1

Political Connection, Local Protection and Domestic Market

Entry Barriers in China

Qun Bao, Ninghua Ye, Ligang Song

1. Introduction

Trade theories assume that large entry costs exist for exporters and sales within one

country’s domestic market involve no or much less entry costs. As a result, exporters

need to show higher productivity advantage to overcome the export costs across

national borders, which is called the ‘self-selection effect’ in trade literatures (Melitz,

2003), and many empirical studies supports the self-selection of exporters (see the

surveys by Wagner, 2005; Greenaway and Kneller, 2007; Bernard et al., 2012). Such

an assumption is quite plausible, since it’s usually much harder to conduct

international business than doing business in the home market. However, if a

country’s domestic market is not closely integrated, like the current Chinese market

that is segmented by its provincial borders due to many institutional factors and local

protectionist policies, we would expect that sales within the domestic market can also

involve substantial market entry costs.

Why Chinese domestic market is still highly segmented after decades-long

market reform? What are the main sources of domestic market entry barriers in China?

Unlike international trade barriers such as transportation costs and tariffs, barriers to

domestic transaction are, to a large degree, created by intra-national protectionism and

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the related tedious administrative procedures1. China’s case is more serious because

of its unique institutional setting. China’s fiscal decentralization has been a

fundamental aspect of its reform programs towards a market economy, which aims at

getting various levels of governments to be fiscally responsible with various forms of

fiscal contracting systems and tax sharing system (Shen et al. 2012). Such reform has

substantially prompted China’s rapid regional economic growth (Zhang and Zou,

1998; Jing and Zou, 2005) through much improved incentives for China’s local

governments to implement various administrative intervention measures including

protection of the local business in order to maximize its local fiscal revenues and

employment. However, these protective measures have inevitably raised interregional

trade barriers and are the fundamental causes for current market segmentation in

China and for firms’ incentives to forge closer relationship with local governments to

overcome those barriers for increasing cross-regional trade.

It’s Young (2000) who first raised the issue of domestic market segmentation.

The author emphasizes that in a partially reformed economy like China, growing

interregional competition leads local governments to impose a variety of interregional

barriers to trade. Following the influential findings of Young (2000), many more

studies have confirmed the existence of domestic market segmentation and trade

barriers between regions (Naughton, 2003; Bai et al, 2004; Poncet, 2005; Fan and Wei,

2006; Holz, 2009; Xu and Fan, 2012). Herrmann-Pillath et al (2014) compared the

effects of political factors and cultural differences on market segmentation and

1 For instance, Djankov et al. (2002) look at the procedures for registering a new firm in 85 countries, and find that government productivity has a significant impact on registering new firms.

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concluded that trade barriers are indeed instigated by local protection, rather than

caused by cultural and dialect differences. In other words, the cross-regional trade is

likely to be hindered more by local administrative intervention than language and

cultural barriers commonly seen in the international trade.2

It is therefore our interest to ask how local protection affects firms’ domestic

entry behavior in China. In a normal and competitive business environment, the sales

activity and destination choices of firms will depend entirely on their own

competitiveness. However, in the presence of trade barriers due to local governments’

administrative intervention, it can be expected that firms will resort to political

lobbying, in an effort to eliminate the negative impact of local protection on their

business by building a closer relationship with the administrative departments.

However, to investigate how political connection affects firms’ domestic sales,

we need detailed information about firms’ sale among different domestic destinations.

For example, we need to know whether firms ever sell their goods to other provincial

markets or prefer just to stay within their own provincial market. Compared with the

detailed transaction data in export market collected by the Chinese Customs, it is very

difficult to collect the statistics about firms’ domestic sale activities within China.

To fill this gap, the World Bank provided some detailed survey data on firms’ sales

destinations for 12,000 firms operating in China in 2004. This survey data

2 Local protection is definitely not unique to the Chinese economic development. In fact, either in developed or developing countries, local governments may intervene in the business environment for different reasons. This phenomenon has aroused widespread concern, such as the research of Sonin (2010) on Russia, Luong (2004), Kazakhstan, Das-Gupta (2006) for India, and Berdahl (2013) for Canada. The Chinese experience offers ample opportunities for studying this issue because of the unique feature of China's political system, including fiscal decentralization, economic tournament among regional economies, and the ways for official assessment on performance which all exacerbate the prevalence of local protection.

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encompasses detailed market information including firms’ locations and destination

for their products including sales to the local markets, other cities within provinces,

other provinces as well as export markets, and importantly some proxies for capturing

the political connection by firms.

Using firms who only sell in the local market as the benchmark, we study those

firms who enter the other cities or provincial markets by establishing closer political

connection to facilitate their sales. In other words, it can be hypothesized that political

connection helps firms to successfully enter domestic markets by lessening

administrative intervention from local authorities in the targeted market. We also use

the behaviors of exporters as a robustness check. As local protection doesn’t matter to

exporters, we would not expect that there is also a strong correlation between political

connection and export activities among exporting firms.

We also show the extent to which local protection is implemented in affecting

firms’ sales in other markets. In the case of minor local protection, political

connection mitigates the effect of local protectionism and helps firms enter other

provincial destinations. However, once local protection becomes too strong, political

connection fails to help businesses to break down the barriers across provinces. In

other words, the effect of political connection is quite limited when the local

protection becomes more serious. It implies that we can’t exaggerate the role of

political connection in facilitating domestic market entry, and reminds us of the fact

that political connection can’t be considered a fundamental solution to keeping off

local protection and administrative intervention.

