political connections and entrepreneurial investment: evidence from china's transition economy

Political connections and entrepreneurial investment: Evidence from China'stransition economy☆

Wubiao Zhou⁎Division of Sociology, School of Humanities and Social Sciences, Nanyang Technological University, 637332, Singapore

a r t i c l e i n f o a b s t r a c t

Article history:Received 8 September 2010Received in revised form 24 May 2012Accepted 31 May 2012Available online 20 July 2012

Editor: D. Jennings

Recent literature in entrepreneurship suggests that market and legal institutions matter forentrepreneurial investment. Yet, prior studies have focused on the role of formal institutions.Building on new institutional theory and political connections literature, this study aims toevaluate the role of political connections in entrepreneurial reinvestment in less developed andtransition economies. The purpose of this paper is threefold. First, it aims to demonstratesystematically how political connections affect entrepreneurial reinvestment. Second, it appliesthis relationship to a subsample group, i.e., Small and Medium Enterprises (SMEs), in order toempirically test whether political connections aremore beneficial for large firms or SMEs. Third, itdemonstrates that political connections substitute for, rather than complement, formal marketand legal institutions. The empirical test uses a nationally representative sample of entrepre-neurial firms from China's transition economy.

© 2012 Elsevier Inc. All rights reserved.

Keywords:Political connectionsInstitutionsEntrepreneurial reinvestment rateChina

Executive Summary

Prior entrepreneurship studies, based on both North (1990, 2005) and Baumol (1990), have focused on the role of formalinstitutions in facilitating entrepreneurial investment. Yet, a number of researchers have found that many less developed andtransition economies have had high levels of genuine entrepreneurial investment for relatively long periods in the last severaldecades with deficient formal institutions (see, e.g., Haber, 2002; McMillan and Woodruff, 1999, 2002; Zhou, 2009). To partiallyresolve this puzzle, the recent entrepreneurship literature suggests that political connections can also play a significantly positiverole in entrepreneurial activities in many less developed economies (especially, transition economies) because of deficient formalinstitutions (e.g., Dinc, 2005; Faccio, 2006; Siegel, 2007).

While this new literature has, in general, established the positive role of political connections under weak market institutions,there has been a lack of systematic research on the mechanisms through which political connections affect entrepreneurialinvestment activities. Moreover, there is little research on the effect of political connections on entrepreneurial firms of differentsizes. Empirically, it is not clear whether political connections are more beneficial to larger firms, since larger firms are morevisible and, thus, more likely to be the target of government involvement in terms of both support/protection and expropriation.In addition, the existing literature seems to assume that political connections substitute for formal market institutions. Yet, it isnot clear whether they may complement or substitute for them, since political connections continue to play a role even underdeveloped market institutions in advanced economies (Dixit, 2004; Faccio, 2006; Pfeffer and Salancik, 2003).

Journal of Business Venturing 28 (2013) 299–315

☆ This paper has been presented at the American Sociological Association Annual Meeting and the Society for Entrepreneurship Scholars Conference. I amgrateful to Jeffrey H. Dyer, Harry Sapienza, the field editor — Dev Jennings, and three anonymous referees for their helpful comments on an earlier version. Thisresearch is partly supported by a research grant from the New Silk Road Fund at Nanyang Technological University, Singapore.⁎ Tel.: +65 6316 8960; fax: +65 6794 6303.

E-mail address: [email protected].

0883-9026/$ – see front matter © 2012 Elsevier Inc. All rights reserved.doi:10.1016/j.jbusvent.2012.05.004

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Adopting the new institutional perspective, and building on the emerging political connections literature, this study aimsto evaluate systematically the role of political connections in entrepreneurial investment in less developed and transitioneconomies. It suggests that, through facilitating resource acquisition and, particularly, protecting property rights, politicalconnections may act as a substitute for deficient market and legal institutions, thus facilitating entrepreneurial reinvestment(especially, among Small and Medium Enterprises) in less developed and transition economies.

The empirical test uses a nationally representative sample of 1946 Chinese entrepreneurial firms in the mid 1990s, whenChina was still in the earlier period of market transition, so that market and legal institutions were not yet well developed. Theresults suggest that entrepreneurial firms with political connections (or higher level political connections) enjoy more security interms of property rights and, thus, have significantly higher reinvestment rates; and such political connections are more useful forsmaller firms and among regions with less developed market and legal institutions.

Results of this study may contribute to the existing literature in three ways. First, they may help understand how politicalconnections facilitate entrepreneurial investment. This paper identifies two mechanisms through which political connectionsaffect genuine entrepreneurship, i.e., facilitating access to key resources and opportunities, and providing private protection ofproperty rights. And, empirical evidence suggests that political connections may indeed facilitate private protection of propertyrights, a notion which has rarely been empirically confirmed. Second, this study finds that smaller firms, though facing similarlevel of government expropriation and distortion as larger ones, have more resource obstacles; and thus, overall, may benefitmore from political connections. Third, our empirical finding also helps resolve the debate on the role of political connectionsduring institutional development by demonstrating that political connections play a diminishing role because their benefitsdecrease and their costs increase as formal institutions improve in a less developed or transition economy.

To entrepreneurial practice, this study suggests that, to succeed in business, an entrepreneur often needs not only businessskills but also continuous political investment in less developed and transition economies. Such political investment and theresulting political connections may provide protection and resources for entrepreneurs. However, it should be noted that theyalso divert entrepreneurs’ energies and attention from more productive activities that propel economic progress for the wholesociety (Baumol, 1990). In this sense, political connections are not always beneficial to entrepreneurs or the society; and formallegal and market institutions should be developed to facilitate long-term entrepreneurial growth in less developed and transitioneconomies.

1. Introduction

Two major recent contributions to entrepreneurship literature are Baumol (1990) and North (1990, 2005), both of whichemphasize the role of institutions in facilitating genuine entrepreneurial investment. To North (1990, 2005), property rightsinstitutions are fundamental, because enterprising individuals will invest only when they expect to be able to keep the fruits oftheir investment. Baumol (1990), on the other hand, focuses on broader institutions. He argues that different institutions affectprofit opportunities, and, thus, rates of return, for different entrepreneurial investment activities. Throughout human history, hestates, only very few institutions have provided positive incentives for genuine entrepreneurship, i.e., private-sector wealthcreation.

However, prior studies, based on both North and Baumol, have focused on the role of formal institutions in facilitatingentrepreneurial investment. Recent literature in new institutional economics suggests that formal institutions provided by thestate are not the only ones that matter for economic development. Informal social arrangements can have equally important andlasting consequences (Dixit, 2004; Rodrik, 2003). In the entrepreneurship field, a number of studies have found that informalsocial arrangements, particularly social network ties, indeed play a significantly positive role in entrepreneurial activities in lessdeveloped economies, and especially in transition economies (e.g., Aidis et al., 2008; Luo and Chung, 2005; Manolova and Yan,2002; Park and Luo, 2001; Peng, 2004; Smallbone and Welter, 2001; Tan et al., 2009; Xin and Pearce, 1996).

Recently, there is a growing literature on the role of political connections, i.e., social network ties to the state and its agents.As noted by a number of researchers, political connections may be a more fundamental aspect of networking and, thus, moreeffective in many less developed economies (especially, transition economies) because of deficient formal institutions (e.g.,Dinc, 2005; Faccio, 2006; Siegel, 2007). Using a variety of measures for political connections, prior studies have consistentlyreported a substantially positive effect of political connections on individual/household income and entrepreneurialperformance (e.g., Li and Zhang, 2007; Li et al., 2008; Rona-Tas, 1994; Walder, 2002; Walder and Zhao, 2006; Xin and Pearce,1996; Zhou, 2009).

While prior studies have established the positive role of political connections under weak market institutions in less developedand transition economies, it is still not very clear how political connections facilitate entrepreneurship. There has been a lack ofsystematic research on the mechanisms through which political connections affect entrepreneurial investment activities. Moreover,most entrepreneurial firms in less developed economies are Small andMedium Enterprises (SMEs); yet, there is little research on theeffect of political connections on entrepreneurial firms of different sizes. Empirically, it is not clear whether political connections aremore beneficial to large firms or SMEs, since large firms are more visible and, thus, more likely to be the target of governmentinvolvement in terms of both support/protection and expropriation. In addition, while the existing literature seems to assume thatpolitical connections substitute for formal market institutions, it is not clear whether they may complement or substitute for them,since political connections continue to play a role even under developed market institutions in advanced economies (Dixit, 2004;Faccio, 2006; Pfeffer and Salancik, 2003[1978]).

