Alternative Legal Institutions, Xinfang and Finance Jiafu An, Jo Danbolt, Wenxuan Hou, and Ross Levine The University of Edinburgh; UC Berkeley

Motivation: Literature Legal institutions → Development of financial market (La Porta et al., 1997; 1998; 1999; 2000 and Beck, Demirgüç-Kunt & Levine, 2001; 2003) Financial markets → Economic growth (Levine, 1993;1997) Legal Institutions → Economic growth (Acemoglu, Johnson, Robinson, 2000; 2001; Nunn, 2008) Legal institution is one of the most important determinants of financial market development and economic growth. There are two strands of literature emphasizing this. The first focuses on legal institutions impact on financial markets. And financial markets in turn have a positive impact on economic growth. The second highlights the direct impact of legal institutions on economic growth.

Motivation: Challenge Legal institutions are defined by western standards. Challenge: Law-finance nexus may not apply to eastern countries such as China. (Allen, Qian and Qian, 2005; Clarke, Murrell, Whiting, 2008) For example, the major legal systems are defined as British common law, French civil law, German and Scandinavian civil law. Franklin Allen et al find despite China’s weak institutions, the economic growth is substantial. Donald Clarke argue that in fact the legal institutions is not a driver of the economic growth in China, instead, it is a consequence.

Motivation: Big Questions Does legal system promote finance in eastern countries, such as China? Why it does or does not? Why, despite their weak legal institutions, some eastern countries still grow their financial markets at an enormous rate?

Institutional Background: Definition Xinfang: an alternative legal system deeply embedded in Chinese society since the first dynasty Xia (2070-1046 B.C.) The xinfang system is broadly defined as a mechanism for citizens to resolve disputes, file complaints, and seek resolutions from government and its associations on higher administrative level. We answer these two questions by first introducing and examining an alternative legal system in China. It’s called xinfang.

Institutional Background: Application This shows that xinfang system does not only exist but also has wide application in the society. In 2004, the number of xinfang cases is more than twice than the number of formal legal cases. It reached 12 million cases in that year. Even though it is gradually decreasing due to government policies, there was still about 7 million cases in 2012.

Institutional Background: Distinction Xinfang law, state policies, social norms, fair and justice required by the Constitutions of the Party. Legal law Consult laws, but sometimes disregard it based on current circumstance and state policy Completely base on the legal rules One distinction between xinfang and legal systems is that the xinfang system does not provide the basis or content to resolve cases. It only provides the procedure of resolving a case. So it is more common law nature. The judges can consult law, state policies, social norms and wide range of other sources. But the formal legal system completely base on the legal rules. It is more civil law nature.

Institutional Background: Distinction The formal legal system (German civil law origin) was established by the end of the Qing dynasty (1912) The xinfang system has always been there since 2000 years BC. So attention should also be paid to the alternative legal systems. So if research on the law-finance nexus in China only looks at the formal legal system, they might miss a large part of the picture.

Hypotheses Xinfang system → Development of financial market Finance Property rights Finance Xinfang Private contract Checks on government

Data: Xinfang We hand-collect xinfang regulations of each province during 1993- 2014. (because, and the process involves) A xinfang regulation is a document describing the operation of xinfang in a province. In total, we obtain 60 regulations covering 27 provinces in 1993-2014 (An, Hou, and Levine, 2016).

Data: Coding We take individual policies of provincial xinfang systems and construct measures of the functioning of each xinfang system in each year in four areas: (1) the efficiency with which the xinfang system resolves cases (efficiency of dispute resolution) (2) the degree to which the xinfang system has explicit checks on conflicts of interest on cases and formal oversight and review procedures of xinfang workers (dispute resolution mechanisms)

Data: Coding (3) the degree to which the xinfang system formally requires particular responses by xinfang workers to people filing a case (“xinfangers”) and does not constrain xinfangers from pursuing their cases (access support and restraints) (4) the degree to which the xinfang system requires rewarding xinfangers for bringing socially beneficial cases and punishing xinfang workers who do not perform their jobs effectively and lawfully (punishment and reward). In particular, we focus on 69 particular “policies”. (An, Hou, and Levine, 2016).

Data: Financial Development the value of provincial equity market as a share of GDP Rajan and Zingales, 1998; Allen, Qian, and Qian, 2005; LLSV, 1997 Total capitalization the value of floating shares in provincial equity market as a share of GDP Circulating cap. the value of total trading volume of the provincial capital market as a share of GDP Allen, Qian, and Qian, 2005 Trading volume the number of listed firms per million population in each province Rajan and Zingales, 1998; LLSV, 1997 No. of listed firms the number of IPOs per million population in each province Rajan and Zingales, 1998; LLSV, 1997 No. of IPOs the value of total loans of banks as a share of GDP Allen, Qian, and Qian, 2005 Total loans the value of medium and long term loans of banks as a share of GDP Other loans the value of short-term loans of banks as a share of GDP Short loans We conduct three levels analyses. We only have firm level data on these measures.

Findings Xinfang system → Development of financial market Xinfang-finance > in provinces with better formal legal institutions, less corruption and larger private economy. Xinfang-finance > in industries with larger size of non-current assets; and more dependence on external finance Xinfang-finance > in non-SOEs (more long term debt and investments)

Contributions We contribute to the law-finance-growth (La Porta et al., 1997; 1998; 1999; 2000 and Beck, Demirgüç-Kunt & Levine, 2001; 2003) by providing a novel dataset of legal system that is based on eastern standards. This paper relates to the research on China (Allen, Qian and Qian, 2005; Clarke, Murrell, Whiting, 2008). We show that after considering the alternative legal system, the law-finance nexus does apply to China, which contradicts the evidence provided by previous research that ignores the alternative legal system.

Contributions We also provides an explanation of a long-standing puzzle that despite their weak legal institutions, some eastern countries can still grow their financial markets at an enormous rate. We show that alternative legal institutions that previously been ignored have a positive impact on financial market development.