1 Political Connection, Local Protection and Domestic Market Entry Barriers in China Qun Bao, Ninghua Ye, Ligang Song 1. Introduction Trade theories assume that large entry costs exist for exporters and sales within one country’s domestic market involve no or much less entry costs. As a result, exporters need to show higher productivity advantage to overcome the export costs across national borders, which is called the ‘self-selection effect’ in trade literatures (Melitz, 2003), and many empirical studies supports the self-selection of exporters (see the surveys by Wagner, 2005; Greenaway and Kneller, 2007; Bernard et al., 2012). Such an assumption is quite plausible, since it’s usually much harder to conduct international business than doing business in the home market. However, if a country’s domestic market is not closely integrated, like the current Chinese market that is segmented by its provincial borders due to many institutional factors and local protectionist policies, we would expect that sales within the domestic market can also involve substantial market entry costs. Why Chinese domestic market is still highly segmented after decades-long market reform? What are the main sources of domestic market entry barriers in China? Unlike international trade barriers such as transportation costs and tariffs, barriers to domestic transaction are, to a large degree, created by intra-national protectionism and
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Political Connection, Local Protection and Domestic Market
Entry Barriers in China
Qun Bao, Ninghua Ye, Ligang Song
1. Introduction
Trade theories assume that large entry costs exist for exporters and sales within one
country’s domestic market involve no or much less entry costs. As a result, exporters
need to show higher productivity advantage to overcome the export costs across
national borders, which is called the ‘self-selection effect’ in trade literatures (Melitz,
2003), and many empirical studies supports the self-selection of exporters (see the
surveys by Wagner, 2005; Greenaway and Kneller, 2007; Bernard et al., 2012). Such
an assumption is quite plausible, since it’s usually much harder to conduct
international business than doing business in the home market. However, if a
country’s domestic market is not closely integrated, like the current Chinese market
that is segmented by its provincial borders due to many institutional factors and local
protectionist policies, we would expect that sales within the domestic market can also
involve substantial market entry costs.
Why Chinese domestic market is still highly segmented after decades-long
market reform? What are the main sources of domestic market entry barriers in China?
Unlike international trade barriers such as transportation costs and tariffs, barriers to
domestic transaction are, to a large degree, created by intra-national protectionism and
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the related tedious administrative procedures1. China’s case is more serious because
of its unique institutional setting. China’s fiscal decentralization has been a
fundamental aspect of its reform programs towards a market economy, which aims at
getting various levels of governments to be fiscally responsible with various forms of
fiscal contracting systems and tax sharing system (Shen et al. 2012). Such reform has
substantially prompted China’s rapid regional economic growth (Zhang and Zou,
1998; Jing and Zou, 2005) through much improved incentives for China’s local
governments to implement various administrative intervention measures including
protection of the local business in order to maximize its local fiscal revenues and
employment. However, these protective measures have inevitably raised interregional
trade barriers and are the fundamental causes for current market segmentation in
China and for firms’ incentives to forge closer relationship with local governments to
overcome those barriers for increasing cross-regional trade.
It’s Young (2000) who first raised the issue of domestic market segmentation.
The author emphasizes that in a partially reformed economy like China, growing
interregional competition leads local governments to impose a variety of interregional
barriers to trade. Following the influential findings of Young (2000), many more
studies have confirmed the existence of domestic market segmentation and trade
barriers between regions (Naughton, 2003; Bai et al, 2004; Poncet, 2005; Fan and Wei,
2006; Holz, 2009; Xu and Fan, 2012). Herrmann-Pillath et al (2014) compared the
effects of political factors and cultural differences on market segmentation and
1 For instance, Djankov et al. (2002) look at the procedures for registering a new firm in 85 countries, and find that government productivity has a significant impact on registering new firms.
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concluded that trade barriers are indeed instigated by local protection, rather than
caused by cultural and dialect differences. In other words, the cross-regional trade is
likely to be hindered more by local administrative intervention than language and
cultural barriers commonly seen in the international trade.2
It is therefore our interest to ask how local protection affects firms’ domestic
entry behavior in China. In a normal and competitive business environment, the sales
activity and destination choices of firms will depend entirely on their own
competitiveness. However, in the presence of trade barriers due to local governments’
administrative intervention, it can be expected that firms will resort to political
lobbying, in an effort to eliminate the negative impact of local protection on their
business by building a closer relationship with the administrative departments.
