Exploring and Explaining the Extent ofConcentration and Diversification in ChineseBusiness Groups

Dylan Sutherland a and Lutao Ning b1

a School of Contemporary China Studies, Nottingham University,Nottingham, UK b East Asia Institute, Cambridge University, Cambridge, UK

Abstract:

Have China's biggest business groups adopted focusedstrategies specialising in their core competencies or,alternatively, have they become diversified conglomerateswith little or no strategic focus? In light of theapparent failures of their diversified East Asiancousins, as well as global industrial consolidationtrends among TNCs, this question is of great relevancetoday. This paper shows China's big business groups havenot significantly contributed to domestic industryconsolidation. Further, it shows that they are in facttypified by high levels of diversification. Suchstrategies, however, are not inconsistent with marketmediated profit maximising behaviour owing to China'simperfect markets and high transactions costs. Policiesforcing specialisation via industrial consolidation, suchas those promoted by SASAC, while in line with globalindustrial consolidation trends, might be unsuitable inChina's emerging market context.

Key Words: Group Company, Diversification, Concentration,Industrial Policy, China

Introduction

The 1990s witnessed poor performances among many EastAsian business groups. This was attributed in part to

1 Corresponding author. Email: Dylan.Sutherland@nottingham.ac.uk or Ln227@cam.ac.uk

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their lack of core business focus and problems ofcorporate governance that accompanied their diversifiedbusiness group structures. The question of whether firmsshould specialize and focus on core competencies, orwhether they should follow diversification strategies,has therefore gained widespread interest in the contextof East Asian business in recent times. There are few,however, if any studies to date, looking at the overallextent of diversification within China’s big businessgroups. This is also surprising given the rapid speedwith which such groups have emerged.

The extent of diversification among China’s largebusiness groups is interesting for at least two reasons,related to both theory and policy. From a policyperspective it is now well recognized that China,following its East Asian cousins, has ambitions ofdeveloping internationally competitive business groups.As early as 1991, for example, 57 groups were selectedfor preferential policy trials. This number was increasedto 120 in 1997 under the ‘grasp the large, let go of thesmall’ strategy (zhua da, fang xiao)’, officially approved atthis time. One early objective of the large enterprisegroup policy was that it should have spurred industryconsolidation and fostered oligopolistic competition inkey industries. Today SASAC, the State Owned AssetsAdministration and Supervision Commission, has become thecentral organization key in formulating industrialpolicies and enterprise reorganization among China’slargest groups. It envisages less than 100internationally competitive large groups and isattempting to force consolidation by merging firms.According to one review:

Increasingly, the SASAC formulates its agenda in terms that a Wall Street investmentbank would understand. The SASAC sees its mission as restructuring the large firmsunder its control, hiving off and discarding non-core businesses, and building strong,competitive firms around a few core businesses. These core businesses should beleaders in their sectors, or they should drop out of the business. SASAC head LiRongrong repeats the mantra of Jack Welch, the legendary head of General Electric,that each business should be No. 1, 2, or 3 in its market—or else it should bediscarded. (Naughton 2005 , 7)

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Are SASAC and, more generally, supervisory agenciesresponsible for China’s other large groups, likely to besuccessful in their efforts to focus these preferredgroups on core businesses? While SASAC oversees around150 of the largest groups, there were also around 2,800large groups at various different levels in 2007, manyoverseen by provincial governments. Profits from China’sgroups have risen from around 1.5% of GDP in 1997 to over6% in 2006. Their share of national exports remains ataround 20% and their subsidiaries increased in numberfrom 24,000 to 27,000 (SSB, 2007).Given their rapidlyincreasing importance to the national economy have thesegroups also led to the industrial consolidation ofspecific industries? Have these groups in general becomemore specialized or, to the contrary, more diversified?In the struggle to catch-up with the global industryleaders this has become a hugely topical question (Nolan2001).

From a theoretical perspective, the rapid emergence ofChina’s large groups provides us with an unprecedentedopportunity to explore some of the predictions of thelarge body of literature that attempts to explain theexistence of such groups. As an intermediate form oforganization, somewhere between the ‘visible hand’ of bigbusiness and the ‘invisible hand’ of the market, groupshave received a good deal of interest at themicroeconomic level in recent year (Chandler 1977; Leff1978; Guillen 2000; Keister 2000; Khanna and Yafeh 2007).While there are numerous explanations for groupformation, one popular approach explains business groupsas a response to market failure and transactions costs.Under particular conditions it is hypothesized the groupform provides competitive advantages to memberenterprises and is therefore a market driven response tothe particular business environment (Hoskisson et al.2005; Chang 2006; Khanna and Yafeh 2007). To what extent,then, might these explanations hold true for China?

For reasons related to both policy and theory, therefore,we explore the extent of concentration anddiversification among China’s large groups. To this end,

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first, we note relevant contributions of the businessgroup literature. Building from this, second, wesystematically investigate the extent to which largegroups have led to industry consolidation, one of theirstated purposes. We estimate two different measures ofconcentration for 37 industrial sectors in the pre andpost-WTO entry period. Third, we examine a closelyrelated question: to what extent have such groups becomemore diversified entities? Fourth, we discuss whetherthese patterns in diversification and concentration areconsistent with business group theory and historicalexperience. The conclusion argues that the pattern ofdiversification witnessed among China’s large groups isconsistent with mainstream explanations for businessgroup formation. From a policy perspective, moreover, ourfindings are important. Diversified business groups are anatural response and to the current business environmentof China today. Policies encouraging consolidation, suchas those promoted by SASAC, work against the currentmarket mediated trends, which favour the formation ofdiversified business groups.

