenefitsofspecialization(Smith,1776),dilutingmanagement'sfocusandmonitoringincentive(Klein,2014),andeveninducing“territorial”politicalconflictswithinthecompany(MilgromandRoberts,1988).
2.2.1.Legalsystem
Manytransactiondifficultiescanbeavoidediftheperformanceoflocalcustomersandsupplierscanbeguaranteedwitheffectivelegalcontractsthatcanbeenforcedquickly,cheaply,andreliably.Contractsthatclearlylayouteachparty'srightsandPleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
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obligationsineachsetofcircumstancescansubstantiallyreducethefeasibilityandgainsfromexpostbargainingtoextractrents.Reliablecontractingcanalsoreduceshirking,stipulateeffort,governinformationsharing,andpredeterminedegreesofcooperation.Carefullydraftedlegalcontractscanpreciselystipulatelegaldevelopmentandprohibittheirinfringement.Theseconsiderationssuggestthatverticalintegrationshouldbemoreextensiveinfirmslocatedinregionswithweakerlegalinstitutions.2.2.2.Marketforces
Marketforcescanalsodisciplineopportunisticbehavior,renderingintegrationunnecessary.Highlyvisibletransactionsprovidemarketparticipantinformationaboutthebehavioroffirmsandtheirinsiders.Importunateshirking,inadequateperformance,anddisdainforlegaldevelopmentallengenderbadreputationsandwarnawayfuturepotentialbusinesspartners.Acquiringareputationasanopportunist,whorenegesonpromisesandmanipulatesbusinesspartners,canbecomeaseriousliability.Inafreemarket,wherepeoplecanchoosetheirbusinesspartners,anyfirmthatplanstoremaina“going-concern”choosestobehavereliablyandhonorably(KleinandLeffler,1981).
Extensivegovernmentinterventioncanweakenmarketforcesbyforcingfirmstotransactwithpoliticallyfavoredfirms.Forexample,heavy-handedregulationinChinadetersentryintotheelectricitygenerationbusinesstoprotectState-ownedenterprises.Thesesporadicallyrenegeoncommitmentstosupplyelectricity,apracticequiteprevalentinthe1990sandnotunknowninthe2000s—perhapsbecauseofsimpleincompetence,orperhapsinattemptstoextractbribesforreliablepowersupplies.Sincenoalternativepowersuppliersarepermitted,electricityusersmustacceptbehaviorthatcouldnotpersistinanopenandcompetitivemarketforelectricity.
Verticalintegrationcanagainprovideawayout.Thetextilesbusinessdiscussedabove,Weiqiao,optedforverticalintegrationbyconstructinganin-houseelectricityplant.ThecheapesttechnologyoperatedonascalelargerthanWeiqiaorequired,sothefirmfounditselfwithmoreelectricitythanitneeded.Forbiddenfromsellingpower,Weiqiaobeganrefiningaluminumtomakeprofitableuseofitsexcesselectricity.
AluminumsmeltingisnotobviouslyrelatedtoWeiqiao'scoretextileoperations,butrequiresvastamountsofelectricity.Sequentialverticalintegrationofthissortcanlooklikeunrelateddiversification,butisnot.Again,thestate'ssuppressionofmarketforcesisresponsible(Alchian,1965).Suchmulti-stageverticalintegrationwouldmakenosensehadWeiqiaobeenabletosellitssurpluselectricity.
IntheUnitedStates,theseconsiderationsareprimarilyofhistoricalinterest.Forexample,theUnitedStatesretainedwartimepricecontrolsonmanygoodsintotheearlypostWorldWarIIera.Peacetimeeconomicfundamentalsleftsomeofthesepricestoolowtocoverproductioncosts,andcausedfirmstoceaseproducingtheprice-controlledgoods.Thisleftdownstreamusersoftheprice-controlledgoodscontendingwithextremeshortagesofcriticalinputs.Sinceofferinghigherpricesinarm'slengthtransactionswasillegal,customerfirmsmergedwiththeirsuppliers(Stigler,1951).Oneunitoftheverticallyintegratedfirmcouldthencompensatetheotherforitscostswithoutviolatingthepricecontrollaws,sincenoactual“sale”occurredatanyspecifiable“price”.
Butin21stcenturyChina,thesesameconsiderationsarise.Heavy-handedregulationinducesverticalintegrationbothbyunderminingmarketforcesthatotherwisewouldencouragemarkettransactionsbetweenverticallyrelatedfirmsandbyinducingdistortionsthatdisruptintermediategoodsmarkets.Hence,ourthirdhypothesisisthatafirmismorelikelytoadoptaverticalintegrationstrategywheremarketsareheavilyregulatedand/orunderdeveloped.
2.2.3.Theothersideofthecoin
OurconsiderationwillbeincompletewithoutpayingattentiontothecontributioninAlchianandDemsetz(1972)whicharguesthatjointteamproductionfacesameteringproblem:itreferstothechallengeinmeasuringeachinput'scontributionandthusappropriatelyincentivizingandrewardingeachinjointproduction.Anowner–managercanorganizeandmonitortheworkersinafirm,thereforedirectlyhandlingthemeteringproblemandimprovingteamproductivity.Klein(2014)linksthistothetransactioncosttheoryofthefirmandpointsoutthatthemeteringandmonitoringproblemisgreaterthemorecomplicatedisafirm.Verticalintegrationcertainlyraisesafirm'scomplexityandthusthepossibilityofinefficientproduction.
Inotherwords,theconcernsraisedinKleinetal.(1978)areaboutthecostsofusingthemarketforverticallyrelatedactivitiesstemmingfromthebargainingandcoordinationproblemswhichinturnstemmingfromindividualfactorowners'tendencytoextractquasi-rentsandshirk.AlchianandDemsetz(1972)focusontheroleofanentrepreneurandhisfirm,asdefinedinCoase(1937),inovercomingcontractingproblemsarisingfromthemeasurementissue.
However,theentrepreneur'smonitoringcapacityislimitedintherealworld,whichinturnlimitsthesizeofafirm.Moreover,theentrepreneur'sincentiveisalsolimited.IntheAlchianandDemsetz(1972)discussion,theentrepreneurisaresidualclaimant,amanager–ownerwhoimposesnoagencyproblemsonherself.However,inreality,wheremanagementandownershipareoftenseparate,themanager'sobjectivecandeviatefromthatofdiffusedresidualclaimants,inducingcostsofincentivealignment(JensenandMeckling,1976).
InthecontextofChina,SOEmanagers'aresurelynotownersofthefirms,andthereforesubjecttotheincentivealignmentissueandassociatedagencycosts.Likewise,privatelyownedfirmsmayhaveaconcentratedcontrolproblemleadingtoresourceextractionforprivatebenefits.Moreover,themarketandlegalinstitutionsinthecountryaregenerallyweak.Althoughtheweaklegalinstitutionsandmarketforcesraisethecostofusingthemarketandthereforeincreasethebenefitofintegrationbetweenverticallyrelatedbusinesses,theyalsoraisethecostofusinginternalorganizationasimpliedbytheanalysisinAlichianandDemsetz(1972)andKlein(2014).WhethertheChinesefirmsbecomemoreorlessverticallyintegratedinresponsetothecountry'sweakinstitutionsseemstobeanempiricalissue.Addingonemorelayerofcomplexity,ChinaissubjecttounderdevelopedcorporatePleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
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governanceandtheseparationofgovernmentandbusinessisfarfromcomplete.Thereforeverticalintegrationdecisionsofthesefirmscouldbeaffectedbynon-valuepursuingmanagerswhichthenextsectionturnsto.
2.2.4.Politicalconnection
OnerousregulationslimitingtherighttooperateabusinessinChinaleadtoseveralveryimportantadditionalconsiderations.Bureaucrats'powerstoallocatetheserights,andtointerfereinbusinesses'operations,fosteraspecializedclassofrent-seekingfirms,whichgainbusinessopportunitiesbytradingfavorswithbureaucratsandsustaintheircompetitiveadvantagethroughcorporateinsiderswhoonceservedasbureaucrats.
Theserent-seekingfirmsoftenusetheirpoliticalinfluencetoobtainlocalizedstate-enforcedmonopolies.Theywouldthenuseintegrationtoextendthescopeofmonopolypowerbyexpandingthemonopolist'smarketpowerupstreamanddownstream.Thatis,averticallyintegratedfirmmightmagnifythereturnstoitsinvestmentinpoliticalcloutbyforeclosingcompetitioninthoseindustriesaswell.