300 W. Zhou / Journal of Business Venturing 28 (2013) 299–315

Building on both recent developments in new institutional theory, which emphasize the role of informal social arrangements,and the emerging political connections literature, this study aims to evaluate the role of political connections in entrepreneurialinvestment in less developed and transition economies. The plan of the paper involves three steps. First, it aims to demonstratesystematically how political connections affect entrepreneurial reinvestment. I utilize empirical evidence to argue that politicalconnections not only help to access key resources and opportunities, but provide private protection of property rights, thusfacilitating entrepreneurial reinvestment in many less developed and transition economies. Second, this study applies thisrelationship to a subsample group, i.e., SMEs, in order to empirically test whether political connections are more beneficial forlarge firms or SMEs. Third, it demonstrates that political connections substitute for, rather than complement, formal market andlegal institutions for more specific rule sets. This is formally tested through comparing the roles of political connections indifferent regions with different levels of institutional development. Its empirical test uses a nationally representative sample of1946 Chinese entrepreneurial firms in 1996.

This paper makes several contributions to the existing literature. First, it contributes to the political connections literature byidentifying and testing a particular mechanism through which political connections facilitate entrepreneurial investment,i.e., private protection of property rights. In addition, it shows that political connections are more useful for smaller firms andunder less developed market and legal institutions. Second, to the new institutional entrepreneurship literature, it demonstratesthat not only formal institutions but also informal social arrangements such as political connections matter for entrepreneurialinvestment, particularly, in the absence of well-developed formal institutions. It also provides empirical evidence showing thatpolitical connections substitute for, rather than complement, formal market and legal institutions. Third, it also contributes tothe more specific literature on Chinese entrepreneurship by showing that political connections may be one of the keys tounderstanding China's rapid entrepreneurial growth in the 1980s and 1990s.

2. Political connections and entrepreneurial investment

2.1. Institutional environment and entrepreneurial activities

Based on both Baumol (1990) and North (1990, 2005), recent entrepreneurship literature has highlighted association betweeninstitutions and entrepreneurship. According to both Baumol and North, institutions can affect entrepreneurship developmentbecause, as “rules of the game” in a society, they structure entrepreneurial incentives to invest and produce. More specifically,North has focused on the fundamental importance of secure property rights: Economic actors will not invest, produce, or engagein market transactions if they do not expect to be able to keep the fruits of their efforts (North, 1990; North and Weingast, 1989).Based on the analysis of the rise of the Western world, North (North and Thomas, 1973; North andWeingast, 1989) has forcefullyargued that a credible commitment on the part of the state to protecting private property rights is necessary for entrepreneurialinvestment and, in turn, long-term economic growth.

Baumol (1990, see also Sobel, 2008) emphasizes different entrepreneurial opportunities for different entrepreneurial activitiesunder different institutional environments. If the institutional environment provides opportunities for and, thus, higher rates ofreturn to private-sector wealth creation (i.e., genuine entrepreneurship or, to use Baumol's term, productive entrepreneurship),enterprising individuals will engage in private-sector wealth creation; otherwise, they will try to secure wealth redistributionthrough political/legal processes (termed “unproductive entrepreneurship” by Baumol). To increase social welfare, therefore,appropriate institutions should be in place to reward genuine entrepreneurship and discourage unproductive ventures.

A growing empirical literature has provided vast support for such institutional arguments. Based onNorth (1990),many empiricalstudies have found that well-functioning formal legal systems to protect property rights are the key to facilitate entrepreneurialinvestment in both developed and developing worlds (e.g., Acemoglu and Johnson, 2005; Besley, 1995; Cull and Xu, 2005; De Soto,2000; Johnson et al., 2002; La Porta et al., 1997; Lu and Tao, 2008). Taking a broader view, research primarily based on Baumol (1990)suggests that government institutions that provide economic freedom (e.g., developedproperty rights institutions, a fair and balancedjudicial system, and effective constitutional limits on government's ability to transfer wealth through taxation and regulation) areessential for genuine entrepreneurial activities (e.g.,Minniti, 2008;Minniti and Levesque, 2008; Sobel, 2008). In addition, a number ofresearchers have pointed out that a developed market system that underpins voluntary exchange and free competition also plays animportant role in entrepreneurs' decisions to invest and produce (see, e.g., Gwartney and Lawson, 2002).

Nevertheless, recent studies offer counterexamples to these institutional arguments. A number of researchers have found thatmany less developed and transition economies have had high levels of genuine entrepreneurial investment for relatively longperiods in the last several decades with deficient formal institutions (see, e.g., Haber, 2002; McMillan and Woodruff, 1999, 2002;Zhou, 2009). Although these economies have all adopted market-based policies, the development of formal market institutionshas been slow and difficult, in general (Hoskisson et al., 2000). First, most did not have strong and independent legalinfrastructures to provide the basis for a market economy. The lack of legal protection for private property rights made somegovernment agents act more like predatory grabbing hands in dealing with private firms and entrepreneurs (Frye and Shleifer,1997). Second, these countries generally exhibited high levels of corruption, signaling inefficient, overregulated environmentswith officials endowed with discretionary powers (Aidis et al., 2008; Djankov et al., 2002). Third, the lack of sufficientintermediaries in capital, labor, and product markets has remained a critical problem in many of these economies (Peng, 2003). Assuch, one would have expected low levels of genuine entrepreneurial activities such as entrepreneurial reinvestment in theseeconomies based on the institutional arguments discussed above.

301W. Zhou / Journal of Business Venturing 28 (2013) 299–315

2.2. Political connections and entrepreneurial investment

How can the above puzzle of high levels of entrepreneurial investment under deficient institutions among many less developedand transition economies be resolved?While a number of explanationsmay be offered, such as fast economic growth and, thus, highdemand for consumer goods in these economies (Hoskisson et al., 2000), one key may be informal social arrangements. Newinstitutional theorists have long argued that formal institutions may not be the only ones that matter for economic development.North (1990), for example, has demonstrated that informal institutions, such as social norms and social ties, have played roles similarto those of formal institutions in law enforcement and information transmission in pre-modern societies. In a further step, recentdevelopments in new institutional economics suggest that informal social arrangements may have consequences as important andlong-lasting as those of formal legal and market systems in contemporary world (Dixit, 2004; Rodrik, 2003).

One such type of informal arrangement is political connections, which have become an increasingly popular topic in economic andentrepreneurship research (e.g., Faccio, 2006; Fisman, 2001; Johnson and Mitton, 2003; Khwaja and Mian, 2005; Siegel, 2007). Priorstudies define politically connected firms as thosewhose largest owners are closely related to at least one current government official(Faccio, 2006; Johnson andMitton, 2003). Compared to other types of network ties, e.g., inter-firm and inter-personal ties (Burt, 1992;Granovetter, 1973), political connectionsmay generatemore benefits for entrepreneurs in less developed and transition economies. Itis argued here that political connections can not only facilitate access to key resources and opportunities, but also help entrepreneursin other aspects of conducting business (particularly, property rights protection) under deficient market and legal institutions in lessdeveloped and transition economies. And such benefits may facilitate entrepreneurial reinvestment in such economies.

Firstly, it is noted above that market infrastructures, such as capital, labor, and product markets, remain underdeveloped in mostless developed and transition economies. As a result, the government often plays a significant role in allocating resources andeconomic opportunities (Faccio, 2006; Haber, 2002; Siegel, 2007). Thus, those economic actors that have connections with thegovernment or government-owned units enjoy advantages in gaining access to such resources and opportunities. Given that access tomany of these resources and opportunities is a necessary condition for entrepreneurs to invest, since it partially determines firmprofitability and survival (Johnson et al., 2002; Shane and Cable, 2002), political connections may, thus, facilitate entrepreneurialreinvestment.

Secondly and probably also more importantly, political connections may provide private protection for property rights in theabsence of effective legal systems. According to new institutional theory, property rights protection is a precondition for entrepreneursto reinvest (North, 1990; see also, Dixit, 2004). Yet, development of legal infrastructures has been slow and difficult in many lessdeveloped and transition economies (Rodrik, 2003). As a result, legal protection of property and contractual rights are, at best, weak inmost such economies (Dixit, 2004; Haber, 2002; McMillan and Woodruff, 1999, 2002).

When a government cannot provide adequate formal protection for property rights, economic actors will attempt to seekprivate protection, such as private security guards and neighborhood-watch organizations (Dixit, 2004). And, as observed bymany researchers, exploiting political connections may be a particularly effective mechanism for protecting property rightsbecause of the coercive power enjoyed by government officials. Using a database consisting of 20,202 publicly traded firms from47 countries, for example, Faccio (2006) has found that political connections are particularly common in countries perceived to behighly corrupt, with poor legal protection of property rights. Government officials, for their part, have incentives to protect theproperty rights of economic actors with whom they have political connections because they, or at least members of their families,will extract at least some of the rents generated by these connections (Shleifer and Vishny, 1994; see also Faccio, 2006).

Therefore, given that political connections provide private protection of property rights and thus allows entrepreneurs to keepthe fruit of their investment from predatory behaviors of the government and its agents and even other citizens, it may be argued,again, that political connections may facilitate entrepreneurial reinvestment.