Business Group Theory: Reasons for Diversification andConcentration

Two bodies of literature are relevant to thisinvestigation of diversification and concentration inChina’s business groups. The first body, broadlyspeaking, asks a fundamental question: why arediversified business groups common in emerging markets?It is now well known that the ‘visible hand’ of bigbusiness first emerged in US and some other Europeancountries (though slightly later) at the turn of 20thcentury (Chandler 1990).Growing aggregate and industrylevel concentration became a distinctive hallmark of USgrowth during the ‘second industrial revolution’, asbusinesses focused on their main lines of business aswell as closely related activities (exploiting scale andscope through ‘three pronged’ investments). In lateindustrializing countries, however, such as Japan andSouth Korea, diversification, as opposed tospecialization, was a far more common strategy for big

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business. Why then do diversified enterprise groups format particular periods of history and under what specificconditions do they form? A number of rationales relatedto the microeconomics of the group’s organisational form,both positive and negative and at times interrelated,have been put forward by different observers forexplaining why enterprise groups form:

i. Compensating for imperfect or under developedmarkets. One of the most commonly used argumentsexplaining business groups suggests they emerge inresponse to poorly developed product, finance andlabour markets (Leff 1976; Khanna and Palepu 1997;Khanna and Yafeh 2007). Business groups may act assubstitutes for markets and also fill ‘institutionalvoids’. This view is popular and there is nowconsiderable evidence such groups may play abeneficial role under such conditions (Khanna andYafeh 2007). It is argued such groups may employscarce resources (management, brands, sales andmarketing and the like) to eke out value and turnaround failing businesses (Nolan and Wang 1999). Oneextension of this to the Chinese case is thepreservation of ‘endowed resources’ in SOEs andgovernment bureaus (Yiu et al. 2007).

ii. Transaction costs. High costs of undertakingtransactions in markets may spur business groups toundertake business between member firms, soprotecting themselves, for example, from thevagaries of under developed legal systems. Relatedto (ii), group membership may also provideinsulation from potential or real intervention andhelp control uncertain political environments while‘improving their access to scarce goods’ (Keister2000): 151).

iii. Project execution capabilities. For late-industrialising countries, not being at theforefront of the world technology frontier,innovation of new technologies is less important.Instead, learning how to use existing technologies

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and developing transferable project executioncapabilities was more important (Amsden and Hikino1994). This might explains why early patterns ofindustrialization witnessed specialization asopposed to diversification in late industrializingcountries. This resource based view sees groups asorganisations that pool and distribute heterogeneousresources (Guillen 2000).

iv. Tunnelling. Groups formed as a means ofexpropriating assets from minority shareholders(Claessens et al. 1999; Baek, Kang, and Lee 2006).Tunnelling has attracted great attention in light ofthe East Asian crisis and poor performance ofJapanese groups in recent times.

v. Rent seeking and monopoly power. More generally,business group membership may also allow groups toproactively affect political change (Yiu et al.2007).

vi. Scale and scope. Historical experience suggests sizemay benefit member firms, particularly economies ofscope, as scale economies are more commonly found atthe plant level (Amsden 1989). Mergers may reducereplication and promote an economic structuresimilar to that found in advanced western capitalisteconomies (Nolan 1996; Smyth 2000). Groupsfacilitate industry consolidation, investment races,export growth and acquisition of technologies.

Business group formation is couched in both negativevalue destroying terms (monopoly and rent seeking, forexample) and also positive value creating terms (reactionto imperfect markets and high transactions costs, forexample). These arguments, moreover, are not mutuallyexclusive: groups may be explained to recourse to morethan one argument. Business groups, moreover, aretypified by certain organizational features which mayallow them to both improve and impair performance. Thesefeatures include; interlocking directorates, internaltransaction mechanisms (finance companies, for example),

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enduring stable relationships between group members andmutual shareholdings. A body of empirical evidence,moreover, now provides support for the idea thatdiversified business groups may sometimes benefitparticipating members: ‘membership in a group raises theprofitability of the average group member in several ofthe markets we examine. This runs contrary to the wisdom,conventional in advanced economies, that unrelateddiversification depresses profitability. Overall, ourfindings suggest that the roots of sustained differencesin profitability may vary across institutional contexts;conclusions drawn in one context may well not apply toanother’(Khanna and Rivkin 2001)(emphasis added).Diversification, in some contexts may be a marketmediated and profit maximising organisational form.

A second important body of literature, dominated byeconomists and political economists, considers morebroadly the reasons for the East Asian miracle (Amsden1989; Wade 1990; World.Bank 1993). It considers the roleof markets, market imperfections and the role of thestate in using industrial policy to nurture big business.Many economists, including notably the World Bank,recognised the close interaction between emerging bigbusiness and the state in the Asian miracle economies(World.Bank 1993) They noted, in particular, the focus ofindustrial policy in specific industries. They argued,however, that industrial policies in general did notwork, in the sense they had little impact on industrialstructure (World.Bank 1993). Others, however, arguedconvincingly that industrial policies fostering rapidgrowth of big business in key sectors (high incomeelasticity of demand, rapid technological change andeconomies of scale, among other things) did promotefaster economic growth and development (Amsden 1989; Wade1990). The so-called ‘late industrialisation’ literaturepoints to the important role of business groups inacquiring technology, boosting exports and facilitatinghigh levels of investment among other things. In thisinterpretation successful East Asian late industrialisingcountries fostered concentration in specific industrieswhere they looked to achieve an ‘optimal degree of

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competition’ (Amsden and Singh 1994). Firm numbers weredeliberately restricted and concentration promoted.

