Reexamining Chinas Economic Growth: Law, Finance, and Political Economy

1
Reexamining Chinas Economic Growth Law,
Finance, and Political Economy

• Franklin Allen
• University of Pennsylvania
• Jun Qian
• Boston College
• Advanced Summer Training Program in Finance
• Chengdu, China
• July 8, 2007

2
Introduction

• Back in 1960s, developing countries chosen by the
  World Bank and other experts to have the highest
  economic growth in the next 40 years
• The economic achievements of China in the last
  twenty-eight years have been quite remarkable
• It is one of the great economic transformations
  in history

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The Largest 20 Economies in the World
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When will China overtake the U.S.?

• Using IMF 2006 estimates
• China 10.1 trillion growth rates from
  1990-2005 of 10.1
• U.S. 12.9 trillion growth rates during same
  period of 3.0
• Extrapolating (a big assumption!) China will
  become the worlds largest economy in 2010.
• 2015 China PPP GDP 1.5 US PPP GDP
• 2020 China PPP GDP 2 US PPP GDP

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Other Successful Economies

• Only three large economies have been as
  successful
• Japan
• South Korea
• Taiwan
• China can do better but no large country has
  done so by a significant amount and in such a
  short period of time

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Other Successful Economies (cont.)

• In recent years India has also been remarkably
  successful
• Not as successful as China
• Contrast with its own past (1950-1980) and with
  China is informative

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Key Questions

• What economic lessons can be learned from the
  remarkable performance of China and India?
• Are they simply applying the conventional wisdom?
• Or are they doing something fundamentally
  different that (Western) economists have yet to
  fully understand?

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Conventional Wisdom

• What is needed for a successful economy and a
  high growth rate is
• Good legal system
• Good financial system
• Good corporate governance
• Good (non-corrupt) government (Acemoglu and
  Johnson 2005)

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Conventional Wisdom (contd)

• Literature on law and finance
• Stronger legal protection of investors is
  associated with more efficient institutions and
  better financial and economic outcomes
• (La Porta, Lopez-de-Silanes, Shleifer, and
  Vishny (LLSV 97, 98, 99, 00))
• Literature on finance and growth
• The development of financial system (stock market
  and intermediation sector) contributes to overall
  economic growth (McKinnon 73, King Levine 93,
  Levine 97, Levine Zervos 98)
• Evidence at industry- and firm-levels (Rajan and
  Zingales 98)
• Literature on law, finance, and growth
• Country level evidence Levine (99)
• Evidence at industry level (Beck and Levine 02)
  and firm level (Demirguc-Kunt Maksimovic 98)

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Alternative Views

• Political economy factors
• Great reversals (Rajan Zingales 03a) Argentina
• Legal system becomes captured by special interest
  groups who obtain rents and they prevent change
  Save Capitalism from the Capitalists (Rajan and
  Zingales 03b)

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Alternative Views (cont.)

• China as a counter-example to law, finance and
  growth literature
• One of the largest and fastest growing economies
  despite its poor legal and financial systems and
  a corrupt and autocratic government
• Alternative and informal financing and governance
  mechanisms have substituted for formal channels
  and mechanisms
• (Allen, Qian and Qian 05)
• India as a counter-example
• India inherited the best legal system in terms of
  investor and shareholder protection
• Because of corruption and ineffective enforcement
  the legal system is not used very much
• Again Alternative and informal financing and
  governance mechanisms have substituted for formal
  channels and mechanisms
• (Allen, Chakrabarti, De, Qian, and Qian 07)

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Lessons

• What lessons can we draw from these alternative
  views?
• China is the extreme example of the Eastern
  Model
• In the West people take it as given that finance
  and commerce should be undertaken using the law
  as the basis for contracts (Western Model)

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Lessons (cont.)

• What should China do going forward?
• The modern corporation on a Western model would
  be the essential vehicle for private economic
  development

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Lessons (cont.)

• This was not written today but rather was the
  view of the drafters of Chinas first Company Law
  in 1904 (Gongsilu)
• It turned out to be very wide of the mark (Kirby
  1995)
• Chinese firms on the mainland and later in Taiwan
  did not use the provisions of the law but again
  conducted commerce outside the legal system

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Alternatives to the legal system in China

• Historically, China did not use the legal system
  in commerce
• However, it had a highly commercialized society
  (late 19th Century to early 20th Century)
• How did this operate?
• Other systems for dispute resolution were used
  instead

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Alternatives to the legal system in China (cont.)