Suchlocalmonopolistswouldalsooptforverticalintegrationtoavoid“doublemarginalization”(Spengler,1950).Doublemarginalizationariseswhereverticallyrelatedmonopolistsfailtointernalizetheimplicationofone'shighpriceontheother'sprofits,andhencecollectlessmonopolyrentsthaniftheycoordinatetheiractiontomaximizetheirjointprofits.Contractualarrangementsmightachievesuchcoordination,sointegrationisparticularlyappealingwherecontractingoptionsarelimited(Cabral,2000).
StateandPartyofficialsmightwelcomesuchexpandedmonopolies.Corruptofficialsmightcooperateintheirestablishmentforashareofthemonopolyrentscreated,buthonestofficialsmightalsofindthatdealingwithasinglefirmsimplifiessocialengineeringnegotiationswiththebusinesssector.
Theseconsiderationsmotivateourfourthhypothesis:themoredeeplyafirmisconnectedwithofficialbureaucrats,themoreverticallyintegratedisthefirm'sbusinessstructure.
2.2.5.Goodgovernment
Atamoregenerallevel,regulationpersemightwellmatterlessthantheoverallqualityofgovernment.Agovernmentmorerifewithbureaucrats'intentonextractingrents,collectingbribes,orevenexplicitlyexpropriatingprivatepropertywouldmotivatefirmstoinvestmoreheavilyinofficialconnectionsmerelytocope.Moreoversuchanenvironmentraisesthecostsofmarkettransactions,andthusreinforcesfirms'incentivestointegratevertically.Notonlywouldfirmswithextensiveinvestmentsinofficialconnectionsverticallyintegratetoenhancetheirrent-extraction,butpoliticallyunconnectedfirmswoulddothesametoavoidarm'slengthtransactionsinmarketsrendereddysfunctionalbypredatorygovernmentofficials.
Hence,ourfifthhypothesisisthatfirmsaremorelikelytointegrateverticallyinregionswithlowerqualitygovernment.2.2.6.Summary
WethusexpectafirmtobemoreverticallyintegratedifitsmanagersarepoliticallyconnectedandifitliesinaChinaprovinceorspecialdistrictcharacterizedbypoorqualitygovernment,weaklegalsystems,and/orill-developedmarkets.82.3.Verticalintegrationandeconomyperformance
Overall,thisreasoningsuggeststhatcoordinationand(expost)bargainingissuesdeterundiversifiedfirmsfromforminginverticallyrelatedindustries.Whereweakmarketdisciplinaryforcesanddysfunctionallegalinstitutionsmakearm's-lengthcontractsofuncertainvalue,verticalintegrationcanbeanefficientsecondbestsolution.Indeed,thisinsightunderliesRosenstein-Rodan's(1943)viewthatastate-coordinatedBigPushisanecessaryprecursortotherapidindustrializationofadevelopingeconomy.Eveninadevelopedeconomy,verticalintegrationcanbeaneconomicallyrationalresponsetoextensivegovernmentintervention—forexample,Stigler(1983)attributesAmerica'slate-1940smergerwavetofirmscircumventingthecountry'spolicyofcontinuingwartimepricecontrols.TheseconsiderationssuggestthatverticalintegrationmightalsobegrowthenhancinginChina.
However,itisalsopossiblethatverticalintegrationinChinacouldreflectpoliticallyconnectedfirms'successfulrent-seekingaimedataccumulatingmonopolypower—withunclearimplicationsforeconomicefficiencyandgrowth.Ontheonehand,theverticalintegrationofmultiplemonopolists,eachalreadyexistingbydintofpoliticalconnections,couldenhanceefficiency(ShleiferandVishny,1993).9Ontheotherhand,verticalintegrationaimedatbuildingnewmonopoliesorextendingexistingmonopoliesfurtheralongproductchainsworsensinefficiencyand,bysignifyinghighreturnstopoliticalrent-seeking,coulddiscourageeconomicactivityandretardgrowth(Krueger,1974;Murphy,ShleiferandVishny,1991).
OnepossiblesynthesisoftheseconsiderationsmightpositmoreverticalintegrationbeingcorrelatedwithelevatedpercapitaGDPlevelsandgrowthratesifverticalintegrationislargelyatacticusedbypoliticallyunconnectedfirmsseekingtocopewithweakinstitutions,butwiththecorrelationbeingofuncertainsignifverticalintegrationismorecommonlyassociatedwith
KhannaandOberholzer-Gee(2005)findthattheextentofgovernmentinterferenceineachprovincecorrelateswiththeexistenceoflargefirms.Theyarguethateitherpoliticalinterferenceprotectsincumbentsorincumbentsmustattainacertainsizetocombatinterference.9Theargumentisasfollows:ahighwaywithonlyonetollboothgeneratesmoreefficienttrafficpatternsthanasimilarhighwayfeaturingmultipleindependentlyruntollbooths,witheachtollboothownermaximizinghertollrevenues.Acoordinationprobleminthelattercaseleadseachoperatortochargetoohighatoll,resultingininefficientlylowtraffic.
8Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
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politicallyconnectedfirmsamassingmonopolypower.Ifso,wemightpositthatpercapitaGDPshouldbemorepositivelycorrelatedwithverticalintegrationwherefirmsarelesspoliticallyconnected.3.Data,measurement,andbasicstatistics
WeexaminethevalidityoftheabovehypothesesusingChinaasourempiricalsetting.Becauseofsubstantialvariationinboththestrengthofmarketforcesandthequalityofinstitutionsacrossitsregions,Chinaprovidesanaturaltestinggroundfortheseissues.Thisvariation,againstalessheterogeneousculturalbackground,providesauniqueopportunitytoexaminetherolesofmarketandlegalinstitutionsinfirmverticalintegrationdecisions.AnotheradvantageisthatpubliclyavailableinformationletsusidentifywhichChinesefirmsreceivepreferentialtreatmentorare‘connected’withgovernmentofficials.
Thefollowingfirstdescribesoursampleandourmeasureofverticalintegration,andthenexplorespatternsoffirmverticalintegration.3.1.Sample
OursampleincludesmostcompanieslistedontheShanghaiandShenzhenstockexchangesfrom2002to2010.TheChinaSecuritiesRegulatoryCommissionrequiresthatlistedcompaniesdisclosesegmentinformationforallbusinesssegmentscomprisingmorethan10%ofconsolidatedsales,assetsorprofits.Disclosedinformationaboutagivensegmenttypicallyincludesanindustryname,adescriptionofproductsorservices,andsegmentsales.Wemanuallycollectthesedatafromannualreportsstartingin2002,sincefromthatyearoncoverageandreportingqualitysubstantiallyimprove.
Companiesreportingnon-positivesalesorincompletesegmentsalesandindustrysectorinformationaredropped.Financialfirmsareexcludedbecausetheirfinancialstatementsarenotcomparabletothoseofotherfirms.Ourfinalsampleconsistsof1912firmsand11,563firm-yearobservations.Thesamplefirmsaccountforalmost80%oftotallistedcompanies.
Wedefineafirm'sprimaryindustryastheindustryinwhichithasthelargestsales.Ourfirms'primaryindustriesspanthewholeeconomy,withthemostcommonbeingthemachinery,equipment,andinstrumentsector,followedbytheglass,mineralandmetalsector,thepetroleumandchemicalsector,andthecommerce(trade)sector.Table1describesthesamplebyyearandindustry.
Table1
Samplebyyearandindustry.Oursampleconsistsofnon-financiallistedcompaniesinShanghaiandShenzhenStockExchangesfrom2002to2010.Allsuchfirmsareincludedexceptcompaniesreportingnon-positivesalesorincompletesegmentsalesandindustrysectorinformation.PanelA:SamplebyyearYear200220032004200520062007200820092010Total
PanelB:SamplebyindustryIndustry
Agriculture,forestryandfishingMining
Foodandbeverages
Textile,apparelandleather
Lumber,furniture,paperandprinting
Petroleum,chemicals,rubberandplasticproductsGlass,mineralsandmetals
Machinery,equipmentandinstrumentMedicineandbiologicalproductsUtility
ConstructionTransportationCommerceRealestateServicesTotal
Obs.156180042033712551336255968552426347212768511,563
Percentage1.3%1.6%4.7%3.6%2.9%10.9%11.6%22.1%5.9%4.5%2.3%4.1%10.8%7.8%5.9%100%
Obs.9651048110912231208131414871457175211,563
Percentage8.3%9.1%9.6%10.6%10.4%11.4%12.9%12.6%15.2%100%
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx7
3.2.Verticalintegrationproxy
Giventhatdirectfirm-levelverticalintegrationdataareunavailable,wemodifythemethodologyofFanandLang(2000)touseChina'sinput–outputmatrixandourfirm-leveldata,describedabove,toconstructafirm-levelproxyforverticalintegrationintensity.Theconstructionofthisverticalintegrationmeasureinvolvestwosteps.
