Business Environment after SOE Reforms: How Unemployment Discourages Foreign Investments

Abstract

State-owned enterprise (SOE) reforms have resulted in mass layoffs in many post-communist regimes. Combining city-level unemployment data obtained from government archives in the 1990s with firm-level financial data, this paper investigates the lasting impact of reform-induced unemployment on China's businesses environment for foreign investors. We find that cities with higher unemployment rates arising from SOE reforms have fewer foreign businesses after China's WTO entry, as measured by the total number of firms as well as the amount of capital investments, around the end of the reforms. We further show that there are two mechanisms at play. First, high unemployment rates reduce municipal fiscal expenditures on educational, medical, governance, and other social services. The worsened infrastructural and institutional quality discouraged foreign investors. Second, citizens attribute their unemployment status and economic grievances to foreign competition, which increases public hostility towards Western countries. Importantly, additional analyses suggest that non-Western countries, such as Russia, are not affected. Also, SOEs gain greater market shares at the expenses of foreign and private firms due to rising unemployment. Overall, the findings show that unemployment problems caused by SOE reforms constitute a negative pull on a country's path towards establishing an open and competitive market economy.