Political Promotion, CEO Incentives, and the Relationship Between Pay and Performance

Existing knowledge suggests that State-owned enterprises (SOEs) are managed inefficiently and influenced by inadequate political goals. This conventional thought, however, contradicts with the observation that state capitalism in China has been one of the most important contributors to its miracle economic growth in the past 4 decades. This contradiction is especially puzzling given that CEOs in Chinese SOEs are poorly incentivized using the traditional managerial incentives measures, i.e., monetary compensation. 

In a newly published article in Management Science (July 2019), Cao, X., Lemmon, M., Pan, X., Qian, M., Tian, G address this puzzle with one possible explanation. Specifically, they suggest that political career aspiration motivates the CEOs of the Chinese SOEs to maximize shareholder values.

To understand how the political career aspiration can be transformed into economic performance, we first need to take a look at the Chinese government’s objectives with SOEs, without assuming priors, as well as how the managerial labor market works for the Chinese SOEs’ CEOs. Despite the corporatization and privatization of SOEs in China since 1978, state remains as the controlling shareholder of many listed firms, and it retains control over personnel decisions with top SOE executives. It is common for the CEOs to be also evaluated for promotion to party leadership or government officials. The former Vice Premier of the State Council, Wu Yi, and a member of the Politburo Standing Committee of the CPC over the 2002 to 2012 period, Jia Qinglin, are both good examples of the up-potentials of this political ladder for people working in the SOEs. More importantly, rather than using employment or fiscal objectives as suggested in the conventional studies, Chinese government explicitly uses economic performance in the personnel evaluation and promotion. Not only the GDP growth is used as one of the key performance indicators (KPI) in promoting the provincial leaders to central government leaders, but also the return to assets explicitly enters the officially laid out KPI computation formula for SOEs managers’ evaluation and promotion.

As such, CEOs’ rewards for efforts come from not only the monetary payment from the current job but also the career rewards as a future politician, making it possibly incentive-compatible to obtain high effort even while one of the incentive constraints is slack. Despite of low monetary incentives, CEOs with a high likelihood of political promotion are likely to exert efforts for good economic outcomes that are measured in his political KPI.

The research empirically examines the two premises suggested above.  First, is political promotion of CEOs based on economic factors? This question concerns whether political career incentives are consistent with shareholders’ interests. Aside from the official government documents, the researchers also confirm this premise with data analyses. Ceretis paribus, the likelihood of CEOs in Chinese SOEs receiving a political promotion is positively related to firm performance measured with returns to assets, returns to equity, market valuations, and stock market returns. This finding suggests that political incentives are not always misaligned with shareholder value maximization.

The second question concerns how the political promotion motive interacts with monetary compensation incentives to affect managerial behaviour. The data analyses show a clear substitution between the incentives for political promotion and monetary compensation incentives. Specifically, the CEOs with better prospects of political promotion accept lower monetary compensations in total and in the form of rewards for economic performance.

Managerial career incentives for the US CEOs have also been previously studied extensively. Some studies show that, among the near-retirement CEOs, those with better prospect of outside board directorship perform better than those with less. Some other studies suggest that, when CEOs are young, performance becomes a more important signal because the prior about the CEO’s quality is more diffuse. Therefore, the CEO works harder due to this implicit incentive. Different from an exogenous quality such as age, political promotion is endogenous, the CEOs can reduce the diffusion by increase managerial efforts.

This paper applies the career incentive theory in the Chinese setting where the institutional background introduces a political promotion career incentive that is less obvious in countries like US. However, the political career incentive lesson is applicable, as any promotion draws indictors of the agent’s ability from the past performance. For example, Hank Paulson, not the head of a failed bank, was named as Treasury Secretary. It would be interesting to know Paulson’s own assessment of the likelihood of becoming a Treasury Secretary and how this prospect motivated him during his business career. Finally, by showing that the state control not necessarily always contradicts with good economic incentives, this research emphasizes the value of understanding institutional differences in conducting economic research beyond the US experience.

Read the full article at https://doi.org/10.1287/mnsc.2017.2966.

REFERENCE

Cao, X, Lemmon, M, Pan, X, Qian, M, Tian, G (2019). Political promotion, CEO incentives, and the relationship between pay and performance. Management Science 65(7):2947-2965.

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