Law and Finance vs. Administrative Governance: The Case of China Chenggang Xu, LSE and Tsinghua University Based on Julan Du and Chenggang Xu, International Economic Association Round Table, 2005 Katharina Pistor and Chenggang Xu, American Law and Economics Review, 2005

China vs. Law&Finance Literature General discoveries on law and finance: –good law as necessary condition for financial development Better law in books (shareholder protection) (La Porta et al., 1997; 1998) Better law enforcement (Johnson et al., 2000; Pistor et al., 2000) Law and finance in China looks opposite –Better financial performance than average transition economies Higher than average in market capitalization and market liquidity Substantially more IPOs and raised much more funds –873 IPOs in (the best in other TEs: Poland: 47) »much more than the total of the EE-FSU markets –Raised 61.6 billion US$ from markets in 1998 and 2001 »much more than the total of the EE-FSU markets –Worse law and enforcement:than average transition economies

Financial market performance: EE-FSU vs. China Total Mkt Cap/GDP Tradeable Mkt Cap/GDP Turnover ratio Aggregate EE-FSU China

Administrative Governance as a substitute for legal governance Chinese financial development did not happen in a governance vacuum Administrative governance substitutes for formal legal governance in transition Institutional condition of the administrative governance: –Regional decentralization Quota system ( ) at jump-start stage of securities markets –Decentralized information collection/revelation process –Provides incentives for information collection

Poor statutory law in China General description –China dismantled the formal legal system before the reforms (the Cultural Revolution) – uniquely bad Had to build legal system from scratch –No protection to private property rights in the constitution until Apr 2004 –The corporate law (1994) was designed for SOEs silent on private ownership Cross country comparison –Statutory law: below average (TEs) in shareholder protection –Law enforcement (perception data): below average (TEs) –Almost by any measurement China’s law is below average, some times far below average

Marginal roles of formal legal governance Absence of private enforcement (courts restricted) –Supreme court announced not to take cases related to security markets till 2002 –Since 2003: take cases only for misrepresentation of information – not for insider trading or market manipulation –Not a SINGLE civil law case has resulted in liability imposed by a court Inactive public enforcement –From , 94% regulatory enforcements had no punishment (60% were ‘internal criticism’)

Function of Quota system Originally designed to control the size of financial markets Under regional decentralization/competition it becomes a de facto governance mechanism –As information system Generates company information from “insiders” Reduces worst “lemons” –As incentive system To disclose information truthfully

Chinese Economy: Regional Governance Structure

Regional governments and their firms Most SOEs in China are regional Regional governments are ‘owners’ of regional SOEs –Better informed than others about ‘their’ firms Regional SOEs are major (or important) financial resources of regional governments Regional competition (e.g. in growth rate) –Incentives to help regional SOEs

Operation of quota system Regional Governments Allocate quota to selected SOEs ; Collect/Send info on these SOEs Central Government Determines National/regional Quota (# of shares to be issued); Allocates quota to regions Admitted Companies IPO in markets CSRC Reviews company info; Companies admitted

Quota System as Information System Severe information problem in markets at IPO stage Mandatory disclosure rule as a solution for countries with rule of law and with other markets China: lack of rule of law; underdevelopment of markets –Ineffective in transplanting standard legal system Quota system: decentralized information collection –allocated the responsibility for collecting and verifying information to the ‘owners’ of firms – regional governments

Quota system provides incentives for disclosure For regional benefits regional governments may cheat –need governance structure The quota system created an incentive structure –Carrots to regional governors in the form of future quotas –Future quota allocations to regions are related to past performances of companies from the regions –Testable hypothesis

Quota Allocation (97-99) vs. Earlier Market Cap (94-96)

Quota Allocation (97-99) vs. Earlier Net Profits (94-96)

Punishments to under-performed regions Delisting firms => loss of quota for the region –No other company could step in and use the quota to issue its shares Delisting can be combined with reduced future quota allocation –Guangdong had the largest number of de-listed firms since 1999 received a low quota since 1999 performed substantially below the national mean and median in

Problems cannot be addressed by quota system Non-state firms –Regional governments have no informational advantages –Incentives to regional governments by the quota system do not help Continuous disclosure –Different roles of regional governments on IPO and continuous operation –Change of corporate governance after IPO – separating regional government from state-owned firms As a purpose In reality

Continuous Disclosure Problem

Conclusion Quota system as a decentralized administrative governance mechanism as a substitute for ‘standard’ legal governance at the IPO stage for jump-start stage Political economy of initial choice and modification –Building on existing institutions –Institutionalization of collaboration (no separation of power) The relative success of the quota system does not imply its superior to a standard legal regime in the long term –No law land trap: Danger of slowing down in establishing rule of law –Biggest problem in introducing standard legal regime: independence of judicial system General lessons for financial regulation in emerging markets