Inthefirststep,wecreateinter-industryverticalrelatednesscoefficients.Thisinvolvescomputingthecoefficientsbetweeneachpairof122industriesdefinedinthe2002Chineseinput–outputtable.Thetablereports,foreachpairofindustriesiandj,thevalueofinputsfromindustryiusedbyindustryjasafractionofthevalueofindustryj'stotaloutput.Wedenotethisfractionasvij.Eitherahighvijorahighvji,orboth,suggestsopportunitiestointegrateactivitiesiniandjinthesamefirm.Wethereforedefinetheverticalrelatednesscoefficientbetweenindustriesiandjas
Vij¼maxvij;vji:
½1
Inthesecondstep,weconstructafirm-levelverticalintegrationmeasurebycomputingtheweightedaverageverticalrelatednesscoefficientsofeachpairofitssegments,excludingsame-segmentpairs.Todothis,weconstructamatrixofindicatorvariables[δi,j]foreachfirm,settingδi,jtooneifthefirmoperatesinbothindustriesiandj,andtozerootherwise.Wethendefinethefirm'sverticalintegrationmeasureas:
nX1X
¼wiVijδi;j
n−1i¼1
j≠i
Vmax½2
withVi,jdefinedasinEq.(1)andwithwiaweightequaltothesalesofthefirm'ssegmentinindustryi.WedividetheweightedsuminEq.(2)byn−1toaccountforitsmechanicalincreasewiththenumberofsegmentsthefirmcontains.10Foraone-industryfirm(n=1),wesetVmaxtozero.
Anexampleillustrates.HuangshanTourismDevelopmentCo.,Ltd.hasthreesegmentsin2002:touroperation,hotels,andtransportation,accountingfor59%,20%,and21%offirmsales,respectively.Usingtheinput–outputtable,weestimatethattouroperationemploys0.0700ofhotelservicestoproduceoneyuanofoutput,andconverselyhotelsconsume0.0020oftouroperationproductsforeveryyuanofoutputgenerated.Theinter-industryrelatednesscoefficientoftouroperationwithhotels,Vij,isthus0.0700,themaximumofthetwoinputrequirementratios.Similarly,therelatednesscoefficientofhotelswithtransportationis0.0056,andthatoftouroperationwithtransportationis0.0465.Theequationabovethenletsusestimatetheoverallextentofverticalintegrationofthefirm,definedas1/2×[59%×(0.0700+0.0465)+20%×(0.0056+0.0700)+21%×(0.0465+0.0056)],or0.0474.
Inotherwords,afirm'slevelofverticalintegrationisthesales-weightedaverageoftheverticalrelatednesscoefficientsofallpairsofindustriesinwhichthefirmreportssales.
WecalculateVmaxforeachfirmeachyear.Table2summarizestheverticalintegrationmeasure.PanelAshowstheaveragesofVmaxtobe0.0258.Thatis,thefirmspotentiallycouldtransact2.58fen(theChineseunitfor“cent”)ofitsbusinessdealingswithin-houseaffiliates,foreveryyuanofoutputitproduces.Intermsoftimeseries,theaveragedegreeofverticalintegrationisstableovertime.Acrossthe15broadindustries,ourproxyindicatesverticalintegrationtobemostpronouncedinmining,agriculture,forestryandfishing,butislowestinmedicineandbiologicalproducts.
WeareinterestedincomparingtheextentofverticalintegrationbetweenChineseandU.S.firms.Inordertomakethecomparisonwefirstexaminewhetherindustriesinthetwocountriesexhibitsimilardegreesofverticalrelatedness.WefindthatChineseinter-industryverticalrelatednesscoefficientsarehighlycorrelatedwiththosecalculatedfromaU.S.input–outputtable.ThePearsoncoefficientarrivesat0.2andissignificantattheonepercentlevel.Then,wecomparetheverticalintegrationintensityofoursamplefirmswiththatoftheU.S.firmsasreportedinFanandLang(2000).TobeconsistentwiththeFanandLang'sstudy,weredefinetheinter-industryverticalrelatednesscoefficientasVij=1/2(vij+vji)andfocusonprivatelyownedmulti-segmentfirms.ThemeanverticalintegrationintensityfortheChinesefirmsbetween2002and2010is0.0235.FanandLang(2000)reportthattheaverageverticalintegrationintensityofU.S.firmsbetween1979and1997is0.0195.ItappearsthatChinesefirmsinthe2000'saremoreverticallyintegratedthantheU.S.firmsinthe1990s.
Oursisoneoftheseveralpossiblemethodsforconstructingaverticalintegrationindex.Onealternativewoulddistinguishinputintegrationfromoutputintegration.Inputintegration,vij,measuresthefractionofindustryj'sinputsourcedfromindustryi;thatisscalingthe(i,j)entryintheI/Otablebyindustryj'stotalinput.Outputintegrationisthenthefractionofoutputfromindustryiallocatedtoindustryj;thatisscalingthe(i,j)entryintheI/Otablebyindustryi'stotaloutput.Onemightlegitimatelydefineverticalrelatednessineitherway,orastheaverage,minimum,ormaximumoftheinputandoutputmeasures,dependingonthequestionathand.Allthesealternativesgenerateresultsqualitativelysimilartothoseshowninthetables.
ForstudiesusingChineseinput–outputdata,acriticalissueisnoiseduetoendconsumptionandimports.Largeamountofendconsumptionand/orimportswouldinducenoiseintotaloutputwhichisusedasthescalingfactor.Uponconsultingexpertson
Forexample,considerathree-segmentfirmwithone-thirdofitssalesineachindustry.Iftheverticalrelatednesscoefficientsforpairsofthesegmentswereeachone,theweightedsumofeachpairofverticalcoefficientsistwo.Dividingthissumbytwo(threeminusone)rescalestheverticalmeasurebacktoone.Unadjusted,thesumwouldrisewiththenumberofsegments.
10Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
8J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx
Table2
Patternsofverticalintegration.Summarystatisticsbyyearandindustryforthefirm-levelverticalintegrationmeasure.FirmsaremoreverticallyintegratediftheirsegmentslieinindustriesthatsourceorsellmoreextensivelytoeachotherinChina'snationalinput–outputtable.PanelA:VerticalintegrationintensitybyyearYear200220032004200520062007200820092010Total
Obs.965104811091223120813141487145717521,1563
Mean0.02440.02510.02630.020.02670.02580.02670.02660.02440.0258
Median0.01250.01310.01310.01310.01310.01310.01210.01160.00970.0124
Std.dev.0.04880.05040.05170.05190.04940.04980.060.05270.04830.0509
Min.0.00000.00000.00000.00000.00000.00000.00000.00000.00000.0000
Max.0.52990.52990.52990.52990.52990.58810.68370.68370.68370.6837
PanelB:VerticalintegrationintensitybyindustryIndustry
Agriculture,forestryandfishingMining
Foodandbeverages
Textile,apparelandleather
Lumber,furniture,paperandprinting
Petroleum,chemicals,rubberandplasticproductsGlass,mineralsandmetals
Machinery,equipmentandinstrumentMedicineandbiologicalproductsUtility
ConstructionTransportationCommerceRealestateServices
Obs.1561800420337125513362560685524263472127684
Mean0.08430.08600.03910.03860.01930.02620.03260.02320.01780.02460.02370.01320.02500.00780.0209
Median0.03460.02990.01430.01660.00780.01620.00650.00720.00150.01750.02060.01020.02580.00410.0126
China'sofficialstatistics,weareconfidentthatourverticalintegrationindicesarelikelytobelesscontaminatedbytheseproblemsandthusreflectdomesticindustrysourcingfromeachother,scaledbydomesticindustrytotaloutput.113.3.Datacaveats
Ourdataareobservationsofindividualfirms.However,verticalintegrationisaccomplishedbyplacingtwoormoredistinctone-industryfirmsundercommoncontrol.Commoncontrolismostreadilyeffectivebycombiningthesefirmsintoone,butcanalsoariseifagroupofseeminglyindependentfirmscomeunderthedirectorindirectcontrolofasingledominantshareholder(Morck,WolfenzonandYeung,2005).12BecausebusinessgroupsarepresentinChina(Fanetal.,2013)andwecannotidentifyverticalintegrationviabusinessgroupsduetodatalimitations,wemaywellunderestimatetheoverallincidenceofverticalintegration.
