Exchange Structures in Transition: Lending and Trade Relations in Chinese Business Groups

by Lisa A. Keister
Exchange Structures in Transition: Lending and Trade Relations in Chinese Business Groups
Lisa A. Keister
American Sociological Review
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The Ohio State University

The networks of interfirm relations that developed in business groups during eco- nomic transition are central to China's reform and are becoming an important part of the country's emergent economic structure. Using a recent and original data set that includes direct observations of economic choices made by firms, the process by which these interfirm lending and trade ties emerged and evolved in the early stages of reform is explored. Initially, information from sources external to the network dominated the formation and direction of exchange relations. Firms turned to their prior connections, took advantage of market position, and drew on bureaucratic power to develop alliances. Over time, internal influences gained importance, and managers increasingly drew on internal nontrade relations and other indicators inside the business group to identify lending and trade partners. The results demon- strate the central but changing role that social relations and environmental cues played in the creation of economic structure during China's transition. This study also contributes to an understanding of the processes of organizational adaptation to a major economic transition and interfirm alliance formation more generally. The findings reveal that firms select exchange partners of known reputation and solicit relations that reduce uncertainty, even when there is a cost involved.

THE EMERGENCE of business groups is one of the most dramatic changes to China's industrial structure resulting from economic reform. A necessary component of economic transition from central planning is the transformation of lending and trade rela- tions between the state and industry (Walder 1995). Business groups (qiye jituan) were the primary vehicle through which the Chi- nese state and large industrial enterprises re-

Direct all correspondence to Lisa Keister, De- partment of Sociology, 378 Bricker Hall, 190 North Oval Mall, Columbus, OH 43210, (614) 688-8685 ( I am grateful for comments from Belton Fleisher, Bill Form, Doug Guthrie, Lowell Hargens, Randy Hodson, David Jacobs, Craig Jenkins, Bob Kaufman, Jim Kitts, Jim Moody, Victor Nee, Barry Wellman, partici- pants in the University of Wisconsin Economic Sociology Workshop, and four anonymous re- viewers. I also thank Gary Hamilton, Robert Feenstra, and the Shanghai and Chinese Acad-

defined their ties (Keister 2000; Li 1995). Business groups are coalitions of firms from multiple industries that interact over long periods of time and that are distinguished by elaborate interfirm networks of lending, trade, ownership, and social relations. The organizational structure of a business group resembles a conglomerate, but relatively ex- clusive internal relations make the groups highly stable and resistant to reorganization (Granovetter 1995; Powell 1990). In the early 1980s, Chinese reformers began to separate firms from administrative bureaus and to reduce state support of firms to en-

emies of Social Sciences for data assistance. This research was supported by grants from the Na- tional Science Foundation (SBR-9633121), the

U.S. Department of Education, the Cornell Uni- versity East Asia Program and Center for Inter- national Studies, IBM, and the Institute for Re- search in the Social Sciences at the University of North Carolina at Chapel Hill.


courage the formation of business groups. Firms that joined business groups gained significant autonomy, and they also became responsible for finding inputs and marketing their products. As the firms sought sources of goods and capital, they quickly developed stable intercorporate exchange ties similar to those found in Japan's keiretsu and Korea's chaebol (Keister 1998).

The networks of relations that developed within China's business groups will likely shape reform and the country's post-reform economic structure, but the process by which these ties developed and the resulting structure of relations has attracted little re- search attention. Business groups decreased interdependence between the state and firms, which facilitated growth during transition by increasing firm accountability, reducing the need for government monitoring, improving incentives for performance, and minimizing political maneuvering (Kornai 1992; Walder 1995). Relations within China's business groups also increased growth and productiv- ity by improving the flow of information among member firms and creating econo- mies of scale (Keister 2000). Following re- form, relations in the business groups will likely continue to shape firm performance (Lincoln, Gerlach, and Ahmadjian 1996), corporate governance (Strachan 1979), lev- els of regional development (Orru, Biggart, and Hamilton 1997), and the nature of for- eign competition (Ghemawat and Khanna 1998; Granovetter 1994). Decisions that firms made early in reform about lending and trade ties will affect China's economic structure for decades because these ties quickly began to solidify into stable inter- firm alliances. Yet the factors that influenced firm decision-making at this pivotal point have not yet been explored systematically.

I explore the formation of interfirm ties in Chinese business groups during reform. Re- search on economic transition shows that as central control declined and markets devel- oped, the conditions and incentives manag- ers encountered changed dramatically. At the start of reform, budget constraints were rela- tively soft and markets had just started to emerge (Jefferson and Rawski 1994; Schaffer 1998). Within a decade, budget constraints hardened, markets replaced cen- tral planning nearly completely, and compe- tition was pervasive (Walder 1995). Manag- ers were increasingly concerned with effi- ciency and productivity (Rawski 1994), but long-term security and strategic advantage also affected their decisions (Jiang 1993; Nee 1992). Studies of transition show that these changes shaped firm behavior and growth, but the impact of transition on inter- firm ties has not been explored. In contrast, research in Western organization theory shows that firms develop stable interfirm ties to reduce uncertainty and related risks (Galaskiewicz 1985; Mizruchi and Steams 1988; Palmer, Friedland, and Singh 1986). Firms initially use external cues to identify trade partners, but over time, relations within a network become more salient sources of information about the reliability of trade partners (Gulati and Gargiulo 1999). These ideas provide a useful starting point for a study of interfirm relations in China, although they require modification to ac- count for conditions unique to China.

I investigate the changing role that fac- tors external to and within Chinese business groups played in the formation of alliances among member firms. I identify factors unique to the Chinese context and explore how these factors affected the formation of interfirm relations. I focus on such influ- ences as rapidly developing markets, chang- ing sources of uncertainty, the legacy of a strong state, and the importance of social connections. I propose that managers drew on prior relations and took advantage of un- even market development to establish lend- ing and trade ties in the early stages of re- form. Firms in developed regions capital- ized on access to resources to form ties with less advantaged firms, and those in less de- veloped areas accepted these ties because they provided security. Early in reform, bu- reaucratic power from a firm's position in the country's administrative hierarchy also

1 continued to be an advantage and to signal status. As time passed, external indicators became less salient, and firms increasingly turned to indicators internal to the business groups for information about potential lend- ing and trade partners. Nontrade relations in the group gained importance, and their in- fluence increased with the duration of the tie. To examine these ideas empirically, I use 1988-1996 longitudinal data on the

transformation of all dyadic lending and trade relations in 40 of China's early busi- ness groups. I focus on three common ties: lending of capital, buying and selling com- mercial goods, and trading personnel. I fol- low all 535 component firms, whether they formed ties or not, to explore the evolution of the structures of 40 separate business groups. I also draw on interviews that I conducted with managers in the member firms to develop the model and interpret the findings.

Prior to reform, all Chinese enterprises were state-owned and overseen by a complex sys- tem of administrative bureaus. The state used firms to generate revenues, and it freely redistributed resources to enact policies and to subsidize unprofitable firms (Jefferson and Xu 1991). Firms had soft budget con- straints: they were not forced to cover ex- penses from sales and income, and they re- ceived credit from state-owned banks for reasons unrelated to risk (Kornai 1986). Managers were not concerned about sur- vival, but like firms in other redistributive economies (Kornai 1979), they faced con- stant shortages of physical resources despite pressure to increase production. While firms were highly dependent on the state, the state also depended on firms to provide scarce in- puts to other enterprises and to provide em- ployees with jobs, housing, medical care, and other social services (Walder 1983, 1995).The complexity of monitoring a large number of firms created dramatic and per- vasive informational asymmetries, and man- agers responded by hoarding resources and bargaining for favorable treatment (O'Brien 1992; Walder 1992). Pressure to meet in- creasing output targets with unreliable in- puts, changing political whims, and incon- sistent payoffs from bargaining created sub- stantial uncertainty.