However, to investigate how political connection affects firms’ domestic sales,
we need detailed information about firms’ sale among different domestic destinations.
For example, we need to know whether firms ever sell their goods to other provincial
markets or prefer just to stay within their own provincial market. Compared with the
detailed transaction data in export market collected by the Chinese Customs, it is very
difficult to collect the statistics about firms’ domestic sale activities within China.
To fill this gap, the World Bank provided some detailed survey data on firms’ sales
destinations for 12,000 firms operating in China in 2004. This survey data
2 Local protection is definitely not unique to the Chinese economic development. In fact, either in developed or developing countries, local governments may intervene in the business environment for different reasons. This phenomenon has aroused widespread concern, such as the research of Sonin (2010) on Russia, Luong (2004), Kazakhstan, Das-Gupta (2006) for India, and Berdahl (2013) for Canada. The Chinese experience offers ample opportunities for studying this issue because of the unique feature of China's political system, including fiscal decentralization, economic tournament among regional economies, and the ways for official assessment on performance which all exacerbate the prevalence of local protection.
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encompasses detailed market information including firms’ locations and destination
for their products including sales to the local markets, other cities within provinces,
other provinces as well as export markets, and importantly some proxies for capturing
the political connection by firms.
Using firms who only sell in the local market as the benchmark, we study those
firms who enter the other cities or provincial markets by establishing closer political
connection to facilitate their sales. In other words, it can be hypothesized that political
connection helps firms to successfully enter domestic markets by lessening
administrative intervention from local authorities in the targeted market. We also use
the behaviors of exporters as a robustness check. As local protection doesn’t matter to
exporters, we would not expect that there is also a strong correlation between political
connection and export activities among exporting firms.
We also show the extent to which local protection is implemented in affecting
firms’ sales in other markets. In the case of minor local protection, political
connection mitigates the effect of local protectionism and helps firms enter other
provincial destinations. However, once local protection becomes too strong, political
connection fails to help businesses to break down the barriers across provinces. In
other words, the effect of political connection is quite limited when the local
protection becomes more serious. It implies that we can’t exaggerate the role of
political connection in facilitating domestic market entry, and reminds us of the fact
that political connection can’t be considered a fundamental solution to keeping off
local protection and administrative intervention.
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Our study helps to understand the motivation of domestic sale activities in
transitional economies like China. Following Bernard and Jensen (1995), extensive
literatures have examined the determinants of the international market entry among
exporters (Wagner, 2007; Greenaway and Kneller, 2007; Bernard et al., 2012)3.
However, much less has been known for firms’ domestic sale behavior, especially for
countries like China whose domestic market is so large and has a profound impact on
firms’ business operation. This study thus provides useful evidence for understanding
the entry behavior of firms in domestic markets.
Our study contributes to the literatures on political connection. A large number of
empirical studies prove that companies can indeed benefit from political ties,
including more convenient access to bank credit (Joh and Chiu, 2004; Cull and Xu,
2005), seeking government-regulated preferential treatment (Kroszner and Stratmann,
1998), and seeking government's crisis rescue packages and policy asylum measures
(Faccio et al, 2006). However, few studies have examined the effect of political
connection on firms’ sale activities, especially for a geographically large transitional
economy such as China. This study confirms that in an economy associated with
market segmentation and local protection, political connection may help smooth the
way for businesses entering into the remote markets. It echoes with previous studies
that the emergence and prevalence of political connection is a reasonable and strategic
reaction of firm especially private businesses in the presence of widespread
administrative intervention.
3 Many studies also explored the reasons behind the rapid expansion of exports based on Chinese datasets (Lu et al, 2010; Manova and Zhang, 2012; Koopman et al, 2012; Ma et al, 2014.).
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The arrangement of this paper is as follows. We describe the data source and
estimation model in section 2; section 3 provides the estimation results on how
political connection affects firms’ sale destinations; section 4 conducts the robustness
tests; and the final section summarizes and concludes.