Ifintegrationviabusinessgroupisthenorm,weshouldfindnodiscernablerelationshipbetweenindividualfirms'verticalintegrationandourvariousothervariables.Ifintegrationoccursthroughbothmechanisms,andifbusinessgroupssimplyaddnoisetoourvariables,anysignificantfindingsbecomeallthemorecredible.
Ofcourse,ifbusinessgroupformationisgovernedbyunknownfactorsthatinteractinauspiciouslywithourvariables,cleareconometricproblemsarise.DealingwiththeseeffectivelywouldrequirethecompletecategorizationofallgrouptiesamongalllistedChinesefirms.Theconstructionofsuchadatasetlieswellbeyondthescopeofthisstudy;however,wehopetoexplorethisissueinsubsequentresearch.3.4.Focalindependentvariables
Thissectiondescribestheindependentvariablesusedtoproxyforpossibleeconomicdeterminantsofverticalintegration.Someoftheseareprovince-levelvariables.ThePeople'sRepublicofChinaisafederalstatecomposedoftwenty-twoprovinces(shěng,or省),fourprovince-levelmunicipalities(zhíxiáshì,or直辖市),fiveautonomousregions(zīzhìqù,or自治区),andtwo
WethankShuchangQi,deputydirectorofcensuscenterinNationalBureauofStatistics,andShouzhongGe,professorofnationaleconomicstatisticsinShanghaiUniversityofFinanceandEconomics,foransweringourinquiry.12Otheralternatives,suchascross-holdings,interlockingboards,directorappointmentclausesincorporatecharters,andthelikearealsopossible.SeeKhannaandYafeh(2007).
11Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx9
specialadministrativeregions(tèbiéxíngzhèngqū,or特别行政区).OurlistofprovincesexcludesTaiwan,whichthePeople'sRepublicconsidersabreakawaytwenty-thirdprovince.ThemunicipalgovernmentsofBeijing,Tianjin,Shanghai,andChongqingexerciseprovince-levelpowers.Thelegislaturesofthefiveautonomousregions–,Guangxi,Xinjiang,InnerMongolia,andNingxia–exerciseslightlybroaderpowersthanthoseoftheprovinces,andeachcontainssubstantialnon-Hanpopulations.Thegovernmentsofthetwospecialadministrativeregions,andMacau,exercisemanyofthepowersofnationalgovernment,thoughnotforeignaffairsordefense.Thetwospecialadministrativeregionsarenotincludedinoursample.Forsimplicity,weusethetermprovincetorefertoalloftheseincludedregions,whichthePeople'sRepublicclassifiesasprovince-leveladministrativedivisions.
3.4.1.Assetspecificityanduncertainty
Verticalintegrationisaresponsetoassetspecificityanduncertaintyassociatedwitharm'slengthtransactions.Wecaptureassetspecificitywithakeyinstitutionalfeature—thequalityofeachprovince'stransportationinfrastructure,asreflectedinthetotallength,inkilometers,ofrailways,waterways,andhighwaysintheprovincedividedbyitstotalgeographicarea,insquarekilometers.Inadequateregionaltransportationinfrastructurerestrictsparties'abilitytofindalternativebusinesspartners,andsoheightensassetspecificityproblemsbyaggravatingthepotentialforhold-upproblems.Thiselevatesthecostsofmarkettransactions,renderingverticalintegrationmoredesirable.
Wegaugeperformanceuncertaintybyinputpriceuncertainty,asinLieberman(1991)andFan(2000).Wedefinetheinputpriceuncertaintyinayearasthestandarderroroftheresidualsofaregressionofthelogofanindustry'sannualinflation-adjustedprimaryinputpriceindexonatimetrendusingtheprevioustenyeardata.Weemploytheinput–outputtabletoidentifytheprimaryinputofanindustry.Priceuncertaintyofafirmisthefirm'sprimaryindustry'sinputpriceuncertaintyasdefinedabove.Higherpriceuncertaintyshouldraisearm's-lengthtransactioncostsandthereforerenderverticalintegrationmorelikely.
3.4.2.Institutionalfactors
Section2hypothesizesthatverticalintegrationshouldcorrelatewithvariousinstitutionaldeficiencies,suchasweaklegalinstitutions,lowqualitygovernment,andlaggingmarketdevelopment.
OurindexoflegaldevelopmentispublishedbyTheAnnualReportofUrbanCompetitivenessinChina(Li,2002–2010).ResearchersattheChineseAcademyofSocialSciencesurveyasampleofordinarycitizens,entrepreneurs,andscholarsinmultiplecitiestogaugethe“competitivenessofcities”inChina.Thequestionsrelatedtolegaldevelopmentmeasure(i)thelikelihoodthatpropertyrightsareprotected;(ii)theprotectionofintellectualrights;and(iii)thedegreeofcontractenforcementbycourts.Applyingaprincipalcomponentanalysistothesesurveydatacreatesacitylevelindexoflegaldevelopment.Weaggregatethecitylevelindextotheprovincelevelbytakingitsaverageacrossallcitiesineachprovince.
ThemeasureofgovernmentdevelopmentalsocomesfromTheAnnualReportofUrbanCompetitivenessinChina(Li,2002–2010),whichisbasedonthesurveyofmultiplecitiesacrossChina.Therelatedsurveyquestionsinclude(i)thedegreeofbureaucratization;(ii)thefrequencyofgovernmentexpropriation,and(iii)thelevelofcitizensatisfactionwithgovernments.Similarly,aprincipalcomponentanalysisisappliedtocreateacitylevelindexofgovernmentdevelopment.Weaggregatethecitylevelindextotheprovincelevelbytakingitsaverageacrossallcitiesineachprovince.
Finally,werequireageneralmeasurecapturingtheextenttowhichintermediategoodsareallocatedbymarketsratherthanbybureaucrats.Unfortunately,suchameasureisnotavailable.Wethereforesubstituteaproxy:theimportanceofemploymentintheprivatesectorasopposedtothestatesector.Specifically,ourmarketdevelopmentproxyisthepercentageofworkersintheprovinceofficiallyregisteredasemployedintheprivatesector–thatis,registeredasemployedinprivateenterprisesorasself-employedindividuals(gètíhùor个体户)–ratherthanasemployeesofstate-ownedenterprisesorstateandPartyorgans.ThesedataarefromTheIndexofMarketizationofChina'sProvinces,ascompiledbyFan,WangandZhu(2002–2010).Theindexmeasuresmarketdevelopmentineachprovincebyyear.Weexpectthatahighdegreeofprivatesectoremploymentisassociatedwithavibrantgeneralmarketactivity.
3.4.3.Rent-seekingpotentialandpoliticalconnections
Section2alsopointsoutthatverticalintegrationmightbemotivatedbyrent-seeking.Wethereforeconstructasetofpoliticalconnectionvariablestocapturefirms'potentialreturnstopoliticalrent-seeking.
FollowingFanetal.(2007),ourfirstpoliticalconnectionvariableisapparatchikCEO,anindicatorvariablesettooneifafirm'sCEOis,orhasbeen,astateorCommunistPartyofficialofthecentralgovernment,theregionalgovernment,oranindustrybureau.
Oursecondmeasure,businessprivilege,alsoanindicatorvariable,issettooneifanyofthefirm'slinesofbusinessisaheavilyregulatedsector(utilities,postalservices,communication,railroadtransportation,airtransportation,mining,metals,orfinance)andtozerootherwise.InChina,therighttooperateinthesesectorsishighlyrestricted,andmustbegrantedbytheState.
