DDP 606. Harry G. Broadman and Geng Xiao. "The Coincidence of Material Incentives and Moral Hazard in Chinese Enterprises." October 1997. 20 pp.

Recent empirical studies at the firm level have found a robust relationship between strengthened incentives and improved performance in Chinese industrial state-owned enterprises (SOEs) since the advent of reform. This positive microeconomic assessment contrasts sharply with the deteriorating conditions of China's SOEs in the aggregate. This paper presents new micro evidence that shows a coincidence of improvement in the effectiveness of material incentives and a worsening of moral hazard, where SOE insiders can make small gains at a large cost to the firm or to the economy. Our findings suggest that Chinese SOE reforms that have centered on the use of incentive contracts have been successful in motivating managers and employees to make and keep profits, but they have failed in preventing these insiders from passing losses and liabilities to the State. In other words there has been "privatization of assets and socialization of liabilities." If this asymmetry of incentives and consequences is left unchecked--for example, without formal ownership changes, introduction of effective internal governance mechanisms and strengthened external discipline through inter-firm competition and commercially-base creditor relationships--the rising losses and liabilities in China's state sector pose a serious threat to the country's banking system and macroeconomic stability.

Harry G. Broadman is Program Team Leader and Senior Economist for Russia at the World Bank. At the time this paper was written, he was the Bank's Senior Economist for China. Before joining the World Bank in 1993, among other positions, he was Assistant U.S. Trade Representative; Chief of Staff and Senior Economist at the Council of Economic Advisers; and on the faculties of Harvard and Johns Hopkins Universities.

Geng Xiao, Lecturer at University of Hong Kong's School of Economics and Finance and Faculty Associate at HIID, is an expert on property rights and economic reform in China. He has advised the Chinese government on enterprise and financial reforms and has been a consultant for the World Bank and the United Nations Development Program.