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How China grows economicallyIts alternative financing and governance mechanisms overcome weak legal and financial systemsBy QIAN MEIJUN25 February 2010Conventional wisdom suggests that well-developed legal and financial systems are necessary for economic growth. Yet, China is a counter-example of this phenomenon; despite the lack of sophistication in its legal and financial frameworks, China has registered the fastest economic growth in the world.Its law and institutions - including investor protection systems, corporate governance, and accounting standards - are significantly less developed than in most advanced countries. While the Chinese government has instituted some measures on paper to protect creditor and shareholder rights, enforcement is lacking.China’s corruption index of 3.6 in 2009 puts it at 79th least corrupt. Further, its accounting system lacks independent, professional auditors, resulting in corporate embezzlement and other fraudulent activities.Financially, China has a large but underdeveloped banking system that is dominated by a handful of large state-owned banks. In terms of size, the banking sector appears to be more important than its stock market, but is inefficient, with a very high ratio of overhead costs to total assets.Prior to 2005, China had the largest amount of non-performing loans - ahead of Hong Kong, India, Indonesia, Japan, South Korea and Taiwan, either as a fraction of total new loans made by all banks or as a fraction of GDP. In the stock market, weak disclosure rules provide poor minority investor protection.Yet, despite the weak legal protection and inefficient financial system, China’s economy grew 8.7 per cent in 2009, ahead of expectations.Our research shows that while the law-finance-growth nexus applies to its state and listed sectors characterised by inefficient mechanisms, China’s private sector is growing much faster and provides much of the fuel for economic growth. The imbalance among these three sectors suggests that perhaps there are alternative financing channels and governance mechanisms that encourage and support the growth in China’s private sector.While state-owned enterprises get about 30 per cent of their total financing from bank loans, private firms get only about 10 per cent. It turns out that self-fundraising activities are the key to private firms’ growth, accounting for more than 60 per cent of their total financing. The sources of self-fundraising include capital raised from family, friends, relatives, corporation networks, informal financial institutions and retained earnings.Funds from founders’ family and friends are important financing sources for private companies during both the start-up stage and the subsequent growth period. During a firm’s growth stage, investment from ‘ethnic Chinese’ (investors from Hong Kong and Taiwan, and overseas Chinese), mostly in the form of private loans and equity, play a considerable role. In some of these cases, there are no formal written contracts between the friends/investors and the entrepreneurs, implying that reputation- and relationship-based implicit contractual agreements are developed as alternative mechanisms to overcome the legal/financial shortcomings.The success of a private sector firm also depends on the support of local government. We found that over 40 per cent of the firms indicate that local governments support their growth without demanding profit sharing; while for some other firms, the government is either a partial owner or demands profit sharing without investing in the firm.Such political connections appear to be methods of removing entry barriers or government bureaucracy, since firms may have government officials to negotiate on their behalf, or the firms offer profit sharing to government officials to obtain business licences.
This common goal of sharing prospective profits helps to align interests of various parties. The implicit contractual agreements and reputation act as enforcement mechanisms to ensure that all parties fulfil their roles to make the firm successful. Profit sharing also provides incentives for officials at various levels to support the growth of the firm.Further, business growth also feeds on competition. The fierce competition in product markets demands efficiency; otherwise, firms may not survive. Therefore, in sum, China’s alternative mechanisms based on reputation, relationship and competition provide good governance and drive growth in the Chinese private sector.There are some characteristics that suggest why alternative governing mechanisms would work in China. Since the country does not have a dominant religion, an important force shaping China’s social values and institutions is the set of beliefs first developed and formalised by Confucius.This set of beliefs defines family and social orders, and are different from Western beliefs on how legal codes should be formulated and how individuals and businesses negotiate. Reputation and relationships form the backbone for the conduct of businesses in China, overcoming the lack of a legal and contractual infrastructure.Moreover, as a large country with a very heterogeneous economy, China does not have the luxury of adjusting its legal and financial systems to the strengths of its economy as easily as smaller countries might do. China may well do better with its alternative mechanisms because they can flexibly adjust to changing situations quickly.The success of the Chinese private sector is all the more remarkable considering that family-run businesses with weak minority shareholder protection is the norm in China, quite unlike professionally managed firms that are the optimal form in countries with strong investor protection.Additionally, in part because of the Confucian influence, fundamental changes in China tend to be gradual and fully implemented only when they are proven correct. Thus, unlike the ‘big bang’ approach adopted by other countries, China has followed a dual-track path in its economic reform where there is continued enforcement of the existing planning system alongside the fast-paced development of financial markets.China is thus an important counter-example to the law-finance- growth nexus argument; it shows how alternative financing and governance mechanisms can overcome weak legal and financial systems and produce economic growth. This lesson has rich implications for economic growth in developed economies as well as developing ones where the environment does not enable institutions to be built as quickly as the economy changes.The writer is an assistant professor in finance at NUS Business School. She specialises in financial systems in China, asset management and governance of financial institutions. This commentary is based on an article first published in the Journal of Financial Economics
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