It should be noted here that political connections may possibly lead to organizational inertia for a firm. It can be argued that,because of the support and protection of government officials, politically connected firms may be less sensitive to environmentalchanges and may thus feel less pressured to reinvest in order to survive. Such organizational inertia, however, may be more likely toexist among a few large politically connected firms because they have more internal resources in addition to external resourcesprovided by government officials. Most SMEs with political connections still face a constant risk of bankruptcy under the turbulenteconomic environment common in less developed and transition economies, due to a lack of internal resources (Hannan and Freeman,1989). As a result, politically connected SMEs retain incentives to reinvest in the firm in order to increase their internal capabilities and,thus, their chance of survival.

The above discussion suggests that, overall, political connections could facilitate entrepreneurial reinvestment through twomechanisms, namely, easier access to key resources and opportunities and private protection of property rights. The first mechanismhas been well documented and confirmed by a number of prior studies. In many less developed and transition economies, politicallyconnected firms aremore likely to receive preferential access to credit (Dinc, 2005; Khwaja andMian, 2005; Zhou, 2009), preferentialtreatment by government-owned enterprises (Backman, 1999), and tax breaks and even government bailouts during hard times (Liet al., 2008; Nee, 1992; Siegel, 2007). Thus, this mechanism will not be retested in this study.

Unlike the first mechanism, however, the second has seldom been verified.1 Yet, this secondmechanism is particularly importantbecause poor protection of property rights discourages entrepreneurial investment, as discussed above. Therefore, two hypotheses

1 A few prior studies have tested whether political connections may increase entrepreneurs’ confidence in the formal legal system. Li et al. (2008), for example,found that Communist Party members are more likely to resort to legal channels in business disputes in China. Unlike prior studies, this study aims to test directlywhether political connections facilitate private protection of property rights.


are proposed here, with one testing whether political connections help protect property rights for entrepreneurs (i.e., the secondmechanism) and another testing whether political connections facilitate entrepreneurial reinvestment.

Hypothesis 1. Within a country with a moderate to low level of institutional development, entrepreneurial firms with politicalconnections enjoy more secure property rights.

Hypothesis 2. Within a country with a moderate to low level of institutional development, entrepreneurial firms with politicalconnections have higher reinvestment rates.

One may reason that a political contact with a higher position has more political power and, thus, may be more capable ofprotecting private firms and may have control over more resources. In addition, such a contact may be more likely to have strongpolitical ties with other higher level political elites, since social networks are often based on social similarities (Burt, 1992).Therefore, it may be argued that higher level political connections may be more useful for the entrepreneurial firm because theyhelp access the influence of higher-level government officials who are more powerful and control more resources.

Nevertheless, it may be argued that, from the perspective of higher level government officials, there may be less incentive toget involved with relatively small private firms as they cannot extract sufficient rents from them. In this sense, one may expectthat most politically connected private entrepreneurs may be connected with low level government officials only. And those whodo have high level political connections may own such connections often not as a result of active political investment, but becausesome of their strong social network ties — family members, relatives and friends — happen to be high level government officials(Zhou, 2009). Given that such strong ties may facilitate trust and social obligations between the high level officials and theentrepreneur (Gulati, 1995; Shane and Cable, 2002; Stafford, 2008), it is expected that the high level officials would behavegenerously toward, and thus support, the entrepreneur.

Therefore, we have:

Hypothesis 3. Within a country with a moderate to low level of institutional development, entrepreneurial firms with higherlevel political connections have higher reinvestment rates than those with lower level connections.

Prior studies have suggested that political connections are more widespread among larger firms in less developed andtransition economies (Faccio, 2006; Johnson and Mitton, 2003). Yet, little has been known concerning the effects of politicalconnections on entrepreneurial firms of different sizes. Empirically, it is not clear whether political connections can be morebeneficial for large firms or SMEs. Because of their size, and, thus, their larger contributions to the economy, larger firms are morevisible. Such higher visibility, however, may be a double-edged sword. On the one hand, higher visibility may help them to obtaina helping hand from the government because of their greater significance in the economy (Frye and Shleifer, 1997). Thus, largerfirms would face less resource acquisition obstacles (Beck et al., 2005; IFC, 2000; Zhou, 2009, 2012). Moreover, as noted above,larger firms are less sensitive to environmental changes because they have more internal resources and, thus, more organizationalinertia. Thus, it may be argued that political connections may have greater benefits for smaller firms.

On the other hand, higher visibility may attract more expropriation and extortion from the government and opportunisticbureaucrats. In China's transition economy, for example, it is noted that larger firms were often required by local governments toabsorb more employees and pay more taxes and levies; and they were also more likely to fall prey to corrupt bureaucrats becauseof their greater revenue (Naughton, 2007). For this reason, it may be argued that political connections may help larger firms more,because larger firms may need more protection from government expropriation and extortion.

Which argument is empirically more plausible? This study argues that both smaller and larger firms can benefit from politicalconnections, but smaller firms may benefit more. In support of this view, it is noted that, although, ex ante, larger firms may morelikely fall prey to bureaucratic expropriation and extortion, they may, ex post, more likely get a helping hand from thegovernment — usually from more powerful government authorities — to stop such predatory behaviors even without politicalconnections. This is because, given the higher contribution of larger firms to government revenue, more powerful governmentauthorities would not be interested in sacrificing long term revenues from larger firms for short term gains, such as heavy taxesand levies and bribes (Frye and Shleifer, 1997). For smaller firms, however, they are not able to get similar treatment from morepowerful government authorities when encountering expropriation and extortion. In this sense, overall, larger firms are notmore likely expropriated or extorted by the government than smaller ones. Therefore, it is argued here that political connectionsare not necessarily more beneficial to larger firms than to smaller ones in protection. And above we have argued that politicalconnections may have greater benefits for smaller firms for resource acquisition, thus, it can be argued that, overall, smaller firmsmay benefit more.

Hypothesis 4. Within a country with a moderate to low level of institutional development, we expect smaller firms to benefitmore than larger ones from political connections.

Above it is argued that political connections may facilitate entrepreneurial reinvestment through facilitating access to resourcesand opportunities and providing private protection of property rights whenmarket and legal systems remain underdeveloped in lessdeveloped and transition economies. Given that many such economies have been under major market and legal reforms, one maywonder how the effect of political connectionsmight change as formal institutions change. To answer this question, as assumed in the


existing literature (see, e.g., Faccio, 2006; Xin and Pearce, 1996), this study argues that political connectionsmay substitute for formalmarket and legal institutions in the absence of the latter, and that their effects may decrease asmarket and legal institutions improve.

The reasons for the substitution argument are as follows. First, as the government introduces market-oriented and legal reforms,thus increasing market allocation of factor resources and improving legal protection of property rights, entrepreneurs will obtainresources and property rights protectionmore easily through formalmarket and legal channels (Peng and Luo, 2000; Zhou, 2009). Assuch, the benefits of political connections for entrepreneurs in resources and protection may decrease. Second, it is noted that usingpolitical influence to get things done often involves economic costs and such costs may increase as formal institutions improve(Shleifer and Vishny, 1994). Entrepreneurs incur such costs not only when exploiting political connections gained throughmoney-power exchanges, but also when using strong political connections, because exploiting political connections often goes handin hand with corruption (Siegel, 2007). Thus, it becomes increasingly costly for firms to exploit political connections to bend rules asformal institutional rules are strengthened (Guthrie, 1998; see also Siegel, 2007). For the same reason, it becomes increasingly costlyfor government agents to get involved in exchanging favors with economic actors (Siegel, 2007). Since the benefits of politicalconnections may decrease and their costs may increase as formal institutions improve, it is argued that the net effects of politicalconnections would decrease.

There are, however, two rival arguments on the effects of political connections as formal institutions improve. According toone such argument, the facilitating effect of political connections may not be due to the absence of market and legal systems, butmight simply be a result of long-existing political markets in many less developed and transition economies that favor resourceallocation and problem solving through political power. If this is true, then the significance of political connections would notchange even when formal institutions improve.

Another rival argument, however, may suggest that political connections may complement rather than substitute for formalmarket institutions, because formal institutions (e.g., legal protection of property rights) are generally limited, thus providingground for informal social arrangements like political connections to play a role even under developed market institutions (see,e.g., Dixit, 2004). Empirically, politically connected firms are found to enjoy a number of benefits, such as relaxed regulatoryoversight, preferential treatment in competition for government contracts, and many others, even in advanced economies such asthe United States (Dixit, 2004; Faccio, 2006; Pfeffer and Salancik, 2003[1978]). Therefore, according to this view, the significanceof political connections may also change little when formal institutions improve.

To test whether political connections indeed function as a substitute for strong formal institutions, one may need to examinethe effect of political connections under different institutional environments. According to the substitution argument, politicalconnections would be more useful in institutionally less developed regions than in more developed ones. Thus, we have:

Hypothesis 5. Within a less institutionally developed region of a country, political connections are likely to have greater effectsthan in a more developed region of a country.

