Pyramid Business Structures In China - Essay Example

?What are pyramidal business groups and how extensive are they in China? Diversified business groups spread across different industries are unavoidable in the developing countries business market. China, considered as the major emerging market in the modern era is filled with several huge corporate companies controlled by wealthy families. This essay explores the basics of the pyramid business structure and checks how far the business model has deep rooted in the Chinese environment. It also analyses whether the pyramidal structure is beneficial or harmful to the Chinese economy through a case study on CITIC. Introduction A pyramid business structure has one person who is a sole controller and owner of one or more organizations. The person and his firms control a chain of other business structures in various industries. Thus the person at the top of the pyramid is the indirect controller of several small firms owned by a handful of his companies. This structure is widely prevalent in all the developing countries especially China. The owner at the top of the pyramid is capable of controlling the actions of every other company under their firms with little investment through this method. Such type of business structure is important for the massive growth of huge corporate in the developing economies. But, developed countries like the USA efficiently controlled this model as early as the 1930's as it curbed the growth of small entrepreneurs and entrusted too much profit into sectored groups. The US government used various strategies like double taxation to control pyramidal business sector (Marck et al, 2005). But, the developing countries depend largely upon the huge corporate and the wealthy families of their countries for various infrastructure activities. Hence, they indirectly encourage their growth. Sir Li Ka-Shing's Cheung Kong industries own nearly 15% of the market capital in the Hong Kong Stock Exchange. Similarly Reliance controls nearly 40% of India's oil and power production. Pyramid ownership structure is a common type of corporate ownership prevalent all around the world. La Porta, Lopez-de-Silanes, and Shliefer (1999) conducted an elaborate study among the major corporate groups spread across twenty seven countries. They concluded that nearly 26% of the firms with huge number of shareholders follow the pyramid ownership structure. Claessens, Djankov and Lang (2000) confirm nearly 38.7% huge public firms in East Asia are managed through pyramid ownership. The pyramid business structure enables the ultimate owner to invest less and control massive cash flow. Another main advantage in this system is the firms controlled and the controller firms can share their resources in terms of capital, labour as well as revenue similar to business groups. But, the owner will be free from paying heavy taxes to the government for the small firms as only a handful of major firms are under his direct control. These controlled firms are used for the benefit of the owner in various ways. They can be discouraged from showing profits as the owner might need them to show losses to evade tax. These firms are run by the money invested by the common public or the shareholder who lack any control over these structures. This gap between control and cash investment paves way for tunnelling or which reduces the firm's total value. “Tunneling” generally defined as the passing of assets or profits from the smaller country to the bigger companies for the ultimate benefit of the huge group’s owner. Research done by various scholars in the western countries as well as the growing eastern market suggests the same. Research done by La Porta, Lopez-de-Silanes, Shliefer and Vishny (2002) confirmed pyramid business structures paved way for tunnelling more than the other business structures after studying the top 27 economies in the western world. Claessens et al (2002) research in East Asian economies confirms the same. Classens et at (1998) claims there are three main problems in pyramid business structure. They are over diversification, inefficient capital allocation and unnecessary mergers. The pyramid structures still bring lots of benefit to the developing countries which lack streamlined capital markets and legal frame work. Huge groups recognize potential small entrepreneurs and make offer them an opportunity for franchising or buy their products for millions of dollars exerting their control over those firms. Such type of assistance proves valuable for small entrepreneurs who are in search of good capital ceaselessly. When a particular firm in a pyramidal group runs in loss, the ultimate owner at the top of the pyramid can gather aid from the other firms at the bottom layer of the pyramid to support the struggling one. They need not invest much from their hand and it will not hurt the other firms to share a small bit of their profit. This is much more effective than in vertical business structures because, there are many firms in the bottom layer of the pyramid. Purpose of the Study The paper explores the presence of pyramid business groups in China in a detailed way. The purpose of the study is to answer two main questions What are pyramidal business groups and how beneficial or harmful they are to a country’s economy? How widespread are the pyramidal business structures in China? Scope of the study Analysing the emergence of Chinese corporate companies has several advantages. China is the best example for a diverse developing economy. The young market paves way for analyzing the birth of pyramid business structures from their birth. Since both the state controlled companies and the private owners co-exist equally, we get an easy ways to compare their pros of cons of the pyramid corporate structure in the government and private sector. The versatile Chinese market