In 1978, the state initiated large-scale in- dustrial reform, and at least three important changes occurred that affected firm behav- ior. First, budget constraints began to harden. Firms were gradually allowed to re- tain profits, and the contract responsibility system gave managers control of most busi- ness decisions. Even in the largest firms, the state reduced its role to that of a shareholder, and firms were increasingly forced to meet operating expenses from revenues (Jefferson and Xu 1991). Second, the nature of uncer- tainty facing managers changed. The effec- tiveness of bargaining and political maneu- vering declined, and uncertainty arising from shortages was reduced as markets de- veloped (Jefferson and Rawski 1994; Wong 1986). Yet uneven market development posed new challenges and created new forms of uncertainty. Product and labor markets developed slowly, beginning on the coasts and near major cities, and remained local at least initially (Groves, et al. 1995; Naughton 1995;Yi 1994).Financial markets developed even more slowly as the state limited the op- erations of private and foreign banks and regulated stock trading until the 1990s (Goldie-Scott 1995; Gong 1995). Third, competition gradually increased, and even the largest firms found themselves compet- ing for resources with innovative state firms, nonstate firms, and foreign companies (Naughton 1992).

To help firms contend with rapid change and to reduce state-firm interdependence, the state encouraged business groups to form (People's Republic of China [PRC] 1980). While the business group concept may be unfamiliar to Western observers, these net- works are pervasive in many Asian econo- mies (Lincoln, Gerlach, and Takahashi 1992). China's business groups quickly be- came a viable organizational form similar to business groups in other countries. Like the keiretsu and chaebol, China's groups are in- terfirm coalitions with a strong core or par- ent company surrounded by highly interlinked firms in related industries. His- torically, business groups have formed dur- ing transition or development when firms welcome the protection of stable relations, and the groups tend to persist if the state does not outlaw them as collusive (Keister 2000). Because they are coalitions rather than independent legal entities, business groups do not pay taxes or issue stocks. Yet they are stable structures with distinct boundaries distinguished by long-term lend- ing and trade ties among member firms that are legally independent. While keiretsu are either vertically or horizontally organized,

China's business groups are all related by relatively vertical relations (Keister 2000). They are not all vertically integrated, but the structure of the groups tends to be more ver- tical than horizontal. In Chinese groups, the core firm is usually industrial, often owns a portion of the subsidiaries, and exercises varying degrees of control over members depending on ownership. The state relin- quished control of the business groups, but it continued to observe and advise them and retained partial ownership in some member firms, particularly in protected industries.

Chinese reformers studied the keiretsu and chaebol and actively formed similar groups in China, as the Japanese state did in earlier decades.' In the early 1980s, Chinese re- formers dismantled the bureaus that oversaw firms prior to reform and transferred firm control to business groups (Keister 2000). They typically selected groups of firms from the same bureau, designated a core firm, and aided in developing the business group's ad- ministrative component (PRC 1986). While it was rare early in reform, some firms also voluntarily formed business groups, and the state encouraged this outside of sensitive in- dustries such as defense. All business groups registered with the state and were considered a group once this process was complete. The reformers targeted state-owned industrial firms because they accounted for 50 percent of total national output and 80 percent of ex- ports and employed 102 million workers in the 1980s (Jefferson and Rawski 1994). Yet collectives Giti), joint ventures (hezi or sanzi), and private firms (siren) also joined business group^.^ By 1985, 58 business

The Japanese state encouraged the formation of the zaibatsu (an early business group) in the 1880s and the post-World War I1 keiretsu. The Japanese and Korean states have also provided business groups with tax incentives, subsidies, and various forms of protection from foreign competition (Granovetter 1995).

*Acollective is jointly owned by a "guardian" organization (another firm, a social organization, or a state agency) and a rural township or urban municipality. Collectives existed prior to 1978 but were often ignored by the state planning sys- tem. They thrived after reform because of their flexible management systems, low labor costs, and ability to retain profits (Oi 1990; Walder 1995).


groups had formed, and by 1993, more than 7,000 existed. In 1993, 50 percent of firms were group members by some estimates, and group assets exceeded 135 billion U.S. dol- lars (Li 1995).

Firms joined business groups to gain au- tonomy, to capitalize on economies of scale, to compensate for market failures (Goto 1982), to gain control of their environments (Cook 1977), to affect political change and develop joint products (Mascarenhas 1989), and for prestige (Keister 1998). Firms could join groups independently, and membership overlap between former bureaus and busi- ness groups faded quickly. Firms also inde- pendently established the stable lending and trade relations that came to define the groups. Cross-shareholding began in the 1990s after the opening of China's stock markets, but mergers were rare as property rights were not well-defined until later in re- form (C. Xie 1996). While the core firm maintained detailed records of firm activities and aided in management, neither the core firm nor the state interceded in the forma- tion of interfirm relations in the business groups because hundreds of ties quickly de- veloped at all organizational levels. Like business groups in Asia, Latin America, and the Middle East, all firms in China's busi- ness groups were connected to at least one other firm in the group through some form of lending, trade, ownership, joint produc- tion, or other stable formal relation. Mem- ber firms were also connected through social relations, although family ties and other so- cial ties are less pervasive in Chinese busi- ness groups than they are in Korea's chaebol (Steers, Shin, and Ungson 1989) or Taiwan's guanxi qiye (Numazaki 199 1).

Rapid change during transition created infor- mational asymmetries that made it difficult for firms to evaluate the needs, competen- cies, and reliability of potential trade part- ners (Keister 1998). Buyers and sellers needed to determine whether particular ties were beneficial, but both were reluctant to reveal too much information about their own needs and competencies (Williamson 1985). The threat of opportunism that accompanied

transition made firms reluctant to be too forthcoming with information, but the joint hesitation to reveal information made it dif- ficult for firms to assess the reliability of others and often prevented trust from devel- oping (Coase 1937; Granovetter 1985). How did managers in business groups decide which ties to pursue or avoid? What influ- enced which firms to become suppliers of resources and which to become receivers? How did these processes vary by resource? I develop a series of hypotheses to address these questions.

Members of China's business groups formed long-term, relatively exclusive lending and trade ties primarily inside the groups, but processes external to the groups shaped the emergence and evolution of these ties. Evi- dence from other transition economies sug- gests that as uncertainty about markets in- creased, managers turned to those they knew to reduce risk. Thus, managers built new ties on existing relations, creating considerable path dependence in interfirm exchange. Similar patterns developed in Hungary where managers, facing equally uncertain conditions, hedged by diversifying assets and drawing on people and other resources that had been reliable prior to transition (Stark 1996). In China, the role that social relations (guanxi) play in organizing eco- nomic activity, particularly in uncertain con- texts, has been well-documented (Bian 1997; Kipnis 1997; Yan 1996). During China's transition, the influence of guanxi was par- ticularly salient in the formation of eco- nomic relations (Bian 1999; Kipnis 1997; Xin and Pearce 1996) as it had been during Taiwan's post-World War I1 economic re- structuring (Numazaki 199 1).

