QJ-Law-Fin-Growth-07 Tsinghua-SEM 1 Reexamining China’s 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 3 The Largest 20 Economies in the World

QJ-Law-Fin-Growth-07 Tsinghua-SEM 4 When will China overtake the U.S.? Using IMF 2006 estimates: –China: $10.1 trillion; growth rates from of 10.1% –U.S.: $12.9 trillion; growth rates during same period of 3.0 –Extrapolating (a big assumption!): China will become the world’s largest economy in : China PPP GDP = 1.5 × US PPP GDP 2020: China PPP GDP = 2 × US PPP GDP

QJ-Law-Fin-Growth-07 Tsinghua-SEM 5 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 6 Other Successful Economies (cont.) In recent years India has also been remarkably successful Not as successful as China Contrast with its own past ( ) and with China is informative

QJ-Law-Fin-Growth-07 Tsinghua-SEM 7 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?

QJ-Law-Fin-Growth-07 Tsinghua-SEM 8 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)

QJ-Law-Fin-Growth-07 Tsinghua-SEM 9 Conventional Wisdom (cont’d)  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)

QJ-Law-Fin-Growth-07 Tsinghua-SEM 10 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)

QJ-Law-Fin-Growth-07 Tsinghua-SEM 11 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)

QJ-Law-Fin-Growth-07 Tsinghua-SEM 12 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”)

QJ-Law-Fin-Growth-07 Tsinghua-SEM 13 Lessons (cont.) What should China do going forward? “The modern corporation on a Western model would be the essential vehicle for private economic development”

QJ-Law-Fin-Growth-07 Tsinghua-SEM 14 Lessons (cont.) This was not written today but rather was the view of the drafters of China’s 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 15 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 19 th Century to early 20 th Century) How did this operate? Other systems for dispute resolution were used instead

QJ-Law-Fin-Growth-07 Tsinghua-SEM 16 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 17 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 18 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 19 Advantages Criminal law –Can use criminal penalties such as imprisonment to affect people’s behavior and provide high-powered incentives Civil law –Can use financial penalties to affect behavior The legal process can be anonymous and transparent

QJ-Law-Fin-Growth-07 Tsinghua-SEM 20 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 21 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 22 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 23 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 it’s 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 24 Why is China successful? The conventional view is that China is successful despite it’s lack of Western institutions The suggestion here is that China is successful because of it’s lack of Western institutions

QJ-Law-Fin-Growth-07 Tsinghua-SEM 25 Examples of inefficiencies US Payments System

QJ-Law-Fin-Growth-07 Tsinghua-SEM 26 Examples (cont.) Check Clearing for the 21 st Century Act At the start of the 21 st Century the US had a 19 th 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 27 Examples (cont.) Google and the scanning of libraries JSTOR is a great academic innovation Google’s 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 28 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 Automobile’s CEO model is remarkably similar to a BMW X5 Legal action by foreign firms has been nearly useless in preventing this Good or bad?

QJ-Law-Fin-Growth-07 Tsinghua-SEM 29 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

QJ-Law-Fin-Growth-07 Tsinghua-SEM 30 Examples (cont.) Diamond industry (Bernstein 92) Mediaeval trade in the Mediterranean (Greif 89) Mediaeval Bills of Exchange

QJ-Law-Fin-Growth-07 Tsinghua-SEM 31 Conclusions China and India’s success contains important lessons Using the law in finance and commerce is a Western idea It can be optimal in static environments

QJ-Law-Fin-Growth-07 Tsinghua-SEM 32 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