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Our study helps to understand the motivation of domestic sale activities in

transitional economies like China. Following Bernard and Jensen (1995), extensive

literatures have examined the determinants of the international market entry among

exporters (Wagner, 2007; Greenaway and Kneller, 2007; Bernard et al., 2012)3.

However, much less has been known for firms’ domestic sale behavior, especially for

countries like China whose domestic market is so large and has a profound impact on

firms’ business operation. This study thus provides useful evidence for understanding

the entry behavior of firms in domestic markets.

Our study contributes to the literatures on political connection. A large number of

empirical studies prove that companies can indeed benefit from political ties,

including more convenient access to bank credit (Joh and Chiu, 2004; Cull and Xu,

2005), seeking government-regulated preferential treatment (Kroszner and Stratmann,

1998), and seeking government's crisis rescue packages and policy asylum measures

(Faccio et al, 2006). However, few studies have examined the effect of political

connection on firms’ sale activities, especially for a geographically large transitional

economy such as China. This study confirms that in an economy associated with

market segmentation and local protection, political connection may help smooth the

way for businesses entering into the remote markets. It echoes with previous studies

that the emergence and prevalence of political connection is a reasonable and strategic

reaction of firm especially private businesses in the presence of widespread

administrative intervention.

3 Many studies also explored the reasons behind the rapid expansion of exports based on Chinese datasets (Lu et al, 2010; Manova and Zhang, 2012; Koopman et al, 2012; Ma et al, 2014.).

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The arrangement of this paper is as follows. We describe the data source and

estimation model in section 2; section 3 provides the estimation results on how

political connection affects firms’ sale destinations; section 4 conducts the robustness

tests; and the final section summarizes and concludes.

2. Data Source and Estimation Strategy

Data used in this paper are from China Investment Climate Survey (2005) of the

World Bank. The World Bank survey randomly chooses 12,400 firms located in 120

cities: Each sample city has 100 firms and the four municipalities (Beijing, Tianjin,

Shanghai, and Chongqing) have 200 firms each. The unique advantage of this survey

is that it collects detailed sales information in four types of targeted destinations,

including locating cities, other cities in the same province, other provinces, as well as

export markets. Thus it enables us to examine the determinants of firms’ entry

decision in any targeted market. We first group the sample firms (exclusive between

types) according to their sales destinations as the following four types: type 1

indicates firms with sales only in the city where they locate, type 2 firms with sales in

other cities of the same province, type 3 firms with sales going to other provinces, and

type 4 firms with exports. The first three categories are all domestic-oriented firms

with type 2 and type 3 having sales across city and provincial administrative

boundaries.

Political connection is the core variable which we concern. In some previous

studies of China’s case, political connection is typically measured by whether the

corporate management or board members have the party membership (Li et al, 2008),

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or whether executives are the National People’s Congress (NPC) or China People’s

Political Consultative Congress (CPPCC) members (Tian and Zhang, 2013), or

whether managers and other senior executives are appointed directly by the

authorities (Wang and Sheng, 2012). These proxies reflect firms’ affiliation with the

governments to some extent. However, they do not speak for the efforts that firms

make to enter other cities or provincial destinations. For example, if managers are

directly appointed by the local authorities, it is more reflective of the political

relations of firms at the localities, and firms are therefore more likely to adopt a

localized business strategy rather than external expansion beyond their jurisdictions.

In light of the potential drawbacks of these proxies, this paper uses "designated

personnel for dealing with administrative businesses" in China's Investment Climate

Survey (2005) to characterize the political connection. By designating personnel to

deal with local governments which have been granted economic autonomy after the

decentralization reform program was implemented in the 1980s and 1990s, it directly

reflects firms’ needs and efforts of making the political connection to pursue their

business interests. We would expect that to whom firms designate as their personnel

to deal with administrative business are more likely to establish close ties with the

authorities, and thus to overcome the entry barriers erected by the authorities more

easily. A binary dummy variable gov is created, where the value 0 means absence of

such personnel and 1 means presence of such personnel, indicating close political

connection. We also use other measures of political connection as the robustness

checks.

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Table 1 provides the statistics about various types of sale behaviors of the sample

firms. First, among the 3,727 sample firms, only 750 firms or 20.12% focus on sales

within the home cities. It means that the vast majority of firms have a tendency to

extend their sales to other markets. Second, 1,068 (approximately 28.66%) firms sell

products only to other cities in the same province, while 1,113 (approximately 29.86%)

selling their products to other provinces. Finally, 21.36% of the samples are firms

engaging in exports.

Table 1 also shows the relative importance of the political connection for various

sale types. Generally, there is positive relationship between the scope of firms’ sale

and the degree of their political connection. In other words, "the farther away that

firm’s products are sold", the more likely firms are to establish a robust relationship

with the government as more distant markets could mean higher entry barriers for the

firms. Specifically, only 17.47% of local businesses designate personnel in charge of

administrative issues. Nearly 21% of companies targeted at other cities in the

province have political ties, and among firms with sales in other provinces, the

proportion increases to nearly 25%. Among exporters, more than 30% of the firms

designate personnel to deal with administrative departments. Thus, we ask the

question as to whether the closeness of political connection helps firms to enter

distant market destinations.