Two important questions emerge from these two bodies ofliterature. Firstly, have Chinese policy makers andbusiness groups spurred industry consolidation (asmeasured by increases in concentration) in China? This,remember, has long been an espoused policy rationale forbusiness group formation. Secondly, if not, arediversification strategies more common among Chinesegroups and are these strategies consistent with rationalprofit maximising behaviour?

Concentration Trends

A key policy objective of ‘grasping the large, letting goof the small’ was to concentrate scarce resources in asmall number of large-scale enterprises groups. Earlypolicy documents, for example, recognised state industrysuffered from the problem of fragmentation (the so-called‘da er quan, xiao er quan’ (large and complete, small andcomplete) problem). Contrary to what may be expected,there was quite a high degree of self-dependency, owingto difficulty in acquiring supplies, within the centrallyplanned large plants. This led to small-scale operations(Marukawa 1995),for example, recounts an auto assemblerthat was forced to produce its own nuts and bolts forlack of suppliers). Early business group policies, whichcontinue today, sought to address the issue of thereplication of investments leading to small scaleproduction units. To what extent have business groupspromoted industry concentration? Are there any particularstatic and dynamic trends?

To address this question we estimate concentration ratiosusing official statistics. Table 1 presents evidence onthe C4, C8 sales share as well as total business groupsales share of industrial output for 37 different areasof business activity for 2000 and 2006.2 We have also

2 While the HHI is also an important tool for examining concentration, given the large number of firms in many industries (for which we little information), it is impossible to estimate the

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calculated similar measurements for asset share and forthe intervening years (2001 to 2005) to investigate theconsistency of our results (we do not report theseresults here as they are largely consistent with oursales figures). We use standard Chinese industryclassifications (at approximately the three digit level,which roughly correspond to ISIC standards). The level ofindustry disaggregation, of course, defines the size ofthe market and must be kept in mind when estimatingconcentration and, in particular, when makinginternational comparisons. While there are many finer,more disaggregated categories of industry classificationused in Chinese statistics (over 900 corresponding to thefour digit level), output for China’s business groups isnot available at these levels. Here, as our purpose is toprovide general insights into industry consolidation (thetypes of industries consolidating through groupformation, magnitude of changes and the relativeimportance of the very largest groups) we use industryclassifications for which comparable data are supplied inChina’s annual Statistical Yearbook (Zhongguo TongjiNianjian, section 14.2 ) as well as the Large EnterpriseGroup Yearbook (Da Qiye Jituan Nianjian, section 2.1,(NationalBureauofStatisticsofChina 2000-2006).3

Column 2 gives the share of total national sales fordifferent industries. It indicates the relative size ofan industry (mining and washing of coal, for example,accounted for 2.4% of all sales for these 37 industries).The last four columns provide details of the number oflarge groups and total number of firms in the industry.The columns in between these give C4 and C8 sales shares,

HHI.3 Care is required in interpretation of our measure of business groupindustry share. This is because while China’s large groups are listedunder particular industry headings, owing to diversified productionit may in fact be the case that streams of sales income may originatefrom activities outside these areas (note, for example, our figuresfor petroleum and natural gas extraction). While it is impossible toknow the extent of this leakage, it is evident that this phenomenon,if anything, is likely to lead to overestimation of industry salesshares. If anything, therefore, our measures of business groupindustry share over estimate the real impact of their contribution toindustrial consolidation.

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as well as total group sales shares for 2000 and 2006. Astatic and dynamic picture, therefore, is provided(though we note the period is somewhat short). Totalindustry share for all large enterprise groups is alsoreported.

-------------------------TABLE 1HERE---------------------------------

The Static Picture

Chandler (1990) showed that during the development oftoday’s leading economies certain industries had atendency towards consolidation and concentration. Othersdid not. In particular, capital intensive sectors, thosemore able to exploit economies of scale, those moretechnologically advanced industries, requiring higherlevels of throughput and highly professional management,witnessed increasing concentration trends over time.Similar trends for other late industrializing countries,such as South Korea and Japan, have also been noted(Amsden 1989). To what extent, from a static viewpoint,does concentration in Chinese industry broadly mirrorthese international historical patterns? Firstly, we notethat the static trends correspond to those witnessedinternationally. For example, smelting and pressing offerrous metals (C8, 82.8% in 2006), manufacture oftransport equipment (C8, 28.9% in 2006), processing ofpetroleum (C8, 76.5% in 2006) and mining and washing ofcoal (C8, 39% in 2006) all are relatively moreconcentrated. Light industries, on the other hand, appearto have less of their sales share contributed by largebusiness groups. Manufacture of textile wearing apparel,footware, and caps (C8, 16.8% in 2006), processing offood from agricultural products (C8, 9.1% in 2006) andmanufacture of leather, fur, feather and related products(C8, 6.1% in 2006) are all less concentrated. From thestatic angle we also note that larger industries (asmeasured here by higher shares of national sales) tendedto be more concentrated. In 2006, for example, the totalall industry average for total business group sales sharefor all industry’s with over 2% of national sales stood

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at 45.8%. For those industries with under 2% of nationalsales, however, the share of business group output was22.4%.