Evidence from other countries indicates that when uncertainty is high, organizational decision-makers turn to those with whom they have dealt successfully in the past in order to protect themselves from malfea- sance and opportunism (Granovetter 1985; Hagen and Choe 1998; Powell 1990). They also target firms with whom their partners are connected because they can more easily ascertain information about the trustworthi- ness and reliability of these potential part- ners (Gulati 1995a; Rousseau, Sitkin, and Camerer 1998; Sitkin et al. 1998). Prior di- rect connections allow organizations to learn about each other's abilities and capacities and, in some cases, to establish an infra- structure of personnel and practices on which the new relation can build. Similarly indirect connections (i.e., common third- party connections) provide either referrals or an indicator that the potential partner has successfully managed prior relations (Baker 1990; Burt and Knez 1982; Raub and Weesie 1990). My interviews suggested that Chinese managers sought information from prior re- lations such as classmates, relatives, friends, political allies, and former trade partners. The CEO of a mining group explained the importance of prior relations:

It is difficult to know who you can trust since reform. All the rules have changed, and everybody is concerned with making money. When I find a company I feel I can trust, it is a relief. Naturally I would ex- change with that company again because it saves me time in the end. Often this means borrowing from a company I traded with be- fore or getting the things I need from an old friend.

As this quote indicates, managers were concerned with cost, but concern with uncer- tainty and the need to establish long-term strategic advantage gave prior external rela- tions considerable salience. Indeed, labora- tory experiments have shown that when un- certainty is high, partners in dyadic ex- change relations continue to trade even when lower prices are available elsewhere (Kollock 1994; Lawler and Yoon 1993, 1996). Thus, I expect that:

Hypothesis 1.Even when less expensive al- ternatives are available to the borrower or customer, the greater the number of prior external direct and indirect ties be- tween two firms, the greater the likeli- hood that the firms develop a lending or trade relation in the business group.

During transition, variations in levels of market development provided critical infor- mation to managers as they formed ex- change ties. Market development in China was gradual and uneven because reformers


favored coastal and southern regions and be- cause entrepreneurial firms in some areas quickly took advantage of new freedoms (Jefferson and Rawski 1992; Naughton 1995). Firms in developed regions had ac- cess to more resources and were better able to become suppliers, while firms in less de- veloped areas were more likely to become borrowers and receivers. Yet access to re- sources had significance, for both buyers and sellers, beyond simple availability. High levels of uncertainty encouraged firms to find trade partners with whom they could form stable relations. Firms that needed re- sources valued suppliers that would be around in the future, and firms that had ac- cess to resources were able to take advan- tage of this position to cultivate dependence on their products that would persist in the future.

To a potential buyer, firms in developed areas appeared to be more reliable, long- term partners because they were more likely to have access to resources in the future. Managers were even willing to pay a higher price to get resources from such firms be- cause of the security the relation provided (Aiken and Hage 1968; Galaskiewicz 1985; Pfeffer and Salancik 1978). Moreover, trad- ing with a firm that was likely to be around in the future could reduce the cost of search- ing for new trade partners, which were par- ticularly high in developing markets. As one manager explained:

Finding what we need can be difficult be- cause we are trying to overcome years of having the state provide everything. We of- ten get materials from the same companies. We even borrow money from the same com- panies. Once we find a company that can get us what we need, we stick with them. Some- times this even means paying more for a product, but at least we know that the next time we need the same thing, that company will be there.

To potential suppliers, the control of scarce resources created opportunities to re- duce risk and to ensure future exchange by fostering dependence on their products (Cook 1977; Pfeffer and Salancik 1978). Resource access was particularly important in China given its legacy of supply short- ages, and managers quickly learned to ex- ploit resource advantages for security and long-term advantage by cultivating alli- ances with less advantaged firms. In the early stages of reform, relatively soft bud- get constraints partially assuaged concerns about compensation from firms with limited resources and further encouraged those in developed regions to exploit firms with lim- ited access to resources. A manager in Liaoning explained:

There is a great deal of competition in China now, and many firms will go bankrupt in coming years. We can improve our chances of survival if other firms need our products and cannot get them from elsewhere. We look for firms that are unable to find what they need elsewhere, and we encourage them to develop exclusive relations with us.

Thus, I expect that firms located in devel- oped areas were more likely to become sup- pliers and those in less developed regions were more likely to become buyers simply because resource availability was greater in more developed regions. However, because firms also valued security and were willing to pay a cost to reduce uncertainty, these re- lations still occurred when the cost of the re- lation was greater than alternatives. Of course, suppliers did not eschew relations with strong buyers or buyers in developed regions, but in relations with weaker part- ners, firms in developed regions had an ad- vantage even if their prices were higher. That is:

Hypothesis 2A. Even when less expensive alternatives are available, firms located in developed regions become lenders and suppliers, and those located in less developed regions become borrowers and customers.

While continued soft budget constraints provided some reassurance to suppliers that they would receive compensation from their customers, suppliers faced additional risk in exchanging with less advantaged firms. To alleviate this risk, firms in more developed areas relied more heavily on prior direct and indirect connections to identify poten- tial customers in less developed areas. As markets developed, however, reliance on prior connections became less important. That is:

Hypothesis 2B. Even if there is a cost in- volved, poor market development in- creases reliance on prior connections, but at a decreasing rate.

Before reform, a firm's rank in the state administrative system indicated the level of bureaucracy to which the firm reported for tax and control purposes; it also signaled a great deal about the firm's status among other firms (Walder 1989, 1992). Although the administrative rank system was abolished early in reform, former rank continued to determine access to resources, political influence, and thus status (Walder 1995). As firms formed lending and trade ties, those with higher prior administrative ranks were more likely to garner controlling positions, and those with lower prior ranks were likely to remain dependent. This is consistent with research that shows that organizational deci- sion-makers look to the environment for other cues about the reliability and trustwor- thiness of potential partners. Various bench- marks can be used to gauge a firm's legiti- macy and trade worthiness (Buchko 1994; DiMaggio and Powell 1983; Oliver 1990). Because former rank was such an indicator in China, I expect that:

Hypothesis 3. Even if it means paying more, the higher the administrative rank of a firm prior to reform, the more likely the firm becomes a lender or supplier in a business group; the lower the prior rank of a firm, the more likely the firm be- comes a borrower or customer.

Over time, budget constraints hardened, bureaucratic control of firms declined, mar- kets developed, competition increased, and bankruptcy became more common. Firms in- creasingly focused on reducing costs and improving efficiency (Jefferson and Rawski 1994). Uncertainty did not disappear, but market development reduced the degree of uncertainty resulting from the transition. Si- multaneously, the value of prior relations (e.g., firms from a prior administrative bu- reau, prior trading partners) became increas- ingly obsolete. Thus, I anticipate that:

Hypothesis 4. The effect of external ties,

market development, and administrative

rank decrease over time.


