Long read: The Emergence of Mafia-like Business Systems in China

A political scientist who specialises in the Chinese political system mailed us this riveting paper authored a couple of years ago by two academics – Meg Rithmire of HBS and Hao Chen of the University of Southern California. The core thesis of the paper is so close to home that it can serve as the outline of a Bollywood movie script:

“A large literature on state-business relations in China has examined the political role of capitalists and collusion between the state and the private sector. This paper contributes to that literature, and our understanding of the internal differentiation among China’s business elites, by documenting the emergence of a particular kind of large, non-state business group that we argue is more akin to a mafia system than any standard definition of a firm. Drawing on large-N descriptive data as well as deep ethnographic and documentary research, we argue that mafialike business systems share organizational principles (plunder and obfuscation) and means of growth and survival (relations of mutual endangerment and manipulation of the financial system)…”

In a deeply researched paper – which everyone who is doing in business in Asia will find worth reading – the authors first explain why the Chinese economy is characterised by large conglomerates: “The presence of large business systems in a political economy like China’s is not surprising. A large literature argues that business systems develop in environments with poor regulatory and other institutions as firms create backwards and forwards linkages and diversify in order to internalize risk. While some think of business groups as entrepreneurial in difficult contexts and as a mostly temporary phenomenon, likely to disappear in crises or with institutional maturation, others imagine these groups as a much stickier corporate form with a more predatory relationship to society. Many large business systems that have emerged in China over the last two decades…bear a greater resemblance to mafia systems than firms organized to “maximize long-run profits” or even some other measure of the firm’s status within the economy (e.g. revenues, market share).”

As one would expect, given the title of the paper, there is extensive discussion in the paper of what exactly ‘mafia-like businesses practices’ entail. Here are two excerpts from the paper: “First, in characterizing certain large conglomerate firms as “mafia-like business systems,” we do not mean that they are the actual mafia in the sense of organized groups who use violence to sell protection or subnational groups whose control of force either challenges or substitutes for the state. Mafia-like business systems do not primarily wield violence as a tool of power, though neither is it unheard of. Violence manifests in a few ways: suicides of system affiliates, suspicious “accidental” deaths and occasional murders, and, most frequently, the use of state violence—arrest, imprisonment, even kidnapping—to settle scores among system participants. Further, mafia-like business systems, unlike the real mafia, use extortion and clandestine activities to pursue legal business—e.g. finance, real estate, entertainment—rather than illegal businesses, such as gambling, prostitution, or drug trafficking. Rather, we identify these firms as more akin to mafia because of the centrality of extortion: they obtain business resources such as state assets, land, credit, or prestige through threat and unfair means, but threat is not one of violence executed by the firm itself but exposure, incrimination and, by extension, the coercive power of the party-state…China’s mafia-like business systems are manifestations of the clandestine competition for the spoils of Chinese capitalism…

….Tania Murray Li, in discussion of Indonesian plantations, describes a mafia system as “an extended, densely networked predatory system in which everyone…must participate in order to get somewhere, or simply to survive. Predation means plunder; it also means consuming weaker animals. Hence anyone who does not become mafia—both defensive and predatory–is simply prey.”

The authors then explain that one of the explicit goals of mafia-like business is to facilitate the flow of public resources into private coffers. Since multiple mafia-like groups are trying to do the same thing, they end up with fighting with each other. Interestingly, this in turn creates weird & wonderful opportunities by employees of these firms: “Mafia systems do not just pursue rents as a sort of “non-market strategy” to enhance corporate performance; rather, they are organized to facilitate the flow of public resources into private coffers, mostly with any productive activity as epiphenomena. The practice of plunder is replicated within the organizational hierarchy. Employees and managers that do not take advantage of and exploit their positions, for example by taking cuts of transactions or wielding information against others to extract personal benefits, find themselves exploited, weakened, and nonetheless compromised by the system such that they come to defend and perpetuate it in order to survive….

The internal replication of the plunder principle creates an organization in which every participant expects to get a “cut” along the way. Indeed, a typical deal proceeds in this way. When crony firms borrow from banks, they do so through an “introductory contact” (jieshao ren, 介绍人 ), who then takes a small fee, usually a percentage of the loan volume. All parties, then, have incentives to inflate deal prices—loan officers and introducers, who get a cut, and borrowers, who enjoy access to cheap credit because of their political connections and the structure of China’s financial system…”The paper uses several case studies to help the reader understand why many Chinese firms don’t seem to be interested in making a profit: “The rapid rise and fall of the China Minsheng Investment Group (CMIG) illustrates the plunder principle as it applies to relations within mafia systems and between them and the state.

CMIG is a nominally privately-owned and managed firm with significant state backing and formal approval from the State Council to become the “J.P. Morgan” of China by investing in industrial upgrading. In 2019, CMIG had 62 shareholders, 57 of which held two percent or less and only one more than four percent. That one shareholder, which held 16.91% of CMIG in March 2019, was a shell company owned and controlled by CMIG’s management team. The idea behind the dispersion of the shareholders was to preserve the independence of the company’s management, a model borrowed from China Minsheng Bank, a major privately-owned bank where CMIG’s founding chairman, Dong Wenbiao had spent most of his career. Within five years of its establishment in 2014, CMIG had accrued over 300 billion RMB in debt, mostly financed by state banks and entered state receivership. Pathologies in the management and organization of CMIG, ones explained by the plunder principle, contributed to the company’s debt burden and failure. CMIG was characterized by a culture of risk-taking and informal relationships. According to interviews, the company’s operational mode was more “do it first and ask later” (先弄了再说) and “mutual enrichment” ( 一起吃肉, literally “eating meat together”) than careful assessment of investment opportunities and professional management of capital. The company culture was also described as “fly-bynight family culture” (jianghu dage wenhua 江湖大哥文化 ), connoting a kind of familial relationship among grifters. Almost all of the shareholders in CMIG and the executive team are personally connected to Dong Wenbiao. Dong and his inner circle served the function that a central family usually does in most mafia systems. As one analyst put it, “The shares of the CMIG are too scattered. No one really cares about the company’s money, nor does it care whether a project is really making money.” In its five short years, CMIG’s principals practiced organized plunder with the state’s resources, likely applying practices honed through years of participation in other mafia systems. Almost all of the group’s activities were either related-party transactions or high-profile wastes of the state’s resources in feigned efforts to invest in strategic sectors. For example, some private firms first invested a few billion RMB to become CMIG’s shareholders. Then, subsidiaries of CMIG later awarded projects and contracts at inflated prices to firms affiliated with those shareholders, including transactions that appear to only provide use of CMIG’s assets for individual executives associated with shareholding firms. Many more of CMIG’s individual shareholders pledged their shares to banks to acquire more loans….The company’s principals combined a learned culture of organized plunder with access to tremendous state resources. Once it became clear that some of CMIG’s shareholders were self-dealing and many of its executives engaged in self-enrichment at the expense of the firm’s future, no one had any incentive to defect from the arrangement….”