Control variables that may affect firms’ sales decisions are also incorporated to

the model in estimations as follows. (1) lnp2003 is the average output: the logarithmic

number of sales revenue divided by the total number of employees in the firm; (2)

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ktl2003 is the capital-labor ratio: the logarithmic number of net fixed assets divided

by the total number of employees; (3) scale2003 is the scale of the firm: the

logarithmic number of main business revenue; (4) age is the age of the firm: the

difference between the year of establishment and the year of study (2004); (5)

rdr2003 is the proportion of research and development (R&D) investment in the main

business revenue. (6) firms ownership dummies: private= {0, 1} represents private

firms, hmte = {0, 1} represents Hong Kong, Macao and Taiwan firms, and fie = {0, 1}

represents foreign-invested firms respectively. In addition, cities dummy variables and

industrial dummy variables are also introduced to control for the region-specific and

the industry-specific fix effects of firms’ sale activities.

3. Estimation Results on Political Connection and Market Entry

3.1 Firms’ entry into different destinations

Table 2 reports the probit model estimation results of firms entering into various

markets showing how political connection affects firms’ entry into different market

destinations. The estimation results indicate that the regression coefficient of political

connection is significantly positive for out-province sellers who enter other provincial

markets, but not for out-city sellers and exporters respectively. The findings may

suggest that close political connection does increase the probability of entry to other

provincial markets, but this effect is not seen in selling products to other cities within

the same province or to export markets.

The estimation results here reveal the extent to which local protection matters in

helping firms’ marketing performance. Firms usually face less administrative

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intervention within the provincial range, and hence the sales to other cities in the same

province are not clearly related to the political connection. It is understandable

because the entry barriers at provincial borders in China are more palpable than those

existed within provinces as one would expect. However, in the effort to open up

markets in other provinces, firms may be confronted with various administrative

obstacles out of local protectionism in other provincial destinations. As a result, the

political ties with governments will help firms to noticeably increase the probability

of overcoming the regional or provincial barriers to trade. Similarly, Herrmann-Pillath

et al (2013) compared the impact of inter-city and inter-provincial boundaries on the

linkage of two adjacent urban economies. The results show that the former has

significant positive effects while the latter has no significant correlation with

economic linkage illustrating that market entry barriers do exist at China’s provincial

borders. The finding in this paper confirms the same point by suggesting that

intervention policies for local protection may be mainly implemented by

provincial-level authorities towards market entry of businesses from other-provinces.

The estimation results also show that the role of political connection in helping

with firms’ overseas sales is not obvious. It implies that the frequent dealings of

export-oriented firms with official departments do not help to explain much about

firms’ export decisions and outcomes. Political connection does not play an apparent

role in helping firms with reducing the costs of international trade for export-oriented

firms. This finding too is as one would expect as firms engaging in foreign trade need

to overcome the international transport costs, cultural differences, language barriers,

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as well as a variety of tariff or non-tariff barriers which are largely beyond the

influence of local governments.

The next question we ask is the extent to which gov promotes the sales of firms

in other provinces. Answering this question helps us to understand the effect of local

protection in China. For example, even though the estimated coefficient of political

connection is positive, if the actual contribution to sales is extremely limited, it may

be the case that the local protection through administrative intervention may not affect

Chinese firms’ domestic sales as significantly as expected. In other words, given the

fact that local protection is popular in China, the actual effect of it on firms’ domestic

entry may be quite limited. So, to understand better the role of political connection in

the entry to the markets of other provinces, we further predict the probability of sales

to other provinces for firms with political connection (gov = 1) and without political

connection (gov = 0) respectively. We find that other things being equal, political

connection will increase the probability approximately by 57.5% (= (0.742-0.471) /

0.471). This calculation means that if a firm attempts to establish political ties with

the local authorities, it will help to increase the probability of entering into other

provincial market by more than fifty percent, which is not a trivial effect. It confirms

that Chinese firms in general significantly benefit in market entry to other provinces

from building ties with the authorities.

For the impact of other control variables, it’s not surprising to see that firms with

larger scale and more R&D expenditure are more likely to enter remote markets

because of the competitiveness that these attributes bring to these firms. From the

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ownership point of view, relative to the state-owned enterprises (SOEs), private firms

are more positive in developing external markets, posing a far higher probability of

entering provincial markets and international markets, while HMTE and FIE show a

higher tendency to export. To compare the importance of the political connection and

other variables such as R&D investment and firm size, the marginal effect of the

explanatory variables is further calculated. The results show that political connection

has a marginal effect of 0.046, second only to firm size (0.063), but much higher than

other corporate characteristics (i.e. R&D investment with a marginal effect of 0.024).

It once again proves that the political connection plays a relatively more important

role in promoting firms in market entry to remote or distant destinations.