• Dispute resolution (see Kirby 95)
• Longstanding custom
• Regulation of Guilds and Families
• Local notables
• We need to better understand modern equivalents

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Alternatives to the legal system in China (cont.)

• The alternative to law in assuring performance is
  other mechanisms such as
• Reputation
• Connections and networks
• Positive financial incentives

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Law, finance and commerce

• The alternatives that China has traditionally
  used raises the issue of what are the advantages
  and disadvantages of making the law the basis for
  finance and commerce

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Advantages

• Criminal law
• Can use criminal penalties such as imprisonment
  to affect peoples behavior and provide
  high-powered incentives
• Civil law
• Can use financial penalties to affect behavior
• The legal process can be anonymous and transparent

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Disadvantages

• Political economy factors suggested by Rajan and
  Zingales and others
• Difficult to change the system if circumstances
  change and a new set of rules becomes optimal
• Any change must be passed by the government
• Interest groups may try to prevent such changes
  if it affects the rents they obtain

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Disadvantages (cont.)

• In democracies the electorate has to be persuaded
  that the change is desirable despite the fact
  that they may have little information about the
  issues
• There is a limited amount of time each year that
  can be devoted to financial and commercial laws
• The legislature has a monopoly and is the only
  body that can make changes

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When is the use of the legal system optimal?

• In a static environment where growth rates are
  low the advantages of using the law can outweigh
  the disadvantages
• The incentives that can be provided by the legal
  system mean that efficient systems can be
  designed that do not rely solely on positive
  monetary incentives
• The fact that change is difficult does not matter
  in such circumstances

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When is the use of the legal system optimal?
(cont.)

• In a dynamic environment barriers to change can
  outweigh the static incentive aspects
• Rather than rely on incentives provided by legal
  mechanisms its necessary to rely on reputation,
  connections, and financial incentives
• However, private systems can change much more
  quickly
• Competition between different systems is possible
  and often the most efficient will prevail

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Why is China successful?

• The conventional view is that China is successful
  despite its lack of Western institutions
• The suggestion here is that China is successful
  because of its lack of Western institutions

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Examples of inefficiencies

• US Payments System

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Examples (cont.)

• Check Clearing for the 21st Century Act
• At the start of the 21st Century the US had a
  19th Century payments system relying on checks
  and the mail
• Checks had to be physically transported from
  where they were deposited to a central operations
  center, then to clearer and then back to the
  banks they were drawn on
• September 11, 2001 acted as a catalyst for change
• Act signed in October 2003 that allows electronic
  image to be a substitute

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Examples (cont.)

• Google and the scanning of libraries
• JSTOR is a great academic innovation
• Googles Print Library Project proposes to do a
  similar thing for books by scanning in the
  libraries of Harvard, Oxford, and Stanford
  Universities, the University of Michigan, and New
  York Public Library
• Google has met tremendous opposition from
  publishers and this has slowed down the project
  considerably

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Examples (cont.)

• Intellectual property
• Shanghai saying We can copy everything except
  your mother
• Chery QQ appeared six months before the Chevy
  Spark which it was a copy of
• Shanghuan Automobiles CEO model is remarkably
  similar to a BMW X5
• Legal action by foreign firms has been nearly
  useless in preventing this
• Good or bad?

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Examples (cont.)

• India
• Economy is unbalanced relative to other emerging
  economies in that 52 of output is from services,
  26 is from manufacturing and 22 is from
  agriculture (67 of workforce)
• Manufacturing has not done well perhaps because
  it is constrained by unions and traditional
  political economy factors
• New industries like software do well because they
  are not constrained by political economy factors
  

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Examples (cont.)

• Diamond industry (Bernstein 92)
• Mediaeval trade in the Mediterranean (Greif 89)
• Mediaeval Bills of Exchange

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Conclusions

• China and Indias success contains important
  lessons
• Using the law in finance and commerce is a
  Western idea
• It can be optimal in static environments

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Conclusions (cont.)

• In dynamic environments such as China and India
  it may be better to use other mechanisms that do
  not rely on the law because this reduces the
  inefficiencies associated with political economy
  factors
• Designing economic institutions that minimize
  political economy problems by not relying on the
  legal system is one of the keys to fast economic
  growth