As the value of information from prior rela- tions declined, the value of information available in the business group grew, and managers increasingly turned to the group for guidance in developing ties. This change is consistent with research that shows that once a set of relations has coalesced into a relatively stable network, the network serves as a source of information on the reliability, competencies, and needs of potential trade partners (Gulati 1995b). Yet unlike in the West, where interfirm networks are usually defined along a single dimension (e.g., board interlocks, strategic alliances), firms in busi- ness groups were linked in multiple ways. In addition to lending and trade relations, firms were connected through ownership ties, in- terlocking board memberships, social ties, and relations formed through joint research and production efforts. These multiple links provided both direct and indirect sources of information about potential trade partners, and the information available through these internal ties became more abundant as the business groups aged and links multiplied. This suggests that:

Hypothesis 5. Even when there is a cost in- volved, the greater the number of inter- nal direct and indirect nontrade ties be- tween two firms, the greater the likeli- hood that the firms develop a lending or trade relation in the business group.

As in other business groups, social rela- tions developed from trade relations (Granovetter 1995). Over time, membership in the same group increased the likelihood that the firms were connected by other ties. Expectations that an alliance would continue to trade were cemented, and managers be- came increasingly reluctant to discontinue economic relations with partners they inter- acted with in other arenas. In addition, firms often preferred to trade with a known part- ner, even if it cost more than trading with a potentially opportunistic stranger. Relational embeddedness thus increased the reluctance of firms to abandon lending and trade rela- tions in established business groups, leading to the development of a thick skein of ties that became increasingly stable (Lincoln et


al. 1992). My interviews suggest that social obligations developed relatively quickly in Chinese business groups and that internal nontrade ties became a source of pressure or obligation to remain in lending and trade re- lations, extending the life of the economic tie sometimes indefinitely. For example, so- cial relations or relations such as those that developed between two firms engaged in joint product development affected the for- mation of lending and trade relations. As a consequence, I expect that:

Hypothesis 6. The longer the past internal lending or trade relation between two firms in a business group, the stronger the effect of internal nontrade ties on the formation of an exchange tie between the firms.

Positional embeddedness (i.e., a firm's po- sition in the overall network) also began to provide information to the focal firm and potential partners that shaped alliances. Con- nections to others who are well-connected (centrality) afforded the focal firm better ac- cess to information about other firms and made it more visible to potential partners (Freeman 1979; Gulati and Gargiulo 1999). As a manager in Yunnan explained, "Some partners are just better than others in terms of how much information they can give. Those with good connections certainly make better partners." Research from the West demonstrates that while centrality increases the set of direct and indirect relations avail- able to supply the firm with information (Gulati and Gargiulo 1999; Powell, Koput, and Smith-Doerr 1996), a central position also captures information beyond the effect of direct and indirect ties. Centrality in- creases awareness of the structure of the overall network (Krackhardt 1990), and it improves the focal firm's visibility (Podolny 1993; Podolny and Stuart 1995). Centrality signals a firm's willingness to trade and its effectiveness at managing lending and trade ties. It also indicates that other firms have evaluated the firm and have decided to trade with it. Trading with a more central firm is thus likely to confer legitimacy on the re- ceiver. Centrality is particularly important in uncertain environments because it intro- duces reputational information beyond what direct and indirect relations provide (Gulati


and Gargiulo 1999; Podolny 1993; Podolny and Stuart 1995). Thus, I expect that:

Hypothesis 7. Even when less expensive al- ternatives were available to the receiver, the greater a firm's centrality in the net- work, the more likely it is to be the sup- plier in lending and trade relations in the business group; the lower a firm's cen- trality in the network, the more likely it is to borrow capital or receive goods.

Just as firms came to rely less on external information sources and as external signals of legitimacy declined over time, firms in- creasingly relied on internal sources of in- formation and legitimacy signals. The value of information available from inside the business group increased and gradually be- gan to play a more central role in shaping alliance formation. This suggests that:

Hypothesis 8. The effects of internal ties, re- lationship length, and network central- ity on the likelihood of a lending or trade tie increase over time.

Because China's markets developed at dif- ferent rates, the types of resources that firms exchanged affected the nature of the rela- tions that developed. Financial markets were particularly slow to develop because the state delayed financial reform longer than other types of reform (Goldie-Scott 1995). Thus, uncertainty in lending continued longer than in other types of exchange, and reputation remained important in lending longer than in other exchange relations. Likewise, because the Chinese legal system was not well developed in the early stages of economic transition, relying on trusted re- lations was often an effective way to in- crease the likelihood that a loan would be repaid. Moreover, concern with reputation increases with the degree of risk involved in the relationship (Kollock 1994), and lending capital is relatively high risk. The impor- tance of trust in financial exchange has been documented in various countries including the United States (Lamoreaux 1994), En- gland (Allen 1993; Cottrell 1980), Scotland (Allen 1993; Munn 1981), Germany (Tilly 1966), other European economies (Cameron

et al. 1967; Mayer 1990), and several Asian and Latin American countries (Fields 1995; Steers et al. 1989; Strachan 1979; Whitley 1990). Thus, I expect:

Hypothesis 9. The impact of external rela- tions, market development, and admin- istrative rank is stronger and lasts longer in the development of lending relations than it does in trade relations.


To examine these hypotheses, I collected quantitative and qualitative data on in-group lending and trade relations in China's early business groups. The quantitative data were biannual 1988- 1996 longitudinal data on all business groups in nonsensitive industries that had registered with the state in 1985. To study early tie formation and evolution, I observed groups that formed early and stud- ied them over time. I used records from the Chinese Economic and Trade Commission (Jingji Maoyi Bu or ETC) to determine that in 1985 the first groups had completed offi- cial state registration procedures and to iden- tify all business groups registered in nonsen- sitive industries (40 groups and their 535 member firm^).^ Prior to 1985, groups had begun to form, but none had registered. In addition to the 40 groups in nonsensitive in- dustries, 18 business groups had formed in sensitive industries (e.g., national security, defense, proprietary technologies). I ex- cluded these groups because the state main- tained close control of interfirm relations in them, maintained a majority ownership share

I am grateful to Gary Hamilton for sharing this list, which he had obtained from the ETC. The initial list contained basic 1990 business group and firm data such as address, industry, assets, and size. I stayed in China in 1995-1996 and, with the assistance of the Shanghai and Chi- nese Academies of Social Sciences (SASS1 CASS), I met with a statistician at ETC. With his aid, I used public records to verify that this was an inclusive list of business groups registered in 1985 and to compile additional publicly available data on business groups. The list of groups has been published elsewhere (Keister 2000; Li 1995).

in their member firms, and closely guarded their records (Bureau of State Asset Manage- ment 1995; Dong and Hu 1995). I begin this study in 1988 when firms had had three years to develop ties, and I observe the firms through 1996 to capture changes over time. I did not add business groups that formed after 1985 because longitudinal data on these would not have been ~ufficient.~

To collect the quantitative data, I adminis- tered a questionnaire to the financial officer of each of the 40 core firms in face-to-face interviews (in Chinese without a translator) in 1995-1996. I was able to obtain the data from a single source for most business groups because core firms kept detailed records of member firm behaviors and prac- tices. Because the average number of firms per business group was small and core firm managers knew managers in the member