3.2 Impact of Political Connection by Entry Type

Table 2 also supports the importance of political connection to the choice of firms’

market entry type. To do that, we use the multinomial-logit model (MNL) to estimate

the effect of political connection on various entry types. Specifically, we divide all

firms into the following four types: { }4,3,2,1=k , with 1=k for LocalFirm firms

who only sell in the home city market, 2=k for ProvFirm firms who enter other

cities markets within the same province, 3=k for Domestic firms who enter other

provincial markets, and 4=k for Exporter. With 1=k (LocalFirm) as the base

category, we use the MNL to model firms’ choices on their sale types:

The explanatory variable vector X refers to political connection and other control

variables. However, it is not straight forward to interpret the coefficients in the MNL

( ) ( )( )∑ =′+

′== 4

2exp1

exp

k k

k

XXkKPβ

β

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model in a satisfactory way. To better interpret the coefficients in the MNL model, we

introduce relative-risk ratios (rrr) in our estimation model. For firm type i, the rrr for

vector X, compared with the base category firm type 1 (ProvFirm), is derived as:

)1(/)()11(/)1(

1/ XKPXiKPXKPXiKP

rrri ==

+=+==

The rrri/1 for political connection shows that one unit increase in political connection

will lead to relative odd of choosing to become firm type i is rrri/1 times than what it

was before. Thus, the value of rrri/1 greater than unity indicates that an increase in

certain explanatory variables leads to higher probability, and vice versa. As noted in

the literature, the empirical application of the MNL model also needs strong

assumptions, particularly the Independence of Irrelevant Alternatives (IIA)

assumption, which requires that the choice of any option does not affect the relative

probability of other options. If the assumption does not hold, one needs to use other

estimation model specifications such as multinomial probit model. In the empirical

analysis, we use the Hausman test in Hausman and McFadden (1984) to test the

independence of irrelevance alternatives to show the validity of the assumption.

The MNL estimation results in Table 2 show that for Domestic firms, the relative

risk ratio of political connection is significantly greater than one, which means that

political connection is indeed beneficial to the entry to other markets outside the

province. Specifically, if designated personnel are in place for dealings with the

authorities, then the relative probability of inter-provincial sales will be increased by

0.379 time from the initial level. However, rrr is not significant in the statistical sense

for ProvFirm firms and exporters, though the value is still greater than 1. For firms

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targeted other cities in the province, the role of firm size and R&D investment are the

most significant factors. For exporters, the most important determinant is firm

ownership. For example, FIE’s export probability is more than 37 times higher than

SOEs’.

3.3 Endogeneity of Political Connection and IV Estimation

We are concerned about the endogeneity problem in capturing the role of political

connection, which may lead to biased estimation results. There must be reasons why

some firms choose to build close ties with the administrative authorities, and some

don’t. Hence, to deal with the potential endogeneity problem, we use the instrumental

variables method by choosing proper instrumental variables for political connection.

In this study, the right instrumental variable can be those firms who are committed to

the establishment of good relations with the authorities but those good relations won’t

directly affect firms’ entry decisions (exclusion restriction). Specifically, we choose

an instrumental variable (disp): whether the firm has disputes or fails to reach

agreements with the government in the last three years. Obviously for firms ever had

disputes with the authorities, it shows that they have weaker ties with the

administrative departments. Things got even worse for those who couldn’t reach an

agreement with the government once they had dispute with the latter. Thus they

should have stronger motivation to build close relationship with the government by

designating personnel to deal with the government departments. On the other hand, it

is difficult to say that there is any obvious correlation between disp and firms’

business entry behavior.

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We adopt the usual two-step IV procedure to re-estimate the model, and the IV

estimation results are shown in Table 3. Our main finding still holds true even if

considering the endogeneity of political connection. For those firms who are subject

to intervention measures for local protection, political connection indeed increases the

probability of their access to other provinces markets, while this effect is not seen in

their business in other cities in the province and export markets.

3.4 The Existence of Local Protection

The above analysis confirms the effect of political connection on the domestic market

entry of firms. However, it does not consider the heterogeneity of local protection.

When examining the relationship between political connection and sales behavior, it

is necessary to consider not only the presence of political connection, but also the

constraints arising from administrative intervention that firms are subject to. For

example, it’s reasonable to expect that firms who face serious local protectionism

would have a stronger demand for political connection than those without. So political

connection should play a bigger role in overcoming regional barriers for those firms

who are experiencing severe protectionism.

The survey also asks "whether local protectionism affects the business operation

and development of the firms". Such survey results enable us to deal with this

heterogeneity issue. Based on firms’ answers to this question, indicators reflecting the

impact of local protectionism borne by businesses are constructed. 498 or 56.5% of

881 firms with political connections report that local protection does not affect their

business operation. We define govlpno=1 for those firms with political ties and free

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from local protectionism. A total of 383 firms or approximately 43.5% believe that

their business operation and development is really hindered by local protection, and

we subsequently define govlpyes=1 for these firms. Table 4 presents the test results

about the combined effects of political connection and local protection on firms’

offsite sale behavior.

The estimation result supports the importance of local protection. For ProvFirm

firms, the role of govlpno is negative, but not statistically significant, while govlpyes

is significantly positive. It means that if firms are subject to local protectionism,

political connection increases firms’ entry probability to other cities in the same

province, and it’s not true for those who aren’t. In comparison with the results in

Table 2, we find that for firms who targeted other cities in the province for sales, the

role of political connection is mainly for keeping its businesses from the impact of

local protectionism. Specifically, for firms who are subject to local protectionism, the

relative probability of out-city sales is 0.761 time higher thanks to political

connection.