3. Data and methods

3.1. Empirical setting

The empirical test uses a nationally representative sample of domestic private firms2 from China's transition economy in themid 1990s, when it adopted a gradual market reform strategy (McMillan and Woodruff, 2002; Zhou, 2009, 2011, 2012). China'scase is appropriate for this test for several reasons. One reason is that, as in some other less developed and transition economies,China's case is puzzling for its high level of entrepreneurial investment under deficient market and legal institutions. On average,Chinese domestic private firms had consistently reinvested over 60% of their profits and, thus, experienced rapid growth in the1990s (for details, see, e.g., Zhou, 2009, 2011). Yet, the institutional environment was, in general, unfavorable for entrepreneurialactivities throughout the 1980s and 1990s. Not only were well-functioning markets (particularly, credit, equity, and labormarkets) largely absent (Naughton, 2007), but the government controlled most key economic resources and discriminatedagainst private firms when distributing these resources (Chang and MacMillan, 1991; International Finance Corporation (IFC),2000; Tsang, 1994). In addition, private property rights were not protected even rhetorically in the Chinese Constitution until2004 (Huang, 2008; Zhou, 2009). A second reason is that, as shown by prior studies (Li and Zhang, 2007; Li et al., 2008; Xin andPearce, 1996; Zhou, 2009), political connections seem to be a quite popular strategy among Chinese private entrepreneurs. Thus,China's case enables us to evaluate the role of political connections in entrepreneurial reinvestment.

Furthermore, it is noted that legal and market institutions differ dramatically across Chinese regions since the early 1980s, as aresult of the decentralization reform (Fan andWang, 2001; Naughton, 2007). The southeastern-Coastal provinces, for example, wererelatively “free,” with little, or less, discrimination against private entrepreneurship, while the Inland and Northern provinces werestill dominated by public ownership and had a far less developed market and legal system by the late 1990s (Zhou, 2011). Thisvariation in formal institutional environment allows us to test whether political connections substitute for or complement formalmarket and legal institutions.

2 Domestic private firms in China are mostly SMEs owned by individual entrepreneurs. There are two types of private firms: non-farm private enterprises(siying qiye) and individual enterprises (getihu). The difference between private enterprises and individual enterprises is the number of employees: A private firmis a private enterprise if it has at least eight employees, but an individual enterprise if fewer than eight employees. In this paper, I use “private firm” to indicateboth types of enterprises.


3.2. Data

The dataset for hypothesis testing comes from the 1997 National Survey of Chinese Private Enterprises, which was designedand administered by a joint research team from the All China Federation of Industry and Commerce and the Chinese Academy ofSocial Sciences (Zhang and Ming, 2000). Following the definition of private enterprise specified in the Tentative Stipulations onPrivate Enterprises, promulgated by the central government in 1988, the survey included only domestic private firms that had atleast eight employees and were owned by private entrepreneurs at the end of 1996.

Using a stratified sampling method, the survey selected an almost nationally representative sample of 1,946 (or 0.2%) of960,000 private enterprises registered with the State Administration for Industry and Commerce in 1996, in 21 of 31 provinces(including autonomous regions and province-level municipal cities). Five of these 21 provinces were in the Southeastern-Coastalregions, four in Northern regions, six in Western regions, and four in Mid-Central regions. The sampling involved two stages. Inthe first, a pre-specified number of counties were selected in each province based on economic development levels, so that bothrich and poor counties were represented. In the second stage, a pre-specified number of private firms were selected in eachcounty based on location and primary industrial sector. Both urban and rural firms were chosen; and within each urban/ruralarea, firms from all industrial sectors were sampled. The number of sampled firms in each province, each county, each urban/ruralarea, and each sector was proportionate to the population size of the private enterprises in each of these categories.

The survey was based on face-to-face intensive interviews with both entrepreneurs (i.e., the largest owners) and accountantsto collect information about the entrepreneurs and their firms in 1996. Interviewers were primarily local employees of the AllChina Federation of Industry and Commerce who were familiar with local private entrepreneurs, and were trained intensively bythe joint research team before the survey.

The dataset resulting from this survey is appropriate for testing the effect of political connections because it includes a rich setof questions, including the size, history, reinvestment behaviors, and basic financial background of each of the firms, and familybackground, social connections, human capital, and occupational history of the entrepreneurs. Most variables on the basiccharacteristics of the firms and entrepreneurs in the 1997 data are also available in the 1995 and 2000 National Surveys of ChinesePrivate Enterprises, which include more firms and more provinces, but not some of the key variables (e.g., political connections)necessary for testing the hypotheses. Distributions of common variables are very similar across the three surveys.

Following Johnson et al. (2002) and Cull and Xu (2005), who tested the effects of legal protection of property rights on firms'reinvestment rates using data from Eastern Europe and China, respectively, only firms with positive profits in 1996 entered thereinvestment regressions. Thus, 91 firms that reported negative or zero profits were removed from the data. The dropped firmsaccounted for 4.7% of the sample and had similar level of political connections (69% for profitable firms and 68% for the droppedfirms). However, they were a little younger and smaller, and were owned more likely by female owners. This procedure leaves aworking sample of 1855 entrepreneurial firms.

3.3. Variables

3.3.1. Dependent variablesFollowing Johnson et al. (2002), the dependent variable in Hypothesis 1 is perception of property rights security. In the survey,

entrepreneurs were asked whether arbitrary charges, fines, or apportionments by government agents created significantproblems for their firms. According to North (1990) and Johnson et al. (2002), arbitrary charges, fines, or apportionments bygovernment agents on businesses suggest a predatory government, thus indicating insecure property rights. Unfortunately, onlytwo answers — yes or no — were provided for this question in the survey. As such, this variable is a binary variable only but not amore informative ordinal one. It is coded 1 if the entrepreneur did not think that such government predatory behaviors was asignificant problem for his/her firm; 0 otherwise. This variable has reasonably high internal consistency reliability. A similarquestion in the survey asked entrepreneurs whether bureaucratic extortions created significant problems for their firms. Thecorrelation between the two variables is 0.89.

The dependent variable in hypotheses 2–5 is Reinvestment rate, which is a standard measure in firm investment studies, and ismeasured as the percentage of after-tax profits earned in the 1996 financial year that were reinvested in the firm (Johnson et al.,2002; see also Cull and Xu, 2005). The distribution of this variable is not very different between the 1995 and 1997 surveys. It hasa mean of 62% in the 1997 survey and a mean of 68% in the 1995 survey. Because the distribution of the dependent variable isskewed, its logarithmic form is used (a small number is used to replace zero for logarithmic transformation).

3.3.2. Independent variablesAs noted above, a private firm is defined as having political connections if its largest owner— the entrepreneur— has strong social

network ties with at least one current government official. The survey included a series of questions directly related to this definition.It asked whether the entrepreneur was a government official in any period before starting the firm and whether any of theentrepreneur's strong ties — father, mother, most intimate relatives, best friends, spouse, or adult children — was a governmentofficial currently or before retirement. According to Chinese regulations, no current government officials were allowed to own privatefirms; thus, therewere no ownerswhowere simultaneously government officials in the data. The survey divided government officialsinto seven categories: (1) ordinary rank and file cadres, (2) main village cadres, (3) main township cadres, (4) guji cadres, (5) kejicadres, (6) chuji cadres, and (7) ting/juji or above cadres. Here, Guji is equivalent to village level in rural areas, or community level inurban areas; keji is equivalent to township level in rural areas or district level in a county-level city; chuji is equivalent to county level;


ting/juji is equivalent to prefectural level. In the Chinese political structure, the first five categories are considered local cadres (jicengganbu) and the last two, leading cadres (lingdao ganbu), who enjoy much greater power and control far more resources than theformer. An individual is considered a government official if he/she falls into any of the above seven categories.

Following both Faccio (2006) and Johnson andMitton (2003), political connection is a binary variable, coded 1 if the entrepreneurwas a government official in any period before starting the firm, or if a close personal connection— the entrepreneur's father, mother,most intimate relatives, good friends, spouse, and adult children — was a government official currently or before retirement; 0,otherwise. Here I include those entrepreneurs whowere government officials previously because these people usually retain formercolleagues/associates as close political contacts. And, I combine entrepreneurs who were government officials previously withentrepreneurs whose family members, relatives, or friends were officials into one group because the two types of entrepreneursoverlap significantly. Cross tabulation shows that 70% of entrepreneurs who were government officials previously had at least onefamily member, or one relative, or one friend who was a government official currently or before retirement.