WesurmisethatcorporateinsiderswithPartyorgovernmentbackgrounds,orwhoobtainedtherighttooperateinaheavilyregulatedindustry,arelikelytobepoliticallyconnected.Wethereforetakethesetwovariablesasreflectingpoliticalrent-seekingability.Weassumethatsuchabilityopensfurtherpoliticalrent-seekingopportunities,andhenceprovidessuperioraccesstobusinessopportunities.
Ourthirdproxyforpoliticalconnectionislong-termleverage,measuredbyeachfirm'slong-termdebtoveritstotalassets.Sapienza(2004),KhawajaandMian(2005),andAllenetal.(2005)arguethatpoliticallyconnectedfirmshavebetteraccesstoPleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
10J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx
bankfinancingingeneral.BecauseChina'sbanksareallstate-controlled,thisbiasisquitelikelyevenstrongerthere.Wethereforesetanindicatorvariablehighleveragetooneifafirm'slong-termdebtovertotalassetsisabovethemedianforallfirmsinthatprovince,andtozerootherwise.Acaveatisinorderhere,however,forthisvariablehasapotentialalternativeinterpretation—betteraccesstocapitalfacilitatesacquisitions,includingacquisitionsofverticallyrelatedfirms.
3.4.4.Othercontrols
Weconsiderseveralmorevariablesascontrols.First,largerfirmsmightbemoreverticallyintegratedthansmalleronessimplybecausetheyarelarger.Forexample,economiesofscaleinacorelineofbusinessmighttranslateintosimilareconomiesinsecondaryandtertiarylinesofbusiness,renderingverticalintegrationlesscostly.Wegaugefirmsizebythenaturallogofthefirm'stotalassets.
YoungfirmsmightbemoreverticallyintegratedthanoldfirmsbecauseittakestimetoestablishexchangerelationshipsinChina'semergingmarketplace.Oryoungfirmsmightbemoreverticallyintegratedifformerlyfullystate-ownedenterprisesarehighlyverticallyintegratedattheirIPOs,andacquiremorefocussubsequently.Tocontrolforeithereventuality,wemeasurefirmagebythenumberofyearsthefirmhasbeenlisted,anddenotethisasyearslisted.
Wealsoincludeprovincialpercapitagrossdomesticproduct(GDP)toaccountfortheeffectsofregionaleconomicconditionsonfirmorganizationalstructure.Thiscontrolalsomitigatesthepossibilitythatourtransportationinfrastructureandinstitutionalvariablesmightproxyforgeneralprovince-leveldevelopment.
Table3summarizesthedefinitionsanddatasourcesforthesevariables.3.5.Descriptivestatistics
Table4reportsbasicdescriptivestatisticsacrosspooledobservationsforeachvariable.Thenumberofobservationsdiffersacrossvariablesbecausesomeareprovince-levelwhileothersareindustry-orfirm-level.SubstantialvariationininstitutionalqualityacrossChina'sregionsisconfirmedbythesubstantialstandarddeviationsoftheprovince-levelinstitutionalvariables.
Table5reportsPearsoncorrelationcoefficientsbetweenpairsoftime-serialmeanvariablesofinterest.Verticalintegrationcorrelatespositivelywithpriceuncertainty,andnegativelywithtransportationinfrastructure.Verticalintegrationalsocorrelatesnegativelywithinstitutionalstrength,asmeasuredbyourprovince-levellegal,government,andmarketdevelopmentindexes.Verticalintegrationsignificantlycorrelatespositivelywithallthreemeasuresofpoliticalconnection.Thesefindingsleavescopeforallthedriversofverticalintegrationconsideredabove.
Finally,thetablewarnsofpotentialmulticollinearitybetweenthetransportationinfrastructurevariableandlegaldevelopment(ρ=0.727),governmentdevelopment(ρ=0.607),marketdevelopment(ρ=0.655)andalsotheprovinciallevelGDPpercapita(ρ=0.787).Likewise,percapitaGDPalsocorrelatessignificantlypositivelywithlegaldevelopment,
Table3
Definitionofvariables.VariableLegal
developmentGovernmentdevelopmentMarket
developmentApparatchikCEO
Definition
Datasource
TheannualreportonurbancompetitivenessinChinaTheannualreportonurbancompetitivenessinChina
TheindexofmarketizationofChina'sprovincesFanetal.(2007)Corporateannualreports
Anindexmeasuring(i)thelikelihoodthatpropertyrightsareprotected;(ii)theprotectionofintellectualrights;and(iii)thedegreeofcontractenforcementbycourts.
Anindexmeasuring(i)thedegreeofbureaucratization;(ii)thefrequencyofgovernmentexpropriation,and(iii)thelevelofcitizensatisfactionwithgovernments.
Anindexmeasuringthepercentageofemploymentinprivateenterprisesorself-employedindividuals.
Anindicatorsettooneifthefirm'sCEOisnoworhaseverbeenabureaucratofthecentralgovernment,alocalgovernmentoranindustrybureau;andtozerootherwise.
BusinessprivilegeAnindicatorsettooneifthefirmoperatesinaheavilyregulatedindustry(utilities,postalservices,
communication,railroadtransportation,transportationbyair,mining,metals,orfinance);andtozerootherwise.
HighleverageAnindicatorsettooneifthefirm'stotaloutstandinglong-termloansexceedthemedianlevelforall
firmsintheprovince,andtozerootherwise.
PriceuncertaintyThestandarderroroftheresidualsofaregressionoflogofthefirm'slargestsegment'sprimaryinput
priceonatimetrendovertheprevioustenyears.
TransportationTotallengthofallhighway,railway,andwaterwayintheprovinceinkilometersdividedbyitstotalinfrastructuregeographicareainsquarekilometers.FirmsizeThenaturallogarithmoffirmassets.YearslistedThenumberofyearssincethefirm'sIPO.PercapitaGDPTheprovince'spercapitaGDPintensofthousandsofyuan.PercapitaGDPTheannualgrowthrateofpercapitaGDP.growthCapitalThenaturallogarithmofcumulativeannualcapitalinvestment,estimatedfromaperpetualinventory
modelwith7%depreciationrate,intheprovincefrom1984.
EducationThefractionoftheprovince'spopulationabletoreadandwrite.
aCSMARaChinaPriceYearbookChinaStatisticalAlmanacCSMAR
CSMAR
ChinaStatisticalAlmanacChinaStatisticalAlmanacChinaStatisticalAlmanacChinaStatisticalAlmanac
CSMARisChinaStockMarket&AccountingResearchDatabase,developedbyShenzhenGTAInformationTechnologyCo.,Ltd.
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx11
Table4
Descriptivestatisticsofvariables.VariablesaredefinedinTable3.Samplesforfirm-levelvariablesare11,563firm-yearobservationsfor1912firmsfrom2002to2010.Province-levelvariableshaveupto279province-yearobservationsover31provincesfrom2002to2010.Priceuncertaintyisanindustry-levelvariablewith848industry-yearobservationson111industriesfrom2002to2010.Variable
Assetspecificity&uncertaintyPriceuncertainty
TransportationinfrastructureInstitutionaldevelopmentLegaldevelopment
GovernmentdevelopmentMarketdevelopmentPoliticalconnectionApparatchikCEOBusinessprivilegeHighleverage
OthervariablesFirmsizeYearslistedPercapitaGDP
PercapitaGDPgrowthCapitalEducation
Obs.848279
Mean0.16070.6532
Median0.17280.5337
Std.dev.0.06270.4746
Min.0.00750.0326
Max.0.25032.3585
2792792790.560.557.42220.700.62307.45000.11100.23063.24300.42400.09800.34001.00001.000014.6500
11,56311,56311,5630.12520.20380.50160.00000.00001.00000.33100.40280.50000.00000.00000.00001.00001.00001.0000
11,56311,56327927927927921.328.78011.97580.14949.25040.1221.28299.00001.49330.14809.39020.91361.19234.31441.50930.09231.03320.078610.84221.00000.3153−0.20665.63070.451428.135721.00009.49200.451411.33510.9725
governmentdevelopment,andmarketdevelopment.Werevisitthesecorrelationsbelowwhenwediscussourmultipleregressions.