The same result holds true for cross-province sales. Both in the entry probability

model and in the MNL model, govlpno and govlpyes are both positive, but the former

is not statistically significant, which means that political connection is an effective

channel to increase the entry likelihood of other provinces only for firms who are

indeed affected by local protectionism. For firms who are subject to the intervention

of local protectionism, the relative probability of inter-provincial sales would increase

by 0.682 times. By comparison, both govlpno and govlpyes are not significant for

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export. In other words, whether or not firms are subject to local protectionism,

political connection does not have a significant effect on firms’ export decisions. It

further shows that political connection plays a role in overcoming trade barriers

between regions within the country, rather than in dealing with international trade

barriers faced by exporters.

3.5 Does Degree of Local Protection Matter?

We have shown the importance of political protection in helping firms to overcome

the difficulties associated with local protectionism. However, the results only

distinguish between firms who are subject to local protection and those who are not.

It’s our interest to ask further question as to whether the degree of local protection

matters. By the degrees of local protection, the World Bank survey dataset asks firms

to report how seriously they consider local protectionism affects their business

operation and development among those 383 firms who are subject to local protection.

Their answers are four types in ascending order (1, 2, 3, and 4). To test the impact of

local protection by degrees, two new political connection variables are created. A total

of 235 of the 383 firms have political connections and think a low degree of local

protection (=1) of the firm, and they are referred as govlplow, while the rest 148 firms

(degree = 2, 3, 4) as govlphigh referring to a high degree of local protection. It is our

concern that whether political connection exerts a more serious impact on sales of

these firms who experience severe local protection. As local protection primarily

affects the sales behavior of firms in the domestic market, we focus on the role of

local protection in affecting firms’ domestic sales.

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Table 5 shows the new estimate results. Inconsistent with our expectations, for

sales in other cities of the same province or sales outside the province, govlplow is

significantly positive, while govlphigh is not significant. For firms who are severely

hindered by local protection, the political connection no longer promotes their

business development in other domestic markets as we expected. This result reminds

us that the role of political connection is by no means omnicompetent for all firms. As

a matter of fact, the role of political connection in market expansion is only limited to

businesses moderately affected by local protectionism. Once firms’ business operation

is intervened by high degree of administrative protection, it doesn’t matter whether

firms have attempted to establish close ties with the governments or not. In other

words, it’s difficult for firms to use political connection as an effective tool to

overcome the regional trade barriers once these barriers become so high due to the

severe local protectionism.

We also introduce the interaction term gov * localpro (localpro=1, 2, 3, 4) to

test whether the role of political connection is positively correlated with the degree of

local protection. The results show that the estimated coefficient of gov * localpro fails

to show statistical significance, which means that there is no simple linear relationship

between the degree of local protection and domestic market entry. It indicates that

political connection is not the panacea in helping firms to overcome market entry

barriers, though conducive to easing the pressure from local protection to a certain

extent. In the presence of too severe administrative intervention, political connection

does not alleviate entry barriers brought by local protection.

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4. Political Connection and Market Entry: Robustness Tests

4.1 Firms Ownership Heterogeneity

As an economy in transition, the Chinese economy is clearly characterized by

business operation heterogeneity between firms of different ownerships. SOEs enjoy

more inclined support and preferential policies rendered by governments, and

encounter fewer entry obstacles brought by local administrative protection. Private

firms, however, face obvious discriminatory policies and grim administrative

intervention, though the overwhelming evidence demonstrates their important role in

macroeconomic growth and employment (Chen et al, 2005; Li et al, 2008).

Apparently, due to the lack of policy support, private firms can only resort to political

ties to resolve trade barriers from local administration. For example, Li et al. (2008)

found that the party membership of private entrepreneurs can remarkably improve

business performance, facilitate access to bank credit, and boost the confidence in the

judicial system. It is therefore necessary to further distinguish the impact of political

connection on the sales behavior of firms of different ownerships. Following the usual

practice, firms are divided into SOEs, private firms and foreign-invested enterprises

(FIEs).

Table 6 shows that the role of political connection does vary with firms’

ownership types. For private firms, govlplow not only significantly increases the

probability of entering the market in other provinces but also different cities of the

same province. Similar to Li et al (2008), this study confirms that in the presence of

local protection, private firms tend to resort to political connection to eliminate

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market entry barriers, and the role of political connection remains significant even in

the market within the same province. In contrast, this role does not exist for SOEs.

Regardless of other cities or provinces, political connection does not influence the

probability of their market entry, and this result does not relate to perceived degree of

local protection. Finally, political connection also helps FIEs to significantly increase

the probability of entering other provincial markets, but not, of entering other cities in

the same province. In this sense, this study does demonstrate some significant

differences in local protection effects on firms of different types.

4.2 Controlling for Travel Expenses

One of the main arguments in the above analysis is that domestic entry barrier exists

mainly due to local protection. However, except for administrative barriers under

local protection, firms still face other normal transaction costs for market entry, such

as for advertisement in remote markets and commercial communications with sales

agents. Obviously, if ignoring these normal costs, the role of political connection in

remote sales will be overestimated, since normal business costs may be attributed to

the result of political connection. In order to control for the normal commercial costs

of firms in market expansion, we introduce the indicator of travel expenses (traratio)

in the estimation model characterized by the percentage of travel expenses to sales

revenue from main business.

