Privatization, Soft Budget Constraint, and Social Burdens: A Random-Effects Stochastic Frontier Analysis on Chinese Manufacturing Technical Efficiency

Traditional panel stochastic frontier studies on privatization of Chinese State-owned firms face a major challenge, namely, the endogeneity problem. The endogeneity problem is present because decision-making process of privatization in China is very likely influenced by some unobserved characteristics of a firm. In particular, better-performing SOEs are more likely to be chosen for privatization because the local governments may have incentives to attract private investors or to retain momentum for future reform. To deal with this challenge, this paper proposes a two-step stochastic frontier model. The first step addresses the endogeneity issue by estimating the probability of privatization with a random effects probit model. The second step estimation investigates the causes of Chinese manufacturing’s inefficiency with a random-effects stochastic frontier model. The estimation results suggest that privatization, hardening budget constraint and reducing firms’ social obligations have significantly contributed to the improvements of firms’ efficiency. However, no evidence is found that more autonomy for managers and lower debt asset ratio may help improve firms’ efficiency.