gives us a chance to analyze the reasons favourable for the emergence of pyramid business groups in the developing countries. Extensive work has been already done on the area which provides us with valid data to use in the research. Literature Review Hypothesis 1 When a firm in the pyramidal business structure is in financial distress, there is high chance for it to cope up without going to bankruptcy as it can gain help from various other sibling firms. Such a privilege is absent in vertical or horizontal business structures. Horizontal business structure: An ultimate owner controls one or multiple companies by investing in them, building them from the core. He is the main investor and has all rights to control the activities of the companies and is responsible for the cash flow of the organization. The ultimate owner owns a major fraction of the shares in the companies. Vertical Business Structure: The ultimate owner is the sole proprietor of firm A. This parent firm in turn own another small firm B. The owner enjoys substantial rights over firm A, but has limited rights over firm B. Oftentimes firm B has its own cash flow management systems raising funds from various investors while the management control is still held by the ultimate owner. Pyramid Structure: The ultimate owner will be the head of firm A. There will be one or more firms controlled by the A. Similar to a basic pyramid structure, there are a number of companies at the lower layer of the pyramid on whom the ultimate owner exerts partial rights. The parent company sits at the top of the structure. Here is an example of one such group. Xiamen Prosolar Technology Development Co., Ltd is owned by nearly four major owners. One local government and three individuals venture capitalists. Among them Ren Mei is the ultimate owner with nearly 32.41% voting rights in the company. She controls the company through a three layer pyramid. Two pyramidal chains are used by Rein Mei to control the company. Though she has invested only 8.77% directly in the Xiamen Prosolar Technology Development Co., Ltd she is the ultimate owner of the company. According to the pyramidal business structure, the ultimate owner will rob firm B and C to rescue firm D. In other words, they invest the money which they otherwise keep in their vault to save the company. The ultimate owner has to put in very little cash from their side to save the company in financial distress as there are plenty of other companies whose resources can be utilised for the same. This is a sort of win-win situation for all the parties involved (Allen & Faulhaber, 1989). Hypothesis 2 Pyramidal structures cannot flourish in countries with good investor protection. Pyramidal structures are not very transparent and follow very complex management strategies which give them a sole dictatorship over the corporate chain. This always ends dangerous to the outside investor as occurrence of tunnelling will be spotted quite late. Let us explore it through an example, CITIC. CITIC CITIC is one of China's leading state-owned investment companies. It was started in 1979 by Rong Yiren. China International Trust and Investment Corp (CITIC) specialize in steel manufacturing. But, they control various businesses from aviation to civil infrastructure. CITIC is quite popular with overseas investors. Being a "red-chip" company it was the first choice for investors who wanted to profit from China's massive growth surge. As of 2012, CITIC owns nearly RMB183.70263 billion capital. The pyramidal business structure followed by the government made in enormously prosperous in the past decades. The CITIC Group Corporation owns assets worth RMB 205.1 billion. CITIC is ranked 221st among the Fortune Global 500 companies list in the world. The company retained the same position for the third time in 2011. The CITIC groups owns various companies like CITIC Bank, CITIC securities, CITIC Metal and CITIC Discastal Wheel Manufacturing. They are by far one of the largest state-owned companies in China. Their financial services are necessary for the ever growing Chinese market with 1.3 billion customers. The CITIC group backed up the proceedings of CITIC Pacific a company specializing in steel manufacturing, and iron ore mining. The company was started in 1987 and it operated as a subsidiary of the CITIC group for a long time. Initially known as CITIC Hong Kong, the company was renamed CITIC Pacific hen Larry Yung Chi-Kin became its Vice-Chairman. Through a series of mergers and acquisitions the company spread its wing to various industries starting from power to infrastructure development. The Chairman of the CITIC group controlled nearly 18.4% of the company's total shares. The company met sever losses in 2008 worth HK $15.5 billion. CITIC Pacific's share price fell by 55.1% in a single day creating huge losses for small time investors (Sutherland et al, 2012). It was revealed later that the company has engaged in various exotic foreign exchange contracts without the knowledge or approval of its other share holders. They entered into derivative foreign exchange contracts when the Euro and the Australian dollar were appreciating against the US Dollar in the hope of accumulating more money and reaping huge profits. But, the value of the Australian currency and the Euro depreciated, backfiring their plans. It was later revealed that, the company authorities knew about the upcoming loss before six weeks. They did not take any steps to keep the investors informed about the same. They incurred a loss of $104 million totally. This incident is an example for what total control means to outside insiders in a pyramidal structure. Though there was no illegal activity or any sort of rule breach, the incident is looked upon as a worst case of corporate governance failure. As explained earlier, the losses of the company were made up by utilizing