For testing Hypothesis 3, I divide political connections into two levels. High level connection is coded 1 if the entrepreneur wasa leading cadre in any period before starting the firm, or if a close personal connection — the entrepreneur's father, mother, mostintimate relatives, good friends, spouse, and adult children — was a leading cadre currently or before retirement; 0, otherwise.Low level connection is coded in the same way, simply by changing leading cadre to local cadre. Here, those who had both a higherlevel connection and lower level connection are included in the group with high level connection. Additional analysis suggests thatthere is no significant difference in reinvestment rates between those with both types of connections and those with high levelconnections only.

3.3.3. Control variablesControl variables include characteristics of both the firm and the entrepreneur. For variables concerning the firm, firm age and

firm size are commonly used in entrepreneurship studies. Younger firms and smaller firms may have lower reinvestment ratesdue to the liability of newness and liability of smallness, respectively, and, thus, fewer entrepreneurial opportunities (e.g., Acs andAudretsch, 1988; Hannan and Freeman, 1989). Firm size here is measured by total sales income at the end of 1996. Both firm ageand firm size are taken logarithm to adjust for their skewed distribution. City firm is a binary variable coded 1 if the mainestablishment of the firm was located in a large city; 0, otherwise. This variable is controlled because firms in cities (particularlylarge ones) enjoyed better legal and market infrastructures. Some de facto private firms in China were registered as public firms(i.e., SOEs or urban/rural collective firms) in order to take advantage of favorable government treatment in terms of both propertyrights protection and resource acquisition (Nee, 1992). The survey included a question involving registration status in 1996. Thus,public firm is a binary variable, coded 1 if the firm was registered as public in 1996; 0, otherwise. It is often argued that higherprofit rates may indicate higher entrepreneurial ability andmore entrepreneurial opportunities, which can facilitate reinvestment(Johnson et al., 2002). Thus, return on sales, the ratio of after-tax profits to total sales income in the 1996 financial year, is also

Table 1Descriptive statistics of the study variables.

Variables Definition Mean s.d. N

Reinvestment rate Percentage of after-tax profits in the 1996 financial year that were reinvested in the firm. 0.623 0.291 1435Political connection 1=The entrepreneur was a government official in any period before starting the firm, or if a close

personal connection — the entrepreneur's father, mother, most intimate relatives, good friends, spouse,and adult children — was a government official currently or before retirement; 0 otherwise.

0.677 0.468 1674

High levelconnection

1=The entrepreneur was a leading cadre in any period before starting the firm, or a close personalconnection — the entrepreneur's father, mother, most intimate relatives, good friends, spouse, and adultchildren — was a leading cadre currently or before retirement; 0 otherwise.

0.125 0.331 1674

Low levelconnection

1=The entrepreneur was a local cadre in any period before starting the firm, or a close personalconnection — the entrepreneur's father, mother, most intimate relatives, good friends, spouse, and adultchildren — was a local cadre currently or before retirement; 0 otherwise.

0.553 0.497 1674

Firm age Number of years since the firm started. 8.708 5.829 1812Firm size Total sales income at the end of 1996 (10,000 Chinese Yuan). 668.543 2592.580 1566City firm 1=The firm was located in big cities; 0 otherwise. 0.267 0.442 1827Public firm 1=The firm was registered as a public firm in 1996; 0 otherwise. 0.049 0.217 1804Return on sales The ratio of after-tax profits to total sales income at the end of 1996. 0.133 0.183 1490Female 1=The entrepreneur was female; 0 otherwise. 0.079 0.270 1851Education Number of years in schooling. 11.389 2.795 1846Age Age of the entrepreneur. 39.571 8.677 1828Property rightssecurity

1=The entrepreneur did not think that government predatory behaviors was a big problem for his/herfirm; 0 otherwise.

0.427 0.495 1855

Inland and Northernprovinces

1=The firm was located in Inland and Northern provinces; 0 otherwise. 0.750 0.433 1855

Note: The dummies for the fifteen industrial sectors of the main business line of each firm are not reported in this table. These fifteen sectors include: agriculture,mining, manufacturing, utility, construction, water resources, transportation, restaurant, finance, real estate, social services, health care, education and culture,and others. When estimating regression models, list-wise deletion is used for handling missing data.


controlled.3 The data indicated 15 industrial sectors for the main business line of the firms. So, fifteen dummy variables forindustrial sectors are also created.

For variables concerning the entrepreneur, gender and human capital variables including education and age are often consideredto affect entrepreneurial behavior (e.g., Amit et al., 1990; Carroll andMosakowski, 1987; Hamilton, 2000). Female is a binary variable,coded 1 if an entrepreneurwas female; 0, otherwise. Education refers number of years of schooling.4 Age is 1997minus the year of theentrepreneur's birth.

In addition to the above firm-level control variables, a regional variable — Inland and Northern provinces — is also created fortesting hypotheses 1 and 5. This variable is binary, coded 0 if the firm was located in Guangdong, Hainan, Fujian, Zhejiang,Shanghai, and Beijing; 1, otherwise. Southeastern-Coastal provinces, including Guangdong, Hainan, Fujian, Shanghai and Zhejiang(plus Beijing — China's capital)5 were relatively “free,” with more developed market institutions and less discrimination againstprivate entrepreneurship in the 1990s (Fan and Wang, 2001; Zhou, 2011).

3.4. Model specification

Logistic regression is used for testing Hypothesis 1, because the dependent variable— perception of property rights security— isbinary. For testing hypotheses 2–5, I estimate the fixed effects model with each province dummy added as a group specificconstant term in each regression to control for substantial environmental heterogeneity across provinces (Naughton, 2007),which may affect both reinvestment rates and popularity of political connections. A general representation of regressions that Iestimate for testing hypotheses 2–5 is shown in the following equation (Greene, 2000):

Yij ¼ α þ γ0Pij þ β0Xij þ ηj þ εij ð1Þfor i=1, …, nj firms in province j; j=1, …, 21 provinces.

In the above equation, Yij is reinvestment rate (logged); α is the intercept; γ is the effect of political connection (or a vector ofthe effects of the two levels of political connection) on reinvestment rate, because Pij denotes political connection (or a vector ofthe two levels of political connection) that varies over the i firm/entrepreneur in each j province; β is a vector of all otherfirm-level effects on reinvestment rate, because Xij is a vector of the control variables that vary over the i firm in each j province;ηj is a vector of province specific constant terms and, thus, the same across all units in province j; and εij is a mean zero firm-levelerror term.6

3 Using return on capital does not change results. I use return on sales to report results because return on capital has more missing values. The correlationcoefficient between return on sales and return on capital is 0.56.

4 To be consistent with the existing literature, I use years of schooling to indicate education of entrepreneurs. The survey, however, asked for level of education.I transformed levels into number of years of schooling using the coding scheme adopted by Xie and Hannum (1996). That is, 0 years for illiterate; 5 years forelementary school; 8 years for junior high school; 11 years for senior high school and vocational school; 13 years for associate degree; 15 years for bachelor'sdegree; and 18 years for master's degree.

5 I include Beijing in this regional cluster because, in terms of all seven indicators in Table 3, Beijing is closer to the Southeastern-Coastal provinces than theInland-Northern ones.

6 For a stratified sample like the one in this study, an alternative way for model specification is to control for strata level variables instead of using the regionaldummies (i.e., ηj in Eq. (1)). And, since both political connections and entrepreneurial activities are primarily local, it would be much better to control forinstitutional and economic conditions through city-level (instead of province-level) variables. This study uses the specification in Eq. (1) for two reasons. First, thefocus of this paper is on the effect of firm-level political connections, not regional effects. Thus, it may be sufficient to use regional dummies for a simple control ofregional effects. Second, the survey only tells which province a firm was located in, not which city. As such, city-level dummies are not available in the data andthere is no way to control for city-level control variables.

Table 2Zero-order correlations between study variables.

Variables 1 2 3 4 5 6 7 8 9 10 11 12 13

1. Reinvestment rate (logged)2. Political connection 0.0703. High level connection 0.024 0.2614. Low level connection 0.050 0.767 −0.4205. Firm age (logged) 0.002 −0.034 0.010 −0.0396. Firm size (logged) 0.096 0.095 0.143 −0.006 0.0687. City firm 0.009 0.113 0.170 −0.006 0.033 0.2218. Public firm 0.015 −0.014 0.006 −0.018 −0.064 0.109 0.0279. Return on sales 0.050 −0.013 −0.035 0.012 0.010 −0.448 −0.100 −0.03010. Female 0.002 0.053 0.076 −0.005 −0.093 −0.046 0.042 0.010 −0.01111. Education −0.002 0.219 0.193 0.078 −0.124 0.203 0.303 0.001 −0.060 0.05312. Age 0.012 −0.032 0.004 −0.032 0.122 0.060 0.025 0.010 −0.015 −0.062 −0.20113. Property rights security 0.036 0.046 0.020 0.029 −0.012 0.022 0.019 −0.014 −0.029 −0.012 −0.011 0.02414. Inland and Northernprovinces

−0.042 0.051 −0.018 0.060 0.135 −0.117 −0.107 0.007 0.076 −0.029 −0.042 0.027 0.123

Note: The dummies for the fifteen industrial sectors of the main business line of each firm are not reported in this table. Correlations with an absolute valueexceeding .05 are significant at p=.05, and correlations exceeding .06 are significant at p=.01.