4.Empiricalresults
4.1.Verticalintegrationanditsdeterminants
Wenowturntomultipleregressionsthatcontrolforotherfactorsthatmightaffectverticalintegration.Weruntheseonpooledfirm-yeardata.Ourprovincelevelvariablesexhibitnovariationacrossfirmswithineachprovince.Likewise,wehaveindustry-levelvariablesthatexhibitlittleornovariationacrossfirmsineachindustry.Finally,someofourfirmlevelvariablesmaywellexhibitlittlevariationthroughtime.Toavoidupwardbiasedt-statistics,weemploystandarderrorsclusteredbyfirmandyearthroughout,asrecommendedbyPetersen(2009).
ThevaluesofourverticalintegrationmeasuresVmaxareboundedbelowbyspikesofobservationsatzero—presumablybecausesomefirmsdecidethenetcostsofoperatinginmultipleindustriesalongthevaluechainoutweighthenetbenefitsofspecialization.Toresolvethisdatacensorproblem,weemployTobitregression.Table6reportstheregressionresults.
ThefirstcolumninTable6,denotedasregression6.1,revealspriceuncertaintysignificantlypositivelycorrelatedwithverticalintegrationintensity.Further,thecoefficientoftransportationinfrastructureissignificantlynegative,suggestingthataweaktransportationsystemcorrelatessignificantlywithgreaterverticalintegration.Weinterpretthispatternasconsistentwithgreaterverticalintegrationoccurringwhereassetspecificityanduncertaintyproblemsposegreaterthreatstooverlyspecializedfirms.
Thesecondpatternisevidentinregressions6.2through6.5,whichallshowmoreextensiveverticalintegrationinprovinceswithworselegalprotectionforprivatepropertyrights,worsegovernment,andlessdevelopedmarketeconomies.Theseinstitutionalvariablesareclearlyeconomicallysignificanttoo.Forexample,basedonregression6.2,settingalltheindependentvariablesattheirmeans,a10%improvementinthepropertyrightsreducesverticalintegrationby7.73%,almost1.52timeslargerthanthestandarddeviationoftheverticalintegrationmeasure.Similarly,a10%improvementin“governmentquality”reducesverticalintegrationby4.77%.Marketdevelopmenthasasimilareconomicsignificance,anda10%improvementreducesverticalintegrationby5.08%.
Wetakethispatternasconsistentwithatransactioncostexplanationofverticalintegration:itletsfirmscircumventweakinstitutionsthatrenderprivatetransactionsproblematic.
ThethirdpatternevidentinTable6pertainstoourmeasuresofpoliticalconnections.BecauseTable5showsthethreeproxiesfor“connections”significantlycorrelatedwitheachother,Table6presentsseparateregressions–6.3,6.4,and6.5–includingeachpoliticalconnectionproxyinturn,ratherthanasingleregressionincludingallthree.Thepoliticalconnectionvariables,apparatchikCEO,businessprivilegeandhighleverage,areallsignificantlypositivelycorrelatedwithverticalintegration.Politicalconnectionshaveveryhigheconomicimpact.Forexample,switchingafirm'sCEOfromnotbeingapriorgovernmentbureaucrattobeingoneincreasesverticalintegrationby40.45%.Weinterprettheseresultsasconsistentwithpoliticallyconnectedfirmsbeingmoreverticallyintegratedduetorentseeking.
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
12J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx
Table5
Pearsoncorrelationofcoefficients.ThevariablesaredescribedinTable3.Numbersinparenthesesarep-levelsforrejectingzerocorrelation.Allcorrelationsofvariablesareoftime-seriesmeans.
Vmax1
2
3
4
5
6
7
8
9
10
11
12
13
Assetspecificityanduncertainty1Priceuncertainty0.0518
(0.02)
2Transportation−−
infrastructure0.06080.0056
(0.01)(0.80)Institutionaldevelopment3Legaldevelopment−
0.1007(0.00)
4Government−
development0.1044
(0.00)
5Market−
development0.0980
(0.00)Politicalconnection6ApparatchikCEO
−
0.0117(0.61)−
0.0384(0.09)−
0.0321(0.16)
0.7274(0.00)
0.60710.7025(0.00)(0.00)
0.65530.84900.6653(0.00)(0.00)(0.00)
7Businessprivilege
8Highleverage
0.04690.0462−
(0.04)(0.04)0.0909
(0.00)
0.12090.2797−
(0.00)(0.00)0.1278
(0.00)
0.080.10740.0003(0.00)(0.00)(0.99)
−
0.0923(0.00)−
0.1433(0.00)−
0.0072(0.75)
−
0.0928(0.00)−
0.1084(0.00)0.0087(0.70)
−
0.1010(0.00)−
0.1393(0.00)−
0.0047(0.84)
0.0508(0.03)
0.00270.2187(0.90)(0.00)
Othervariables9Firmsize10Yearslisted
11PercapitaGDP
12PercapitaGDP
growth13Education
14Capital
0.4320(0.00)−
0.0214(0.35)
−−0.00140.10940.1247(0.95)(0.00)(0.00)
−−−−−−0.03820.08720.04410.26230.25060.06680.20430.0376(0.09)(0.00)(0.05)(0.00)(0.00)(0.00)(0.00)(0.10)
−0.00200.33810.32350.29700.3011−−−
0.0232(0.93)(0.00)(0.00)(0.00)(0.00)0.02700.03360.0010(0.31)(0.23)(0.14)(0.96)−−0.58220.78530.68760.7466−−0.00680.07220.0348(0.00)(0.00)(0.00)(0.00)0.12450.1063(0.76)(0.00)(0.13)(0.00)(0.00)
0.1063(0.00)−
0.0183(0.42)−
0.0405(0.07)0.0027(0.90)
0.1453(0.00)0.0962(0.00)
0.0990(0.00)−
0.1330(0.00)
0.00080.7874(0.97)(0.00)0.0294(0.20)−
0.2271(0.00)0.7087(0.00)0.0286(0.21)−
0.3133(0.00)0.56(0.00)0.0298(0.19)−
0.2800(0.00)0.7300(0.00)
0.06(0.00)0.1663(0.00)0.3001(0.00)0.0282(0.21)
0.0232(0.31)
0.1408−
(0.00)0.1913
(0.00)
−−
0.01990.2277(0.38)(0.00)0.1260−
(0.00)0.0617
(0.01)
0.0340−
(0.14)0.3293
(0.00)
−
0.3834(0.00)0.4914(0.00)0.5012(0.00)
−0.2421(0.00)−0.0623(0.01)
0.4149(0.00)
Table6showsthatthecoefficientontransportationinfrastructurebecomesinsignificantafterincludinglegal,governmentandmarketdevelopmentmeasures.Thismightbecausedbyhighcorrelationbetweentransportationinfrastructureandinstitutionvariables.Totheextentthattransportationinfrastructureispoorinunderdevelopedregions,thevariablemaycapturetheregionalinstitutionalenvironmentinsteadoftransactiondifficultiesfromassetspecificity.
AllthespecificationsinTable6controlforthepercapitaGDPoftheprovinceinwhichthefirmisbased.Thiscontrolissignificantlypositive,indicatingthatfirmsaremoreverticalintegratedintheregionsofhigherlivingstandards.Further,theresultsshowthatlargerfirmsaremoreverticallyintegratedthansmallerones,butolderfirmsarelessverticallyintegratedthanyoungerones.
5.Robustness
Asrobustnesschecks,weapplyaninverselogistictransformationtoourverticalintegrationmeasure,mappingVmaxintoVmax′=ln[1/(1−Vmax)].WethenregressthetransformedmeasureonthevariablesintheTable6,usingeitheraTobitorleastsquaresregression,againwithstandarderrorsclusteredbyfirmandyear,andagaingetsimilarresultstothoseshown.