the resources from other companies in the pyramidal structure. The investors who bought the company shares in the six weeks period were the ones to be heavily hit. The company’s brand image did recover in a short time and it continues to show massive profit till date. But, little can be done in the developing economies to curb such situations and protect the investor rights (Almeida & Wolfenzon, 2004). Hypothesis 3 The companies in the lower layer of the pyramid will get little profit share from the main company at the top of the pyramid, while the major company uses the smaller firms for their profits extensively. Pyramid is a popular control structure for most of China's new IPO (initial public offering) firms, both the government controlled and entrepreneur owned. There are various reasons for the emergence of such corporate pyramid in China. Both the government and the private sector use this business structure due to various reasons. The government controlled IPO's enter into this structure because they are strictly controlled by the law regarding the transfer of state ownership (Bebchuck, 1999). They are unable to sell their shares in the free market as and when necessary. Hence, they make use of the lower layer companies in the pyramid to manage their financial issues. The system does not act as insurance for all the lower layer firms in the pyramid because the ultimate owner can readily dismantle the controlled firms if the parent company faces any financial risks. In China, the government owned companies control more complex pyramid structures than the ones in the private sector. Government offices tend to establish such a structure when they have less fiscal burden and human resource issues as a part of their expansion plan (Brandt & Li, 2003). While the government companies form pyramid structures to manage their surplus flow of money and time, the private companies form them due to extensive financial constraints the government forces upon them. Small scale entrepreneurs look upon the pyramid structure as an easy way to raise money from the public (Demruger et al, 2002). The private entrepreneurs in China are often looked down by the banks unless they have very good reputation. The foreign investors do not trust them as much as they trust the government firms. Thus the private business owners are forced to create internal financial markets where cross-subsidization among various affiliated firms will not be an issue. The pyramidal business structure offers more space for such cross-subsidization than the vertical or horizontal business structures. We could always see that the initial return on investments in the government controlled IPO's are much smaller in proportion when compared with the private sector pyramids. The pyramids structure enables the companies to list their bureaucratic costs and facilitate decentralization. Again justifying the hypothesis, the flow is bottom-up in the pyramidal structure. The parent firms always make use of the companies at the lower layer of the pyramid to fill their pockets. They rescue them form financial stress only if the parent firm is strong in finance (Claessens, S., Djankov S, Lang, L, 2000). It is evident from Cloessen's work that both the government companies as well as the private companies indulge in this form of business widely. In most of the East Asian countries the local government adopts to pyramidal ownership structure if they want to maximize the profit of the company. The US was the first country to note such a flaw as stated in the hypothesis. They effectively banned the practice of the pyramid business structures way back in1930's. The UK government adapted the same practice in 1970's. The US government successfully implemented the dividend tax strategy to curb the companies from controlling a number of firms. President Woodrow Wilson stated “No country can afford to have its prosperity originated by a small controlling class. The treasury of America does not lie in the brains of the small body of men now in control of the great enterprises,... It depends upon the inventions of unknown men, upon the originations of unknown men, upon the ambitions of unknown men. Every country is renewed out of the ranks of the unknown, not out of the ranks of the already famous and powerful in control.” (Morck, 2007) Efficient use of Pyramidal structure in Japan It is a well accepted notion that a 'big push' is necessary for rapid growth of any economy as it facilitates the entire growth of several complementary industries. Japan started to follow zaibatsu as early as 1914 for its total development. When the Meiji government failed to establish the task of total development the corporate companies which grew in small empires through the zaibatsu structure took over the task of the government. 'Big push' means total or overall development. It is based on the concept that any industry cannot survive without the co-operation from another’s. For example, for CITIC pacific is a steel manufacturing company. The company will not flourish if there is no active automobile market in the country and continuous supply of coal and labour. If a single company is able to control all three, they can easily pave way for the total development of the area. The pre-war Japan emerged as a superpower before World War I using this pyramid structure. They effectively marginalized the feudal elite in the country, allowed enough freedom for mass privatization and opened their market to foreign trade (Morck and Nakamura, 2007). Not all countries were able to follow Japan’s footsteps successfully. Similarly, Japan itself was not able to sustain this particular model long after war as it started to accumulate wealth to a particular class of wealthy families instead of equal distribution of wealth to all class of people. After the World War I, the country experienced