The new estimation results reported in Table 7 show that the estimated

coefficients and the statistical significance of govlpno, govlplow and govlphigh

remain the same, indicating that the earlier conclusions reached are robust.

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Meanwhile, in line with the expectations, traratio is significantly positive in the

equations for markets in other provinces and in other cities of the province. The

results indicate that with the normal commercial costs for sales being controlled for,

political connection still has significant positive impact on offsite sales for those firms

who are suffering moderate intervention from local protectionism. It means that

regarding domestic market entry, firms need to bear the normal costs of sales across

the regions, but also seek political ties to overcome administrative intervention arising

from local protectionism.

4.3 Sale Probability vs. Sale Volume

While we have shown the important role of political connection in increasing the

entry probability to markets in other provinces, we wonder whether political

connection also affects firms’ sales volume. Regional trade barriers caused by local

protection are in general considered similar to the initial fixed costs of entry in the

international trade, which raise the threshold for market entry. However, once firms

successfully overcome these barriers, their sales in the destination market may

essentially depend more on other things such as market size. In other words, given the

market entry threshold under local protectionism, political connection is expected to

influence more the entry probability, rather than firms’ sales volume. In this respect,

by distinguishing the impact on entry probability and sales volume, it will help us

better understand the entry barriers caused by local protection.

It’s worth mentioning that there are many samples firms with zero sales since

only a small part of the sample firms have sales in a particular market, which may

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lead to the sample selection bias. For this consideration, the self-selection model

developed by Heckman (1979) is introduced to amend the self-selection phenomenon

in the particular destination. According to Heckman (1979), due to the presence of

self-selection in destination market entry, it is necessary to identify how firms are

selected engaging in certain destination in the first market selection equation. In this

paper, we use the type of license or certificate of registration as the identification

variable, since the variable only affects firms’ market entry decisions rather than their

sales volume.

Table 8 provides the Heckman model estimation results about political

connection and market sales, where equation (1) represents the probability of entry in

a specific market and equation (2) represents the sales volume in a specific market.

No strong evidence is seen that political connection increases the sales volume in

remote markets, though it does facilitate domestic market entry. Regardless of sales in

other cities or in other provinces, the estimated coefficient of political connection fails

in the test of significance. It verifies that firms may ease entry barriers by virtue of

political connection, but the consequent sales performance depends more on such

factors as firms’ competitiveness. For example, in markets outside the province, firms

with large size and more R&D investment usually have a larger sale volume.

4.4 Importance of Sales Targets - A Case of Government Orders

Many studies on economic consequences of political connection have found that

politically connected firms have more access to government orders (Faccio, 2006;

Goldman et al, 2008). For example, based on the data on the United States’ listed

23

companies, Goldman et al., (2008) found that after the U.S. presidential election,

businesses with links with the winning party are able to win more government orders.

Does the same thing also happen in China that firms’ close ties with the authorities

help them to obtain more government orders? To this end, this study further examines

the relationship between political connection and business-to-government sales from

the perspective of government orders. For example, for ProvFirm firms, we further

divide them into two types: ProvFirm firms with government orders and ProvFirm

firms without government orders. We expect that political connection would have a

larger effect on ProvFirm firms with government orders than those without.

According to the regression results shown in Table 9, govlplow is significantly

positive for all types of firms. For sales to other provinces or other cities in the

province, the absolute values of rrr of govlplow of firms with government

procurement orders (2.940 and 4.086 respectively) are much higher than those

without (1.565 and 1.873 respectively). It indicates that the dealings between firms

and the authorities do include direct government orders. Meanwhile, for firms with no

direct access to government orders, the coefficient of political connection remains

significantly positive, which means excluding the impact of government orders,

political connection is still able to increase the entry probability for those firms.

4.5 Other Measures of Political Connection

Finally, we wonder whether our key finding suffers from the specific measure of

political connection used. To do that, we use the following alternative measures of

political connection as robustness checks as reported in Table 10.

24

The first alternative measure is Days of General Manager (GM)’ spending with

the authorities (govday). In similarity with designated personnel for political

connection, the connection of firms’ managers with government agencies also reflects

the closeness of political connection. To be specific, the World Bank survey asked

"average days of General Manager dealing with the government in a month". govday

is set to 1 if the time is greater than the median value of six days, and 0 otherwise.

Further, the MNL estimation results indicate that, relative to the baseline, govday is

significantly positive for Domestic firms. It means that from the perspective of

govday, political connection also promotes market entry, again confirming the

importance of political connection in impacting on firms’ business in distant markets.

The second alternative measure is whether the general manager is appointed by

the authorities (govapon). Apparently, direct appointment by the government speaks

for closer ties and a sound relationship between firms and the authorities. However,

the estimation results do not support the importance of govapon in offsite sales. The

reason may be that direct appointment is usually seen in SOEs or partially privatized

SOEs, so this indicator reflects the changes in the ownership of firms, rather than the

efforts by the firms to expand the market. Additionally, for firms whose GM is

directly appointed by the authorities, it may have strong incentives to stay in the local

markets instead of expanding their business outsides.