I paid particular attention to the potential for sample selection bias. My data collection and analysis methods were designed to deal with these issues. I did not to select the sample accord- ing to whether the firms had particular relations. Berk (1983) explains that sample selection bias in estimating linear models originates with the assumptions that the endogenous and exogenous variables are related linearly and that the mean of the disturbances is zero. Systematically omit- ting observations according to their value on Y alters the expected values for the observed Ys, and the original regression line no longer fits the data. This undermines both external and internal validity and is problematic even if the researcher is prepared to confine causal inferences to the portion of the population selected for the study. Although nonlinear models do not make the clas- sical assumptions underlying Berk's discussion, sample selection can still distort the shape of nonlinear equations. To avoid sampling on the dependent variable, I did not sample firms ac- cording to whether they had ties. Rather I included all business group members. As a result, having (or not having) a particular tie did not af- fect whether a firm was included in my analyses. These strategies are consistent with Lincoln's (1984) recommendations for studying dyads within a network of this sort. By definition, nongroup members could have no within-group ties. Because nongroup members were less likely to form the long-term, stable relations that were typical in the business groups, however, includ- ing nongroup members in the analysis would likely have strengthened the observed associa- tions.


firms well, they easily answered questions about their backgrounds and relations. For 28 member firms, the core firm did not have complete data for a member, and I inter- viewed the financial officer in those firms to complete the questionnaire. In 13 additional cases, the core company had incomplete records, and I was unable to interview the member firm's financial officer (the finan- cial officer was unavailable or I was unable to locate the firm). I recorded missing data for the affected questions for these firms.5

To record the interfirm dyad data, I pre- sented the financial officer with a matrix that arrayed all member firms both vertically and horizontally. This allowed the officer to quickly refer to company records and indi- cate the presence or absence of a tie. The to- tal possible dyads was 16,306; however, be- cause most of these were absent, it was pos- sible to collect a relatively large amount of data fairly quickly. I carefully distinguished missing data (e.g., ties about which the fi- nancial officer did not have information) from absent ties (e.g., ties that the financial officer knew were missing), and I empha- sized this difference to respondents. When managers turned over, I treated the current manager as the relevant source of ties. When firms changed business groups, I allowed them to matriculate from the survey, and I did not add firms over time. There was no discernible difference in the quality of firm records between the early and later periods, given managers' relatively intimate knowl- edge of each other, and there was little change in the number or types of nontrade ties reported over time.6

In 1990, the 40 business groups I studied owned 68 percent of total Chinese business

All 40 business groups participated and were cooperative. Early in reform before competition accelerated, managers were less protective of company information than they were in more re- cent years. My connections with CASS and SASS added legitimacy that increased positive response.

Over the study period, reported personnel ties ranged from .078 to .083, where .078 is the per- centage of possible personnel ties that actually had formed in the first year and the percentage varies each year. The range of reported commer- cial ties was .1 to .3, and financial ties ranged from .0099 to .010.

group asset^.^ Because these were the first groups to form and because business groups typically grew during the late 1980s, in 1990 these 40 were the largest groups. Their core firms were located in 15 of China's 29 prov- inces and in Beijing, Tianjin, and Shanghai (municipalities under direct central govern- ment jurisdiction). The member firms were located in all provinces, independent mu- nicipalities, and autonomous regions. Most of the firms were former state-owned enter- prises, but many business groups also in- cluded joint ventures and collective enter- prises. The firms were in various industries, including manufacturing and services, as well as China's central, or pillar, industries (energy, transportation, communications). The firms were typical of business group members in terms of industry, geographic spread, and the levels of competition they faced. Compared to firms not in business groups, these firms tended to be more heavily indebted, slightly larger, have more state shares, and to have somewhat softer budget constraints (Lee and Hahn 1999).

To better understand the mechanisms by which interfirm ties formed, I also con- ducted less structured qualitative interviews (in Chinese) with the general manager (or the vice president for operations in about 10 percent of cases) in each of the 40 business groups. In about 15 percent of firms two managers were available, and I interviewed both. I also selected a random sample of 35 small, medium, and large business groups in Shanghai, a coastal city that began to de- velop early, and conducted qualitative inter- views in these. Finally, I selected 12 addi- tional business groups in underrepresented cities and industries and conducted qualita- tive interviews in these groups to further ex- pand my understanding of the groups. In these interviews, I asked managers a stan- dard series of questions about such issues as business group-firm interactions, govern- ment intervention in the group, labor prac- tices, and characteristics of the managers. I also allowed the managers to direct these conversations toward issues that I may have neglected. In many business groups, the fi-

Author's calculation (sum of assets recorded in current data set as a percentage of State Statis- tical Bureau estimates of business group assets).


nancial officer also gave me copies of non- sensitive company literature and firm finan- cial records. I did not include information from these interviews in the quantitative data set.



My unit of analysis was the interfirm dyad, that is the


n =Enit (nit -1)=16,306


ordered pairs of the 535 member firms within the 40 largest business groups (40 separate networks) with every other firm in the same business group in each time pe- ri~d.~

I included only business group mem- bers because my focus is voluntary, repeated relations within these group^.^ I included business group members whether they had ties or not. Because membership is not de- fined by having ties, some firms were not connected to any other firms. Thus, my in- terest was in the off-diagonal cells in a ma- trix of the 40 distinct networks, or each of 40 (n x n) matrices at five points in time where the rows (i =1, . . . n) were senders in a relation and the columns (j=1, . . . n) were receivers. I arrayed these as column vectors, p, such that p = 11, 2; 1, 3; . . . 1, n; 2, 1; 2,3; ...2,n; ...n-1,l;n-1,2 ,...n1, n) and modeled the likelihood of an i, j tie. Specifically, I follow Lincoln (1984) and Lincoln et al. (1992) in modeling the pres- ence (yesfno) of each type of directional tie (personnel, commercial, financial) as a func- tion of firm, dyad, and province attributes such that:

where yiit is a directional tie from firm i to firm j; yjit is a reciprocal tie from firm j to

This is equivalent to the n (n -1) =285,690 total dyads minus dyads containing firms in dif- ferent business groups.

Firms outside business groups did develop lending and trade ties, but the ties they formed seldom coalesced into the close-knit relations that are characteristic of relations in business groups.

firm i; and yijt-~ is a lagged tie from i to j. The dependent variable is a dichotomous in- dicator that firm i sent personnel, commer- cial goods, or capital to firm j three or more times in time t. Pi and Pi are column vectors of province-level variables for provinces in which firms i andj were located. Rij is a vec- tor of dyad-level variables; Xi and Xi are vectors of firm-level variables. Wyij is a dyad autoregressive term included to control bias that might occur because some dyads con- tained the same firms.1° p, a, k', xi;.,y:, y;, and pare coefficients to be estimated. I used i province-level variables and error compo-

' nents to model regional effects; uijkand E~ are the region-specific and dyad-specific er- ror terms respectively. I used fixed effects to control for group-level variation (i.e., 39 group dummy variables) and estimated gen- eralized linear mixed (pseudo-likelihood) equations in SAS that allowed the decompo- sition of the error term into its fixed and ran- dom components (Wolfinger 1993).11 Table 1 contains variable definitions and descriptive statistics.12 The dependent vari- ables were dichotomous indicators of the presence of each of the three exchange ties in the business group. Personnelij, was a dummy variable coded 1 if firm i sent per- sonnel to firm j three or more times in the current year and 0 otherwise.13 I coded the

lo Wyij= wherep and q are dyads and p +q. W,, = lln, if dyads p and q share a com- mon firm, and 0 otherwise. Wyij is the mean of the dependent variable over all dyads that include firm i or firm j (excluding ij). This method is similar to the spatial autoregressive model used in contagion models (Doreian 1980; Land and Deane 1992; Tolnay, Deane, and Beck 1996).

l1Because the business groups were not nested in regions, it was not possible to use random ef- fects models to control for the contextual effects of group and region.

l2 The number of regressors in these models is large, but the large number of observations pro- vides ample degrees of freedom. Including poten- tially relevant variables provides a more conser- vative test of hypotheses when there are suffi- cient degrees of freedom (Blalock 1979; Johnston 1984).

l3 I chose three as the cutoff because fewer ex- changes did not indicate an ongoing exchange re- lation, and after three exchanges, preliminary analyses suggested that the firms were likely to continue to trade. I experimented with higher cut-


Table 1. Definitions, Means, and Standard Deviations for Variables in the Analyses: Business Groups in China, 1988 to 1996
Variable     Definition     Mean
Dependent Variables Personnel tieii,     1 = firm i sent workers to firm j 3 or more times; otherwise 0.     
Commercial tieii, Financial tieij,     1 = firm i sold commercial goods to firm j 3 or more times; otherwise 0. 1 = firm i loaned funds to firm j; otherwise 0.     