From an international comparative perspective are China’sindustries highly concentrated? Comparisons with EastAsian countries in earlier periods of development areinstructive. In Japan the average (unweighted) three-firmconcentration ratio was 57.6 in 1937, 53.5 in 1950, and44.1 in 1962 (Amsden and Singh 1994: 946). In South Koreathe all-industry average three-firm concentration ratiowas 62.9% in the 1980s and Japan’s was 56.3% (Amsden andSingh 1994: 948). In China our estimated all industry C4average was around 23%. While international comparisonsbetween China and other countries may not be strictlycomparable owing to different systems of industrialclassification, this evidence nonetheless suggestsChinese industry remains considerably less concentratedthan that of Japan and South Korea in earlier periods.This finding is widely echoed by the numerous otherstudies of concentration by Chinese academics (Tai and Li1994; Yin 1996; Wei 2002, 2003; Cui and Geng 2006; Yinand Tian 2007). To what extent is monopoly a problem in Chinese industry?Historically, market regulators in the United Statesconsidered that if the market share of the top four firmsexceeded the 40% threshold an industry was considered tobe monopolistic. Today more liberal criteria are appliedand a 40% market share is considered acceptable (partlybecause international competition is considered to erodea monopolists position, thus domestic market share is notconsidered so important). From a static viewpoint ourestimations show only three industries in which the C4exceeded 40% in 2006 (extraction of petroleum and naturalgas; processing of petroleum, coking, processing ofnuclear fuel; production and distribution of electricpower and heat power). These industries accounted for14.4% of total sales for these 37 industries. By thesecriteria, therefore, only a relatively small share ofChinese industry, found in pillar industries, can beconsidered uncompetitive. There were only 5 industries of

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the 37, moreover, in which the C8 exceeded 40% in 2006.Our results suggest the problem of monopoly may be overexaggerated at present, at least for manufacturingindustries as a whole. Chinese business groups,therefore, do not yet appear to have given rise to thedesired high levels of concentration and market powersimilar to those seen in other successful East Asiancountries.

Dynamic Trends in concentration

How has concentration changed over time? Have businessgroups spurred consolidation and if so, in which sectors?Do these trends follow that of other successful EastAsian countries? Unfortunately, we only have a relativelyshort period over which to make our comparisons,coinciding with WTO entry.

Firstly, we note that the 37 industry C4, C8 and totalbusiness group concentration averages are quite stableover this six year period. The all industry unweightedaverage C4 sales share stood at 19.8% in 2000 and 19.7%in 2006, the C8 at 23.3% and 23.5% and total groups salesshare at 33.6% and 33.2%. Averages, in this instance,are not ideal as they may disguise large but offsettingswings between industries. Perhaps certain industrieshave consolidated and this has been offset byfragmentation in others? Inspection of specific sectorsshows that those that we might expect to see increases inconcentration (based on historical experience) revealvery mixed trends. The manufacture of transportequipment, special purpose machinery, general purposemachinery, foods and medicines, for example, all exhibitrather static trends (as measured by C4). There are evenfalls in concentration in the manufacture ofcommunication equipment, computers, other electronicequipment, electrical machinery, smelting and pressing offerrous Metals, mining and washing of coal, on the otherhand, are witnessed (as measured by C4). If we turn ouranalysis to other measures of concentration, such as theaggregate measure of group contribution to sales inspecific industries, we also note roughly similar

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patterns. This analysis suggests that the groups’ role infostering industrial consolidation is quite limited atpresent.

Are these trends surprising? Concentration also declinedin the early years of Japan’s post-war development (eventhough MIT1 fostered oligopolistic rivalry and investmentraces among large firms and was also responsible forweakening Japan’s anti-monopoly laws). Between 1950 and1962, concentration increased in only three of 20industries and stayed roughly the same in two butdeclined in all the rest (Amsden and Singh 1994: 946).Initial falls in concentration were attributable to thelarge number of new firms entering the market. Similarforces are driving fall in concentration in China. InJapan, however, concentration subsequently quicklyrebounded. Aggregate concentration (the share of thehundred largest manufacturing firms in total sales) inJapan also declined sharply in the 1950s, remainedconstant or fell slightly in the 1960s but rosesignificantly in the 1970s. In South Korea, as well,concentration rose continuously and quickly, as the top 5and 10 business groups grew much faster than GDP. Between1970 and 1982 the share of total manufacturing shipmentsproduced under a competitive market structure, it isreported, decreased from roughly 40% to 30% while theshare produced by oligopolies increased from 35% to 50%(Lee et al., 1986)’ (Amsden and Singh 1994: 948). BothJapan and South Korea, therefore, during some of theirmost impressive periods of growth, achieved increasingindustrial concentration as they concentrated scarceresources in a small number of large groups.

Between 1997 and 2006 the large group share of GDP rosefrom around 1.5% to nearer 7% (SSB 2007). Despite thisspectacular increase in national economic importance,groups did not significantly contribute towards industryconcentration, even in the capital intensive,technologically advanced and high income elasticity ofdemand industries where it might be expected.

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What is the Extent of Diversification in Chinese Groups?Is it Market Driven?

China’s business groups then have not contributedsignificantly towards industry consolidation. Isdiversification a common strategy and is this behaviourmarket mediated and profitable? Do groups choose todiversify (instead of focus) in the search for greaterreturns? We now consider these two important questions.We have already noted that diversification, in certainmarket environments, may be consistent with profitmaximization.

Firstly, we note much evidence suggests diversificationis a common strategy in China. A recent survey undertakenin 2003 of China’s 2,692 large groups found only 890 werefunctioning in a single core area (Table 2). Another1,200 or so were operating within businesses only of somerelevance to their core business, though ultimatelyoutside it (Table 2). The survey is somewhat vague as tothe exact meaning of ‘business relevance’. Nonetheless,it does show that around one quarter of all groups haddiversified into completely unrelated industries by 2003.It has been noted that ‘groups around the world varyconsiderably in form: some are extremely diversifiedwhereas others are more focused’ (Khanna and Yafeh 2007:331).