The third measure is Degree of closeness in relationship between firms and

government departments. The World Bank survey also encompasses an evaluation of

the relations with various government departments, covering tax (relatax), public

25

security (relapub), and labor and social security (relalab). For this consideration,

these new indicators are introduced to measure the degree of political connection, but

the results do not support the importance of such relations in offsite sales. Similar

with the direct appointment of GM, if firms have close relationships with those

government departments, it reflect that firms may focus more on their local business,

and thus firms have less motivation to sell their goods to remote destinations.

5. Conclusions

Considering the widespread trade barriers existing between regions in the domestic

market in China, this paper examines in detail the impact of political connection on

multi-destination sales decisions of the sample firms gathered from the World Bank

Survey in 2005. The main findings are as follows.

First, in the presence of local protection, firms’ political connection with local

governments is indeed conducive to their entry in remote domestic markets, especially

in other provincial destinations. In contrast, this role is absent for export-oriented

firms, implying that political connection mainly eases domestic trade barriers brought

about by local administrative protection. This core conclusion is robust and stands

firm, taking into account the endogeneity of political connection and the control of

firms’ normal travel expenses.

Second, we also find that the role of political connection is closely related to firm

ownership types. Private firms can better benefit from the close political connection

with local governments, while there is no strong evidence on that the sales behavior of

SOEs links to political connection. It means that local protection mainly affects the

26

market expansion of private firms, so that private firms are more inclined to seek

political connection to overcome market entry barriers especially in markets of other

provinces.

Third, another important finding is that the role of political connection largely

depends on the degree of local protection. Firms who are subject to local

protectionism gain more from political connection, proving local protection is indeed

an important source of domestic entry barriers. However, political connection hardly

plays any role once local protection becomes severe, which reminds us that political

connection is not a panacea for removing the domestic entry barriers.

This paper provides empirical evidence for an overview of domestic market

entry barriers in the process of transition in China. As a result of the increased

competition of local authorities, the prevalent domestic market segmentation and

regional trade barriers seriously hamper the business behavior of domestic market

expansion, and it forces Chinese firms, especially the private firms to resort to close

political ties with local governments to overcome such market entry barriers.

However, recognizing the positive role in freer market entry, it is worthy of attention

that political connection is by no means a fundamental solution to deal with

administrative interventions which are still rampant at China’s provincial borders.

Firms need to spend additional resources and costs in developing and nurturing

political connection with government officials and departments, thereby increasing

their transaction costs for doing business, but also creating huge opportunities for

rent-seeking activities to take place in government administrations. Removing local

27

administrative intervention in Chinese domestic market by building a unified and

integrated domestic market will therefore help nurturing private entrepreneurship by

engaging firms into more ‘productive’ rather than ‘unproductive’ or even ‘destructive’

activities (Son and Song 2015). Such market integration also has high significance for

long-term growth of the Chinese economy as it reduces firms’ transaction costs.

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Table 1 Statistical summary of sale destinations and political connection

Sale type The home

city

The other

cities

The other

provinces Exporter Total

Observations 750 1,068 1,113 796 3,727

share（%） 20.12 28.66 29.86 21.36 100

Firms with political

connections 131 225 278 247 881

Share（%） 17.47 21.07 24.98 31.03 23.64

Source: Authors’ own calculation based on the original survey data.

35

Table 2 Estimation Results on the Determinants of Sale Behaviors

Sale probability Sale type

other cities

other provinces

exporters ProvFirm Domestic Exporter

gov 0.096 0.148* 0.143 1.216 1.379** 1.305

(0.090) (0.088) (0.115) (0.169) (0.192) (0.247)

scale2003 0.113*** 0.218*** 0.419*** 1.216*** 1.431*** 2.222***

(0.032) (0.032) (0.041) (0.060) (0.072) (0.151)

lnp2003 0.005 -0.096** -0.359*** 0.953 0.874* 0.504***

(0.046) (0.047) (0.056) (0.068) (0.064) (0.051)

ktl2003 0.031 0.041 -0.120*** 1.025 1.074* 0.803***

(0.026) (0.028) (0.035) (0.041) (0.046) (0.048)

age 0.000 -0.000 -0.000 1.000 0.998 0.999

(0.001) (0.001) (0.001) (0.001) (0.003) (0.001)

nrdr2003 0.023 0.074*** 0.068*** 1.085** 1.127*** 1.101**

(0.015) (0.019) (0.024) (0.037) (0.037) (0.046)

private 0.109 0.248** 0.660*** 1.152 1.483** 2.156**

(0.117) (0.125) (0.199) (0.212) (0.289) (0.742)

hmte -0.136 0.312 1.817*** 0.903 1.480 13.442***

(0.195) (0.207) (0.233) (0.274) (0.453) (5.535)

fie -0.579** 0.160 2.214*** 0.355*** 1.457 38.443***

(0.272) (0.193) (0.239) (0.134) (0.449) (16.180)

industry yes yes yes yes yes yes

36

region yes yes yes yes yes yes

sample 1719 1781 1528 3712

prob>chi2 0.000 0.000 0.000 0.000

Note: ***, ** and * denote 1%, 5% and 10% significance level respectively. Numbers

in the parentheses are standard errors.

Source: Authors’ own estimations.