External Influences

External direct tiesii Number of direct ties outside business group between managers in firms i and j; otherwise 0.

External indirect tiesii Number of indirect ties outside business group between managers in firms i and j; otherwise 0.

Labor marketsi Number of individuals in province employed in private sector divided by number employed in public sector.

Commodity marketsi Number of private and collective firms in province divided by number of state-owned firms.

Financial marketsi Deposits of foreign banks in province divided by deposits of all banks.

Internal Influences

Internal direct tiesG Number of direct ties inside the business group between firms i and j; otherwise 0.

Internal indirect tiesii Number of indirect ties inside the business group between firms i and j; otherwise 0.

Centralityij Number of links weighted by centrality of partners (Bonacich centrality, normalized).

Established pre- 197gi 1 = firm i was established before 1978; otherwise 0.

Core firmi 1 = firm i is the core (or central) firm in the business group; otherwise 0.

Notes: Numbers in parentheses are standard deviations. Only off-diagonal dyads in the same business group are included; N = 16,306. Personnel ties include both white- and blue-collar workers; commercial goods include both finished goods and productive inputs. Each measure subscripted i, j, or ij has a trans- posed dyad counterpart subscripted j, i, or ji. Independent variables are measured at t -1.

measures of commercial and financial ties measured in the prior time period.15 A sigsimilarly.14 The lagged dependent variable, nificant positive estimate of the a coefficient yU,,was equivalent to the dependent variable, indicates that if firm i sent the resource to

firm j in one time period, it was more likely offs but found no substantive differences in the to send that resource in the next period. The results. I also experimented with using more de- reciprocal term, yji,,indicates whether firm j tailed specifications of the dependent variables also sent the resource to firm i; a positive (e.g., finished goods and intermediate goods rather than all commercial goods), but the find- ings were not appreciably different. As reform varied across dyads, the mean of Xii does not al- progresses, these distinctions may become mean- ways equal the mean of Xji. As the means in ingful. Table 1 indicate, there was considerable variation l4 As all firms were represented the same num- on each dependent variable because not all dyads ber of times in the set of all dyads, the mean of had ties. Xialways equals the mean of X,, but as the pres- I5 Removing the lagged dependent variable did ence of directional relations from firm i to firm j not materially alter the results.


Table 2. Pearson Correlation Coefficients between Variables in the Analysis

Variable (1) (2) (3)

    External direct tiesij
    External indirect tiesij
    Labor marketsi
    Commodity markets,
    Financial marketsi
    Administrative rank,
    Internal direct ties,,
    Internal indirect tiesG

(10)Established pre- 1978, (1 1)Core firmi

estimate of p indicates reciprocity. I entered firm characteristics as both a trait of both firm i and firm j. A significant positive esti- mate of % indicates that the greater the value of Xithe more likely firm i was to be the sender in the dyadic tie. A positive 1/, indicates that the greater the value of Xj,the more likely firm j was to be the receiver. I also entered regional characteristics as traits of both firm i and firm j. A positive estimate of h: indicates that as the value of Pi increased, i was more likely to be the sender. A positive estimate of 1/, indicates that as P, increased, j was more likely to be the re- ceiver. A positive estimate of n:, indicates that attributes of this pairing make a tie more likely. Table 2 presents Pearson zero-order correlation coefficients among the regres- sors.

I measured external direct connections as the number of ties outside the business group between each pair of firms. I used manag- ers' reports to sum within each dyad (1) the number of interfirm (i.e., across the dyad) pairs of managers who were classmates (tongxue) in college, (2) the number of in- terfirm pairs of managers with family, exter- nal professional, or other external social connections, (3) an indicator of whether the firms had a lending or trade relation before the business groups formed, and (4) an indi- cator of whether the firms were in the same administrative bureau before reform. I measured internal direct connections as the number of nontrade ties in each dyad that originated from contact inside the business

(4) (5) (6) (7) (8) (9) (10) (11)

group. These ties included ownership ties and ties formed through joint production, re- search, and marketing. The formation of these ties dates to the establishment of the group, and none began prior to 1985. I indi- cated indirect ties, both external and inter- nal, as the number of times a pair of firms was connected through indirect associations (via ties to alters). Using separate indicators of each of these ties (e.g., school ties, past lending ties) produced similar substantive results.16 Tie duration was the number of years the firms had a repeated, internal lend- ing or trade tie.17

I measured market development separately for each dependent variable to capture varia- tions in market expansion for the corre- sponding resource. In the personnel tie mod- els, I measured labor market development as the number of individuals in the province

l6 I did not control for whether a firm had ties to nongroup members because there were very few extra-group ties in the early stages of reform. My interviews also suggested that there was little connection between the rare external ties firms had and the structure of lending and trade rela- tions in the business groups. In preliminary analyses, I controlled for firm exports, but be- cause I found no consistent effect, I omitted this from the analyses.

l7 Reported numbers of interfirm nontrade connections did not increase over time. Rela- tively low manager turnover during this time made changes in leadership rare. Controlling for changes in management did not improve model fit.


employed in the private sector as a propor- tion of those employed in the public sector. In the commodity tie models, I indicated commodity market development as the num- ber of private and collective firms as a per- centage of the number of state-owned firms. In the financial tie models, I measured finan- cial market development as deposits of for- eign banks as a percentage of total bank de- posits. I used province-level indicators be- cause municipal data (often collected by various agencies) are less accessible and less internally consistent. Moreover, given China's size and regional variation, marked province-level differences correspond well to differences in opportunities and con- straints (Nee 1996). I followed Walder (1992) in using an ordinal coding of administrative rank.18

I measured centrality within the business groups using Bonacich's (1987) eigenvector measure of network centrality. This measure, which I calculated in UCINET and trans- ferred to SAS as a standardized variable, is greater for organizations that are linked to many other organizations that are also highly connected. The Bonacich measure of cen- trality has been widely used in research on interfirm relations that attempts to represent organizational position in a network (Gulati and Gargiulo 1999; Mizruchi 1993; Podolny 1994). The variable cost minus cost else- wherei indicates whether the resource was available cheaper elsewhere. I used manag- ers' accounts of the cost of the resource (the interest rate for lending relations) and the cost the firm would pay if they were to use the next most likely source of the good or capital to create the indicator. The alterna- tive cost was widely known because most exchange was conducted within the business group. If the two firms did not trade, I coded the cost as the cost if the trade were to exist (again, this was widely known as all ex- change considered here occurred in the same business group).