various financial issues. The US government was quick to learn its lesson from Japan’s deteriorating economy and banned the pyramidal structures in the US soil quickly though double taxation (Karpoff & Rice, 1989). The double taxation scheme followed in the US makes the ultimate owners at the top of the pyramid pay more taxes when they exert control over other companies or simply try to transfer assets or money internally to other firms. But, in spite of these measures, 90% of the country’s wealth is still accumulated within 1% of the population. The new tax reforms paved way for the enactment of dividend taxes, but abolished all consolidated taxes for business groups enabling them to carry out the structure in a different format (Morck, 2004). However, the companies were prevented from growing too big. The Securities and Exchange Commission established to control the massive growth of the corporate companies ensured a particular level of protection to the public investors way better than the laws in other countries (Karpoff & Rice, 1989). As a part of economic transition that occurred in 1980's the Chinese government encouraged both the government and the private industry to form business groups known as 'quiye jituan'. Firms from various industries formed coalitions of various levels to create huge business groups which will stay binded for a long period of time. The 'quiye jituan' was expected to grow as strong as Japan's 'Zaibatsu' or Koreas 'Chaebol' (Kiester, 1998). Each Chinese groups in the 'quiye jituan' operated autonomously developing stable multi-firm exchanges across the country. But soon, they deteriorated into control houses of the parent companies. The pyramidal structure started to pop up when the parent companies started creating small subsidiary companies to include in the pyramid instead of forming an alliance with already existing firms. This allowed the owner of the key company to expand his business to various industries easily with little capital and still retain their rights upon them directly. Several successful companies started to follow the same structure owing to their high profits and control (Khanna & Palepu, 1997). Emergence of pyramidal business structure in Government Fan & Wang (2003) conducted an elaborate research on the 'Emergence of pyramidal structures in China'. They studies over 742 new IPO firms controlled by various Chinese local governments and 130 firms controlled by private entrepreneurs. Their research states the government companies started to indulge in pyramidal business structures because any government owned asset was prohibited from sales by the government whereas such a restriction was not applicable for the private sector. The government companies which were struggling to maintain their hold on certain markets were looking forward eagerly for ways to sell their assets and modernize themselves in technology and infrastructure ( Khanna &Yafeh, 2005). They were looking for credible decentralization methods zealously during the economic transition period. Hence, the government agencies created pyramidal layers and exerted their rights over small firms. They transferred the assets to such companies and sold them, taking back the money to use it for the benefit of the parent company. Managers gained indirect autonomy through the pyramid business structure. They felt their hands were tied when they were working directly for the government as they were forced to do what the government states. The pyramidal structured provided them the space necessary to use various strategic techniques. Hence, firms which had very little labour problems and good legal knowledge started to indulge in creating pyramid businesses. These pyramidal structures were cost effective it motivated group formation and helped in the betterment of firm performance e (Keister, 1999; Khanna and Palepu, 2000). All this led to massive emergence of government owned pyramid business structures. Emergence of Pyramid model in the private firms The private entrepreneur owned pyramid firms have grown extensively occupying an important part of China's economy. It is a common practice for the entrepreneurs to make their business public by selling shares in the capital markets. These entrepreneurs control the publicly listed companies through complex pyramids. For example, CITIC group controls the over 13 companies. The CITIC Pacific is not directly listed under the CITIC group companies through they are responsible for any major decision taken in the company. There is no evidence of 'tunnelling' in the company so far. But, their lack of efficient governance created major loss for the shareholders ( Khanna &Yafeh, 2007). Another example worth observing is the Li Ka-shing Group in Hong Kong. Li Ka-Shing served as a member in the board of directors group in CITIC. He developed the company into one of China's largest conglomerate, though he served in the company for only one year. Li Ka Shing started the Cheung Kong Holdings Limited which serves as Hong Kong's leading multi-national conglomerate. The group controls nine companies out of which Hutchinson Telecommunications, Hutchinson Whampoa Limited, Cheung Kong Infrastructure Holdings Limited and TOM online are prominent ones. Though investor protection rights is very high in Hong Kong, the ultimate owner Li Ka Shing's company directly owns nearly 34% of cash flow in the Hutchinson companies. The Li Ka-Shing Family directly owns, Cheung Kong, Start TV and Husky Oil. The Cheung Kong comapny holds nearly 10 companies including Hutchinson Whampoa. Most of these companies in turn own another company. Hutchinson Whampoa alone controls three companies Cluff Resource, Cavendish International and China Strategic Invest. Cavendish International in turn controls the Hong Kong Electric company and is linked closely with Star TV. Li Ka-Shing controls nearly 