Table 3 IV Estimation Results

Sale probability Sale type

other cities

other provinces

other cities

ProvFirm Domestic Exporter

ivgov 0.272 1.511*** 0.342 1.255 4.312*** 2.191

(0.549) (0.572) (1.004) (0.652) (2.311) (1.541)

CV yes yes yes yes yes yes

Sample 1719 1781 1325 3712

prob> chi2 0.000 0.000 0.000 0.000

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.

37

Table 4 The Existence of Local Protection

Sale probability Sale type

other cities

other provinces

exporters ProvFirm Domestic Exporter

govlpno -0.109 0.076 0.127 0.946 1.209 1.226

(0.185) (0.185) (0.248) (0.162) (0.204) (0.280)

govlpyes 0.580** 0.572** 0.381 1.761** 1.682** 1.456

(0.233) (0.228) (0.326) (0.367) (0.350) (0.408)

CV yes yes yes yes yes yes

N 1719 1781 1528 3712

prob> chi2 0.000 0.000 0.000 0.000

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.

38

Table 5 Does Degree of Local Protection Matter?

Sale probability Sale type

Other cities Other provinces ProvFirm Domestic

govlpno -0.110 0.077 0.927 1.139

(0.185) (0.185) (0.162) (0.197)

govlplow 0.791** 0.670** 2.312*** 1.858**

(0.313) (0.310) (0.649) (0.536)

govlphigh 0.333 0.466 1.406 1.548

(0.327) (0.320) (0.427) (0.458)

CV yes yes yes yes

N 1719 1781 2921

prob> chi2 0.000 0.000 0.000

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.

39

Table 6 Firms’ Ownership Heterogeneity

Private firms SOEs FIEs

outcity outpro outcity outpro outcity outpro

govlpno -0.228 -0.054 -0.323 0.878 0.371 0.154

(0.209) (0.216) (0.671) (0.604) (0.678) (0.611)

govlplow 0.777** 0.598* 1.672 -0.180 -0.279 1.590*

(0.377) (0.370) (1.142) (1.279) (0.856) (0.927)

govlphigh 0.350 0.567 0.868 0.485 -1.755 0.356

(0.419) (0.439) (0.774) (0.856) (1.092) (0.666)

traratio 0.204*** 0.368*** 0.275 0.810** 0.776 1.097*

(0.060) (0.075) (0.377) (0.375) (0.527) (0.566)

N 1357 1336 186 185 116 204

prob> chi2 0.000 0.000 0.000 0.000 0.000 0.000

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.

40

Table 7 Estimation Results after Controlling for Travel Costs

Sale probability Sale type

Other cities Other provinces ProvFirm Domestic

govlpno -0.131 0.079 0.915 1.122

(0.187) (0.188) (0.161) (0.196)

govlplow 0.756** 0.644** 2.281** 1.747*

(0.315) (0.317) (0.643) (0.511)

govlphigh 0.300 0.421 1.364 1.481

(0.328) (0.324) (0.415) (0.442)

traratio 0.233*** 0.392*** 1.227*** 1.508***

(0.062) (0.072) (0.093) (0.106)

CV yes yes yes yes

N 1719 1781 2921

prob> chi2 0.000 0.000 0.000

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.

41

Table 8 Political Connection and Sales Volume

Other cities Other provinces Export

probability volume probability volume probability volume

gov 0.074 -0.023 0.146* -0.006 0.144 0.019

(0.091) (0.025) (0.089) (0.024) (0.116) (0.012)

govlpno -0.074 -0.056* 0.045 -0.004 0.095 0.016

(0.111) (0.032) (0.109) (0.030) (0.139) (0.015)

govlpyes 0.322** 0.018 0.300** -0.007 0.230 0.022

(0.138) (0.039) (0.131) (0.034) (0.178) (0.017)

N 1811 1860 1539

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.

42

Table 9 Do Government Orders Matter?

Other cities without GP

Other cities with GP

Other provinces without GP

Other provinces with GP

govlpno 0.841 1.180 1.123 1.028

(0.157) (0.318) (0.200) (0.367)

govlplow 1.873** 4.086*** 1.565* 2.940**

(0.561) (1.488) (0.212) (1.253)

govlphigh 1.228 1.872 1.501 1.406

(0.406) (0.764) (0.461) (0.666)

CV (0.398) (0.723) (0.320) (0.537)

N 2921

prob> chi2 0.000

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity. “GP” means government procurement.

Source: Authors’ own estimations.

43

Table 10 Other Measures of Political Connection

Indicators Definitions ProvFirm Domestic Exporter

govday Days of General Manager (GM)’

spending with the authorities

1.133

(0.162)

1.359**

(0.196)

1.202

(0.243)

govapon whether general manager

appointed by the authorities

0.996

(0.173)

0.977

(0.176)

0.674

(0.224)

relatax Relation with tax department 0.872

(0.128)

1.013

(0.149)

0.730

(0.154)

relapub Relation with public security

department

1.211

(0.198)

1.239

(0.207)

0.995

(0.233)

relalab Relation with labor and social

security department

0.863

(0.133)

1.027

(0.159)

0.752

(0.166)

Note: ***, ** and * denote 1, 5 and 10% significance level respectively. Numbers in

the parentheses are standard errors. The regression includes all other firm-level

control variables such as firm size as well as regional and industrial dummy variables,

not reported here for brevity.

Source: Authors’ own estimations.