Theinput–outputstatisticsofthe“wholesale”and“retail”sectorsareaggregatedandlabeled“commerce”inTable2.Theseinputandoutputflowsmaybeexcessivelyaggregated,andthusqualitativelydifferentfromothersectors(Acemogluetal.,2009;Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx13
Table6
Tobitregressionsofdeterminantsofverticalintegration.Tobitregressionsexplainverticalintegrationwithpriceuncertaintyinthefirm'sprimaryindustry,thequalityofthetransportationinfrastructureoftheprovinceinwhichitislocated,province-levelindexesoflegaldevelopment,governmentdevelopment,andmarketdevelopment,ourapparatchikCEOdummyforapoliticallywell-connectedCEO,ourbusinessprivilegeindicatorthatthefirmoperatesinaheavilyregulatedsector,ahighleverageindicator,firmsize(logoftotalassets),yearslisted(yearssincethefirm'sIPO),andthepercapitaGDPofthefirm'sprovince.Afirmisassumedtobelocatedintheprovincecontainingitsheadoffice.Standarderrorsareclusteredatthefirmandyearlevel,withZstatisticsareinparentheses.One,two,orthreeasterisksdenotesignificanceat10%,5%and1%levels,respectively.Regression
Assetspecificity&uncertaintyPriceuncertainty
Transportationinfrastructure
6.1
0.0432***(4.20)
−0.0080***(4.07)
6.20.0458***(4.46)−0.0027(1.30)
6.30.0467***(4.)−0.0027(1.27)
6.40.0280***(2.70)−0.0017(0.83)
6.50.04***(4.42)−0.0026(1.24)
InstitutionaldevelopmentLegaldevelopmentGovernmentdevelopmentMarketdevelopment
−0.0181**(2.15)
−0.0122***(2.85)
−0.0010***(3.31)−0.0183**(2.18)
−0.0116***(2.70)
−0.0010***(3.30)−0.0183**(2.18)
−0.0138***(3.22)
−0.0009***(2.92)−0.0184**(2.19)
−0.0117***(2.73)
−0.0011***(3.38)
PoliticalconnectionApparatchikCEOBusinessprivilegeHighleverage
0.0058***(3.06)
0.0160***(9.91)
0.0047***(3.53)
OthercontrolsFirmsizeYearslistedPercapitaGDP
ClusterbyfirmandyearObservationsLoglikelihood
0.0043***(7.87)−0.0003*(1.71)0.0003(0.59)Yes11,56382690.0043***(7.78)−0.0002(1.32)0.0017***(2.85)Yes11,56382930.0042***(7.65)−0.0002(1.40)0.0018***(2.93)Yes11,56382980.0027***(4.80)−0.0002(1.14)0.0019***(3.11)Yes11,56383420.0035***(5.98)−0.0002(1.44)0.0018***(3.00)Yes11,5638299
FanandLang,2000).Asafurtherrobustnesscheck,wethereforereestimateourregressionsexcludingthesesectors.Thiscutsabout1250firm-yearobservationsfromthepanel,butyieldsqualitativelysimilarresultstothoseshown.
Tocontrolforpanelpersistence,weclusterresidualsbyfirmandtime.Anextremelyconservativerobustnesscheckcollapsesour2002through2010panelintoasinglecross-sectionoftime-seriesaverages.RunningregressionsanalogoustothoseinTable6onthiscross-section,Table7revealsqualitativelysimilarresultstothoseshown,exceptthatthe“legaldevelopment”variablebecomesinsignificant.
Overall,weinterprettheseresultsasconsistentwithverticalintegrationbeinglinkedtoassetspecificityandpriceuncertainty,andwiththesefactorsencouragingverticalintegrationasanorganizationalresponsetoweakpropertyrightsprotection,poorqualitygovernment,andill-developedmarketeconomies.Theseresultsarealsoconsistentwithalinkbetweenverticalintegrationandpoliticalrent-seeking.
5.1.Verticalintegrationandeconomyperformance
Wenowexaminetherelationshipbetweenverticalintegrationandregionaleconomydevelopment.Verticalintegrationasasecondbestresponsetoarm'slengthtransactiondifficultiesamidaweaklegalsystemandweakmarketforcescouldcorrelatewithelevatedpercapitaGDPlevelsandgrowthrates.Incontrast,verticalintegrationundertakentomagnifythereturnstopoliticalrent-seekinghasalesscertainimpact.Asafirstpassinvestigationofthisissue,weturntoasetofprovincelevelregressions.
Wefirstclassifyeachfirmaseitherpoliticallyconnectedornotaccordingtoeachofourthreepoliticalconnectionindicatorvariables—havinganapparatchikasaCEO,operatinginarestrictedindustry,andobtaininghigherthanmedianleveragefromstatebanks.Nextwecalculatetheaveragevalueofourverticalintegrationmeasureacrossallpoliticallyconnectedfirmsineachprovince.Thisyieldsthreemeasuresoftheintensityofverticalintegrationamongpoliticallyconnectedfirmsineachprovince,oneforeachofourpoliticalconnectionvariables.Wethenrepeatthisprocedureforpoliticallyunconnectedfirms,andobtainthreeanalogousmeasuresoftheintensityofverticalintegrationamongpoliticallyunconnectedfirmsineachprovince,oneforeachofourpoliticalconnectionvariables.Wedothisforall31provinceseachyearfrom2002to2010.
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
14J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx
Table7
Cross-sectionregressionsofdeterminantsofverticalintegration.TobitregressionsinTable6arerepeatedonasinglecross-sectionofdata,constructedbytime-averagingthepanelofdatafrom2002to2010usedinTable6.Variablesareasinthattable,andaredefinedindetailinTable3.Zstatisticsareinparentheses.One,two,orthreeasterisksdenotesignificanceat10%,5%and1%levels,respectively.Regression
Assetspecificity&uncertaintyPriceuncertainty
Transportationinfrastructure
7.1
0.0637**(2.31)−0.0062(1.50)
7.2
0.0629**(2.30)0.0002(0.04)
7.3
0.0617**(2.26)0.0003(0.06)
7.40.0351(1.25)0.0005(0.11)
7.5
0.0601**(2.20)0.0003(0.07)
InstitutionaldevelopmentLegaldevelopmentGovernmentdevelopmentMarketdevelopment
−0.0125(0.44)−0.0267***(3.29)−0.0014*(1.71)−0.0131(0.46)−0.02***(3.26)−0.0014*(1.73)−0.0102(0.36)−0.0267***(3.30)−0.0013*(1.69)−0.0132(0.46)−0.0269***(3.32)−0.0014*(1.75)
PoliticalconnectionApparatchikCEOBusinessprivilegeHighleverage
0.0104*(1.87)
0.0147***(3.84)
0.0078*(1.95)
OthercontrolsFirmsizeYearslistedPercapitaGDPObservationsLoglikelihood
0.0056***(4.75)0.0008***(2.66)−0.0015(1.21)191219420.0052***(4.36)0.0002(0.71)0.0005(0.33)191219570.0050***(4.22)0.0002(0.46)0.0006(0.43)191219580.0038***(3.04)0.0003(0.88)0.0008(0.57)1912190.0041***(3.09)0.0002(0.75)0.0006(0.44)19121959
Ourleft-handsidevariablemeasureseconomyperformanceaseitherannualpercapitaGDPlevelorannualpercapitaGDPgrowth.Weregresstheseontheintegrationintensityoftheprovince'spoliticallyconnectedandunconnectedfirmsandonourinstitutionalvariables—legaldevelopment,governmentdevelopment,andmarketdevelopment.FollowingPetersen(2009)weclusterthestandarderrorsbyprovince.
Wesupplementthesewithafewothercontrols.Physicalandhumancapitalareknowntobeafirst-orderdeterminantsofeconomicgrowth(see,e.g.,BarroandSala-i-Martin,1995).Wemeasureaprovince'sphysicalcapital,denotedascapital.Toestimatecapital,weuseaperpetualinventorymodelthatsumstheannualprovincialcapitalinvestmentfrom1984withadepreciationrateof7%.13Humancapitalismeasuredasthefractionofeachprovince'spopulationclassifiedbytheNationalBureauofStatisticsofChinaas“literate”,whichisdenotedaseducation.Standardgrowththeoryalsoimpliesaconvergenceeffect:economieswithlowerinitiallevelsofpercapitaGDPcangrowfasterthanthosealreadysustaininghighincomes(BarroandSala-i-Martin,1995).WethereforeincludethelogarithmoflaggedpercapitaGDPasacontrolvariableinourgrowthregressions.
Table8displaystheresults.TheverticalintegrationamongpoliticallyunconnectedfirmsattractspositivecoefficientsintheregressionsofbothpercapitaGDPlevelandgrowth,buttheverticalintegrationamongpoliticallyconnectedfirmsgeneratesinsignificantcoefficients.