4. Empirical results

Tables 1 and 2 present descriptive statistics of and zero-order correlations among the variables, respectively. The averagereinvestment rate is 62%. This is remarkably higher than rates for private firms in other transition economies. According to a largesample firm-level survey in five transition economies conducted by Johnson et al. (2002) in 1997, the average reinvestment ratefor private firms was about 50% in Poland and Romania, 40% in Slovakia and Russia, and 30% in Ukraine.

Table 1 shows that 68% of interviewed entrepreneurs had political connections, suggesting that exploiting politicalconnections was a widespread phenomenon in China's private sector in the mid 1990s. Among these politically connectedentrepreneurs, 13% had high level political connections with leading cadres, and 55% had low level political connections with localcadres, suggesting that there were indeed far fewer high level political connections, as discussed previously. It also shows thatonly 42.7% of entrepreneurs claimed that their private property rights were secure. This low percentage complements the

Table 3Comparison between Inland and Northern provinces vs. Southeastern-Coastal provinces.

Inland and Northern provincesa Southeastern-Coastal provincesb

Per capita GDP in 1996 (Chinese Yuan)c 3059.690 7824.440GDP growth rate in 1996c 0.103 0.099Property rights security 0.392 0.532Reinvestment rate 0.598 0.732Political connection 0.691 0.635High level connection 0.121 0.135Low level connection 0.569 0.500

a Inland and Northern provinces include Anhui, Gansu, Guangxi, Hebei, Henan, Hubei, Jiangsu, Jiangxi, Liaoning, Qinhai, Shandong, Shanxi, Shaanxi, Sichuan,and Yunnan.

b Southeastern‐Coastal provinces include Beijing, Fujian, Guangdong, Hainan, Shanghai, and Zhejiang.c Source: China Statistical Yearbook 1997. (China Statistical Bureau, 1997).

Table 4Logistic regression estimates for the effect of political connections on perception of property rights security.

Variables Perception of property rights security

(1) (2)

Political connection 0.327⁎⁎(0.128)

High level connection 0.371⁎(0.205)

Low level connection 0.319⁎⁎(0.132)

Firm age (logged) 0.133⁎⁎ 0.133⁎⁎(0.067) (0.067)

Firm size (logged) −0.002 −0.003(0.041) (0.041)

City firm 0.178 0.174(0.148) (0.149)

Public firm −0.275 −0.273(0.315) (0.316)

Return on sales −0.361 −0.365(0.378) (0.379)

Female −0.208 −0.210(0.242) (0.242)

Education −0.023 −0.024(0.025) (0.025)

Age −0.009 −0.009(0.007) (0.007)

Inland and Northern provinces −0.567⁎⁎⁎ −0.569⁎⁎⁎(0.124) (0.124)

15 dummies for industrial sectors added addedConstant −0.975 −0.956

(1.129) (1.130)Log pseudolikelihood −844.98502 −844.94566Observations 1294 1294

Notes: robust standard errors in parentheses.⁎⁎⁎ Significant at 0.01.⁎⁎ significant at 0.05.⁎ significant at 0.1.


anecdotal evidence of widespread government predatory behaviors in China reported by previous studies (e.g., Nee, 1992; Peng,2004; Xin and Pearce, 1996).

Table 3 compares Inland and Northern with Southeastern-Coastal provinces, revealing that the two clusters varied widely interms of economic development, legal protection of private property rights, and exploitation of political connections. First, whileboth clusters were similar in terms of GDP growth rate, Inland and Northern provinces lagged far behind in economicdevelopment, as their average per capita GDP was only 39% (3059.69/7824.44) of that of Southeastern-Coastal ones. This mightsuggest that Inland and Northern provinces on average had much less developed market institutions, because regional per capitaGDP was highly correlated with market development (Fan and Wang, 2001; Zhou, 2011). Second, Inland and Northern provincesindeed had weaker legal protection of property rights. On average, 39.2% of entrepreneurs in Inland and Northern provincesreported secure property rights, compared with 53.2% in Southeastern-Coastal ones. Third, political connections were morewidespread in Inland and Northern provinces. On average, 69.1% of entrepreneurs in Inland and Northern provinces werereported to have political connections, compared with 63.5% in Southeastern-Coastal ones. And this difference was primarilydriven by low level political connections (56.9% in Inland and Northern provinces and 50% in Southeastern-Coastal ones). Overall,therefore, Inland and Northern provinces indeed lagged behind Southeastern-Coastal ones in terms of market development andlegal protection of private property rights.

4.1. Major findings

Results for testing Hypothesis 1 are reported in Table 4. Here I regress perception of property rights security on politicalconnection (or the two levels of political connection) and all firm-level control variables, together with the binary variable ofInland and Northern provinces.

Overall, Hypothesis 1 is supported. Column 1 shows that political connection indeed has a significantly positive effect,suggesting that entrepreneurs/firms with political connections perceived more secure property rights, with being politicallyconnected increasing odds of property rights security by a factor of 0.39 (e0.327 — 1≈0.39). Column 2 further shows that highlevel connection has a stronger effect than low level connection, suggesting that high level connections are more useful inprotecting property rights. Substantively, high level connection increases the odds of property rights security by a factor of 0.45(e0.371 — 1≈0.45); and low level connection increases the odds by a factor of 0.38 (e0.319 — 1≈0.38).

Table 4 also shows that firm size has an almost zero effect on property right security. This result supports our previousconjecture in Section 2.2 that, overall, larger firms are not more likely expropriated or extorted by the government than smaller

Table 5Fixed effects estimates for the effect of political connections on reinvestment rate.

Variables log(reinvestment rate)

(1) (2) (3)

Political connection 0.682⁎⁎⁎ 0.597⁎⁎ 2.801⁎⁎⁎(0.234) (0.230) (0.986)

Political connection×log (firm size) −0.460⁎⁎(0.170)

Firm age (logged) −0.032 −0.032(0.080) (0.082)

Firm size (logged) 0.374⁎⁎⁎ 0.701⁎⁎⁎(0.104) (0.192)

City firm −0.049 −0.048(0.297) (0.315)

Public firm 0.500⁎⁎ 0.498⁎⁎(0.235) (0.210)

Return on sales 1.121 1.367(0.995) (0.997)

Female 0.689⁎ 0.677⁎(0.367) (0.356)

Education −0.071⁎⁎ −0.074⁎⁎(0.034) (0.034)

Age 0.017 0.017(0.011) (0.011)

15 dummies for industrial sectors added addedConstant −1.783⁎⁎⁎ −3.033⁎⁎⁎ −4.872⁎⁎⁎

(0.158) (0.892) (0.971)R2 0.005 0.032 0.038Observations 1346 1267 1267

Notes: robust standard errors in parentheses.⁎⁎⁎ Significant at 0.01.⁎⁎ significant at 0.05.⁎ significant at 0.1.


ones. It is also seen that coefficients of Inland and Northern provinces are negative and highly significant, suggesting that theseregions indeed had weaker legal protection of property rights, confirming the findings from Table 3.

Hypothesis 2 argues that entrepreneurs with political connections would reinvest more of their profits. Results for testingHypothesis 2 are reported in columns 1 and 2 in Table 5. Column 1, which is the baseline model, regresses reinvestment rate ononly one variable: political connection. Column 2 is the fully specified model, which controls for all other covariates in addition topolitical connection. In both equations, the coefficient of political connection is positive and statistically significant. Substantively,results in column 2 suggest that having political connections increases reinvestment rate by 82% (e0.597 — 1≈0.82). Therefore,Hypothesis 2 is supported.

Hypothesis 3 suggests that entrepreneurs with higher level political connections would have higher reinvestment rates.Columns 1 and 2 in Table 6 present the results for testing this hypothesis. These two equations are specified in the same way as incolumns 1 and 2 in Table 5, except that, here, political connection is replaced by two variables— high level connection and low levelconnection. Again, we see that coefficients of both high level connection and low level connection are positive and statisticallysignificant in both columns. In addition, both columns suggest that the coefficient of high level connection is larger than that oflow level connection. To interpret, results in column 2 suggest that having high level political connections increases thereinvestment rate by 91% (e0.645 — 1≈0.91), and having low level political connections increases the reinvestment rate by 80%(e0.588 — 1≈0.80). And, results from the Wald test suggest that the difference between the coefficient of high level connectionand that of low level connection is statistically significant. Thus, Hypothesis 3 is also supported.