I controlled for the lagged presence of an ijfinancial tie in the personnel and commer- cial models to examine interdependence among exchange relations. If one firm loaned capital to another, it was more likely

l8 Using a dummy coding of administrative rank had no noticeable effect on the results.


to take an active interest in the survival of the borrower and lend other resources as well (Lincoln et al. 1992). I also controlled for whether the organization was established before 1978 (prior to reform) and whether it was the core firm to indicate other sources of resources that might have affected firm resource needs.




Researchers have documented the role that interfirm relations in business groups play in coordinating economic activity, but little is known about the processes that produce these ties. The coefficient estimates in Table 3 provide some insight into these processes. Table 3 presents the logistic coefficient esti- mates for models predicting three types of interfirm relations in China's business groups. Each subsample is slightly less than the full set of 16,306 dyads because of miss- ing data. Consistent with the notion that the identity of one's partner matters in a re- peated exchange (Granovetter 1985), the findings indicate that prior economic and so- cial relations between firms increased the likelihood that they would establish lending and trade ties in the business groups, even when less expensive alternatives were avail- able. Hypothesis 1 predicted that prior, ex- ternal direct and indirect interfirm ties in- creased the likelihood of lending and trade relations in business groups. The results pro- vide strong support for this hypothesis: Co- efficient estimates for the number of exter- nal direct and indirect ties were significant and in the predicted directions.

The importance of social connections (i.e., guanxi) has long been observed in China. Yet evidence that economic actors, particularly corporate decision-makers facing increasing competition and decreasing survival possi- bilities, would pay a cost to trade with others of known reputation is significant for two reasons. First, researchers have recently ar- gued that the importance of guanxi has de- clined in recent years (Bian 1997; Guthrie 1998). Second, students of China's transition have argued that power is being transferred from those with bureaucratic power to those


Table 3. Coefficients from the Logistic Regressions of Three Types of Interfirm Relations on Selected Explanatory Variables: Business Groups in China, 1988 to 1996
In-Grou~ Interfirm Tie
Hypothesiss     Personnelijr     Personnely, CommercialijrCommercialy, Financialijr     Financialijr
Independent Variab.e     (Direction)     Model 1     Model 2 Model 3 Model 4 Model 5     Model 6
External Influences                 
External direct tiesij                 
External indirect ties,,                 
Market developmentib                 
Market development,b                 
Market development,                 
x direct ties:                 
Market developmenti                 
x indirect tiesit                 
(Market developmenti                 
x direct                 
(Market developmenti x indirect tie^^,)^                 
External direct
tiesij x time
Market developmenti                 
x time                 
ranki x time
Internal Influences                 
Internal direct
Internal indirect
Tie duration,,
x direct tiesi,
Tie durationij
x indirect tiesij
Internal direct
tiesvx time
Tie duration,
x time

(Table 3 continued on next page)

(Table 3 continued)
Inde~endent Variab.e     Hypothesisa (Direction)     Personneli,, Model 1     In-Group Interfirm Tie Personnelyt CommercialijtCommercialytFinancialyt Model 2 Model 3 Model 4 Model 5     Financialyt Model 6
Cost of Resource                 
Cost minus cost elsewhere, (Cost minus cost el~ewhere,)~ (Cost minus cost el~ewhere,)~ Control Variables     All (-) All (+) All (-)     -.402*** (.053) --        
Reciprocity (tie,,Jb                 
tie^ in1988 (lagged dependent variable) Financial tieij                 
Established pre- 197gi                 
Core firm,                 
Dyad autoregressive term                 
Number of cases Pearson x2         16,111 608.35     16,111 830.25     15,941 610.26     15,941 911.12     15,917 614.47     15,917 978.89

Notes: Numbers in parentheses are standard errors. Included in the regression (but not displayed) are dummy variables for each of the 40 business groups, an indicator of profitsfassets, and indicators of owner- ship structure, industry, percent profits remitted to the state, geographic proximity to Beijing, geographic distance between the firms, and total assets.

a Hypothesis refers to the argument being tested by the explanatory variable; sign indicates the predicted direction.

"Market development" and "market" variables are equivalent. The market development and reciprocity variables are specific to the dependent variable (e.g., in models predicting the presence of a personnel tie, the lagged dependent variable is the presence of a personnel tie, and the market development variables refer to labor market development).

*p< .05 **p< .01 ***p < .001 (two-tailed tests)

with market power (Nee 1996). My results the relationship between external social re- suggest not only that social connections con- lations and the development of commercial tinue to matter in China, but also that power exchange relations. The bars in this figure relations with origins in the previous system represent the predicted probability of a com- are still meaningful (both prior administra- mercial trade tie at cost levels ranging from tive rank and joint membership in a prior -100 to 100 yuan. The variable indicating bureau affect exchange). These findings also the number of external ties is evaluated at 1 support Oberschall's (1996) argument that for the curve labeled "had prior ties." This drawing general conclusions about China variable is evaluated at 0 for the curve la- and about economic transitions generally can beled "no prior ties." Figure 1 indicates that be misleading if the evidence is based exclu- at all cost differential levels, firms that had sively individuals. prior ties were more likely to trade commer-

Figure 1 uses the coefficient estimates in cial goods than were firms that did not have Table 3, Model 4 to illustrate the strength of prior ties. Indeed, the slopes of the curves


nomic transition and the process of transi- tion more generally. While research on mar- ket transition has been accumulating in re- cent years, most evidence about how transi- tion occurs is derived from research on in- dividuals or economic aggregates (Bian

1997; Nee 1996; Y. Xie and Hannum 1996; Zhou, Tuma, and Moen 1997). Important exceptions exist (Guthrie 1997; Nee 1992), but direct observations of the economic choices made by actors during transition are rare (Oberschall 1996). My results concern one of the most fundamental economic de- cisions made during transition: the decision to trade, not just once but repeatedly, with another actor. The results suggest that al- though cost is an important determinant of exchange, environmental uncertainty mat- ters even more. To minimize long-term costs, firms opted to trade with others that would be stable trading partners. This indi- cates much about the decision-making of organizational decision-makers and also im- plies that firms located in relatively devel- oped areas will enjoy advantages in exchange that are likely to persist post-transi- tion. One strategy often used by the Chi- nese government to gradually introduce re- form is to introduce a change in only a few test areas, followed by the universal intro- duction of the policy if the test is successful. Reformers have used this strat- egy when introducing various reforms in- cluding the manager responsibility system, financial reform, labor reform, and housing reform. While gradual reform has clear ad- vantages over more rapid reform typical in other transition economies, the exchange advantages enjoyed by those in the early- developing regions might create long-term inequities.

Although influences external to the busi- ness group were clearly related to the for- mation of lending and trade ties within the business group, the importance of these in- fluences decreased over time. Interacting the indicators of external ties, market develop- ment, and former administrative rank with a continuos indicator of year (included in Model 2 for each dependent variable) pro- duced a consistent negative effect. This find- ing is particularly relevant when considered with the increasing importance of influences originating inside the group.