34% of the Hong Kong Electric company. The family owns 35% cash flow rights in Cheung Kong. Cheung Kong controls 34% cash flow in Hutchinson Whampoa. The Li Ka-Shing family owns 5% cash flow right in the China strategic investment company, but 34% of its control rights (Obata & Seki, 2003). The pyramidal business structure cannot do much harm to the investors if the laws of the country or a nation are favourable to investor protection. The level of investor protection in the country influences the value and performance of the pyramid structure to a great level. During the East Asian economic crisis in the 1990's, major firms like the Hyundai Group in Korea and the Nursalim group in Indonesia suffered heavy blow causing major losses to the investors. Only companies in the lower layer of the pyramid suffered huge market value loss whilst the companies on the top layer of the pyramid were quite secure. Obata and Seki (2003) who did a comparative research on the three groups Hyundai from Korea, Nursalim from Indonesia and Li Ka-Shing's Cheung Kong group from Hong Kong clearly support this thesis. Their observation about the Nursalim group states "the value of PT. BDNI Capital, one layer below Gadjah Tunggal in the pyramid, suffered a loss in market valuation during the Crisis. While its market value to book ratio was 1.41 (industry average of 1.09) in 1995, and 1.78 (1.35 industry) in 1996, it became 0.68 (0.57 industry) in 1997, 0.15 (0.20 industry) in 1998 and 0.15 (0.17 industry) in 1999." Similarly their observation about the Hyundai Motor located in the top layer of the pyramid structure is given below. "Its market value to book ratio was 0.72 (0.49 industry) in 1997, 0.51 (0.54 industry) in 1998, and 0.69 (0.51 industry) in 1999 while it was generally below the industry average before the Crisis: 1.28 (1.25 industry) in 1995 and 0.78 (0.91 industry) in 1996." Considering the extent to which the pyramidal structures are spread in China, we can say they are quite well spread. Joseph et al (2005) work considered a sample of 742 government firms and 52 firms private firms. They eliminated all the central government firms and other business structures like vertical and horizontal. They studied the structure of the firms carefully through a series of years to determine whether they are actually using pyramidal business structure. They used the CSMAR ( China Stock Market and Accounting Research) database to collect data about the company. They also collected the details about various companies from their website and through by checking how many times their sole proprietorship had been changed in the past. Their results are shown below. They indicate nearly 70% of the total companies follow the pyramidal business structure in the sample gathered (Fan & Wang, 2002). They also calculated the number of layers in the pyramids in every company they analyzed. Their results are shown in the tabulation given below. They considered the companies established from 1991 to 2001 (Fan & Wang, 2006). Methodology of Research Following their same methods of data collection and research we extended the research to companies established between 2001 and 2008. The result shows nearly 32% of the firms are still controlled by the influential and wealthy families. The data is collected efficiently from internet. We collected the data from 9,217 companies in total from the database. We could observe on an average it takes 3.3 layers for an ultimate owner to control a listed of companies. The results correlated are given below. The details regarding pyramid business structures in other countries are gathered from the academic works of many writers. (Liu, Zheng & Zhu, 2010) Conclusion It is only common in a country like China with medium investor protective laws to have extensive number of companies with pyramid business structures. Business groups serve useful purposes in poor countries. They have an enormous social responsibility in the developing economies. But, the role of huge corporate in developed economies still very uncertain. Studies about corporate ownership around the world state the pyramid business structure is preferred by the primary shareholders who wish to control the firms which surpass their cash flow rights ( La Porta, De Silanes, Shleifer). The pyramidal control structures are very common in nearly all the world countries outside the US and the UK. Pyramidal control structures, super voting rights and cross share holding are common in the developing economies as well as the developed economies. Though the pyramidal business structure is beneficial in various ways, it has the following drawbacks. Poor utilization of resources: The family of the ultimate owner grow dominant over time and the control rights of all the firms revolve entirely within the families. This will create problems when it comes to managing the company resources fruitfully. They can easily use the resources common for the shareholders for their personal benefits or to maintain brand image (Liu & Lu, 2007). Lack of innovations: Considering the big picture of nation’s economy they control the rise of new entrepreneurs who does not comply with their laws. Accumulation of power and assets by a small group of people will result in poor innovation and distorted of capital allocation (Liu, Zheng & Zhu, 2010). Political Influence: Political influence also plays a major role in building pyramidal business structures. The ultimate owners are usually people with high political contacts or politicians themselves who are in position to draft laws and regulations in favour of the parent company. One good example is Rong Yiern, the founder of CITIC. He served as the Vice President of the People's Republic of China from 1993 to 1998. The pyramidal structure is wide spread in spite of its ample drawbacks. 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