2. Data Source and Estimation Strategy
Data used in this paper are from China Investment Climate Survey (2005) of the
World Bank. The World Bank survey randomly chooses 12,400 firms located in 120
cities: Each sample city has 100 firms and the four municipalities (Beijing, Tianjin,
Shanghai, and Chongqing) have 200 firms each. The unique advantage of this survey
is that it collects detailed sales information in four types of targeted destinations,
including locating cities, other cities in the same province, other provinces, as well as
export markets. Thus it enables us to examine the determinants of firms’ entry
decision in any targeted market. We first group the sample firms (exclusive between
types) according to their sales destinations as the following four types: type 1
indicates firms with sales only in the city where they locate, type 2 firms with sales in
other cities of the same province, type 3 firms with sales going to other provinces, and
type 4 firms with exports. The first three categories are all domestic-oriented firms
with type 2 and type 3 having sales across city and provincial administrative
boundaries.
Political connection is the core variable which we concern. In some previous
studies of China’s case, political connection is typically measured by whether the
corporate management or board members have the party membership (Li et al, 2008),
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or whether executives are the National People’s Congress (NPC) or China People’s
Political Consultative Congress (CPPCC) members (Tian and Zhang, 2013), or
whether managers and other senior executives are appointed directly by the
authorities (Wang and Sheng, 2012). These proxies reflect firms’ affiliation with the
governments to some extent. However, they do not speak for the efforts that firms
make to enter other cities or provincial destinations. For example, if managers are
directly appointed by the local authorities, it is more reflective of the political
relations of firms at the localities, and firms are therefore more likely to adopt a
localized business strategy rather than external expansion beyond their jurisdictions.
In light of the potential drawbacks of these proxies, this paper uses "designated
personnel for dealing with administrative businesses" in China's Investment Climate
Survey (2005) to characterize the political connection. By designating personnel to
deal with local governments which have been granted economic autonomy after the
decentralization reform program was implemented in the 1980s and 1990s, it directly
reflects firms’ needs and efforts of making the political connection to pursue their
business interests. We would expect that to whom firms designate as their personnel
to deal with administrative business are more likely to establish close ties with the
authorities, and thus to overcome the entry barriers erected by the authorities more
easily. A binary dummy variable gov is created, where the value 0 means absence of
such personnel and 1 means presence of such personnel, indicating close political
connection. We also use other measures of political connection as the robustness
checks.
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Table 1 provides the statistics about various types of sale behaviors of the sample
firms. First, among the 3,727 sample firms, only 750 firms or 20.12% focus on sales
within the home cities. It means that the vast majority of firms have a tendency to
extend their sales to other markets. Second, 1,068 (approximately 28.66%) firms sell
products only to other cities in the same province, while 1,113 (approximately 29.86%)
selling their products to other provinces. Finally, 21.36% of the samples are firms
engaging in exports.
Table 1 also shows the relative importance of the political connection for various
sale types. Generally, there is positive relationship between the scope of firms’ sale
and the degree of their political connection. In other words, "the farther away that
firm’s products are sold", the more likely firms are to establish a robust relationship
with the government as more distant markets could mean higher entry barriers for the
firms. Specifically, only 17.47% of local businesses designate personnel in charge of
administrative issues. Nearly 21% of companies targeted at other cities in the
province have political ties, and among firms with sales in other provinces, the
proportion increases to nearly 25%. Among exporters, more than 30% of the firms
designate personnel to deal with administrative departments. Thus, we ask the
question as to whether the closeness of political connection helps firms to enter
distant market destinations.
Control variables that may affect firms’ sales decisions are also incorporated to
the model in estimations as follows. (1) lnp2003 is the average output: the logarithmic
number of sales revenue divided by the total number of employees in the firm; (2)
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ktl2003 is the capital-labor ratio: the logarithmic number of net fixed assets divided
by the total number of employees; (3) scale2003 is the scale of the firm: the
logarithmic number of main business revenue; (4) age is the age of the firm: the
difference between the year of establishment and the year of study (2004); (5)
rdr2003 is the proportion of research and development (R&D) investment in the main