-------------------------TABLE 2HERE---------------------------------

Is diversification within China’s groups high byinternational standards? Group diversification, asmeasured by the number of two-digit industries in whichthe group operates, varies considerably between countries(Brazil averages 1.4, Chile 5.1, India 4.2, Indonesia2.1, South Korea 1.7, Mexico 2.7, Philippines 3.1, Taiwan1.6, Thailand 3.5)(Khanna and Yafeh 2007: 334). While itis difficult to make exact comparisons a review of some

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of the largest centrally supported key groups controlledby SASAC shows they are diversified across numerousbusiness activities. COFCO (China Foods) has businessesacross food processing and manufacturing, trade ofagricultural products, bio-energy, real estate, hotel,logistics and financial services. Shenhua Group has majorbusinesses in coal production and sales, production anddistribution of electricity and heat power, coalliquefaction and chemicals and railway and porttransportation. China Poly Group Company has businessesin international trade of military and civilian products,real estate, logistics management and cultural and artsbusiness. China Merchants Group’s main business areas aretransportation and related construction, services andmanagement, financial services and property development.China Railway Engineering Corporation has diversifiedinto many business areas such as architecturalengineering and construction (railway, road and tunnelconstruction), engineering research and design,manufacture of special purpose machinery, real estate andproperty development. Xinxing Ductile Iron Pipes Group aswell as having businesses in smelting and pressing offerrous metals, it also manufactures and sells textiles,military apparel, footwear and caps.4 Numerous other casestudies suggest considerable evidence thatdiversification strategies were common among China’slargest groups from early reforms (Nolan 2001). While noaggregate level data is available to validate thisquestion, our impression is that levels ofdiversification within Chinese groups are high even byinternational standards. Is Group Formation Market Mediated and Profitable?

Given that diversification appears common, a secondimportant question is whether this is a profitablestrategy (as theory suggests it may be in somecircumstances) freely initiated by groups? It has beenargued that Chinese business groups, owing to stateintervention, are not necessarily a market mediated

4 Source: SASAC and each group company’ website.http://www.sasac.gov.cn/n1180/n1226/n2425/index.html

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response to the external market environment. Groups, forexample, have been likened to ‘sanpans welded together’(Smyth, 2000). In this scenario they are seen as ratherfragile affiliations of firms, as opposed to marketmediated profit maximizing responses to the particularmarket conditions.

Firstly, we note that the market driven diversificationof Chinese business groups has been greatly facilitatedby the emergence in recent times of more dynamic marketsfor property rights. At the beginning of reforms stateowned assets were ‘like stagnant water, permanentlyimmobile’ (Jefferson and Rawski 2002): 591). Recentreview of the development of the market for propertyrights in China sees their development, on the whole, asa positive movement in economic reform. Policies fordecentralized and market-based mediation of ownershiprights, it is noted, ‘even in highly imperfectconditions, will be more beneficial to Chinese enterprisereform and economic growth than state mediated propertyrights markets’ (Jefferson and Rawski, 2002: 585). DoChinese business groups benefit from these markets? In2002 China’s 2, 672 group companies had 24,523subsidiaries (with over 50% ownership) (SSB 2003: 40,43). By 2006, however, a total of 2,856 groups controlled27, 950 subsidiaries (SSB, 2007: 44, 47). The totalnumber of enterprises within the groups had increasedfrom 27,152 to 30,806, an increase on average from around10.2 to 10.8 close members per group (this, moreover,does not include the number of participating enterpriseswith less than 50% equity ownership). While the increasein average numbers of close members in groups may notappear so impressive, when viewed from the perspective ofassets, sales or profit growth the contribution ofsubsidiary companies becomes more striking (Table 3).Indeed, acquisition and organic growth of subsidiarieshas been central to business group growth in recenttimes.

-------------------------TABLE 3HERE---------------------------------

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While the share of assets has grown faster than profits,indicating subsidiaries on the whole are less profitablethan the core group company, the increase in contributionto profits is also not insignificant. This suggests thatalthough subsidiaries may on the whole be less profitablethan parent companies, they still have increased overallgroup profitability. Parent companies, therefore, at thenational level, on average, do not appear to be absorbingloss making firms. Rather, it would suggest that whilesome may be less profitable, there is evidence that theseacquisitions nonetheless make a contribution to groupprofit.

Other survey evidence confirms the view that expansion ofsubsidiaries in business groups is market mediated to alarge extent. Table 4 shows data on the extent of stateintervention in facilitating firm entry to a businessgroup. It is clear that business groups and firms enjoysome degree of autonomy from state bodies in the processof group formation. While some enterprises may well beforced into groups (approximately 10% in state ownedgroups), this survey of mergers and acquisitions carriedout in 2004 found that 60-80% were undertaken by firms ontheir own initiative (Table 4). Around 20% of firmsentering groups did so with the involvement of statebodies. This, however, would be expected in an economy inwhich state ownership is still very important. As mightbe expected, collectives saw less direct stateinvolvement.

-------------------------TABLE 4HERE---------------------------------

The final piece of evidence we present to show thatformation of diversified business groups may be a profitmaximising response for enterprises in China rests on asurvey of 1,125 groups that acquired non-core businessassets in 2003. As Table 5 shows, the primary reasonswere to ‘improve profitability’ and ‘productively utilise

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group wide resources’. While there are some differencesacross different areas of business activity, what issurprising in this survey is the consistency of theresults across industries. Clearly, this survey suggestsdiversification appears to be a group level profitmaximizing strategy rather than any strategy imposed fromabove. It also suggests, as theory predicts, that thefunction of groups in substituting for markets may wellbe the key factor in group formation.