Hypothesis 4 argues that entrepreneurs' political connections would have a higher effect on reinvestment rates for smallerfirms. To test this hypothesis, I add into the fully specified models in column 2 of Tables 5 and 6 the interaction between politicalconnection (or the two levels of political connection) and firm size. Results are presented in column 3 in Tables 5 and 6. It is notedthat the coefficients of the interaction variables are all negative and statistically significant. Substantively, as firm size increases bya factor of e, the effect of political connection decreases by 63% (e−0.460≈0.63); the effect of high level connection decreases by53% (e−0.640≈0.53) and that of low level connection decreases by 66% (e−0.409≈0.66). Thus, Hypothesis 4 is also supported.

Hypothesis 5 argues that political connections would be more useful in Inland and Northern provinces than inSoutheastern-Coastal provinces. To test this hypothesis, I split the whole sample into two sub-samples based on the tworegional clusters and regress reinvestment rate (logged) on political connection (or the two levels of political connection) and all

Table 6Fixed effects estimates for the effect of different levels of political connections on reinvestment rate.


(1) (2) (3)

High level connection 0.764⁎⁎⁎ 0.645⁎⁎⁎ 3.926⁎⁎⁎(0.218) (0.227) (1.145)

High level connection×log (firm size) −0.640⁎⁎⁎(0.208)

Low level connection 0.665⁎⁎ 0.588⁎⁎ 2.530⁎⁎(0.272) (0.267) (0.975)

Low level connection×log (firm size) −0.409⁎⁎(0.168)

Firm age (logged) −0.032 −0.034(0.080) (0.083)

Firm size (logged) 0.373⁎⁎⁎ 0.702⁎⁎⁎(0.105) (0.191)

City firm −0.053 −0.042(0.307) (0.328)

Public firm 0.503⁎⁎ 0.483⁎⁎(0.237) (0.199)

Return on sales 1.112 1.282(0.993) (0.952)

Female 0.687⁎ 0.683⁎(0.367) (0.351)

Education −0.072⁎⁎ −0.078⁎⁎(0.032) (0.034)

Age 0.017 0.016(0.011) (0.011)

15 dummies for industrial sectors added addedConstant −1.783⁎⁎⁎ −3.013⁎⁎⁎ −4.664⁎⁎⁎

(0.156) (0.867) (0.966)Wald test for equality of coefficients between high level connection and low level connection 5.970⁎⁎⁎ 4.840⁎⁎ 3.490⁎⁎R2 0.005 0.032 0.039Observations 1346 1267 1267

Notes: Robust standard errors in parentheses.⁎⁎⁎ Significant at 0.01⁎⁎ Significant at 0.05.⁎ Significant at 0.1.


control variables (as in column 2 of Tables 5 and 6) for both sub-samples. Results are reported in Table 7. Columns 1 and 2 suggestthat political connection has a significantly positive effect on reinvestment rates in Inland and Northern provinces, but only apositive but not significant effect in Southeastern-Coastal provinces. The same pattern is found in Columns 3 and 4, where thecoefficients of both levels of political connections are positive and significant with high level connection having a stronger effectin Inland and Northern provinces, but positive but not significant in Southeastern-Coastal provinces. In addition, Wald test resultssuggest that there is a significant difference for the coefficients of the variables between column 1 and column 2 and betweencolumn 3 and column 4. Hypothesis 5, therefore, is supported.

Effects of some control variables in Tables 5–7 deservemention, as well. Overall, firm size has a significantly positive effect. Thismay be partly because larger private firms usually enjoyed better treatment from the government, and had more economicopportunities (IFC, 2000). Being registered as a public firm also has a positive effect on reinvestment rates, suggesting that suchhybrid firms may indeed have enjoyed favorable government treatment in terms of both property rights and resource acquisition(Nee, 1992). Education of the entrepreneur, however, has a negative effect. One possible explanation for this is that entrepreneurswith higher education were more likely to work in urban service sectors, which usually had lower reinvestment rates than therural manufacturing sector.

Somewhat surprisingly, despite strong individual coefficients for variables like political connections and firm size, Tables 5–7show quite small R2 — the proportion of variation in the sample data explained by the regression model — for each regressionequation. Although a larger R2 does not necessarily mean that the regression model better fits the data (Wooldridge, 2002), andother entrepreneurship studies using similar Chinese national survey data reported similar R2 (e.g., Li et al., 2008), there is a needto explain the low values of R2 in the tables. There may be two primary reasons. The first resides in the wide variation in thedependent variable — log (reinvestment rate), which has a mean of −1.368 with a standard deviation of 4.599. The largevariation in log (reinvestment rate) has been reported in prior studies (Johnson et al., 2002; see also Cull and Xu, 2005) and willincrease the total sum of squares (the denominator of R2). The second reason may involve the omitted variable bias. Like mostentrepreneurship studies, at this point, this study suffers from the omitted variable bias primarily because of the difficulty inmeasuring the true abilities of entrepreneurs, which potentially affect entrepreneurial activities and outcomes (Hamilton, 2000),although human capital variables and returns on sales that have been controlled in the regressions may capture abilities of

Table 7Fixed effects estimates for the effect of political connections in different regions.


Southeastern-Coastal provinces Inland and Northernprovinces

Southeastern-Coastal provinces Inland and Northernprovinces

Political connection 0.588 0.603⁎⁎(0.391) (0.281)

High level connection 0.835 0.639⁎⁎(0.602) (0.276)

Low level connection 0.531 0.597⁎(0.406) (0.324)

Firm age (logged) 0.048 −0.025 0.049 −0.025(0.232) (0.102) (0.233) (0.103)

Firm size (logged) 0.449⁎ 0.348⁎⁎⁎ 0.440⁎ 0.347⁎⁎⁎(0.213) (0.116) (0.217) (0.118)

City firm 0.406 −0.097 0.402 −0.099(0.223) (0.333) (0.207) (0.348)

Public firm 0.970 0.447⁎ 0.983 0.448⁎(0.712) (0.241) (0.719) (0.241)

Return on sales −0.115 1.445 −0.230 1.441(0.800) (1.220) (0.880) (1.218)

Female 0.416 0.755 0.376 0.754(0.335) (0.457) (0.302) (0.457)

Education 0.015 −0.086⁎ 0.011 −0.086⁎⁎(0.029) (0.042) (0.022) (0.040)

Age 0.004 0.022 0.006 0.022(0.022) (0.014) (0.024) (0.013)

15 dummies for industrial sectors added added added addedConstant −2.611 −3.136⁎⁎⁎ −2.556 −3.120⁎⁎⁎

(1.425) (1.032) (1.373) (1.009)Wald test for equality of coefficients in tworegions

592.290⁎⁎⁎ 271.57⁎⁎⁎

R2 0.101 0.031 0.101 0.031Observations 240 1027 240 1027

Notes: robust standard errors in parentheses.⁎⁎⁎ Significant at 0.01.⁎⁎ Significant at 0.05.⁎ Significant at 0.1.


entrepreneurs, partially. The omission of the ability variable will reduce the fit of the regression model to the data (and thusdecrease the numerator of R2). It should be noted, however, that the omission of the ability variable may have little affect on themain results reported in this paper, because political connection— the independent variable— is measured with social connectionbased on kinship and long-term friendship, which may have little correlation with ability.

4.2. Robustness tests

In this study, I have combined into one group entrepreneurs who were government officials previously (type 1) withentrepreneurs whose family members, relatives, or friends were officials (type 2) because the two types of entrepreneurs overlapto a high degree. I have attempted testing the effect of each type of political connection independently using the same modelspecification as in Eq. (1). The results suggest that the hypotheses are still supported if political connection is defined based oneither type 1 or type 2 only, but not both.7

Following the political connections literature (e.g., Faccio, 2006; Johnson and Mitton, 2003), this study uses a binary measurefor political connections. However, this measure is somewhat crude, since it does not indicate numbers of political connections,though reinvestment rates are sensitive to even this minimum specification. As such, it may not be able to fully capture the effectsof political connections. The survey allows us to identify numbers of political connections (and numbers of high/low levelconnections) for each entrepreneur, although there are too many missing values for these alternative interval measures and, thus,I do not use them for reporting results. Results suggest that hypotheses 1–5 are still largely supported by using the alternativeinterval measures of political connections.8

5. Discussion

5.1. Contributions

This paper makes several contributions to the existing literature. First, it serves as an important addition to the literature onthe role of political connections. As mentioned previously, although prior studies in this literature have found positive effect ofpolitical connections, there has been a lack of systematic research on the mechanisms through which political connections affecteconomic outcomes. Based on new institutional theory (Dixit, 2004; North, 1990), this paper identifies two mechanisms throughwhich political connections affect genuine entrepreneurship, i.e., facilitating access to key resources and opportunities, andproviding private protection of property rights. And, empirical evidence suggests that political connections may indeed facilitateprivate protection of property rights, a notion which has rarely been empirically confirmed.