Theseresultsareeconomicallysignificanttoo.ConsidertheGDPgrowthregressionusinganapparatchikCEOtogaugepoliticalconnection.Allelseequal,aprovincewhoseapparatchik-freefirmshaveameanverticalintegrationintensityone-standarddeviationgreaterreaps0.extrapercentagepointsofadditionalpercapitaGDPgrowthannually.Theeffectisclearlylargeenoughtomatter,almostfourpercentofthemeanGDPgrowthrate.
Theseresultsarerobust.Weusemedianstogenerateourverticalintegrationintensitymeasures,andourfindingsarequalitativelyunchanged.Employingasset-weightedmeansgeneratesqualitativelysimilarresults.
Althoughwefindthatthepositiveassociationbetweenverticalintegrationandeconomicvalueconcentratesinpoliticallyunconnectedfirms/regions,somecaveatsariseindrawingconclusions.First,ourdataareforlistedfirms,whichaccountforonlyafractionofprovincialeconomicoutput.Second,weleavethedirectionofcausalityunproveninthatbotheconomygrowthandverticalintegrationmightbeendogenouslydeterminedbylatentfactors.Thus,whileouranalysissuggeststhatverticalintegrationamongpoliticallyunconnectedfirmshasapositiveassociationwithlocaleconomydevelopment,theresultcouldreflectomittedfactorsandthereforebeopentootherinterpretations.
ThecalculationformulaisCapitali,t+1=Capitali,t+Ii,t−δCapitali,t,whereIi,tisannualcapitalinvestmentforprovinceiinyeart,andδisadepreciationrateof7%followingKingandLevine(1994)andFogel,MorckandYeung(2008).
13Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx15
Table8
Regressionsofeconomyperformanceonverticalintegration.DependentvariablesareeitherprovincialpercapitaGDPlevelorgrowthrate.Connectedfirmsaredefined,alternatively,byhavingpoliticalapparatchiksasCEOs,operatinginrestrictedindustries,orhavingabovemedianloansfrombanks.Verticalintegrationintensityamongpoliticallyconnectedfirmsisthemeanvalueofverticalintegrationofpoliticallyconnectedfirmsineachprovince.Verticalintegrationintensityamongpoliticallyunconnectedfirmsisdefinedanalogously.Legal,government,andmarketdevelopmentaredefinedasinTable3,capitaliscumulativeannualcapitalinvestmentfrom1984withadepreciationrateof7%,educationisliteratepopulationasafractionofthetotal,andpercapitaGDPdenotestheregionalpercapitaGDP.Standarderrorsareclusteredattheprovincelevel,withTstatisticsinparentheses.One,two,orthreeasterisksdenotesignificanceat10%,5%and1%levels,respectively.Regression
Connectiondefinedas:Performancedefinedas:
Verticalintegration
IntensityamongconnectedfirmsIntensityamongunconnectedfirms
8.1
ApparatchikCEOGDPlevel0.0662(0.10)5.2742***(3.09)
GDPgrowth−0.0022(0.03)0.3434**(2.45)8.2
8.3
BusinessprivilegeGDPlevel0.4207(0.36)3.6158*(1.86)
GDPgrowth0.0076(0.07)0.3778**(2.61)8.4
8.5
HighleverageGDPlevel0.0686(0.08)6.1610***(3.07)
GDPgrowth−0.0513(0.44)0.5952**(2.26)8.6
InstitutionaldevelopmentLegaldevelopmentGovernmentdevelopmentMarketdevelopment
0.4934(1.13)0.48**(2.07)0.1288***(5.39)−0.0232(0.39)0.0323(1.53)0.0052*(1.78)0.5003(1.13)0.5065**(2.14)0.1256***(5.25)−0.0188(0.31)0.0346(1.56)0.0050(1.69)0.4384(1.03)0.5041**(2.25)0.12***(5.34)−0.0274(0.46)0.0333(1.51)0.0051*(1.78)
ControlsCapitalEducationPercapitaGDPObservationsAdjustedR2−0.0483(0.57)1.7360(1.36)
2790.70
0.0018(0.27)0.0490(0.90)−0.0211***(3.74)2790.05
−0.0372(0.44)1.6682(1.30)
2790.69
0.0019(0.28)0.0452(0.81)−0.0210***(3.)2790.05
−0.0371(0.47)1.5687(1.30)
2790.70
0.0024(0.41)0.0351(0.70)−0.0213***(3.90)2790.06
6.Conclusions
PatternsofverticalintegrationinChinacorrespondwelltolikelyregionaltransactioncostdifferences.Firmsaremoreverticallyintegratedinprovinceswithweakerpropertyrightsprotection,worsegovernment,andlaggardmarketreforms.Theseobservationsareconsistentwithverticalintegrationbeingusedtoovercometransactiondifficultieswherepropertyrightsprotectionandmarketdisciplinaryforcesareweak.Theyarealsoconsistentwithverticalintegrationbeingusedtoovercomeimpedimentstodoingbusinessposedbyoverlybureaucraticgovernmentsthataredisinclinedtorespectprivatepropertyrights.Theseresultspersistaftercontrollingforlocaltransportationinfrastructure,inputpriceuncertainty,firmsize,ageasalistedfirm,andregionaleconomicdevelopment.
Firmswhosemanagershaveclosertiestobureaucratsarealsomoreverticallyintegrated.Provinceswheremarketinstitutionsareweakarelikelyalsoplaceswherepoliticalrent-seekingpaysahighreturn.Ifpoliticalrent-seekinghelpsfirmsgainstateenforcedmonopolypower,rent-seekersshoulddirecttheirlobbyingtowardsgainingverticallyintegratedmonopolies.Thisisbecauseaverticallyintegratedmonopolycanextractunambiguouslyhigherprofitsthanastringofverticallyrelatedsingle-marketmonopolies(Spengler,1950).Thissuggestsalesslaudableuseofverticalintegrationtomagnifythereturnstopoliticalrentseekingbyforeclosingcompetitionalongbroaderswathesofavaluechain.
OurfurtherfindingisthatmoreextensiveverticalintegrationinpoliticallyunconnectedfirmsisassociatedwithelevatedprovincialGDPlevelsandgrowthrates,whilemoreextensiveverticalintegrationinpoliticallyconnectedfirmsisnot.Thesefindingssupportthepropertyright(Alchian,1965)andtransactioncosts(Kleinetal.,1978)explanationsofverticalintegration.ButtheyalsopointtoaparallelpoliticaleconomyexplanationofverticalintegrationthatisrelevantinChina.Ourfindingofnoimprovementinprovincialeconomyperformancewhereverticallyintegratedfirmsarepoliticallyconnectedsuggeststhisalternativepossibilityatleastbetakenseriously.
Furtherworkisneededtotestthispossibilitymorethoroughlyanddiscountalternativeexplanationsofourfindings,andnumerouscaveatsapply.Certainly,China'sexperiencemay,butneednot,extendtoothereconomies.Nonetheless,theevidencehereprovidesabenchmarkforcomparisonwithotheremergingandtransitioneconomieswithsimilarinstitutionalasthenia.
InChina,successivereformsareprogressivelyseparatingbusinessfromgovernment,butatmarkedlydifferentpacesindifferentprovinces.Wherethatseparationisleastadvanced,stateandPartyofficialsarealsofreesttopreyuponprivatebusinesses.Perhapstheonlyviablebusinessesinsuchregionsarethoserunbythepotentialpredators,eitherdejureviadirectstatecontrolordefactoviatheircronies.
Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
16J.P.H.Fanetal./JournalofCorporateFinancexxx(2014)xxx–xxx
Sincethemostpoliticallyconnectedmaynotbethemostcreativeentrepreneurs,growthintheseregionsmaywellbetriplyimpeded—byweakinstitutionsforcinggreaterverticalintegration;byentrustingcorporatedecision-makingtothepoliticallyconnected,ratherthanthemostableentrepreneurs;andbylargeverticallyintegratedmonopoliescapableofinflictingworseoverallwelfarelossesthanseparatesingle-marketmonopoliescouldmanage.Thepotentialcostsofsuchathreefoldself-reinforcingdragoneconomicgrowthshouldbeofconcerntoChinesepolicy-makersifincreasinginterregionalinequalityisviewedasapotentiallyserioussourceofsocialinstability.References
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Pleasecitethisarticleas:Fan,J.P.H.,etal.,InstitutionaldeterminantsofverticalintegrationinChina,J.Corp.Finance(2014),http://dx.doi.org/10.1016/j.jcorpfin.2014.05.013
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