-------------------------TABLE 5HERE---------------------------------

Numerous case studies have shown that diversificationstrategies were common among China’s large businessgroups, even from early in reforms (Nolan 2001). Thisstudy complements these case studies by providing furthernational level data. We have shown that growth in groupsubsidiaries has driven both asset and profit growthwithin the groups (though the latter to a lesser extent).5

Evidence on subsidiary acquisitions, moreover, suggeststhat while state firms are more likely to be merged intothe groups, the enterprises themselves also have asubstantial degree of autonomy (though less than privategroup ownership forms). Finally, surveys of businessgroups moving into new markets show that the primaryreason for expansion is to increase profits. Combined,this evidence suggests that China’s business groups haveformed and grown primarily as a response to marketpressures.

Discussion: Explaining Diversification in China’s Groups

We have shown so far that China’s big business groups donot appear to have contributed towards industryconsolidation, that Chinese industry by internationalstandards is fragmented, and that these groups are highly5 Interestingly, no mention is made of innovation or pressure to develop new products. Indeed, while spending on R&D has increased in China’s large groups, this has mostly been in a specific subset of large groups (those pressured directly by the State Council, figures).

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diversified and have been growing quickly as a result ofsubsidiary acquisition. Does business group relatedtheory help explain the rapid growth and diversificationpatterns witnessed in China? Section 2 explained thatbusiness groups may form for a number of reasons, bothpositive (a response to market failure, for example) andnegative (monopoly and tunnelling). We now brieflyreconsider these arguments, exploring them with referenceto the Chinese case.

Do imperfect market explanations and transactions costsapproaches help explain growth the rapid diversificationpath of China’s groups? Financial, product and labourmarkets, are all relevant (Khanna and Palepu 1997). Theyhave certainly, owing to the transitional economy, alsobeen weak in China. Table 5 strongly supports the viewthat group wide resources can be used to improve theperformance of member firms. Various case studies,moreover, confirm that groups were formed to share humanresources and utilise strong brand names, conveying vitalinformation in product markets (see, for example, thecase of Sanjiu Group, which rapidly diversified). Thebusiness group literature also stresses, in particularthe role of groups in substituting for financial marketsin emerging economies (Khanna and Yafeh, 2007). Sucharguments appear especially germane to the Chinese case.Financial constraints for Chinese enterprises have beenparticularly acute. Under-developed capital market andfinancial institutions could not provide adequate fundsfor many types of business. Indeed, such groups weredeliberately based on companies capable of being‘investment centres’ (Sutherland 2001). In one of the fewdetailed empirical studies of China’s large groups,(Keister 1998) relates group subsidiary performance to arange of group features (finance companies andinterlocking directorates, for example). The firm levelevidence showed that financial companies within groupswere especially important to their member firmsperformance (Keister, 2000: 198). Keister (2000) alsoshows certain features of China’s groups (research anddevelopment facilities, for example), improve enterprisegroup performance. Groups in China, it is argued,

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mobilise finance, facilitate human resources, flows intechnology and management, general product and marketinformation flows, as well as facilitating exchanges inimperfect product markets that could not happen throughthe market place.

Transaction costs between unrelated parties are also highwhen legal and judicial institutions are underdeveloped,contract enforcement costly and corruption rife (Khanna &Palepu, 1997). The path of China’s reform has beengradual with partial changes, dualistic systems anddecentralization. The rule of law and institutionalstructures are still weak. China, in internationalrankings, is still considered to be among one of the morecorrupt nations in the world. To reduce the risk of doingbusiness in such markets business groups may also form.Again, evidence from Table 5 suggests that risk reductionand securing supplies are important factors determiningreasons for diversification. Although time series data onthe volume of intra-group trade are not readilyavailable, the static data of 2004 and 2003 (table 4 and5) indicates one third large group enterprises undertookM&A in 2004 and 41.8% of total large groups entered intonew business areas, 15.7% did so to secure materialsupplies. Forms of vertical integration are consistentwith the idea that reductions in transactions costs areone motivating factor for business group formation.

What about the pursuit of monopoly power and financialtunnelling? Are China’s groups acquiring similarlydestructive features as those some believe wereresponsible for the downturn in performance of Japaneseand South Korean groups? Firstly, we note that ourearlier investigation of market concentration showed fewexamples of highly concentrated markets. Even by what arenow considered to be quite low thresholds for monopoly(C4 greater than 40%) China has few such examples.Tunnelling, on the other hand, has been noted as apossible issue among Chinese groups, particularly owingto the weak nature of corporate governance such groupsare associated with (Kuijs, Mako, and Zhang 2005). In the

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mid and late 1990s it is reported up to 1,100 groups‘packaged’ good assets for stock market listing. Thisgave parent companies the opportunity to ‘tunnel’resources from these listed arms. Despite thispossibility, detailed evidence on the extent oftunnelling remains scarce for China. While it has become‘an unquestioned axiom’ in the literature, there is infact far less clear supporting evidence (Khanna and Yafeh2007: 346). Concerns in China’s case may be based more ona response to the experience of South Korea, for whichmore evidence exists. Indeed, tunnelling has become amain focus on much recent literature on business groups.Despite this, however, the extent of pyramidal groups,which facilitate tunnelling, is still not clearlyappreciated (for China and other countries). Directevidence of tunnelling, moreover, is quite difficult tointerpret and the unquestioned axiom, at least accordingto one comprehensive review, is open to question (Khannaand Yafeh 2007). While tunnelling might well exist as areason for the formation of business groups in China insome instances, it cannot fully explain the mushroomingof such groups (which now have around 30,000 memberenterprises). Investors, after all, are free to invest inbusiness group firms and yet continue to choose to do so.This suggests they perceive at least benefits to groupmembership.

China’s groups may well be forming for a set of reasonssimilar to those seen in many other emerging markets.Most importantly, their growth and diversificationpatterns cannot be attributable only to government policyand fiat. Instead, the formation of diversified businessgroups in China appears to a large degree as a marketmediated response to the particular market environment.