In addition, while prior studies have found that political connections are more widespread among larger firms (e.g., Faccio,2006; Johnson and Mitton, 2003), there is no research on, and, empirically, it is also not clear whether political connections aremore beneficial to large firms or SMEs. This study finds that smaller firms, though facing similar level of governmentexpropriation and distortion as larger ones, have more resource obstacles; and thus, overall, may benefit more from politicalconnections. Moreover, it is often assumed in the existing literature that political connections may substitute for formal legal andmarket institutions, and may, thus, have a decreasing effect as the latter improve (e.g., Faccio, 2006; Xin and Pearce, 1996). Yet,this assumption has rarely been empirically tested. Taking advantage of uneven institutional development across Chinese regions,it is found that political connections have larger effect in regions with less developed market and legal institutions, thus providingempirical support to the substitution argument.

Second, this paper contributes to the general entrepreneurship literature. Primarily based on economic theorists such as North(1990, 2005) and Baumol (1990), the prior entrepreneurship literature has focused on the role of formalmarket and legal institutionsin entrepreneurship. Based on North (1990) and recent developments in new institutional economic theory (e.g., Dixit, 2004; Rodrik,2003), this study has demonstrated that political connections as an informal social arrangement also matter for genuineentrepreneurship, especially, underweakmarket and legal institutions. Given that political connections arewidespread amongmanyless developed and transition economies, this result may help resolve the puzzle of high levels of entrepreneurial investment underdeficient institutions in these economies.

In addition, our empirical finding that supports the substitution argument also helps resolve the debate on the role of politicalconnections during institutional development. While many empirical researchers have assumed that political connections maysubstitute for formal legal and market institutions, some new institutional scholars have conjectured that informal socialarrangements such as political connections may complement, rather than substitute for, formal institutions because the latter aregenerally limited (e.g., Dixit, 2004). Based on empirical data from China, this study supports the substitution argument bydemonstrating that political connections play a diminishing role because their benefits decrease and their costs increase as formalinstitutions improve in a less developed or transition economy. However, it should be noted that although political connections

7 Using the fully-specified model for testing Hypothesis 2, for example, when political connection is defined as type 1 entrepreneurs only, its coefficient is 0.538(0.279); and when political connection is defined as type 2 entrepreneurs only, its coefficient is 0.445 (0.220). Here in parentheses are robust standard errors.

8 These results are available upon requests. All of these results are based on the fully specifiedmodels with all control variables included. That is, Hypothesis 1 istested as in Table 4, Hypothesis 2 as in column 2 in Table 5, Hypothesis 3 as in column 2 in Table 6, Hypothesis 4 as in column 3 in Table 5 and 6, and Hypothesis 5as in Table 7, except that the binary variables of political connections are replaced by the interval measures.


play a diminishing role during institutional development, they could still play a positive role even under developed marketinstitutions in advanced economies, as found by prior studies (e.g., Pfeffer and Salancik, 2003[1978]).

Third, in terms of more specific literature on Chinese entrepreneurship, the findings of the paper will contribute to understandingthe rapid growth of China's private entrepreneurial firms in the first two decades of the economic reform (1978–1999). It has beennoted that China's rapid entrepreneurial growth is puzzling (Zhou, 2011). Unlike Eastern Europe and former Soviet states, the Chinesestate did not have any government programs to deliberately develop its domestic private sector (e.g., IFC, 2000; McMillan andWoodruff, 2002; Zhou, 2009). In addition, as discussed in Section 3.1, the formal institutional environment was not conducive to theprivate sector during that period. Such an unconducive institutional environment has led some China scholars to argue that mostprivate entrepreneurial firmswere under the guise of local public ownership, and that the rapid entrepreneurial growthwas largely aresult of active support from local governments, which had both interest in and resources to support locally owned public firms(Huang, 2008). Other scholars, however, have emphasized the significance of social network ties. Drawing on the growing literatureon the role of political connections in China's transition economy (e.g., Li and Zhang 2007; Li et al., 2008; Walder and Zhao, 2006;Zhou, 2009), this study suggests that strong network ties to government officials may be one of the keys to understanding China'srapid entrepreneurial growth. Given that political connections can facilitate resources and private protection of property rights and,thus, entrepreneurial reinvestment in the absence of developedmarket and legal institutions, it is seen that about two thirds (68%) ofthe entrepreneurs in the survey data had political connections, whichmay suggest the significance of political connections in China'sentrepreneurial growth.

If political connections indeed play a significant role in China's entrepreneurial growth, then this means that, to succeed inbusiness, a Chinese entrepreneur often needs not only business skills but also continuous political investment (Zhou, 2009).While such political investment and the resulting political connections may provide protection and resources for entrepreneurs,as argued in this paper, they also divert entrepreneurs' energies and attention from more productive activities that propeleconomic progress for the whole society (Baumol, 1990). In this sense, China's private entrepreneurship could have developedmore rapidly and strongly if the legal and market environment had been more conducive.

It should be noted that, although, in general, political connections may play a positive role in many less developed andtransition economies because of deficient formal institutions, their value can be attenuated or even turn into a liability for firmsand entrepreneurs under certain political environments in such economies (for a review, see Siegel, 2007). For example, in someless developed economies, political regimes that come into power often expropriate the power of those they have displaced and,thus, firms are found to experience reversals of fortune to their detriment when the political elites to which they are tied fall frompower (Fisman, 2001; Johnson and Mitton, 2003; Siegel, 2007). In this sense, the existence of a stable and strong political system,such as that in China, may be a reason that political connections can have long-lasting positive effects on entrepreneurial growthin less developed and transition economies.

5.2. Limitations and future research

This study has several limitations that may suggest directions for future research. First, constrained by data, it has adoptedbinary measures that do not measure quantities of political connections. Also, these measures have included only strong politicalcontacts connected directly with entrepreneurs. Weak political ties that may also be useful have not been included (Granovetter,1973), nor have indirect but strong political ties (e.g., close friends of one's parents).9 Future research may use more refinedmeasures of political connections to fully capture effects of political connections. Ideally, these should measure both quantity andthe strength of political ties, as in the social network literature (e.g., Burt, 1992; Granovetter, 1973).

Second, since the data are cross-sectional in nature, there is a potential problem of endogeneity. Although this is less a problemfor this study as it focuses solely on strong, durable political connections based on kinship or long-term friendship, endogeneitycan arise if both the quantities and the strength of political ties are measured. Thus, future research may need to tackle thisproblem using either a longitudinal research design or an instrumental variables approach.

Third, constrained by the data, I have tested the contingent role of political connections under different institutionalenvironments by comparing effects of political connections in two different regional clusters that varied significantly in formalmarket institutions. Although this approach is defendable, future research may implement better tests through examiningchanging effects of political connections, either through interacting political connections with regional level institutional variablesusing a Hierarchical Linear Modeling approach, or comparing their effects at different points in time for the same firms using alongitudinal research design.

In addition, as this study uses survey data from China in the mid 1990s, one may wonder how political connections may affectentrepreneurship in China today, in the early 2010s. Since China was accepted into the WTO in 2001 and, particularly, since anamendment was introduced into the Chinese Constitution in 2004, the Chinese government has been taking measures to providemore protection for private property rights and to level the playing field between state-owned enterprises and private firms(Zhou, 2009). In addition, upon seeing the high economic growth in provinces, such as Zhejiang, that have adopted liberal policiesconcerning entrepreneurship, regional governments throughout China have issued special government orders to elevate thestatus of private firms/entrepreneurs, to remove predatory and discriminative regional practices against them, and to easecomplex administrative procedures for them since the late 1990s (Zhou, 2011). All of these new policies are a blessing for private

9 Since I measure political connections as a binary variable in this study, omitting indirect strong ties like close friends of one's parents will not affect results,since effects of such ties have been captured by those of direct ties.


entrepreneurial firms, especially SMEs which have been particularly discriminated against by the government, previously. As aresult, based on the findings of this paper, we would expect that political connections would have less effect on entrepreneurshipin China today. Future research may investigate this issue using more recent data.

6. Conclusion

Recent literature in entrepreneurship suggests that market and legal institutions matter for entrepreneurial investment. Yet,prior studies have focused on the role of formal institutions. Building on new institutional theory and political connectionsliterature, this study aims to evaluate the role of political connections in entrepreneurial reinvestment in less developed andtransition economies. It argues that, through facilitating resource acquisition and, particularly, protecting property rights, politicalconnections may act as a substitute for deficient market and legal institutions, thus facilitating entrepreneurial reinvestment inless developed and transition economies. Its empirical test uses a nationally representative sample of Chinese entrepreneurialfirms in the mid 1990s, when China was still in the earlier period of market transition, so that market and legal institutions werenot yet well developed. Its results suggest that entrepreneurial firms with political connections (or higher level politicalconnections) enjoy more security in terms of property rights and, thus, have significantly higher reinvestment rates; and suchpolitical connections are more useful for smaller firms and among regions with less developed market and legal institutions.

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