Most findings in the law, institutions, finance, and growth literature show that the success of an economy depended on a well-developed legal or financial system. But for China, even without a well-developed legal or financial system, its private sector is driving one of the fastest growing economies in the world. In this article, Assistant Professor Qian Meijun explains this unusual phenomenon.
China is no doubt one of the fastest growing economies in the world today. Among the three sectors in China - state, listed and private - it is the private sector that has been growing much faster and contributing to most of China's economy.
And this is in spite of relatively poorer applicable legal protection and standard financing channels in the private sector.
How can this be when most research work point to standard corporate governance mechanisms and financing channels as determinants of success of an economy?
"For China, the success of the private sector suggests there exist effective alternatives to financing channels and corporate governance mechanisms," said Asst Prof Qian Meijun, referring to the findings in her paper "Law, finance, and economic growth in China"published in the Journal of Financial Economics.
The paper was co-written with Professor Franklin Allen of The Wharton School, University of Pennsylvania, and Associate Professor Qian Jun of Boston College's Carroll school of Management.
Earlier studies have shown that certain trader organizations in China as far back as the 11th century were able to overcome problems of asymmetric information and the lack of legal and contract enforcement mechanisms. This is because they had developed institutions based on reputation, implicit contractual relations, and coalitions.
A parallel can be drawn to what works in China's private sector today in terms of how firms raise funds and contract with investors and business partners.
China's social values and beliefs
Cultural and religious beliefs on the development of institutions, legal origin, and investor protection are important factors in an economy's success.
It has also been demonstrated that a managerial reputation effect can replace formal governance in an IPO firm. This is consistent with the evidence from the Chinese venture capital industry.
"The above factors are of particular relevance and importance to China's institutional development. Without a dominant religion, one can argue that the most important force shaping China's social values and institutions is the set of beliefs first developed and formalized by Confucius," remarked Asst Prof Qian.
This set of beliefs clearly defines family and social orders, and are very different from western beliefs on how legal codes should be formulated and how individuals and businesses negotiate.
Reputation and relationships
In China, only those firms that have the strongest comparative advantage can survive and thrive. This can be explained by entry barriers, which are a relevant factor for the growth of China's private sector as lower entry barriers foster competition.
Yet, there exist non-standard methods to remove entry barriers in China.
"For example, to ease the problem of application for a business license because of government bureaucracy, most of the firms' founders or executives ask the friends of government officials to negotiate on their behalf, or the firms can offer profit sharing to government officials," cited Asst Prof Qian.
This alternative mechanism based on reputation and relationships provide the most important support for the growth of the private sector.
Cooperation among suppliers
Alternative effective corporate governance mechanisms in place also contribute to the private sector's success.
Studies have shown that if cooperation among different suppliers of inputs is necessary and all suppliers benefit from the firm doing well, then a good equilibrium with no external governance is possible, as internal, mutual monitoring can ensure the optimal outcome.
In fact, such trade credits are an important form of financing for firms during their growth period.
Profit sharing
Further, the profit sharing model adopted also makes it an incentive compatible for officials at various levels to support the growth of the firm.
The common goal of sharing high prospective profits can align interests to overcome obstacles and achieve their common goal.
"Under this common goal in a multi-period setting, implicit contractual agreements and reputation can act as enforcement mechanisms to ensure that all parties fulfill their roles to make the firm successful," commented Asst Prof Qian.
Comparing China
When comparing China to other transitional countries such as Russia, Vietnam and Eastern European countries, Asst Prof Qian believed that there is a difference as China's economy is much larger and more diversified than other transitional countries, with the exception of Russia,
"With a small and homogenous economy, a country can adjust its legal and financial systems to the strengths of its economy much easier than a large country like China can."
The success of China's Private sector demonstrates alternative mechanisms can work wonders even in large and diversified economies.
"For fast changing economies, alternative mechanisms may work better," said Asst Prof Qian.
In a nutshell
With one of the largest and fastest growing economies in the world, China's experience differs from most of the countries studied in the law, institutions, finance, and growth literature, and is an important counter example to the existing beliefs.
The system of alternative mechanisms and institutions plays an important role in supporting the growth in the private sector, and they are good substitutes for standard corporate governance mechanisms and financing channels.
Going forward, Asst Prof Qian commented that the results of her team's findings posed questions for both researchers and policy makers and suggested that much more research is required in order to better understand how alternative mechanisms work where standard mechanisms are not available or not suitable.
"There are important factors connecting law, institutions, finance and growth that are not well understood. A better understanding of how these alternative mechanisms work to promote growth can shed light on optimal development paths for not only China, but also many other countries. At present, it is not clear if established mechanisms give rise to growth in an economy, or it is the growth of an economy that gives the demand for established mechanisms."
Dr Qian Meijun is currently an Assistant Professor with NUS Business School. She joined the Department of Finance & Accounting on 6 July 2006 after receiving her doctorate in finance from Boston College's Carroll School of Management. Her research interests include mutual fund governance, performance evaluation, and law and finance. The above article is an adaptation from her paper "Law, finance, and economic growth in China" published in the Journal of Financial Economics Vol. 77 (2005) 57 - 117.
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