Conclusions

Have Chinese enterprise groups (including keyenterprises) facilitated industry consolidation? This wasone touted advantage of forming enterprise groups. As inJapan and South Korea, such microeconomic agents ofgrowth were considered important for facilitating

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consolidation and achieving optimal size (for EOS). Largeconglomerates could facilitate higher levels ofinvestment, avoid ruinous competition and play a centralrole in acquiring and mastering new technologies as well.Presumably, such organizations could have been corralledby a powerful central ministry (such as Japan’s MITI)into investment races and export promotion.Concentration, therefore, appears as one interestingindicator of the success of China’s industrial policies.In the light of striking global industry consolidationtrends, moreover, such consolidation efforts areincreasingly also considered by policy makers to be avital step towards creating large internationallycompetitive Chinese organizations. Li Rongrong, SASAChead, is now reported to have adopted the policy of being1,2 or 3 in a business sector.

This paper shows, however, that as a whole, whenconsidering 37 industrial sectors, China’s large groupsdo not yet appear to have made significant contributionsto industry consolidation. Indeed, somewhat to thecontrary, the aggregate picture for around 2,800 ofChina’s largest groups points towards high levels ofdiversification. Business group expansion is increasinglyfuelled by acquisition of subsidiaries, often in non corebusiness areas. While the share of GDP of these groupshas increased from around 1.5% of GDP to nearer 7%between 1997 and 2007, the impact on industryconsolidation has not been noticeable. Even in capitalintensive sectors, those Chandler has noted as fosteringthe large industrial corporation, big business groups donot appear to have increased their market shares. By2003, on the other hand, around one quarter of theselarge groups reported to be totally diversified andanother one half doing business in areas only somewhatrelated to their main business. Even the centrallyapproved SASAC groups, those particularly targeted to beindustry leaders, show very high levels ofdiversification.

Is the emergence of large diversified group sosurprising? Nolan (2001), in his early case studies,

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noted the natural tendency towards diversification evenfrom early in reforms. More recent theoretical debateseems to provide further explanation for why such groupsmay emerge. Specifically, imperfect markets and hightransactions costs seem a highly plausible explanationfor business group development. In this sense, theseorganizations are natural predators of the particulartype of economic ecology now found in China. We providesome evidence to suggest subsidiary acquisition isprimarily market driven and that profit growth has beendriven by such behaviour. In this sense, the emergence ofthe market for property rights is clearly beneficial. Wefurther note, however, that this process naturally leadsto diversification as core groups with financial, brand,marketing, distribution or technological strengths,including also project execution capabilities, formbusiness groups.

What are the policy implications? Is SASAC’s more handson approach, one that has called for greaterspecialization and forced mergers to achieve scale,warranted? Naughton, for example, notes: ‘a strongerSASAC also foreshadows a stronger role for thebureaucracy in Chinese economic development, which maynot be the best outcome for an increasingly sophisticatedmarket economy’ (Naughton 2005). We do not pass judgementon the specific aims of these industrial policies, namelythe creation of less than 100 internationally groups.Instead we note, given the empirical and theoreticalarguments so far presented, that such a policy is likelyto meet quite severe resistance given the strongcentrifugal forces at play in China’s emerging marketeconomy. With weak financial, product and labour marketsand high transactions costs, the current tendency forfirms is towards diversification as a profit maximizingstrategy. Attempts to consolidate industries from above,therefore, may end up creating businesses less suited tocurrent market environment. Clearly, one longer termpolicy alternative involves addressing the currentunderlying reasons for market failure and hightransactions costs. By addressing these fundamentalissues the centripetal forces that more developed markets

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foster might lead, eventually, to specialisationstrategies.

References

Table 1: Estimations of Business Group Concentration for Different Industries (Shares of Total Industry Sales Value), C4, C8 and All Business Group Sales Shares.

Sales/total all industry sales20

C4 C8

2000 2006 2000 2006

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06

Mining and Washing of Coal 2.4 26.8 26.2 39.0 39.0Extraction of Petroleum and Natural Gas 2.5 119.

0141.0 119.

0141.

0Mining and Processing of Ferrous Metal Ores 0.4 52.7 6.7 52.7 8.7Mining and Processing of Non-Ferrous Metal Ores 0.5 10.5 57.8 10.5 62.2Mining and Processing of Nonmetal Ores 0.3 9.3 7.5 9.3 7.5Processing of Food from Agricultural Products 4.0 4.6 5.4 7.5 9.1Manufacture of Foods 1.5 8.3 10.0 13.1 13.2Manufacture of Beverages 1.3 13.3 15.4 20.4 22.1Manufacture of Tobacco 1.0 45.2 27.9 54.0 28.7Manufacture of Textile 4.8 4.3 7.0 6.6 9.4Manufacture of Textile Wearing Apparel, Footware, and Caps

1.9 5.6 11.5 9.3 16.8

Manufacture of Leather, Fur, Feather and Related Products

1.3 3.1 3.8 3.1 6.1

Processing of Timber, Wood manufacture, Bamboo, Rattan, Palm, and Straw

0.7 16.9 6.1 19.8 7.0

Manufacture of Furniture 0.6 16.0 10.7 16.0 11.1Manufacture of Paper and Paper Products 1.6 7.8 8.9 10.9 12.3Printing, Reproduction of Recording Media 0.5 0.9 3.2 0.9 5.0Manufacture of Articles For Culture, Education and Sport Activity