As the structure of lending and trade rela- tions developed in the business groups, the groups increasingly became sources of infor- mation for their member firms about the abilities and competencies of potential trade partners. The results in Table 3 support the argument that nontrade ties in the business group, both direct and indirect, increased the likelihood that a lending or trade relation developed. Similarly, the longer the firms were allied, the more weight decision-mak- ers gave to other internal connections. These results support Hypotheses 5 and 6.20 Like- wise, the results suggest that more central firms in the business groups were more likely to become suppliers in lending and trade relations, again net of the cost of the resource. A manager in a company that manufactured cardboard shipping crates sug- gested that centrality was a cue that manag- ers actively sought in potential trade part- ners:

A firm that has a lot of trade partners cannot hide what sort of partner it is. I hear more about firms that deal with many others than I do about those that are relatively isolated. It only makes sense. But I also seek out firms that have a lot of partners, not only because I can save myself some time by trusting that other companies would only continue to deal with a company if the com- pany is good. Besides, it looks good to be involved with well-known firms.



In addition to the general patterns I de- scribed above, there were important differ- ences in the process by which financial ties formed. Hypothesis 9 predicted that the ef- fects of prior social connections were stron- gest in the formation of lending relations: Trust is more important in lending relations

20 I use lagged values of the explanatory vari- ables to approximate temporal ordering and re- duce the potential for reverse causality. Although Hypothesis 5 could be tested in both directions by including internal nontrade ties as an addi- tional dependent variable, the additional analy- ses add little additional information.




Financial exchange


0 I
-1 00 0
Cost minus Cost Elsewhere (1,000s of Yuan)

Figure 3. Relationship between Cost Minus Cost Elsewhere and Lending and Trade Relations

Notes: Lines represent the predicted probability of an ij lending or trade relation using coefficients from Models 2, 4, and 6 in Table 3. Cost minus cost elsewherej is evaluated at values ranging from -100 to 100. The variable indicating external ties is evaluated at 1; other explanatory variables are evaluated at their


than in trade relations because lending rela- tions allow the borrower to postpone fulfill- ing his portion of the agreement. In the trade of commercial goods, reputation and trust- worthiness are important, but they tend to be less critical than they are in financial rela- tions because the exchange of goods for money often takes place simultaneously. Of course, when credit is extended, trust gains importance, but the extension of credit was rare in early reform in China relative to its use in the West. Likewise, in the trade of personnel, the supplier rarely sent workers without compensation or the receipt of other workers in exchange. Relative to other simi- larly sized coefficients, the coefficient esti- mates for prior relations in Table 3 are con- sistently higher for financial ties than for commercial ties and consistently higher for commercial ties than for personnel ties. In Figure 3, I use coefficient estimates from Table 3 to compare the likelihood of a tie to the cost difference across resource type (evaluated at the mean for variables not in the figure). The graph suggests that firms assumed greater cost to trade with familiar partners in financial ties than they did in commercial or personnel relations. The fig- ure also shows that for personnel exchanges, cost differential has a more dramatic nega- tive effect on the likelihood of an exchange than it does for either commercial or finan- cial exchange.

Similarly, firms that made loans to other organizations developed an interest in the success and survival of the borrower. The direction of control in debt relations gives the lender control over the borrower. Both theoretical and empirical evidence support the notion that the borrowing firm is depen- dent on the lender, and because of the risk involved in lending, the lender may become involved in other operations of the borrower. Research in the West indicates that borrow- ers may offer board seats to the lenders in order to co-opt the source of control, and the increased likelihood that the lender has a seat on the board of a client attests to the lenders power in affecting other behavior of the borrower (Lincoln et al. 1992; Mizruchi and Steams 1994). This logic explains why there was interdependence in lending and trade relations in the early Chinese business groups. That is, firms that loaned capital to others were likely to also be suppliers of per- sonnel and commercial goods to the same customer.


Lending and trade relations in China's emer- gent business groups provide a unique op-


portunity to study the processes that gener- ate interfirm relations. My results indicate that processes external to the business groups as well as processes originating within the groups influenced the formation of interfirm lending and trade ties. Chinese firms sought to reduce uncertainty by ex- changing with those with whom they had prior direct or indirect connections. They also traded with those that had secure access to scarce resources, even when less expen- sive alternatives are available. Combined with qualitative evidence that suggests that managers cultivated such dependence, the findings provide evidence that organiza- tional decision-makers seek power through dependent exchange ties. Consistent with re- search on social dilemmas, my findings also demonstrate that reputation influenced lend- ing and trade even when less expensive al- ternatives were available. Evidence that eco- nomic actors avoid arms-length transactions and are willing to assume direct costs to con- tinue trading with established partners raises doubts about the assumptions made by mar- ket theorists that economic actors prefer trade across a market.

Perhaps most relevant to understanding business groups, the findings demonstrate that the processes underlying the formation of lending and trade relations vary over the life of the business groups. Over the first de- cade in which China's business groups ex- isted, changes were already evident in the processes that lead firms to ally with each other. In the early stages of development, processes originating outside the groups had the strongest influence on the formation of ties. As time passed, however, the impor- tance of external social relations and other external indicators of the trustworthiness and reliability of potential partners de- creased. At the same time, processes origi- nating within the business groups became more important. Firms increasingly sought to ally with business group members with whom they had other ties and who were cen- tral players in the network of interfirm ties within business groups.

Because conditions in China were similar in many ways to other transition economies, these results provide important information about the process of economic transforma- tion more generally. Relatively high uncer- tainty, changing sources of uncertainty, market failure, managers who were not ac- customed to markets, and expanding com- petition were prevalent in China as they are in many transition economies. The strong but declining role of the state, the continued importance of bureaucratic power, and hardening budget constraints were also typical of a transition economy. My find- ings suggest that regional differences in market development during transition may be institutionalized and thus shape eco- nomic exchange after transition. Similarly the continued importance of bureaucratic power during transition may cause the post-transition economic structure to reflect pre- reform advantages. Perhaps most consequential for understanding transition econo- mies, however, is the finding that internal ties became increasingly important predic- tors of economic relations, even if at a fi- nancial cost. Thus, while business groups may be advantageous early in reform, in- creasing internalization of ties may create inefficiencies that have negative long-term consequences.

Although the transition context is unique, these results also speak to the general pro- cess by which interfirm relations emerge, and thus to the general process by which so- cial structures come into being. The some- what unique transition context required some modifications of existing theory, but much of what we know about organizations from other contexts remained true. My re- sults highlight the critical role that social re- lations play in the formation of economic ties, particularly under uncertainty. The re- sults also confirm in a unique setting the no- tion that external connections decline in sa- lience and internal relations become more important as interfirm networks develop. Exploring the relevance of ideas from orga- nization theory in a transition economy fa- cilitates an examination of the idea that ac- tors will forego less expensive alternatives in favor of trading with known others when uncertainty is high, a notion that has previ- ously been studied only in laboratories. Per- haps most generally, these findings contrib- ute to our understanding of the process by which social structure emerges and highlight the importance of uncertainty reduction in that process.


Lisa A. Keister is Assistant Professor of Sociol- ogy at the Ohio State University. She is author of Chinese Business Groups (Oxford University Press 2000), Wealth in America (Cambridge University Press 2000), and "Engineering Growth: Business Group Structure and Firm Performance in China's Transition Economy" (American Journal of Sociology, 1998, vol. 104, pp. 404-440). She is the recipient of the National Science Foundation's Faculty Early Develop- ment Career Award, which she is using to study financial market development in China. In addi- tion to her work on China, she also studies wealth inequality in the United States.


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