0.5 8.6 6.7 10.0 9.0

Processing of Petroleum, Coking, Processing of Nuclear Fuel

4.8 82.1 74.9 82.8 76.5

Manufacture of Raw Chemical Materials and Chemical Products

6.5 5.4 7.0 7.9 9.8

Manufacture of Medicines 1.5 19.1 20.6 28.8 30.2

Table 1 continued Sales/total all industry sales2006

C4 C8

2000 2006 2000 2006

Manufacture of Rubber 0.9 30.1 11.9 36.4 18.0Manufacture of Plastics 2.0 3.8 4.6 6.0 6.6Manufacture of Non-metallic Mineral Products 3.6 4.0 6.4 6.1 8.9Smelting and Pressing of Ferrous Metals 8.2 28.6 14.7 39.5 22.4

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Smelting and Pressing of Non-ferrous Metals 4.1 7.8 16.0 10.3 23.1Manufacture of Metal Products 2.7 6.6 7.0 9.5 8.5Manufacture of General Purpose Machinery 4.2 6.5 7.9 9.9 10.4Manufacture of Special Purpose Machinery 2.5 8.1 7.3 11.7 11.0Manufacture of Transport Equipment 6.4 23.1 26.1 28.9 33.4Manufacture of Electrical Machinery and Equipment 5.6 24.1 12.4 30.7 16.5Communication Equipment, Computers and other ElectronicEquipment

10.5 15.3 8.9 23.1 12.4

Measuring Instruments and Machinery for Cultural Activity and Office Work

1.1 20.3 5.4 24.0 6.4

Manufacture of Artwork and Other Manufacturing 0.8 … 2.8 … 3.5Production and Distribution of Electric Power and Heat Power

7.1 65.6 55.6 68.3 64.3

Production and Distribution of Gas 0.3 13.9 38.7 13.9 42.9Production and Distribution of Water 0.2 8.5 26.8 8.5 31.6

Source: China Statistical Yearbook (various years); China Large Enterprise Group Yearbooks (various years)

Table 2: Extent of Diversification among China’s LargeBusiness Groups by 2003

  Within theSame Industry

Differentindustries, butrelevant to thecore business

CompletelyDifferentIndustries

 

No ofFirms

% oftheTotal

No ofFirms

% oftheTotal

No ofFirms

% oftheTotal

Totalnumberoffirms

888 33.0 1178 43.8 626 23.2 2692By Type of Ownership

State-Owned and Controlled Enterprises

559 34.5 754 46.6 306 18.9 1619

Wholly state owned* 515 34.9 701 47.6 258 17.5 1474 State controlled* 44 30.3 53 36.6 48 33.1 145

Collectively OwnedEnterprises

77 27.5 119 42.5 84 30.0 280

Wholly collectivelyowned *

49 23.7 84 40.6 74 35.8 207

Collectivecontrolled*

28 38.4 35 48.0 10 13.7 73

Others 252 31.8 305 38.5 236 29.7 793

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Source: SSB (2003: 18) (Yearbook of China’s Large Corporations)

Table 3: Share of Assets and Profits Earned By SubsidiaryCompanies for China’s Largest Enterprise Groups

2002 2006Share of assets from son companies 55.8 66.1Share of group profits coming fromson companies

62.5 69.8

Source: (SSB 2002, 2006: sections 1.13 and 1.15)

Table 4: Role of State and Market In Entry To BusinessGroup in 2004

Number of Firmsjoining group

How Firm Joined Group

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Mother company ownership

Numberof Firms

Percentage of Total Group Companies

Government mandated

Enterprise group initiated

Enterprise groupwith government help

Other

Total 910 32.9% 7.7 % 60.9% 23.4% 7.7%State owned and controlled

595 38.5% 10.3% 56.6% 26.1% 6.6%

Wholly state owned

541 38.6% 11.1% 55.1% 26.4% 7%

Controlled 54 37% 1.9% 72.2% 22.2% 1.9%Collective total

75 29.3% 1.3% 72% 17.3% 9.3%

Wholly owned 60 31.2% 1.7% 70% 16.7% 11.7%Controlled 15 23.4% 0% 80% 20% 0%Other 240 25.1% 3.3% 67.9% 18.8% 10%

Source: (SSB, 2004: 6)

Table 5: Reasons for Enterprise Group Diversification for 2003

Industry Number of Firms Moving into New Areas of Business

Risk Reduction %

To ImproveProfitability %

UtilisingGroups’ Own Advantages in Resources%*

Securing Raw Material Supplies %

Other Reasons%

Agriculture, Forestry, AnimalHusbandry and Fishing

19 26.3 52.6 57.9 10.5 10.5

Mining (coal, petroleum andnatural gas, ferrous and non-ferrous metals)

53 37.7 62.3 81.1 18.9 20.8

Manufacturing 659 26.0 53.0 55.5 19.1 20.3Production and distribution ofElectricity, Gas and Water

27 25.9 70.4 63.0 25.9 22.2

Construction 83 22.9 54.2 66.3 7.2 15.7Transport, Storage and Post 24 8.3 45.8 58.3 8.3 25.0Information Transmission,Computer Services and Software

5 20.0 40.0 80.0 0.0 0.0

Wholesale and Retail Trade 145 26.9 58.6 54.5 12.4 23.5

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Hotel and Restaurants 5 40.0 80.0 20.0 20.0 20.0Financial Intermediation 5 40.0 40.0 60.0 0.0 20.0Real Estate 51 35.3 51.0 47.1 2.0 21.6Other 49 32.7 63.3 75.5 8.2 30.6Total 1125 26.8 54.8 58.1 15.7 20.8

Source (SSB, 2003:20)Note: This survey is based on a set of multiple questions. The total percentage

in each categories therefore do not equal to 100%.* refers to groups’ financial, managerial and human resources, etc., which can be best used for financing and coordinating subsidiaries to enter into new business areas.

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